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 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 investments is not always easy. Studies have shown that people tend to prefer known risks over unknown risks. 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 understand.
People are also 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.
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 $1.3 million , but it was projected (though, again, not “guaranteed”) that the contract would 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 cause the policy to lapse — without cash value or death benefit. To support his unease, he pointed to the columns labeled “guaranteed assumptions,” wherein 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.
After the discussion with his broker, Mr. Cautious went back to his insurance advisor and explained with dismay that he hadn’t realized it was possible for the policy to lapse even if he paid all of the scheduled premiums. Mr. Cautious indicated that, going forward, he really only wanted to look at policies where all of the benefits were guaranteed. 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: ones 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 UL is, how it works, and the true nature of the risks that are most likely to impact performance. The aim: to demystify this conservative investment alternative and promote a more objective discussion.
About Indexed UL
Indexed UL is flexible premium permanent life insurance that contains both an insurance component and an investment component. Like other permanent life insurance products, [remiums 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? The growth of an IUL 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. This contrasts with:
(1) current assumption UL policies based on a flat crediting rate established by the insurance carrier and adjusted from time to time;
(2) whole life policies based on a flat dividend rate established by the insurance carrier and adjusted from time to time; and
(3) variable universal life policies based on the actual investment returns of specific equity investments.
As illustrated in the above flowchart, projections of Indexed UL policy performance are based on the forecasting of two variables: (i) annual policy charges; and (ii) the collared return on the Index. Each of these is discussed in detail below.
Annual policy charges
There are typically 4 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; they are 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. This is the only charge 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, some 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.
Receiving wildly varying returns that average 8.38 percent per year is not, however, 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.