Diversification is an important concept within the world of financial planning, and rightly so. It rarely makes sense to put all of your eggs in one basket, and one could argue following that advice is even more important when it comes to working with hard earned retirement funds.
This idea is well known within investing and in recent years has extended to fixed index annuities, as carriers now provide clients with a wide variety of options for both index allocation and crediting methods within available contracts. It’s logical, then, that this strategy should extend to cash-value life insurance (specifically fixed index universal life insurance), where clients also have the opportunity to allocate the cash value within the policy to an index allocation and a crediting method that determines how much interest they may receive in a given year.
Many clients will naturally be attracted to the option that provides the most potential for earning interest, but it’s important to remember that might not be appropriate for that person based on their specific financial situation. The option with the highest interest potential will likely include less consistency and more volatility, meaning more potential risk of earning 0% interest for the client.
So how can financial professionals be effective in communicating which options might be an appropriate fit for their client? Making allocation choices is actually a lot like setting a lineup in baseball – a timely analogy since the baseball season is in full swing.
Understanding Your Options
A baseball team is usually comprised of a variety of hitters. The typical player is expected to hit singles and doubles, and may occasionally hit a home run. And although the home run hitters are more likely to hit the ball out of the park, they generally may also have a higher probability of striking out.
The same can be said about the different allocation options within a fixed index universal life (FIUL) insurance policy. An allocation option is a combination of an external index and a crediting method that determines how much interest the client can receive in a given year. Some allocation options may offer the potential for more interest – in this case, a home run – but may provide less consistency and more volatility. Others may have a lower interest potential – the singles and doubles hitters – but may provide more stability.
Because it’s impossible to predict the environment and which allocation option will be the home run hitter at any given time, it’s important to focus on consistency and getting on base. Diversifying allocation options can provide your client with more opportunities to make that happen.
There are various crediting methods to consider when discussing allocation options that may be suitable for a client’s situation. Crediting methods relative sensitivity to the volatility, performance, and interest potential all vary.
When looking at the various crediting options available in the marketplace, monthly sum with a cap may be considered to be a “home run hitter” because it appears to offer the most interest potential. However, it also has the most sensitivity to volatility, so it may also get you the most zero interest scenarios or “strikeouts.”
Selecting just one allocation option may provide the potential for more home runs and strikeouts – but diversifying among a variety of allocation options may help limit the extremes and provide more consistency.
Crediting methods are only half of the equation when it comes to considering an allocation option. In addition to the crediting method, your client also needs to consider the index used in that allocation option.
As an alternative to indexed interest, your client also has the option of allocating part or all of their cash value to a fixed interest account. Regardless of which allocation option they choose, the cash value is always protected from negative performance (although policy fees and charges will reduce values).
Choosing the Lineup
Knowing all the choices, which allocation option should your clients choose? Will they swing for the fences – or aim for consistency? The answer depends on their financial goals and risk tolerance.
But with so many options, it can be tough to know what may be suitable for their situation, especially because each option is going to perform differently in any given economic environment. For example, if we look at various economic environments over the last decade, the best allocation strategy – or “home run hitter” – would have been different for the beginning of the 2008 financial crisis than it would for the fourth quarter of 2011 when we were approaching the fiscal cliff. Similarly, the most effective option for early 2011, when fears of global recession were widespread as stocks rose and fell, would not work as well at the beginning of 2015 when equities were returning over 10% and were expected to continue rising. (It is important to keep in mind that past results are not an indication or predictor of future results.)
This brief eight-year window demonstrates that there is no clear path to knowing the economic outlook and which allocation option would have been the most effective. Even the best market analysts cannot predict what next year’s environment result will be, or hint at what the home run hitting allocation option might be. So, what can you do to help your clients choose an allocation mix that may be appropriate for them
This is how the power of diversification comes into play. Diversification among allocation options can help smooth out the highs and lows. So instead of looking for each year’s home run hitter, it may be more effective to have consistent performers with the potential to get on base. Remember, diversification does not protect against loss or ensure that your clients will earn an interest credit every year, but it may help provide more consistent results by spreading out the interest potential and volatility of the policy over different economic cycles.
Clearly there are different approaches to take when discussing an allocation lineup with your client for their FIUL policy. Although they certainly could hope for home runs from a single source – it may be more effective to help your client create a team that can work together to deliver the results they need.
--- Read Getting Up to Speed on the NAIC’s AG 49: What You Need to Know on ThinkAdvisor.