f you have read anything about the new "universal life" insurance, which has been widely praised in many newspapers and magazines, it probably sounded like the greatest thing since sliced bread.
It is, most certainly, a great advance over traditional whole-life insurance. But it is not the sliced bread of the insurance industry. In fact, it carries some risks and problems that many buyers may not be aware of.
In concept, universal life insurance works like this:
You make deposits into a savings fund, on whatever schedule suits you best. The insurance company pays higher interest on the savings element of your policy than you could get from regular whole-life insurance. At present, it is assumed that those interest payments will accumulate tax-deferred (although tax deferral isn't yet a sure thing: see below).
Every month, the company withdraws enough money from your savings fund to cover the cost of your life insurance. You get an annual statement, showing your deposits, your insurance cost, the amount of interest earned by your savings fund each month and the increase in your cash values.
Universal life policies are unusually flexible. You may add extra money to the savings fund (if you decide that it makes economic sense to do so). You may raise the amount of your insurance without taking out another policy (although you may have to take a health exam). You may withdraw cash from the policy without treating your withdrawal as a loan. You may quit paying premiums for a while, during which time your savings fund will cover the cost of your insurance.
This flexibility makes the policy readily adaptable to your changing insurance and financial needs.
But it's not the flexibility that makes universal life insurance so hot. It's the high tax-deferred interest rate that the company is offering on the savings fund--rates now ranging from 10 1/2 percent to 13 percent. These interest rates are raised or lowered periodically, in line with other market rates.
You cannot, however, take those advertised rates at face value. They are not comparable with the interest rates offered on other savings vehicles.
An insurance company paying, say, 11 percent will first deduct a fee, ranging from 5 percent to 10 percent of each premium. Most companies also have big first-year charges. On a $100,000 policy, a 40-year-old man might pay anywhere from $260 to $1,000 in the first year, in fees and costs. Most companies (although not all) also pay only 4 percent interest on the first $1,000 in your savings fund.
That "11 percent interest" that sounds so nifty in the ads is paid only on what's left.
William Scheel, professor of insurance at the University of Connecticut, analyzed an 11 percent policy sold by E.F. Hutton Life Insurance Co., the innovator in the field. Taking fees into consideration, its savings fund effectively "earns nothing in the first few years," he told my associate, Virginia Wilson. "The policy breaks even in year four or five, and goes to 8 percent by the 10th year."
By contrast, you can get 10 percent to 13 percent on top-quality tax-exempt municipal securities, and 17 percent on taxable money funds. In January, millions of savers will be able to deposit $2,000 a year into an Individual Retirement Account where they can earn money-fund interest rates, tax-deferred.
The tax deferral on universal life insurance is also open to question. The Internal Revenue Service gave a private-letter ruling to Hutton Life that seems to assure tax-favored treatment for policyholders. But the tax issues apparently are being reevaluated. There are also important questions still open regarding the effect of universal life policies on the taxes of the insurance companies themselves.
The present prices and interest rates on universal life policies assume that all the issues will be resolved in the taxpayer's favor. If any of the issues go the other way, you'll wind up with lower yields on your savings fund (or a higher cost of life insurance).
Whole-life buyers might want to wait for the next IRS ruling before buying (or switching to) universal life. For the most bang for the buck, it still makes sense to buy a low-cost term insurance policy and keep your savings somewhere else.