#150 | Lincoln Wealth Accumulate IUL 2019 – Part 2
The reason why Index Credit Multipliers have proliferated in Indexed UL products is quite simple. Every Indexed UL illustration shown at the maximum AG49 rate has an embedded option profit assumption, meaning that every dollar that goes to purchase options on the illustration shows up at the end of the year as an amount greater than one dollar. The core math of Indexed UL illustrations is as follows – dollars allocated to options get illustrated profits. More dollars to buy options mean more illustrated option profits. Hence, the frenetic race to build ever bigger charges to generate ever bigger Index Credit Multipliers and ever more aggressive illustrated performance with seemingly no limit, all while remaining AG49 compliant. Such is the state of Indexed UL.
Lincoln’s tack with WA 2019, however, is a clever new take on the now-normal Index Credit Multiplier. Imagine that you’re offered two $100 bets on a coin toss. Bet A has a payoff of either $0 or $200 for heads. Bet B is two sequential bets where the full winnings from heads on the first bet are rolled into the second bet, creating a payoff of $0 or $400. But here’s the catch – the largest bet you can ever make with Bet A is $100. You can’t roll your $200 winnings from round 1 of Bet A into a new $200 Bet A wager. Instead, you can only bet $100 and only receive another $200 payoff. As a result, the Bet A breaks even with Heads/Tails and has a payoff of $300 with Heads/Heads. Bet B, on the other hand, only pays of $400 with Heads/Heads. Every other outcome loses $100.
Mathematically, the two bets are both worth exactly $100 – but only if the coin is true. In reality, though, we don’t make bets on coin tosses precisely because they are true. Instead, we make bets on financial markets because the outcomes are random, varied and often skewed. Let’s replay the same two bets but instead of a coin, we’re using the S&P 500. Heads is if the market is up, tails is if the market is down over a year. The result is not the same as using a coin toss and not even close. Instead, the S&P 500 has historically been characterized by years of gradual increases punctuated by significant downturns. Since 1950, about 75% of annual returns in the S&P 500 have been positive and 50% of positive annual returns are sequentially followed by another positive annual return. In this scenario, both bets rise significantly in value because the likelihood of making money or breaking even increases. But the value of the Bet B is now larger than the value of the first bet because the likelihood of sequential positive returns is so high. Ask yourself – looking at the history of the S&P 500, which of the two bets would you take?
Traditional Index Credit Multipliers are analogous to Bet A. They deduct a specific asset-based charge and use it to buy index exposure. The next year, regardless of whether or not the previous year had a positive credit, they deduct another asset-based charge to buy another ICM. The Positive Performance Credit is analogous to Bet B – it starts with an asset-based charge, purchases an Index Credit Multiplier and then rolls the proceeds of that ICM into a new ICM. The PPC is akin to a double-or-nothing bet.
It is entirely possible that future iterations of Lincoln’s product or Indexed UL products released by other companies will rely entirely on PPC-type multipliers rather than “traditional” Index Credit Multipliers. The reason why is very simple – an illustration only shows sequential positive returns, despite the fact that real-world returns will not pan out that way. Sequential positive returns mean that there is no visible difference on the illustration between a PPC and an ICM because both are being triggered every year. There is no indication on the illustration that an ICM will be paid with every year of a positive return and the PPC only credits interest in double-or-nothing scenarios of two consecutive positive returns. In other words, illustrations are literally incapable of fully disclosing the risk of PPC-type multipliers because they can’t show variable returns. And yet, the illustrated benefits of a PPC come through clearly. Using rough math, switching wholesale from an ICM to a PPC will produce a multiplier that is higher than what it would have been otherwise. Take a look at the table below, which compares a standard product, a product with an ICM and a product with a PPC. The AG49 maximum illustrated rate is 6.12% and I assumed a 4.5% option budget with a 4.5% asset-based charge, just to keep things simple. I also didn’t assume any policy charges and I deducted the asset-based charge at the end, which isn’t exactly how Lincoln does it but it makes the math cleaner for a simple example.
|No ICM||100% ICM||136% PPC|
In this case, the PPC is 36% higher than the Index Credit Multiplier. That is not a coincidental number. The illustrated rate for this scenario is 6.12% and the option budget is 4.5%, which implies an option profit of, you guessed it, 36%. All the PPC does is roll the asset-based charge forward so that it earns the illustrated option profit and then is reinvested to earn the option profit assumption again. The higher the option profit assumption, the more leverage from using a PPC versus a “traditional” ICM, which in itself is leverage on option profits. And the impact of all of this leverage is not trivial – just look at how the IRR for this little two-year sequence jumps from 6.12% to 7.74% with an ICM and then to 8.14% with a PPC. Increasing the illustrated rate to 6.6% pushes illustrated option profits to 146%, right at the AG49 limit, and boosts the IRR on the ICM scenario to 8.7% and the IRR on the PPC scenario to 9.3%. It doesn’t take much to make a PPC-type multiplier roar. Indexed crediting is leverage. Index Credit Multipliers are leverage on leverage. The Positive Performance Credit is leverage on leverage on leverage. And for Indexed UL illustrations with up to 45% assumed option profits, more leverage always creates better illustrated performance.
Which is exactly why Lincoln handles it with kid gloves in their product. As I noted in the previous post, Lincoln doesn’t allocate the full asset-based charge to funding the PPC. Instead, they carve off whatever they need to fund the guaranteed multiplier and then allocate the rest to the PPC. Below is my rough guess at the PPC allocations for each account.
|Market Option Price||4.5%||4.5%||5.35%|
|Market Cost of ICM||1.25%||2.5%||3.0%|
|Actual Asset-Based Charge||2.00%||4.0%||6.0%|
|Allocation to the PPC||0.75%||1.5%||3.0%|
Relative to the scenario above, these are pretty conservative allocations to the PPC. For example, just running the raw numbers on the Perform account results in an 8.05% IRR for the two-year scenario above – not surprisingly, that’s 30bps higher than the 7.75% illustrated IRR at age 100 for a 45 year old. Had Lincoln chosen to allocate all of the asset-based charge in the Perform account to the PPC, the age 100 IRR would likely have been closer to 8.05% and an effective illustrated rate north of 8.35%. That’s the power of the PPC.
All of the analysis above has been working with a generic version of a double-down multiplier but there are some specific parts of the way Lincoln designed the PPC itself that need to be covered as well. The way that Lincoln calibrates the amount spent towards the PPC with the final maximum bonus amount is through something it calls the Positive Performance Range Maximum (PPRM). Intuitively, it’s the ratio of the multiplier purchased by the PPC allocation in the first year multiplied by the current cap as a percentage of the option budget. For example, if a 2.25% PPC allocation buys a 50% multiplier on an indexed account with a 10% cap and 4.5% option budget, then the PPRM = 50% * 10% = 5% / 4.5% = 111%. The lower the allocation to the PPC, the lower the available multiplier on the account and therefore the lower the PPRM and vice versa. It’s simply a way to translate the growth in the double-down bet amount into a ratio of the option budget, which ultimately determines the second year PPC multiplier.
Each of the three accounts eligible for a PPC have different allocations to the PPC, which you can see above. Therefore, they also have different current PPRMs of 69.11% for Balance, 103.67% for Perform and 136.11% for Perform Plus. That’s what Lincoln is referring to on the illustration when they describe each account’s exposure as medium, high or highest. If this all seems a little bit confusing to you then welcome to the club. It took me a few days to really start wrapping my head around the intuition for the PPC and I’d be lying if I said I thought I had it completely nailed. But I think the simple intuition is pretty easy – the bigger the allocation to the PPC, the bigger the PPRM and the bigger the final illustrated benefit of the PPC.
Some of the other parts are not quite so counterintuitive. For example, if option prices drop and Lincoln can suddenly afford a 12% cap with the same option budget, then the cost of the guaranteed ICM will drop and the allocation to the PPC will increase. That alone will increase illustrated performance, but it’s not acting alone. The higher illustrated option profits from a higher cap and higher AG49 maximum illustrated rate will fuel even more illustrated benefits from the PPC. Or, Lincoln could make the decision to keep the cap, drop the formal option budget and reallocate the savings into the PPC. On the flip side, rising option costs will increase the cost of the ICM and put pressure on the cap, both of which could be a drag on the PPC allocation and performance. The only fixed part of the equation about how Lincoln spends both the option budget and the asset-based charge is that it is obligated to allocate the right portion of the total amount to fund the guaranteed ICM for each account. Other than that, Lincoln has the full flexibility to allocate all or none of the option budget to supporting the cap or the PPC. It will be very interesting to see how Lincoln manages those two non-guaranteed elements in tandem over time.
The other quirky part about the PPC is that the formula makes an adjustment based on the account value in the current year and in the previous year. This might seem strange but it makes a lot of sense in practice. The first ICM within the PPC has a notional value equal to last year’s account value. Assuming a positive credit, the new account value will be higher than last year’s account value, which means that the value of the ICM is slightly lower as a percentage of account value. As a result, the PPC is a little bit less powerful than it might appear at first blush. But if Lincoln hadn’t done it this way, the cost to provide the PPC would have floated by anything that changes account value from one year to another – premiums, credits, charges, withdrawals, you name it. They would have had an option notional mismatch that is not beneficial. But because they make the adjustment, what you’ll see is that paying premiums effectively lowers the illustrated power of the PPC and that taking withdrawals actually increases the illustrated power of the PPC. Like I said, it’s quirky but it makes a lot of sense once you understand how the PPC works. You can’t offer a true double-down deal if the other person can add even more money to the bet right in the middle of it.
In the world of Indexed UL, the PPC makes perfect sense. Illustrated option profits of up to 45% have a regulatory stamp of approval in AG49. Leverage has a stamp of approval in AG49. The PPC simply provides a new way to increase leverage on illustrated option profits to deliver even better illustrated performance. It would be hard for someone to say that the ICMs are a reasonable and responsible product feature while throwing shade at the PPC. Lincoln even has a compelling argument for the PPC on the basis of historical S&P 500 sequences of returns. If the S&P 500 really does deliver sequential positive annual returns 50% of the time, then why would the PPC be a problem? Doubling down seems like a pretty good financial strategy, actually.
But how does it look in the real world? We’ll tackle that question in the next post with stochastic analysis using the proprietary Dynamic Illustration Tool.
This article makes repeated reference to the option profit assumption embedded in every Indexed UL illustration and I would be remiss if I didn’t mention that I’ve written several articles on why I believe that assumption to be fundamentally flawed or, at least, tenuous and uncertain. Without the assumption of long-term option profits, Indexed UL illustrates similarly to traditional Universal Life and all Index Credit Multipliers, including the PPC, illustrate limited or no benefits. But if you believe in long-term option prices, then you have to believe that every multiplier is a good multiplier.
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