Heads I Win, Tails I Don't Lose
This is a game we would all like to play. It is exactly the proposition given to the insurance industry a decade ago as indexed products became an accepted product segment. Since that time, indexed annuities have outpaced even the loftiest expectations placed on it by those who believed in the product. However, indexed life has gained only modest ground on the rest of the industry—it is now ready to explode!
When indexed universal life (IUL) was first unveiled there were many questions agents wanted answers to. Can IUL outperform VUL over the long term? How valuable are the minimum guarantees and floors? Are these products too good to be true?
Early on the industry focused almost entirely on the "upside potential" of the product on account of the 1990s bull market. It was easy to sell against traditional fixed UL, due to the expectation that an equity-based credited rate would outperform a fixed credited rate over the long term. However there was a hesitancy to compare IUL to VUL, because the maximum credited rates could not compete with 20% or 25% or 30%. The reality of 2000–2003 forced us to revisit whether 20%–30% was the right benchmark to use for an accumulation vehicle. In today's environment the reality is that an investor, whether focused on the short term or the long term, needs to understand the impact a down market can have on investment portfolios.
How many agents sold VUL in the late '90s based on 10% expectations and watched policies blow up when −10%, −15%, and −25% destroyed values? It is one thing when a client sees account values decrease due to market corrections. It is entirely another when they see entire policies disappear because COI's and internal expense loads take values to $0. This is exactly what happened in the last bear market.
Today's clients are willing to pay a much higher price for guarantees and safety. What's surprising is that the price of those guarantees is decreasing with the new IUL products being sold today. For instance, there are products being sold today that have 14% and even 17% annual caps, with the same lock in/reset mechanism that make indexed products work.
One would think that these high cap rates would come with a decrease in minimum guarantees to offset this higher upside potential. However the opposite is true. The best IUL products today have 3% lifetime credited rate guarantees or credit 1% each and every year—regardless of the index performance. Some of these guarantee structures are even higher than those embedded in traditional fixed UL products.
Consequently, many are reopening the discussion and comparing IUL to VUL again—this time using realistic comparisons. As you dig into the comparison you may be surprised to see the results. Not only does IUL provide the safety needed in extended down markets and the ability to quickly rebound after a down year, but it also can outperform VUL over a long time horizon.
The following examples illustrate both the safety embedded in IUL and the long term expectations of IUL relative to a VUL.
Safety
Assume you have a 35 year old client that is willing to trust you with $10,000 a year for the next 30 years and has a goal of accumulating $1,000,000 by age 65. You show him a particular VUL product and tell him that as long as the market averages 8.0% per year the product will meet his growth objectives. In addition, you show him an IUL product with a 14% cap and tell him that as long as the average credited rate is 8.0% over the life of the contract, his goals will be met.
In addition to the illustration, you need to discuss the impact of one bad year. For example what if the market has a 25% correction in year 10? The IUL policy can still meet the client's expectations without any additional premiums above the original $10,000 per year funding. With the VUL policy, the client would have to increase future premiums by 25% to attain their $1,000,000 goal.
What if there was a 25% correction in year 20? Again, the IUL policy could still meet the client's expectations without any additional premiums. However, the VUL policy would need to increase premiums by 130% to meet expectations.
| Original Illustration | 25% Correction Year 10 | 25% Correction Year 20 | ||||||
|---|---|---|---|---|---|---|---|---|
| IUL | VUL | IUL | VUL | VUL1 | IUL | VUL | VUL2 | |
| Deposits | 300,000 | 300,000 | 300,000 | 300,000 | 350,000 | 300,000 | 300,000 | 430,000 |
| Age 65 Value | 1,076,546 | 1,076,546 | 1,003,784 | 889,040 | 1,024,484 | 1,003,643 | 790,726 | 1,004,351 |
Long Term Expectations
Those critical of indexed products will quickly make the case that it is not fair to assume a VUL and an IUL can average the same credited rates over time. It is obviously impossible to predict how each product will perform over time, but we can look at history to compare how the products would have performed over a long time horizon.
There are four main components of a VUL credited rate: 1) price appreciation, 2) dividend yield, 3) M&E charges, and 4) fund management expenses. If you assume that dividend yields (currently around 1.6% on the S&P 500) are approximately equal to M&E charges and fund management expenses embedded in a VUL, then you only need to track price appreciation. With IUL, all products currently pass through only the price appreciation of the index, excluding dividends. What you are left with is a simple comparison of average historical returns focusing on index price appreciation.
Over the last 40 years (between 1/1/1965–1/1/2005) the annualized return in the S&P 500, excluding dividends has been 6.9%. If you overlay the crediting mechanism of an IUL (14% annual cap, 0% annual floor) the average credited rate is actually 7.7%! For a single premium policy, this differential would have lead to a 60% higher cash value for the IUL policy over a 40 year period of time.
Now, historical returns may have no bearing on future performance. However, what you need to take from this is that the new IUL products have the potential to compete long term with the performance of VUL products. When you combine that with the safety and security embedded in IUL products, the choice is obvious.
| Date | S&P 500 | VUL Cr Rate | IUL Cr Rate |
|---|---|---|---|
| 1/1/1965 | 84.75 | ||
| 1/1/1966 | 92.43 | 9.1% | 9.1% |
| 1/1/1967 | 80.33 | −13.1% | 0.0% |
| 1/1/1968 | 96.47 | 20.1% | 14.0% |
| 1/1/1969 | 103.86 | 7.7% | 7.7% |
| 1/1/1970 | 92.06 | −11.4% | 0.0% |
| 1/1/1971 | 92.15 | 0.1% | 0.1% |
| 1/1/1972 | 102.09 | 10.8% | 10.8% |
| 1/1/1973 | 118.05 | 15.6% | 14.0% |
| 1/1/1974 | 97.55 | −17.4% | 0.0% |
| 1/1/1975 | 68.56 | −29.7% | 0.0% |
| 1/1/1976 | 90.19 | 31.5% | 14.0% |
| 1/1/1977 | 107.46 | 19.1% | 14.0% |
| 1/1/1978 | 95.10 | −11.5% | 0.0% |
| 1/1/1979 | 96.11 | 1.1% | 1.1% |
| 1/1/1980 | 107.94 | 12.3% | 12.3% |
| 1/1/1981 | 135.76 | 25.8% | 14.0% |
| 1/1/1982 | 122.55 | −9.7% | 0.0% |
| 1/1/1983 | 140.64 | 14.8% | 14.0% |
| 1/1/1984 | 164.93 | 17.3% | 14.0% |
| 1/1/1985 | 167.24 | 1.4% | 1.4% |
| 1/1/1986 | 211.28 | 26.3% | 14.0% |
| 1/1/1987 | 242.17 | 14.6% | 14.0% |
| 1/1/1988 | 247.08 | 2.0% | 2.0% |
| 1/1/1989 | 277.72 | 12.4% | 12.4% |
| 1/1/1990 | 353.40 | 27.3% | 14.0% |
| 1/1/1991 | 330.22 | −6.6% | 0.0% |
| 1/1/1992 | 417.09 | 26.3% | 14.0% |
| 1/1/1993 | 435.71 | 4.5% | 4.5% |
| 1/1/1994 | 466.45 | 7.1% | 7.1% |
| 1/1/1995 | 459.27 | −1.5% | 0.0% |
| 1/1/1996 | 615.93 | 34.1% | 14.0% |
| 1/1/1997 | 740.74 | 20.3% | 14.0% |
| 1/1/1998 | 970.43 | 31.0% | 14.0% |
| 1/1/1999 | 1,229.23 | 26.7% | 14.0% |
| 1/1/2000 | 1,469.25 | 19.5% | 14.0% |
| 1/1/2001 | 1,320.28 | −10.1% | 0.0% |
| 1/1/2002 | 1,148.08 | −13.0% | 0.0% |
| 1/1/2003 | 879.82 | −23.4% | 0.0% |
| 1/1/2004 | 1,111.92 | 26.4% | 14.0% |
| 1/1/2005 | 1,211.92 | 9.0% | 9.0% |
| Annualized: | 6.9% | 7.7% | |
- Assumes increase in annual premium from $10,000 to $12,500 in year 11
- Assumes increase in annual premium from $10,000 to $23,000 in year 21