#341 | Prudential FlexGuard IVUL

Quick Take

Prudential FlexGuard IVUL is the second (after Equitable MSO, which has been in market largely unchanged since 2010) of what will inevitably become a new category in the life insurance market, Variable UL products with subaccounts that offer structured payoffs – in this case, buffered strategies. Against Prudential’s long-standing accumulation VUL, Custom Premier II, FlexGuard IVUL offers similar accumulation performance if illustrated at comparable rates after adjusting for fee differences. But the surprising bit is how FlexGuard IVUL competes against Protector VUL, Prudential’s blockbuster Guaranteed VUL product. FlexGuard IVUL offers significantly lower Single Premium guarantee solves but requires an allocation to the buffered crediting strategies. FlexGuard IVUL also introduces a couple of new concepts into the Life lexicon, particularly Interim Value, which serves as the value for all mid-year transactions and is a marked departure from any other indexed Life product in market.

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Earlier this year, Prudential filed an S-3 for FlexGuard IVUL, a Variable UL product that borrows the buffered strategies from Prudential’s massively successful FlexGuard RILA (annuity) product. I covered the filing in a previous post because there was enough information to draw a few key conclusions – there would be buffered strategies, a 0% Floor strategy and at least a handful of traditional separate account options. Beyond that, not much else was clear. Would this product compete in the accumulation space or sport a secondary guarantee? Would it serve as a replacement or a compliment to the current portfolio? Would rates be set comparably to annuities or more like traditional life insurance? How would it be illustrated? But now that the product is out, the picture is quite a bit clearer.

First things first, FlexGuard IVUL is additive to the Prudential VUL suite and doesn’t directly replace any product. Custom Premier, Prudential’s traditional accumulation VUL offering, has been on the market since what feels like the dawn of time. It reminds me of the Jaguar Land Rover 5.0 V8 that started showing up in their cars around 2009 and still powers the company’s most performance-oriented trims, despite the fact that the engine is practically a museum piece and has a prehistoric thirst for gas. Why does JLR keep it around? Because it is magnificent. That’s Custom Premier. It’s old – but potent. The proof is that as the VUL market has grown since 2020, one of the products at the vanguard was Custom Premier, notching 140% sales growth in 2021, 130% sales growth so far in 2022.

At the same time, Prudential has palpably stepped off the gas with Protector VUL over the last couple of years. I wrote a series (Part 1, Part 2, Part 3, Part 4) on the Guaranteed VUL market a few years ago and one of my observations was that it seemed like Prudential was very aggressively priced and was due for a pullback. I made the case by comparing the pricing for the product versus its closest competitors, but also from another angle – the fact that Prudential was running for the exits in the Variable Annuity with Guaranteed Lifetime Withdrawal Benefits (GLWB) space. VA with GLWB and GVUL are different products with very similar risk profiles. It does not make sense for a company pulling back in VA with GLWB to go all-in on cheap GVUL. In my view, it was only a matter of time before Prudential would bring Protector VUL pricing back down to earth.

So where does FlexGuard IVUL fit? Very much in the same place as FlexGuard RILA. Historically, the RILA product category has been exclusively focused on accumulation and with a particular angle – exposure to equity performance with some level of downside protection and no fees. This is very savvy marketing. The reality is that RILA products provide exposure to the index, which doesn’t include dividends, but that distinction is often somewhat lost in the marketing material. And, of course, RILA products do have fees, but the fees are embedded in the caps and/or participation rates offered in the product.

The same story applies for FlexGuard VUL. The product offers two 10% Buffer options, which means that the client is exposed percent-for-percent to losses below the Buffer. One option offers a traditional Cap, currently set at 18%, and the other offers a “Step Rate Plus” strategy, which is the greater of 8% or 70% of the index return, as long as the index shows any positive return. Neither strategy has explicit fees. Both buffer strategies are offered as 1 year terms, which is in-line with what is commonly found in IUL products but different than the focus in FlexGuard RILA on the 3 and 6 year strategies that reign supreme in the RILA market.

In annuityland, the fact that RILA uses embedded rather than explicit fees is savvy marketing and nothing more. Why? Because variable annuities are not illustrated products. But in life land, where the illustration dominates, this embedded versus explicit fee issue creates real comparison challenges. Consider this basic question – should you illustrate FlexGuard IVUL at the same gross rate as Custom Premier VUL? Prudential sets the default rate for FlexGuard IVUL at 1% lower than the 8% rate it uses as the default for the separate account options in FlexGuard IVUL and Custom Premier. Is that the right way to approach it? In my view, thinking about how you should illustrate FlexGuard IVUL versus traditional VUL is a two-step process.

The first step is to neutralize the effect of fees. As I’ve written before, Variable UL products typically offer fund lineups that are fattened up with 12b-1 fees and revenue sharing arrangements. Looking at Prudential’s fund lineup, I would ballpark that the total drag from those two line items is around 35bps, which would be in line with most other VULs in the industry. In my view, illustrating Custom Premier at 35bps higher than FlexGuard IVUL is probably a fair comparison between the two.

Not surprisingly, illustrating Custom Premier with a 35bps edge over FlexGuard IVUL leads to illustrated performance that is very, very similar. That’s what we would expect. There is no reason to think that the economics for the two products would be markedly different. That being said, the policy charge structures are a bit different. Right out of the gate, initial policy charges in FlexGuard IVUL  are quite a bit steeper than in Custom Premier. Some of that is due to higher Target premiums in FlexGuard IVUL, but the difference remains even if you increase the face amount on Custom Premier to equalize the Targets.

All in, policy charges in FlexGuard IVUL appear to be around 30% higher in the first 10 years than in Custom Premier. However, some of that number reflects higher surrender charges in FlexGuard IVUL because Prudential is one of the very, very few companies that still deducts a pro-rata surrender charge on a face reduction. Over the long run, FlexGuard IVUL gives back some of the economics in the form of lower COI charges, which is a curious choice for a product that appears to be focused primarily on accumulation. More on that in a minute.

The second step in evaluating how you illustrate FlexGuard IVUL is the actual illustrated rate itself. The question of how to illustrate these types of Buffered strategies in VUL is very, very tricky. Variable UL is not governed by the illustration model regulation, so there’s a lot of gray area in how to illustrate the product. The only hard line is that life insurers can’t illustrate above 12%. For traditional indexed accounts in Variable UL, most life insurers have used AG 49-type hypothetical historical lookback approaches for determining the maximum illustrated rate, essentially equating it to Indexed UL.

I can understand why they do it that way, but I think there are some landmines with this approach if applied writ large. Life insurers have universally taken the approach that the illustrated rate for a Variable UL product is decoupled from the actual separate account fund selection. In other words, they don’t tell you that you can illustrate a Small Cap Index at 12% but you can only illustrate a money market fund at 3%. The decision is left with the advisor as to what is appropriate.

Using lookbacks, however, is prescriptive in a way that is intended to reflect the fundamental risk and return characteristics of the crediting strategy. This is a problem unto itself because it is inconsistent with how VUL illustrates. But even more problematic is the fact that the lookback prescribes not only the methodology, but also the assumptions because it uses historical data with, for example, historical average S&P 500 total returns north of 12.5%. You can’t even illustrate that rate in Variable UL, and yet it underpins the data in the lookback methodology for the indexed account. The results for the prescriptive method are therefore fundamentally incompatible with how Variable UL is illustrated.

The problem becomes much more acute with buffered strategies as in FlexGuard IVUL. Prudential includes some summary lookback data in the narrative section of the illustration. The 40-year average hypothetical historical lookback return for both buffer strategies is north of 11%. If Prudential had set the default illustrated rate for the strategies using these lookbacks, it would have wreaked havoc on the illustration and competitive positioning. Agents would have (potentially) been using these illustrations as some sort of “certified” or “verified” or “historical” projection, when it is nothing of the sort. The proper interpretation of the results are that these strategies capture something like 90% of historical S&P 500 returns – based on current rates that reflect current (or near-current) option pricing and option budget. They are purely hypothetical.

So thank goodness Prudential didn’t set the default illustrated rate at 11%. That would have been a real problem. Instead, they took the very reasonable approach of setting the maximum illustrated rate for the buffer strategies at 9%, which is 1% less than the 10% max rate for the rest of the separate account funds, and the default illustrated rate at 7%. It’s hard to argue against this approach. It is consistent with the philosophy of VUL illustrations and leaves the decision in the hands of the advisor and the client. There is no prescription of returns – and that’s a very, very good thing.

However, that means advisors are left with the tricky responsibility of figuring out an appropriate rate for illustrating this product. One option is to use the lookback for guidance and “conservatively” illustrate at the maximum of 9%. That is a very bad idea. If you follow the RILA market at all, you know that RILA rates bounce around like crazy. Why? Because RILA rates are highly contingent on volatility dynamics in the market, far more so than traditional 0% Floor strategies. They should change on every monthly sweep date and sometimes by pretty big margins, think 2-3% for the Cap, whereas traditional IUL Caps rarely move at all. Every Cap change will change the lookback. It is not reliable. It is not predictive. It uses assumptions that Prudential won’t even let you illustrate in a regular VUL. You can safely ignore it unless you want to use it for some sort of explanatory purpose.

Another option is to try to figure out what Prudential’s option budget is for the strategy and base the illustrated rate (loosely) on that. However, that doesn’t really work for buffered strategies because most of the option budget comes from the short put position that creates the Buffer. That is real equity risk and it is really volatile. It’s very difficult to come to some sort of long-term view just by trying to back into the fair-market value of the strategy because it’s always changing.

The third option is, in my view, the only one – look to the experts. Firms in the Defined Outcome Fund (DOF) space have written extensively about what Buffer strategies “look like” for the purposes of using them in model portfolios. Ballpark, a 10% 1 Year buffer strategy has roughly the same risk and return profile as a 60/40 equity/fixed income allocation. That’s a very helpful guide. Here’s what illustrated rates for the strategy should look like based on the equity return assumption (top) and bond return assumption (left). Note that these illustrated rates should also apply for a 60/40 portfolio in Custom Premier plus 0.35% to normalize for fees.

So let’s go back to the question – how should you illustrate FlexGuard IVUL relative to traditional VUL products? It depends on your assumption for both the allocation and expected returns being used in the traditional VUL product. But in general, I actually think that Prudential’s 1% default haircut for FlexGuard IVUL is a useful rule of thumb if the illustrated rate in the VUL reflects a 100% equity allocation. The equity risk premium over a diversified basket of corporate bonds is around 2.5%, at least from what I recall after researching this a few years ago. Illustrating a VUL at 8% with a pure equity allocation equates to illustrating FlexGuard IVUL at 7% assuming a 5.5% bond portfolio yield. The same sort of relationship holds across the range of usual VUL illustrated rates.

Prudential was, in my view, smart to make space for FlexGuard IVUL in its portfolio and give it room to tell its own story separate and apart from Custom Premier. Buffered strategies are foreign to the life insurance world. Prudential and Equitable, which is coming to market soon with buffered strategies in MSO II, are going to have to do a lot of education. It’s easier to do that by talking about a distinct product rather than just an allocation option in the current product. It makes sense. This is the opening round of what may become a very active part of the market as more and more companies get into the RILA space and can pull those strategies over into VUL. Whether the VUL market evolves to look more like the RILA market, with its long-duration crediting strategies and broad slate of buffers, remains to be seen. But there’s certainly room to grow on the FlexGuard IVUL chassis.

But that’s only half of the FlexGuard IVUL story. When I saw some preliminary due diligence material on the product back in August, I was quite surprised to see that FlexGuard IVUL sports a secondary guarantee provision that offers more competitive pricing than Prudential’s flagship Protector VUL product, particularly for single pay scenarios. This may seem like a bit out of place given the seeming focus of the product on accumulation, but it’s not. It’s actually right in line with how the RILA market has evolved over the past few years.

To shortcut a much longer story, companies who have traditionally written Variable Annuities with GLWB have begun to see that RILA is a better chassis for GLWB than VA. Why? Because the defined outcome nature of the payoffs makes them more predictable, modelable, hedgable and controllable than traditional Variable Annuity products, even those with so-called volatility managed funds specifically designed for use with Living Benefits. We modeled RILA with GLWB at Brighthouse back in 2017 and the proof was in the pudding. RILA is a superior chassis for guaranteed income. I’m honestly surprised that it’s taken this long for life insurers to come around to it.

Given that Prudential has released a GLWB rider on FlexGuard RILA, it makes sense that they’d also bolt a secondary guarantee on FlexGuard IVUL. The risks, as I said earlier, are very comparable. If buffered crediting reduces tail risk and provides better economics in annuities, then it should do the same thing in VUL. To get the competitive lifetime secondary guarantee in FlexGuard IVUL, the client has to allocate to the buffer strategies for at least the first 10 years. After that, they can allocate to either the buffer strategies or the limited slate of PGIM funds available in the product.

The effect on pricing for single pays is strong. Take a look at single pay pricing for the two products from age 35 to 65:

However, because FlexGuard IVUL is a dual-purpose product, Prudential charges an explicit fee for including either the guarantee to 90 or to 121. Even more interesting is the structure of the explicit fee. Typically, adding a guarantee to a product results in some sort of a flat charge, almost like a sub-premium being paid to the guarantee out of the policy cash values. But that’s not how it works for FlexGuard IVUL. Instead, Prudential assesses what looks like an additional Cost of Insurance charge denominated by Net Amount at Risk. Take a look at the expenses for the age 121 and age 90 guarantees relative to the base COI charges:

The graph actually makes the math look more complex than it actually is. The charges for the guarantee are a simply a percentage of the base COI that is tiered by age. Take a look:

To my knowledge, this is the first time a life insurer has explicitly priced a secondary guarantee as an additional net amount at risk denominated charge. I wish I could say that the rates themselves were insightful but, alas, it looks like they used the back of the envelope with this one. Regardless, it’s an interesting approach. If the separate account assets perform well and the policy goes into corridor, then the additional charge for the guarantee will have minimal effect, as it should because the guarantee is nowhere near being in the money. But if the separate account assets perform poorly, then the additional charge will be amplified by the growing net amount at risk which will further bring the policy towards the guarantee. This is very reminiscent of how GLWB fees work in Variable Annuities and, I think, represents an advancement towards more sophisticated designs in the Guaranteed VUL space.

My hunch is that adoption of pure buffered strategies in Variable UL is going to be slow. The vast majority of the sales in RILA come from independent broker dealers and banks. FlexGuard RILA was massively successful because Pru could deploy its legion of wholesalers into existing institutional relationships that have established and well-oiled machines for annuity sales that had already begun to shift towards RILA.

No such well-oiled machine exists for life insurance, which has spotty adoption in independent broker dealers and banks, and there is very little (if any) crossover between the wholesaling efforts of most life insurers in the life and annuity space. It’s not like an advisor who sells FlexGuard RILA is going to want to sell FlexGuard IVUL. More likely, they’re not even going to know it exists because their Prudential annuity wholesaler doesn’t get paid to talk about it.

Success for FlexGuard IVUL is likely going to come from the traditional life side of the business, where the product will compete with both established accumulation VUL products – including Pru’s own Custom Premier – and, arguably, Indexed UL. In my view, it faces an uphill battle on both. Advisors selling VUL are probably doing it by making the argument that the client can invest in whatever they want and the key motivation for the sale is tax control. FlexGuard dilutes that story by limiting the fund lineup and focusing on the buffers.

Against Indexed UL, FlexGuard isn’t necessarily going to illustrate better but more importantly, it can’t be premium financed and can’t be sold by non-registered reps. That significantly limits its appeal against traditional Indexed UL. In order to get attention, Prudential is going to have to educate agents and sell the appeal of the buffer strategy. Perhaps calling that an uphill battle doesn’t quite do justice to the climb.

That’s what makes the competitive secondary guarantee in FlexGuard IVUL such a brilliant move. It’s a Trojan Horse. If an agent wants the most competitive single premium guarantee that Pru has to offer, then they’re going to have to sell FlexGuard IVUL – and, by extension, get educated on the product and the buffer strategies. From there, who knows? Maybe they’ll want to sell it for accumulation, too.

One final note worth mentioning about FlexGuard IVUL is that it uses an Interim Value for mid-term value calculations that, I think, is going to catch some folks by surprise when they actually use this product. Any indexed crediting strategy that can result in negative credits must use a daily calculated Interim Value that reflects the change in the underlying value of the strategy since the anniversary. Otherwise, clients could surrender their policy at par just before they receive the negative credit.

The Interim Value in FlexGuard IVUL isn’t directly related to index movements. Instead, it calculates the intrinsic value of the positions that make up the crediting strategy – in other words, the sum of the value of the fixed income position and the options portfolio. That means the Interim Value is dependent on the movement of the index, current equity volatility and interest rates. It can and will change every single day. More importantly, the changes may not be particularly easy to attribute to any one thing because option pricing is complex and non-linear.

Any mid-year policy transaction will reflect the Interim Value, not the previous anniversary value. That’s important to know because, in the real world, very few transactions occur right at policy anniversary. If you’re not prepared to discuss the Interim Value, then you’re probably going to get some concerned phone calls when the client actually starts using their policy for income or even looking at mid-year values. Be prepared. This is a fine-print sort of thing during the sales process but, in the real world, what the client is going to see 364 of 365 days in the year is the Interim Value. If you sell this product, you at least need to be conversational about how it works.