This is a guest blog written by Bobby Samuelson, founder of SamuelsonDesign and executive editor of The Life Product Review.
On its face, Indexed UL offers an incredibly simple and appealing proposition – upside potential and downside protection.
But both proponents and detractors of IUL continue to grapple with how well IUL delivers on its core value proposition relative to what the the glossy marketing brochures say.
I’m going to tackle three key questions that are at the heart of the debate.
does IUL actually offer principal protection?
One of the hallmarks of IUL marketing is the idea that IUL offers upside potential and downside protection. The former part is certainly true, but the latter is less certain.
IUL only offers downside protection in the context of other life insurance policies that also have fixed policy expenses. In IUL, fixed policy expenses can go as high as 30% of a fully funded (7 pay maximum non-MEC premium) after only 10 years.
In other words, the floor for this product isn’t 0% – it’s negative 30%.
Any indexed credits will serve to offset the fixed losses from the charges. This is a relatively standard formula for UL products, but is a bigger problem for IUL for three reasons:
- First, IUL marketing touts principal protection but the product clearly does not offer any protection of principal. A quick run through YouTube will show you that too few IUL customers understand that principal protection only applies to the credits, not to the policy charges.
- Second, IUL products usually do not have generous guarantee provisions as in Whole Life or CAUL that allow for cash values to get near basis under worst-case assumptions.
- Third, IUL fixed policy charges tend to be much more expensive than other general account life insurance products due to higher commissions and the provision of higher upside via higher caps. The average IUL product is 25% more expensive than CAUL over the first 10 years assuming 7 maximum non-MEC premiums. In terms of raw fixed charges (excluding premium loads), IUL is 35% more expensive.
are dividends really not included?
The stock line with Indexed UL is that the reference index does not include dividends, and, therefore, neither does the product.
This is true in the limited sense that a dividend isn’t directly paid to the policyholder. But that doesn’t mean that dividends have no impact on policy performance.
In reality, dividends serve to partially subsidize the price of hedging equity upside. The alternative to purchasing the hedges directly is to trade exposure to the underlying index, which does include dividends. The price to hedge is partially reduced by the foregone dividends which could have been earned by trading the underlying index, which allows the carrier to provide a higher cap given a particular hedging budget.
A good rule of thumb is that the cap will increase by about 1% for every 1% of additional dividend yield.
Given that about 50% of observations in the S&P 500 have been at 12% or higher, roughly half of the dividend will be recouped via the higher cap.
are current caps sustainable?
One of the key assumptions in Indexed UL marketing is that the caps available today are sustainable in the long run.
There are two fallacies to this assumption.
The first is that the cap is a factor in product construction. It isn’t. The cap is merely the result of what a particular option budget can purchase in equity exposure from a counterparty. It’s the result of matching the carrier’s earnings with the market option price.
In other words, the cap is an outcome, not a determinant.
The second is that carrier earnings (the options budget) and the market price for options are roughly correlated, meaning that the caps today are sustainable over the long run.
In reality, the two generally move in the same direction but with very different speeds. Carrier earnings lag market yields and react slowly to changes. Options prices react immediately.
In the case of capped options, interest rates play a major role in determining the price of the option.
Right now, carrier earnings are beating market interest rates by a substantial margin, meaning that capped options prices are cheap and carriers have plenty to spend. Therefore, caps are high.
If interest rates stay low, carriers will have less to spend as their yields converge to the market and caps will go down. If interest rates go up, carriers will have slightly more to spend but options could cost dramatically more.
The net result is dramatic.
If carrier yields just matched market interest rates, caps would drop to roughly 9.5%, holding all else constant.
exploring these three questions
The end result of tackling these three questions is a more contextual look at Indexed UL.
If dividends really do play a part in IUL performance, then we should not shy away from making comparisons to Variable UL using tools like John Hancock’s IUL Translator.
What we find by looking at IUL in the context of VUL is that IUL is really a product built for conservatism. If you think equity markets are going to boom, you’d be much better off in VUL than IUL.
So what about if you’re a bit of a bear?
Well, because of the fact that IUL doesn’t offer true principal protection, your client might be better off in a Whole Life or Current Assumption UL with stronger guarantees.
Indexed UL fits well as a slightly riskier alternative to CAUL and a much less risky alternative to VUL. In both cases, it’s fair to assume that IUL’s performance will reflect its risk. especially considering that IUL caps are likely to be lower than they are today relative to market interest rates.
We can effectively toss out the notion that IUL offers the best of both worlds – true downside protection with all of the upside of a VUL.
Instead, it’s more like the notorious part car, part truck Chevrolet El Camino.
Yes, IUL provides upside, but not as well as VUL. And yes, it provides downside protection, but not as well as Whole Life.
But if you want a bit of both, a low cap, low commission, low cost IUL could be a good option.