The Optimal Investment Strategy through Variable Universal Life Insurance

Abstract

The Optimal Investment Strategy Through Variable Universal Life Insurance ABSTRACT Universal Life (UL) and variable universal life (VUL) insurance are among the most popular products in the life insurance industry. These policies provide variables rates of return depending on the investment performance of specific investment media, allow flexible premium payments and offer the traditional tax advantages of cash value life insurance. Using the basic economic concepts of marginal and averages rates of return, the authors of this paper provide a theoretical basis for determining the optimal premium contribution to UL or VL that maximizes the after-tax rate of return. The sensitivity of the optimal premium level to changes in the parameter values is also illustrated graphically. Introduction Universal life insurance (UL) and variable universal life insurance (VUL) were introduced in 1979 and 1984, respectively, to provide variable rates of return, flexible premium payments and the favorable tax treatment of cash value life insurance in an effort to help curb the flow of personal investment funds away from insurers. These policies comprised approximately 32 percent of total life insurance sold in 1987 [2]. This percentage is expected to rise as the result of the Tax Reform Act of 1986 (TRA), which adversely affected the tax treatment of many competing investment media. The cash value of UL policies typically earns a rate of return that tends to approximate money market rates and generally provides policyowners with a minimum guaranteed rate of return.(1) The VUL policyowner can select the investment medium from choices that frequently include money market funds, medium- or long-term bond funds and equity funds. The rates of return credited on the savings element of VUL policies are, thus, a function of market performance and there are no minimum guaranteed rates of return.(2) Within specified limits, the amount of premium paid on UL and VUL is at the discretion of the policyowner. The tax advantage of VUL is the same as for traditional cash value life insurance; therefore, VUL is a popular technique for deferring or avoiding income taxation on investment earnings.(3) VUL policies can be categorized into front-, back-, or no-load policies. Front-load policies have flat and/or proportional expense loadings that apply to every premium payment. They may also include a surrender charge. Back-load policies have no specific expense charges applicable to premium payments, but include surrender charges that gradually reduce the longer the policy is in force and may be eliminated after a certain holding period. No-load policies have neither proportional expense loadings nor surrender charges.(4) Insurers issuing no-load policies cover expenses and profits through the differential between credited and achieved interest rates and/or markups on the mortality charges. The relative tax advantage of VUL increases over time, so there is generally a minimum holding period before VUL dominates alternative investment strategies such as a buy-term-and-invest-the-difference approach.(5) Several studies have been performed on the tax advantages of life insurance products, including cash value life insurance and annuities. Adelman and Dorfman [1] compared tax-deferred annuities with other investment alternatives and measured the effect of tax rate changes on the investment results. Broverman [4] studied the internal rate of return on life insurance and annuities by examining contingent death benefits over premiums paid and illustrated that the holding period is a critical factor in determining investment performances. Warshawsky [13] conducted research on the effect of the 1982 Tax Equity and Fiscal Responsibility Act and the 1984 Tax Reform Act and found that the higher the interest rate, the better the life insurance performance over competing investment alternatives. …