As I wrote in the May 2014 FSP Insights column, policy illustrations may be useful to understand how a particular policy may work - but they also have the tendency to encourage the buyer to form an expectation that the policy will largely “work” the way it’s projected.
Illustrations for policies such as indexed universal life (IUL) run the risk of heightened expectations for unrealizable results. This primarily occurs when the illustration assumes a seemingly “conservative” crediting rate to reflect long-term results in equity indices. While current policy “caps” may well produce appealing policy credits in years when the equity markets are performing well, it’s important to look more deeply to see how crediting rates are determined out of volatile equity index returns.
Interesting Things to Know About Interest
Buyers of an estimated 90 percent of all IUL policies choose the Standard & Poor’s 500 1-year “point-to-point” index as the basis on which the annual crediting rate will be determined retroactively each year on the policy’s anniversary date. However, in most of these policies, the applicable index excludes reinvested dividends. For example:
The crediting rate averages in this particular time frame suggest that illustrated rates much greater than 6.15 percent will likely not produce the expected result. But there are more issues to consider. For example, there can be a significant difference in the 365-day “point-to-point” calculation of crediting rates based on the fluctuations in the chosen index in rolling 365-day periods. Once again, using the popular S&P 500 index, consider the different results within just a two-week period in August 2011 compared with its look-back to August 2010:
Anecdotally, we know that many buyers of IUL are not buying these policies for low-cost protection only. Accumulating cash value in a life insurance policy may be a strategically valuable complement to more traditional investment strategies. But some insurers add even more “zing” to the numbers by suggesting positive arbitrage at the point where tax-free cash value loans are taken to supplement retirement income. This is accomplished when borrowed funds are credited with a favorable interest rate – and one that is projected always to be greater than the interest rate paid on the accumulating loans. But here’s the reality check: There isn’t always a positive relationship between the two rates, even when tied to outside interest rate indices. See the chart below for an example:
Testing an arbitrarily chosen projection of a lifetime 13 percent cap (typically guaranteed only at 3.5 to 4.0 percent) – with an alternative 11 percent lifetime cap assumption – the actual arbitrage underlying the illustrated 1 percent positive arbitrage (allowing generous policy loans) could wind up reducing the actual loans by as much as 25 percent.
In this chart, we assessed results from 1985 through and including 2012 (using midyear monthly results). The reality is that the indices on which crediting rates and loan rates are determined as dynamic and volatile. There is no ascertainable fixed relationship between these two rates.
A Caution for Producers and Consumers
Today’s life insurance policies – especially IUL – have evolved into complex financial instruments. There are many moving parts, and the explanation of how those parts “work” and interact can be difficult to understand. Policy illustrations can be a valuable tool to visualize how the policy works in a specific scenario. But those same illustrations almost always create an overly optimistic impression and expectation about policy performance. Because illustration “math” is almost always based on assumed constant rates of return, producers, financial planners, and other advisors need to better understand the mechanics and interactions of the assumptions underlying IUL policies.