Average returns are often called the "simple" average. You just add up the annual returns and divide by the total number of years. While the calculation is simple, when your investment can go up and down in value from year-to-year, this is not always a good representation of real performance because average returns do not take market volatility into account.
Volatility is a very important aspect of any performance calculation. Real returns, also known as “the compound average” or “actual annualized growth” do the best job of describing performance when analyzing typical investments that go up and down in value. This method is a more accurate representation of investment performance because it takes the annual volatility into account.
The example pictured above compares average returns to real returns over a six-year period. In the table, you can see that we start with $1.00 and in the ﬁrst year we earn 30%, so the account ends the year with a $1.30 value. In the second year, we start with the $1.30 value, but lose 10% during the year, dropping our ending value down to $1.17. If we just continue this trend of positive 30% gains followed by negative 10% losses, after six years we have a value of $1.60 on the original $1.00 investment.
Average Annual Return Method
If we used the average annual return method, we could very easily and accurately state that our average annual return was 10%. Just add up all the actual performance returns and divide by the number of years. However, If we had earned a 10% compounded return on our $1.00, we should have had $1.77 at the end of six years, not the actual ending value of $1.60.
Real Annual Return Method
By using the real return method, we add 1.00 to each annual return, resulting in 1.3 when up 30% and 0.9 when down 10%. We then multiply those numbers together and raise the product to the power of 1/6 to adjust for the fact that we have combined returns from 6 periods. This gives us a real return of 8.2%, equaling the actual ending value of $1.60.
The Negative Impact of Interest
In a Variable Universal Life (VUL) product, there is the potential for negative interest because VUL ties its cash-value accumulation to the volatile stock market. Negative interest has a devastating effects on a policy’s cash value. A product like Indexed Universal Life (IUL) is different because the volatility and potential for negative returns is not possible in that product.
One of the biggest impacts of negative interest is that the majority of the internal policy expenses come from the Cost of Insurance (COI) Charge. The Actual COI is calculated by taking the mortality charge (which is the cost to provide the pure death beneﬁt protection) and multiplying that charge by the Net Amount at Risk. The Net Amount at Risk is the difference between the death beneﬁt and the account value. When a policy earns negative interest the account value decreases and the Net Amount at Risk increases, which in turn increases the Cost of Insurance. These costs can add up and lead to the VUL Death Spiral.
VUL and IUL Crediting Rates
Let's consider the hypothetical illustration above: We have a 45-year old client who is going to make $10,000 premium payments each year until he reaches age 100. We are structuring a VUL and an IUL policy with the minimum death beneﬁt, identical expenses, and the same cost of insurance charges. With the IUL product, we are assuming a 13% cap with a 0% annual guarantee. With the VUL, we are assuming no management expenses on the investment portfolio and no dividends.
When you look at the graph above, you see the curved lines of both average crediting rates. However, when we look at the VUL actual performance, we see a dramatically different story. What’s really interesting, is that both of the VUL lines depicted on this chart have average returns of 7.93%, but there is a big difference in the actual value the client would have received. When you look at the actual performance of the IUL, you can see it does a pretty good job of matching it’s average.
Universal Life (UL) was developed to not allow negative interest. With VUL, there is a high probability that at some point a client will earn negative interest. That negative interest leads to the VUL death spiral and pre-sale illustrations that cannot match post-sale reality. With IUL there is no potential for negative interest, and therefore the actual results are consistent with the illustrated rate, if you aren’t too aggressive in the assumed rate.
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