#191 | PennMutual Diversified Advantage VUL

In the wake of the recent regulatory inquiry into multipliers and modifications that may need to be made to AG49 to “deal with” them, life insurers have started to explore what the next generation of Indexed UL will look like. If PennMutual’s Diversified Advantage VUL is any indication, the next phase of Indexed UL isn’t Indexed UL at all – it’s VUL. PennMutual was one of the first companies to introduce indexed account options on a VUL chassis and, since then, several other companies have followed suit in the years since. Indexed crediting strategies will undoubtedly continue to migrate from the traditional, stand-alone IUL chassis into Variable UL products. But that’s not what makes Diversified Advantage VUL (DAVUL) the harbinger of Indexed UL to come. The real story with DAVUL is that it pioneers a potent new multiplier option that will invariably spill back into the traditional Indexed UL market. It’s a clever design that can deliver superior illustrated performance than multipliers without the same level of regulatory scrutiny. If you’re looking for the next phase of the Indexed UL illustration war, then look no further than Diversified Advantage VUL.

PennMutual’s history with Indexed UL is an interesting one. They burst onto the scene in 2007 with a product that sported a 14% cap with a 2% floor and illustrated at more than 9% rates. The little company from Horsham suddenly became a darling in the fastest growing part of the life insurance industry. But all good things come to an end. As it turns out (and as I wrote about extensively at the time), PennMutual wasn’t directly hedging the cap and was instead relying on internal hedging against their Variable Annuity block, a strategy that works well in the short-term but is unsustainable in the long-run. PennMutual’s illustrated advantage gradually waned as it dropped caps and other insurers pushed the limits on illustrations by using exotic indices, long-dated account options or non-standard crediting strategies. The market shifted towards more aggressive and speculative products, but PennMutual stood its ground. While other companies focused on the upside potential part of the IUL story, PennMutual refocused on the downside protection side of the equation by retaining a true 1% crediting floor that has fallen out of fashion. They’ve eschewed charge-funded multipliers, proprietary indices and non-disclosed persistency bonuses in favor of focusing on fairly simple, straightforward and conservative product designs. That’s their philosophy when it comes to indexed crediting.

At least, indexed crediting in a fixed Indexed UL chassis. Diversified Advantage VUL is a hard-break from PennMutual’s philosophy for its Indexed UL products – and not without cause. Variable UL is, after all, is a registered product with a prospectus and sold by registered representatives. PennMutual needs to compete in the Indexed UL illustration war, but they’re doing so on their own terms by deciding to ramp up the risk and illustrated performance for indexed accounts within DAVUL rather than on a traditional IUL chassis. You can’t argue with their logic and you have to give them credit for being circumspect about how, when and who can sell leverage within an indexed crediting strategy. We’d probably all be better off if other companies took a similar approach when it comes to leveraged exposure but alas, that’s not what’s happening.

Diversified Advantage offers three indexed account options – Classic, Enhanced and Uncapped. The first two are nothing particularly abnormal compared to Indexed UL products. Classic has a 1% floor with an 11.5% cap, which is similar but slightly less rich than the 10% cap, 1% floor and 15% ICM in PennMutual’s street IUL, Accumulation Builder Flex. Enhanced is a typical charge-funded index credit multiplier account, but with a 0% floor and 12.25% cap. The charge for the account is 2.5% per year and includes an index credit multiplier of 50%. In terms of illustrated performance, the look-back for the Classic account is virtually identical to the lookback for the Enhanced account (7.09% vs. 7.10%). The two accounts are identical for the purposes of determining the illustrated rate, but the 12.25% account costs less to hedge. Ballpark, I’d guess that switching from 1%/11.5% to 0%/12.25% saves about 0.20% in hedge costs, which is not nothing in the world of tight option budgets. It also means that if PennMutual hadn’t made the switch, the multiplier would be smaller than 50%. So although these two accounts illustrate at basically the same rate, they’re not the same thing. The 1%/11.5% combination is more valuable because it costs slightly more to hedge. But PennMutual probably came to the not-unreasonable conclusion that if you’re willing to pay the 2.5% asset charge, you probably don’t care about the 1% floor, which allows them to save a few hedge bucks to reinvest into the multiplier to maximize illustrated performance. Makes sense.

Where Diversified Advantage breaks from the pack is in the Uncapped option. There are plenty of so-called “uncapped” options in the market, but none of them look like this one. Some uncapped options rely on esoteric crediting strategies or proprietary indices, both of which are designed to tamp down on performance, to provide uncapped returns. Other uncapped options have participation rates less than 100% or have a spread that’s taken right off the top of the index return. The Uncapped account in DAVUL has none of these things. It’s a 120% participation rate on the S&P 500 without a cap. Yes, you read that right. More than full exposure to upside with a 0% floor. It’s the Indexed UL that Indexed UL has claimed to be for years – full upside potential, full downside protection. Well, almost full downside protection. It does have a 2.5% asset charge, but that’s pretty dang marginal in comparison to being fully exposed to downside risk in the S&P 500. This thing looks magical.

From an illustration standpoint, it certainly is. The maximum illustrated rate for the product is 9.43%, which PennMutual then grosses up on the illustration by the 120% participation rate to 11.26%. After deducting the 2.5%, the net rate hitting the illustrated performance of the account is a whopping 8.78%. But that’s not the crazy part of the story. The crazy part is that PennMutual is being conservative in setting the maximum illustrated rate for the product, which is probably smart because they’re operating in a gray area of AG49. Technically, the indexed account options within a Variable UL product do not have to comply with AG49. If PennMutual had just borrowed the AG49 methodology for determining the illustrated rate, the illustrated rate for the product would have been a stratospheric 13.56%. However, PennMutual decided to play it safe and follow AG49 for both the definition of the Benchmark Index Account and the maximum 45% option profit allowance, which is how they (presumably) came up with a 9.43% illustrated rate*. Kudos to PennMutual for playing it “safe,” even though this account still produces absolutely jaw-dropping illustrated performance relative to normal multiplier accounts.

Now, let’s talk about why this Uncapped strategy is so damn effective and the best way to do that is to compare it to the Enhanced (multiplier) account. Both of these accounts have the same option budget augmented by the same 2.5% asset charge. Theoretically, they should produce the same illustrated performance, but they obviously don’t. The net rate hitting the illustrated values in the Enhanced account is 8.15%, far below the 11.06% that would be produced by the Uncapped account if PennMutual unchained it. Why is that? The best way to see why is to stop thinking about illustrated performance in absolute terms and instead think about it in terms of how much illustrated performance is delivered per percentage point of option budget which, by the way, is the same thing as the illustrated option profit for the trade. To get a feel for this, take a look at the table below:

Cap Call Cost AG49 Maximum Rate Option Profit
10% 4.7% 6.1% 130%
15% 5.7% 8.1% 141%
20% 6.1% 9.5% 154%
25% 6.2% 10.3% 166%
Uncapped 6.3% 11.3% 179%

What this table is showing is that raising the cap dramatically increases the implied option profit of the strategy and, therefore, the illustrated “efficiency” of the trade for delivering illustrated performance. Under normal circumstances and in normal products, you really don’t notice these effects because the marginal increase from a 10% cap to, say, a 15% cap is pretty small. Most buy-up caps on the market are a 1% charge (or less) for a 2.5-3% bump in the cap, which doesn’t fundamentally change the economics of the deal. It looks better than the no-charge account but not disproportionately better. All of that goes out the window when you push the cap even higher. Suddenly, you’re getting enormous bang for the buck in terms of illustration efficiency. By the time the cap is gone, the strategy is showing implied option profits of 180%. This is why Uncapped looks so much better than Enhanced. Whereas Enhanced uses its asset-based charge to buy more options at an implied 130% profit, Uncapped puts that same 2.5% at work at 180% efficiency.

In short, this Uncapped crediting strategy in Diversified Advantage VUL is a better mousetrap than traditional Index Credit Multipliers if your goal is to win the illustration war. It’s vastly more efficient for delivering illustrated bang-for-the-buck. What’s curious about what PennMutual ultimately did, though, was that they didn’t maximize the structure. Another option for the account would have been to just vary the charge by whatever amount will buy a 100% participation rate. The moving part, in this strategy, is the fee and not the cap or the participation rate. I’ve actually written about this concept before and the fact that I’m surprised that no life insurer has pursued it. Turns out, PennMutual actually filed exactly this strategy but chose not to put it in the product because they didn’t think the market was ready to have fees that fluctuated rather than caps or participation rates that fluctuate. It’s only a matter of time before someone puts that account into an Indexed UL product.

Now, let’s put on our real-world hats and look at this crediting strategy. Will it really deliver vastly more efficient results than the Enhanced structure or any other capped structure, for that matter? Of course not. All of the pricing that PennMutual is using is based on today’s price for options. As I’ve written about extensively in other pieces, not all option prices change at the same time and due to the same factors. Participation rates will bounce around more often and more dramatically than caps. For example, if volatility jumps from 15% (which was reflected in the numbers above) to 20%, the participation rate on that account would drop from 120% to about 75% but the affordable cap wouldn’t change by more than 50bps. In the real world, the two strategies are equivalent once you take into account the fact that the price of options is highly volatile. But, of course, Indexed UL illustrations don’t take that into account. They live in the magical world of stasis and permanence for things that change every millisecond.

I would argue that nothing else highlights the abject foolishness of the hypothetical historical lookback methodology embedded in Indexed UL illustrations better than the Enhanced and Uncapped strategies in DAVUL. Theoretically, these two strategies should deliver the same economics over the long-run. And yet, they illustrate dramatically differently because the options used to hedge them are priced very differently right now. Caps are “expensive,” participation rates are “cheap.” Therefore, caps illustrate 30% profits while participation rates (in this case, a 120% participation rate) can illustrate 80% profits under the same methodology. How is that possible? Is one strategy really that much better than the other one? Of course not – that’s just a momentary pricing blip that appears to deliver permanent advantages. Welcome to the insanity of Indexed UL.

Regardless, you can’t fault PennMutual for how they built Diversified Advantage VUL. They’re delivering what the market wants, which is lights-out illustrated performance courtesy of more indexed crediting leverage with the caveat that the illustrated performance is only available in a registered chassis. But forget illustrated performance for a minute. This Uncapped account tells an undeniably attractive story regardless of illustrated performance, especially when options are dirt cheap like they are right now. A client can get 120% exposure to the upside of the S&P 500 and the tradeoff is that the client takes a 2.5% haircut and loses part of the dividend payout**. To be honest, I’m not sure I wouldn’t select the Uncapped account in DAVUL over an equity fund given the current market environment, even though I don’t think that it will actually produce superior performance in the long run. It’s what fits my psychology at this particular moment. It tells a story that I like. And unlike many other Variable UL products with indexed crediting buckets, DAVUL doesn’t restrict the ability for clients to allocate into and out of the indexed account. That’s an astonishingly generous benefit that allows clients full flexibility to take advantage of the indexed accounts when it suits them and allocate into more traditional separate accounts when things change. And, to boot, DAVUL is an attractive VUL product in its own right with relatively low fixed costs, a solid variety of fund choices and a 0.4% bonus that effectively refunds the fund fees after year 11. It’s very hard for me to hate this product. I might even like it – maybe even a lot.

The tragedy, though, is that DAVUL is going to be weaponized for illustration warfare in Indexed UL. That’s a tragedy because it’s a solid product even if you don’t illustrate it aggressively. Illustrations should be irrelevant for all products, but especially this one. DAVUL tells a comprehensive and well-rounded suite of stories that will resonate with a wide range of clients looking for a variety of different risk profiles over their investing cycles. It’s one of the very few products on the market that truly does several things well within one chassis – and for that it deserves consideration, aggressive illustrated performance be damned.

*Here’s the implied math on the illustrated rate. PennMutual’s option budget is about 5.2%, which is ballpark what it costs to deliver a 12.25% cap these days. The price for 120% participation in the S&P 500 is about 7.7% these days, which is equal to the 5.2% option budget plus the 2.5% asset-based charge for the account. Multiply 7.7% by 1.45 and you get 11.17%, spitting distance from the 9.43% * 120% = 11.28% maximum illustrated rate for the product. Therefore, PennMutual complies with the 145% maximum illustrated option profit assumption.

**I’ve written about this before, but I think it bears repeating in the context of the Uncapped account. Indexed UL products do receive some of the benefits of dividend yields even though they (generally) track indices that do not include dividends. Dividend yields effectively serve to lower the price of options, which means that the carrier can offer a higher cap than if the index did not pay any dividends.