AG 49: Have we gone too far in limiting illustrative rates on IULs?

Recent regulations have addressed “overly optimistic” assumed rates in indexed universal life (IUL) contracts in order to curb “abusive” illustrations. Prior to NAIC AG 49, the maximum illustrative rate was set by the insurance carrier and was normally based on an average look-back of 20 to 30 years. AG 49 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 truly realistic to go all the way back to 1950? The fact is, today’s markets are vastly different than they were mid-century.

Prior to 1980 there were no 401ks, and IRAs were in their infancy. People’s retirement plans were mostly pension plans managed by institutional investors.

If an individual was 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 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 makes IUL shine relative to the market.

The problem with the new regulations is that they include market data for a 30-year period during which the market was vastly different than it is today, and an 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 the maximum illustrative rate at 7.2 percent 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 percent, 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” actual scenario?

More importantly, as a prospective buyer, I would want to know what I can expect of this product during typical bear and bull markets. Lacking an automated system to track this, one must manually calculate this using calendar year returns of the market going back 30 years.