Universal life, now 5 years old, still prompts insurance questions

It's been five years since E.F. Hutton tried to cut down the confusion over whether to buy whole-life or term insurance by introducing the first ''universal life'' policy. Since then, over 100 companies - many of which said they would never do it - have brought out their own versions of universal life.

One of the byproducts of this half-decade of insurance advancement has been more confusion.

Universal life was supposed to be the life insurance industry's answer to recommendations that consumers avoid whole-life policies, with their 3 and 4 percent returns and high early-year premiums, in favor of much cheaper term insurance. The money saved on lower policies, it was argued, could be invested at a much higher return elsewhere. ''Buy term and invest the rest'' in a ''side fund'' became the catch phrase among ''smart'' insurance advisers.

The key to universal life is that it has the side fund built in. Whenever a customer pays a premium, part of that payment covers the cost of straight insurance. The rest of the side fund is invested at rates competitive with money market yields. Taxes on the income from this investment are deferred until the policy is canceled and cashed in or until any excess cash is withdrawn.

In addition, the side fund can be used as a source of future premiums. When the fund gets large enough, the policyholder can elect not to make a scheduled premium payment. The unpaid premium comes out of the side fund, which has been earning tax-free interest. This can be particularly useful if there is a drop in the individual's income or if the individual incurs a major expense, such as an unexpected home repair.

But if premiums can be paid regularly without dipping into the side fund, both this fund and the face amount of the policy - the insurance coverage - become part of the death benefit.

This kind of flexibility is considered a major reason for the rapid growth of universal life. The product accounted for 20 to 25 percent of all new individual life premiums sold in 1983, up from 10 percent in 1982 and less than 2 percent in 1981, reports the Life Insurance Marketing Research Association, an industry trade group.

''Universal life is buy term and invest the difference,'' explains Robert Grossmann, senior vice-president for research at Cantor, Fitzgerald & Co., a Los Angeles brokerage. ''You give them (the insurance company) a dollar and tell them how much to put in insurance and how much to invest.'' Some people, he says , do have the discipline to invest in and maintain their own side fund while buying term insurance. But whether they actually come out ahead of a good universal-life policy is ''borderline,'' he adds. He contends it would be easier if universal life were not ''getting so complicated.''

That complication is a major reason that a product that was fairly simple when it began has become rather confusing, says James Hunt, a former Vermont insurance commissioner now working with the Washington-based National Insurance Consumer Organization.

''Some of the products, when they first came out, had lower commissions and withdrawal charges,'' Mr. Hunt says. ''There's been a trend away from that.''

In a recent report on universal life, Mr. Hunt's group found higher commissions and sales charges; inappropriate use of the term ''no-load''; quoted interest rates that were far higher than the policyholder would actually receive; and cases of two similar-looking products being offered by the same company, except that one had much higher sales charges.

Currently, many insurance companies are quoting interest rates on universal-life side funds of 11 or 12 percent. Some companies, however, pay a lower rate on the first $1,000 of cash values or charge the policy with higher premiums for death protection. Also, while a company may advertise its universal-life policies as ''no-load,'' that is, without a sales charge, it may have what are known as high ''back-end loads,'' or surrender charges. These charges may amount to as much as 10 percent of the premiums deposited after the first year and range down to 1 percent in the tenth year, or there may be no charges for full surrender and only a $25 fee for partial surrenders.

All of these fees and charges can reduce a stated 11 percent return by as much as half, Mr. Hunt notes, although the reduction is usually more like two of three precentage points.

On some policies, there is a $1,000 ''threshold,'' which is the cash value that has to be built up before the high interest rate is applied. You'll get a better return without the threshold.

Two companies with very low charges, Mr. Hunt says, are USAA Life of San Antonio and Northwestern Mutual Life of Milwaukee. While both have sales charges (3 percent at USAA, 7.5 percent at Northwestern), and both have very low or nonexistent policy fees and no charge for full surrender, although they do have a $25 partial-surrender fee.

At USAA, where almost all sales contacts are made my mail or phone, the typical universal-life customer is between 30 and 39 years old and is buying about $75,000 of coverage, says Kenneth McClure, the company's executive director of marketing services. The average premium for that coverage is about $ 1,200.

Even though USAA's 111/4 percent return is quite competitive by money fund standards, ''most people who buy universal life are buying it for life insurance reasons,'' not high returns, Mr. McClure says.

Comparing premiums, rates of return, fees, loads, and surrender charges for universal-life policies can be a time-consuming and confusing process. In the meantime, you still need life insurance. To cover that need, the easiest course is probably to keep your whole-life coverage, if you have it, or take out a one-year term policy. A few phone calls can give you most of the information you need to compare term policies and rates. Literature you get in the mail can give you the rest.

You may find, as many insurance buyers have, that term insurance, too, has become more competitive. Rates have come down considerably - especially for nonsmokers - and insurance agents are more willing to discuss term insurance than they once were.

Also, term still has the advantage of lower costs in a person's younger years than any other kind of insurance, making it attractive for a young family.