Life Insurance: Drowning In Fees

Variable universal life insurance is the fastest-growing product in the life-insurance industry.

Some 20% of new money is going into such policies today, up from 7% just five years ago. Consumers are snatching up VUL because it's one of the few ways, outside of 401(k) plans and individual retirement accounts, to invest in mutual funds and get tax-free growth. So why does financial planner Bert Whitehead of Franklin, Mich., refer to VUL as a "sucker's policy"?

Plain and simple, the answer is the fees. They are so mind-boggling that in many cases, even insurance agents don't understand them. Many fees are buried in the fine print of a prospectus, and other are lumped together as footnotes in sales material. To make matters worse, comparison-shopping is almost impossible because each company's fees and terms are different. Experts estimate it can take 10 to 20 years to break even after fees, depending on how much you pay into the policy each year and how the underlying mutual funds perform. If you don't have a long investment horizon, VUL is almost a sure way to lose money. Says Bill Fleming, an insurance specialist in Coopers & Lybrand's Hartford office: "The best exit strategy with variable universal life is death."

Unlike term insurance, which has no payoff unless you die, a VUL policy builds up cash value over time. The catch is you have to fork over big premiums for a number of years--and meanwhile hope your funds perform well--before the policy becomes "fully funded." That's the point at which there's enough money in the account to pay the insurance and fees. But if your funds fare poorly or policy costs go up, you can wind up paying premiums for longer than the original projections suggest.

HUGE PREMIUMS. Take a $1 million policy from Equitable Life, the leading marketer of VUL, for a 35-year-old healthy, nonsmoking man. The policy is similar to products offered by other life insurers, such as Prudential, Nationwide, and Northwestern Mutual. The premium is $9,540 a year for 10 years for the policy to become fully funded. This assumes that the funds invested earn 10% annually net of management fees. By comparison, a $1 million level premium term policy would cost $920 a year for 20 years.

Enormous premiums are required for VUL because a large portion of the payments goes toward fees, rather than the policy itself. First, the insurer deducts about a 4% sales charge, also called a "load," from every premium, a process that instantly cuts the $9,540 payment by $353. Then there's a life-insurance cost--in this case, it's 18%, or $1,685, in the first year, and that goes up as the policyholder gets older. A first-year administrative fee runs about $300, followed by a permanent monthly expense of $6. You can also count on an ongoing mortality expense fee, a state premium tax, and a fund management fee.

CASHING IN. The fees alone reduce your first-year premium by 17%. Many companies also tack on levies if you want to transfer money between funds, and most charge you for taking out a loan against the balance. Jerry Golden, executive vice-president of Equitable and creator of VUL, admits the fee structure is too complex and thinks it will eventually be simplified. But he justifies the high fee levels by saying, "We have to pay our agents something."

VUL is an especially bad deal if you need to cash in the policy within 10 to 15 years. That's because you'll be hit with a large surrender fee. In the Equitable example, if you cash in the policy after one year, you're subject to a surrender fee of $5,576. That means you'll get back only $2,385 from a $9,540 contribution plus a 10% investment gain. You'd still be under water until year 15, when the surrender charge disappears.

In an analysis of the Equitable policy, James Hunt, an actuary and consultant to the Consumer Federation of America (CFA), showed how all the fees make it difficult to achieve stellar investment returns. He concluded that by cashing in the policy in the fifth year, it would lose 2.2% of its value on an annualized basis. Even if you held it for 20 years, it would gain only 7.0%. "Buying term insurance and investing the difference would be more profitable," Hunt says.

The surrender fee underscores why VUL is, at best, a long-term investment. As Equitable's Golden says, "You're not supposed to cash in life insurance. Your goal should be to hold it." Still, more than 50% of all people who buy VUL cash in their policies before the surrender fee expires, according to industry estimates. This suggests agents are marketing the policies to the wrong people. But they have a strong incentive: commissions of at least 55% of the first year's premium and 4% for the next 10 years.

A big selling point is you can borrow against your cash balance and not have to repay the loan while you're alive. The loan amount will be deducted from the money paid to your heirs. What often isn't made clear is that when you take the loan, you have to pull a matching amount of money out of the stock mutual funds in the policy and put it into a money-market fund as collateral. This limits the ability of the policy to earn enough to cover the annual insurance cost and reduces the odds of breaking even on the fees.

Despite drawbacks, VUL can benefit a narrow group of people. The ideal candidate is someone who has a high net worth, needs a tax shelter, can shell out big bucks up front to capture the benefits of compounded growth, and doesn't need the money anytime soon. If you fit this profile and are interested in VUL, a good bet might be a policy from Ameritas Life (800 552-3553), which offers a low-load option in 48 states and expects to have it available in the last two, New York and New Jersey, within the year. Before you agree to any contract, get the CFA (202 387-6121) to do a cost analysis for $40. This is a cheap way to avoid being sold a sucker's policy.

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