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 deserves 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 return over current assumption universal life insurance.
It's tough to be correlated to the market when 90+ percent of your holdings are in assets that have little to no correlation with the stock market. In other words, IUL may walk like the stock market (and a lot of agents/brokers may want that to be true) 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 10, 11, 12, etc. percentage cap rate, there's something like a 0 or 1% 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
Remember back to that intro to Stats class you took in college. You know, the one the sophomores across the hall said was an easy A for the math credit you needed. You no doubt happened upon a seemingly insignificant concept known as regression to the mean.
Regression to the mean the notion upon which several statistical procedures and inferences take shape. It is the recapitulation of the Law of Large Numbers (though admittedly somewhat subtle) and is the foundational 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 economic 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 11% 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 average return 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 11%. So, if I were in market my return would be 7%, -10%, and 15%. The IUL is 7%, 0%, and 11%.
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 $118,770 or 5.90% CAGR.
We've talked about looking at indexing in Monte Carlo simulations. We also noted there that indexing strategies have at times 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 does experience bad stretches of time.
Despite being subject to movements in the stock market, indexed universal life insurance can produce dramatically different results from the market during these times periods. 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 for purchasing life insurance.
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 return one to two hundred basis points above current assumption universal life. The indexing is how it gets there.
It's a little riskier than whole life insurance, and for that there is maybe 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.
11 thoughts on “Indexed Universal Life: Market Neutral?”
Good article, any particular IUL’s you like? What’s the average guaranteed rate you will find in these IUL’s?
IUL’s seem too risky, what if you get a 0 index credit with a minimal floor rate that can’t keep up with coi etc. Do you see that as a valid concern or should these IUL’s be overfunded a bit? How people design these to supplement retirement seems tricky if not risky as hell, too many moving parts!
Sure seems like a product you would have to babysit for your client unlike wl where you set it and forget it.
The market changes a lot so it’s tough to hold one out as the ones we like. When we look at a case, we analyze just about everyone and then we do the following:
1. We look at the math
2. We look at the logic
Math is simple, who shows us the best numbers
Logic is a bit tougher. We need to look at things like financials, reputation, historical performance (not just the IUL)
The problem you bring up about performance is understood but significantly abated when set up and funded correctly. We don’t use IUL for anything but retirement income/wealth accumulation. When we do this, we are solving based on outlay for minimum death benefit under guideline premium test. So COI and all other costs are as low as we can get them, and cash values are as high as we’re ever going to get them.
You’re correct in stating that it needs some attention, but it’s certainly worth the extra benefit at times and if you ignore IUL categorically in favor of whole life, you may do so at your peril.
What peril are we talking about? lol sounded ominous.
So your saying an IUL is better than a parwl for retirement scenarios?
The largest reason and call me an outlier, but with the way the deficits are heading, currency is diving. I don’t think there will be an upside for a long time…
The perfect storm is brewing.
There’s no way to say categorically that ParWL or IUL is better in retirement scenarios…too many variables to make that sort of sweeping statement.
Both products can work quite well as a supplemental retirement income stream, but as to one being better than another…depends on the age of the insured, their health, how long
are they willing to fund, and any number of other variables.
What do you mean by their not being an upside for a long time?
Well said. Only thing I’d add is that IULs also contain a fixed component, so that for any segment or year we can decide to move a portion or all funds to the fixed rate (currently 4-5.5%) if we feel like we’re in for bad times. Not trying to get into a ‘timing the market’ discussion, just adding that the option is available…
Also, the options budget is a factor of the fixed interest you’re giving up by choosing the indexing method. They don’t just assign 10% or whatever of their budget to options, but rather they choose hedging amounts based on what policy owners “give up” when they forgo the fixed rate and choose an indexing method.
I have a WL policy with LLIC (not one of your best of 7 insurance companies, but again, it is how it was set up that matters most), but I wanted to start thinking legacy for my 2 boys, ages 7 and 4. Knowing how much longer they have in terms of time and compounding, what is your thought of an IUL over a WL policy for minors? It seems that the theoretical 2% edge over 70 plus years should statistically knock the socks off of any WL policy.
One of the common boasted benefits of UL on children is that the cost of insurance is so low that you can accumulate a good bit of cash during that period to your (or the insured’s) advantage. Sounds great in theory; in practice I’ve not always seen that necessarily yield quite as much extra cash as others would have you believe.
Still, there are indeed times we’ve seen indexed universal life insurance project considerably higher than whole life insurance when the insured is a child and it’s certainly not a bad idea at all.
One thing you can’t guarantee in IUL is the cost of insurance. Also the guaranteed cash value of a Whole life policy vs the guaranteed cash value of an IUL is not comparable. Finally all of the IUL illustrations I have seen that are presented to the public are using a linear rate of return far above the market averages of the past 10, or 20 years. Much of what is presented to the public (my opinion) is nothing more than pie in the sky!
Nothing in this blog post spoke to the guaranteed rate of indexed universal life insurance, nor was there any comparison to the guaranteed cash value of whole life insurance to indexed universal life insurance. But since you brought it up…
The cost of insurance for both products rises over time. Whole life insurance simply places a much larger charge on this component in the beginning to capitalize the expense later on. We can accomplish a very similar strategy by funding the universal life insurance policy with a matching premium relative to the death benefit that we’d see in a whole life insurance policy. So for example, if the premium for a $1 million whole life policy is $30,000 per year, we should fund the universal life insurance policy at $30,000, event if the required premium is much less.
If you don’t think whole life insurance cost of insurance fluctuates after issue, you’ve not looked at many in force whole life policies for insureds at advanced ages. Dividends can at times slow or decrease due to mortality assumptions about the bloc of insured’s in these situations. While they do not usually have to worry about losing their coverage if they simply pay their premiums and never take policy loans, this aspect of whole life insurance can cause the same problem for which many criticize universal life insurance. Now, in both cases, the “problem” is easily manageable with a half way competent agent, so to suggest that either is a major fault that exposes the policy owner to major risk is an overblown scare tactic.
We were probably one of the first web-based resources to challenge indexed universal life insurance projections. We have blog posts dating back to 2011 that argued for subdued interest rate assumptions on indexed insurance products. We have also taken a lot of time to discuss the mechanical nuances of indexed universal life insurance and how that might lead someone to make overly optimistic projections on various IUL aspects especially income scenarios.
You’re absolutely entitled to your opinion. And if you wish to only transact business with whole life insurance because that’s the end of your comfort level, I have no problem with that. But further projecting your own biases or misunderstanding of indexed universal life insurance in an attempt to dissuade people from it is a disservice to the public at large.
Truthfully, we probably recommend whole life insurance versus index universal life insurance at least 5 to 1 respectively these days, but that does not mean we’re going to suggest that whole life insurance is better. It’s different. No need to speak badly about one or the other.
A few questions,
1. Will ParWL or IUL for cash accumulation be better or worse under 2017 CSO tables
vs 2001 CSO, & is it too late to be issued a policy under 2001 CSO?
2. Will a survivorship policy accumulate more cash?
3. Will a policy via premium deposit account accumulate more cash than annual
payments? For example, $70,000 lump sum via premium deposit vs. 7 annual
payments of $10,000.
1. For most CSO 2017 policies, we will most likely see a small decline in rate of return on cash value when compared to CSO 2001 products. This is due to the higher required death benefit on CSO 2017 products, due to lower mortality assumptions the table establishes.
2. I’m guessing you mean will survivor ship accumulate more cash than a single life policy. This is a mixed bag that depends on the company, but the general trend at this point is gives single life policies a slight edge.
3. The policy won’t accumulate any more cash per se, but you will achieve a slight bump in overall rate of return due to the interest paid on the premium deposit account. Of course, you have to factor in the interest you would earn elsewhere and determine if you’re better off leaving the money there until you it goes into the life insurance policy. Keep in mind that interest earned on a deposit account (or premiums discounted, depends on how the company does it) is taxable to you as ordinary income.