One of the niftiest features of whole life insurance is the option to make it paid-up at any point in your lifetime. The reduce paid-up feature for whole life allows you to electively stop paying premiums and guarantee the policy will never lapse so long as you are willing to accept a smaller death benefit on the policy than the one you currently have. But what about paid-up universal life insurance? Does this same feature exist for people who own universal life insurance?
As outlined above, all whole life policies have a feature that the policyholder can trigger at pretty much any time to stop paying premiums and guarantee the policy will remain in force for the insured's entire life. The policy continues to earn guaranteed interest and dividends. Dividends can still purchase paid-up additions, which means the death benefit can grow, but the policyholder cannot pay any premiums (including paid-up additions) to the policy. In order to make this happen, the policyholder has to be okay with the loss of some death benefit. The exact amount of death benefit lost depends on when exactly in the lifetime of the policyholder elects the reduce paid-up option, but it can be a few hundred thousand dollar drop in outstanding death benefit.
This feature is a key component to life insurance used for retirement income planning. It allows us to stop the requirement to pay a premium while the policyholder pivots from accumulating cash value to distributing cash value.
You'll hear us comment on the reduce paid-up option for whole life insurance often, but we say nothing about this when it comes to universal life insurance. That's because the option doesn't exist. Universal life insurance does not have an option to make the policy paid-up.
Given this, it's understandable to wonder if this is a huge drawback for universal life insurance. Perhaps this is a critical aspect making universal life insurance inferior to whole life insurance? Some might suggest such a thing…and those who do are wrong.
Remember that universal life insurance is extremely flexible. There is no specifically set premium. The policy instead has a schedule a expenses the insurance company will either take from the premiums the policyholder pays or deduct them from the policy's cash value. So long as the policy continues to cover these expenses, the policy remains in force. There is a point when all of these expenses end; this is generally around the insured's age 95–in some cases age 100. But prior to this point, all universal life insurance policies have some level of cost the policyholder must cover either through premiums paid to with cash value from the policy.
In truth, the same is true for whole life insurance policies, but whole life insurance does not place the obligation to meet these expenses on the policyholder per se. Instead, the whole life issuing company require the policyholder pay a specific premium that seeks to collect the money needed to cover these expenses. If the insurance company is wrong about the amount of money it needed to do this (never happens) then the insurance company will make up the shortfall itself.
This flexibility of universal life insurance gives it the ability to replicate the end goal of a reduce paid-up whole life insurance policy. Let's walk through an example.
He's interested to know what will happen to his cash value by age 65. He's a little leery of universal life insurance because he read somewhere that the expenses of universal life insurance will go up as he ages and he's afraid this will take all of his cash value away.
He's not super concerned about death benefit after age 55, but he would like to keep a death benefit of some level in place through retirement.
Here are the ledgers of both whole life and universal life insurance policies that will accomplish his goal of no payments at age 55 and beyond. These policies are also designed to maximize cash value with his premiums.
First the whole life insurance ledger
|Year||Age||Premium||Cash Value||Death Benefit|
|1||41||$ 25,000||$ 18,053||$ 981,080|
|2||42||$ 25,000||$ 38,803||$ 1,044,730|
|3||43||$ 25,000||$ 64,695||$ 1,107,933|
|4||44||$ 25,000||$ 92,290||$ 1,171,071|
|5||45||$ 25,000||$ 121,504||$ 1,233,780|
|6||46||$ 25,000||$ 152,397||$ 1,296,296|
|7||47||$ 25,000||$ 185,275||$ 1,358,923|
|8||48||$ 25,000||$ 220,092||$ 1,421,381|
|9||49||$ 25,000||$ 257,024||$ 1,483,916|
|10||50||$ 25,000||$ 296,197||$ 1,546,557|
|11||51||$ 25,000||$ 337,197||$ 1,609,414|
|12||52||$ 25,000||$ 380,647||$ 1,672,589|
|13||53||$ 25,000||$ 426,650||$ 1,736,216|
|14||54||$ 25,000||$ 475,331||$ 1,800,388|
|15||55||$ 504,136||$ 1,235,060|
|16||56||$ 534,480||$ 1,269,378|
|17||57||$ 566,489||$ 1,304,986|
|18||58||$ 600,234||$ 1,341,845|
|19||59||$ 635,785||$ 1,379,850|
|20||60||$ 673,243||$ 1,418,910|
|21||61||$ 712,739||$ 1,459,215|
|22||62||$ 754,376||$ 1,501,016|
|23||63||$ 798,338||$ 1,544,652|
|24||64||$ 844,674||$ 1,590,353|
|25||65||$ 893,454||$ 1,638,101|
And now the Indexed Universal Life Insurance Ledger
|Year||Age||Premium||Cash Value||Death Benefit|
|1||41||$ 25,000||$ 12,293||$ 704,763|
|2||42||$ 25,000||$ 36,091||$ 727,629|
|3||43||$ 25,000||$ 61,270||$ 751,877|
|4||44||$ 25,000||$ 87,908||$ 777,584|
|5||45||$ 25,000||$ 116,084||$ 804,829|
|6||46||$ 25,000||$ 147,406||$ 835,219|
|7||47||$ 25,000||$ 180,549||$ 867,431|
|8||48||$ 25,000||$ 215,620||$ 901,571|
|9||49||$ 25,000||$ 252,778||$ 937,798|
|10||50||$ 25,000||$ 292,230||$ 976,234|
|11||51||$ 25,000||$ 335,492||$ 1,019,496|
|12||52||$ 25,000||$ 381,511||$ 1,065,515|
|13||53||$ 25,000||$ 430,429||$ 1,114,433|
|14||54||$ 25,000||$ 482,425||$ 1,166,429|
|15||55||$ 513,438||$ 806,097|
|16||56||$ 546,493||$ 819,739|
|17||57||$ 581,765||$ 849,377|
|18||58||$ 619,325||$ 879,441|
|19||59||$ 659,353||$ 909,907|
|20||60||$ 702,019||$ 940,705|
|21||61||$ 747,504||$ 971,755|
|22||62||$ 795,923||$ 1,018,781|
|23||63||$ 847,459||$ 1,067,798|
|24||64||$ 902,319||$ 1,118,876|
|25||65||$ 960,737||$ 1,172,100|
Notice that moving from year 14 to 15 (age 54 to 55) the whole life policy loses $565,328 in death benefit–a 31% reduction in death benefit. This is what the policyholder must be willing to give up in return for no need to pay future premiums to the policy.
Also notice that moving from year 14 to 15 the indexed universal life insurance policy loses $360,332–also 31% of the death benefit. We've effectively accomplished the same thing that happens when a whole life policy owner triggers a reduce paid-up feature in terms of reduced death benefit.
But I have to be clear about some important things regarding the universal life insurance policy.
While we've reduced the death benefit by the same amount, the universal life insurance policy DOES NOT now guarantee that no future premium will ever be necessary. Universal life insurance expenses can change and this could lead to a need to pay a future premium to the keep the policy in force. The probability of this happening is extremely low, but there is no guarantee of no premiums and the death benefit will always remain in force. No universal life insurance contract will do this like a whole life policy.
But, we've effectively accomplished a situation where the likelihood of ever needing to pay additional premium is very close to a zero probability with this change to the policy. And we can evaluate this through the policy's expense disclosure.
Universal life insurance policies fully disclose policy expenses. This is not the case with whole life insurance, so we cannot evaluate the yearly expenses the insurance company assumes against the whole life policy. Since the whole life issuing company is guaranteeing the expenses never change, insurance law allows life insurers to conceal whole life expenses and life insurers justify this practice as a trade secret.
In year 14, the annual expenses of the universal life insurance policy are $1,832. This breaks down as $1,772 in insurance expense and a $60 policy fee. In year 15, once we drop the death benefit to mimic a reduce paid-up scenario, the annual expenses of the policy fall to $971. This breaks down to $911 in insurance expense and a $60 policy fee. In the beginning of the 15th year, the projected cash value is $482,425 (it's the cash value at the end of the 14th year). If the policyholder put all the cash in fixed account currently paying 3% per year, the policy will produce $14,473 in interest, which is $13,502 more than needed to cover the expenses. If the index feature caps out, then the policy earns over $48,000 in interest.
It takes the policy 14 years after the death benefit reduction to return to an annual expense of ~$1,800. In that same timeframe the cash value of the policy grows by more than $646,000.
Lastly note year 25, Victor's age 65. The whole life policy is paid-up and requires no premiums. It hasn't required any premiums since year 14. It's current projected cash value is $893,454. The indexed universal life insurance policy is not paid-up, but we did reduce the death benefit to mimic the elements of a reduce paid-up policy. The cash value is $960,737. That's $67,000 more than the whole life policy projects. Since this is indexed universal life insurance, we do get to pick the assumed index interest credit. In this example, we assumed 5.75%.
The key takeaway I want to highlight is that while the universal life insurance is not paid-up the ongoing expenses are low. We keep them there intentionally–anyone who knows how can do this with universal life insurance. Keeping these expenses low mitigates if not eliminates concerns about ongoing increasing expenses.
The expense to offer you a $1 million death benefit is the same regardless of the product type. The cost is the same for whole life insurance, universal life insurance, and even term life insurance in any given year. Your probability of dying doesn't change with type of life insurance you choose to buy.
This seemingly silly point poses subtly critical components of life insurance policy management. The cost to offer you life insurance doesn't change from whole life insurance to universal life insurance, so if we can mimic the effects of a reduce paid-up whole life policy on the universal life insurance side we can accomplish nearly the same results from an insurance company expense to offer you the benefit of life insurance point-of-view.
But notice one more additional thing about the ledgers. The universal life insurance death benefit was never as high as the whole life insurance death benefit. Heck we don't even need the reduction in death benefit to accomplish an outstanding death benefit lower than the whole life policy in year 15. So reducing the death benefit on the universal life insurance policy likely relieves the insurer of several reserving pressures further versus the whole life policy. This results in more benefit to you the policyholder because the life insurer is on the hook for a much smaller liability.
The fact that we can mimic reduce paid-up universal life insurance doesn't mean it's a full proof strategy that will always come out ahead of whole life insurance. I don't mean to be exhaustive in identifying all the ways that whole life insurance might come out a head, but to give you couple rules of thumb I'll note that there are two major fact patterns that rarely work out in universal life insurance's favor.
First extremely short pay scenarios with payment plans of 10 years or less often favor whole life insurance. Some of the reasons for this are extremely straight forward. For example, since most universal life insurance surrender periods are 10 year or longer, a reduction in death benefit during this time often incurs fees that are counterproductive to cash value accumulation.
Second much older insured also often find whole life insurance to accommodate them better. This is often tied to the first situation (short payment period) because older insured policy owners are generally looking at paying premiums for a shorter time period than younger insureds.
If, for example, Victor was a 60 year old make looking to make premium payments to age 65, universal life insurance is likely a bad candidate for him.
Lastly I want to mention the force out rule. Any time a life insurance policy death benefit reduction violates the 7702 qualification test (either Cash Value Accumulation or Guideline Premium Test), cash value is often forced out of the policy to remain compliant with the test (life insurers are not in the business of managing/administering contracts that aren't life insurance).
A death benefit reduction that violates the 7702 test is much easier accomplished with universal life insurance than whole life insurance. A force out on its down it's necessarily huge problem. But you should know that there are circumstances that could make the force out taxable to the policyholder as ordinary income. For this reason, I would categorize death benefit reductions as a more advanced subject in life insurance policy management that require the guidance of a seasoned professional.
Brandon launched the Insurance Pro Blog in July of 2011 as a project to de-mystify the life insurance industry. Brandon was born in Northern New England, and he currently calls VT home. He attended Syracuse University and graduated with a triple major in Economics, Public Administration, and Political Science.