Sequence-of-returns risk

Two accounts can earn the same returns and end with different values. When nothing is added or taken out, the order of the returns makes no difference. Once income is being drawn, early weak years leave less money for the later strong ones to grow. That is sequence-of-returns risk, and it is a central risk for an indexed universal life (IUL) policy in its income years.

How it works in an IUL

During accumulation, the 0% floor means a falling index year credits zero and the account keeps its value before charges. During distribution, sequence risk remains:

• income taken in a zero-credit year comes out of an account that earned nothing that year;
• cost of insurance and other charges continue every month;
• a policy loan keeps accruing interest, so a run of zero-credit years compounds the loan balance while the account value drops;
• a participating loan leaves the loaned value in the index account, so it earns zero in a flat year while interest still accrues.

The floor narrows the range of outcomes compared with a portfolio that can fall 20% or more in a year. The order of the credits still shapes the result.

Worked example

Illustrative figures, not a forecast. An account value of US$1,000,000 pays US$70,000 at the start of each year for five years, before charges. The same five credits arrive in two orders: three years at a 9% cap and two at the 0% floor.

• Cap years first (9%, 9%, 9%, 0%, 0%): the account ends at US$904,910.
• Floor years first (0%, 0%, 9%, 9%, 9%): the account ends at US$863,606.

Both paid US$350,000 of income from the same five credits. The second order ends US$41,304 lower, because its 9% credits came after two years of income had been drawn from an account that earned nothing.

In an international IUL

An offshore bond invested in equity funds takes the market fall in a bad year, so its sequence-of-returns risk is high. An IUL with a 0% floor carries less, and what remains sits in the income years. Ways to manage it include:

• stress-testing the income plan at Assumed Basis #2, Basis #1 less 1% a year, and under runs of zero-credit years;
• keeping planned income well inside what the account value supports, and reducing it after a zero-credit year;
• choosing between a fixed loan and a participating loan with the sequence in mind;
• reviewing the policy at least once a year.

Common questions

Does the 0% floor remove sequence-of-returns risk?

It removes negative index credits, which protects the account during accumulation. When income is being drawn, zero-credit years still reduce the account, because charges, withdrawals and loan interest continue while the credit is zero.

When does sequence-of-returns risk matter most?

In the first years of drawing income. Weak years then shrink the base that every later credit builds on, and the effect carries through the rest of the plan.

How can sequence risk in IUL retirement income be reduced?

A well-funded policy before income starts, an income plan stress-tested at a lower basis, and income that can be reduced after a zero-credit year all reduce it. Annual reviews show whether the plan is still sustainable at the current loan balance.

Go deeper: loan or withdrawal: which way to take income.