A universal life insurance policy is designed as an “open architecture” type of policy. This means that all the various components of the policy; the investment options, investment management fees, policy fees and cost of insurance are identifiable.
The universal life policy was originally designed in the early 1990's to provide for greater flexibility and control by the policy owner. For example:
- If the policy owner pays only the cost of insurance and the applicable policy fees, then the policy will essentially operate as a level term-to-100 policy, with no or increasing .
- If the owner deposits premiums in excess of the cost of insurance, then this excess premium can be invested in one or more of the investment options available within the policy, as chosen by the owner. The death benefit will then be the face amount of the policy plus the investment portion, referred to as Face Plus.
Any income earned from the universal policy’s investments is exempt from tax. However, unlike Whole Life, a universal life policy can have negative rates of return if any of the excess premiums are invested in non-guaranteed funds (such as equity or bond funds), depending on the returns achieved in those funds.
To avoid the risk of negative rates of return, excess premium deposits can be invested in the available guaranteed interest rate accounts.
The investment options within a universal life policy are flexible and include a wide range of options, depending on your risk tolerance. This means you can choose your ideal mix of equity, bonds, mutual funds and more, and make changes between those funds at anytime.
The policy typically has two types of insurance costs, both of which are guaranteed. The first is a level cost to age 100, known as “level cost of insurance" (or LCOI). The second is yearly renewable term (YRT). The YRT cost of insurance has a very low cost of insurance in the early years and then rises quite sharply as one approaches life expectancy. The result of using YRT is that it will produce higher early cash values as a result of the low insurance cost. However, in the later years the cash value or premiums will have to be sufficient to cover the much-higher insurance costs.
It is important to examine the projected rate of return in the universal life policy. If any funds are invested in mutual funds, they can achieve a negative rate of return due to the high degree of risk. As a result of the lower current interest rates, the guaranteed investment funds currently offer a guaranteed minimum rate of return of approximately 1.5%.
A universal life policy allows the policy owner to modify their premium payments year to year, as long as there are sufficient funds in the policy to cover the cost of insurance. This gives it a degree of flexibility.