How to overfund UL

“What?” you might say, “I didn’t know universal life insurance (UL) had an expiry date!” Relax. You’re right. UL doesn’t come with an expiry date. As long as you pay the premiums on time, you’re covered.

“But if lifelong payment seems like a long commitment, universal life has a clause—quick-pay UL insurance—that allows the insured to make large payments (overfunding) during the first five to 10 years of the policy. Each installment pays the cost of insurance in addition to accumulating in the investment account of the UL. The objective of this overfunding is to accumulate enough assets in the investment side of the UL, where it pays the subsequent cost of insurance for the rest of an insured’s life.

“There is, however, a legal limit on how much you can add to the investment side of UL. If payment exceeds this limit, then the excess payment is placed into a side account (a.k.a. transit account). This side account then pays into the UL after the insurer stops payments or as additional investment room becomes available. Keep in mind, these premiums are paid with tax-free interest from within the UL, which can be an advantage for a typical client.

Let’s take Bob, for example

“Bob, 60, wishes to buy a UL policy. He wants a base coverage of $100,000. His cost of insurance is $2,600 annually, level for life, payable until age 100. He wants to overfund it by paying premiums of $10,000 each year for five years, for a total of $50,000. He’s hoping this will create enough capital to pay for the cost of the insurance until age 100. However, if he’s wrong and the investment side of the UL runs out of money prematurely, he’ll have to restart paying premiums, or lapse his coverage. This can be a big problem for everyone involved.

“The analysis he needs to do isn’t that much different from what we perform for retirement planning: “Do I have enough capital to create payments for life?” We need to calculate the probability of running out of money and then minimize that probability to an acceptable level. For a UL policy, that acceptable level is 0% (we must make sure there’s no probability of depletion). To do it right, an advisor should use a retirement calculator based on actual market history—no Monte Carlo simulators—and actual sequence of returns (see “Market valuation” and “Probability of depletion: Scenario 1” this page).

“In Bob’s case, as for the vast majority of people, five annual payments of $10,000 don’t create a large enough investment pool to finance all remaining insurance premiums. So, how many payments does Bob have to make to ascertain he has a self-funding UL for life? By increasing the number of annual payments from five to eight, he can achieve his objective. These additional three payments not only ensure a sustainable self-funding investment pool, but the insurance coverage is substantially higher too (see “Sustainable self-funding,” page TK).

“Here’s another scenario: Bob purchases the same UL, but instead of level premiums until age 100, his premiums are YRT-100 (yearly renewable term to age 100). With YRT-100, the premiums are low in the early years, and increase as one gets older (see “Probability of depletion: Scenario 2,” page TK).

“As it works out, if Bob wants to purchase a YRT-100 UL insurance and overfund it, he’ll have to pay the maximum allowable premium for 19 years to ensure the investment portfolio can pay the cost of mortality and expenses until age 100 (see “Determining premium,” page TK)

“These basic guidelines could help you meet your clients’ objectives of creating a self-funding UL based on market history.

Jim Otar

Jim C. Otar, M.Eng., is a retired certified financial planner and professional engineer; he founded Retirementoptimizer.com Inc.