Have we gone too far in limiting illustrated rates on IUL? : BLOG
January 7, 2016 by Tom Martin
Recent regulations have addressed “overly optimistic” assumed rates in IUL contracts in order to curb “abusive” illustrations. Prior to NAIC AG49 the maximum illustrative rate was set by the insurance carrier and was normally based on an average look-back of 20 to 30 years. AG49 limits the maximum illustrative rate to the average rate based on stochastic modeling of 25-year holding periods going back to 1950.
While the prior model could be criticized for including mostly bullish periods by going back to the mid-80s or 90s, is it realistic to go all the way back to 1950?
The fact is that today’s markets are vastly different than they were mid-century. Prior to 1980 there were no 401(k)s and IRAs were in their infancy. People’s retirement plans were mostly pension plans managed by institutional investors. If an individual were invested in the market directly, his access to information was basically limited to the stock quotes he read in the paper the following day.
Computer infrastructure did not accommodate high frequency or program trading. There were no “flash crashes” produced by technical glitches. There was no “day trading.” Individuals did not have access to online brokerage accounts where they could instantly react to the market with $7 trades.
All that began to change in the 1980s with the introduction of 401(k)s, expansion of IRAs and the emergence of personal computing power. As a result, the behavior of the post 1980 market is vastly different than the pre-1980 market. This is not to suggest that the markets will either be more bullish or more bearish as economic factors will dictate the market’s direction. But, it is fair to say today’s market is, and will continue to be, more instant, more emotional and more volatile than before. And this increased volatility is one of the things that make IUL shine relative to the market.
My criticism of the new regulations is that it includes market data for a period of 30 years in which the market was vastly different than today and its arbitrary assumption of a 25 year holding period. A more useful approach would be to have stochastic (Monte Carlo) modeling over a variety of holding periods. Clients should be able to know how their IUL would have performed during specific bull market periods as well as specific bear market periods.
For instance, one of my favorite survivorship IULs currently offers a floor rate of 2 percent with a cap of 11.25 percent. A prospective buyer of this product might be 60-70 years old and should probably plan on having the policy for at least 30 years. The new regulations cap on the maximum illustrative rate at 7.2 percent is based on the average of 25 year holding periods going back to 1950. But if we back-test 30 year holding periods back to 1980, we see that the worst 30-year period produced an annualized return of slightly more than 7.2 pecent in an average return of 7.88 percent and a maximum of 8.64 percent. Is the client actually able to make an informed decision if my “best case scenario” on the illustration is worse than the actual “worst case” scenario?
More importantly, as a prospective buyer, I would want to know what I can expect of this product during a typical bear market and a typical bull market. Lacking an automated system to track this, I manually calculated this for the product I just described using calendar year returns of the market going back 30 years.
Since 1985, there have been two, five-year bear markets: 2000-2005 and 2005-2010. The annualized return of the S&P (without dividends) during these periods was -3.79 percent and -1.62 percent respectively. The annualized return on the indexed product I referred to earlier during these periods would have been 5.17 percent and 6.13 percent respectively.
The period of 2000-2010 represents the only 10-year bear market since 1985 where the S&P performed at an annualized rate of -2.89 percent. Meanwhile my IUL would have performed at a rate of 5.65 percent. While normally I would not be thrilled with a 5.65 percent rate, relative to the market performance I would be ecstatic.
A very bullish five year period would have been from 2010 to 2015 in which case the S&P performed at an annualized rate of 13.02 percent. During this time, my IUL would have delivered a respectable 9.33 percent. The thirty year period ending 2015 would have produced an annualize return in the market of 8.73 percent while my IUL would have done 7.73 percent.
Of course the rates are before the deduction of any insurance or contract charges that would be accounted for in the insurance illustration.
Examining hypothetical performance during moderate markets, bull markets and bear markets are far more useful than assuming a single static crediting rate over an arbitrary frame of time. It also supports my true feeling about IUL: You will like it in a bull market, be satisfied in a moderate market and love it in a bear market.
As producers, the point that we should be trying to impress on our IUL clients is not what kind of average crediting rate the IUL will produce but how the product will perform relative to other investments.
While it’s dangerous to assume overly optimistic scenarios, it’s equally dangerous to assume overly pessimistic scenarios. Virtually every financial decision we make from buying a house, to starting a business, to investing for retirement requires us to examine and weigh the worst case scenario, the probable scenario and the best case scenario. AG49 forbids us to do that with IUL.
