With an IUL policy, your available cash value can earn interest based on changes in an external market index and has protection from negative index performance. We call this indexed interest. The amount of indexed interest you receive may be affected by many factors. In this episode of Money Script Monday, Brian goes over three different methodologies you can use to predict the type of return you can expect from your IUL policy.
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Video transcription
Hi, welcome to another episode of "Money Script Monday." My name is Brian Manderscheid. Today, we're going to answer the question, "What type of return can I expect from my IUL policy?"
Before I begin, just a little disclaimer, we've all heard this, is past performance does not predict future results. While I'm going to share with you three different methodologies to predict what an IUL policy may do in the future and those are risk premium, back testing, and actual results, none of these three methodologies will actually predict what an IUL policy will do in the future.
#1: Risk premium
First, let's talk about risk premium. The basics of how an insurance company is able to offer an index policy is when you, the policyholder, send the insurance company premiums.
They're going to invest those into their general portfolio, which is mostly made up of investment grade bonds. Next, they're going to take a portion of that return, called the investment spread, and put it in their pocket for profitability. What's left for you, the policyholder, is the fixed rate.
You have the option of choosing the fixed rate, for this example let's use 4%, or you can forego the fixed rate for the potential of a higher return, let's say of up to 12% and with the S&P 500, but also have a potential for a 0% return with the floor of the policy.
So, you would expect over the long run by taking that additional level of risk of forgoing the 4% to be rewarded. And what the insurance companies have found is, over the periods of time, looking at what they've credited fixed rates and for IUL policy owners to index rates for IUL policy owners is roughly a 200 basis point to 300 basis point risk premium. So, roughly a 2% to 3% greater return by taking that level of risk.
Again, in our example, rather than receiving a 4% fixed rate, you have the potential to earn, let's say, 6% to 7% over the long run.
While this is a very simplistic way to answer the question, let's move on to back-testing, which gets into past performance.
#2: Back testing
In this example we're going to look at a 15-year rolling segment every single day the stock market was open. We're going to look at a S&P 500 as well as a volatility control index.
S&P 500 with a 12% Cap
First, let’s talk about the S&P 500 example. For this one, we're going to use a 12% cap rate, 0% floor and a 100% participation rate. We're going to go all the way back to January 4th, 1960.
A couple of things before I get into the numbers is again, we're using past performance of the index and we're using a consistent cap rate every single year. The reality is cap rates are going to move in both the upward and downward direction based on primarily interest rates, but also based on the volatility of the underlying index.
In periods of time where, let's say, there's really high interest rates, like the early '80s, we may have cap rates of 20% or even greater than that. In periods of time where interest rates are low, like they are today, or maybe in the future as well, cap rates may suffer and drop if interest rates stay low or drop even further than they are today.
- Average return: 7.09%
- 80th percentile: 6.17%
- 90th percentile: 5.54%
- 100th percentile (worst case scenario): 3.25%
Volatility Control with a 130% Participation Rate and No Cap
Let's move on to a volatility control index. The basics of how a volatility control index works, is you have two components, a bond or a fixed component and an equity component, which is typically the S&P 500.
The index has a computer-generated algorithm, so it's not a human guessing game, which basically blends between bonds and equities based on the volatility of the market. Essentially, it acts like a prudent investor should. When the volatility is high and stock market's very volatile, you should move more to cash or bond position. When volatility is low and equity returns are great, you should move more into an equity position.
That's essentially how a volatility control index works. It smoothes out the ride by having a fixed component, an equities component and balancing between the two based on the volatility of the market.
In this scenario we're going to use 130% participation rate, a 0% floor, and no cap rate. We're only going to go back to March 2nd, 1989 because that's as far as you can go back using the index data.
- Average return: 8.67%
- 80th percentile: 7.33%
- 90th percentile: 7.09%
- 100th percentile (worst case scenario): 6.61%
The benefit of a volatility control index is there's a lower probability of getting zero and you can have a more consistent smooth ride up versus a pure equity component of, let's say, the S&P 500.
#3: Actual results
We talked about risk premium, a simplistic way to estimate policy performance and back-testing, which is using past performance and current cap rates. Let's finish off with actual results.
We're going to look at two prominent companies that have been offering IULs for a significant period of time.
Company A, we're going to look at May 2006 through December 2016. This looks at every single policyholder who owns a IUL contract through Company A.
These policyholders over that time frame have earned a 6.59% return.
In looking at that time frame, we've had one of the biggest stock market drops we've ever had in 2008 and 2009, also followed by a big bull market following the Great Recession.
Company B, we're going to look at a different time frame, from June 2007 through August 2017. We're not going to look at their entire book of business, but just one specific product and one specific index, which is the S&P 500 with a cap rate.
Looking at this, a smaller pool, these actual policyholders received an 8.1% return.
Now again, this is not an apples to apples comparison because we're using two different time frames, as well as Company A with every single policyholder, every single index allocation available, with Company B, just one specific product and one specific index.
We talked about three different ways to answer the question, "What type of return can I expect from my IUL policy?" We talked about the risk premium, back testing, and actual results. Just that disclaimer again, past performance does not predict future results.
What I would say is, IUL policies offer so many great benefits, the tax deferred growth, the income tax free access, and the income tax free death benefit.
Regardless of the policy performance, there are a lot of great benefits of an IUL. What I would suggest is use a conservative illustrated rate that you feel comfortable with rather than over-projecting what these policies may do in the future. With that, thank you again for tuning in to another episode of "Money Script Monday." We'll see you next time.
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