Life Insurance: Avoid Universal and Variable Policies

Adam Bold

Life insurance really has only one purpose: replacing the income of someone who dies prematurely. If you die, you want your loved ones to live the lifestyle they're accustomed to.

There are two types of life insurance policies. One is term life; the other is universal or variable life. The primary difference: Term life premiums pay only for insurance. For universal life, only part of the premium pays for insurance. The rest goes toward various investments, fees, and expenses. More on that in a moment.

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Term life works much like auto or home insurance with one primary difference: Coverage is for a defined period (e.g., 10 years). Your premiums provide peace of mind from knowing your family will have financial comfort if you die. In my opinion, it’s the best way to replenish lost income. If you die, the insurance company pays your beneficiaries the amount you’re insured for. The cost is low—depending on your age, health, and a number of other risk factors—and you rest easy knowing your premiums are protecting your loved ones.

With universal and variable life policies, the pitch is this: You're going to pay for life insurance anyway, so why not put part of that money into investments to accumulate money over time?

I think there are several problems with that approach. First, your premium is split three ways. A portion goes to a life insurance policy, another to investments, and the rest to fees. Some of the products come with high upfront fees, sometimes five percent or more. Insurers also charge fees to manage your investments and additional fees that cover their overhead and other operating costs. So owning the same mutual funds inside an insurance policy is more expensive than owning them in an investment account.

Insurance companies may also attempt to sell you on the idea that investment growth in your life insurance policy is tax-deferred and can also help offset the cost of your annual insurance premium. But any savings from making a tax-deferred investment is more than outweighed by the extra fees.

Also, universal and variable life insurance products commonly offer limited investment options. These policies might have just 20 or 30 funds to choose from; you’d have far more if you invested on your own.

What's worse is that universal and variable life insurance policies typically carry surrender penalties. This means you may have to own them for seven years, or longer, to avoid paying a penalty to access your money. Quite often, people realize too late that they shouldn't have bought a variable life insurance policy. But they’re stuck with it for years because they don't want to pay the penalty to dump it.

A much better strategy is buying term life insurance and using the money you’d otherwise spend on variable life insurance to invest on your own. That way your life insurance costs will be much lower. And over time, you’ll be positioned to increase value in your own investment account, compared with a bundle of insurance and investments in a universal or variable policy. The reason: You won’t be paying extra fees that ultimately eat into your personal investment returns.

One of my basic investing rules is this: Your decision to invest should only be based on whether that investment meets your goals and objectives. Make sure to read and understand the terms and conditions of an investment or insurance policy before you buy it. If you can’t understand it, hire someone to explain it, or walk away. You don't want to own anything that limits your ability to earn higher returns or has strings and penalties attached.

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Adam Bold is the founder of The Mutual Fund Store, which provides fee-only investment advice with locations coast to coast. He's also host of The Mutual Fund Show, a call-in radio program broadcast across the country. Bold is author of the book The Bold Truth about Investing (April 2009). Bold is Chief Investment Officer of The Mutual Fund Research Center, an SEC-registered investment adviser, which provides mutual fund and asset allocation recommendations, and research to stores in The Mutual Fund Store system.