#426 | Indexed UL on the Efficient Frontier

Back in early 2019, I wrote a 3-part series entitled Indexed UL on the Risk Spectrum (Part 1, Part 2, Part 3) that argued that by every metric, Indexed UL is a relatively low risk, low return proposition more akin to a fixed account than a pure position in equities. It was a controversial view. Back then, the risk/return positioning of Indexed UL was more of a debate as charge-funded multipliers pushed real risk and illustrated returns through the roof. But over the past few years, expectations about Indexed UL performance have tempered. Even fervent fans of Indexed UL acknowledge that the expectations for returns should be only modestly higher than comparable fixed accounts. Undoubtedly, the industry has a more realistic view of risk and return in Indexed UL than it did 6 years ago.

The bigger question, however, is not where Indexed UL slots on risk and return but how it gets there. Modern Portfolio Theory is built on the concept of non-correlation or, even better, negative correlation of certain asset returns. Combining fixed income and equities works, at least theoretically, because the two asset classes often move in opposite directions. When that happens, there is a benefit to diversification that creates the pronounced bend in the Efficient Frontier, which represents the optimal combinations of the two asset classes in terms of risk and return. Here’s how it looks:

I covered this concept in more detail in #380 | Whole Life as a Fixed Income Alternative – Part 3 back in October of 2023 in order to point out that Whole Life is a natural fit as an alternative to fixed income because it is always non-correlated to equities and provides a higher return than comparably rated fixed income assets, particularly after accounting for tax drag. So how does Indexed UL fit on the chart? That’s a much trickier question.

Let’s start with a conceptual framework. Indexed UL is perfectly correlated to equities (S&P 500) for positive credits, at least up to the Cap, which is by far the most common crediting strategy in IUL. Above the Cap and below the Floor, Indexed UL is perfectly non-correlated. The net result is a strategy that produces about 75% of returns at the Floor or the Cap and only 25% of returns matching the underlying S&P 500 index between the Floor and the Cap. For the purposes of this article, we’re also ignoring policy charges by making the assumption that the choice of life insurance as a wrapper for its protection and tax advantages has already been made. The question, then, is what kind of assets should go in the wrapper. So by just looking at the pure crediting mechanism, you get a return distribution that looks like this:

The return distribution for Indexed UL is completely incompatible with the traditional concept in finance of measuring risk by standard deviation, which itself assumes that asset returns are a bell-shaped standard normal distribution. Indexed UL just doesn’t fit. You can still calculate the standard deviation, to be sure, but it isn’t an accurate descriptor of how returns in Indexed UL actually work.

Where things get interesting, however, is when the Indexed UL product is blended with a traditional equity portfolio. Doing so allows for the traditional metric of standard deviation to be more useful and answers the question of how incorporating Indexed UL modifies the risk/return profile when paired with equities. Below is the return distribution of 11 portfolios ranging from 100% SPX / 0% IUL to 0% SPX / 100% IUL across 1,000 annual return observations. The grays are portfolios ranging from 10% to 100% SPX and the yellow is 100% IUL. Each bucket label represents the top of the returns in the range, so 10% means 0.0001%-10% returns.

Indexed UL compresses S&P 500 returns from a range of -40% to 70% on an annual basis to 0-10% (Floor-Cap) and the compression effect becomes more and more pronounced as the portfolio becomes more and more concentrated into Indexed UL. In that sense, Indexed UL does exactly what it’s supposed to do – mitigate downside risk while still offering upside potential. That’s true whether the client has 10% of the portfolio in IUL or 100%. If the goal is risk mitigation, then Indexed UL fits the bill.

But is it efficient? If you take each one of the 11 portfolios above and graph them on a risk/return basis relative to the traditional efficient frontier comprised of 11 portfolios of fixed income and equities, here’s how it looks assuming a 10% S&P 500 Cap:

The short answer of whether Indexed UL is efficient is that it depends. The portfolios incorporating more than 60% equities are less efficient with the remaining 40% in Indexed UL than in traditional fixed income. Even though Indexed UL mitigates both risk and return, it does so in a way that is more correlated to the S&P 500 than the non-correlation assumption used here for fixed income returns. Hence, the reason that the traditional fixed income/S&P 500 portfolios bow out and above the IUL/S&P 500 portfolios. In short, if the client has a strong equity tilt, they’re better off using fixed income to mitigate equity risk than Indexed UL.

But for portfolios comprising less than 40% fixed income, the opposite is true. Indexed UL in isolation is a superior alternative to Fixed Income. The more the client tilts towards fixed income, the greater the advantage of a portfolio incorporating Indexed UL than fixed income. To put it another way, fixed income isn’t a great asset class on its own, but it can be a great asset class when paired with equities. The opposite is true for Indexed UL. It has some attractive characteristics on its own, but those characteristics don’t pair well with holding traditional equities, at least not when compared to traditional fixed income.

This observation strikes at the heart of the fundamental appeal for Indexed UL. Traditionally, the folks selling Indexed UL are not performing holistic financial planning that contemplates the interaction of the life insurance policy with the rest of the client’s portfolio. They’re simply selling a fixed life insurance product that has an appealing narrative of downside protection and upside potential. In isolation, that story works. But combined with the rest of the client’s assets, it’s a demonstrably sub-optimal solution for all but the most conservative of investors.

The degree to which Indexed UL is sub-optimal is dependent on two things – the correlation between fixed income and the Cap offered by the insurer. Correlations between fixed income and equities are the topic of much debate. There have been periods when correlations were positive and periods where correlations were negative. The analysis above assumes zero correlation, something of an average expectation. Negative correlations create more of an argument for incorporating fixed income rather than Indexed UL. Positive correlations go the other direction. The table below shows a negative (-0.3) correlation and a positive (0.3) correlation. The challenge in the real world, of course, is coming up with a reasonable correlation assumption for the next 50 years or so.

The Cap is arguably simpler. The model assumes that the fixed income yield is locked at 5.5% and that is slightly higher than the carrier’s option budget. That sort of option budget could currently purchase a 10% Cap, which is what is modeled above in the base case. But options have been much cheaper in the past and could continue to become more expensive. It is possible that carriers could only afford an 8% Cap or may be able to buy a 12% Cap. Where the long-term Cap falls hugely impacts the efficiency of Indexed UL relative to a traditional efficient frontier:

At an 8% Cap, there’s a tough argument for Indexed UL except for extremely conservative portfolios. At a 12% Cap, Indexed UL shows very well, almost matching the benefit of combining fixed income with equities across the whole efficient frontier. You might even argue that a 12% Cap is efficient. But the problem, of course, is that the 12% Cap argument relies on option prices plummeting. The comparison is always dependent on the rates offered by the life insurer and therein lies the rub. The pivot point for the entire analysis is something that is subject to the life insurer’s discretion and is not well understood by the agents selling and clients buying these policies. Only fools and charlatans would attempt to make long-term projections about option prices, much less how carriers will translate those prices through to actual rates.

The core insight of this analysis is simple but powerful and controversial – Indexed UL is a great story in isolation, but it is not a great story when paired with traditional equity-oriented portfolios. So where does Indexed UL fit? Arguably, it’s the optimal fit for people entering or already in retirement and are stepping off of the gas on their equity holdings. That’s part of the reason why Fixed Indexed Annuities are such a slam dunk. The average age of an FIA buyer is around 62 and FIAs are often positioned within a holistic financial plan as a de-risking strategy moving into retirement. That makes perfect sense. But for the traditional Indexed UL demographic of younger customers, it’s a sub-optimal choice compared to traditional equities and fixed income.

The better choice that allows for traditional investments, retains all of the tax benefits of life insurance and has a comparable (if not lower) cost structure is Variable UL. These days, there is no reason to choose an Indexed UL over a Variable UL that also offers indexed accounts. Period. Variable UL allows policyholders to lean heavily into traditional portfolios of equities and fixed income when they are accumulating assets and then transition to indexed and fixed accounts when they are in retirement. It’s the optimal choice*.

Almost. I’ve argued before that, actually, combining Whole Life and Variable UL is the optimal choice because Whole Life is a superior asset class to fixed income and offers higher returns than fixed accounts due to the participating nature of the policy. Take a look at the efficient frontier with Whole Life relative to Indexed UL:

Whole Life consumes none of the client’s risk budget and has guaranteed zero correlation with equities, but offers a return that is on-par with fixed income, as discussed in numerous other articles. Indexed UL offers a higher average return with a 10% Cap (6% vs. 5.5%), but with more risk and correlation to equities. Again, in isolation, Indexed UL looks superior to Whole Life. But in the context of the total asset portfolio, a combination of Whole Life and equities is the optimal solution.

This begs the question – what can Indexed UL do to be a better fit for a total asset portfolio? Four things. First, life insurers can get serious about offering attractive fixed account rates that are comparable to the underlying option budget supporting the currently declared indexed rates. Fixed accounts have the same sort of stability features as Whole Life that make them a great alternative to traditional fixed income in the context of an overall asset portfolio. Unfortunately, most life insurers do not offer competitive fixed crediting rates in their Indexed UL products, as discussed in #374 | The Missed UL Opportunity, although a few have increased their fixed crediting rates since that article was published in 2023.

Second, life insurers can lean into the standalone story courtesy of structured crediting strategies – index-linked structures that incorporate equity-linked downside risk. These sorts of strategies continue to be enormously popular in annuities, where they are styled as Registered Index-Linked Annuities (RILA) and sold as an equity risk management mechanism for pre-retirees. The attractiveness of the strategy relative to holding pure equities depends on the desirability and price of risk mitigation, which is exactly how they’re sold. Successful RILA sellers make the argument for RILA instead of traditional equities. That works if you’re actually taking downside risk and have a substantial amount of upside potential, but it doesn’t work for Indexed UL.

The company most actively pushing into this market in the life insurance is Prudential with FlexGuard IVUL, which just got a slew of updates. FlexGuard IVUL now includes a Dual Directional strategy that provides a positive return equal to the negative index return as long as the Buffer of 10% or 15% isn’t pierced and, as confusing as it sounds, is an increasingly common feature in the RILA market. They’ve also added an Enhanced Cap strategy that uses both a Spread and a Cap and 15% Buffer options. All of these updates seem designed to push the core story of FlexGuard IVUL as an alternative to traditional equity allocations with a slew of defined outcome structures.

Third, and most importantly, life insurers should completely rethink their strategy around engineered indices. As discussed in #418 | The Future of Engineered Indices, the narrative around these indices has shifted from brand name to look-back performance to illustration gimmicks to actual performance. All of these goals have fallen short. Brand names are everywhere these days and no longer mean much. Look-back performance has been shown to have no relation to real-world performance. Illustration gimmicks only make that problem worse. And when banks and insurers attempt to pivot their indices to deliver actual performance, they often get the structure wrong and set themselves up for failure. If it’s extremely hard for any active manager to beat the benchmark, why should we expect any difference from formula-based indices that can’t be modified after launch?

Instead, engineered indices should focus on actually delivering diversification benefits within Indexed UL products. When equities zig, then engineered indices should zag. They actually delivered the goods in the 2024 calendar year, as shown in the table below. Each bar represents a different engineered index. The color of the bar corresponds to the index’s volatility target. The y-axis represents the return for the year.

Engineered indices definitely zigged when the S&P 500 zagged. 40% of the indices posted negative returns when the S&P 500 delivered nearly 25%, which is mostly a product of negative Treasury yields and Excess Return deductions. The average return for the year was just a hair over 2%. Through the end of February, the S&P 500 was up about 1.25%, but about half of indices have outperformed the S&P 500 and some by quite a bit due to higher YTD returns in gold, international stocks and Treasuries. Those indices are performing a diversification function that is core to the appeal of Indexed UL as a part of an overall asset portfolio. The last few years have been so dominated by the US that some of the diversification benefits of these indices have been hidden. But this year, they’re starting to show – and that’s a good thing for indexed insurance products.

Finally, Indexed UL can focus on where it actually fits as a stand-alone product. In a holistic financial plan, Indexed UL gets crowded out by Variable UL, which also has indexed and structured strategies, and Whole Life. But there are a lot of people who aren’t getting a holistic financial plan because they don’t have enough assets for it to make sense or, if they do, those assets are tied up in a standard 401k plan or IRA. These people are looking for a safe place to park money, earn a reasonable return with a simple strategy and not get hit with a 1099 at the end of the year, all inside of a policy that offers the death benefit protection they need anyway.

For folks like that, Indexed UL can be a great fit. One of the great ironies of Indexed UL is that although some carriers have focused their efforts on the top end of the market fueled by premium financing, the best fit for Indexed UL is actually in the lower to mid-market segment. Not surprisingly, that’s where the product category is growing by leaps and bounds. The beauty of Indexed UL is its simple story of upside potential with downside protection. Indexed UL is the product for people who can’t afford or fully wrap their heads around combining Whole Life and Variable UL. It’s the easy way out – and that’s not necessarily a bad thing, even if it’s not, technically speaking, the most optimal choice.

As Indexed UL increasingly goes down market, the requirement for the industry to treat these folks responsibly increases. Companies selling Indexed UL based on illustration gimmicks and aggressive planning tactics have long fallen back on the argument that their customers are “sophisticated,” never mind the fact that no one who doesn’t sell or manufacture life insurance for a living is sophisticated about it. That argument doesn’t work when you’re selling policies in $2,000 premium chunks. We owe it to these policyholders, and to ourselves, to live up to the trust that these folks have placed in the product and the carriers that sell it.

*I was an Economics major in college and someone decided to print up t-shirts for the department. It was a stark black shirt that simply said “Economics: The Optimal Choice.” I wore it with pride despite the derision from my friends, who still make fun of me about it – and with complete justification.