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A universal life (UL) policy is like term insurance with a side fund. After mortality and contract expenses are deducted from your monthly contribution, the remainder of your premium goes into an accumulation (savings) account. The accumulation account earns a variable interest rate that is usually guaranteed not to fall below a certain stated interest rate. Like whole life, this accumulation (cash value) account grows tax-deferred.

Unlike a whole life policy, universal life insurance has a flexible premium and an adjustable death benefit. Provided you satisfy evidence of insurability requirements, the company can raise the actual death benefit in the policy, rather than issue you a new policy, assuming you are willing to pay the additional premium. Likewise, it can decrease the face amount of your policy without surrendering a portion of it.

Universal life insurance policies offer two death benefit options. Option 1 pays a straight death benefit, which includes the cash accumulated in your contract. Option 2 offers an increasing death benefit. When you die, your beneficiary gets the death benefit plus the accumulated cash value.

Unlike a whole life policy, the premium is "unbundled." Each year you receive a statement which shows you a month-by-month breakdown of the mortality charges, contract charges, the portion of your premium that goes into your accumulation account, and the amount of interest earned.

IMPORTANT NOTE: The interest rate that is declared is usually tied to an index. The rate is generally better than bank money-market rates. Whatever the current interest rate, remember that you are accumulating interest on the portion of the contributions that goes into the accumulation account. A current interest rate of 7% may only be producing a 3% to 4% internal rate of return on the entire contribution, particularly in the early years of the policy. So don't think of it as a regular bank account. You are still paying for the cost of insurance and administrative charges.

Pulling Out Early Can Cost You a Bundle

Your UL policy keeps track of two separate figures for your cash-value in the policy. One figure is your current accumulation account; the other figure is what you get if you surrender your policy. Your money goes to work for you right away, but if you pull out too soon the company penalizes you, similar to a decreasing back-end sales charge. Depending on the type of UL contract you have, the cash surrender value may not equal the accumulation account until year 20! If you're purchasing a UL policy, make sure you're in it for the long haul.

Sample Universal Life Values*

*Assumes a 35-year-old male, non-smoker, $100,000 face amount accumulating at 7.00% interest. The amounts in the table are only provided to demonstrate how cash surrender value can differ from the accumulation account. The numbers are not intended for demonstration of detailed calculation.

The key thing to remember is that it is the current interest rate that drives the policy. Because the premium (scheduled contribution) is flexible, which means you can raise the premium or lower it within specified limits, the rate at which your cash value grows depends on the amount of your premium plus the rate of interest you earn.

If the actual interest rate over the years averages less than your original current interest rate assumption, your policy will accumulate less cash than projected; if interest rates fall substantially, the policy could possibly lapse. Put simply, the amount of the level premium (scheduled contribution) you agreed on in Year 1 did not accumulate enough cash value to offset the yearly increase in mortality costs. In other words, the contract charges ended up eating into the cash value necessary to keep your policy in force. To keep the policy in force, you may have to increase your premiums.

IMPORTANT NOTE: Make sure the level premium in Year 1 is sufficient to meet your policy objectives, whether it is maintaining a level premium throughout the life of the policy, accumulating a certain amount of cash in the policy by a given year, or causing the premium payments to vanish at some future point.

SUGGESTION: Have your insurance agent run a universal life illustration with an assumed interest rate that is 1–2 interest rate points lower than the current interest rate and see how many years the current premiums keep the contract in force. If the illustration shows the policy will now lapse sooner than the time you were planning to hold onto it, consider raising your scheduled contribution (level premium).

IMPORTANT NOTE: Be careful when reviewing a universal life illustration. If you're thinking of purchasing a universal life policy because you'll need insurance during retirement, make sure the illustration is run at least through age 90. You may be looking at an illustration that only goes to age 65. You want to make sure the policy doesn't lapse when you turn age 70. If you start to notice that the cash in the accumulation account has stopped increasing or is beginning to decrease in the later years of the illustration, have the insurance agent run another illustration that goes out to age 90. Another sign that your annual or monthly contributions may not be sufficient is if the guaranteed column lapses in less than 10 years.

These policies look very attractive when interest rates are high. As with other interest-sensitive contracts, policyholders that purchased these contracts when double-digit interest rates were prevalent have either had to raise their annual contributions or extend the number of years to pay premiums.

Advantages of Universal Life over Other Forms of Cash-Value Insurance

• The premiums are truly flexible. If you have sufficient cash value, you can use money in your accumulation account to pay future mortality costs and contract expenses. In other words, if funds accumulate quickly, you may choose to skip future premium payments.
• If you use the money in your accumulation account to pay future contract expenses, you are not charged "interest" for borrowing from the contract as you are when borrowing from the guaranteed cash-value in a whole life policy to pay the premium. Your death benefit stays intact.
• The "net" interest rate you are charged for borrowing money from the policy is typically lower than a whole life policy. Typically, you are credited interest on the borrowed funds. It's not as much as the current rate, but it lowers your actual borrowing rate.
• The premiums can be substantially lower than those in a whole life policy; the UL policy provides you with more premium possibilities.

Disadvantages of Universal Life over Other Forms of Cash-Value Insurance

• The current mortality charges are not guaranteed. If the company increases the mortality costs, you may have to increase your premiums. If not, the policy may lapse at some future point.
• Likewise, if the current interest rate drops and remains lower than projected, your current schedule of contributions (monthly or annual premium) may not be sufficient to keep the policy in force. Your policy could lapse as money is continually withdrawn from your accumulation (savings) account to pay mortality and contract expenses.