#378 | Whole Life as a Fixed Income Alternative – Part 1
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For the past 35 years or so, Whole Life has often been positioned against traditional fixed income in a very particular – and peculiar – way. We all know the narrative. Falling interest rates created a long-term phenomenon where Dividend Interest Rates consistently stayed above new money interest rates. Agents could (and did) sell Whole Life as an asset class with less risk and higher yields than fixed income. It was a very, very easy sale made even easier with the rising popularity of short-pay products focused on accumulation.
Over the past year, that story has come undone. Take a look at the chart below showing Northwestern Mutual’s Dividend Interest Rate in yellow relative to the Moody’s Aaa bond yield in gray.
These days, a novice investor can generate a higher gross return than Whole Life and take virtually no credit risk simply by buying an Aaa-rated bond. The return-driven story for Whole Life is nowhere near as compelling as it was even just 18 months ago. The entire world has been reoriented. And, unlike some of their Indexed UL counterparts, mutual life insurers selling participating Whole Life are (rightfully) staying the course by maintaining a unified portfolio as the basis for the DIR, which means increases in DIRs will likely be slow and small. Case in point – Northwestern Mutual just announced a 0.15% increase in their DIR for 2024. That’s good news, to be sure, and proof that DIRs will eventually increase as the portfolio turns over, but it’s nothing compared to the massive increase in market yields over the same period of time.
The effects are starting to show. Of the major Whole Life sellers, MassMutual, Guardian and Penn Mutual are generally more oriented towards accumulation sales and they are down between 11% and 15% year-to-date. New York Life also has a heavy accumulation bent and it is down, but by a lesser amount. By contrast, Whole Life companies that tend to sell more protection-oriented products are flat or up year-to-date, including Northwestern Mutual.
The solution, in my mind, is not to double-down on the story that worked in the past. I’ve seen some agents attempt to sell Whole Life on the basis of future increases in the Dividend Interest Rate that will bring things back to “normal” which, in their view, is a permanent yield advantage for Whole Life to the tune of 2-3% on an annual basis. In other words, they’re making the assumption that the past 35 years was “normal” and an indicator of a structural relationship between bond yields and DIRs on Whole Life. They’re banking on outsized performance.
That is a fundamentally misguided approach. If you look at the long-term relationship between DIRs and bond yields, the average returns are virtually identical, as you’d expect considering that mutual companies invest (mostly) in bonds. The difference between the average of Moody’s Aaa bond yields and Northwestern Mutual’s DIR since 1950 is a scant 3 basis points.
I would argue that’s a ringing endorsement of Whole Life as a fixed income alternative. It really works. It delivers gross returns (not including expenses) on-par with high-quality corporate bonds. And if the company has strong earnings from non-participating lines and those earnings also go to fuel the dividend to participating policyholders – shareholders, effectively – then Whole Life might even outperform. Isn’t that exactly what it’s designed to do? Yes, it is, and that’s also exactly how we should be pitching it in today’s rate environment.
The lightbulb moment for me came, unusually, from a conversation I was having with my own financial advisor. He’s with a large RIA and knows nothing about life insurance. We make a great match. As rates started to increase last year, he asked me if I’d thought about moving some of my cash into fixed income. We got together for lunch to discuss some options. The more we talked, the more it dawned on me that investing in fixed income is difficult. Far more difficult than it looks at first blush.
Consider the fact that inherent in any fixed income investment decision, there are at least four factors at play – credit, maturity, liquidity and tax treatment. All of them have profound implications for the outcome of the investment decision and yet all of them are complex, arcane and rarely understood by the general investing public.
Credit
Of the four, credit is probably the most commonly understood. Everyone generally knows that risky borrowers have to pay higher interest rates. What is not commonly understood, however, is exactly how credit is rated and the relative risks assigned to each rating. How much safer is a AAA-rated bond, the highest possible credit, and a BBB-rated bond, which is the bottom of investment-grade? If you look at basic data from S&P, AAA-rated bonds have a 15-year cumulative default risk of 1.1% versus 5.4% for BBB. Is that worth the extra yield? How do defaults translate into actual losses? Is 15 years the right time horizon for the client? I would argue that actually assessing credit risk for a fixed income investment is much trickier in practice than it is in theory.
Maturity
Unlike stocks, investing in bonds requires a fairly complex series of decisions regarding time horizon. Bonds with longer maturities tend to have higher yields than bonds with shorter maturities. On the surface, that sounds like a reason to buy long bonds, but what if you think interest rates are going to increase? In that case, you’d rather be investing on the shorter end of the curve. What about a scenario where the yield curve is inverted? Then buying a short bond with a higher yield potentially exposes you to reinvesting in the near future when rates have dropped.
At the same time, maturity and credit also interrelated because your view of the credit of one borrower over a short time horizon might be different than your long-term view of the borrower’s credit. For example, buying a Blockbuster bond in 2005 that matured in 1 year was a very different experience than a bond maturing in 2015, when the company had already been through bankruptcy and defaulted on its debt. The typical argument about maturity is that a client should do a bond ladder. But bond ladders are simply a diversification tactic. The tradeoffs still exist.
Liquidity
Decisions on credit and maturity have consequences and the primary way to see the consequence on a daily basis is through the market value of the bond holdings. Fixed income prices are quite a bit more volatile than most people typically think. The longer the maturity of the bond, the more volatile the fair market price relative to interest rate changes (“duration”). The lower the credit rating of the bond, the more volatile the fair market price relative to overall risk appetite in the market (“credit spreads”). Put those two together and the fair market value of even a diversified, laddered bond portfolio will move around quite a bit more than most people think. Take a look at this chart below showing the change in annual fair market value of a simple laddered Treasury portfolio tilted toward longer-duration bonds over 40 years in 255 economic scenarios from the American Academy of Actuaries scenario generator.
Does this level of volatility matter to clients? Well, that depends on how closely matched the fixed income portfolio is to the client’s actual income needs and investment horizon. If it’s perfectly matched, then liquidity doesn’t matter because the client isn’t touching the investment until maturity anyway. But if it isn’t perfectly matched, then two problems arise. The client has to reinvest at market rates when short investments were supposed to be spent but aren’t or the client needs more income sooner and has to sell long investments in order to generate income. In other words, income and investment planning always works perfectly on the spreadsheet. It never works perfectly in real life. Any difference between the two and the client will be subject to liquidity considerations in fixed income.
Taxation
Let’s say a client is in a high tax bracket and wants a fixed income product with some tax advantages. Great – we have these things called municipal bonds that are exempt from federal income tax treatment and, in some cases, state income tax as well. These bonds solve an important market desire for tax-advantaged yields, but the problem is that they’re already priced to reflect their tax benefits. Buying a muni bond with a 4% yield may or may not be a better deal than buying a corporate bond with the same rating and a 6% yield. It depends on each client’s unique tax situation. And, on top of that, the muni bond market has its own bizarre maturity/credit/liquidity tradeoffs that are, in some ways, unique to that market. It’s not a place for novices.
Complexity
Let’s say that, like me, you’re a little bit befuddled by all of the choices and tradeoffs available to you in the bond market and you’d like to see what other options you have for fixed income. The good news is that there are a lot of options available. The bad news is that, like bonds, they have their own types of tradeoffs in credit, maturity and liquidity. And to make matters worse, these other fixed income instruments tend to be much more complex than typical bonds. Think CLOs. And if you don’t know what a CLO is, then you already get the point. The same thing goes for CMBS, RMBS, ABS, MLPs, REITs, private lending pools and other fixed income alternatives.
The Challenge of Fixed Income
What dawned on me in going through this thought process is that I am not a sophisticated fixed income investor – and I highly doubt that the average Joe investor or even financial advisor is either. Fixed income is actually quite a bit more complex than it looks and it requires a lot of tricky decisions that have real consequences. So yes, although yields are currently more attractive than ever, actually executing a comprehensive fixed income strategy to take advantage of today’s yields is exceedingly difficult.
There’s also the not-so-small matter of returns in fixed income asset classes over the past couple of years. Virtually every corner of fixed income has been pummeled as interest rates rose at the fastest clip since the early 1980s. The chart below shows the daily price values of three large BlackRock bond funds since 2004 – Agg (dark blue), High Yield (light blue) and 7-10 Year Treasuries (purple). In general, there’s a lot more volatility than most people would suspect, but the performance in all three over the past year has been atrocious. Fixed income investors have been understandably confused about what to do. Perhaps that’s part of the reason why US bond mutual fund and ETF outflows have been about $186 billion since the beginning of 2022, although the trend has started to move back towards positive inflows.
The solution, it seems, is for consumers to pour their money into tools that essentially outsource fixed income investing to a third party and allow the consumer to reap a net return with some level of rate guarantee. Retail money market funds have attracted inflows of around $630 billion since the beginning of 2022 and now stand at over $1.5 trillion of assets. Multi-Year Guarantee Annuities that pay a fixed guaranteed rate for a certain period of time had sales of over $100 billion in 2022 and are on track to do more like $125 billion this year. CDs as a percentage of total bank deposits are also kind of tricky to find online, but an S&P article earlier this year pointed to a huge uptick in CD deposits towards nearly 10% of US Bank deposits, putting CD flows since the beginning of 2022 at somewhere around a trillion dollars. Customers want to take advantage of the current rate environment, but not necessarily by buying fixed income themselves.
Money market funds, CDs and MYGAs all share a common attribute – they’re inherently short-term. They’re meant to be a solution for near-term financial needs ranging from immediate (money markets) to 2-7 years (CDs and MYGA). This is a great fit for older customers with clear and proximate retirement income needs. However, that’s not necessarily an accurate descriptor of all fixed income investors. For pre-retirees who want to reliably accumulate assets through both equity and fixed income exposure, these tools are short-term solutions to a long-term challenge. What they need is a way to systematically reap the benefits of fixed income while enjoying the same sort of stability and guarantees inherent in these other short-term financial tools.
What they need, in other words, is participating Whole Life.
