Variable Universal Life Insurance: How It Works, Costs, Risks, and When It Makes Sense

Quick Article Guide

Here’s what we'll cover in this post:

• What is Variable Universal Life insurance?
• How Much Does Tax Drag Actually Reduce Mutual Fund Returns?
• How Do Advisory VUL and Retail VUL Compare?
• What Are the Actual Risks of VUL?
• How Does Funding Level Affect Policy Sustainability?
• When does a VUL policy actually make sense?
• When is VUL the wrong choice?
• Common misconceptions about VUL
• What Should a Prospective VUL Buyer Verify Before Signing?
• Summary
• Frequently Asked Questions about Variable Universal Life Insurance
• How JRC Insurance Group can help

What is Variable Universal Life insurance?

VUL is a form of permanent life insurance that combines a death benefit with market-based cash value investments. Premiums are flexible: the policyholder can pay the minimum required to cover policy charges, or contribute significantly more to build cash value. Excess premiums are allocated among subaccounts — equity, bond, fixed-income, or blended — that function similarly to mutual funds. The death benefit, cash value, and sustainability of the policy all depend on how those subaccounts perform over time.

VUL was introduced in the mid-1980s. It gained broad adoption during the late 1990s, when illustrations routinely assumed 10% to 12% annual returns. When markets corrected, policies funded on those assumptions collapsed. The episode established what remains the central lesson of VUL: the product is only as reliable as the return assumption and funding level behind it.

How Much Does Tax Drag Actually Reduce Mutual Fund Returns?

Morningstar publishes a Tax Cost Ratio measuring the unavoidable annual drag from taxable distributions in retail funds, assuming the top federal bracket for ordinary income and capital gains. For the three years ending December 2024, the average drag was 1.82% annually for US Large Cap funds, 1.85% for US Small Cap funds, and 1.35% for Fixed Income funds.

Estimated Average Annual Tax Cost Ratio (3-Year Period)

Source: Morningstar as of 06/30/2025.

The compounding effect is significant. Vanguard's Total Stock Market Index Fund (VTSAX) returned 12.77% pre-tax over the 10 years ending October 2024. After taxes on distributions, the return was 12.29%. After taxes on distributions and sale of fund shares, the return was 10.52%. Applied to a $100,000 initial investment:

VTSAX is a passive index fund with unusually low turnover. Actively managed funds generate more short-term capital gains and higher tax drag. The effect is largest for high-income investors in the top federal bracket, smaller in middle brackets, and absent in tax-advantaged accounts.

Inside a VUL policy, these distributions and turnover do not generate annual tax liability because the subaccounts are held within a life insurance contract. Whether the policy's internal costs exceed the tax drag being avoided depends on policy structure (advisory versus retail), time horizon, and the investor's marginal tax bracket. Those factors are addressed in the sections below.

How Do Advisory VUL and Retail VUL Compare?

VUL is sold in two structurally different forms. Advisory VUL carries no commissions, no surrender charges, and no premium loads beyond state premium tax; fund expenses are typically 0.10% to 0.35% higher than retail mutual funds. Retail VUL pays upfront commissions to the selling agent, recovers those commissions through higher early-year charges, and imposes surrender charges that usually decline over 10 to 15 years. The two variants produce materially different breakeven timelines when compared to taxable investing:

The advisory VUL figure improves further once the cost of protection is backed out for clients who would otherwise be paying for a separate term life policy. In that case, advisory VUL and taxable investing are roughly equal in year one and advisory VUL is cheaper from year two forward. The retail VUL breakeven window is the main reason many advisors have shifted toward advisory structures for accumulation-focused clients, even when the long-run total cost is similar.

What Are the Actual Risks of VUL?

The risks most often cited — market volatility and increasing cost of insurance — are real but incomplete. The specific mechanism that causes VUL policies to fail is the interaction between sequence of returns, net amount at risk, and cost of insurance charges:

Cost of Insurance (COI) is the largest single expense inside the policy and is charged annually based on the Net Amount at Risk (NAR) to the insurer. NAR equals the death benefit minus the cash value. If a policy has a $500,000 death benefit and $200,000 in cash value, the NAR is $300,000 and the COI charge that year is calculated on $300,000 of at-risk death benefit at the insured's current-age COI rate.

When markets decline, cash value falls, NAR rises, and COI charges increase — all simultaneously. The same expense that a strong market would have absorbed now compounds against a smaller cash value base. A policy that was sustainable at a 7% average return with low volatility can fail at the same 7% average return with high volatility, because the order of returns matters. This is the sequence of returns risk specific to VUL, and it operates more aggressively than in an IUL because IUL policies have a floor that prevents cash value from declining on index performance alone.

How Does Funding Level Affect Policy Sustainability?

The single largest determinant of whether a VUL policy succeeds or fails is how it is funded relative to the MEC limit. Policies funded near the non-MEC maximum behave very differently from minimally funded policies in three specific ways:

• The Cost of Insurance represents a smaller percentage of the total account value each year, so the COI drag on returns is materially lower.
• The Net Amount at Risk is smaller, so COI increases during market downturns are cushioned by a larger cash value base.
• The probability of lapse under adverse return sequences drops substantially — Monte Carlo analysis across thousands of simulated return paths consistently shows well-funded VUL policies failing at a fraction of the rate of minimally funded ones at the same average return assumption.

The practical implication is that a VUL policy should either be funded close to the non-MEC maximum or not be used at all. Minimally funded VUL — premiums set just above the required charge level with reliance on market returns to keep the policy in force — is the design most likely to fail. If the budget only supports minimum funding, a term policy plus a separate taxable investment account is almost always the better structure.

When does a VUL policy actually make sense?

VUL is appropriate when all of the following apply:

• There is a genuine need for permanent life insurance — estate planning, business continuity financing, irrevocable trust funding, or supplemental retirement income in a household that has already maximized other tax-advantaged accounts.
• The policyholder is in a high federal tax bracket (32% or higher), where the spread between pre-tax and after-tax returns is wide enough to justify the policy's internal costs.
• The time horizon is 20 years or longer. Shorter horizons do not give tax-deferred compounding enough time to overcome the early-year cost drag.
• The client is comfortable with equity market volatility and has the discipline not to reallocate aggressively during downturns.
• The policy is funded close to the non-MEC maximum, not minimally funded.

When is VUL the wrong choice?

VUL is the wrong choice when any of the following apply:

• There is no need for life insurance. The protection cost inside the policy is a drag on returns that a taxable investment account does not carry.
• The client is in a lower tax bracket. Tax-deferred compounding is worth less when the tax being deferred is small.
• Other tax-advantaged accounts — 401(k), IRA, HSA, 529 — are not yet maximized. A deductible 401(k) contribution beats a non-deductible VUL premium in almost every realistic scenario.
• The investment horizon is under 15 years. The early-year cost structure does not amortize over shorter periods.
• The budget only supports minimum funding. A minimally funded VUL is a lapse risk waiting to happen; term insurance plus a taxable account produces a better outcome with less complexity.

If you're still weighing whether this type of policy makes sense for your situation, review our Variable Universal Life pros and cons breakdown for a more straightforward comparison.

Common Misconceptions About VUL

Several claims about VUL circulate widely and are either wrong or incomplete:

• "VUL is a bad investment."  This is true for minimally funded retail VUL sold to clients who don't need life insurance and aren't in high tax brackets. It is not true for properly funded advisory VUL held by high-bracket clients with long horizons. The product is not the problem; the design and the client-product fit are where failures occur.
• "You can't lose money in permanent life insurance."  This is incorrect for VUL. Cash value can and does decline when subaccounts perform poorly. VUL has no floor. If this matters, Indexed Universal Life (IUL) has a 0% floor but caps on upside and its own sequence of returns issues.
• "Tax-free loans are free money."  Policy loans are not taxed if the policy stays in force. If the policy lapses with a loan outstanding, the loan is treated as a distribution and becomes taxable — potentially at the worst possible moment. Loan management over a long retirement requires active monitoring, not set-and-forget.
• "The illustrated rate is what the policy will earn."  Illustrations are not predictions. A 7% or 8% illustrated average return does not tell you how the policy performs in the actual sequence of returns that occurs. Monte Carlo stress testing against thousands of randomized return paths produces a more realistic view of policy durability than a single-scenario illustration.

What Should a Prospective VUL Buyer Verify Before Signing?

• Confirm the funding level. A VUL policy should be designed to fund near the non-MEC maximum over the planned premium-paying period. Ask explicitly whether the illustrated premium is a minimum-funded or maximum-funded scenario.
• Obtain the expense page. Many carrier illustrations omit the expense and policy-charge pages by default. Without them, any independent analysis is running on generic assumptions instead of the actual policy's COI schedule. If the illustration provided does not include a year-by-year breakdown of COI charges and policy expenses, request a rerun with those pages included.
• Ask for advisory versus retail pricing. If the policy is being sold as retail, ask specifically whether the advisor is licensed to offer an advisory VUL structure and what the cost comparison looks like for the same coverage.
• Stress test the illustration. A Monte Carlo simulation against historical S&P 500 return distributions will show how the policy performs across adverse return sequences, not just the single illustrated path.
• Plan for policy loan management. If the strategy involves drawing tax-free income via policy loans in retirement, establish the loan management rules upfront: how much can be taken, when, and what the monitoring schedule looks like to avoid lapse.

Summary

Variable Universal Life is a legitimate wealth accumulation tool for a narrow but real segment of the market: high-bracket households with long horizons, maxed retirement accounts, a genuine need for permanent insurance, and the budget to fund the policy near the non-MEC maximum. Within that segment, properly structured advisory VUL can outperform taxable investing meaningfully, particularly over 20+ year horizons where tax-deferred compounding compounds faster than the policy's internal costs compound against it.

For everyone else, the better answer is usually simpler: term life insurance for the protection need, tax-advantaged accounts maxed in order of tax benefit (401(k) match, HSA, Roth/Traditional IRA, 529, remaining 401(k) capacity), and a taxable brokerage account for anything beyond that. VUL earns its place in a plan when those simpler instruments have been exhausted and a specific objective remains that they cannot address.

Before moving on, if you’re trying to decide whether VUL is the right fit, our pros and cons guide summarizes the key trade-offs in a more concise format.

Frequently Asked Questions about Variable Universal Life Insurance

How JRC Insurance Group Can Help

JRC Insurance Group is an independent life insurance agency representing 63 highly rated providers. We specialize in high-risk cases and complex coverage design, including Monte Carlo stress testing of IUL and VUL illustrations against actual carrier COI schedules. Our analytical tools allow us to evaluate whether a proposed VUL policy is likely to perform as illustrated across a range of market scenarios, not just the single scenario the illustration shows.