Understanding What You Need to Know But Don’t
By Bill Boersma
A marketing piece by a well-known and major player in the life insurance industry was recently forwarded to me. It touted the track record of its indexed universal life (IUL) products by claiming its products have a track record of following through on expectations. (It was sent out in July of 2021, so keep that in mind. I wrote this piece over a year ago, but am only self-publishing it now. My usual outlets were reticent to touch it.) At first glance, it isn’t different than much of anything I see. However, when one knows what’s actually going on, it becomes apparent it is utter nonsense and, to put it charitably, misleading.
Despite the years of low interest rates and the hubbub about underperforming policies, IUL included, the carrier is going on the offensive to let everyone know it has followed through on projections. In a way, it has. In a way, it is misrepresenting the truth.
The related details are as follows. The carrier is reflecting on roughly the past decade of performance and reviewing a hypothetical policy on a middle-aged man. It states that the policy has performed well over time and, in fact, has outperformed projections. The cash value internal rate of return from the actual index performance was 5.79% relative to the original illustrated internal rate of return of 5.74%.
As an aside, I have a consulting client who purchased the same product with the same insurance carrier at almost the same time. His cash value IRR through April 2021 is 2.30%. It appears the carrier worked diligently to craft a specific, hypothetical policy, built to exacting parameters during a very particular time period to look as good as it possibly could. Why wouldn’t they? It’s to be expected.
Furthermore, the carrier provided a graph charting illustrated versus actual performance, with illustrated credits at 8.14% and actual index credits at 8.45%. I’ll assume this is all accurate, but is it true? I will suggest that what is accurate/true/real/honest/ethical/factual/etc., can be anything one wants it to be per this marketing. What do I mean?
Some Context
During the time period of this analysis, the S&P 500 performed at 13.919% and 11.697% if we don’t include dividends.* As everyone should know, but few do, IUL policy crediting ignores dividends, so we have to take 222 basis points of the return off the top.
Looking backward is fine for evaluating performance, but I’d rather look forward, so I don’t run into a wall. I need to know what lies ahead. It’s in the future that I want to know if what I have will work or not.
While I understand someone who bought this policy years ago may not be disappointed because they’re purportedly getting what they thought they had, this is a dangerous mindset. Let’s take a moment to think about this. We’re talking about a marketing piece that’s crowing about a policy owner client getting what they expected to get. I can’t be the only one who finds that odd. Is the new definition of success not being disappointed?
The marketing piece does provide that the cap rate of the product has gone from 14% at issue to 9% by January 2020. What if the cap rate remained at 14%? The actual crediting rate would have been 9.74%, 129 basis points greater than their projections and what the policy owner could have reasonably expected, given the actual market return.
The first reasonable question to test their claims is to determine if it means the policy ended up where it was projected to be based on the sales ledger or where it was supposed to be given the actual S&P 500 returns and the embedded policy assumptions. Those are not the same thing. What if the cap rate was 9% from the beginning? The actual index crediting would have been 7.05% rather than 8.45%, 140 basis points lower. But the cap didn’t stay at 14% or start at 9%, so why the query? Because if we move forward, over the coming years, at this lower cap rate, the policy can’t possibly continue to perform to illustrations as is the focus of the marketing. This piece had to go out before the window closed, and they can no longer make the claim. And it will close… actually, it has closed, and we’ll circle back around to this.
There are a couple of things to focus on here. One is that many intelligent people have been saying for a long time that cap rates were unrealistically high, and they were going to come down. They were right. The lower cap rate makes the upside performance potential of the policy difficult, if not impossible, to attain. Those who understand the financial markets and how life insurance works and how life insurance companies invest their money realize what’s in store, and it’s not debatable. Marketing chooses to ignore this.
The Elephant in the Room
What else is there to bring this into context? The elephant in the room is that it took a market doing almost 14% to net an 8.45% crediting rate to net a 5.79% return on premium to cash value. Who is going to count on that moving forward when all the returns over 9%, that were included in crediting in the past, are eliminated moving forward?
We might hope it does, but is that reasonable? Given a stock market that always ultimately corrects and won’t go on a tear indefinitely while tied to lower cap rates that may very well go even lower, no reasonable person should fight the assumption that the policy will not, and likely cannot, continue to live up to the hype of this marketing piece. Don’t you get the feeling that they’re saying everything’s fantastic and we’re the good guys, and it’s worked so far, so you don’t have anything to worry about moving forward? Of course, that’s the intent of the piece. The reality moving forward is different, and things cannot continue on the same track.
Assuming the cap rate doesn’t continue to fall and stays where it is, the market would likely need to perform in a very specific way to keep this policy on track (continuing the 8.14% original illustrated index crediting.) For example, even if the total S&P 500 returned 20% level every year for the next five years, and in the sixth year, the S&P 500 return was a bust so the crediting was 2% (the floor for this product), the 6-year return would be 7.80%, less than the 8.14% initially illustrated. Of course, we know there are many moving parts, and in a life insurance policy with ongoing expense charges, the “when” of the return can be as important as how much the return is. Sequencing of returns can significantly affect policy performance. The market during the next half dozen years could have an annual compounded return of 20%, or 100% for that matter, and not be able to hit the target if there were any flat or down years, even one.
The IUL Story
The beautiful story of IUL is “upside potential with downside protection,” but let’s be realistic. The S&P 500 (without dividends) over the same 11 years would have grown at 11.70%, a 38% increase over the average policy crediting of 8.45%. Adding the 222 basis points of dividends that the index ignores would further increase the market performance over that of the IUL product. Considering the current 9% cap, the actual S&P 500 return from 2010 through 2020 would roughly double the IUL gross crediting rate over the same period. That’s quite a spread.
Also, I just remembered that I’m doing my numbers off of the gross crediting rate, not the actual cash value rate of return after expenses. That’s another 266 basis points to subtract. (The difference between the 8.45% average index credit and the 5.79% cash value internal rate of return.) This policy has to stand on its head and spit nickels to overcome all the headwinds it’s facing. Yes, the risk profile between the IUL policy and the actual S&P 500 is different – the policy includes the benefit of life insurance and there are potential tax benefits. I won’t take any of that away from the insurance, but the actual cash value return is 812 basis points lower than the actual market return and represents 58.4% of that return. That may be fantastic for a life insurance policy, but I’m not confident most policy owners feel they experienced the upside potential of the market with this, as they understood it.
If cap rates continue to decrease, policy crediting would be further suppressed. I’ve reviewed convincing data and analysis that given the insurance carrier portfolio returns, bond laddering and options pricing, affordable caps will continue to come down, possibly a couple hundred more basis points. In this particular example, if I assume a 6% cap and the same returns for the next 11 years as the past 11 years, the indexed crediting would be 4.89%. That’s only a little over half the crediting they’re crowing about. There’s no reasonable S&P 500 performance that could possibly keep the policy on track.
The graph above represents recent history and correlation of cap rates and the AG-49 rate. The AG- 49 rate is based on calculations that take over 10,000 data points over the past 66 years into account.
This table represents my own calculations based on the actual S&P 500 return over the past three decades while bracketing the returns with a 0% floor and the assumed cap rates shown. This is over a much shorter time period and incorporates, relatively speaking, an infinitesimally small set of data points. Yet, the numbers aren’t far off. We’ll come back to this.
Let’s review. For this policy to keep pace with projections, market returns must be equivalent to an equity growth rate of return year in and year out without any down years. Doesn’t everyone know that’s impossible? The track record the marketing piece is crowing about only kept pace because the market performed so fantastically that it overpowered the effects of the plummeting cap rate that will hold down the return for the foreseeable future.
Were those who marketed and sold this in 2010 counting on the cap rate plummeting? If they were and sold it anyway, it would be an example of an exceptional lack of ethics. Understanding this, does it look like the policy is living up to their illustrations? Would this satisfy their “… philosophy for staying on pace.”? Of course not! They got lucky! If the market did perform at the historical rates they assumed in their initial projections, then this policy performance would have fallen far short of projections.
Opening another can of worms… what about that comment above about ethics? They did know cap rates would come down and that they were illustrating incredibly aggressive assumptions while selling a much more conservative story. They can’t deny it because doing so would require believing their finance and investment specialists didn’t recognize the effect on portfolio yields of older, high-yielding bonds being replaced with newer bonds with lower yields. Even if the cap rate stayed at 14%, the market would have had to continue at historical equity growth returns to hit their target, and significantly higher in a lower cap environment. Is that what the policy owner was thinking? Let’s be candid… the policy owner absolutely did not understand that and was told and believed this was a significantly more conservative transaction.
We shouldn’t be surprised about declining crediting rates because we’ve seen this with whole life and traditional universal life over the years. IUL isn’t totally different because it, too, is a product largely driven by the insurance carrier’s portfolio returns and not solely by the equities market. None of the policy owner’s premium is even put into equities, so how could it realistically bear resemblance to equity returns? The upside of the market without the downside risks… that’s a very tortured statement.
Next, right above their table in the ad showing market history and policy crediting, they state that their guarantees are designed to ensure positive value to policy owners. How this statement is possible is beyond me. It’s an absolute and provable falsehood.
This contract does not have the insinuated guarantees. The guarantees include a crediting floor and other contractual maximum policy and mortality charges. But, depending on how the policy was built, even if the policy performed meaningfully above guaranteed crediting rates, it could completely fail at some point, with the policy owner losing everything, even at current policy and mortality charges. At guaranteed charges and guaranteed crediting, the policy would fail much earlier, meaning it would not ensure positive value to policy owners. It’s surprising how many policy owners believe the floor in an IUL policy means they can’t lose their money. The guaranteed floor is largely irrelevant regarding losing money or not. Other factors are more meaningful and essential.
I used the carrier’s own software to perform several “what ifs,” and it’s impossible to put enough money into the contract to keep it from lapsing at guarantees. So not only are their guarantees not designed to ensure positive value, but a policy owner is likely to lose everything if the policy performs at guarantees, even if they threw money at it hand over fist. If it doesn’t make sense to you that a financial transaction with an ongoing positive return can lose money, consider this: if you were offered an investment with a guaranteed 5% return, but it had a 6% expense factor, how long would you stay above water? The expenses of the policy result in the actual cash value return being meaningfully lower than the crediting rate.
Even if the carrier’s marketing piece relates that the cash value return over the life of the policy is 266 basis points lower than the crediting (8.45% – 5.79%), what about down the line when the mortality charges increase? I have an insurance ledger in my hand for another case on my desk that shows the cash value goes from $1,343,000 to $443,000 in one year while assuming a 6.25% crediting rate. 6.25% on $1,343,000 is $83,938. That’s $900,000 short of overcoming the policy expenses in that single year.
With no cherry-picking involved, this is the most recent annual statement I have from my consulting client with the same policy. The $4,307 of expenses are close to the $5,065 of policy crediting. This particular policy year wasn’t stellar, with 3.5% policy crediting. The expenses represent 3.0% of the beginning of year policy value, which would be greater than the 2% minimum crediting if this was a down year in the S&P 500, so the cash value would have backslid. Just imagine what the expenses could be when the insured gets older. Yes, you can lose everything, even with perpetual positive crediting, as evidenced by this client’s policy projection.
This 2019 projection is assuming a 6% crediting rate, but it’s not really cutting it, so clearly the 2% floor isn’t going to salvage anything.
The Coup de Gras
Sometimes, people accuse me of being over the top when warning of policy performance and scaring policy owners with predictions of reduced cap rates. “The rates won’t keep coming down,” they say. “We’re at the bottom of the curve,” they say.
Maybe you won’t be as shocked when you hear what I have to share next.
Not only was this insurance carrier putting out this marketing piece in July 2021 touting their track record with full knowledge it was unsustainable and they wouldn’t be able to make the claim moving forward based on the details of their marketing piece, but at the point of publishing it, they had already further reduced their cap rate!
When I began reviewing this, I didn’t have current information, so I looked at my consulting client’s in-force ledger from April 2021 (same product issued the same time.) It reflects an 8% cap rate (reduced from 9% to 8.5% in May 2020 and 8.0% in September 2020.) Furthermore, for due diligence, I called the regional office and discovered that the cap rate had been dropped to 7% in June 2021! Another 22% drop in only months, not years? A 50% drop since policy issue less than a dozen years ago? All those S&P 500 returns between 7% and 14% flushed down the drain moving forward?
With a 7% cap, the almost 14% S&P 500 total market return from 2010 through 2020 would credit the policy 5.61% compared to the 8.45% actual crediting and 8.14% projected crediting during the same period. That’s a 33.61% reduction in crediting for the same returns… and during a gangbuster equities market.
Can you imagine what the actual market return would have to be for the policy to continue its track record or even its projection? Don’t bother trying because it can’t happen. Even if the market performed at 20% year in and year out indefinitely, or at any stratospheric number, with a 7% cap rate, the policy could never be credited with better than 7%. You can’t credit a policy at 8.14% when your cap is lower than that! It’s literally impossible to continue what they are insinuating, yet they pushed it out in their marketing piece anyway.
Do you see the correlation? The cap goes from 14% with an 8.14% projected rate when issued in 2010 to an 11.25% cap with a 7.13% rate to a 9.5% cap with a 6.49% rate to an 8% cap with a 5.77% rate. Doesn’t that all neatly line up in the big picture with the 2010-2020 AG-49 / Cap Rate graph and the table with my calcs shown earlier?
My client bailed on his policy, so I don’t have an actual in-force with the 7% cap, but definitionally, the maximum projected crediting rate will be lower yet.
Remember earlier when I said that the window had already closed? This is why I said that. The assumed parameters for this hypothetical example seem reasonable to an untrained eye looking backward but are no longer supportable with current facts. The insurance carrier absolutely understood this when the piece went out.
As bad as all of this looks, it’s even worse. It’s essential to understand how the regulations that create the guardrails for IUL projections work. One important aspect is to realize that one of the AG49 reg parameters is based on an arithmetic average of the geometric averages for 25-year rolling periods going back 66 years. This means that the maximum regulatory allowable projected rate is a 50/50 proposition. Another parameter is that the maximum rate is based on the following line, cut and pasted directly from the regs.
Do you see what that says? The projected crediting rate can’t be greater than 145% of what the company is making on its money in the portfolio dedicated to supporting your policy. I’m no rocket scientist, but that seems to indicate an allowable assumption of a 45% profit on options trading year in and year out. Is that reasonable? If so, wouldn’t it be better to transition into the options trading business? If the carrier’s general account is returning 4%, then their indexed life insurance can project a 5.8% return, assuming application of the balance of the AG-49/49A regs, regardless of the profitability of their options trading. Reasonable minds can disagree on how realistic this is, but the actual wording of the regulations is essential for advisors and consumers alike to understand.
Now, we have guardrails that allow a max rate based on an average, as well as questionable profit assumptions. But wait, there’s more. AG-49A was implemented in 2020 because as soon as the 2015 AG-49 regs were implemented (an attempt to rein in unrealistic assumptions), insurance carriers began to game the system to end run the new regs. This is not some conspiratorial thought. It is well documented and discussed by the National Association of Insurance Commissioners (NAIC) itself and many others. The bottom line is that something was wrong, so they tried to fix it, and when that didn’t end up working, they tried to fix it again. It was recently announced they’re looking to revise yet again because every time they roll out new rules, the carriers do something to end-run them. (The regs were updated again earlier this year.)
Unless you’re a true nerd, I wouldn’t assume you’d want to peruse www.naic.org and read up on all of this. However, if you did, you would see I was one of the dozen members of the Independent Proposal Comments Group, led by Bobby Samuelson, who were desperately trying to make the new regs better for consumers. Reading through transcripts of NAIC subgroup meetings and all the letters submitted by insurance companies, their advocacy groups, and consumer protection advocates is enlightening.
Another thing you would find in there is the fact that despite the admonition of many, the decision was made to not have the new regs applied to older policies when the very abuses in some of those policies were what drove the new regs.
Effectively, it says we know the old regs allow projections that are too unrealistic and aggressive, but we’re going to allow them to remain in place. It’s like discovering a fatal flaw in a car that causes the brakes not to work but deciding not to tell anyone who already owns that car. In fact, one of the arguments against making the regs apply to earlier policies is to avoid the discomfort policy owners may experience if they were presented with updated projections that didn’t look as good and the lack of faith that may generate toward their agent. I can’t make this stuff up!
None of this was a secret. They knew it! They knew it, and they sent this marketing piece out anyway. How on earth can anyone ever trust anything they ever say again? It should be an embarrassment to the company, and it’s a disgrace to the industry. They knew everything was falling apart when they sent out the July marketing piece, yet they consciously chose to do so anyway.
I’m not particularly eager to write this about an industry I’ve been a part of my entire professional life. Still, I don’t know how to attempt to save it without pointing out these serious issues that need to be addressed. Please be as distressed about this as I am.
* Per www.DQYDJ.com
Bill Boersma is a CLU, AEP and LIC. More information can be found at www.OC-LIC.com, www.BillBoersmaOnLifeInsurance.info or call at 616-456-1000 or email at bill@oc-lic.com.
Securities offered through Valmark Securities, Inc. Member FINRA, SIPC. Investment Advisory Services offered through Valmark Advisers, Inc. a SEC Registered Investment Advisor. OC Consulting Group and its affiliates are separate entities from Valmark Securities, Inc. and Valmark Advisers, Inc.
