How Indexed Universal Life Insurance Minimizes Sequence of Returns Risk

We started sounding the alarm about the sequence of returns risk way back in 2013.  Since that time, others jumped on our train to warn retirement savers that one of the most dangerous risks they face is the timing of market movements.  These movements can hit savers harder as they accumulate more assets and it becomes far more destructive as one draws nearer to retirement.  It's difficult to diversify this risk in the traditional investment advice arena.

We also noted all the way back in 2013 that life insurance is a spectacular shield against the sequence of returns risk.  Its immunity to losses greatly reduces the impacts of bad market timing.  I don't mean timing like buy low sell high (or vice versa).  I mean timing like a correction comes along at the most inconvenient time.

All those years spent accumulating assets take a major step back when the media overstates the dangers of a virus all in the greedy pursuit of eyeballs through click-baity headlines.  Now thanks to widespread panic, your portfolio takes a nosedive and wipes out years worth of diligent savings.

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The Sequence of Returns Risk Explored

When it comes to accumulating money through an investment or savings plan, the timing of returns matters.  The absolute impact to your portfolio is augmented as your portfolio value increases.  If you find yourself confused by this statement, think about simply in the following context:

(100 x 0.05) < (1,000 x 0.05)

Multiplying 100 by 0.05 results in a smaller product than when we multiply 1,000 by 0.05.

So when your portfolio grows larger, the net loss or gain in dollars grows larger.  For most people, portfolio size will grow larger as time increases, in other words, it's larger when you are old.

There is a subtle, but very important implication to this fact.  The older you are, the larger your account balance.  The larger your account balance, the more impact movement in your savings/investments has (up or down doesn't matter).  This means the more you benefit from positive growth.  It also means the more threatened you are by negative growth.

A market correction is far more problematic for an older saver because it nets a bigger loss of value.  This is a key implication behind the advice that younger people can afford more risk.  It's not that time removes risk (it absolutely does not).  This advice comes under the assumption that when you are young, you are most likely to hold fewer assets.  Fewer assets mean movement in the market has a less absolute impact on your overall holdings.

When it comes to traditional market securities (e.g. stocks and bonds) avoiding sequence of returns risk is nearly impossible.  Bonds purchased directly for the sole purpose of income production (a microscopic subsection of the retail investor world) enjoy the most insulation from this risk.  Everyone else must accept the perils of inconvenient market movements if they wish to make heavy use of these investment options.

If you're fortunate enough to save/accumulate enough wealth to more than cover your living expenses, the sequence of returns risk might not matter much to you.  If you do accomplish this, you're in a small group of Americans who accomplish extraordinary circumstances–congratulations.

Everyone else, however, must live with the consequences of market movements or else build a better strategy to minimize the risk.

One of the best ways to highlight the implications of the sequence of returns risk is to look at a timeline of investment returns and then show the impact on the investment when we change the timing of the returns.  Consider this 20-year timeline spanning 1999 to 2018:

VFINX 1999 to 2019 Sequence of Returns

The line represents the accumulated account balance of a $10,000 annual investment into Vanguard's S&P 500 Index Fund (VFINX).  I'm assuming a once annually paid $10,000 investment at the beginning of the year.  I used annual return data provided by the portfolio visualizer to compute returns and adjusted values to incorporate a net 1% annual fee.  Returns include any payable dividends.

The resulting compound annual growth rate (CAGR) of the investment is 6.60% over the 20-year timeframe.  If you're thinking the return is less than what you've seen quotes elsewhere for the same time period, keep two important factors in mind.  First, this is a systematic investment, not a lump sum one-time investment.

Second, the 1% annual fee matters and most quoted returns exclude fees.

This timeframe is particularly interesting because it includes three really bad years, in this case, they happened very early on when the overall account balance of the investment was small–at it's smallest point actually.  This is why younger savers can “afford the risk.”

Watch what happens when we flip the returns and run the same $10,000 annual investment through the exact same annual returns, they just happen with different timing (i.e. reverse order):

VFINX MF 2018 to 1999 Sequence of Returns

The average rate of return is identical in both scenarios–it happens to be 7.1%.  But when the three negative years hit late in the timeframe, when the account balance is much larger, the actual results are significantly different.  Now the compound annual growth rate is a paltry 2.81%.

The change in ending account balance is around $147,000.  But take note that in year 16, when the investment reached its peak, the CAGR at the time was 7.81%.  This is precisely why older savers cannot afford the additional risk.

Minimizing the Risk Means Minimizing the Upside

A common reason for ignoring the sequence of returns risk is the effect it has on potential gains.  Savings account do a pretty good job minimizing the sequence of returns risk, but they also significantly reduce the upside potential when vast market expansions take place.  Think of the difference in results achieved if one kept all of his/her money in a savings account for the past 10 years versus being in the stock market.

Sure recent headlines about the Corona Virus and resulting market plunges causes them little concern financially speaking, but they also accumulated far less wealth in the past 10 years assuming an identical savings rate to someone who placed all the money in the market.

Traditional financial advice for years thumbed its nose at the idea of a sequence of returns risk through its suggestion that taking on more risk was a method for addressing under-savers.  The idea was for those who were behind on asset accumulation to accept higher risk allocations as a means to make up their accumulated shortfalls.

“Mr. Investor at your age you should have $600,000 in accumulated assets, but you only have $250,000.  You have three options to remedy the situation:

  1. Save more money
  2. Delay retirement
  3. Take on more risk

which option do you feel most comfortable taking?”

I never considered option three as a real option, but a lot of other financial professionals do.

Is there a way to minimize the sequence of returns risk why not necessarily eliminating the hopes of higher returns?  Indexed universal life insurance (IUL) could be an answer.

I don't want to leave anyone with the impression that IUL is immune to the sequence of returns risk…it's not and I'll quantify that statement in just a bit.  But it has features that make it more protected from the phenomenon than most other accumulation strategies without a major sacrifice to accumulation potential.

Indexed universal life insurance is a specific type of universal life insurance, that pays the policy owner interest based on the movement of a market index–usually stock market indices, but some also offer bond indices as well.

What happens to indexed universal life insurance if we run it through the exact same sequence of returns form the scenarios we highlighted above?

Let's take a look:

IUL 1999 to 2018 Sequence of Returns

In this example, we're using the same $10,000 paid annually to an indexed universal life insurance policy.  We have adjusted the cash values for all expenses charged by the life insurer.  The specific index account option we selected was an uncapped S&P 500 index with a 1% guaranteed floor.

We also included any guaranteed bonus interest (also known as an index credit enhancement).  The resulting CAGR is 5.29%.  This lags the traditional index investment, and we'd anticipate this.  If indexed universal life insurance came out ahead, it would call into question all sorts of things we think we know about various investment markets.

This means the growth curve for indexed universal life insurance is less steep than for a traditional index investment.  But do take note of the fact that in no year, does the cash balance on the indexed universal life policy fall.  This is a critical component behind IUL's insulation from some of the impacts of the sequence of returns risk.

Now, let's look at the results for indexed universal life insurance when we do the same reverse order of returns we did to the index investment:

IUL 2018 to 1999 Sequence of Returns

The overall accumulation does go down.  Indexed universal life insurance is not immune to the impact of sequence of returns, but notice how much closer the end result is to the original scenario.  The CAGR, in this case, is 5.01% and we end up with about $11,000 less.

The impact of changing the order in which the returns take place is nearly 13.5 times larger with the mutual fund versus the indexed universal life insurance policy.  Also notice that yet again, there is no point in the 20 year period when the account balance declines from the previous year.

Indexed Universal Life Insurance Significantly Reduces Sequence of Returns Risk

The strong downside protection offered by indexed universal life insurance significantly reduces the dangers posed by the sequence of returns risk.  IUL is not immune, the order of returns still matters.

But because indexed universal life insurance stops losses, it provides a unique strategic opportunity to maintain some upside potential while eliminating substantial drawdowns from market corrections.

Recent market fluctuations left some people a little nervous.  Fundamentally speaking, there's really nothing wrong with the U.S. economy.  Nothing that would necessitate a 1,000 point drop in the Dow Jones Industrial Average.  But sometimes markets move with erratic behavior that completely ignores the soundness of financial statements.  This serves as a stress-inducing reality of market investing.

We heard no concerns from indexed universal life insurance policyholders over the past week.  They knew that worst-case scenario, they might not receive an interest credit for the most recent time period.  But even that reality didn't play out, as most held market segments that were still up despite the market plunge.

8 thoughts on “How Indexed Universal Life Insurance Minimizes Sequence of Returns Risk”

  1. Awesome, I just listened to the last two 8% stock market return podcast and the following IUL one. Really good insight. (A semi retired Financial Advisor, still doing the Insurance side though)

  2. While IUL does reduce the sequence of returns risk, there are other factors in IUL that seem to make the risk higher than you note above. Your charts do not seem to integrate insurance charges that would be greater with a lower account value and greater net amount at risk. A bigger factor is the planned use of leveraged loans for retirement income. A low or zero credit turns the loan charge rate into a loss increased by the size of the loan relatively to the net cash value. Then there are aggressive IULs that have asset charges or other added costs that effectively mean there is not a 0% floor.

    • Hi Chris,

      Given your past contributions, I’m a bit surprised by the awful straw-man (actually straw-men) you committed here. You’re not really arguing against the point of this blog post, but rather building your very own topic in another universe to (perhaps) create your own platform to discuss IUL on our web site. I’m not sure why you’d choose to do this, but since you came here and started it, I’ll address your points:

      1. Higher net amount at risk policies and negative/flat market years. There’s no argument from us that this would be a bad application of indexed universal life insurance. We’ve written extensively about how to properly design and implement IUL or the purpose of wealth accumulation through life insurance. Higher death benefit than necessary for MEC/7702 compliance doesn’t fall into those recommendations. Bringing that up either uncovers your own misunderstanding of how to use life insurance in this fashion, or it’s used as a means to cast doubt in your favor among those who don’t fully understand the subject by making your first straw-man. In either case, making that argument pegged to this blog post puts us in two entirely different zip codes.

      2. Bringing up indexed loans commits the same fallacy above only using a different subject line. We didn’t say anyone would use an indexed loan in the blog post, we never discussed distributions at all. Again, this is a manifestation of your lack of understanding or an intention to mislead by poorly executed grandstanding veiled by an attempt to appear as a good samaritan. Regardless it’s a topic totally unrelated to the subject at hand and commits the same half-assed argument we’d expect from a character like Suze Orman et. al.

      3. There are lots of flavors of lots of products/idea/strategies out there. I can find broad index funds that charge considerably more than average. If I follow your logic from above, people should be very concerned about index investing because those index funds exist. To claim that IUL poses additional risk because some products are not well suited for a specific application or they have less favorable attributes than other IUL products probably takes the cake for the most illogical argument ever made by a commenter on this blog.

  3. You should check out MPI create by Curtis Ray and see how he uses an IUL to create an Uninterrupted Compound interest account to have a consistent income in retirement, the way he sets the IUL is with option B with the least amount of life insurance and maximum cash benefit that has a 0 floor and up to 11.5 interest rate. Than he uses the uses the insurance companies money by way of a 4% loan earning 7% and is able to add an additional 3% to your cash value along with the 7% your Money is earning with your main monthly premium. It’s a win win for you and the insurance company. (Promotional Comment Removed).

      • Can you please revisit this? I understand the potential issue of borrowing to buy more life insurance but I don’t believe, in the case of MPI, that that is the method in play. MPI simply borrows the insurance company’s money and places and exposes it to the underlying success of the policy’s indexing strategy, albeit limited by the interest rate spread, which recently has allowed a few percent advantage. To explain this post away by referring to your previous post regarding purchasing more insurance seems flawed. Please explain further.


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