Understanding Indexed Universal Life's Sequence of Returns Risk

Louis LopesWritten by Louis Lopes, CLU ChFC

Many people understand that when planning for retirement, it's essential to consider not only the potential return of an investment but also its associated risk.

Modern Portfolio Theory emphasizes the importance of diversifying your portfolio with different assets that have varying risk-return profiles.

Risk is typically measured by the standard deviation of the asset. The greater the variance around the average return, the higher the risk.

Yet, there's another type of risk to be aware of—sequence of returns risk. This risk is the potential danger that the timing of investment returns could adversely affect retirement savings, especially as the investor starts drawing income for their retirement. This article compares two sequences of returns from an Indexed Universal Life Insurance policy to illustrate the risk.

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What is a Sequence of Returns Risk?

A sequence of returns risk refers to the danger that the timing of withdrawals from a retirement account will negatively impact the investor's overall rate of return. When an individual retires, they transition from contributing to their retirement accounts to withdrawing funds.

Indexed universal life insurance policies rely on the performance of a stock market index to determine their rate of growth. These returns can vary significantly from year to year, potentially causing your policy's cash value to diminish at a much faster rate than anticipated.

In a Bull market, with positive performance, the gains will help offset the withdrawals. However, in a Bear market, the money isn't replenished, and this can adversely impact one's retirement savings indefinately. In the following section we've outlined two scenarios to illustrate how market volatility can impact one's retirement savings.

Illustrating the Impact of a Sequence of Returns Risk

In this example, we'll compare two sequences of returns:

Year12345678910
Annual Return-20%-8%-6%4%6%8%12%14%18%24%

Year12345678910
Annual Return24%18%14%12%8%6%4%-6%-8%-20%

They are mirror images. They both have an average rate of return of 5.2%. The standard deviation is the same. $100,000 will grow to the same $153,884 at the end of 10 years with either scenario. See charts:

Annual Return and Account Value

Without taking money from the account

[COLUMN-LINE CHART Annual Return and Account Value]

Annual Return and Account Value

Without taking money from the account

[COLUMN-LINE CHART Annual Return and Account Value]

The two sequences have vastly different impacts if we were to take $5,000 out of the investment at the end of each year.

Annual Return and Account Value

Taking $5,000 out of the account at the end of each year

[COLUMN-LINE CHART Annual Return and Account Value]

Annual Return and Account Value

Taking $5,000 out of the account at the end of each year

[COLUMN-LINE CHART Annual Return and Account Value]

As a side note, one valuable aspect of having cash-value life insurance in retirement is its ability to smooth out the volatility of the stock and bond market. The cash value is completely liquid and isn't tied to market fluctuations. You can borrow from the policy tax-free in a down market and repay the loan when the market recovers.

It functions like a tax-free bank account with a superior return. Learn more about using life insurance as an Asset Class.

How is this Relevant to Indexed Universal Life?

Indexed universal life will have a fluctuating sequence of returns. Many people plan to use the policy to draw income in their retirement years, so the connection is clear. Even if the policyholder never takes money out of the policy, money is being taken out of the cash value every year to pay for policy expenses and mortality charges for the death benefit.

The typical life insurance illustration shows the same rate of return every year for 30, 40, 50, and 60 years. Most illustrations are run at the maximum rate allowed under regulations. The maximum allowed is a 25-year geometric average of returns for the past 66 years.

The average sits at the 55th percentile mark of returns, meaning 45% of the 25-year periods would have performed worse than the maximum illustrated rate. But let’s put aside any skepticism about the average return over time and assume that it will be the return as illustrated. We still face the sequence of returns risk in an indexed universal life policy.

How Great is the Sequence of Returns Risk?

We can use a Monte Carlo simulation to assess the sequence of returns risk. This simulation involves running a thousand randomized sequences of returns with the same average return and standard deviation. The shocking finding is that 50% of policies will lapse before age 100, even if the long-term average return matches the illustration.

To elminate the sequence of return risk, existing policyholders would need to increase their premiums by as much as 35%. This added expenses are often too much for a retiree living on a fixed income, especially if they are already struggling to pay their current premium payments.

Mind you, even if the agent is conservative and runs the illustration at a lower interest rate that the agent believes is more realistic, the policy will have a significant probability of failing. The issue is not the long-term rate of return. The risk is pure due to the sequence of return risk.

Can I Mitigate IUL Policy's Sequence of Return Risk?

We recommend avoiding indexed universal life altogther if you are risk-averse. A whole life insurance policy offers comparable life insurance coverage and the opportunity to build cash value without the same risk. Whole life insurance policies can also be customized to offer living benefits if you become terminally ill or require assisted living.

If you're set on buying an IUL, consider purchasing a policy that offers a minimum interest rate to protect your investment during periods of poor performance. IUL's are meant to be a long-term investment, so make sure you review your policy at least once a year, and set some money aside as a buffer for your policy during down years.

For those who already hold an IUL policy, diversify your policy's accounts to spread your risk across different asset classes or indices. This will help offset the impact of a poorly performing index. You should also choose conservative indices with less volatility and steady growth as they are less likely to suffer large losses in an unfavorable market.

Another alternative would be to access your policy's current cash value and fund a new whole life insurance policy with it. To learn more about whole life insurance policies that offer permanent life insurance coverage and accumulate tax-deferred interest, see our article, "What is Whole Life Insurance and How Does it Work?"

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Written by:

Louis Lopes

Louis Lopes, CLU ChFC

Chartered Life Underwriter, Licensed Life and Health Agent

Louis has been in the insurance business for over 30 years. He specializes in “high risk” cases as well as more complex coverages for long term care, disability, and estate planning.

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