Variable universal life subaccounts: what you choose and what you cannot

A variable universal life policy gives you a menu of investment choices inside an insurance contract, and the most useful thing to understand is where the menu ends. You decide how the policy's account is divided among funds. You do not decide what those funds cost, which funds are offered, how many transfers you may make for free, or what the insurer deducts each month for the death benefit. This article follows the money from the moment a premium arrives to the moment it is invested, and sorts what is yours to control from what is not.

For the overall picture of the product, including who it suits and the case against it, see Variable universal life (VUL) insurance. Here the focus is the machinery under the dashboard.

The two places money can sit

Insurers keep money in two kinds of accounts, and a variable policy touches both.

The general account is the insurer's own pool of assets, mostly bonds and loans, which backs the promises it makes in traditional policies. When a whole life policy states a guaranteed cash value, the general account stands behind it. The insurer bears the investment risk. How those investments work is described in how life insurers invest your premiums.

A separate account is a different arrangement. Money allocated to the variable part of your policy is held in an account that is kept apart from the insurer's general assets. State insurance law generally treats separate account assets as set aside for the policy owners who invested in them, rather than as part of the insurer's pool available to its other creditors. The details differ by state and by contract, so the prospectus is the place to confirm how a particular product is structured. What does not differ is who carries the investment result: in the separate account, you do.

That is the central trade. In the general account, the insurer takes the market risk and promises a result. In the separate account, you take the market risk and the insurer promises only to run the account honestly and to pay the death benefit according to the contract.

What a subaccount is

The separate account is divided into subaccounts. Each subaccount invests in a fund, a pooled portfolio managed to a stated objective: a broad stock index, a bond portfolio, a money market fund, an international fund, a mix of stocks and bonds that shifts with age. Many of the funds look like ones you could buy elsewhere, and some share a name and a manager with a retail mutual fund. They are not the same thing. The subaccount is an investment option inside the insurance contract, with its own unit values and its own layers of cost, and you do not own fund shares directly.

When you allocate $10,000 of net premium 60% to a stock subaccount and 40% to a bond subaccount, you are buying units in those subaccounts. The unit price moves with the fund's net asset value. Your account value is the number of units times their price, summed across subaccounts, plus any amount held in a fixed option.

The menu is the insurer's

The insurer chooses which funds are offered. It can usually add funds, close them to new money, merge them or replace one with another, subject to the contract and securities rules. You pick from the list; you cannot ask for a fund that is not on it. If a fund is closed, you generally move your allocation to another option. Ask how many subaccounts the product has and how the insurer treats a fund it drops.

The fixed account, if there is one

Many variable policies include a fixed account, an option that sits in the general account and credits a declared interest rate with a stated minimum. It behaves like a cash holding place. Because it is in the general account, the insurer carries the risk there, and the contract usually limits how much you can move in or out and how often. The minimum rate is a contract term; the current rate is not. If you put money here, you are choosing the insurer's guarantee over market exposure.

Who carries what risk

It helps to separate three things people often blend together.

The last two rows deserve attention. A death benefit guarantee, where one is offered, is a promise attached to conditions, much like the no-lapse guarantees discussed in no-lapse guarantees on universal life: how they work. It reduces the chance that a market decline ends the policy, but it does not turn the account into a guaranteed one.

Layer by layer: what comes out of the money

A premium is not the same as the amount invested. The route from premium to subaccount looks like this.

1. Premium load. A percentage comes off each payment, covering sales costs and premium taxes. See Premium taxes and the DAC tax: the taxes inside your premium for what a premium tax is.
2. Monthly deductions from the account. The insurer takes the cost of insurance charge, which is based on the net amount at risk, and an administrative fee, plus the cost of any riders.
3. Mortality and expense charge. Many variable contracts take an annual percentage of the account value for the insurer's mortality and expense risk, often drawn monthly. This is the Mortality and expense (M&E) charge.
4. Fund expenses. Each fund inside the subaccount charges an expense ratio, an annual percentage taken from the fund's assets. You do not see it as a line on a statement; it lowers the unit price.
5. Surrender charges. Leaving the policy in the early years may cost you a percentage of the account.

An example with invented round numbers shows how the percentage-based layers add up. Say a policy has $100,000 in subaccounts. A fund expense ratio of 0.75% costs $750 a year. A mortality and expense charge of 0.60% costs $600. Together the two percentage layers take $1,350 a year, which is 1.35% of the account, before any insurance cost or administrative fee. If the subaccounts earn 6% in a year, the account grows by roughly $6,000 before these costs and by about $4,650 after them, $6,000 minus $1,350, still before the monthly cost of insurance. The real figures for any product are in its prospectus, and they differ from company to company; these are an illustration of the arithmetic.

The full catalog of fees in permanent policies is in fees and charges inside permanent life insurance.

Net amount at risk: why the insurance cost moves

The monthly insurance charge is calculated on the net amount at risk, which is the death benefit minus the account value. Say a policy has a $500,000 level death benefit and a $100,000 account. The net amount at risk is $400,000. If a strong market takes the account to $200,000, it falls to $300,000, and the insurance charge shrinks with it. If a weak market takes the account to $60,000, it rises to $440,000, and the charge rises too.

That feedback is the quiet danger in a falling market. The account is smaller exactly when the insurance charge, relative to it, is larger. A companion article, a market drop inside a variable universal life policy, quarter by quarter, follows that effect quarter by quarter.

With an increasing death benefit (option B), the death benefit is the face amount plus the account value, so the net amount at risk stays near the face amount whatever the market does. The charge then does not fall in a rising market. The choice is explained in Universal life death benefit options A and B.

Transfers, rebalancing and the limits on both

Moving money between subaccounts inside the policy is generally not a taxable event, because you have not sold anything outside the contract. That is one of the features buyers like, and it is real. But there are limits.

• Free transfers per year. Many contracts allow a stated number of free transfers a year and charge a fee after that.
• Anti-frequent-trading rules. Insurers and funds restrict rapid in-and-out trading, because it harms the other owners in the fund. Expect limits on frequency, and sometimes on how a transfer request may be made.
• Minimum amounts. Some subaccounts or the fixed account have minimums or maximums on transfers.

Rebalancing is a service many insurers offer: at a set interval it moves your account back to the target mix. Say you want 60% in stock and 40% in bond subaccounts and start with $100,000, so $60,000 and $40,000. Over a year the stock subaccount rises 20% to $72,000 while the bond subaccount stays at $40,000. The account is now $112,000, with stocks at about 64.3%. Rebalancing to 60/40 means stocks of $67,200 and bonds of $44,800, so $4,800 moves from the stock subaccount to the bond subaccount. Nothing is lost or gained by the move itself. It keeps your risk from drifting up with a rally, and it means selling some of what has done well. Ask whether the service is free and whether it counts against your free transfers.

Automatic dollar-cost averaging programs, which spread a lump sum into subaccounts over months, are also common. They reduce timing risk on a single entry date and do not change the long-run risk of the investments.

Death benefit, loans and the securities rules

A variable policy is both life insurance and a security. That has three consequences for you.

First, the seller must be licensed for both and must deliver a prospectus, which lists the subaccounts, the charges and the risks. Reading that document is the best use of an evening; variable life insurance and the securities rules that govern it explains who regulates what and how to check the seller.

Second, policy loans work much as in other permanent policies: the loan is secured by the account and reduces the death benefit if unpaid. The part of the account that backs a loan often moves out of the subaccounts and earns a fixed rate, which means it no longer follows the market.

Third, taxes. Growth inside the policy is tax-deferred, and the death benefit is generally income-tax-free to a named beneficiary. You cannot deduct investment losses inside the policy. Overfunding can turn the policy into a modified endowment contract. A tax professional can speak to your situation.

What you can do, what you cannot

A plain division helps, because it shows where your attention pays off.

You control:

• How premiums are allocated among the offered subaccounts and the fixed account.
• When to transfer, within the contract's limits.
• Whether to use rebalancing or averaging programs, where offered.
• How much premium to pay, within the policy's limits, and how often.
• The death benefit option and the face amount, subject to the contract.

You do not control:

• Which funds are offered, or whether they remain on the menu.
• Fund expense ratios and the mortality and expense charge, beyond choosing among funds with different ratios.
• The maximum monthly cost of insurance, which is set by the contract (the insurer's current rates may be lower).
• Market returns.
• The securities and insurance rules that shape transfers, sales and disclosures.

Questions to ask before you choose subaccounts

1. What is the expense ratio of each subaccount I am considering, and what is the all-in annual percentage charge on the account, including the mortality and expense charge?
2. How many free transfers do I get a year, and what happens after?
3. Is there a fixed account, what is its guaranteed minimum rate, and are there limits on moving money in and out?
4. Does the insurer offer rebalancing, and does it count as a transfer?
5. If a fund I hold is closed or replaced, how am I notified and what are my options?
6. What does the illustration assume as the return, and how does the policy look at a lower return and at zero?

Key takeaways

• In a variable universal life policy, money allocated to subaccounts sits in a separate account and you carry the investment risk; the fixed account, the maximum insurance cost and the death benefit promise are where the insurer carries risk.
• The insurer chooses the fund menu, sets the charges within the contract and limits transfers; you choose the allocation, the premium and the death benefit option.
• Percentage-based layers (fund expenses and the mortality and expense charge) combine, so add them up, then add the monthly cost of insurance.
• The net amount at risk shifts with the market, so the insurance charge is relatively heavier when the account is smaller.
• Read the prospectus and ask for an illustration at a low and a zero return before relying on the policy to stay in force.