#134 | The Case For VUL
There is no product category more maligned than Variable UL. At its peak in the late 1990s,the general euphoria about the stock market, what Alan Greenspan called “irrational exuberance,” found its avenue in the life insurance business with VUL. And why not? VUL offered a way to use booming stock market returns to fuel tax-free policy distributions or cheap life insurance premiums with illustrated rates at 10% or higher. It quickly grew to become the dominant Universal Life product category and as ubiquitously sold as Indexed UL is today. VUL’s fate was inexorably tied to the fate of the bull market and when equities cratered in the early 2000s, so did VUL. But unlike equities, VUL sales never recovered. Today, VUL makes up just a tiny sliver of the overall accumulation product market. This raises an interesting question – what’s keeping VUL on the mat?
In my mind, the answer comes down to a central misconception in our industry. We have a terrible time separating the performance of a product, whether real or illustrated, from the product itself. The fact is that they are two very different things. In any Universal Life policy, the product itself is life insurance coverage that can be maintained as long as specified and scheduled policy charges are satisfied. That’s the core of how every Universal Life policy works. Life insurance protection provides us with the other benefits that we enjoy, particularly the fact that gains in life insurance accrue tax-deferred and can be accessed tax-free through policy loans.
To the extent that the client pays more than the required charges and creates a savingsaccount within the product, what we call the account value, then the account value is also eligible to earn interest. Interest can be earned with fixed interest credits (UL), indexed interest credits (IUL) or by investing in separate account funds (VUL). The level, timing and variability of these interest credits make up the performance of the product.
Most of the black eyes in the history of our industry have come from our inability to separate these two factors and VUL is a prime example. The product itself got blamed for poor performance in a cratering equity market. The general narrative was that Variable UL failed, but that’s not actually what happened. The product itself continued to provide life insurance coverage funded with a specified schedule of charges – in other words, it did what it was designed to do. The problem was that the separate account funds, which have nothing to do with the insurance company or the product itself, did not meet the expectation of continuous12% returns forever shown in the as-sold illustration. And even there, was the problem with the funds or the 12% illustrated rates? As usual, selling illustrated performance rather than life insurance got us in trouble.
But instead of laying the blame at the feet of agents and carriers who should have known better, a different story took root – that the product itself actually was the problem. The story goes that the annual charge deductions in Variable UL simply aren’t a good fit for equity volatility. When markets are down, policy charges still come out. And actually, it’s worse than that. One of the biggest charges in later years is Cost of Insurance Charges, which are based on Net Amount at Risk (NAR = Death Benefit – Account Value). As performance declines, COI charges actually go up. Theoretically, this interaction of increasing charges with declining account value kicks off a death spiral at the first hint of a downturn that will destroy every Variable UL standing its path. And that, my friends, is why VUL from the 1990s blew up. Definitely not 12% illustrated rates. VUL just doesn’t work.
Except that’s not actually true. The death spiral doesn’t exist – at least, it’s not nearly as prevalent or problematic as the story above might lead you to believe. Just think about it. Those fixed policy charges being deducted in down years are coming out monthly, which essentially means that they’re being dollar-cost-averaged into the account value. Furthermore, if the policy has been overfunded properly, then the policy charges don’t make up more than a few percent of the total account value – hardly enough to collapse the entire product. Even COIs cut both ways. Yes, COIs increase when NAR increases from a shrinking account value. But in bull years, they decrease as NAR decreases, which means that the policy performs better than might otherwise be expected. The only time policy charges should kick off a death spiral is in extremely, abnormally adverse return scenarios.
That’s the intuition. Fortunately, the Dynamic Illustration Tool gives us a chance to test it out. For this analysis, I used a 45 year old Preferred Male with a $1M death benefit and a standard Universal Life charge structure. The funding pattern is 7 near-maximum non-MEC premiums. Each scenario uses random historical S&P 500 returns and is ranked from the highest performing S&P 500 scenario to the lowest. I should also note that the S&P 500 here does not include dividends, so don’t focus on the expected performance of the products itself. The goal of this analysisis to show the degree to which different volatility and return sequences flow through the charge structure of the VUL contract and impact the actual 20thyear CSV IRR. If all policy charges were deducted as a percentage of the account value, then a particular S&P 500 scenario would produce an identical return in the VUL product minus the charges. But since the charges are a combination of fixed amounts, premium loads and COIs, there is going to be a deviation – the question is how big the deviations are in different return scenarios.
What this chart is showing you is that VUL products generally follow the performance of the separate account assets. In other words, the death spiral understanding of how volatility interacts with the policy charges doesn’t play out in the real world. You can see that the VUL performance tracks almost linearly with the S&P 500 with occasional and minor deviations. The part that the death spiral story gets right is that the deviations seem to almost universally be in the wrong direction. Every time the blue line dips below what appears to be the trend, that’s a scenario where the particular return sequence from the S&P500 interacted badly with the product. You can see that those deviations are more common and larger in size in scenarios with lower S&P 500 returns, but they’re hardly catastrophic. You don’t see situations where the S&P 500 return is 3% over 20 years and the policy lapses because of the charges. VUL is actually remarkably stable even in extremely bad return scenarios.
Simply put,the idea that VUL is a poor fit for equity volatility is simply false under certain conditions, the chief of which is that the policy has been funded to the non-MEC maximum. The small deviances in the graph above are the result of policy charges constituting a small percentage of the account value. But if charges equate to a large percentage of the account value because the policy hasn’t been fully funded, then the deviances are going to be larger. A lot larger. Just take a look at the graph below, which is identical to the previous scenario but with half as much premium being paid.
This is why people get spooked about VUL – if it hasn’t been properly funded, then policy performance is all over the place as equity volatility interacts with policy charges. But even here, just one out of the 500 scenarios had a policy that actually lapsed by year 20. All of the other ones just exhibited various amounts of drag from the policy charges. I’d even go so far as to say that as long as equity returns are above 5% over 20 years, even an underfunded policy like this one generally hangs together and delivers about the same performance relative to the S&P 500. Yes, it’ll bounce around more, but it does what it’s fundamentally supposed to do.
The other condition necessary for the success of a VUL product is proper client expectations. Showing a VUL illustration at 12% is like leaving a fresh piece of meat on your back porch and expecting it not to rot. Funding a VUL at a minimum premium based on a 12% illustrated rate is like getting your client to eat it. Not to belabor the analogy, but the problem wasn’t the meat but rather how agents handled and served it. And, perhaps, the fault also laid at the feet of the butcher who was more than happy to sell meat to a customer who had no idea what to do with it. But, regardless, the fact remains that VUL illustrated rates are a choice. They are securities products. They don’t have “crediting rates.” The illustrated rate is just a tool for showing how the product works, not for setting client expectations. Interpreting it as anything more than just that implies that you’re in the business of projecting separate account returns for the next 60 years down to the decimal point – and I suspect that’s a business most insurance agents don’t actually want to be in.
If those conditions are met, then VUL is a powerful tool that is far too underappreciated. Yes, yes, I know that equity markets are currently teetering like the town drunk – but that has nothing to do with the product called Variable Universal Life. That product offers a variety of different ways to get performance, including options with and without a lot of equity risk. The simple fact is that VUL is and will always be the most versatile and applicable product we sell. If you want proof of that, look no further than the trillions of dollars that retail investors put into financial products that are not general account life insurance contracts. The only product we have to offer to clients that looks like the other places they put their money is Variable UL. Simple as that. And on those merits, VUL should be a much larger market than it is today. That’s why I’m bullish on VUL.
So, why are VUL sales on the mat? I wanted to lay out the technical case before I got to the real reason. Yes, there’s a common misunderstanding about the interaction of policy charges and equity volatility. Yes, agents have been spooked by VUL policies imploding after not being funded, illustrated and managed properly. Yes, a lot of agents have dropped their securities licenses and can’t sell VUL anyways. But there’s a major reason I left off – VUL isn’t sexy. All it does is take investments that are similar to what the client is already making elsewhere and wrap them in tax efficiency and death benefit protection. The agent isn’t selling a secret sauce. It’s just, you know, a basic, boring, life insurance sale that trades on the core elements of the product – death benefit protection and tax efficient accumulation, fueled by traditional asset classes like stocks and bonds. Effective, but kind of boring, right?
Wouldn’t it be so much more fun and interesting to sell a product that has no risk*, illustrates better than VUL**, generates huge income distributions*** and can be premium financed****, all courtesy of an asset class that delivers consistent 50% compounding profits forever*****? Wouldn’t that be a much cooler conversation to have with your wealthy prospects? Wouldn’t it be great to offer something that other advisors who only use boring, traditional asset classes don’t know about? And wouldn’t it be even better if you didn’t need a securities license to sell it?
See, the biggest challenge for VUL is Indexed UL. Our industry has decided to convince itself that Indexed UL is truly the better solution, that we have created an asset class that is a superior application for life insurance than traditional asset classes. That we, the life insurance industry, have cracked the code on a low risk, high return asset that apparently no one else can see or create. Doesn’t that seem more than just a little bit preposterous? Not when there’s so much money being made in believing that it’s actually quite reasonable. And until we get straight on Indexed UL, attempting to grow VUL is going to be a hard bargain – despite the fact that it is actually the inherently superior product chassis.
*Of course, Indexed UL isn’t actually riskless, but a lot of agents like to act like it is.
**At the same crediting rate, many IUL products blow the doors off of VUL thanks to all of their bonuses and multipliers.
***There is no illustrated loan arbitrage in VUL, but modern IUL products that built with bonuses and multipliers can show several percentage points of illustrated loan arbitrage, AG49 be damned. As a result, illustrated income from some IUL products dwarfs illustrated income from VUL products with several percentage points higher illustrated rates.
****One of the many dirty little secrets of the Indexed UL market is that a large portionof the business is premium financed. Virtually all of those sales are predicated to varying degrees on the idea of continuous arbitrage between the illustrated rate in the policy and the cost of borrowing the premium from the lender. The same sale is not possible nor permissible with Variable UL due to Reg T.
*****Without the notion that systematically buying equity call options produces long term profits, Indexed UL would illustrate identically to Universal Life.