Universal life insurance not yet the answer to whole-vs.-term debate

It was supposed to be the answer to the life insurance industry's ''big debate'': Should people buy whole life policies and build up a savings pool while enjoying fixed premiums their entire lives, or should they buy cheap term insurance and invest the money they save on premiums in something else?

It is commonly known as universal life, though it goes by a variety of colorful names, including CompleteLife (E. F. Hutton), The Challenger (Life Insurance Company of Virginia), and T Plan Life (Transamerica Occidental Life). The Hartford Insurance Group is even so bold as to call it The Solution.

But is universal life really the answer? For now, at least, probably not.

Certainly, the timing for universal life could not have been better. With many investments paying two to three times as much, the case against traditional whole-life policies that earned no better than 6 percent seemed to grow stronger all the time. And as the case got stronger, a growing tide of policyholders began to borrow on their insurance at 6 to 8 percent and invest it for 16 to 18 percent. Or, they canceled coverage in favor of term.

Thus, universal life appeared attractive indeed. After all, it offered people higher returns, the flexibility to pay as much in premiums as they could afford (or even skip premium payments), and the chance to take money out when it was needed instead of having to borrow on the policy or cancel it altogether.

With universal life, the policyholder makes periodic payments to the insurance company, just as he would do with whole life or term coverage. The company puts the money into an individual savings fund that earns higher interest than a regular whole life policy would. Every month the company makes withdrawals from the policyholder's savings fund to pay for premiums on the life insurance policy. If the policyholder cannot make a payment, the company simply makes the payment from the policyholder's savings fund.

A major improvement in universal life is the disclosure of all fees and expenses. With whole life, people usually do not know what portion of their premiums are going for commissions, office expenses, or actual coverage. Nor do they know how the premiums are divided in later years. Universal life provides an annual statement detailing fees, interest credited to the account, and withdrawals for premiums.

Besides giving people more information and flexibility, the dozen or so insurance companies that have been selling univeral life have touted the tax-free aspects of the savings feature. But the assumption that the higher interest payments would accumulate on a tax-deferred basis has not been proven yet, and the Internal Revenue Service has yet to rule on this question.

Until it does, this remains one of several reasons why people should wait before signing up for universal life.

In the first place, the high rates of return advertised by the companies - some as high as 11 or 12 percent - are quickly diluted. That's because of first-year costs (such as sales charge, medical examination expense, and the fee for setting up a new account) as well as a management fee that, because of a minimum charge, could be as much as 5 to 10 percent of premiums in the early years. These costs can cut that high return to nothing the first year or so. After that, it can take up to 10 years before it earns even 10 percent.

In the second place, if the Internal Revenue Service rules that the easy access to the savings fund makes these policies more of a savings tool than an insurance vehicle, the effective rate would automatically be cut. The IRS has had this case for several months; a decision is not expected for several more. If it does favor universal life tax deferrals, many more companies will probably offer the coverage. Then, competition should result in lower charges and thus give people rates of return closer to those claimed in the ads.

One way to get insurance protection and tax-sheltered interest that is in no danger of being compromised by an IRS ruling might be to buy the less expensive term insurance and put the additional money you would have spent on a whole life policy into an individual retirement account (IRA). The Economic Recovery Tax Act of 1981 made IRAs available as of the first of this year to all employees. An IRA allows an indivudual to put up to $2,000 a year into a retirement fund. Two-earner married couples can put in twice as much and a couple with only one spouse working can deposit up to $2,250.

However, you cannot withdraw money from an IRA without severe penalties before age 59 1/ 2. It does not have the withdrawal flexibility of universal life. But universal life does answer whole life's claim to providing a savings vehicle, and does it at much higher interest rates.

Another uncertainty for universal life centers around the current drop in short-term interest rates. For the last couple of years short-term rates - in a reversal of traditional trends - have been higher than long term rates. Now that interest rates are falling, the insurance companies may not be able to keep offering the high returns their ads have been claiming.