#221 | Reconciling FIA and IUL
One of the curious things about the life insurance industry is how little crossover there is between the life insurance side and the annuity side in terms of advisors, brokerages and even life insurers. Most agents who do significant volume in one product tend to not sell much of the other. If you were to look at the top distributors of life insurance and annuities, you’d see very few common names, with firms like Crump and Ash as the exceptions. Even in the national broker-dealer and wirehouse world, firms that would appear on both lists aren’t actually as unified as you might think. The people at these firms managing the life insurance business tend to be old-school life insurance folks who don’t interact very often with their annuity counterparts who typically have very different backgrounds. The same effect occurs at life insurers, too. Very few life insurers have much integration between the life insurance and annuity side. Despite the fact that life insurance and annuities are two sides of the same mortality coin, they exist in very different worlds – almost as if that coin is floating, with one side exposed only to water and the other side only exposed to air.
But, increasingly, this is starting to change. The independent marketing powerhouses on the annuity side of the world like FIG, Gradient, Magellan and Advisors Excel are beginning to do significant life insurance production and the vast majority of it is Indexed UL. Life insurance shops that have embraced Indexed UL have started to see that there might be opportunities on the FIA side and are starting to drive meaningful production as well, although nowhere near as voraciously as the annuity IMOs have attacked Indexed UL. There seems to be a lot of commonalities between the two products, but are they really as similar as they seem?
In some ways, yes, they are. Both products earn a yield from the life insurer’s investments in generally fixed income assets and spend that yield on call option packages in order to create exposure to the movement of the external index. Therefore, the two products share a lot of optical similarities. They both, for example, can have exposure to the S&P 500 index using a point-to-point calculation methodology where the interest is limited by a cap. Or they can both have literally any exposure to any index using any methodology under the sun, as long as there’s a liquid hedge market for it. Indexed crediting is limitless and its lack of limits highlight the central truth about both Indexed UL and FIA – the indexed crediting is just the icing on the cake. If you want to understand the products, you have to stick your fork through the icing and take a bite of the cake. That’s where the differences become clear and meaningful.
Let’s start at the ingredients. FIA products are usually filed and almost always sold as single premium products. IUL products are almost always filed and sold as flexible, recurring premium products. Because FIA products are single premium, the life insurer generally does true asset-liability matching. In other words, if you put $100,000 into an FIA product, you can envision the life insurer flipping using that $100,000 to buy an asset that will mature at (basically) the end of the surrender charge period. The yields from that asset then go to purchase the options that will provide the indexed exposure. But because Indexed UL is a recurring premium product, there’s no distinction (from an investment standpoint) between new premiums and renewing premiums, so all of the premiums are bundled together into one giant portfolio.
This, then, is the first true distinction between FIA and IUL. Newly issued FIA rates are based on currently available market yields, whereas newly issued IUL rates are based on a portfolio rate. In the long run, the average rate offered on newly issued annuities and the portfolio rate will end up being identical because there is no real structural difference in how the money is invested. The only difference is how the yields are divvyed up. FIA rates are fair in that each policyholder gets rates based on the actual yield that the invested assets the life insurer purchased with their deposit earned. IUL rates are fair in that all policyholders in a portfolio get the same rate. But that’s not how it looks at any given moment. Right now, portfolio rates are higher. In a few years, the opposite could very well be true. In the same way that although the current weather in Anchorage might be warmer than in Phoenix (that has happened), you’d be foolish to conclude that Anchorage is always warmer than Phoenix. Don’t be fooled by the portfolio rate / new money distinction.
The second major distinction between the two products is in the charges. A lot of folks like to market FIA as a “no-charge” product and that’s obviously not true, even if it technically is. A more accurate statement might be that FIA is a “no-visible-charge” product, although it doesn’t have quite the same ring to it. The life insurer obviously is taking a spread from the invested yield before purchasing options, which is identical to charging an asset-based fee. Indexed UL, on the other hand, offers a wide range of charges – Cost of Insurance, base charges, premium loads and asset-based fees in addition to any embedded spread. Therefore, all else being equal, Indexed UL caps will always be higher than FIA caps because Indexed UL products can recoup commissions and overhead through other policy charges. But does that mean the net rate is better for the client? Of course not.
Let’s use a real example. Let’s assume a $250,000 premium for both IUL and FIA. The IUL product is a standard, full-comp IUL that has a realistic cap like Nationwide’s Accumulator II IUL and the FIA also has a standard cap of about 4% right now. For the purposes of this analysis, we’ll just use the maximum AG49 rate for both to do the comparison. A 4% cap produces a 2.65% maximum AG49 illustrated rate and, therefore, the IRR in the FIA after 10 years is 2.65%. Nationwide Accumulator II IUL, however, has an 8.25% cap and a 5.28% illustrated rate but produces an IRR at year 10 of 2.64%. Why is that? Because there are about $63,000 in policy charges in the first 10 years of the contract that are dragging on the cash values. Of that $63,000, nearly a third is related to premium loads and half of that load is related to premium taxes, which life insurance has to pay but annuities don’t (except in a couple of states and even then at lower rates). This sets up a structural disadvantage for IUL compared to FIA. Don’t be fooled by the fact that IUL has higher caps or the fact that FIA has “no charges.” The net number is what matters.
Third, FIA and IUL differ in how the market views the “term” of the product. If you were to ask someone who sells a lot of IUL what the “term” of the product is, they’d look at you funny. Indexed UL is marketed as an evergreen product, something the client will keep for the rest of their life. For the vast majority of IUL products, the lion’s share of the illustrated performance comes many years after issue. It’s not uncommon for an IUL strategy to be positioned for what it “will do” over the next 50 years. The term of an FIA, by contrast, is generally understood to be the length of the surrender charge period. A 10 year product is a product with a 10 year surrender charge. Life insurers pricing IUL usually have a level surrender assumption (say, 6% per year), but the annuity pricing team at the same company will use a ballooned lapse assumption for FIA with something like 2% per year within the surrender charge period, 50% at the end of the surrender charges and 10% thereafter. This aligns with how FIAs are marketed as well, with almost all of the focus on what happens within the surrender charge period. The only real exception to this rule is FIAs with income riders but, even then, the riders are calibrated to accumulate the most value during the surrender charge period.
This might seem like a minor distinction, but it’s not. It’s actually probably the most pivotal difference between the two products. FIA products are transactional and short-term in the same way that a bank CD is. Making a wrong decision on an FIA is necessarily a short-term problem the only cost is the opportunity cost of the capital, which actually can be accessed without surrender penalties through free withdrawals (generally 10% per year). At the end of the term, the FIA can be rolled into something new with guaranteed no loss of principle. Indexed UL is a totally different game. Indexed UL is marketed as a perpetual strategy where the benefits really start to play out in the long-term. There is no principle protection in Indexed UL because of the explicit policy charges. A wrong decision in Indexed UL means actually losing money. For example, in the same scenario above, if the policy had delivered 0% every year the FIA would have $250,000 of account value at year 10 but the IUL would have only $186,000 in account value. With FIA, the stakes are limited and short term. With IUL, the stakes are unlimited and long-term.
Illustrations reflect this difference in severity and time horizon. FIA illustrations are quite simple and straightforward because the product itself, at least in its mechanics, are also simple and straightforward. The illustrated rates are shown only over a 10 year period. For indexed crediting, the illustration is shown using the most recent 10 years of indexed data, the worst 10 of the last 20 years and the best 10 of the last 20 years, to give the client a feel for the range of results. The guarantees show simply a return of principle. But with IUL, the illustrations last until the client is 121 and use an average rate of return based on the hypothetical historical lookback methodology from AG49. It’s almost as if FIA illustrations are going out of their way to show the client that anything could happen over the next 10 years and, by contrast, IUL illustrations are going out of their way to show the client that what happens in the short term is irrelevant and the only thing to consider is the long-term average effect. The two could not be more different in their approaches for illustration.
Both approaches to illustrations share the same flaw – the application of current rates to historical index data – but the result is different. Indexed UL illustrations are gamed by multipliers and bonuses so that the average rate will be inflated and the product will not reflect the higher risk introduced by these new product features. The goal of IUL, in short, is to increase the risk to therefore increase the average illustrated rate of return. The game in FIA is to use the benefit of hindsight to create specialized, engineered indices that perform particularly well in the periods of time shown in an FIA illustration. What’s true in both cases is that life insurers are gaming the illustrations to make their products look more attractive than they actually are. But for Indexed UL, that gaming involves more risk to the client whereas in FIA, the gaming is simply a matter of engineered lookbacks that may or may not actually produce more return in the real world. Or, to put it bluntly, the games in IUL actually can hurt clients but the games in FIA merely have the potential to disappoint them. These are worlds apart.
Some people express surprise that I’m generally a critic of Indexed UL and generally a fan of FIA. Because Indexed UL has such a long-time horizon, exposes clients to real downside risk and is sold based on hyper-inflated level illustrated rates, I’m a critic. It’s extremely hard, I think, for a client to make an informed decision about Indexed UL and the consequences of making a bad decision are long-lasting. But because FIA has a short-term time horizon, does not expose clients to downside risk and is sold using illustrations that show a range of returns, I think it’s relatively easy for a client to make an informed decision about an FIA and the consequences of making a bad decision are minor, if any, beyond opportunity cost of capital. To put it bluntly, making an informed decision about IUL requires that you become an expert in IUL. Making an informed decision about FIA does not have the same requirement, not even by a long shot, and that’s a good thing because very few people are experts in FIA or IUL. Including the people who sell them. So how then do we reconcile FIA and IUL? Stop thinking about them as twins and, instead, think of them as two perfect strangers who happen to share a last name and birthday. A coincidence, yes, but nothing more. The two products are as different from one another as these two strangers, despite the seeming similarities, and must be understood on their own terms. FIA is a short-term product with limited risk. IUL is a long-term product with quite a bit of risk. Disappointment in FIA is underperformance. Disappointment in IUL is losing money. Handle accordingly. There’s a reason why FIA sales are $70B+ and IUL is less than $3B – and we should keep it that way.