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An All-Purpose Variable Income Annuity

Posted on November 23, 2016 by Kerry Pechter -

Good retirement income ideas, like comets, have a way of appearing, disappearing, and circling back again. They never become bad ideas, per se. It’s just that changing interest rates, regulations and demographics create either fertile or infertile conditions for them.

The immediate variable annuity (IVA) is one of those good ideas. Like its cousin, the single-premium immediate annuity (SPIA), an IVA pays out a mix of earnings, principal and so-called mortality credits (the benefit of longevity risk pooling) each month. An IVA improves on a SPIA, however, by offering the potential for rising income payments in retirement.

For a decade, as other types of annuities have gained or lost popularity, a team at Chicago-based Achaean Financial—founded by former CEO of Lincoln Retirement Lorry Stensrud, with former Ibbotson Associate president Mike Henkel and Milliman actuary Tim Hill—has been waiting for the stars to align in favor of a specific IVA design, one that Stensrud and Hill were granted a patent for in 2014, five years after filing for it.

Their product—a chassis that Achaean calls Income Plus+ but which life insurers and broker-dealers are likely to manufacture and distribute under a variety of names and with a variety of issuer- or distributor-specific customizations—is now ready for prime time, according to Stensrud and Henkel. They claim to be close to announcing their first underwriting and distribution partners.

“We’re going full speed ahead to get our core group of life companies aligned with distribution partners,” Stensrud (below, right) told RIJ recently. “We’re past the talking stage with our partners,” said Henkel, who is president of Achaean Solutions and the firm’s technology lead. Besides running Ibbotson, Henkel was once co-head of Envestnet’s Portfolio Management Consultants Group and lead of its Retirement Services Group.

The two men imagine Income Plus+ as the successor to the variable annuity with the guaranteed lifetime withdrawal benefit (VA/GLWB), and a much-needed solution to the headaches that in-force VA/GLWBs have created. They think it has something for everyone in the retirement income value chain: cost-effective guaranteed income with upside potential for retirees, a potential exit strategy from high-fee, capital-intensive VA/GLWB contracts for insurance companies and advisors at broker-dealers, and as a potential rollover solution or income option for people leaving retirement plans.

How ‘Income Plus+’ works

Even in the arcane world of annuities, the mechanics of an IVA aren’t the easiest to describe or understand. When someone buys an IVA, the insurer calculates an initial payment based on the client’s age, the premium, and an “assumed interest rate,” or AIR. The AIR (which may be as high as 3.5% or more in a “normal” interest rate climate or as low as 1% in today’s climate) is a provisional best estimate of average future returns. The initial payment represents not a fixed dollar amount but a fixed number of units.

The value of the units fluctuates. The issuer invests the premia of groups of policyholders in pools of stocks and other risky assets. If the assets appreciate in value, so do the value of the units. The number of units never goes down, and the contract may or may not guarantee that the monthly payment won’t go down.

Income Plus+ works much like a classic IVA, but with a couple of important differences. These differences allow it to offer not only the attraction of upside potential, but also the flexibility—i.e., cash surrender value and a death benefit—that many retirees want. It even offers the potential, especially when asset prices are rising, for annual increases that match the inflation rate.

Achaean’s key innovation is a “banked amount.” It’s a cushion or buffer, funded by excess contract returns, from which the insurer can dip into either to support the guaranteed minimum payout during lean years, to pay inflation-based bonuses whenever the fund is liquid. “If the banked amount is positive and inflation is say 2% then the payment would go up by 2%,” said Henkel. “That would then be the new guaranteed payment for the rest of the annuitant’s life.”

In short, excess returns go into the banked amount before, and sometimes instead of, raising the client’s annual income. The banked amount becomes part of the insurer’s general fund and earns interest—for the insurer—at the general fund rate. The buffer is reminiscent to the “smoothing” accounts that some defined contribution plans in Europe use to spread risk among participants.

“You still invest the bulk of the premium in a way that provides a pooling effect and mortality credits,” Henkel told RIJ. “The insurer can invest in a way that’s reasonable to meet the guarantee. The banked amount helps self-capitalize the guarantee. The insurer can turn there first if there’s not enough return to make the guaranteed payments. Any excess return over what the insurance company needs to pay out becomes a death benefit at the end of the policy.”

“The banked amount belongs to the policyholder,” Stensrud said. “It can be taken as income, as death benefit or, in a future version, as a quasi-LTC (long-term care) benefit. Each life company will have variations on the theme as to how they payout increasing income.”

Something for everyone

“For the policyholder, we offer high initial income, a greater chance of increasing income, a guaranteed [inflation] ratchet and the lowest cost,” Stensrud told RIJ. There’s also liquidity.

“The cash surrender value of the product is simply premium-less-payments (minus any surrender charge schedule put in place by the underwriter). So, the policyholder will always get back his initial premium less any friction from a surrender charge.” The product will vary, he said.

The initial payout from an Income Plus+ contract, according to Stensrud, would be equal to 93% to 95% of the payout of a comparable SPIA, although that might vary from issuer to issuer. (Today, a $100,000 male single-life life-only SPIA pays about $540 a month, according to immediateannuities.com.) That would be comparable to the 5% payout from a typical living benefit on a variable annuity or indexed annuity.

Income Plus+, depending on its specific design, may also be better able to produce rising income in retirement than a VA/GLWB. During the income phase of a VA/GLWB, when fees of 3% or 4% and monthly withdrawals of 5% are simultaneously draining its cash value, there’s little chance, barring a raging bull market, of reaching the new high-water account balance that’s necessary for a step-up in monthly payouts.

By comparison, “Our hurdle rate for increasing income is really low,” Henkel (at left) said. “The product only needs to earn 4% to provide an increase in annual income, versus 7% or 8% or 9% in a GLWB. When you’re taking withdrawals from a GLWB with high fees, they come out of the separate account. The separate account goes into a death spiral and you never get an increase in income.” In the IVA, unlike the VA/GLWB, “shortfalls don’t deplete the separate account,” he added. “That’s one of the big advantages.”

Relief for broker-dealers

Before it can find a consumer audience, Income Plus+ will need to appeal to broker-dealers and their advisors. Henkel and Stensrud say that the appetite among distributors for an IVA like Income Plus+ is strong, for two reasons. It has the potential for new sales to retiring baby boomers. It also has the potential to stimulate a new wave of 1035 exchanges out of high-fee VA/GLWBs that have no hope of generating step-ups in income. In order to justify a transfer, advisors must be able to offer a demonstrably suitable alternative to the existing contract. Income Plus+ could fill the bill.

“Brokers and advisors have billions of dollars worth of variable annuities on their books,” Henkel told RIJ. “A lot of the contracts are in qualified plans. Now they have they have fiduciary liability around them. It’s not the best thing for the investor. There’s nothing to move them to. There’s a real desire from the broker-dealer to have these products.” The insurers with all these VAs in force, tried to get rid of them with buyouts. The broker-dealers have hated them for sending those letters.”

Achaean is already working on technology to identify and document the suitability of those 1035 exchanges. “We’re asking, how can we help a broker-dealer or insurer approach these [variable annuity contract holders], determine who would be better off switching to an Income Plus+ annuity type and then documenting why a 1035 exchange is in the client’s best interest,” Henkel said.

“We can say to a broker-dealer, give us a dump of all your policyholders, their ages, annuity types—but no Social Security numbers—and we’ll run Monte Carlo simulations to compare the potential outcomes of their existing annuities with the results of switching to Income Plus+. Once advisors have that data, they can create personalized sales stories.”

An IVA could also be positioned as a suitable 1035 exchange destination for retirees who own annuities that don’t produce income, or who don’t want to exercise their right to convert those products to SPIAs. “Distributors want this as a settlement option to an investment-only variable annuity or for an accumulation indexed annuity,” said Stensrud.

Either an indexed annuity or a separate account annuity could be developed on the chassis of Income Plus+, he told RIJ. Advisors, he believes, could collect a commission on the sale of the IVA or charge asset-based fees on the investment in an IVA. In contrast, advisors consider money allocated to SPIAs as a lost source of revenue. “If advisor is actively advising, I don’t doubt that they can collect fee,” he said.

Relief for insurers

Like advisors, a lot of insurance companies would like to get billions of dollars of in-force VA/GLWBs off their books. The richness and flexibility of those products, which made them so marketable, translate into liabilities for the underwriters. It’s hard to reserve against the longevity risk embedded in a book of the guaranteed lifetime income riders, because it’s hard to predict how many policyholders will actually exercise them.

If contract owners swapped their in-force VA/GLWBs for IVAs based on the Income Plus+ chassis, their risk as well as their expenses could go down. “For the carrier, we have 50-70% lower capital requirements, product ROEs (return on equity) in the mid-teens to mid-twenties, ROAs (return on assets) of 100+ bps, reduced-vega risk (volatility) and hence lower hedging costs, and lower longevity risk,” Stensrud said.

“There are two or three hundred billion dollars worth of variable annuities that are sitting [on the books of life insurers like Prudential, MetLife and others],” Henkel added. “Thirty percent or 40% of the policyholders will be the right age [for a transfer to an IVA]. They will be ready to start taking income, and swapping to an Income Plus++ type product will be great for them.”

“In a worst-case scenario, where there is no excess return, the insurer has underwritten a SPIA,” he said. “You would like to see excess returns as early and as frequently as possible. You don’t necessarily want a home run right away. You’d want to hit singles until the bank account has built up a decent reserve. Then you can afford to take more risk with separate account assets.”

An objective analysis

To get a third-party opinion about Income Plus+, we spoke to Jeffrey Dellinger. The author of “The Handbook of Variable Income Annuities” (John Wiley & Sons, 2006) and a creator of i4Life, Lincoln Financial’s version of an IVA, Dellinger can claim to know as much as anyone alive about this type of product. He and Stensrud were at one time colleagues at Lincoln.

“The general concept of Lorry’s IVA design [is] on the right track. It provides a guaranteed benefit floor—which gives some individuals the degree of comfort they need to make an IVA purchase—while reducing the cost of it by also incorporating a benefit ceiling,” Dellinger wrote in a recent letter to RIJ, after studying the Income Plus+ patent.

“With a floor benefit attached to an IVA, it becomes more of a GLWB alternative. And if it is marketed as helping insurers extract themselves from a block of business with overly generous benefits and capital intensiveness, that holds appeal for insurers,” he wrote.

Dellinger prefers his own original IVA design, however, which applies all excess returns to future guaranteed income. “Instead of building up a side fund when favorable investment experience emerges, that design… applies any excesses to the purchase of additional annuity units payable on all future benefit payment dates,” he wrote.

Dellinger thinks that the opportunity for Income Plus+ may have been greater several years ago, when carriers were at their most eager to cleanse their books of the riskiest VA/GLWB contracts. But he believes that potential for success still exists and the product can stand on its own merits.

“Because insurers have redesigned their VA Guaranteed Living Benefits (VAGLWBs) to be less rich—once they finally performed better quantitative analyses of them and had their actions less governed by the VA/GLWB “arms race”—and because some of those insurers, in effect, bought back the overly generous benefits they had sold, the market for VA/GLWB to protected IVA transfers is perhaps a little less hot than back when Lorry began pursuit of this opportunity [in 2009]. The provisional patent application for this was filed in April 2009. Nonetheless, there’s still an opportunity.

“Acceptance of IVAs takes a while,” he wrote. “With lower costs, higher initial income, and substantially higher growth opportunities than GLWBs, IVAs have a lot of attractive aspects. All by themselves, even if GLWBs had never existed, IVAs have some attractive characteristics.

The Trump factor

His belief in the singular value of IVAs has sustained Stensrud’s effort to bring Income Plus+ (not to be confused with Financial Engines’ “Income+” program) to market for a decade. He filed for a patent in April 2010. “Lorry has been absolutely relentless in continuing to pound away at this,” Dellinger said. “It has to break through with underwriting and distribution at the same time. The problem has never been because it wasn’t a good product. It’s just that nobody wanted to be first.” Conditions now appear to be right, because Achaean has commitments from broker-dealers and insurers. He isn’t ready to disclose them, however.

The election of Donald Trump could pose a threat to the product, in part because the new president is expected to sweep away many Obama initiatives, including the Department of Labor’s conflict-of-interest rule. Although the rule worked in favor of Income Plus+–because of its potential as a compliant reason to recommend an IVA as a rollover target from a 401(k) plan or as a destination for a 1035 transfer—Stensrud doesn’t see it as essential to his product’s success.

“If the fiduciary standard of care is overridden by legislation, it doesn’t change the fact that the current VA with living benefit product-set is unsustainable for carriers, that fixed annuities are dead under Solvency II for non-U.S. carriers, and that the Income Plus+ features and benefits are better for both the underwriter and the individual in a head-to-head comparison in both general account and separate account versions,” he told RIJ.

“We’re going full speed ahead to get our core group of life companies aligned with distribution partners. The distributors all want to be in the retirement income space. We need highly rated, big name underwriters,” he added.

“The hardest part has been getting the insurers interested,” Henkel agreed. “They all know that this would be better than what they have. But they don’t want to create a product until they know that a distributor is going to sell it. Getting the broker-dealers on board—that’s what makes the difference. You need somebody who can say, ‘We will sell this.’ Once you break that dike, then the insurers will come in.”

No reason to raise rates now, writes heterodox economist

Posted on November 17, 2016 by Editorial Staff -

Next month, the Federal Reserve Board is—or was, until the November 8 election—expected to raise its benchmark interest rate by a quarter-point. But a new paper from the Levy Economics Institute at Bard College (home of “heterodox” economics”) claims that the U.S. economy isn’t nearly strong enough yet to merit an uptick in rates.

In the paper, “Normalizing the Fed Funds Rate: The Fed’s Unjustified Rationale,” economist Flavia Dantas of SUNY-Cortland, claims that the U.S. job market is much softer than the official 4.9% unemployment rate would suggest. She estimates that we’re million of jobs away from a level of employment that would trigger serious inflation and force the Fed to tighten.

“The urgency and rationale behind the rate hikes are not theoretically sound or empirically justified,” Dantas writes. “Despite policymakers’ celebration of ‘substantial’ labor market progress, we are still short some 20 million jobs… Also, there is little empirical evidence or theoretical support for the FRB’s suggestion that higher interest rates are necessary to counter ‘excessive’ risk-taking or provide a more stable financial environment.”

Professor Dantas believes that inflation is low because the necessary ingredients for it—high employment levels and upward pressure on wages—are absent from the economy. The real unemployment rate is about 12%, she writes, if you count the 7.7 million people officially unemployed today, the 6.1 million people who are employed part-time but would like full-time jobs, and the 7.4 million unemployed who are implied by the 2.9% decline in the U.S. labor force participation rate since the Great Recession.

Dantas blames that situation not on growth-stifling governmental policies but on the decline of labor unions and the subsequent loss of workers’ strength to bargain for higher wages. Only in the unlikely event that employment and wages increase substantially, she believes, inflation will not become a threat and the Fed will have no reason to raise rates.

That could change, she concedes, if the government chooses to spend a lot of money and put a lot of people to work, but “Without a stronger fiscal spending response, the slack in the labor market is likely to remain, as are low levels of inflation.”

As for those who believe that low interest rates and the excess reserves that remain in the banking system will foster inflation regardless of developments on the employment front, Dantas, like other heterodox economists, disputes the idea that the banks’ ability to lend money necessarily will result in indiscriminant lending and high inflation.

“Easy credit conditions,” she writes, “cannot stimulate the economy or cause a credit boom when the expected proceeds from position taking in real assets are low or the private sector wishes to deleverage their position by retiring their IOUs.”

There’s No Morning-After Pill

Posted on November 16, 2016 by Kerry Pechter -

Along with millions of other Americans, I was glued to the news channels on election night, watching with disbelief and puzzlement as polls closed and the electoral map turned into a sea of red. I did not give Donald Trump’s take-no-prisoners campaign style a reasonable chance for victory. His win reminds me very much of the lessons I have learned from years of investment management:

We are blind to our blind spots. In this election, the mainstream media and elite observers consistently underestimated the degree of frustration and discontentment of mid-America and the impact of an uneven recovery since 2008 on the average citizen. A growing portion of American workers felt left behind.
When we offer our “educated” and “independent” view about the future, or establish a base case regarding an outcome, is our view truly objective? Is our analysis skewed by the destination we visualize? Do we unknowingly promote the factors that favor our desired conclusion? The we-have-never-seen-a-back test-we-didn’t-like phenomenon that validates an investment strategy is evident in politics as well. Even many Trump supporters did not count on a Trump victory, let alone a shut out.
Behavioral finance shows how, after the fact, people selectively recall that they anticipated the outcome. In retrospect, they quickly identify the factors that were “obvious” all along. In reality, we only think that we know the reasons, factors and behaviors for an outcome after the fact. We will soon hear post-mortem analyses of the election results. Pundits will revise reality to fit their narratives. Many will maintain that they privately believed that Trump’s “path to 270” was much wider than it seemed. They are not liars; rather, everything seems so much clearer after the fact.

The question now is: how quickly can we, as the stewards of our client assets, abandon our own biases (extreme optimism on the part of Trump supporters and pessimism on the part of Clinton supporters) to act (and not react) to re-position our client portfolios for the future. For now, the markets seem to predict an economic revival, with much needed fiscal stimulus, deregulation, and tax reform.

Expansion would naturally lead to inflation. This could mean a faster pace for interest rate hikes (both FOMC and the market driven long rates) and bad news for bonds. Internationally, U.S.-dependent emerging markets may be hurt. But this is just speculation. The markets may have temporarily forgotten that the GOP is as fractured as the electorate and that change is not a slam dunk.

In managing investments, before we tactically allocate our clients’ portfolios to pursue opportunity or to mitigate risk, we first develop a view—our base case, in which we have the greatest conviction about the global economic and political environment going forward. But conviction isn’t certainty. In the case of this election, the popular base case was a Hillary win. Her supporters discounted conflicting evidence as outliers and counter-signals as noise. But in politics, as in finance, every base case contains uncertainty.

After eight years of unconventional monetary policy in the U.S. and globally, investors and savers embraced risk in search of income and return. This compressed risk premia and term premia, but did not reduce the variance of return (i.e., the range of possible returns). Consequently, financial assets have more potential for risk and less for return. And, in a low return world, there is less room to absorb normal losses.

In his 1921 book, “Risk, Uncertainty, and Profit,” American economist Frank Knight distinguished risk from uncertainty. Risk, he wrote, applies to situations where one can assign probabilities to specific outcomes—based on “known knowns”—without being certain about any of them. Uncertainty, on the other hand, applies to situations where one can’t identify a range of outcomes. There are too many “known unknowns” and “unknowables.”

With no governing history, Trump is a known unknown. The stark difference between his behavior and temperament during the campaign and after his victory forces us to wonder: Who is the real Trump? We can attempt to guess his potential policy positions on trade, immigration, the environment, on our global alliances and treaties, or on our fiscal policy, but as citizens (and stewards of client assets) our biggest concern is uncertainty about Trump’s positions. Our country, its people, and the investment world face uncertainty about the next four years without any clear method for assessing the risks.

In the end, I am reassured by the sturdiness of our electoral process. It speaks loudly and favorably about America that an outsider can run a low budget campaign without the support of his own party and still win the highest office in the land. It speaks loudly about the strength of our democracy and respect for the rule of law that power has transitioned peacefully from one administration to the next.

Will pensions become subject to state income tax in Illinois?

Posted on November 16, 2016 by Kerry Pechter -

Thousands of Illinoisans ages 50 and older are trying to prevent their state government from re-establishing a tax on retirement income. Back in 1984, the state government voted to exempt pension income from state income tax.

During a press conference at the Capitol in Springfield this week, officials from AARP produced a petition of more than 15,000 names protesting the proposed tax and delivered it to Governor Bruce Rauner, House Speaker Michael Madigan and other senior officials.

Illinois is one of 41 states with a state income tax and one of 27 that exempt Social Security income from their income tax. But it is one of only three of the 41 that exempt all pension income from state income tax. The number of senior citizens in Illinois is expected to grow to 2.7 million in 2030 from 1.7 million in 2010. Illinois’ neighbors—Michigan, Indiana, Wisconsin, Iowa and Missouri—tax non-Social Security retirement income.

But older Illinoisans do not want to the cost of digging Illinois out of its ongoing fiscal crisis to fall on them. Taxing retirement income (except Social Security) would bring in about $2 billion in new taxes, according to the Chicago Tribune.

“Instituting a state income tax upon retirement income in a piecemeal manner to address Illinois’ fiscal mismanagement, financial woes, and political gridlock is unfair to our retirees who worked and saved for decades,” said Ryan Gruenenfelder, AARP Illinois Manager for Advocacy and Outreach. “Retirees did not put the state in the current fiscal crisis. It is shortsighted to propose to balance the state’s economy on the backs of retired individuals.”

According to an AARP survey conducted a year ago, some 90% of Illinoisans ages 50 and older oppose the tax. The survey showed that 92% of respondents believed a tax on retirement income would have a negative impact on their household budget; nearly 60% would consider moving to another state; nearly 70% would be forced to reduce their household spending; and a third would have to return to the workforce.

After the survey, AARP mailed petitions to Illinois members asking them to sign on to a clear message to their elected leaders, urging them to oppose efforts to create a tax on retirement income.

What Happens Now for Retirement Policy?

Posted on November 16, 2016 by Will Hansen -

As Senior Vice President for Retirement Policy at The ERISA Industry Committee (ERIC) and a political enthusiast, I have closely followed this election cycle and was surprised at the lack of focus on retirement policy, including Social Security, throughout the Presidential, Senate, and congressional races.

While President-elect Donald Trump has remained mum on the subject of retirement policy, it does not mean he does not have a position. Retirement policy is often avoided by elected officials because it is difficult to put forth a viable plan of action that appeases a majority of the population. We may quickly learn more about Trump’s position once we see who will lead the regulatory agencies. Whomever he places in those key positions, I think we can all agree that Americans need to save more for retirement and that the voluntary private retirement system can help to achieve that goal.

Based on the outcome of the election for President and Congress, I believe we will not see much movement at all in the retirement space from a legislative angle. Neither side (Republican or Democrat) has a filibuster proof majority in the Senate, which means compromise is still necessary to move forward with legislation.

In recent years, the legislative body has focused on issues that need immediate attention. While some argue that we are in a state of crisis with our current retirement policy in America, it is not so dire that the legislative body must act in the next few years; this includes a major overhaul of the tax system. Most tax reform proposals will impact retirement policy, but I do not see how Congress tackles tax reform when neither side will likely compromise on key issues within tax policy.

ERIC will continue to advance the legislative priorities that protect the voluntary retirement system. We will continue to advocate to:

Move PBGC premiums off-budget;
Increase electronic disclosure requirements;
Assist pension plans with non-discrimination testing;
Advance policies that assist large employers in providing student loan repayment programs; and many others.

With that said, the action will now turn to the states. If Congress remains deadlocked on key issues, the states will push forward with legislative proposals in the retirement and compensation area. We will continue to see states implement state-run retirement plans, paid sick leave, and other reforms that will require the attention of our nation’s largest employers.

On the regulatory front, I do think there will be a move to repeal various Executive Orders and other regulations that were advanced under President Obama, including:

The overtime rule;
Paid sick leave for federal contractors;
Revisions to EEOC EEO-1 form; and the
Conflict of interest rule.

In addition, I expect a decrease in the number of new regulations that impact private retirement plans and other compensation practices.

Transamerica’s new living benefit offers 1% more payout for 5-year deferral

Posted on November 16, 2016 by Editorial Staff -

A new living benefit, Income Edge, is now available for most Transamerica variable annuities, the firm, whose principal offices are in Baltimore and Cedar Rapids, Ia., announced this week.

The optional rider allows income to begin after age 59, and “the opportunity for up to a 6% annual income payment rate for life if they start income between ages 65 and 79 and 7% at age 80 or older.

These annual income payment rates are based on a single life withdrawal after a deferral period of at least five complete rider years. For a joint life contract with less than a five-year delay, the payout rate is 3.5% until age 65 and 4.5% until age 80.

The rider fee is 1.40% per year of the withdrawal base (with an allowable maximum of 2.15%). For instance, if the withdrawal base remains $100,000 or more but the account value eventually drops to much less, the fee will remain at least 1.40% of the withdrawal base, or $1,400.

Depending on the share class of the contract, the mortality and expense risk fee will range from 0.45% to 1.90% of the account value, and the first-year surrender charge will range from 0% to 9%.

The fee will not be deducted from the Stable Account unless the other options are exhausted. For New York only, once the Select and Flexible investment options are exhausted, no rider fee will be deducted.

Owners of the product can invest up to 60% of the separate account assets in stock funds as long as at least 20% of the portfolio is invested in a stable value account and 20% is invested in bond funds or other designated options.

The payout bands for single-life contracts are 4% until age 65 and 5% until age 80, with payouts for joint-life contracts a half percentage point lower. For investors who delay income for five complete living benefit years, the rates are all a full percentage point higher.

The rider must be elected at issue, but customers can cancel the living benefit during a 30-day window after issue and once every five years thereafter. The living benefit can be elected by customers of any age up to 85. The living benefit withdrawals are available only after the first rider anniversary following the investor’s 59th birthday.

Edward Jones’ 401(k) plan accused again of ERISA violations

Posted on November 16, 2016 by Editorial Staff -

In a class action lawsuit filed in federal court in Missouri, participants in the Edward D. Jones & Co. Profit Sharing and 401(k) Plan are suing the plan’s sponsor, the broker-dealer Edward Jones, for breach of fiduciary duty under the Employee Retirement Income Security Act of 1974 (ERISA).

In their complaint, filed November 11 in the Eastern District of Missouri, the plaintiffs claimed that the plan’s fiduciaries violated ERISA by “maintaining the higher fee share class of identical investment options in lieu of the lower cost share class,” including a “poorly performing money market account,” in plan, and offering participants an “unreasonable number of high risk investment options.”

The suit is the second of this type filed against the Edward Jones retirement plan in U.S. District Court in St. Louis, where the firm is headquartered. Last August, in McDonald v. Edward D. Jones & Co. L.P. et al, the firm was accused of offering high-fee investments to participants in its plan, which had nearly $4 billion in assets and 36,000 participants as of year-end 2014.

“Instead of acting for the exclusive benefit of the Plan and its participants and beneficiaries with respect to managing the Plan’s assets,” that McDonald suit charged, the defendants forced participants “into investments that charged excessive fees that benefitted the mutual fund partners of Edward Jones.”

Those partners included American Funds, Franklin Templeton, Invesco and other well-known asset managers, who were among the fund companies that paid Edward Jones about $175 million in revenue-sharing fees in 2015 to help Edward Jones advisors market those funds to their clients. (See chart below for companies with funds in Edward Jones 401(k), their share of plan assets, and the total amount of revenue-sharing fees they paid Edward Jones in 2015.)

Fund families rev sharing and % in EdJones 401k

The implication was that in return for paying millions of dollars for “shelf space” at Edward Jones, the fund companies were allowed to charge higher fees for their products to participants in the Edward Jones retirement plan than were reasonable and in the best interests of the participants, when much less expensive funds were readily available.

The suit also alleged that Edward Jones caused the plan to pay Mercer HR Services, Inc., too much for recordkeeping and plan administration. According to the suit, the plan’s payments to Mercer increased by 314% between 2010 and 2014 even though market rates for recordkeeping services declined over that period and even though the number of Plan participants only increased by 22%.

Will pensions become subject to state income tax in Illinois?

Posted on November 16, 2016 by Editorial Staff -

After the survey, AARP mailed petitions to Illinois members asking them to sign on to a clear message to their elected leaders, urging them to oppose efforts to create a tax on retirement income.

Honorable Mention

Posted on November 16, 2016 by Editorial Staff -

New York Life’s participating DIA owners get their first dividend check

For the first time, New York Life is paying out a dividend on its “Mutual Income Annuities,” which are deferred income annuities whose contract owners participate in New York Life dividend distributions.

New York Life is the nation’s top seller of fixed income annuities, including deferred income annuities with and without a dividend. The mutual income annuity was launched in 2015. Northwestern Mutual offers a competing product with a slightly different design.

“Expanding our mutual structure to benefit pre-retirees and retirees seeking guaranteed lifetime income shows our commitment to broadening the community of policy owners who benefit from both our products and our mutual company structure. We expect even more consumers who are seeking retirement income solutions to enjoy the advantages of ownership that come with our participating income annuity product,” New York Life chairman Ted Mathas said in a release this week.

New York Life, America’s largest mutual life insurer, simultaneously announced that it expects to pay participating policy owners a record dividend payout of $1.77 billion in 2017, an increase of 5.4% over what it expects to pay this year. Since 2012, New York Life has increased its dividend payout by 35 percent, despite five years of record low interest rates and uneven U.S. economic growth. Next year will be the 163rd consecutive year that New York Life has paid a dividend to policy owners.

Capital One’s broker-dealer will eliminate commissioned sales on IRAs

The online and retail brokerage arm of Capital One Financial will eliminate commissions on advised IRAs to conform with the Department of Labor’s fiduciary rule for tax-advantaged retirement accounts, which is scheduled to take effect on April 10, 2017, Financial Advisor IQ reported this week.

Capital One Financial said the decision to ban trade commissions and allow only fees on assets under management in retirement accounts was a “natural decision” for the firm.

The firm said it would abide by the decision to eliminate commission-based servicing of those retirement accounts “regardless of potential changes to the] [fiduciary rule.” Since the presidential election, there’s been wide speculation in the retirement industry that the incoming Trump administration will eliminate the rule.

Capital One Financial’s financial advice and planning business is only a year old, operating out of several regional offices and a call center in Wilmington, Del. The unit manages about $26 billion.

Voya attributes growth to technology investments

Voya Financial Advisors, Inc., the retail broker-dealer and registered investment adviser of Voya Financial, has launched “Business Builder,” a modeling and forecasting system that lets its advisors “set and manage the progress of business growth goals.”

The broker-dealer’s annual advisory sales grew by 30% during 2015, and annual recruiting Assets under Management (AUM) rose 115% through the third quarter of 2016. A Voya release attributed that growth to ongoing investments in new technology for advisors.

The Business Builder tool is aimed at advisors of retail clients or retirement plans. The tool lets advisors see overall Gross Dealer Concession (GDC), sales, and net new assets across several product categories. It also “provides capabilities for adjustments to better fit the unique TEM (tax-exempt market) business model,” the release said.

Last summer, the broker-dealer established a content repository where advisors can find online tools, webinar content, newsletters, discussion groups, and a network of expert partners and contributors. Recently, it expanded its social media program to help advisors create customized communications.

Trump Wins: What Happens Now?

Posted on November 10, 2016 by Schwab Center for Financial Research -

Our view, expressed over the past month, was that a surprise win by Donald Trump would likely be one of the most unsettling outcomes for the markets. Indeed, that has come to fruition. As the realization of a Trump win began to set in, Dow Jones Industrial Average futures dropped more than 800 points; meanwhile, the S&P 500® Index fell more than 100 points, triggering circuit breakers. Dow futures later recovered some of those losses.

The carnage reflects the significant uncertainty associated with a Trump presidency, and the shock to traders and investors who were relying on the polls. It’s likely of little solace at present, but at times like these it is more important than ever to remind ourselves that panic is not a good investment strategy, and that your portfolio should be connected to a financial plan.

Stocks weren’t the only market seeing a dramatic move—the Mexican peso, a barometer of the vote, fell by more than 10% by the time the election was called, the largest drop in eight years. Demand for perceived safe-haven assets also supported gold’s surge and a drop in the 10-year Treasury yield to a two-week low. Expectations for a Federal Reserve rate hike in December also sank, as did the U.S. dollar and emerging market stocks. And the CBOE Volatility Index, which was below 13 as recently as two weeks ago, has surged to over 25.

The drama harkens back to the so-called Brexit vote in June, and the market’s reaction to it. The hit to the U.S. futures market that June evening triggered the Chicago Mercantile Exchange’s limit-down price curbs for overnight trading. Those rules kick in when S&P Globex futures drop by at least 5% from the prior session close. The rule was triggered again over election night, when the futures fell to below 2,029, which means the contract cannot trade at a lower price for the remainder of the overnight session.

In terms of tomorrow’s regular session trading, circuit breakers will kick in if the S&P 500 drops by 7% (Level 1), 13% (Level 2) and 20% (Level 3) from Tuesday’s close. That works out to 1990, 1862, and 1712 by our math. Trading will halt for 15 minutes for Level 1 and Level 2, unless the drop occurs after 3:25pm ET. A Level 3 halt would occur immediately and last for the remainder of the trading day.

But if Brexit is anything resembling a proxy, remember that the recovery was as swift as the sell-off … not that that’s a prediction for what’s to come. Volatility is likely to remain extremely elevated in the near to medium term as the unknowns associated with a Trump presidency become resolved. To the extent that expectations around Fed policy could be a needle-mover, the futures market is showing plunging expectations for a December rate hike; meanwhile, global central banks would likely lean back toward additional monetary policy easing. This could help to settle markets.

How President Trump will govern is a huge wild card. If he carries through on his anti-trade, pro-tariffs rhetoric, we believe it would be highly detrimental to economic growth. Tax cuts, an infrastructure spending plan, and reduced business regulation might offer offsetting boosts, but they would bring the problem with the deficit and debt back into the spotlight and likely sink the U.S. dollar.

But let’s not get ahead of ourselves. Remember, our system of government was established and operates with numerous checks and balances in order to mitigate extreme policy risks. And Trump still has to put together a cabinet, which is possibly a taller order than would have been the case under a Hillary Clinton presidency. Then there’s the issue of Trump’s relationship with Congress. The Democrats can still clog up legislation in the Senate. One also wonders how Trump will deal with Republicans, given the rampant animosity expressed in both directions throughout the campaign.

The bottom line: We suggest investors ignore the noise while the dust settles and stick to their long-term asset allocations. Volatility is likely to be extreme. Reacting emotionally is a time-tested poor strategy for managing one’s money.

Anecdotal Evidence: Trump and the DOL Rule

Posted on November 10, 2016 by Kerry Pechter -

In the new president-elect, we have a national leader who believes that none of the ordinary rules, traditions or protocols apply to him—whose chief legal advisor once shut down the George Washington Bridge for spite and whose chief political advisor once shut down the federal government for reasons I can’t remember.

So it’s impossible to predict what might happen in the realm of retirement policy next year. Yesterday, a lot of people wondered about the future of the Department of Labor’s conflict-of-interest rule. Excellent question. I assumed that the newly sworn-in president would reverse all of his predecessor’s major accomplishments, including Obamacare, the Iran nuclear deal and, when he becomes aware of it, the fiduciary rule.

If that happens, we have at the very least a giant sunk cost. A whole new industry sprang up around the rule since last spring, as dozens of firms spent countless dollars and hours fighting it and then figuring out how to comply with it. Phyllis Borzi and her team most of the last eight years on either the DOL rule or health care.

A sudden reversal of the rule would likely whiplash those firms that have created special technology solutions to help firms comply with the data-gathering and reporting requirements of the rule. This week, eMoney Advisor introduced a “Fiduciary Framework” for advisors and Broadridge Financial Solutions announced a new DOL Fiduciary Standard solution for broker-dealers.

At least one ERISA attorney thinks the DOL rule won’t die, at least not right away. Jason C. Roberts, CEO of the Pension Research Institute, wrote on LinkedIn yesterday:

“It will probably take several months or longer for the new administration and Congress to organize. President-elect Trump may not even have a Labor Secretary on board by April 10th. The Senate must first approve all key political appointees sent up to Capitol Hill by the new President.

“Even with one party in control of Congress, the review process for nominations to the various federal agencies and Cabinet could take some time. It’s also unlikely that the new administration could put the DOL rule on hold, since it was adopted last April and became effective last June (although the compliance dates are next year).

“The new Congress can start over again and try and overturn the DOL rule through the legislative process, but this is often a time-consuming process, even if both houses of Congress are controlled by the same party. There’s also the question of whether the financial services industry would want to return to square one after spending millions of dollars to reconfigure their compliance systems and products as we draw closer to the 2017 deadline.”

On NAPANet, attorney and former PLANSPONSOR editor Nevin Adams wrote, “Though candidate Trump never specifically addressed the fiduciary regulation, he has consistently spoken of his intention to reduce the reach of government regulations, and it seems reasonable to think that he’d see the fiduciary regulation in that light.

“Lending credence to that sense are the recent comments by Anthony Scaramucci, managing partner of Skybridge Capital, and an adviser to the Trump campaign, who recently criticized the regulation as an example of government overreach that would divert too much capital into low-cost passive ETFs and index funds.

“‘We’re going to repeal it,” Scaramucci was quoted as saying by InvestmentNews on the sidelines of the Securities Enforcement Forum in Washington last month. [Scaramucci compared the rule to the Dred Scott decision of 1857, which affirmed the right of slave owners to take their slaves into the western territories of the U.S.]

“Nor would it be all that hard for the Trump administration to do so. American Retirement Association CEO Brian Graff notes that one possible approach would be to issue an executive order indicating no enforcement of the rule while going through the administrative procedure process of actually repealing it.”

He and many others would welcome the death of the rule. It would make traditional business models viable again. It could also relieve downward pressure on fees, revive the fortunes of active fund managers, remove restrictions on soliciting rollovers from plan participants, and allow a return to the incentives that wholesalers have paid to broker-dealers and to insurance marketing organizations, and that distributors paid to advisors, brokers and agents. Higher profit margins all around could lead to a renaissance of new product development.

The DOL rule isn’t the only part of retirement policy that the election’s outcome will affect. With control of the presidency, the legislature and the Supreme Court, Republicans can move to privatize Social Security, provide a safer safe harbor for deferred income annuities in 401(k) plans, and perhaps fight the establishment of state-sponsored defined contribution plans. The president-to-be may decide to replace Federal Reserve chairman Janet Yellen, whom he criticized during the campaign for suppressing rates to help the Democrats. One certainty is that Sen. Elizabeth Warren won’t have a public policy role in the executive branch.

Then there’s the matter of taxes. Unlike Mr. Obama, the next president will probably have little appetite for raising the amount of income subject to FICA taxes or capping the tax expenditure on retirement savings. (For speculation about the future of interest rates, see today’s RIJ cover story.)

Interest rates could depend on how the president-elect decides to frame the U.S. national debt. At the time of the country’s founding, opinion on the Revolutionary War debt was split into two major camps. Many people regarded the debt as a dangerous liability and an obstacle to growth. Alexander Hamilton took the opposite position, reframing it as an asset—every liability is somebody’s asset—and supporting its value by guaranteeing interest payments and establishing open market operations. Paradoxically, he produced America’s first wealth effect.

During the election campaign, the president-to-be talked about negotiating a deal with U.S. creditors to pay down the debt at a reasonable cost to the country. That would be the anti-Hamilton path. He also talked about spending trillions of dollars in deficit spending on the military and on infrastructure. That would increase the debt. But we can’t count on history to help predict what Mr. Trump will do, because he doesn’t seem to think that history, customs or even laws apply to him.

Federal judge rejects NAFA’s suit against DOL

Posted on November 10, 2016 by Editorial Staff -

The National Association of Fixed Annuities has lost its legal bid to reverse the Department of Labor’s conflict of interest rule and its impact on the sale of fixed indexed annuities (FIAs). In light of the Republican election sweep this week, the outcome may be moot.

In a 92-page opinion, U.S. District Judge Randolph Moss, District of Columbia, denied NAFA’s request for a preliminary injunction against the rule and granted DOL Secretary Tom Perez’ motion for a summary judgment in favor of the government.

In a statement, NAFA said it would appeal the ruling to D.C. Circuit Court of Appeals. “We are obviously disappointed by the court’s decision, but we have always assumed this case would get decided by a higher court and we are pleased the issues will get de novo review by the Circuit Court,” said Chip Anderson, executive director of NAFA.

NAFA’s attorneys asked for the injunction on several grounds:

By broadening the definition of a fiduciary to someone who provides investment advice—as opposed to someone who provides investment advice “on a regular basis”—violated certain 1984 case law, Chevron vs. National Resources Defense Council.
The DOL Department exceeded its authority in extending ERISA fiduciary duties –those governing advisors to 401(k) plans)—to IRAs.
The Best Interest Contract Exemption (BICE) “impermissibly creates a private cause of [legal] action” by allowing FIA owners to file class action suits as a recourse against FIA sellers (as opposed to settling disputes through arbitration).
The BICE limiting compensation to a “reasonable” level is void for vagueness.
The DOL’s decision to move FIAs from PTE (Prohibited Transaction Exemption) 84-24 to the BIC Exemption was arbitrary and
The DOL’s Department’s regulatory flexibility analysis was inadequate.

Judge Moss rejected the reasoning behind all of these positions, accusing NAFA at one point of “mixing apples and oranges.” He disagreed, for instance, with NAFA’s contention that an agent or advisor can recommend the purchase of an annuity without providing financial advice.

“NAFA’s own declarations leave little doubt that those engaged in the annuities business do not simply dispense products but, rather, provide individualized investment advice,” the judge wrote.

NAFA represents the life insurance companies who manufacture indexed annuities and the large distributors of those products. According to its 2014 federal Form 990, it had one full-time employee, Kim O’Brien, and an annual budget of about $1 million.

In recent years, indexed annuities have become the best-selling type of annuity, thanks to their guarantees against market loss, exposure (through equity options) to stock market risk, guaranteed lifetime withdrawal options, as well as the generally large sales incentives offered by manufacturers. FIAs were also the product-of-choice for the new private equity firms that entered the life insurance business after the 2008-2009 financial crisis.

But, in the final version of the conflict-of-interest, the DOL surprised the industry by categorizing FIAs, along with variable annuities, as complex products that required a higher degree of regulation than in the past.

The DOL’s final rule said that intermediaries can’t advise IRA owners to buy FIAs or VAs with tax-deferred money unless the intermediaries use the Best Interest Contract Exemption (BICE). To qualify for this new exemption, advisors or agents must sign a Best Interest Contract, pledging to act in the client’s best interest and not their own. It also requires them, as fiduciaries, to accept only “reasonable” fees.

These new requirements threatened to reduce FIA sales by exerting downward pressure on incentives and raising the legal risks of selling FIAs as one-off product sales instead of within the context of a long-term comprehensive plan. After the final DOL rule was issued last April, NAFA sued the DOL.

AUM of 500 top asset managers edges down, to $76.7 trillion

Posted on November 10, 2016 by Editorial Staff -

Assets managed by the world’s largest 500 asset managers fell in 2015 for the first time since 2011, according to Pensions & Investments (P&I) magazine and Willis Towers Watson, the global advisory firm.

Total assets under management (AUM) were $76.7 trillion at the end of 2015, or 1.7% below the 2014 mark of $78.1 trillion. North American firms’ AUM was $44 trillion at the end of 2015, down 1.1%. Assets of U.K. and European managers declined by 3.3%, to $25.1 trillion. U.K.-based firms’ assets decreased 2% to $6.6 trillion.

Brad Morrow, head of manager research, North America, Willis Towers Watson, attributed the decline to a challenging investment landscape and currency fluctuations. “At the same time, asset owners are internalizing asset management capabilities at the larger end of the spectrum and consolidating at the smaller and midsize end. This will continue to put pressure on revenues,” he said in a release.

Actively managed assets, which account for 78.3% of assets, fell 2.8% in 2015, while passive assets declined by 5.5% during the year. Although the top 20 managers experienced a 1% decrease in assets from $32.5 trillion to $32.1 trillion, their share of total assets increased slightly from to 41.9% from 41.6%.

Traditional equity and fixed income still make up 78.2% of all assets (45.4% equity/32.8% fixed income), but they declined by 7.1% during 2015, the research showed.

Alternative assets grew by 25.1%. The increase showed that “in an environment of low returns and increased uncertainty, investors are under pressure to identify other means of achieving more diversity and higher returns,” said Morrow.

The research also reveals that in the past 10 years, the proportion of asset managers from the U.S. in the top 500 has increased to 52.5% from 41.9%. Within the top 20 in 2015, there were 12 U.S. managers, accounting for 69% of assets (up from 11 managers and 65.5% of the assets at the end of 2014). European firms managed the remaining assets.

Assets of the U.S. top 20 companies in 2015 increased 1.2% to over $22 trillion in 2015, while assets of European top 20 companies decreased 3.3% to just under $10 trillion in the same period.

Some of the main gainers by rank in the top 50 (including through mergers or acquisitions) during the past five years include Aegon Group (to 25th from 63rd), New York Life Investments (to 39th from 67th), Dimensional Fund Advisors (to 49th from 74th), Sumitomo Mitsui Trust Holdings (to 33rd from 55th) and Standard Life (to 50th from 71st).

17 life-annuity issuers meet Conning’s ‘multi-year success criteria’

Posted on November 10, 2016 by Editorial Staff -

Conning has released the seventh edition of its annual study evaluating individual life-annuity companies. The study identified 17 companies in three size categories that met its “multi-year success criteria,” the research firm announced this week. The consulting firm did not make the names of the companies public.

“We identified seventeen companies that met our multi-year success criteria across the three analyzed size categories. Of those successful companies, thirteen also met the criteria in last year’s analysis, which is a significant accomplishment in this challenging environment for new sales and low interest rates,” said Terence Martin, Conning’s director, Insurance Research.

The study, “2016 Individual Life-Annuity Growth and Profit Leaders: Leading for the Long Term” analyzes insurer performance, names the growth and profit leaders, and identifies characteristics shared by those successful firms.

“Companies that met our criteria to be considered growth and profit leaders did so by successfully managing market and organizational complexity,” said Steve Webersen, head of insurance research at Conning.

“For some, sustained product focus was a critical component. The successful product mix differed between the small and mid-sized company categories. Expense and investment performance advantages made significant differences for many of the leading firms, with nuances among the size categories,” he added. “Close analysis of the strategies and positions of peer companies that have excelled in these financial measures yields insights for companies of any size to improve its performance.”

Trump and the Trajectory of Interest Rates

Posted on November 9, 2016 by Kerry Pechter -

As soon as Donald Trump sealed his Electoral College victory over Hillary Clinton, analysts at banks, fund companies and consulting firms released predictions about the election’s impact on interest rates. No one can do more than guess.

Until Tuesday, the Federal Reserve appeared on track to raise the fed funds rate by a quarter of a point at its December meeting. Now that looks less likely. Trump said during the campaign that stock prices would drop if rates go up and accused Janet Yellen of holding rates down to help Democrats.

As for the markets’ immediate reaction yesterday, Bankrate.com reported that “the prospects of higher government spending and more government borrowing for infrastructure improvements sent long-term Treasury yields racing higher. The 10-year Treasury note yield soared above 2%…, closing at 2.07%, the highest since Jan. 22.”

Here are few of the predictions published yesterday. The probability of a December rate increase “has fallen sharply” following the election, said Dominic Rossi, global CIO for equities at Fidelity International.

“The dollar, which has been trending higher in anticipation [of a Hillary Clinton victory], has consequently reversed. Both were threats to the bull market, and these have now been postponed. Monetary policy will remain accommodative,” he wrote.

Andrew McCormick, the head of T. Rowe Price’s U.S. taxable bond team said in a new white paper that U.S. short-term rates may go lower initially as investors seek the haven of U.S. Treasuries, but “there could be pressure for rates to go higher as investors digest the deficit spending pushed by Mr. Trump.”

The New York Times noted Wednesday that in the campaign Trump promised a large tax cut, up to $1 trillion in spending on infrastructure, and new barriers to imports. By stimulating the economy, those policies could foster inflation and inspire the Fed to raise rates.

At Aite Group, analyst Julie Conroy seemed to take Trump’s accusation of artificial rate-suppression by Yellen as a call for higher rates. “Trump has clearly stated that he believes that interest rates are being held at an artificially low rate, so expect to see a rate hike early in his term,” she said.

Her colleague, Gabriel Wang, added, “the market may experience an immediate increase in interest rates. However, given the expected short-term market turmoil, it is unlikely that the Fed would be willing to raise rates immediately in the middle of a market period with heightened volatility.”

Some commentators think a December rate hike by the Fed is still possible or even likely. Mark Dowding, co-head of investment-grade debt at BlueBay Asset Management, wrote that the U.S. economy “retains reasonable momentum and, … if US asset markets stabilize, the Federal Reserve remains likely to raise rates in December.”

David Lloyd, head of institutional fixed-income portfolio management at M&G Investments, said, “Much of what Trump has said suggests the balance of risks is towards a more hawkish Fed. In the short term, the market will obsess over whether Trump’s rhetoric softens somewhat – i.e., whether he tries to forge a constructive working relationship with Yellen. If he sticks with his campaign tone, the rates market could get quite lively.”

In its post-election commentary, Goldman Sachs Asset Management said it expected “volatility to remain elevated over the near to medium term” and that market reaction to the election result is likely to resemble the UK referendum scenario, including:

A volatile, risk-off response, followed by
A gradual reversal as investors recognize that changes under a Trump administration will take time to play out and the Federal Reserve is likely to remain in wait-and-see mode, and then
Isolated bouts of volatility as the administration’s policy priorities, and ability to execute them, become clearer. As a result, we expect volatility to remain elevated over the near to medium term.

One observer believes that Yellen’s job is jeopardy. “Given Trump’s critical statements on the Fed, it seems likely that he would push for a change of leadership as soon as Yellen mandate’s end on January 2018,” said Monica Defend, head of Global Asset Allocation Research, Pioneer Investments.

Once in office, Trump can fill two vacancies on the Fed’s seven-member board. In 2018, when their terms end, he can replace the Fed’s top officials, Janet L. Yellen, the chairwoman, and Stanley Fischer, the vice chairman.

The View from the (DOL) Trenches

Posted on November 3, 2016 by Kerry Pechter -

Just a few years ago, mutual fund companies happily anticipated the “rollover opportunity”—a windfall that would come from managing the trillions of dollars in Boomer savings that were pouring out of 401(k) plans and into retail IRAs. “Capturing Rollovers” was their mantra.

Asset managers’ euphoria ended last spring, however, when the Labor Department released the final version of its conflict-of-interest rule. Starting in April 2017, the business of selling mutual funds to retail IRA clients will be held to nearly the same ethical standards as selling mutual funds to participants in qualified plans.

Financial services companies, especially the brokerage sector where employee-advisors earn commissions from manufacturers on the sale of funds and annuities, are now adjusting to the new rule. The actions of these distributors will have a big impact on the asset managers and insurers who rely on them to market their mutual funds, ETFs and annuities.

In Boston two weeks ago, hundreds of dark-suited mutual fund company executives gathered for the Money Management Institute’s Fall Solutions conference. During one general session, they heard experts from Morningstar, PwC and Envestnet—firms that are helping guide asset managers and broker-dealers through the DOL transition—share insights from the front lines of the disruption.

Jeff Schwantz of Morningstar, Arjun Saxena of PwC and James Lumberg of Envestnet described a world where broker-dealers’ product shelves will shrink, fund companies will condense their offerings, advisor compensation and revenue-sharing will be “levelized,” holistic planning will replace investment selection as advisors’ core competence, and compliance teams will call on IT departments to help them document and, if necessary, defend every step of the advisory process.

Shrinking product shelves

Saxena (right), a principal in PwC’s New York office, predicts that a lot of actively managed funds with high expense ratios and rich front-end loads will simply vanish. “At broker-dealers using the BIC exemption and offering commission-based retirement accounts, here will be a constrained product shelf—mutual funds and annuities—for retirement clients, and the box of allowable financial advisor discretion on pricing will also get smaller,” he said.

“If firms used to have 4,000 mutual funds available for retirement investors, in the future they will have one-fourth fewer funds,” he added. “At the same time, the fund manufacturers will take a hard look at their own lineups, and they will merge or kill the so-so performers or the ones that had high fees or low take-up by investors. It’s probably healthy. At one time, there were more funds than listed equities in the US market.”

Commissions are likely to be standardized across products. “Broker-dealers are looking for BIC-friendly share classes. They are having discussions about mutual fund share class design with asset managers. Right now you have gradation in fund design. When one asset manager has a class A US mid-cap equities fund that pays a 3.5% front-end load, another has a 2.5% load and another has a 4.5% front-end load, it’s hard for a wealth manager to say that there’s no conflict of interest in choosing among them,” Saxena said.

“The easy way for a broker-dealer to offset that conflict is to say, here’s our new preferred standardized design, and have that new share class design uniformly apply to all asset managers who want be on the brokerage IRA platform MF product-shelf going forward.”

Saxena added, “The reality is that the need for risk mitigation will force broker-dealers to lean more toward simpler products in retirement accounts, and their advisors will do the same. That’s the direction we’ll see over time. If you want to see the future, just look at the 401(k) world. Three, five or seven years out, the IRA space will likely look a lot closer to that.”

Revenue-sharing will be levelized

Just as commissions that broker-dealers pay advisors will be standardized, so will the revenue-sharing dollars that fund wholesalers pay to broker-dealers, Saxena said. “Previously, a top asset manager might have paid a wirehouse a couple of million dollars in annual platform access fees. That payment might have allowed the asset manager to present at advisor sales conference or make a certain number of wholesale calls on the broker-dealer,” he said.

“There will be discussions and negotiations between broker-dealers and asset managers. The larger distributors that have critical mass will have the most negotiating leverage. They will be the market makers. That’s the process that’s underway now. There’s no easy way around it,” the PwC principal added.

Broker-dealers exercise control

Depending on their relationships with their advisors, broker-dealers may try standardize the processes that advisors use with clients, if only to simplify their new compliance responsibilities under the DOL rule.

“It remains to be seen how prescriptive around financial planning the [distributors] will get,” said Jeff Schwantz, head of Advisor Solutions, North America, at Morningstar. “Will there be one financial planning solution utilized for all clients? Some firms will go with full-fledged planning. Some firms will adopt a single sales process that they feel good about. If you’re a wirehouse wealth manager or a captive advisor, the sales process is already prescriptive and homogeneous. If you’re an independent advisor, you have historically had more autonomy to provide advice and a wider choice of products.”

Saxena noted, “Some advisors are used to running their own franchise, but that box has gotten smaller. Their employers will be saying, ‘I’ll take a more active role in deciding which funds get to stay on my product shelf or not for retirement clients.’”

‘Ripple effect’

Changes in one link of the fund distribution chain will inevitably force changes in other parts—in ways that no one can currently predict, according to Schwantz (below left). He wonders what will happen if advisors start charging by the hour or go on retainer instead of charging on the basis of account value.

“How soon will the phenomenon of ‘episodic advice’ become the norm, and how will it affect others in the product chain? It’s a challenging problem,” he said. “If advisors start charging retainers, how will other service providers in the chain be affected? The other service providers might not be aligned to that model.

“For instance, today, financial institutions incur clearing and trading fees and today pass those fees along to the client. That creates friction points. If the client is paying the advisor a flat retainer, the way attorneys and other professionals are paid, but a service provider is aligned to fees that are expressed in basis points, the friction intensifies. How will that put pressure on firms that are wed to a basis-points model? How will they unwind that model and stay relevant as providers?”

Holistic financial plans

It’s widely agreed that one-off product sales will be hard to defend under the DOL rule. To justify a product recommendation, the advisor will have to show that the product plays a logical role in a comprehensive plan, and then show that the plan is in the client’s best interest.

“The focus has been moving from the product view to the portfolio view to the household view,” said Schwantz. “Advisors will have to answer the questions, ‘How does the product work in the portfolio? What purpose does it serve?’

“The DOL doesn’t see how ‘best interest’ can be delivered without a plan,” said James Lumberg (below right), co-founder and executive vice president at Envestnet, the Chicago-based technology platform provider. “Knowledge of the client, the creation of a plan, the implementation of the plan—documenting each of these will be part of documenting best interest. Tying what you’ve done back to the client’s specific situation will be an important part of showing due diligence.”

A single standard for all accounts

Increasingly, industry members are predicting that the standards set by the DOL rule will eventually apply to all accounts, IRA and taxable. In a world where many clients have both kinds of accounts, and where advisors are trying to be more holistic, it’s awkward to do otherwise.

“If the advisors put their “white hats” on for retirement accounts and take them off for non-qualified accounts, there’s a difference in client experience,” Schwantz said. “Morningstar surveyed broker-dealers in January through March. They were evenly divided in how they would deal with two different experiences. But a more recent survey showed that approximately 80% of the firms say the sales experiences will be similar and not differentiate between retirement and non-qualified accounts.”

This means signing the Best Interest Contract and accepting the liabilities that go with it. “Early on, we heard people saying, ‘We won’t use the BIC. We won’t put ourselves in that position,’” Lumberg said. “They were driven by a desire for risk avoidance and by ignorance about the BIC. But as they’ve become more comfortable with the rule, they’ve decided that they’d rather use the BIC [and take the risk of lawsuits] than risk being out of compliance [and vulnerable to DOL action]. We’re hearing more and more firms saying, ‘We’ll BIC everything.’”

“To have two stories is not workable long-term,” said Saxena. “You need a unified client experience. It’s more a practical problem for advisors than a regulatory requirement. It’s difficult for an advisor to tell clients that their advice on taxable accounts is different from their advice on pre-tax accounts. You will see many firms offering similar if not the same product offerings on taxable and pre-tax accounts. There’s an expectation that, perhaps in 2018, the SEC will act to harmonize its regulations with the DOL’s.”

Document your process

Because the DOL rule gives investors the right to sue for violations of their best interests, brokerages need to start preparing now for the class action lawsuits they may face in four or five years. That means integrating currently unconnected data sets and configuring information technology systems to do so.

“ERISA standards by their nature are prudent process-driven,” said Schwantz. “Financial institutions need to carefully scrutinize their decisions within their value chain and then document those decisions in writing. Show your investment committee process. Show all the analyses that you did. Show how you arrived at the recommendations you made to clients.

“That’s what most organizations are thinking now. They’re appointing BIC officers, and trying to show, ‘Here are all the processes within the value chain on how we use to show clients that our advice is in their best interest. That’s the risk mitigation process. And it’s likely to require new information technology to scale,” he said.

“Under the suitability standard, firms weren’t necessarily capturing the rationale for their advisors’ recommendations,” Saxena said. “Now the compliance departments will say, ‘You have to capture the data about the clients’ circumstances and the advisor recommendations starting at the point of sale, and then retain it for at least six years.’”

Simplicity is better

Financial institutions are racing to become compliant with the DOL rule by either the preliminary deadline next April or the hard deadline on January 1, 2018, but some have a lot of work to do. “Many of the broker-dealers are still searching for a light switch in a dark room,” said Lumberg. “They’re not as ready as they should be.

“I’m seeing two approaches to the rule among broker dealers. One approach is to say little about the DOL change, lie low, and promise nothing to clients. The other is to come out and offer a robust new value proposition. So it’s both a burden and an opportunity.”

He tends to look on the bright side. “The DOL rule is good for investors, and it offers opportunities for those who deliver more value and for the robo-advisors,” said Lumberg. “Digital innovation benefits investors. It’s an opportunity to simplify things. Over the long term, simplicity is better for the industry and for clients.”

Big Danger at the Lower Bound

Posted on November 3, 2016 by Kenneth Rogoff -

Markets nowadays are fixated on how high the US Federal Reserve will raise interest rates in the next 12 months. This is dangerously shortsighted: the real concern ought to be how far it could cut rates in the next deep recession. Given that the Fed may struggle just to get its base interest rate up to 2% over the coming year, there will be very little room to cut if a recession hits.

Fed chair Janet Yellen tried to reassure markets in a speech at the end of August, suggesting that a combination of massive government bond purchases and forward guidance on interest-rate policy could achieve the same stimulus as cutting the overnight rate to minus 6%, were negative interest rates possible. She might be right, but most economists are skeptical that the Fed’s unconventional policy tools are nearly so effective.

There are other ideas that might be tried. For example, the Fed could follow the Bank of Japan’s recent move to target the ten-year interest rate instead of the very short-term one it usually focuses on. The idea is that even if very short-term interest rates are zero, longer-term rates are still positive. The rate on ten-year US Treasury bonds was about 1.8% at the end of October.

That approach might work for a while. But there is also a significant risk that it might eventually blow up, just the way pegged exchange rates tend to work for a while and then cause a catastrophe. If the Fed could be highly credible in its plan to hold down the ten-year interest rate, it could probably get away without having to intervene too much in markets, whose participants would normally be too scared to fight the world’s most powerful central bank.

But imagine that markets started to have doubts, and that the Fed was forced to intervene massively by purchasing a huge percentage of total government debt. This would leave the Fed extremely vulnerable to enormous losses should global forces suddenly drive up equilibrium interest rates, with the US government then compelled to pay much higher interest rates to roll over its debt.

The two best ideas for dealing with the zero bound on interest rates seem off-limits for the moment. The optimal approach would be to implement all of the various legal, tax, and institutional changes needed to take interest rates significantly negative, thereby eliminating the zero bound. This requires preventing people from responding by hoarding paper currency; but, as I have explained recently, this is not so difficult. True, early experimentation with negative interest-rate policy in Japan and Europe has caused some disenchantment. But the shortcomings there mostly reflect the fact that central banks cannot by themselves implement the necessary policies to make a negative interest rate policy fully effective.

The other approach, first analyzed by Fed economists in the mid-1990s, would be to raise the target inflation rate from 2% to 4%. The idea is that this would eventually raise the profile of all interest rates by two percentage points, thereby leaving that much extra room to cut.

Several central banks, including the Fed, have considered moving to a higher inflation target. But such a move has several significant drawbacks. The main problem is that a shift of this magnitude risks undermining hard-won central bank credibility; after all, central banks have been promising to deliver 2% inflation for a couple of decades now, and that level is deeply embedded in long-term financial contracts.

Moreover, as was true during the 2008 financial crisis, simply being able to take interest rates 2% lower probably might not be enough. In fact, many estimates suggest that the Fed might well have liked to cut rates 4% or 5% more than it did, but could not go lower once the interest rate hit zero.

A third shortcoming is that, after an adjustment period, wages and contracts are more likely to adjust more frequently than they would with a 2% inflation target, making monetary policy less effective. And, finally, higher inflation causes distortions to relative prices and to the tax system – distortions that have potentially significant costs, and not just in recessions.

If ideas like negative interest rates and higher inflation targets sound dangerously radical, well, radical is relative. Unless central banks figure out a convincing way to address their paralysis at the zero bound, there is likely to be a continuing barrage of outside-the-box proposals that are far more radical.

For example, the University of California at Berkeley economist Barry Eichengreen has argued that protectionism can be a helpful way to create inflation when central banks are stuck at the zero bound. Several economists, including Lawrence Summers and Paul Krugman, have warned that structural reform to increase productivity might be counterproductive when central banks are paralyzed, precisely because it lowers prices.

Of course, there is always fiscal policy to provide economic stimulus. But it is extremely undesirable for government spending to have to be as volatile as it would be if it had to cover for the ineffectiveness of monetary policy.

There may not be enough time before the next deep recession to lay the groundwork for effective negative-interest-rate policy or to phase in a higher inflation target. But that is no excuse for not starting to look hard at these options, especially if the alternatives are likely to be far more problematic.

Anecdotal Evidence: How to Charm a Client

Posted on November 3, 2016 by Kerry Pechter -

A friend who lives in one of America’s most desirable brains-and-money towns recently told me that he decided to move his $1.5 million investment portfolio to a wealth manager at one of the wirehouses. After a quick mental calculation of the potential costs, I asked why.

The advisor had done him a big unsolicited favor, my friend said. Before their formal relationship began, while chatting over coffee, my friend told the advisor about a problem he was having with his son’s private school tuition bill. His son needed to leave the school at mid-year. But the school wanted him to pay $12,000 for the cancelled semester.

Later, the advisor gave my friend a call. He had taken the liberty of intervening in my friend’s dispute with the school and had resolved the matter. The school had withdrawn its claim to the $12,000. The exact details remain a mystery to me, but the advisor must have redeemed a favor from what Tom Wolfe, in Bonfire of the Vanities, famously called the “favor bank.”

Imagine the relief that you’d feel on hearing such news. No need to call your lawyer and play hardball with the school. No need to argue with the ex-wife about who screwed up. No sunk cost to fester in the pit of your stomach. Think of the gratitude that a prospect would feel toward such an effective fixer.

Wealth managers of the world, the message is clear. When dealing with your HNW clients and prospects, success depends less on performance or fees than on solving clients’ problems and simplifying their complex lives. They will appreciate you for it, and you need only say, ‘It was nothing.’ I’m not the first to observe this principle. I’m just offering more evidence for it.

Out of professional curiosity, I asked my friend about the wirehouse fees. The advisory fee would be 75 basis points a year; that works out to about $1,000 a month. He didn’t know yet what the fees on his underlying investments would be. Did he realize, I asked, that he might pay upwards of $200,000 in fees over the next 10 years?

Knowing that his grandfather lived past 90, I suggested that my friend apply $100,000 to a deferred income annuity starting at age 85, park the rest of his portfolio in low-fee ETFs and cut his anxiety level in half. But he had already made up his mind to go with the wirehouse advisor. To be sure, my friend did not get rich by being a fool: he was an early Apple investor. Either way, his financial future is not in jeopardy.

The dishwasher technician’s mistake

Never underestimate the financial naïveté of Americans who have had little exposure to our industry. Recently, a young technician came to my house to repair our computerized dishwasher. We started talking about personal finance. After the repair was finished, we opened my laptop and looked at a few sites online, including Betterment.

To get started with Betterment, you input your age and income. He did that, and hit the Continue button. The next screen asked him to choose from three financial goals. He selected “an annual retirement income of $57,900.” What surprised me was his delight and on learning that Betterment could provide him with almost $58,000 a year in 38 years. I explained that the income depended primarily on his saving habits. Beware of hearing precisely what you hoped to hear, I told him.

My plan to petition the airlines

Do you ever check a piece of luggage at the airport, and responsibly pay the $25 baggage fee? (Southwest Airline customers can ignore this question.) Did it gall you to reach the gate and find that people who didn’t check their bags at the ticket counter could check their bags for free at the gate—because the overhead racks were full?

I’ve wondered what behavioral finance gurus like Daniel Kahneman or Mier Statman would make of this. Are these luggage-huggers actively gaming the system? Do they gloat over saving $25? Or do they dread trekking down to the dimly lit baggage claim area, to stare at the revolving “carousel” with the rest of us, lunging for their bag when it sails by? I may petition the airlines to let checked bags fly free, and charge $25 for using the overhead bin. Imagine that.

Life insurers ‘out of levers’ to fight low rates: Conning

Posted on November 3, 2016 by Editorial Staff -

The life-annuity industry is running out of levers to boost returns in the extended low interest rate environment, according to a new study by Conning. Besides raising allocations to lower quality bonds, remedies to the yield-drought are hard to find.

“Life-annuity insurers have lived with the decreasing interest rate environment for more than a decade, and for the past five years have been under increasing pressure as interest rates dipped to historically low levels,” said Mary Pat Campbell, vice president, Insurance Research at Conning.

“Insurers have been shifting allocations to reach for yield. This shift was pronounced from 2011 to 2015, as the impact of the financial crisis faded and the bite of low interest rates intensified. The dominant industry response has been in shifting bond credit quality, as insurers increased allocations to BBB-rated bonds for extra yield, while at the same time keeping below investment grade allocations at historic lows.”

The Conning study, “Life Insurance Industry Investments: Where are the Return Levers?” analyzes life industry investments for the period 2011-2015 for the industry as a whole, by insurer size, and for five peer groups. The study discusses strategic issues facing life insurers and examines the industry’s investment profile in detail.

“As insurers take on additional risk to boost returns, there can be consequences of potential losses,” said Steve Webersen, head of Insurance Research at Conning. “The shift to greater reliance on BBB-rated bonds is widespread over the industry, and represents a further credit risk concentration. This shift to BBB-rated bonds has performed well over 2011 to 2015; yet the question remains as to how long that performance can continue. Just as important, what investment return levers remain for the industry in the future?”

“Life Insurance Industry Investments: Where are the Return Levers?” is available for purchase from Conning by calling (888) 707-1177 or at www.conningresearch.com.

Cambridge advisors will use the BIC, accept “levelized” commissions

Posted on November 3, 2016 by Editorial Staff -

Cambridge Investment Group, which serves some 3,000 independent advisors nationwide through its registered investment advisor and broker-dealer entities, will continue to support both fee-based and commission-based accounts for its advisors’ IRA clients, the firm announced this week.

Like Raymond James and Morgan Stanley—but unlike Merrill Lynch—Cambridge will let commission-based advisors serve retirement clients. Under the new Department of Labor conflict-of-interest rule, those advisors can do so only if they pledge to act in clients’ best interests, not their own or their firms’.

Cambridge intends to apply the Best Interest Contract provision announced by the DOL last April for certain commission-based accounts. Commissions will be the same (“levelized”) for similar investment options. Discretionary advisory business will be supported through level fee (a percentage of assets under management) platforms.

“Cambridge has long been a leader in fee-based accounts, but we believe the investing client and their trusted financial advisor must have access to appropriate choices they can consider for their unique retirement needs,” said Amy Webber, president of Cambridge. “We’ve identified four business paths our advisors can choose from.”

The four business paths are:

Non-retirement investing client (with after-tax accounts).
Small accounts (under $25,000).
Best Interest Contract (IRA clients with commissioned advisors).
Level fee fiduciary (Investment advisor representatives who charge a percentage of assets under management).

Cambridge said its Fiduciary Services team is creating Advisor Fiduciary Plans. The plans will show advisors how their accounts are affected by the new DOL rule, and how they can comply with the rule by the April 10, 2017 preliminary deadline and the January 1, 2018 final deadline.
Cambridge Investment Group, Inc. is a privately controlled firm consisting of multiple broker-dealers and RIAs, including Cambridge Investment Research Advisors, Inc., a large corporate RIA; Continuity Partners Group, LLC, a special purpose broker-dealer and registered investment advisor; and Cambridge Investment Research, Inc., an independent broker-dealer.

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