Variable life insurance (VLI) is a type of permanent life insurance that offers both a death benefit and a cash value component, which can be invested in a variety of financial instruments, such as stocks, bonds, and mutual funds. The primary appeal of variable life insurance is the opportunity for cash value growth, driven by the performance of the investments selected by the policyholder. This contrasts with other types of permanent life insurance, like whole life insurance, where the cash value grows at a fixed rate determined by the insurer.
The key feature of variable life insurance is that the policyholder has control over how the cash value is invested, which means the policyholder can potentially earn higher returns. However, this also introduces investment risk, as the cash value can decrease if the selected investments underperform.
Key Components of Variable Life Insurance
- Premiums:
- Premiums in variable life insurance policies are flexible. While there is a minimum required amount to maintain the policy, policyholders can adjust how much they contribute above the minimum. However, it’s important to understand that paying lower premiums might impact the policy’s ability to generate sufficient cash value or even cause the policy to lapse if the cash value is not enough to cover the cost of insurance.
- Cash Value Component:
- The cash value is the portion of the premium that is invested. Unlike whole life insurance, where the cash value grows at a fixed rate, the cash value of a variable life insurance policy is tied to the performance of underlying investments. Policyholders can allocate their cash value into different investment sub-accounts (such as stock funds, bond funds, or money market funds) based on their preferences and risk tolerance. The performance of these investments directly impacts the growth of the policy’s cash value.
- Investment Options:
- Variable life insurance offers a wide range of investment options, including equities (stocks), fixed-income securities (bonds), mutual funds, and other vehicles. The policyholder can typically choose the investment mix according to their risk tolerance and long-term financial goals. The value of the cash component will fluctuate depending on how the chosen investments perform in the market.
- Death Benefit:
- The death benefit is the amount of money that will be paid out to the beneficiaries upon the policyholder’s death. With variable life insurance, there are usually two types of death benefits:
- Option 1 (Fixed Death Benefit): This provides a fixed death benefit, which is the amount specified in the policy. The cash value may fluctuate, but the death benefit remains the same.
- Option 2 (Variable Death Benefit): In this option, the death benefit fluctuates with the policy’s cash value. If the investments perform well, the death benefit increases, but if the investments perform poorly, the death benefit could decrease.
Policyholders may have the flexibility to switch between these options during the life of the policy, but switching might affect premiums or the amount of coverage.
- The death benefit is the amount of money that will be paid out to the beneficiaries upon the policyholder’s death. With variable life insurance, there are usually two types of death benefits:
- Loan and Withdrawals:
- Variable life insurance policies allow policyholders to take loans or make withdrawals from their cash value. However, loans accrue interest, and any unpaid loans will reduce the death benefit. Withdrawals may reduce the overall cash value and may be subject to taxes if the amount withdrawn exceeds the premiums paid (i.e., the cost basis). It’s important to note that taking loans or withdrawals may impact the policy’s long-term growth and coverage.
- Charges and Fees:
- Variable life insurance policies come with various charges that can affect the cash value and death benefit. Some of the common fees include:
- Cost of Insurance (COI): This fee covers the cost of the insurance protection and typically increases with the policyholder’s age.
- Administrative Fees: These are the costs for maintaining the policy.
- Investment Management Fees: These fees are paid to the managers of the investment sub-accounts chosen by the policyholder.
- Surrender Charges: If the policyholder decides to cancel the policy within the first few years, surrender charges may apply, reducing the cash value that can be refunded.
These charges can add up over time and affect the overall performance of the policy.
- Variable life insurance policies come with various charges that can affect the cash value and death benefit. Some of the common fees include:
Pros of Variable Life Insurance
- Potential for Higher Returns:
- One of the biggest advantages of variable life insurance is the opportunity for higher cash value growth, driven by the performance of investments chosen by the policyholder. If the policyholder chooses growth-oriented investments like stocks or high-yield mutual funds, the cash value can grow significantly faster than in a whole life policy, where the growth is typically guaranteed but limited.
- Investment Flexibility:
- Policyholders can allocate their cash value across a broad range of investment options, giving them more control over how their money is invested. This is particularly appealing for individuals who are knowledgeable about investing or want to take a more active role in managing their policy’s cash value.
- Tax-Deferred Growth:
- The cash value in a variable life insurance policy grows tax-deferred, meaning policyholders do not have to pay taxes on the earnings until they are withdrawn. This feature allows the value to compound over time without being diminished by taxes in the short term, which can be advantageous for long-term financial planning.
- Lifelong Coverage:
- Like other permanent life insurance policies, variable life insurance provides lifelong coverage. As long as premiums are paid and the policy is managed properly, the policyholder will have life insurance protection for their entire life, unlike term life insurance, which expires after a set period.
- Loan Options:
- If the policyholder needs access to cash, they can take loans against the cash value. These loans are typically easier to obtain than traditional loans, and they are repaid through the cash value of the policy, rather than requiring an external repayment plan.
Cons of Variable Life Insurance
- Investment Risk:
- The biggest downside of variable life insurance is the investment risk. Since the cash value is tied to the performance of investments, there is no guarantee of growth. In fact, if the investments perform poorly, the cash value can decrease, potentially affecting the death benefit. This risk makes variable life insurance more complex and less predictable than other types of permanent life insurance, like whole life insurance.
- Complexity and Management:
- Variable life insurance is not as straightforward as other types of life insurance. Because it involves investment decisions, policyholders need to actively manage their policy to ensure it meets their financial goals. This can be challenging for individuals without a background in investing or those who are unwilling or unable to monitor their investments regularly.
- High Fees and Expenses:
- Variable life insurance policies tend to come with higher fees compared to whole life insurance or term life policies. These fees include administrative charges, investment management fees, and the cost of insurance. Over time, these costs can significantly reduce the cash value, especially if the policyholder’s investments don’t perform as well as expected.
- Potential for Lapse:
- If the cash value in the policy decreases significantly, the policyholder may not have enough funds to cover the cost of insurance, which could lead to the policy lapsing. If the policy lapses, the policyholder would lose the death benefit and any accumulated cash value.
- No Guaranteed Returns:
- Unlike whole life insurance, which guarantees a fixed return on the cash value, variable life insurance does not guarantee any specific return. The performance of the investments can fluctuate significantly, and the returns are based on the risk taken by the policyholder, which can lead to financial uncertainty.
Who Should Consider Variable Life Insurance?
Variable life insurance is best suited for individuals who:
- Have a Higher Risk Tolerance:
- Since the cash value is tied to the performance of investments, variable life insurance is more appropriate for individuals who are comfortable with the possibility of market volatility and are willing to take on more risk for potentially higher rewards.
- Want Flexibility in Investment Choices:
- If you have a solid understanding of investing and prefer to have more control over how your money is invested, variable life insurance offers a wide range of investment options, allowing you to align your policy with your risk tolerance and financial goals.
- Are Looking for a Long-Term Investment Vehicle:
- Variable life insurance can serve as both a life insurance policy and a long-term investment strategy. If you’re interested in using life insurance as a way to grow wealth over time, variable life insurance can be a good fit, though it requires active management.
- Want Lifelong Coverage:
- If you need permanent life insurance coverage (coverage for your entire life), variable life insurance provides that, along with the opportunity to accumulate cash value. This can be ideal for people with long-term financial goals, such as estate planning or providing for future generations.
Conclusion
Variable life insurance offers the dual benefits of life insurance protection and investment growth, but it also comes with significant complexity and risk. The potential for higher returns from investments can be appealing, especially for those who are financially savvy and have a high tolerance for risk. However, the market volatility, high fees, and the need for active management make variable life insurance less predictable and more complicated than other life insurance options.
Before committing to variable life insurance, it’s essential to understand your financial goals, risk tolerance, and the level of involvement you’re willing to take in managing your policy. If you prefer simplicity, lower fees, and guaranteed returns, other types of permanent life insurance like whole life insurance may be more appropriate. However, for those who are willing to take on some investment risk and are looking for both life insurance and an investment vehicle, variable life insurance can be a valuable option.Va