Putting a Pacific Life IUL Under the Microscope–Historical Stress Tests
Aside from Roth accounts (Roth IRAs (including conversions) and Roth 401Ks), the only other tax-free planning tool for retirement purposes is what is commonly referred to as a Life Insurance Retirement Plan or LIRP. The majority of the time, this refers to a maximum funded Index Universal Life (IUL) contract. Reviewing our extensive article on LIRPs, including various types, proper structure, costs, pitfalls, and a multitude of uses, will be helpful. Here, we will focus on its potentially powerful use in producing tax-free retirement distributions.
I am fond of saying “let the math guide”. My own internal due diligence on LIRPs/IULs is more rigorous than other advisors (who barely look beyond an illustration). I have done this for years to satisfy myself, and will here share some of those summary findings. In full disclosure, I own 3 LIRPs and have experienced better than illustrated results. So, in diving in, we’re going to let math dictate.
The vast majority of objections by some pundits and gurus regarding a LIRP have to do with what they perceive as high fees which, they claim, will ultimately cause the policy to perform poorly and a far cry from what the official illustration projects. Cynically, many talking heads that object to the use of a LIRP do so because their talkshow isn’t sponsored by LIRP companies, or their firm doesn’t sell them. Setting the cynicism aside, let’s examine the high fee and poor performance claim by stress testing a few Index Universal Life policies properly structured as a LIRP. In doing so, we will take the “guts” of an IUL (all fees and expenses) along with cap rates, par rates, and guaranteed floors, and create a proxy for the IUL in order to simulate and stress test the parameters that compose the IUL. This “proxy” will be referred to as a Theoretical Synthetic Asset (TSA).
The Big Red Ball
Recently, physicist Cary Forest led a team at the University of Wisconsin-Madison that created a device called the Big Red Ball. This aptly named device simulates the magnetic field of the sun and allows scientists (and students) to learn close up how the sun’s magnetic field likely operates. Of course, it is not the sun; but is it helpful in understanding the sun and the properties of its magnetic field? Does it create insight and understanding on a meaningful level? You bet.
This is how the TSA (a proxy) can be helpful in gaining insight into how a LIRP may have performed from a historical point of view.
Significant legislation over the past several years has tempered insurance illustrations, limiting insurance companies from showing the potential positive effects of arbitrage when borrowing from a LIRP using an index/participating loan. Further, many LIRP companies utilize “performance multipliers” (through the use of options on equity markets) to potentially enhance the account value and distributions (a very real potential), but illustrations are no longer allowed to show the potential positive effects of those multipliers if they are performance based. If the insurance company pays a flat credit/bonus, that can be shown.
Illustrations, in general, are now more conservative than they have arguably ever been. While it’s hard to fault a conservative stance, these limitations also can mislead clients by not exposing the full advantages that LIRPs have the power to potentially deliver. I fully understand the intent of this limiting legislation, but, in my opinion, it is an overreach. It is important to show a range of possible outcomes. This is what our simulations attempt to do.
An inherent weakness of insurance illustrations is that they typically show a flat rate of return (6%, for example). This is the assumed return every year. This may be a realistic average (based on cap and par rates), but will a LIRP, tied to the positive performance of an index (or indexes) give a constant, flat return? Of course not. This is another element the simulations will expose, using the raw returns of the index allocations. These returns fluctuate year to year, of course, and is an important factor to consider. This is something called “sequence of return” risk.
To minimize internal fees, the death benefit will be dynamically managed to its lowest allowable amount under IRS guidelines.
Finally, just to add stress to the simulations, we will inflate the costs of insurance 15% above the actual current costs of the policy. This will add tens of thousands of dollars in fees over the lifetime of the client that don’t actually exist in the illustration. Additionally, we will increase the borrowing cost for loans by 10% above the actual borrowing costs (unless the borrowing cost is contractually guaranteed).
In other words, we will use actual raw, volatile returns from equity indexes and increase the costs of the LIRP policy to add handicaps to the simulation. In general, if we have the opportunity to be more conservative and add stress, we take it.
Methodology of Analysis
Many times, advisors show historical returns as if a client started investing right on Jan 1st of a year and held. They tout average rates of return based on that history. But how many people do you know that only contribute on New Year’s Day? While it shows a particular possible outcome, this type of lookback is not telling the full story. If you had started on April 3rd, or September 27th, the results will be different (sometimes drastically so).
In an effort to alleviate this, we will analyze rolling periods of time (15 years, 30 years, 40 years, etc) beginning on the 1st and 15th of every month. This creates dozens to hundreds of analyzed periods to consider, showing a vast array of potential outcomes historically.
Using the average return of the index strategies chosen, we will compare the actual current illustration to TSA’s most recent, worst, median, and best periods analyzed.
Pacific Life has had the #1 selling IUL for more than a decade. Recently, they were ranked one of the most ethical companies in the world and the best insurance company for retirement planning. So, it makes sense we analyze one of their best selling IUL/LIRPs called the PDX 2.
- 55 Year Old Male
- Contribution Amount: $50,000 Years 1-5 (Ages 55-60)
- Distributions: Years 21-40 (Ages 75-94)
- Distribution Frequency: Monthly
- Rolling Time Periods Analyzed: 40 Years
- Allocation: S&P 500 Index Strategy
- Illustration Annual Rate of Return: 5.96%
- Annual Cap: 10%
- Floor: 0%
- Annual Lock-in
- Health Rating: Standard
- Persistency credit:
This is a fairly straight forward index strategy, nothing fancy. Pacific Life has a robust performance multiplier offering that cannot be illustrated due to current regulations as discussed above.
What’s up with this persistency credit that starts in year 11? This is something established at the beginning of the policy. It’s based on several factors, but suffice it to say it’s a dollar credit according to that schedule. Essentially, this is sharing in the profit of the company. You can think of it as a dividend of sorts (Pacific Life is a mutual company, after all). This is a fairly unique approach to this type of credit. Notice how it increases for most of the years followed by a decrease in amount in the last 4 years? That is by actuarial design for the client and is more advantageous than simply averaging that schedule out for a flat amount.
Plugging these parameters into Pacific Life’s illustration software, we get a tax-free distribution amount of $42,505 per year. Ok, fine. But is that reliable or realistic? If not, how much is it off? Is it conservative? If so, by how much?
We’re going to add in the following performance multiplier schedule for the sake of the historical simulations that become available in year 2 of the LIRP.
Let me dissect this a bit. During the first 20 years of the policy, whatever the market returns to us in a given year (subject to the floor and cap) gets multiplied by 2.43. So, if the market returned 5% in a given year, the LIRP would achieve 12.15% (5% x 2.43). If the LIRP earned 10% in a given year from the market, it would be credited 24.3%. Pretty simple.
Now, how do they do this? See the “Multiplier Fee” column? I have a hard time calling this a “fee” because in reality Pacific Life is taking an extra 7.5% (in years 2-20) of your account value and buying additional options on the index for you. They don’t profit from that “fee”, only you do (potentially). That additional investment in options is what creates the performance multiplier. That fee is deducted from the account value, not directly from the return achieved.
Do you have to use this feature? Nope. If you decide not to have Pacific Life invest the extra 7.5% in options for you, that’s your call. Can you use it for 2 years, turn it off then next year, then turn it on again the year after that? Yep. Very flexible and client friendly.
Want to see it in action? Well, you can’t with an official illustration, but we’ll use the TSA as a proxy to simulate it from a historical lens. Starting on Jan 1, 1960, we analyzed rolling 40 year time periods on the 1st and 15th of every month with the parameters of the LIRP, including performance multipliers and fees. This gave us 546 unique 40-year periods. How do they stack up against the illustration?
Now, I really like this because we see that the worst 40-year period analyzed does show less income than the illustration. That may sound strange to say, but it’s transparent. It shows that having a string of less than stellar returns for a few years (rather than a constant return as shown on the illustration) makes a difference. Granted, the fees in the historical simulations are higher than the illustration by 15% and the borrowing rate assumed is 5.4% instead of the current 4.4%. That’s a big deal. Those handicaps to the TSA incurred $48,000 of additional insurance costs that don’t exist, not to mention tens of thousands in additional borrowing costs. This did add a lot of stress, but that’s the point. With all that stress, we still get a respectable outcome.
Turning to the most recent, median, and best time periods, we find serious outperformance through the lens of annual distributions (tax-free income) despite the handicaps. What if we assumed actual current costs and borrowing costs? How much better would the simulated results be?
A lot better, but I’m going to leave that up to your imagination.
So, is the extra investment (the multiplier fee) for additional options worth it? According to the simulations, the majority of the time, yes. To be transparent, Pacific Life does offer another multiplier option that is cheaper but with less upside potential. You would likely find the “worst” time period return a little better than presented here but the median and best time periods performing slightly less favorable. However, those results still outshine the official illustration.
Here's an interesting tidbit: The official illustrated rate of return is 5.96%. Out of the 546 unique 40-year periods analyzed, more than 85% had higher average returns than the illustration's projected return (cap rate 10%, floor 0%).
This is a very tight deviation and helps build confidence in the rate of return on the official illustration.
Overperformance/Underperformance of Annual Distributions
How much more (or less) annual income did the simulations reveal in each period compared the illustration's projection?
Sometimes the graph tells the story just fine. I think you get it.
Examining Total Value (cumulative income + remaining account value) gives further insight year by year, again illustrating how volatile returns impact (positively and negatively) may affect the LIRP along with all fees (recall that the TSA is a proxy for the LIRP and has inflated fees much higher than the actual LIRP for the purpose of stress testing). Notice how the illustration's line is a smooth ride (using a constant 5.96% every year). However, when simulated the TSA, we get a more realistic look at what real-world experience could be (through a historical lens).
Guru's and Fees
Finally, let me return to where I started: fees. A typical mutual fund expense ratio (which does not include tax costs, brokerage costs, or trading costs) is 0.5%-0.75% per year. Taxes tend add another 1-1.2% per year on average (something a LIRP/IUL does not have to deal with when set up properly), potentially bringing typical expenses for mutual fund investors to 1.5% to 1.95% per year. Yes, you can find lower and higher.
In retirement plans, many find their total fees (record-keeping, fund fees, advisor fees, administrative fees, etc.) to be around 2.22%, with a wide range on the low side of 0.2% to 5% on the high side. Taxes on distributions add even more cost.
What about the fee ratios of this Pacific Life LIRP? For this comparison, I find it best to use the average fees compared to Total Value.
As we contemplate the data on fees (remembering that the costs of insurance have been inflated 15% higher and the borrowing costs have been inflated by 1 percentage point, or nearly 23% higher as a ratio than current actual, for the purpose of adding stress), we see higher fees when considering the multiplier schedule. At first glance, this certainly feels objectionable, however, cost is only objectionable in the absence of value. So, what is the net total value difference between the scenarios with and without the optional multiplier involved?
Well, that likely says it all. Does the multiplier add net value? Over 85% of the time, yes. In many cases, the result is a seven figure net value difference to the positive.