Value of a Universal Life Insurance Policy

This information below appeared in CNN Money.com in Walter Undergraves’ column Ask the Expert.

…let me first explain to readers who are unfamiliar with VULs and EIULsjust what they are.

Although they're often referred to as retirement plans, in fact these are nothing more than insurance policies, specifically variable universal life (VUL) and equity indexed universal life (EIUL). Both are designed so that a portion of the premium you pay buys insurance coverage, while the rest goes into investments that build the "cash value" portion of the policy.

With a VUL, you invest in portfolios known as "subacccounts," which are essentially the equivalent of mutual funds. Most VUL policies offer a dozen or more such subacccounts, everything from domestic and international stock funds to all sorts of bond funds.

An EIUL, on the other hand, allows you to invest a portion of your premium in an investment whose return is pegged to a benchmark such as the Standard & Poor's 500 index. The idea is that you get the upside of stocks' returns, but also downside protection in the form of a small guaranteed return.

So how do these policies amount to retirement plans? Well, the pitch in both cases is that you invest in the policy, your cash value builds without the drag of taxes over time and in retirement you begin withdrawing money as you need it for living expenses.

And there's one more big lure: instead of just pulling the money from the policy, you borrow against your cash value at attractive rates. Since policy loan proceeds aren't taxable, you have the prospect of tax-free retirement income.

All this sounds delightful, of course, but there are some major downsides to consider. First, a portion of your retirement savings is going to life insurance, and the cost of that coverage is often higher than what you would pay for a regular old term insurance policy.

Then there are a variety of marketing fees and sales commissions that cut into your return. In the case of VUL, there are the annual operating costs for the sub accounts as well as an annual fee known as the "M&E" or mortality and expense charge, all of which lower returns even more.

The investment fees are less explicit in EIUL policies, but they're there nonetheless, built into the formulas that are used to calculate returns.

Speaking of those formulas, they're typically so complicated and convoluted, it's difficult for any average person to follow them, let alone understand whether or not you're getting a good deal. (Equity-indexed annuities are similar to equity indexed universal life policies from an investment point of view.)

And both types of policies come with a big potential tax trap - namely, if you've borrowed from the policy and then let it lapse, the investment earnings you've withdrawn that were touted as tax-free become taxable. So if you've been using the policy for income in retirement, you could end up facing a substantial tax bill late in life when the last thing you need is to be shelling out beaucoup bucks to the IRS.

I think these policies are too expensive, too complicated and too much trouble to be worthwhile.

In my opinion, you're better off maxing out your 401(k), investing in an IRA if you can, funding any other tax-advantaged accounts you may have access to (such as a SEP or solo 401(k) if you've got business, freelance or self-employment income), and then moving on to tax-efficient investments in taxable accounts, including low-cost index funds, ETFs and tax-managed funds.

If you've done all this and still have money to invest for retirement and are considering a VUL or EIUL, I recommend you first read "Variable Universal Life: Worth Buying Now?," which was written by James Hunt, a former Vermont insurance commissioner now with the Consumer Federation of America.

If you're still hot on getting one, I suggest you take the policy, the cash-value projections and all the information you can get about fees and costs and go to a financial planner who doesn't depend on the sale of such policies for his or her livelihood for a second-opinion about using the policy for retirement income.

​If after doing this, you're confident that you understand the costs and the risks and you still want to buy such a policy, fine. But if that decision comes back to haunt you later on, don't say you weren't warned.