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Underfunded Universal Life Insurance: Everything You Need to Know

Universal life insurance has come under fire lately. Many people who purchased these policies in the 1980’s and 1990’s didn’t really understand how they worked (in their defense, insurance salespeople often didn’t get it, either) which led the policies to becoming underfunded. Their choices were then to pay a lot more in premiums or let the policy lapse. What is an underfunded universal life policy? How does a policy become underfunded? Is there anything someone can do to prevent a policy from becoming underfunded? 

What is an Underfunded Universal Life Insurance Policy?

Universal life insurance contains both an investment portion and a life insurance portion. The death benefit is either level, meaning it stays the same throughout the life of the policy, or increasing, ie. it increases during a certain period of the policy. In policy illustrations, the insurance company shows how the policy will perform if there are no adjustments to the policy charges and the interest rate the insurance company sets forth doesn’t change. Generally, neither of these things is always true during the life of the policy.

At some point, if policy charges increase and the interest rates earned in the cash value account of the policy decrease, and if the policy holder has stopped paying premiums and started withdrawing money from the policy, it can cause the policy to be underfunded, ie. the amount left in the cash value account of the policy isn’t enough to pay for the insurance cost to keep the policy in force. This will eventually cause the policy to lapse.

How Does a Policy Become Underfunded?

Universal life insurance policies are set up to be cheaper than whole life policies, which are astronomically expensive. Universal life insurance also typically tries to build cash value as quickly as possible. As the cash value account gets larger, the amount of pure life insurance that needs to fund the death benefit gets smaller. If everything stays the same—the charges and the crediting rate, ie. the interest rate that the cash value account in the policy earns, stays funded and everyone is happy. 

>>MORE: Why is Whole Life Insurance Not Worth It?

If the crediting rate goes down, cash value will build more slowly than anticipated, and the policy’s peak value will come sooner. This will get even worse and sooner if the policy holder has started withdrawing money from the cash value account and stopped paying premiums. The cash value will reach zero before the insured turns 100, and the insured either has to pay more expensive premiums to keep the policy in force or allow it to lapse. If he allows it to lapse, he basically spent the last ten or twenty or so years throwing money away because his heirs will not get a tax-free lump sum when he dies. Nor does he have any cash value to fund retirement with. This has happened to many people who didn’t understand how universal life insurance works. 

If the crediting rate goes up, the cash value builds faster. This is much more favorable, because there’s more cash value to fund the insurance cost and withdrawal from the policy. This is a great scenario that everyone hopes for.

If the crediting rate is as expected, ie. equal to or similar with the one insurance companies set it up in the policy’s illustration, and the insurance charges are also similar to what insurance companies expect. And if the policy holder pays premiums and/or withdraws from the cash value account of the policy as expected, it is likely that the policy will be doing just fine.

Other reasons policies become underfunded is borrowing too aggressively against the cash value, stopping paying for premiums earlier than expected and having to use the cash value to pay the premiums unexpectedly, or paying only the minimum allowed while crediting rates have decreased. As you can see, any changes in crediting rates and/or insurance charges can potentially cause a universal life insurance policy to be unfunded.  

>>MORE: Understanding Indexed Universal Life Insurance – Why Is it A Good Option for Retirement Savings?

How to Prevent Your Policy From Becoming Underfunded?

Basically, universal life insurance is not just a “set it and forget it” type of plan. You have to pay attention and monitor the policy. If charges go up, you’ll need to increase the amount of the premiums. If credit rates drop, you’ll also need to make adjustments. If you or your financial advisor monitor the policy closely, it actually should work as intended. When things change, negatively or positively, be open to make necessary adjustments to keep the policy in force.

In whatever scenario, the rule of thump is that paying more premiums in the early years of the policy will always help prevent the policy from being unfunded. In the early years of the policy, since you are still young, the insurance charges will be minimal, most of the premiums will go to build the cash value account. With compounded interest rates, the cash value account will grow faster with more money in it early on.

Having the policy designed in the right way to serve your goals is also important. If you only plan to pay premiums for the first 20 years of the policy, if you can also afford to pay $200 a month, and if you want to start withdrawing money from the policy to support your retirement income from age 65 to 80, the policy needs to be designed in such a way early on. When things change, you need to be open to adjust your plans accordingly as well. Make sure you work with a good licensed advisor to help you monitor the policy and make adjustments as needed.

>>MORE: Should I Invest in S&P 500 Index Through An Indexed Universal Life Insurance Policy?

What to Do If You Have an Underfunded Universal Life Policy?

You can pay however much money you’re behind to keep the policy in force. You could let it lapse, which is a harsh financial lesson but can be the best option in some cases. You could reduce the death benefit or sell the policy altogether in a life settlement. Talking to a licensed advisor is your first step.

>>MORE: Calculator: How Much Do I Need to Save Monthly For My Retirement?

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