Over the course of my life insurance consulting career, it’s been much more common to be called in to fix things that are already in place than to be called in to help understand and build something right from the get go.
There’s an all-too-common thread in many of these situations, and it’s that what policy owners are buying isn’t always actually what they think they’re buying. A list of examples would be very long but anything from the whole life (WL) and universal life of the 1970s and 1980s through premium financing and the intricacies of modern policies today would be on the list.
Indexed Universal Life
To illustrate what I mean, I’ll take the most simplistic of examples. We’ll start with indexed universal life (IUL). The pitch is fantastic, and it focuses on the story of an IUL policy having the upside potential of the stock market while having no down side risk. You could make double digit returns and never have a negative return. I have to admit, that sounds exciting.
What’s the told vs. sold difference here? Let’s start with what an index actually is and focus on the S&P 500. If I ask you what the S&P 500 return has been over time, you’d likely have at least a guess for me. Over the past decade, it’s been greater than 13%, over the past 40 years it’s been over 11% and over the past 100 years better than 10%. My experience is these numbers ring true to many people. However, the S&P 500 returned less than 6% over the past 20 years so it matters greatly what period you’re looking at.
The S&P 500 Relative to the S&P 500 Index
On a decade-by-decade basis, only half of the past 10 decades had total returns in the double digits with two full decades experiencing a negative return. But this isn’t the most important thing to understand. More important is what the S&P 500 Index actually is. Few people understand that the S&P 500 and S&P 500 Index aren’t the same thing. The S&P 500 Index doesn’t incorporate dividends in its return numbers. Does that make much of a difference?
With the exception of the past decade of a historical bull market, there’s no backtesting from today where the S&P 500 Index is double digits. The past 20 years? 3.69%. The past 50? 6.68%. The past 100? 5.97%. Over the past 100 years, reinvested dividends account for roughly 40% of total return. In the past 30 years, it’s about a quarter of the return. There are entire decades in which over half of the return is due to the dividends. If these are the S&P 500 numbers that indexed policies are actually built from, how should that affect decision making?
The National Association of Insurance Commissioners issued Actuarial Guideline 49 (AG49) in 2015. This guidance was an attempt to reign in crediting assumptions of IUL policies being marketed. Some like and some hate the guidelines, but they’re the rules of the land today. The current allowable crediting rates for new and in-force ledgers are based on 65 years of backtesting of 25-year periods. There are many thousands of data points and other parameters to be incorporated, but in the end, the crediting rates allowed are the result of a geometric average. This average is often referred to as the “compounded annual growth rate” or “time-weighted rate of return.” When we talk about averages, half the results are above this number and half are below. Remember, this is the maximum allowable illustrated crediting rate, yet it’s the number very often used as a default rate for sales ledgers and for managing existing contracts.
I’m not confident that regulatory maximums were ever meant to be default illustration rates. Effectively it means that an annual premium arrived at by using the AG49 limit has a 50% chance of turning out better than and a 50% chance of turning out worse than illustrated. Would a prospective policy owner really move forward on this modeling if that was fully understood? With some policy designs, the contract would stay in force, but with many I see in the field, the policy would cease to exist with the policy owner losing all premiums, cash value and death benefit.
Yes, even with a policy with downside protection that can never be credited at less than 0%, the cash value can go down, eventually to zero, with the policy lapsing. This truth is actually a surprise to many.
When the prevailing understanding of a consumer is that the S&P 500 is double digits and the proposed insurance ledger is assuming, say 6.5%, it may seem quite conservative. But if the actual dividend exclusive returns are understood to be a few hundred basis points lower, all of a sudden the transaction may not seem so conservative.
Sequencing of Returns
None of this analysis even takes into consideration the sequencing of returns. In the real world, it’s exceedingly important when a return is realized, not just what the return is. A 0%, 10%, 5% sequence is different from a 10%, 5%, 0% sequence. Interestingly, the only way an IUL ledger can be illustrated, an exactly even return year in and year out forever, is absolutely positively impossible to actually happen. There is, however, some limited access to independent modeling showing the effects of various sequence of returns, and it generally shows the policy falling apart well before expectations, and this would certainly affect choices of the decision maker.
Now that we better understand what IUL returns are built from, let’s look at the returns in policies themselves. Over and over again, I deal with policy owners who have a substantive misunderstanding of what they’re getting for their money. For some reason, when life insurance consumers hear the crediting rate, whether it’s the dividend rate of a WL policy, the market rate of a securities based policy or the rate we’re discussing of an IUL product, they think that’s the actual rate their premiums are earning, even though it’s actually not even close. There are commissions, premium taxes, overhead expenses, policy fees and mortality charges coming out. The net crediting rate ranges from modestly lower to drastically lower depending on the type of contract, how it’s built and the phase of the policy life we’re focusing on.
The Effect of Expenses
Looking to a real life example from not long ago, a very wealthy and financially sophisticated consumer was considering a significant IUL purchase. His attorney brought me in to provide some analysis. A meaningful point of the policy was cash accumulation, but per my perspective, it wasn’t at all built for such. Looking forward for this 50-year-old gentleman, the internal rate of return (IRR) on premium to cash value at age 65 was 1.10% assuming a 6.28% crediting rate. The expenses in the contract in the first 10 years totaled 58% of the cumulative premiums. Assuming the very unrealistic ledger provided to him panned out, the best IRR on premium to cash value over the life of the contract never exceeded 50% of the assumed credited return.
Why does this disconnect matter? Because he was single-mindedly focusing on the gross rate the agent told him rather than the deal she sold him. A well built contract could look much better, but even that will never perform as understood by most consumers.
Rather than focusing on the marketing story and the maximum allowable illustration rate, if a policy owner understood how indexes were actually calculated, the internal expenses of the contract, the effect of sequence of returns, the actual return on committed premiums, etc, do you think he might start asking additional questions?
What About WL?
Let’s turn our focus to traditional WL. Even more so than with IUL, the policy owners I talk with focus on the dividend rate. An actual life WL ledger recently provided to me assumed a 7.1% dividend rate. After five years, the IRR on premium to cash value was projected to be negative 6.13%. This is how WL is supposed to work, but the policy owner had no idea. After 10 years, the projected return was 1.23%. Because the dividend has come down, the new projected return after 10 years is half that. In 15 years, the projection is 2.90%, at 20 years it’s 3.64% and at 30 years it’s 4.02%. The dividend rate has been reduced again so even these numbers are outdated, and the new prospective return is lower.
The told vs. sold issue is especially important in this situation as the gross dividend rate was strongly and loudly and emphatically touted for the premium financing deal this policy was a part of. I'll tackle that issue in my next piece.