#86 | PacLife PDX – Part 7 – Leverage, Leverage, Leverage

This post draws heavily on previous posts that discuss the mechanics of the Performance Factor, which I divide into two independent parts – the MX Factor and the QX Factor. You can find the initial post on the MX Factor here and the two posts on the QX Factor here and here. 

One of my more astute readers shot me a note last week with a very simple question – what happens when you start looking at PDX through the lens of lower illustrated returns? Of course, he knew the answer. The fact that PDX is extremely sensitive to the illustrated rate assumption is broadly acknowledged in the market. What’s more interesting, though, is why PDX is so sensitive. That’s what we’re going to tackle in this post.

If you really want to understand why PDX is so levered to the illustrated rate assumption, you have to start by rethinking what is meant by the term “illustrated rate.” In an Indexed UL, the illustrated rate is taken to mean the rate of return illustrated to be credited to the eligible account value in the policy in any given year. The eligible account value is usually the average account value in the preceding 12 months. So if you say that the illustrated rate in a product is 6%, then you’re taking for granted that the 6% is multiplied by the average account value and added to the end of year account value.

The problem with applying the usual logic to PDX is that there is a direct link between the base charge and the Performance Factor, as I’ve discussed at length in previous posts, which augments the indexed credits being applied to the policy. This is the mechanism I call MX (detailed in Part 2). As you’ll recall, the base charge in PDX is directly used to purchase more call options (and therefore index exposure), which leads to a Performance Factor greater than 1. But that base charge is also being deducted from the account value, which makes the question of the “illustrated rate” a bit squirrely. The table below shows a quick mathematical example that I think illustrates the problem pretty well.

As you can see, the imputed illustrated rate in this particular scenario for PDX is 11.97%, which sounds absurdly high. It is certainly absurdly high, but the problem is the fact that the base charge exists on both sides of the illustrated rate equation – it is both deducted from the account value and applied to the index credit. This renders the concept of an “illustrated rate” inapplicable to PDX because the base charge appears on both sides of the equation. You can get illustrated rates in PDX that are easily as high as 25% in some thin-funded scenarios, but that’s not a helpful or useful way of thinking about the performance of the product because a significant portion of the illustrated rate is just going to refund the base charge. Fortunately, there’s a simple way to get around this problem and make PDX look and feel like a conventional product, at least when it comes to the idea of the illustrated rate.

As with algebra, the easiest way to clean up the equation is to eliminate the common variable from both sides. In this case, that means eliminating the base charge from both the policy deductions and the Performance Factor. Doing so will put PDX back on the same mechanical playing field as its peers. The math is pretty simple – just subtract the base charge from the policy deductions and from the calculated credit. In the example above, that means the calculated credit is equal to $51,420 ($82,100 credit minus the $30,680 base charge). Below is the same example I used above but reworked to eliminate the base charge. You can see that the final account values are identical, which is the “proof” for the formula.

There’s a lot to unpack here, so grab a cup of coffee and stick with me. First, notice that the calculated illustrated rate has dropped from 12% to 8%, which is the direct result of removing the base charge from both sides of the equation. You can fairly and accurately say that PDX is illustrating performance of 8% and that that number is comparable to illustrated rates in other life insurance products. This solves the main problem.

Second, even though the base charge has been eliminated from both the deductions and credits, notice that the gains from the base charge have been preserved. This is the key. Remember that the base charge is essentially used as extra options budget, so whatever option profit assumption is applied to the option budget is also applied to the base charge amount (which, again, shows up in the form of the MX portion of the Performance Factor). The illustrated rate in PDX, then, isn’t really an illustrated rate unless you go through all of the math that I did above. The illustrated rate in PDX is actually just one part of the ratio that all money spent on options will be illustrated to earn in any given year, with the other part of the ratio being the options budget. For PDX, the ratio is 6.21% (max AG49 illustrated rate) divided by 4.1% (options budget), which is equal to 1.51.

In the example I used, the ratio is 1.46 (6% illustrated rate / 4.1% option budget) and you can clearly see it playing out in the illustrated benefits of the base charge. Once you deduct out the base charge from both sides of the equation, all that matters is the multiplier on the base charge. If the multiplier is big, the benefit is big. If the multiplier is small, the benefit will be small – or even negative.

To be clear, the illustrated performance of all Indexed UL products is powered by the ratio of the options budget to the illustrated rate. I wrote an entire article on this issue in the AG49 series (which you can find here). But the differences between PDX and every other product is that the net returns from the base charge can be both positive or negative. The only way to see that in full clarity is to strip out the base charge from both sides of the illustrated rate equation. All you’re left with, then, are the illustrated gains (or losses) from the ratio multiplied by the base charge. The base charge is a fixed cost. The earnings on that fixed cost are pegged to the ratio of the illustrated rate to the options budget. Small changes in the ratio can amount to huge percentage impacts on the gains from the base charge. Remember what I said about PDX being leveraged? This is the very definition of leverage.

Before we look at real numbers from the illustration, I want to keep working through my example. I used a 6% illustrated rate. But what happens to my little example if I start monkeying around with the illustrated rate and, by extension, the ratio? See below.

So, why is PDX so sensitive to changes in the illustrated rate? Because the MX Factor is leverage and leverage is always sensitive to return assumptions. You can clearly see this playing out in the numbers above. When the illustrated rate drops by 17%, the net gains from the MX portion of the Performance Factor drop by 53%. When the illustrated rate drops below 4%, which is below the option budget of 4.1%, the MX gains actually go negative. I’m sure you won’t be fully convinced by my little example, so I created the graph below using illustration output on a 45 year old Preferred Plus male and $1M of death benefit with 7 maximum non-MEC premiums.

The black dashed line is a 1-to-1 ratio of the illustrated rate to the Year 30 CSV IRR. A product that moves in lock-step with this dashed line, as PacLife’s very simple and straightforward PIA 5 product does, is an indication that there is little funny business (leverage or other nonlinearities) in the policy structure. For example, at a 6% illustrated rate, the gap between the illustrated rate and the CSV IRR in PIA 5 is 0.95%. At 3%, it increases to just 1.18%, which is a remarkable testament to the stability of the product under very different return scenarios. For Option 2 PDX, the gap at 6% is actually negative thanks to the leverage within the product and clocks in at -0.78%, meaning that the CSV IRR is 6.78%. But leverage cuts both ways. At 3%, the gap is a whopping 2.92%, meaning that the CSV IRR is just 8 basis points. In other words, as I’ve said before, good outcomes look really good with leverage and bad outcomes look really bad. The chart below fills in the gaps. You’ll also notice that Option 1 PDX is significantly less levered than Option 2 PDX, thanks to lower base charges.

In short, removing the base charge from both sides of the equation is kind of like that old Warren Buffet quote – when the tide rolls out, you see who’s swimming naked. In this case, removing the base charge allows you to see just how levered PDX is, particularly in its Option 2 flavor, and explains why this product is extremely sensitive to illustrated rate changes. In a broader sense, this same math applies to any product where a charge also goes to fuel upside in the product. Account options within Indexed UL products that have a 1% floor and higher caps, which are quite common, are more levered than accounts with a 0% floor and lower caps. Products like AXA’s IUL Protect that have an explicit asset charge that (partially) funds a multiplier are more levered than products without the charge and the multiplier. What sets PDX apart is not the presence of leverage, which is present in every Indexed UL illustration, it’s the size and impact of the leverage. In Option 2 PDX, the base charges can eat up 4-5% of the account value in a product that has been funded to the max and much more than that if the product has been funded with less premium, but those charges go to fuel stupendously attractive upside when performance is strong. All of this analysis just solidifies what I wrote at the beginning of this review on PDX – if you like Indexed UL, PDX gives you more leverage to the bet than any other product and will consequently deliver very attractive payoffs. But if things don’t work out well, it will punish consumers more than any other product. So if you’re selling PDX, you better have extinguished any kernel of doubt about long-term options profits being greater than zero – and I would expect to see your brokerage account chock full of equity call spreads as investments.

But recasting the math in PDX by removing the base charge from both sides of the equation also casts a new light on the product itself that, frankly, I didn’t even see until I started building models for this post. This kind of feels like my Intro to Calculus class where we spent the entire year talking about complicated stuff only to be shown in the last week how to do a simple derivation. If you feel like this PDX series has been flirting with the outer edges of your mind and you just want something simple to walk away with, then you’re really going to like the next post.