How to avoid the Variable Life Insurance traps?

Variable life insurance can be a powerful financial tool, and this is a good time to consider using it. But it also is fraught with traps, and those traps recently were sprung on many policyholders. Here’s how to avoid those traps and know when to use variable life.

In the best of circumstances, the benefits of variable life can be exciting. I detailed them most recently in our January 2000 issue. Variable life is a cash value, permanent life insurance policy. You can take a distribution from or borrow from that cash account during your lifetime.

The difference between it and other cash value life policies is that you choose how the account is invested from among funds offered by the insurer. Your cash value and often the policy death benefit increase with your investment returns, so they can increase much faster than with other cash value policies. All gains in the cash value account are tax-deferred until you withdraw them.

A major benefit of variable life is that you can borrow the cash value ? tax free under most policies. You can pay premiums for a number of years, and the cash value and death benefit will rise. They you can stop paying premiums and start borrowing from the cash value. The loans can be a source of tax-free retirement income for many years if the investments did well.

The loans don’t need to be repaid during your lifetime, as long as you leave enough in the cash value account so the income pays future premiums. At your death, the outstanding loans are subtracted from the death benefit.

That’s the best-case scenario. But the bear market casts a different light on variable life. Cash values are declining. People who thought they were through paying premiums now have to pay more to keep the policies in effect. Death benefits also might be declining. Those who invested in the most aggressive stock funds saw declines of 50% or more. In effect, these policyholders are receiving margin calls.

Of course, the end of a bear market is a good time to consider purchasing a policy such as variable life. If indeed the bear market is over (as I expect it is), it could be years before you risk another serious market decline. You might have a significant cushion by then.

But buy carefully. There are ways to minimize the damage from a bear market traps, and there are other traps you need to avoid.

The policy illustrations shown to a potential buyer usually show the benefits of borrowing the cash value tax free in the future. The loans generally are assumed to be zero cost. On its books, when you take a loan, the insurer takes an equal amount out of your investment account and puts it in a loan account. The loan account earns interest, but is not invested in your mutual fund choices. The insurer loans you its own money. In a zero-cost loan, the interest earned by the loan account equals the interest charged on the loans.

But few policies guarantee zero cost loans, especially on loans made 10 or 20 years from now, even if they are assumed in the illustrations. More often, you’ll be charged a net 2% on the loan. That meager 2% makes a big difference in how long you can borrow tax-free from the cash value. If borrowing is important to you, insist on a zero-cost loan guarantee.

The loan itself could be a trap. Suppose you are borrowing from a variable life policy. Then the markets decline, causing your death benefit and cash value to shrink. Another effect could be that your premiums continue for longer than expected or the premiums increase. The temptation in this case might be to surrender the policy.

But surrender could be a mistake. If you surrender a policy, then all outstanding loans suddenly become taxable distributions. It becomes cheaper to keep the policy in force than let it lapse.  Keep this trap in mind when deciding how much you reasonably can borrow from the policy.

Most importantly, there are different ways for an insurance company to design a variable life policy. They can be designed so that the effects of a stock market decline are less disastrous.

One way to design a variable life policy is to have the investment results affect the premium payments. As the cash value rises rapidly in a good market, the premium is reduced, and vice versa. This is the type of policy that is most affected by a bad market. Your cash value will decline rapidly, and the premium charged will increase.

An alternative is for the premium to stay the same. Changes in investment performance affect the cash value account and the death benefit, and perhaps how long you pay premiums. In this type of policy, an extended period of good investment performance also increases the death benefit to a level far above the amount initially purchased.

Unless you like the risks of the first type of policy, buy only the second type. If you already own the other type, your insurer might be able to convert it to the second type or into a hybrid of the two.

As with all variable insurance policies, costs are an important consideration. Don’t look only at the performance of the different funds offered. Be sure to check the expenses of those funds, and the other fees the insurer will subtract before these net investment returns are added to your cash value account.

Because the stock market is below its highs and the economy is likely to recover in 2002, this could be a good time to buy a variable life policy. But be sure the policy fits your needs. The policies are an expensive way to buy insurance and to invest. You already should have the basic needs of your retirement taken care of from other sources. The variable life policy should be only for what might be considered extra money. You can borrow from the policy in retirement if additional cash is needed. If not, your beneficiary will receive, income tax free, a benefit that far exceeds the premiums you paid.