The other day I was part of a conversation with another agent about Indexed Universal Life. The conversation was more of a challenge to my position that, like whole life insurance and current assumption universal life insurance, indexed universal life also deserved just as much credit for being market neutral and falling into the alternative investment category I've discussed in the past.
I was asked how this could possible be the case. Indexed universal life after all is a product that pays an interest rate that is subject to the percentage change of an index. That very foundational attribute makes it a highly market correlated asset. Or does it?
If it Walks Like a Duck…
We'll begin with a quick look under the hood. Indexed universal life (or IUL) is a product that has cash values made up of at most 10% options and at least 90% bonds and other low risk assets (cash, and highly rated mortgage notes). In practice companies rarely go beyond 4% options and 96% bonds et. al. The idea behind IUL is to design a permanent cash value life insurance product that will average a few 100 basis point yield over current assumption universal life insurance.
It's kind of tough to be market driven correlated when 90+ percent of your holdings are in assets that have little to no correlation with the stock market. In other words, IUL may way like the stock market (and a lot of agents/brokers may badly want that) but IUL surely doesn't quack like the stock market.
Some people focus on the positive. They are known as optimists. I hear they live delightful lives filled with happy thoughts. Then there are the pessimists…
The people who have to ruin IUL by reminding us that despite the 12, 14, 16, etc. percentage cap rate, there's something like a 0 or 2% minimum rate and that roughly every 3.5 years the stock market becomes a bear market where those minimums are likely to become a reality. Oh shucks. But maybe there is some gold in this design.
Some Math Theory
For those who have at least stumbled there way through a introductory statistics course, you've no doubt happened upon a seemingly insignificant concept known as regression to the mean. Regression to the mean the notion upon which all statistical procedures and inferences are built. It is the recapitulation of the Law of Large Numbers (though admittedly somewhat subtle) and is the foundation concept behind the chief tool in inferential statistics: regression analysis.
For a quick overview, regression to the mean was first an observational relationship of data as it tended to localize around a mean. Ever heard of the winner's curse? If you took a fair coin and flipped it 6 times a day for a year you should average out 3 heads and 3 tails a day (or something really close). But there will be days when you have more heads than tails. There might even be days where you have all of one and none of the other.
Regression to the mean is simply the notion that days where you land on heads 6 times aren't normal. And you'll very likely notice that the day immediately following you have fewer results that wind up heads (i.e. you regressed closer to the mean).
Ok, so what does regression to the mean have to do with indexed universal life and market neutral assets? Well, if the stock market operates on the same principles we know to dominate every other economics and functional process, put very simply, bad years will be followed usually (not necessarily always, but almost always) by much better years.
I'm Still Not Following You
Let's use an example. Hypothetically, let's use an indexing strategy that credits 14% maximum and 0% minimum. If the index moves 7% in he first year our credited interest rate will be 7%. If in the following year, the market tanks -10% our credited interest rate will be 0.
Now Here's where the Magic Happens
You know the people who tell you the worst time to sell is when the market takes a dive? We call them stock brokers. You know those people who tell you the best time to buy is when the market dives? We call them smart.
Remember the principle. And keep some handy math facts at hand. The mean yield for the S&P 500 is 10% (careful about this, it's arithmetic not geometric mean) and the standard deviation is 15%. This means when we see the market dive 10%, it isn't “normal” but it's also not cause for incredible alarm (if you want to know why no cause for alarm, email me, the explanation goes beyond the scope of this post).
We do however know that the market will likely return something much better in the near future. In fact, since the 1980's every time the market has gone negative, it has turned around and returned over 20% in the following year (there is an exception from 2000-2002 when the S&P remained negative for 3 straight years).
So we begin at 7%, we then get 0 since the market dropped 10%, and let's say the market comes back (regresses to the mean) moving 15% we'd get 14%. So, if I were in market my return would be 7%, -10%, and 15%. The IUL is 7%, 0%, and 14%.
Let's Look at the Compound Annual Growth Rate
If I had a $100,000 investment in the stock market I'd wind up at $110,745 at the end of year 3. That's 3.46% CAGR. On the IUL I'm at $121,980 or 6.85% CAGR.
We've talked about looking at indexing in Monte Carlo simulations. We also noted there that indexing strategies over the past 10 years have performed dramatically better than the S&P itself. Let's be careful here. This is not to infer that indexing is better than simply investing in the stock market or trying to mimic the S&P. What you should be able to take away is this: the stock market had a really bad decade, indexing didn't despite being subject to movements in the stock market. This further highlights the fact that indexing is a market neutral strategy.
Keep in Mind Safety is Still a Major Concern
A lot of agents/brokers have taken to presenting indexed products as an alternative to the stock market likening it to a way to get stock market like returns with the down side risk. This is a huge misrepresentation of the product championed–in part–by agents who lack a securities license and want your stock market money. Safety (i.e. lower risk) is still a major consideration.
In other words, you're not going to get the big up swings without having to deal with the big declines. Whether it's worth it or not to even go after the higher returns alluded to by investment salesmen is a different discussion for a different day.
Remember the product is designed to yield one to two hundred basis points above current assumption universal life. The indexing is how it gets there. The product is a little riskier than whole life insurance, and for that there is a slightly higher rate of return. So, for yet another market neutral choice within the life insurance as an alternative investment play, indexed universal life certain has a place for discussion.