You Know Everything
"You know everything…"
One of my producers accused me of that this week. He was mostly joking, but his point was clear – we talk about some interesting topics in this forum, and they usually make him think a bit. I hope that this week makes all of us think about how we illustrate IUL contracts, because someone went and crunched the numbers on an issue that I have been talking with my producers about for months regarding the illustration of income coming out of IUL contracts.
What’s the issue? Participating variable rate loans. When these first hit the street, I was amazed at the income potential. It sounds fantastic! The loan balance can actually earn indexed interest, and with rates where they are, we could end up with a 2% or higher positive arbitrage based on current loan rates and the illustrative rate in an IUL contract. Conceptually, I am not going to argue with this. The problem comes with the execution. How on earth can we illustrate policies this way when the market does not behave this way? Simple; we can’t.
Why not? Consider the historical performance of the S&P over the last 20 years. How many down years were there? Quite a few. What happens in those down years? If you look at a life illustration (a forward projection with a level rate of return and loan interest rate), nothing happens. You still earn the spread between the illustrative rate and the loan rate. It looks great on paper, and with some of the illustrative rates I see used, the positive arbitrage is as high as 3%. But if the market does not behave this way, what happens if we managed to put together an illustration that combined the highly variable returns with a variable rate participating loan?
Based on the analysis this individual completed, policy lapse is what happens. Reality can be a nasty business.
To take it a step further, he determined the loan interest rate based on its underlying index to create a "loan adjusted net rate of return" each year. My concern is that no one has done any kind of exhaustive study (that I know of anyway) regarding the impact of these loans and non-linear rates of return on actual policy performance. Clearly, drawing conclusions based on a very limited data set is a bad idea, but I think it is safe to say that these policies will underperform versus the sales illustration. Even worse is when simplifying assumptions (like a linear rate of return for instance) creates a model that does not represent the real world. "Garbage in, garbage out," as they say.
So what are we to make of all of this? I wish there was an easy answer. I think moving away from showing income on sales illustrations is something to consider, but difficult, if not impossible, in practice. Perhaps the best practice is to use the old withdrawal to basis, then wash loans approach on illustrations? (Even that is a problem, but a topic for another time.) When it comes time to actually take the income, the agent and client can talk about the best way to do it based on their current personal economic condition as well as the current economic climate.
At that point, I would want a contract that would let me choose how to take the income, rather than having to make a decision today about an event some 15 or more years in the future. I also want to review this annually to make sure actual performance will still support the income I want to take from the policy each year. Wouldn’t we monitor this annually if we were taking income from a more traditional investment portfolio? Damn right we would! Seems like common sense, right?