What you see might not be what you get with certain retirement plans

When planning for retirement, it’s easy to focus on how much you’re saving, how your investments might grow over time, and the retirement income (and lifestyle) the plan will provide for you. But it’s also important to ensure that the underlying structure of your supplemental executive retirement plan appropriately manages risks so it can deliver the financial benefits you desire.

For example, SERPs built on indexed universal life insurance have become popular in the credit union space in recent times. On the surface, UIL SERPs are flexible plans that let you set the premiums and save for retirement. But there are potential problems beneath the surface that many people miss.

When shopping for and putting IUL SERP plans in place, most board members and executives focus on the projected average returns without realizing that the return on these types of plans doesn’t depend on the stock market alone. The return also relies heavily on 1) the “cap” (a limit) on the returns an executive can get, set annually by the insurer and 2) “sequence of returns risk”—that is, the risk that comes from the timing of investment gains and losses.

At PARC Street, we call this sequence of returns risk “the luck factor.”

So, what is this sequence of returns risk, exactly? How does it work with an insurance company’s cap to influence an executive’s ultimate retirement payout under an IUL SERP? And what can you and your board do to mitigate “the luck factor”? Let’s dive in.

What is sequence of returns risk?

Sequence of returns risk refers to the impact on your retirement income of the order in which investment returns occur on your SERP IUL investment account.

When you are building—or “accumulating”—a balance in an IUL policy, the sequence of returns likely will have only a minor impact on future retirement withdrawals so long as premiums are being paid and no withdrawals are being made—especially if you have many years (say 20) before retirement. Still, a market downturn early in the accumulation phase can reduce the growth potential of the policy’s cash value and lead to lower-than-expected growth over time, even if the market recovers later. The annual resetting feature of IULs, through which gains are locked in annually, provides some protection, but a series of poor early years can still set the policy back significantly.

Having several down years at the start of the accumulation period doesn’t happen often, but it does happen. And no one wants to be surprised with a lower-than-projected retirement payout.

Sequence of returns risk becomes more critical during the plan’s distribution phase when the policyholder begins taking withdrawals to supplement their retirement income. If the market performs poorly during the early years of withdrawal, the cash value of an IUL policy could be significantly reduced. This is because withdrawals taken during a downturn deplete the cash value more quickly than if returns were positive. Unlike in the accumulation phase, there is no opportunity for the cash value to recover from losses if funds are being continually withdrawn. This could put the payback of the original loan to fund the plan in jeopardy.

The return environment at the time you retire makes a big difference. Consider these two possibilities:

1. Initial high returns: Suppose you retire in a period of strong market performance. Your investments might grow significantly even as you withdraw money. For example, if you withdraw $20,000 annually from a $500,000 portfolio in a bull market, the growth of your investments can offset your withdrawals, potentially allowing your savings to last longer.
2. Initial poor returns: If you retire during a market downturn, your investments lose value soon after you start withdrawing funds. For instance, if your portfolio drops to $400,000 shortly after you begin withdrawals, and you continue to take out $20,000 each year, your portfolio is shrinking at a faster rate. The losses early in retirement reduce the base from which your investments can recover, putting you at greater risk of running out of money.

The essence of sequence of returns risk at retirement is that the timing of your withdrawals relative to investment performance can significantly impact the amount of the projected retirement benefit possible. When markets are down early in retirement, withdrawing money from a shrinking portfolio can accelerate the depletion of your funds.

As was mentioned earlier, this problem can be exacerbated by the insurance company’s cap, which limits the gain an executive’s plan can realize even when the market has a good year. Don’t forget: On the plan cost side, the insurance company also charges cost of insurance and interest for any loans made to the executive the initial loan that was part of the plan setup.

The ‘luck factor’ in IUL versus whole life

So why are we particularly concerned with sequence of returns risk when SERPs are built on indexed universal life?

IUL SERPs are particularly susceptible to this kind of risk because the growth of the cash value of the policy is credited based on an options strategy (which determines the cap and the floor) tied to the performance of an underlying index, such as the S&P 500. Returns on any index are not guaranteed. Plus, your IUL SERP returns will be subject to caps and floors, which could limit your returns on your investment, and the cap can be changed by your insurer at their discretion.

In contrast, SERPs built on whole life insurance don’t have sequence of returns risk. The return on whole life is a dividend announced annually based on the insurance company’s profitability. Our data shows that this return rate has varied only slightly over many years.

Taming the ‘luck factor’ in IUL SERPs

If you are looking at setting up a SERP based on IUL, we recommend a conservative plan design to mitigate sequence of returns risk so the “luck factor” is less likely to diminish your ultimate retirement payout.

One way to mitigate these key risks of an IUL SERP is to give the plan a “haircut” of 30%—meaning work with the idea that returns will be 30% less than projected. So if the max rate is 5.7% based on cap and floor, we’d recommend designing the plan with a 4% rate that still gives the desired return.

At PARC Street Partners, we use LISA—Life Insurance Sustainability Analysis—to help our clients better understand IUL plans. This tool takes sequence or returns risk into account when running an analysis on a split-dollar IUL SERP.

Sequence of returns risk is a critical factor that can significantly affect the performance of a SERP based on IUL. Understanding and managing this risk is essential for executives relying on these plans to provide a stable and reliable income stream in retirement. We’d be delighted to help you sort through the options.