Notwithstanding the assumed percentage of the return, this type of projection is suitable for a mutual fund, where money just sits, and gains or losses will reflect the fund's average performance over a given span of years. It's a different story for variable universal life, however, because money flows into and out of the account during the life of the policy. Gains will not only be impacted by average market returns, but also how much money happens to be in the subaccounts during the peaks and valleys of performance in a manner not unlike retirement withdrawals.
"The real issue is that we not only have deposits going in from time to time, we also have withdrawals coming out," says Michael Kitces, director of financial planning with Pinnacle Advisory Group in Columbia, Md.
The withdrawals are in the form of insurance charges, administrative fees and all other expenses associated with the policy. These fees and expenses naturally go up over time to reflect mortality rates. They can also increase as cash value goes down.
If a policy was front-loaded, for example, a bear market in its initial years is going to hurt more than if deposits had been spread out more evenly, Kitces notes.
It will also be harder to recover the lost cash value, particularly with the snowballing expenses the policyholder will be hit with along the way, he adds. "The policy will not instantly blow up and run out of money. But it has essentially been irrevocably damaged," Kitces says. "It's sort of a hidden disaster."
It's a dynamic that can easily upend the straight-line projection a policyholder used as the basis to buy the policy. Olsen says, for example, you could take a VUL policy with an annual return projection of 11% and compare it to one in which a 10% return was guaranteed each and every year. In such a case, even if the 11% projection holds true, it's more likely the 10% policy will finish with greater gains.
The effect of variations in the market will also depend on the situation of a policyholder. A 35-year-old man, for example, would probably want the bad years to happen right away, Olsen says. By comparison, a 65-year-old man with the same policy, living off the investment, would want to put it off to the last year.
"The biggest problem with the projections is they don't let you model the impact of having really awful years at the wrong time," Olsen says. "Regular VUL illustrations turn out to be filed under science fiction. The only thing you can say about them is they are wrong."
The one tool that gives clients a way to somewhat measure their exposure to unforeseen fluctuations would be stochastic modeling, or Monte Carlo simulators, but they are rarely used. That situation could change, however. The NASD is considering rule changes that would lift restrictions that currently prevent registered reps from using the tool for VUL policies and other life insurance products.
Proponents of the change say Monte Carlo simulators would be ideal for VUL projections, giving clients an estimation of how likely it is that their policy will survive to the time of their death. "In the right hands, and with the right caveats, it's a much better tool for helping clients form reasonable expectations than any straight-line or historic presentation," says Richard M. Weber of The Ethical Edge insurance consulting firm in Carlsbad, Calif.