How Policy Drawdowns Work
There are three ways to take drawdowns from an IUL, whether it be for supplemental retirement income or to pay off a third-party premium financing lender. You can take Withdrawals, Fixed Policy Loans, or Participating Policy Loans.
1. Withdrawal.
In a withdrawal scenario, the drawdown amount is literally withdrawn from the Gross Accumulated Cash Value to payoff the third-party lender. From that moment forward, the remaining Net Accumulated Value of the policy receives the annual after-floor/after-cap index credit each year.
2. Fixed Loan (AKA “Wash Loan”).
When taking a Fixed Policy Loan, the drawdown amount is removed from the policy Gross Accumulated Cash Value and placed into a separate account that credits a fixed return (3.00% as a hypothetical example) instead of the annual after-floor/after-cap index credit each year. The carrier then “loans” the policy owner the same drawdown amount and “charges” interest on the policy loan at the same interest rate the fixed account credits (3.00% in this example), making it a wash loan. Similar to the Withdrawal scenario, from that moment forward, only the remaining Net Accumulated Cash Value of the policy receives the annual after-floor/after-cap index credit each year.
3. Participating Loan (AKA “Indexed Loan”).
When taking a Participating Policy Loan, with some carriers, the drawdown amount is removed from the Gross Accumulated Cash Value and placed into a separate index account that receives the same (or similar) annual after-floor/after-cap index credit as the policy’s Cash Value. With other carriers, the drawdown amount actually remains in the policy’s Gross Accumulated Cash Value. The carrier then “loans” the policy owner the same drawdown amount and “charges” interest on this policy loan. Sometimes the interest rate charged is a fixed amount (5.00% for example), and sometimes the interest rate is a variable floating rate. In this policy loan strategy, the policy owner is hoping the S&P 500-correlated floor & cap index crediting method will outpace the Participating Loan interest charged.
The anticipated benefit of the Participating Loan is that from the moment the Participating Loan is taken, the annual after-floor/after-cap index credit is applied to the Gross Accumulated Value in the policy, not the Net Accumulated Value. If the funds were moved into a separate index account (supposing the carrier of choice uses this method), these funds are also credited based on the after-floor/after-cap index credit methodology.
This is perhaps the most misunderstood (and undervalued) component of premium financing. The fact that the annual index credit is applied to the Gross Accumulated Value (not the Net Value) means that as the index credit is applied to the larger gross value.
As an example, when comparing a Financed Policy (after the third-party lender is paid off) to a Non-Financed Policy, if the Financed Policy had a Gross Accumulated Value of $7,000,000 in a given year (after charges) and a Participating Loan amount of $6,000,000, the Net Cash Value would be $1,000,000.
If the Non-Financed Policy’s Gross Accumulated Value was the same $1,000,000 as the Financed Policy’s Net Value in the same year, if the index credit in that year was 10%, the Non-Financed Policy would receive a $100,000 index credit that year (10% of the $1,000,000 cash value).
However, the Financed Policy would receive a $700,000 index credit that year (10% of the $7,000,000 Gross Accumulated Value). Of course, that would be partially offset by the Participating Loan interest charged, so if the Participating Loan rate was 5%, the $6,000,000 Participating Loan amount, that would result in $300,000 interest charged in that given year, making the Net Policy Cash Value increase by $400,000 in that year ($700,000 index credit minus $300,000 interest charged equals $400,000 net gain). That is four times the cash value gained by the Non-Financed Policy in that given year.
To be fair, if the S&P 500 produced a negative return in that year (which would have resulted in a 0% index credit), the Non-Financed Policy’s Cash Value would receive zero gains after the policy charges were deducted from the cash value that year. However with the Financed Policy, in addition to the charges, the $300,000 in Participating Loan interest would also be subtracted from the Net Cash Value (not the Gross Accumulated Value, but the Net Cash Value).
The accounting of this is all done on a ledger behind the scenes with the carrier, making it easy for the policy owner. In other words, the policy owner does not need to do any independent accounting to manage the interest charged and credited.
To evaluate the risk of Participating Loans and the potential negative arbitrage between the loan interest charged and the 0% index credited in given years, my backtesting software analyzes 121 different historical 40-year periods of S&P 500 performance, builds a proxy for the premium financed IUL with the Participating Loan component, and models the 40-year period that produced the Worst Compounded Annual Growth Rate of the 121 different historical 40-year periods, for this is the type of scenario wherein the Participating Loan proposition might incur a negative outcome.
During the challenging 40-year sequence, we evaluate the relationship between the Participating Loan interest accrued versus the gains made by keeping the payoff amount in the policy’s Gross Accumulated Value (or separate index account if the carrier uses such methodology). Over such time, if the debt outpaces the growth on such Participating Loan funds, it would be prudent for the client to make their decisions based on whether or not they want to incur that risk, despite how much more profitable such proposition may be during better index performing times. I always provide this analytical report to my clients and review it with them.
If the 40-year period that produced the Worst Compounded Annual Growth Rate of the 121 different historical 40-year periods shows a net gain in such Participating Loan proposition, that stress-test becomes just as valuable in the client’s overall education and awareness.
To be clear, this evaluation model is not a modified version of an IUL illustration. That would violate AG-49A guidelines and several other compliance regulations. I created a Hypothetical Synthetic Asset – a fictitious index account – that behaves very similar to an IUL in regards to charges, crediting methodology, and participating loan methodology.
The goal is to see how these factors could potentially affect short-term and long-term outcomes during times of volatility. For example, in certain sequences of returns we analyze, there are several consecutive 0.00% index credits within the first ten years of the 40-year sequence.
In other scenarios we model, the consecutive 0.00% index returns happen in the middle of the 40-year sequence during the beginning years of income drawdowns (or right before or after the lender payoff, similar to a premium financed life insurance scenario), both of which put excessive stress on cash value accumulation which is needed to keep the policy in force.
In an effort to be extremely clear in this discussion, the scenario that I called “the 40-year period that produced the Worst Compounded Annual Growth Rate of the 121 different historical 40-year periods analyzed” is not the worst possible 40-year outcome imaginable. It is just the worst one of the 121 different periods I analyzed. It is within the realm of possibility that the next forty years could be even worse than the Worst 40-Year Period out of these 121 periods I analyzed, just as it is possible that the next forty years could produce an even better outcome than the Best 40-Year Period I analyzed.
Perhaps this overly granular explanation is painfully redundant, however I believe it is important to communicate in a crystal-clear manner so it is virtually impossible to misinterpret my mathematical findings.
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