#56 | Indexed UL and Illustrated Rates
Whenever I talk about Indexed UL, someone inevitably asks me what illustrated rate is best for Indexed UL. I have a love/hate relationship with this question because the answer is irrelevant. Illustrations of future performance are always inaccurate. Choosing the “right” illustrated rate is a bit like scouring a casino to find the “right” slot machine. As with Indexed UL, the machine’s unique odds are impossible to figure out and glitziness doesn’t necessarily translate into dollar winnings. We’re faced with such a dearth of knowledge that choosing the right illustrated rate is an exercise in futility. The only question is how far off from reality the illustration will be. But on the other hand, understanding Indexed UL well enough to critically evaluate the methods for calculating illustrated rates is essential. I find that people who know they don’t know much about the product tend to be very conservative. People who don’t know that they don’t know much about it tend to be very aggressive. But folks who really know the product take a much more textured look at illustrated rates by taking all of the different calculation options into account. I’m going to give a brief tour of the options and provide a bit of insight into the technical underpinnings.
The General Account Yield Method
Indexed UL is fundamentally driven by the same economics as Current Assumption UL (CAUL). The carrier’s general account yield is the long-term performance driver in both cases. The only difference is how the yield is passed through to the policyholder. In CAUL, the yield is paid to the policyholder in the form of a stated crediting rate. In IUL, the yield is paid to an investment bank that supplies the equity upside potential. For example, assume that CAUL offers a 5% crediting rate and IUL offers a 10% upside and 0% downside. Indexed UL offers the shot at a 5% gain (5%+7%=10%) or a -5% loss relative to the opportunity cost of capital (the 5% CAUL crediting rate). Assuming that the market is competitive and liquid, we’d assume that the long-term results of the tradeoff would be close to the same for both options because the risk is symmetrical (+5% and -5% for the client, +5% and -5% for the investment bank). Most products these days have a 12% cap, which seems to favor the client, but caps are non-guaranteed and I’ve argued in other posts that they’re currently inflated due to low market interest rates and high carrier portfolio rates.
This method leads to illustrating the Indexed UL at rate the carrier is paying to the investment bank (5% in the example above). The beauty of this method is that it is neutral as to the performance of equity markets, which would clearly benefit Indexed UL. In other words, if you’re not comfortable make statements about long-term equity returns, then this is the method for you. Show IUL at basically the same rate as CAUL or your best guess as to what the carrier is spending with the investment bank.
The Indexed UL Translator Method
If you do want to incorporate long-term equity assumptions into the general account yield story, then the IUL Translator (www.iultranslate.com) is probably your best bet. This simple tool essentially tells you how much equity returns will impact Indexed UL rates over the carrier’s general account yield. Indexed UL will clearly beat CAUL in a booming equity market. But how big is the impact? The Translator uses pricing data from investment banks to determine the riskiness of the Indexed UL crediting strategy in relation to the riskiness of full equity exposure. Given that risk and return are two sides of the same coin, determining the riskiness allows us to also determine the return. For example, an IUL with a 10% cap and 0% floor would cost approximately 4.4% to purchase from an investment bank. Assuming that equities perform at 8%, then the IUL would perform at approximately 5.5%. In other words, the excess return from equities of 3.6% (8%-4.4%) would translate to about 1.1% in extra IUL return.
The Translator primarily tells us three things. First, the driver of IUL performance really is the general account yield because it impacts the cap and provides the baseline rate of opportunity cost of capital. Second, Indexed UL provides an attractive solution if equity performance is fairly low because it still captures some of the benefit of equity volatility (via the 12% cap and 0% floor) without much risk. Third, if you really think equities are going to boom, then VUL is a much better option. If equities actually do 8%, then a VUL will beat an IUL at 5.5% hands down.
Choosing an illustrated rate with the Translator comes down to making a reasonable assumption about caps (think of a 2-to-1 ratio to AAA bond yields over time) and equities. Given that the historical risk premium for equities over bonds has been about 2-4% (depending on how you calculate it and who you ask), then an equity assumption at 7-9% with a 5% option budget and 10% cap seems reasonable. If you use those metrics, you’ll end up with illustrated rates on IUL between 5.5% and 6%. And, in either case, VUL presents a better long term solution if the client is willing to stomach the risk. If not, then IUL may be a conservative way to get some equity exposure while taking a fairly significant haircut on returns. And if you think about it, then this is exactly what the IUL pitch should be – less risk, less return.
The Hypothetical Historical Lookback Method (HHLM)
Despite all of the merits of the two methods outlined above, the carriers have banded around using the Hypothetical Historical Lookback Method. The HHLM calculates performance assuming that the policy was purchased 20-50 years ago (depending on the carrier) and that the cap never changed. Both of these assumptions are fatally flawed. Indexed UL products have only been available since the mid-1990’s and no carrier has released the actual performance of its block of business. Far from being “historical,” the HHLM is purely hypothetical. Given that caps are a function of matching the carrier’s general account yield to the price of equity exposure, we know for certain that caps would not have stayed static over any lengthy period of time because general account yields change and so does the price for equity exposure. The HHLM essentially takes valid data and applies invalid assumptions to it. The results aren’t half right – they’re completely wrong. But they sure do look nice. The HHLM can generate illustrated rates between 7-9% for conventional indexed account options and in excess of 11% for others.
The HHLM is arguably a subset of both the General Account Yield Method and the Translator Method. It represents one potential outcome out of an infinite number of outcomes. Over the past 25 years (the standard HHLM period), carrier yields have ranged between 7-9%, very close to what the HHLM generates. Looking at historical carrier yield data to determine future illustrated rates with no adjustment for assumed equity performance would net close to the same numbers as the HHLM. Assuming historical equity returns of 10-12% with dividends (depending on the period and calculation method) on the Translator method will also get you very close to the HHLM. Put another way, the HHLM is math without theory. It doesn’t explain why the product does what it does, it just shows the data. The other two methods constitute true theories as to why IUL does what it does.
The “Right” Illustrated Rate
So what’s the right illustrated rate? There is no such thing, but both the General Account Yield Method and the IUL Translator Method will help you better explain to clients what Indexed UL actually does and why. It’s a fixed income product with an equity kicker. The fixed income piece is explained by the carrier’s investment yields. The equity kicker piece is explained by the IUL Translator. If you want to use the HHLM, then fine, just make sure that the client knows that it’s purely hypothetical and has absolutely no historical validity or bearing on future returns. The best way to illustrate IUL is to use the illustrations to explain the products. Once you’ve done that, then choosing an illustrated rate is a secondary consideration. Show 2%, 4% and 6%. Who cares? It’s not an important consideration if the client really understands the product. So let’s stop trying to find the “right” illustrated rate and instead start educating clients on what the product actually does.