#207 | Indexed UL’s Honeymoon Decade
I was recently copied on an email chain amongst a bunch of high-end agents and industry commentators including a prominent, long-time and relentlessly self-promoting Indexed UL advocate. Most of the folks on the email chain are generally skeptical of Indexed UL, which naturally kicked off a rather robust discussion about the merits of the product with the IUL advocate. Much of the debate was well-trod turf but the IUL advocate made an interesting point and played it as a trump card – Indexed UL has been around long enough to deliver verifiable performance and, by any measure, that performance has been phenomenal. He’s not alone in holding that opinion. I’m increasingly hearing a similar narrative from insurers, particularly the ones selling Indexed UL and have a vested interest in maintaining the AG49 status quo that allows them to illustrate better performance in Indexed UL than in traditional Universal Life. After all, Indexed UL has delivered the goods, hasn’t it?
Yes, it has. It would be disingenuous to argue anything different. Most folks who make this claim start their performance data at any period of time ranging from 2003 to 2007 but, in any event, long enough to include the financial crisis. No matter when you start, the output is the same – Indexed UL has performed better than a traditional Universal Life product. I personally have seen policy statements dating back that far that corroborate the claim, posting 7%+ average crediting rates through that period of time. If you’re an advocate of conservatism in Indexed UL performance expectations, as I am, then this might seem like it’s hard data to swallow. How can you advocate for illustrated rates lower than AG49 when actual crediting rates on IUL policies have exceeded AG49 for as long as the product has been in existence? Ouch.
But there’s more to the story. As I wrote about extensively in a series called Indexed UL in the Mirror, macroeconomic trends lined up perfectly for Indexed UL to have a phenomenal decade regardless of equity market performance starting in about 2010. Interest rates fell through the floor which subsequently pushed down the price of call options and, particularly, call spread options used to hedge caps. In other words, options were dirt cheap. And at the same time, insurers were still reaping the benefits of previously high crediting rates in their portfolio yields. Combining these two factors meant extremely high caps and, therefore, outsized Indexed UL performance. Even moderate equity returns through that period of time would have still produced stellar crediting performance in Indexed UL just courtesy of high caps. It was a very good time to be writing Indexed UL products.
Indexed UL was perfectly positioned to take advantage of favorable S&P 500 returns, but the S&P 500 delivered below average returns from 2003-2019, producing just 8.27% average annual returns against 8.8% for the full historical period. How is it that Indexed UL outperformed in an underperforming S&P 500 environment? Because Indexed UL doesn’t take advantage of S&P 500 in the same way that a straight investment in the S&P 500 would. Instead, Indexed UL feeds more off of the shape of the S&P 500 returns rather than the returns itself because of the cap and floor of the product. In other words, sharp and steep changes in the S&P 500 have a minimal impact on Indexed UL returns because returns above and below the floor are chopped off. You can’t look at average S&P 500 performance and infer how an Indexed UL would have done over the same period. Instead, you have to look at how the S&P 500 delivered its performance over the period.
Historically, about 26% of annual returns in the S&P 500 are below 0%, 50% are above 10% and the remaining 24% are between 0% and 10%. That return distribution produces, on average, a 6.3% average annual credit for an Indexed UL product with a 10% cap. Imagine another scenario where all of the returns above 10% were increased by 1.5x and all of the returns below 0% were cut in half. The S&P 500 average return would spike, but the Indexed UL return wouldn’t change by a dime. That’s why the “performance” of the S&P 500 is irrelevant and the shape of the returns is paramount.
Return shape is where the period since 2003 deviates dramatically from historical norms. Since 2003, just 17% of annual credits would have resulted in a zero, which is just 66% of the average historical occurrence of 0% credits. The figures become even more skewed when you look in the most recent 10 years when just 10% of annual credits would have resulted in a zero. On the flip side, cap credits were more prevalent – 52% since 2003 and a whopping 61% over the last decade. If it’s disingenuous to argue that Indexed UL hasn’t had a stellar run, then it’s even more disingenuous to argue that the S&P 500 didn’t deliver picture perfect performance over the period in question. Even the Crisis cooperated. Imagine how bad it would been for Indexed UL if the decline in the S&P 500 had been protracted over several years and followed by a swift recovery. Instead, we had a swift fall and a slow and steady recovery. Like I said, picture perfect performance.
Even without digging into the details and characteristics of the last 17 years, it should be pretty obvious to folks making this argument that 17 years, let alone the 10 years since most companies have been selling IUL, is enough history to draw long-term conclusions. So let’s take a longer perspective. Below is a chart showing the percentage of annual credits that would have resulted in a zero on an annual basis (the dark red) and the average for the decade (light red).
This chart shows a lot of things, but particularly how much the world can change in a decade. The 1990s would have also been a perfect decade for Indexed UL but, instead, it ended up being a perfect decade for Indexed UL that was closed out with 2.5 years of negative returns. But other decades were particularly bad – especially the run from 2000-2009, which isn’t usually discussed by folks promoting Indexed UL. They’re happy to point out that Indexed UL would have outperformed equities over that decade, but less likely to mention that Indexed UL would have underperformed UL (and did, actually, according to an old Aviva study on their own block of business). What about the four decades from 1950 to 1990? That’s a pretty sorry time for Indexed UL, with frequent punctuations of years where more than 50% of policyholders would have earned a goose-egg. Then there are the moribund decades of the 1960s and 1970s, when Indexed UL would surely have been an inferior performer to Universal Life.
If history is a guide, then here’s what history is telling us – Indexed UL had a very good run and, in all likelihood, it’s about to be followed by a bad run. Clients and carriers have been lulled to sleep by abnormally favorable S&P 500 performance served perfectly on a platter for Indexed UL. What happens when clients collect a couple of zero credits and start to realize that, in fact, these products can lose money and, sometimes, a lot of money? It’s not going to be pretty and I would argue that insurers are completely unprepared for it. One of the big trends in Indexed UL of late has been to jack up policy charges in exchange for a higher cap and/or bonus or multiplier. That’s a beautiful strategy in a linear return environment, which obviously only happens on an illustration. But it has teeth that only become apparent when clients get a zero on their statement and see massive policy charges taking a bite out of their account value. What do you think those folks are going to do? Well, chances are pretty good they’re going to start asking tough questions about those policy charges and their agents and the insurer aren’t going to want to answer them.
How much history do we need to really get a grip on Indexed UL performance? Generally speaking, the longer the time horizon and the more variables at play, the more time you need to watch the strategy unfold. This does not bode well for Indexed UL. Policyholders are usually planning to hold these things for 30 years or more and there are a ton of factors at play above and beyond just equity returns, including, for starters, option prices and portfolio yields. You’d need to make sure you had a long enough period of time to capture a few cycles for all of them. So I think we’ll have a pretty good feeling for actual, verifiable, empirically trustworthy Indexed UL performance in…maybe…83 years? That would get us to a nice, round century of history. Seems reasonable.
Until then, we’re left with theory and conjecture. That’s all we have. The last 17 years of data is meaningless at best. And where does theory take us? Unless you believe in long-term, structural profits from buying call spreads, which would put you in a tiny minority comprised entirely of people in the life insurance industry, then it’s probably best to illustrate at something far less than the AG49 maximum rate.