Everything we do in life involves some element of risk. Some risks are known, and believed to be understood, while others are more uncertain and involve either probability or magnitude that we find difficult to quantify.
When investing, we generally seek to obtain the highest return possible given the amount of risk that we are able and willing to tolerate. Unfortunately, gauging the degree of risk associated with various investments is not always easy.
Studies have shown that people tend to prefer known risks over unknown risks, according to The Quarterly Journal of Economics. In many cases, this propensity, referred to as “ambiguity aversion,” can cause us to overweight or exaggerate risks that we are unable to quantify or that we do not entirely understand.
At the same time, people are prone to downplay risks that are common and familiar, where undue significance may be attributed to our own subjective personal experience (i.e., “I’ve done this for years, and nothing truly bad has happened to me, so it must not be very risky.”). Taken together, these (often subconscious) biases can prevent us from properly assessing our alternatives – resulting in decisions that are based on perceived risk, rather than actual risk.
Chances are, you know people who are frightened of flying in airplanes but don’t think twice about getting into an automobile, despite statistics that place the odds of dying in a plane crash at 1 in 11 million while the odds of dying in a car crash are (according to some sources) as high as 1 in 5,000.
One example of this in the investment world is the way in which some people attempt to evaluate the use of life insurance as an investment. Consider the case of “Mr. Cautious”, a 50-year old man in better-than-average health who was recently weighing the purchase of an indexed universal life insurance policy (the “Policy”). Mr. Cautious’ insurance advisor had recommended this product as a conservative way to build cash over a mid-to-long term time horizon. It would also pay an attractive death benefit to Mr. Cautious’ family in the event of his death. According to the Policy illustration:
- Mr. Cautious would pay total premiums of $500,000 over 7 years ($71,429 per year), after which point it was projected (though not “guaranteed”) that there would be no further premiums required.
- The Policy’s initial death benefit would be $1,300,000, but it was projected (though, again, not “guaranteed”) that this would begin to grow each year beginning in Year 7.
- Each year, the Policy’s Cash Value would be credited with interest based on the performance (excluding dividends) of the S&P 500 Index (the “Index”), collared by a guaranteed floor of 1 percent and a current cap of 13 percent that was subject to fluctuation upward or downward at the discretion of the insurance carrier.
- Based upon the non-guaranteed assumptions that Policy charges would remain at their initial projected levels and that the collared return on the Index would average 7.5 percent per year, it was projected that the Policy’s cash surrender value at the end of the 10th year would reflect a 4.6 percent internal rate of return (“IRR”) on the scheduled premiums. By the end of the 15th year, the cash surrender value IRR was projected to reach 5.65 percent, and it was projected to be 6.04 percent by the end of the 20th year.
The proposal sounded attractive to Mr. Cautious, who knew that the projected returns were considerably higher than what he could currently earn with 10, 15 and 20 year municipal bonds, but when Mr. Cautious discussed it with his investment advisor, he was told that the strategy sounded “risky”. The broker drew Mr. Cautious’ attention to the fact that most of the benefits projected under the Policy illustration were not “guaranteed”.
He suggested that the projected 7.5 percent average return on the Index seemed aggressive, and expressed concern that a lesser return (which he believed to be more likely) could eventually cause the Policy to lapse – without cash value or death benefit. To support his unease, he pointed to the columns labeled “Guaranteed Assumptions,” where the Policy’s cash surrender value was never projected to rise above $376,000 (notably less than the scheduled premiums), and the Policy was only projected to last until age 80 before lapsing.
Stories like Mr. Cautious’ are not uncommon. Stocks, bonds, mutual funds and real estate all carry their own varying degrees of risk and also lack “guaranteed” results, but to many people these are considered known risks – where they believe they have sufficient information available to confidently project future results. The lack of familiarity with life insurance as an asset class often prevents people from applying a similar, objective analysis to insurance products.
Nothing in life is risk-free, and Indexed Universal life insurance products are no exception. Interestingly, though, the concerns about these products that are most often cited are ones that are (at least statistically) extremely remote.
The paragraphs that follow provide an overview of what Indexed Universal Life Insurance is, how it works, and the true nature of the risks that are most likely to impact performance – in an effort to demystify this conservative investment alternative and promote a more objective discussion.
What is Indexed Universal Life?
An Indexed Universal Life Insurance policy (an “Indexed UL policy”) is a flexible premium permanent life insurance policy that contains both an insurance component and an investment component. Like other permanent life insurance products: Premiums are deposited in the policy’s cash account, which is reduced by policy charges and increased by a crediting methodology set forth under the terms of the policy.
What differentiates an Indexed UL policy from other types of permanent life insurance used for cash accumulation is that the growth of the policy’s cash value is based on the performance of an equity index (usually the S&P 500), excluding dividends, collared by a cap and a floor – rather than based on a flat crediting rate that is established by the insurance carrier and adjusted from time to time (a product referred to as “current assumption universal life”), based on a flat dividend rate that is established by the insurance carrier and adjusted from time to time (a product referred to as “whole life”), or based on the actual investment returns of specific equity investments (a product referred to as “variable universal life”).
As illustrated in the above flowchart, projections of Indexed UL policy performance are based on the forecasting of two variables: annual policy charges; and the collared return on the index. Each of these is discussed in detail, like so:
Annual Policy Charges
There are typically four different charges deducted from the cash value of an Indexed UL policy. Two of those charges (a Premium Load Charge and a Monthly Charge per $1,000 of Death Benefit) are, essentially, sales charges – somewhat analogous to the transaction fees or management fees that one might pay to money managers, brokers, or investment advisors.
The Premium Load Charge is assessed each time a premium is paid, while the Monthly Charge per $1,000 of Death Benefit is only assessed for the first 10 years after the policy is issued. The third charge is a (generally nominal) Annual Expense charge. The fourth charge, the Monthly Cost of Insurance per $1,000 of Death Benefit, is the mortality charge associated with providing the policy’s death benefit – and this is the only charge that is scheduled to increase each year.
Collared Index Return
As described in the text of the flowchart above, the historical average “compound” return on the S&P 500 Index with a 1 percent floor and a 13 percent cap is 7.5 percent. To better explain what this number means, a bit of background is in order. The average annual (uncollared) S&P 500 Index return for all calendar years between 1920 and 2013 was 8.38 percent. It is important to recognize, though, that receiving wildly varying returns that average 8.38 percent per year is not the same as receiving level returns of 8.38 percent each year – and if you had a bank account that was credited with actual S&P 500 Index returns from 1920 to 2013 (excluding dividends), your average compound return would only be 6.45 percent.
For a simplified example of this concept: Imagine that you invest $1,000 and realize a 20 percent loss in Year 1 followed by a 20 percent gain in Year 2. Although your average return over the 2 years was 0 percent (-20 percent plus +20 percent, divided by 2), your investment at the end of the 2nd year would only be worth $960, resulting in a compound return of negative 2.02 percent per year.
In other words: Volatility reduced the compound return on this investment by 1.93 percent! Now look at the return over the same time period, but with a collar of 1 percent and 13 percent. The average collared return for all calendar years between 1920 and 2013 was 7.80 percent (0.58 percent less than the average return without the collar).
However: Because the collar dramatically reduces volatility, the average compound return on an account credited with the collared return from 1920 to 2013 would have been 7.65 percent. The collar reduces the impact of volatility from 1.93 percent to only 0.15 percent. The point of this analysis is not to suggest that the collared return from an Indexed UL policy will outperform direct investment in the S&P 500 (in the long run, it won’t – because direct investors receive dividends in addition to market appreciation), but instead to illustrate how reducing volatility can dramatically improve investment returns.
At this point in the discussion, any good investment advisor might remind you that past performance is no guarantee of future results – and this is entirely correct. Even if historical averages hold true, the fact that the average return over 94 one-year periods was 7.65 percent does not mean that you will have a return of 7.65 percent in any given one-year period. In any given one-year period, it is not only theoretically possible to realize a return equal to the 1 percent floor, but this is, in fact, what happened in 33 of the 94 one-year periods between 1920 and 2013.
But what if we focus on performance over a ten-year period? There have been 85 rolling ten-year periods between 1920 and 2013 (1920-1929, 1921-1930, 1922-1931, etc.). In this case, while it remains theoretically possible to realize a ten-year average return equal to the 1 percent floor (a result that would require the S&P 500 Index to produce an actual return of 1 percent or less for ten straight years), this never occurred in any of the 85 rolling ten-year periods dating back to 1920. In fact, since 1920, only once has the S&P 500 Index produced even 4 consecutive years of 1 percent or less (1929-1932), and on only three other occasions has it produced 3 consecutive years of 1 percent or less.