A Tale of Two Stories

VUL & IUL

How to beat the upside potential of VUL with downside protection

For years, life insurance has been used as an accumulation vehicle. Today, accumulation oriented life insurance is more attractive than ever.

1. New products are much more efficient by minimizing the internal costs of the death benefit and expenses providing higher accumulated values
2. New products are much more flexible, providing features that give clients access to cash values earlier and cover more risks such as long term care, nursing home costs, terminal illness, chronic illness, critical illness, etc
3. The taxation benefits of life insurance--tax-free inside build up and tax-free distributions. In a world where future tax rates are uncertain at best, this gives life insurance a huge advantage over other accumulation vehicles.

However, in order to use life insurance as an accumulation vehicle, clients need access to products providing interest credits that will out-pace traditional fixed life insurance products. Two of these products are Variable Universal Life (VUL) and Indexed Universal Life (IUL).

Sales in accumulation oriented sales concepts have increased rapidly in recent years; however the impact on the sales of VUL and IUL has differed greatly. Since 2000, IUL sales have grown over 33% annually while VUL sales have decreased more than 11% on an annual basis (see figure 1). In the early 2000's one would have expected that VUL sales would have decreased due to the decrease in the stock market. However, as the stock market rebounded VUL sales did not (see figure 2) whereas IUL took off. This is most likely due to a realization that VUL can not sustain a bear market while IUL can. Although experts can't agree when a bear market will occur, everyone agrees that we will see bear markets again in the future.

Conceptual/Contractual Differences

The IUL chassis allows for solid performance in almost any environment. This is based on 4 different factors:

1. Upside potential: An IUL credits interest based on the performance of an external index (typically the S&P 500--excluding dividends). The performance of the index is usually measured annually and subject to a maximum credited rate or cap. Newer IULs have caps as high as 16% giving them significant upside potential.
2. Downside Protection: An IUL has floors that eliminate the downside of the index. Every product has an annual floor of 0%-1%. Some products even have global floors guaranteeing the long term annualized credited rate over the life of the product as high as 3.0%.
3. Lock-in: All interest credited is locked-in and can never be taken away due to future negative index performance.
4. Reset: In a negative index environment, the initial index value used in the crediting formula resets. For example if the index drops from 1000 to 800 in a year the next year's starting value is 800--so clients get to "ride the index back up."

Conceptually, IUL offers similar upside as VUL. However, the addition of the downside protection, annual lock-in, and annual reset leads to potentially higher long term average credited rates than VUL. The only long term benefit VUL has over IUL is the ability to specifically tailor the investment program for an individual client rather than having the performance of the product tied to the overall stock market.

Comparing Long Term Returns

VUL gives clients the ability to direct premiums to various subaccounts managed by money managers and large institutional fund companies. However, there are a few comments that are warranted in regards to this subject. Time and time again empirical evidence shows that fund managers rarely beat the long-term overall performance of the stock market (or indices representing the stock market). In fact as the time period measured increases the likely hood of outpacing the market becomes less and less. In addition most VUL clients choose modeled portfolios, constructed to reduce risk, which waters down the overall potential return. Lastly, the psychology of most individual investors leads them to move out of one fund and into a different fund at the wrong time. It's called "chasing returns" and ultimately leads to buying high and selling low. The net impact is that VUL performance rarely keeps pace with the S&P 500--the index most IUL products are tied to.

On the flip side, the best IUL products would have actually outpaced the S&P 500 historically due to the downside protection, lock-in, and reset mechanisms. In fact, historically (assuming a 16% annual cap and 0% annual floor) an IUL product would have averaged an annualized credited rate of 8.41% over the last 50 calendar years (see figure 3). The S&P 500 by itself (removing the 16% cap and 0% floor) would have only averaged an annualized return of 7.09%. So the IUL chosen here would have beaten the performance of the market (excluding dividends) by almost 1.5%!

This enhanced return has to do with the higher cap rates in the newer IUL products. For example if the cap rate was 12% versus 16% the annualized credited rate over the last 50 years would have only been 7.05% leading to no positive gains over the market performance. So newer products, with higher caps, give clients a high likelihood of outpacing the market and VUL credited rates.

Downside Protection

Probably the biggest differentiation between VUL and IUL comes from the downside protection. There's no doubt that there are some clients who would rather fully participate in the stock market. However, these clients don't always understand the impact of a bad year (or bear market). In fact this impact is exactly the reason why VUL sales have continued to lag even though the market has flourished over the last several years.

The impact of a negative market on VUL products can be felt in three ways. The first impact is obvious, if the funds perform poorly then the fund values decrease. The next impact is not as intuitive but it comes straight from basic math. If a VUL has a 20% net loss how much of a positive net gain is needed the next year to break even? The answer is 25% not 20%. That means that a bad year needs to be followed by an even better year, net of fees, just to break even!

The last impact of a negative market on VUL has to do with the basic design of universal life. With universal life, the internal charges are based significantly on the fund value. The lower the fund value, the higher the net amount at risk (death benefit minus the fund value), the higher the internal costs. As fund values decrease and costs increase, this decreases the fund values even further which forces the policy into a "death spiral." This is the exact reason many VUL's unraveled in the early 2000's. To quantify the impact, if you replace an average year's net return with a 10% net loss, it decreases the long term fund values by more than 25%--that's just for one bad year that is not anticipated! How many VUL clients would be comfortable if they knew this?

Conclusion

In the end the newer IULs, with the higher caps and other value added features, have contributed significantly to their appeal and will ensure their continued success. On the flipside, the viability of VUL for most clients will continue to suffer due to the inherent design of life insurance and VUL's inability to provide downside protection. Considering VUL sales are still almost $2 billion annually it is extremely likely that IUL will eventually capture a large portion of its market share and continue to be the fastest growing product segment in the life insurance industry. So for a client who wants to take advantage of the taxation power of life insurance, wants to have access to the embedded features in today's products, wants the upside potential of VUL, but wants the protection needed in a bear market, look to IUL before you reach for VUL.