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

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.

© 2016 RIJ Publishing LLC. All rights reserved.

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

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.  

© 2016 RIJ Publishing LLC. All rights reserved. 

Advisors: Your next prospect could be a “mystery shopper”

Just in time for Halloween, Fidelity Clearing & Custody Solutions (FCCS) announced a “Mystery Shopping” program for registered investment advisory firms.

That’s correct. Real investors—not actors—will pose as typical prospects, interact with financial advisors, and then report their levels of satisfaction with the sales process to the advisor’s firms.

Sounds scary, especially for the advisors who don’t know they’re being evaluated.

A unit of Fidelity Investments, FCCS has hired two independent market research firms to conduct the program. FCCS clearing and custody clients—registered investment advisors (RIAs), retirement plan recordkeepers, broker-dealers, banks and insurance companies—will get a price break when they use the program.

To get an “A” on this test, advisors should try to make a warm first impression.  In its release, FCCS cited Cerulli research showing that today’s advisors believe clients choose them on the basis of their “personable image” and “high-touch service” much more than for an “exclusive or high-end image.”   

“Advisors need to be keenly aware of how they may ‘fit’ with each prospect,” said David Canter, executive vice president, practice management and consulting at FCCS. “Mystery Shopping can provide that outside perspective to firms so they improve their first interactions with clients.”    

The Mystery Shopping program is part of Fidelity’s Relationship Quality Framework, an overall approach to help map a client experience to the stages of a client’s journey with a firm, starting with the prospect experience.

To run the program, Fidelity hired HawkPartners and GfK, two market research firms with mystery shopping experience for various non-financial industries. The “shoppers” will be looking for misbehaviors such as:

  • Missing key client details during the discovery process
  • Touting a “personalized” experience while using an automated phone system
  • Excluding key associates from the sales process
  • Hosting a website that does not reflect the firm’s brand
  • Understanding potential clients’ perceptions of an office setting
  • Providing confusing directions to the firm’s office

Fidelity offered a testimonial from Brighton Jones, a Seattle firm that has used the program. Tyler Mayfield, the firm’s chief operating officer, called the program “an ideal research tool to uncover insights that we’ve now translated into an improved approach for initial prospect conversations.”

© 2016 RIJ Publishing LLC. All rights reserved.

A new robo-advice solution from TD Ameritrade

TD Ameritrade has soft-launched a new digital advice offering called Essential Portfolios, which it calls “an automated, low-cost advisory service for digital-first investors.” The official national launch will occur in early 2017, said a TD Ameritrade release.

The service costs 30 basis points (0.3%) per year. Each of the five model portfolios consists of non-proprietary ETFs and cash with weighted average expense ratios of 0.06% to 0.08%.  Other features and upgrades, including tax loss harvesting, will be added in coming months, the TD Ameritrade release said. There’s a $5,000 investment minimum.

Investors can assess their own risk tolerance levels, and set long-term financial goals. The algorithmic platform matches them with portfolios based on their goals, the release said. Morningstar Investment Management LLC advised on portfolio construction. 

The launch follows TD Ameritrade’s June re-release of an enhanced version of Amerivest Managed Portfolios, which offers investors a “self-guided digital advice experience,” paired with “as much or as little human interaction as investors want.”

© 2016 RIJ Publishing LLC. All rights reserved.

Strategic Insight buys BrightScope

Strategic Insight, the data and business intelligence provider for asset managers, community, has acquired BrightScope, the aggregator and evaluator of retirement plan data that was founded by Mike and Ryan Alfred in 2008, according to a release this week. 

The acquisition follows Strategic Insight’s recent acquisition of Market Metrics and Matrix Solutions. “Strategic Insight is focused on being the industry’s one-stop shop for data and insights, as well as providing accelerated product delivery for its clients,” the firm’s release said.  

Strategic Insight (SI) provides proprietary data, business intelligence, research and marketing services to the global asset management community, including investment flow data, advisor sales analysis, in-depth research, analytics, editorial content and events for investment managers, asset owners and custodians, plus Transaction Cost Measurement of over 500 million trades per month. 

Strategic Insight, backed by Genstar Capital, delivers its products and services through four divisions: SI Data, SI Research, SI Intelligence and SI Interactive. Its editorial properties include PLANSPONSOR, PLANADVISER, Chief Investment Officer, Global Custodian, and The Trade.

© 2016 RIJ Publishing LLC. All rights reserved.

FAQs (and Answers) from DOL

The first tranche of answers to “FAQs” about the exemptions from the Department of Labor’s “conflict of interest” rule, issued last April, was released by the DOL yesterday. It was much anticipated by executives and attorneys at brokerage firms, life insurance companies and online providers of “robo” advice. 

Several questions sought clarification of the “streamlined” version of the Best Interest Contract Exemption, which “enables advisers and firms that receive only a ‘level fee’”—i.e., advisers who charge a fixed percentage of assets instead of commissions—to avoid some of the red tape and legal liability associated with signing a formal pledge to act in their clients’ best interest.

On questions asking if the advisors whose sales generated level commissions or level third-party payments could use the streamlined BIC, the DOL said no.  

Regarding advisors who sign the pledge in order to accept commissions without violating the new rule, the DOL was also asked if brokerages could still use the “grid,” a compensation format that defines incentives such as bonuses for meeting production goals, and under which the percentage commissions paid to advisors may rise based on escalating sales thresholds.

The DOL said yes, but set strict limits on incentives or compensation that, by varying, might create conflicts of interest with the client—such as payments to advisors of retroactive bonuses for meeting sales volume thresholds or fixed percentages of the varying compensation that brokerages receive from mutual fund companies or insurance companies.   

“If, for example, different mutual fund complexes pay different commission rates to the firm, the grid cannot pass along this conflict of interest to advisers by paying the adviser more for the higher commission funds and less for the lower commission funds (e.g., by giving the adviser a set percentage of the commission generated for the firm),” the DOL said in its answer to Question 9.

Annuities were a focus of FAQs 21, 22 and 23. The DOL re-emphasized that insurance agents must use the more rigorous Best Interest Contract Exemption if they want to sell fixed indexed annuities to IRA clients, and that insurance companies, or insurance marketing organizations that are financial institutions or act for insurance companies, must monitor their conduct for violations of the clients’ bests interests. 

The FAQs offered some good news about rollover recommendations, said Seth Rosenbloom, associate general counsel for Betterment for Business, a low-cost, web-mediated 401(k) service that includes personalized investment advice for plan participants, including rollover advice.

Rosenbloom  told RIJ that the answer to Question 14 explained how a rollover recommendation could proceed under the streamlined BIC even “if, despite prudent efforts, the financial institution is unable to obtain the necessary information or if the investor is unwilling to provide the [fee] information” proving that the rollover is in the client’s best interest.  

 

© 2016 RIJ Publishing LLC. All rights reserved.  

The Inherent Risk of High-Priced Assets

Although the United States economy is in good shape—with essentially full employment and an inflation rate close to 2%—a world of uncertainty makes it worthwhile to consider what could go wrong in the year ahead. After all, if the US economy runs into serious trouble, there will be adverse consequences for Europe, Japan, and many other countries.

Economic problems could of course originate from international political events. Russia has been acting dangerously in Eastern and Central Europe. China’s pursuit of territorial claims in the East and South China Seas, and its policies in East Asia more generally, is fueling regional uncertainty. Events in Italy could precipitate a crisis in the eurozone.

But within the US, the greatest risk is a sharp decline in asset prices, which would squeeze households and firms, leading to a collapse of aggregate demand. I am not predicting that this will happen. But conditions are becoming more dangerous as asset prices rise further and further from historic norms.

Equity prices, as measured by the price-earnings ratio of the S&P 500 stocks, are now nearly 60% above their historical average. The price of the 30-year Treasury bond is so high that it implies a yield of about 2.3%; given current inflation expectations, the yield should be about twice as high. Commercial real-estate prices have been rising at a 10% annual pace for the past five years.

These inflated asset prices reflect the exceptionally easy monetary policy that has prevailed for almost a decade. In that ultra-low-interest environment, investors have been reaching for yield by bidding up the prices of equities and other investment assets. The resulting increase in household wealth helped to bring about economic recovery; but overpriced assets are fostering an increasingly risky environment.

To grasp how risky, consider this: US households now own $21 trillion of equities, so a 35% decline in equity prices to their historic average would involve a loss of more than $7.5 trillion. Pension funds and other equity investors would incur further losses. A return of real long-term bond yields to their historic level would involve a loss of about 30% for investors in 30-year bonds and proportionately smaller losses for investors in shorter-duration bonds. Because commercial real-estate investments are generally highly leveraged, even relatively small declines in prices could cause large losses for investors.

The fall in household wealth would reduce spending and cause a decline in GDP. A rough rule of thumb implies that every $100 decline in wealth leads to a $4 decline in household spending. The return of asset prices to historic levels could therefore imply a decline of $400 billion in consumer spending, equal to about 2.5% of GDP, which would start a process of mutually reinforcing declines in incomes and spending leading to an even greater cumulative impact on GDP.

Because institutional investors respond to international differences in asset prices and asset yields, the large declines in US asset prices would be mirrored by similar declines in asset prices in other developed countries. Those price declines would reduce incomes and spending in other countries, with the impact spread globally through reduced imports and exports.

I must emphasize that this process of asset-price declines and the resulting contraction of economic activity is a risk, not a prediction. It is possible that asset prices will come down gradually, implying a slowdown rather than a collapse of spending and economic activity.

But the fear of triggering a rapid decline in asset prices is one of the key reasons why the US Federal Reserve is reluctant to raise short-term interest rates more rapidly. The Fed increased the overnight rate by just 0.25% in December 2015 and is likely to add just another 25 basis points in December 2016. But that will still leave the federal funds rate at less than 1%. With the inflation rate close to 2%, the real federal funds rate would still be negative.

Market participants are watching the Fed to judge if and when the process of interest-rate normalization will begin. Historical experience implies that normalization would raise long-term interest rates by about two percentage points, precipitating substantial corrections in the prices of bonds, stocks, and commercial real estate. The Fed is therefore trying to tamp down expectations concerning future interest-rate levels, by suggesting that changes in demography and productivity trends imply lower real rates in the future.

If the Fed succeeds, the decline in asset prices may be diminished. But the danger of sharp asset-price declines that precipitate an economic downturn should not be ignored.

© 2016 Project Syndicate.

Eleven firms, and their new DOL-related policies

How 11 Brokerages, Wirehouses and Insurers Are Adapting to the DOL Fiduciary Rule

LPL. In May, the independent broker-dealer moved to standardize commissions on variable annuities at 5.5% for most contracts, and by the start of 2017, cap commissions on mutual funds at 3% to 3.5% and pay brokers a standard 0.25% trail fee. The firm will also standardize commissions for non-traded real estate investment trusts and certain insurance products.

Great American Life. In August, Great American, the third-ranked seller of fixed indexed annuities, introduced a zero-commission FIA with a living benefit rider for retirement clients of fee-based broker-dealer advisors and registered investment advisors. The Index Protector 7 offers higher caps on its point-to-point index crediting method—up to 6% compared with 3% to 4% cap on similar products.  

Edward Jones. On August 17, the broker-dealer said it would stop selling mutual funds on commission to retirement investors and reduce investment minimums on fee-based accounts to make them more attractive to IRA investors.

State Farm. Starting in April 2017, State Farm will only sell and service mutual funds, variable products and tax-qualified bank deposit products through a self-directed customer call center.

Jackson National. In September, Jackson National Life, the largest seller of variable annuities in the U.S., launched its first fee-based VA, Perspective Advisory. It offers the same investments and benefit options as Jackson’s top-selling commission-based VA, Perspective II.

Nationwide. On September 26, the Columbus, Ohio-based insurer announced its purchase of Jefferson National Life, an issuer of flat-fee, no-commission variable annuities aimed at the RIA and fee-based advisor market.

Merrill Lynch. On October 6, the unit of Bank of America announced that after April 10, 2017, its IRA account owners will not be able to pay for trades on a commission basis. Their accounts will be assessed a percentage of assets. Brokers may reduce the fee ratio for those who trade but don’t need full services.

Commonwealth. On October 24, Commonwealth Financial Network said its advisors would stop offering commission-based products in IRAs and qualified retirement plans as of April 10, 2017.

Morgan Stanley. On October 26, the wirehouse announced that, in contrast to Merrill Lynch, it would keep its commission-based IRA business when the fiduciary rule takes effect next year. Its advisors will use DOL’s Best Interest Contract (BIC) exemption when charging commissions on transactions involving tax-deferred assets.

Ameriprise. On October 26, Ameriprise, like Morgan Stanley, said it would continue offering commission-based transactions on IRA accounts and use the BIC exemption, adding that it might reduce the breadth of commission-paying investment options offered to retirement investors.   

Raymond James. On October 27, the broker-dealer, which has both independent advisors and employee-advisors, said it would continue offering commission-based transactions on IRA accounts and use the BIC exemption, like Ameriprise and Morgan Stanley.

© 2016 RIJ Publishing LLC. All rights reserved.

Investors not applauding Genworth sale to China Oceanwide

China Oceanwide Holdings Group Co., Ltd., a Chinese company, has agreed to buy all of the outstanding shares of Genworth Financial for about $2.7 billion, or $5.43 per share, according to a release this week. The acquisition will be completed through Asia Pacific Global Capital Co. Ltd., a China Oceanwide’s investment platform.

Genworth shares sold for as much as $36 in mid-2007 and for less than $1 in early 2009, at the post-crash market bottom. The share price recovered to over $18 by May 2014 but fell steadily to as little as $1.70 last February.

Shareholders, who have been stewing for months over Genworth’s debt load, reacted to the deal by selling Genworth stock. The share price fell almost 4%, to $4.26, in early trading on October 27.

Beijing-based China Oceanwide is a privately held, family-owned holding company founded by Lu Zhiqiang. It has operations in financial services, energy, culture and media, and real estate assets globally, including the U.S., with about 10,000 employees.

The transaction is subject to approval by Genworth’s stockholders as well as other closing conditions, including the receipt of required regulatory approvals.

China Oceanwide will also give Genworth $600 million to settle debt maturing in 2018, on or before its maturity, and provide $525 million of cash to the U.S. life insurance businesses. This contribution is in addition to $175 million of cash previously committed by Genworth Holdings, Inc. to the U.S. life insurance businesses.

Separately, Genworth also announced preliminary charges unrelated to this transaction of $535 million to $625 million after-tax associated with long term care insurance (LTC) claim reserves and taxes.

The announcement of those intended charges, along with the acquisition by China Oceanwide as well as Genworth’s risky concentration in the uncertain long-term care insurance market, caused A.M. Best to downgrade several of Genworth’s ratings and place the company and its subsidiaries under review with “negative implications.”

Genworth needed to restructure its U.S. life insurance businesses by “unstacking” Genworth Life and Annuity Insurance Company (GLAIC) from under Genworth Life Insurance Company (GLIC) and to address its 2018 debt maturity. The $1.1 billion infusion from China Oceanwide will help it do that, the release said.   

A Genworth spokesperson shed light on what “unstacking” means in this context. “Separating GLAIC from GLIC is one of the steps Genworth is taking to isolate the LTC downside risk that is pressuring its holding company and subsidiary ratings.  It also will allow any future dividends from the Life and Annuity company to be paid directly to the holding company, which currently is impeded by the legal entity organization,” she told RIJ.

A.M. Best has downgraded the Long-Term Issuer Credit Rating (Long-Term ICR) to “bbb” from “bbb+” and affirmed the Financial Strength Rating (FSR) of B++ (Good) of Genworth Life and Annuity Insurance Company. A.M. Best also downgraded the FSR to B (Fair) from B++ (Good) and the Long-Term ICRs to “bb+” from “bbb” of Genworth Life Insurance Company and Genworth Life Insurance Company of New York. Additionally, A.M. Best downgraded the Long-Term ICRs to “bb-” from “bb+” of Genworth Financial, Inc. and Genworth Holdings, Inc., as well as their existing Long-Term Issue Credit Ratings by two notches. A.M. Best has placed all Credit Ratings under review with negative implications.

In another development, a Louisiana law firm is investigating the Genworth sale on behalf of its shareholders to determine if the China Oceanwide’s $5.43 per share offer undervalues the company or not. The firm, Kahn Swick & Foti, includes former Louisiana attorney general Charles C. Foti, Jr.

Genworth, once part of GE Capital, would be a standalone subsidiary of China Oceanwide. Genworth’s day-to-day operations are not expected to change. Its senior management team will continue to lead the business from its Richmond, Va., headquarters. The insurer will maintain its existing businesses, including its MI businesses in Australia and Canada.

“Genworth will also continue to focus on its key operational priorities, most notably executing its multi-year LTC rate action plan, which is essential to stabilizing the financial position of the legacy LTC business. China Oceanwide has no current intention or future obligation to contribute additional capital to support Genworth’s legacy LTC business,” the release said.

The transaction, which both companies’ boards have approved, is expected to close by the middle of 2017, subject to approval by Genworth’s stockholders and closing conditions, including regulatory approvals. Goldman, Sachs & Co. and Lazard are advising Genworth. Citi and Willis Capital Markets & Advisory are advising China Oceanwide.    

© 2016 RIJ Publishing LLC. All rights reserved.

High stock valuations reduce insider-buying, buybacks: TrimTabs

The purchase by corporate executives of their own firms’ stock—aka “insider buying”—dropped to just $110 million in the first three weeks of October through Friday, according to TrimTabs’ review of Form 4 filings with the Securities and Exchange Commission.  

“The best-informed market participants seem unenthusiastic about U.S. stocks at current prices,” said David Santschi, CEO at TrimTabs Investment Research. “Insider buying is running at the slowest pace for October in the past five years.”

“The pullback in buying by both insiders and companies isn’t an encouraging sign for U.S. equities,” Santschi added.  “Corporate America seems to be battening down the hatches.” TrimTabs Asset Management, a sister company, offers funds that pick stocks on the basis of their liquidity, or the supply and demand for their shares, rather than their fundamental value.

In a research note, TrimTabs explained that the weakness in buying is not just seasonal.  On the first 15 trading days of October, insider buying was $390 million in 2012, $360 million in 2013, $540 million in 2014, and $260 million in 2015.

Share repurchasing programs have also slowed. Stock buyback announcements fell to a nine-quarter low of $115 billion in the third quarter of 2016, and would have been much lower without Microsoft’s single $40 billion buyback. Buybacks have totaled just $8.2 billion in October, as of Friday, October 21.

© 2016 RIJ Publishing LLC. All rights reserved.

TIAA survey shows popularity of closed-end funds

Closed-end funds can bolster the income of people who are in or near retirement and help offset today’s low-interest rate environment, according to 85% of financial advisors surveyed recently by Nuveen, a unit of TIAA Global Asset Management.

Two-thirds of advisors surveyed now use closed-end funds compared with just over half (51%) in 2013, Nuveen found in September. They do so to increase income (58%) and to diversify income (53%)  

Nearly two-thirds (62%) of advisors recommend increasing closed-end fund allocation at retirement to diversify income. About one-third recommend using closed-end funds to take advantage of modest amounts of leverage and to boost returns without changing the risk composition of an investor’s portfolio.

Clients in or near retirement are extremely concerned about protecting principal (73%) and covering health-care costs (72%), about three-quarters of advisors told Nuveen. About two-thirds of advisors said that closed-end funds can increase cash flow and are appropriate for long-term investors.

Dubick & Associates conducted the survey for Nuveen last April using a sample of 326 advisors from the Discovery Database. Advisors were employed by wirehouses, regional broker/dealers, independent broker/dealers, registered investment advisors, banks and insurance companies.  

© 2016 RIJ Publishing LLC. All rights reserved.

A Word to the Wise Advisor

In a financial world that’s shifting from commissions to fee-based compensation, how will advisory firms deal with the fact that most clients don’t like the word “fees”?

As broker-dealers scramble to adapt to the Department of Labor’s new fiduciary rule over the next six months, one challenge will be to teach thousands of advisors how to explain the effect of the new rule on, among other things, fees—a topic that increasingly concerns investors.

“There will be more conversations about fees,” Invesco Consulting’s Gary DeMoss of told hundreds of mainly sell-side executives at the Money Management Institute’s 2016 Fall Solutions conference in Boston this week. “It’s an awkward conversation to have, but your clients will want to hear it from you first.

“You must explain the ‘what’ of DOL, the ‘why’ of DOL, and how it will impact them. Make it about them and how it’s beneficial for them,” DeMoss said. He drew a ripple of laughter from the audience when he warned them not to say, “I must put now put your interests ahead of mine. Bummer.”

The MMI membership consists of asset managers, broker-dealers, TAMPs (turnkey asset management programs), and technology and solutions providers. The audience at the conference was mainly sales and marketing executives and others on the product and distribution platform side of the investment business. 

Laughter was not abundant at the conference. Manufacturers and distributors of mutual funds face significant disruption by the DOL rule, as the brokerage industry shifts toward the sale of institutional share-class funds, index funds and exchange-traded funds by fee-based advisors.

Simultaneously, it is shifting away from the actively managed funds that for years have produced commissions for advisors and provide revenue-sharing dollars for broker-dealers. Broker-dealers are also expected to vastly reduce the number of fund offerings on their shelves.  

In a separate presentation at the conference, A.T. Kearney predicted that the U.S. financial services industry will lose about 6.7% of its $300 billion in revenues over the next five years—much of which will come at the expense of the wealth management businesses of the four so-called wirehouses: UBS, Wells Fargo, Bank of America/Merrill Lynch and Morgan Stanley.   

As one broker-dealer executive put it, “For the last several years, advisors have been moving money out of higher cost shares into institutional shares that pay less or no revenue sharing.  The move to ETFs is doing the same thing.  The DOL rule will only accelerate that. I think everyone agrees that eventually revenue sharing will go away—at least in its current form.  The question for each firm is how will they transition to this.”

Part of that transition will involve training advisors to explain the changes to clients, most of whom don’t know how much they’re currently paying in fees. The explanation may include the news that the client is being moved from commission-based compensation to fee-based or to an automated digital advice platform.

To help companies solve this communication problem, Invesco Consulting hired Maslansky + Partners, a firm once associated with political-linguistic guru Frank Luntz. The firm studies how people understand specific words and messages. It pioneered “Live Instant Response Dial” focus groups, where participants indicate their reactions to a speech that’s in progress.

“There will be more conversations about fees and we need to be doing it the right way,” DeMoss said. It’s essential, he said, for the advisor to know exactly what and how each client is paying for services; otherwise, the advisor will look bad. Firms that try to avoid talking about the DOL are making a mistake, he added: “Anything unexplained or unexpected will be a problem down the road. Don’t leave anything out there for clients to find out about on their own.”

The word “fees” is itself problematic. During Invesco focus groups, people were asked to name the word they liked least: fees, charges, costs or commissions. “Costs” and “charges” were neutral words, with only 6% and 15% of people objecting to them, respectively. “Commissions” was liked least by 26%, but 53% of the group members liked “fees” the least. 

There was some question about whether most clients know what “fee-based” compensation means. DeMoss believes that clients know that it means a percentage of assets under management and that “fee-based” never includes commissions. [“Fee-based” advisors do accept commissions, if properly licensed, according to Yahoo finance.

In Maslansky focus groups, people were also asked which type of account sounded most appealing to them. The overall answer was “flat-fee” accounts, with a 44% share of the vote. “Fee-based” came in second at 35%, followed by “advisory” accounts and “level-fee” accounts. There was a question whether clients believed that flat-fee believed that it meant a fixed dollar amount or a fixed percentage of assets.

Focus group participants were also asked which would bother them more—news that they would incur “unexpected fees” or that their portfolios had “underperformed.” By a roughly two-to-one margin, respondents said they would rather hear about underperformance than new fees. When asked whether they would rather have 8% returns and a non-attentive advisor or 6% returns and an attentive advisor, 69% chose the latter.

Going forward, advisors will need to be upbeat without raising client expectations too high. “Talk about the benefits of the DOL rule and then talk about what it is. Make it all about the client and how it will help them.” Advisors should make a habit of using the word “you” and not the word “I,” DeMoss said.

“Fear-based selling is out,” he told the audience. “So are pretty models, impressive mansions and superlatives about performance potential. Blaming the government doesn’t work. Clients don’t want to hear bashing.” Above all, simplify the process, no matter how difficult that may be. “It’s easy to make investing look hard,” he added. “It’s hard to make investing look easy.”

© 2016 RIJ Publishing LLC. All rights reserved.

Could your job vanish after November 8? Here’s a remedy

Where risk appears, insurance follows. Great American Insurance Group, recognizing the possibility for economic chaos after an election whose outcome one candidate has not promised to accept, is offering supplemental unemployment insurance to executives who think their jobs may soon vanish.

The product is called IncomeAssure.

“As we enter the final stretch of the presidential campaign, economists are increasingly alarmed that the economy may suffer a massive post-Election Day hangover that could impact jobs and income,” said a Great American press release.

“Given the intense dislike each side feels for the opposing candidate, it’s highly doubtful we can look forward to much ‘comfort level’ regardless of who is elected — which is why workers are wasting no time signing up for IncomeAssure.”

The product combines with state unemployment benefits to provide policyholders with up to 50% of their former weekly salary should they become involuntarily unemployed. People who are unexpectedly laid off quickly discover that state unemployment insurance alone won’t cover mortgage payments, tuition, medical bills, or most household expenses, the release said.

“Rather than a state benefit that can be capped at $300 a week,” said David Sterling of Sterling Risk, the Woodbury, NY, insurance brokerage that is administering IncomeAssure, “IncomeAssure covers salaries up to $250,000 a year. It allows policyholders to maintain their current lifestyle and pay their bills while unemployed, regardless of which candidate wins the election.”

© 2016 RIJ Publishing LLC. All rights reserved.

Passive equity funds still gaining assets: Morningstar

Active U.S. equity funds continued to lose assets in September, with an estimated $23.6 billion in net outflow. That was slightly less painful than August’s negative $25.4 billion flow, according to Morningstar’s monthly flow report on U.S. mutual funds and exchange-traded funds, or ETFs.

What active funds lost, passive funds largely gained. U.S. equity attracted steady flows on the passive side, with an estimated inflow of $19.3 billion in September, up from August’s $16.4 billion. Net flow for mutual funds is based on the change in assets not explained by the performance of the fund and net flow for ETFs is based on the change in shares outstanding.

Highlights from Morningstar’s report about U.S. asset flows in September:

  • Flows into passive international equity funds slowed to $2.1 billion in September from $6.4 billion in August, a trend driven by falling flows into emerging-markets in recent months.
  • Taxable-bond funds continued their undisputed rule as the category group with the highest inflows in September, with active funds receiving $10.4 billion and passive funds $12.9 billion.
  • The MSCI Emerging Markets Index posted a 1.3% return in September. Flows into emerging-markets funds remained positive, but much lower than in July and August.
  • The top Morningstar category remains unchanged from August: intermediate-term bond. However, intermediate-term bond was joined by the short and ultra-short bond categories on the list of top inflows.
  • The bottom five categories were also little changed from last month, with large growth, world allocation, and Europe stock sustaining the largest outflows. WisdomTree Europe Hedged Equity and its Deutsche counterpart, Deutsche X-trackers MSCI Europe Hedged Equity, continued to suffer outflows.
  • In September, all top 10 providers except Vanguard and State Street, which are known as passive specialists, experienced outflows on the active side.
  • Vanguard continues to be the top passive provider in September with nearly $21.0 billion in inflows. State Street fell to fourth place behind Vanguard, iShares, and Fidelity, with $1.5 billion in inflows.
  • Fidelity continued to receive inflows to its passive products after lowering fees three months ago. However, the company still experienced a $3.4 billion outflow on the active side.
  • Prudential Total Return Bond, an intermediate-term bond fund that carries  a Morningstar Analyst rating of Bronze, emerged as the top-flowing active fund.
  • After garnering an $11.1 billion inflow in July, SPY attracted $600 million in August, which reflects the general trend away from the U.S. market. September’s $1.2 billion outflow could mean that active managers reallocated to other asset classes after temporarily placing assets in SPY.

© 2016 RIJ Publishing LLC. All rights reserved.

Trump, Buffett, and how the wealthy are taxed

The individual income tax has never taxed the very wealthy much. Donald Trump may have claimed huge losses starting in the early 1990s, but, like other rich investors, he wouldn’t have paid much tax regardless. Despite paying some tax, Warren Buffett’s release of his 2015 tax return affirms that conclusion.

There are two major reasons: first, paying individual income taxes on capital income is largely discretionary, since investors don’t pay tax on their gains until they sell an asset. Second, taxpayers can easily leverage capital gains and other tax preferences by borrowing, deducting expenses, and taking losses at higher ordinary rates while their income is taxed at lower rates. Such tax arbitrage is, in part, what Trump did.

To be fair, some, like Buffett, live modestly relative to their means and still contribute most of what they earn to society through charity. Some pay hefty property and estate taxes and bear high regulatory burdens. And salaried professionals and others with high incomes from work, whether wealthy or not, may pay fairly high tax rates on their labor income. Still, there are many ways for the wealthy to avoid reporting high net income produced by their wealth.

The phenomenon is not new. In studies over 30 years ago, I concluded that only about one-third of net income from wealth or capital was reported on individual tax returns. Taxpayers are much more likely to report (and deduct) their expenses than their positive income. In related studies, I and others found that rich taxpayers reported 3% or less of their wealth as taxable income each year.

But your favorite billionaire did not get that way by earning low single-digit returns to his wealth. Buffett’s 2015 adjusted gross income (of $11.6 million) would be around one-fiftieth of one percent of his wealth, which in recent years has been estimated to be near to $65 billion. Yet, over the past five complete calendar years, Buffett’s main investment, Berkshire Hathaway, has returned an average of over 10% annually.

The wealthy effectively avoid paying taxes on those high returns either by never selling assets and thus never recognizing capital gains, deferring income long enough that the effective tax rate is much lower, or by timing asset sales so they offset losses, as Trump likely has been doing to use up his losses from 1995.

When you die, the accrued but unrealized gains generated over your lifetime are passed to your heirs completely untaxed, though estate tax can be paid by those who, unlike Buffett, don’t give most away to charity.

“Tax arbitrage,” the second technique, is simple in concept though complex in practice. It allows an investor to leverage special tax subsidies just as she’d arbitrage up any investment—in this case, to yield multiple tax breaks. If you buy a $10 million building with $1 million of your own money and borrow the other $9 million, you’d get 10 times the tax breaks of a person who puts up $1 million but, because she doesn’t borrow, buys only a $1 million building.

The law limits the extent to which most people can use deductions and losses from one investment to offset income from other efforts, but “active” investors are exempt from most of those restrictions. In real estate it is quite common for the active individual or partner to use the interest, depreciation, and other expenses from a new investment to generate net negative taxable income to offset positive income generated by other, often older, investments.

The main trick is simply to let enough income from all the investments accrue as capital gains. For example, take a set of properties that generate $1 million in rents and $500,000 in unrealized appreciation. If expenses are $1,200,000, net economic income would be $300,000 ($1,000,000 plus $500,000 minus $1,200,000); but net taxable income would be a negative $200,000 ($1,000,000 minus $1,200,000) since the unrealized appreciation is not taxable income.

Real estate owners enjoy other tax benefits as well. They can sell a property without declaring the capital gain by swapping the asset for another piece of real estate—a practice known as a “like-kind” exchange. Often, when a property exchanges hands it ends up being depreciated more than once.

At the end of the day, tweaks to the individual income tax system, including higher tax rates, are unlikely to increase dramatically the taxes paid by the very wealthy. Instead, policymakers need to think more broadly about how estate, property, corporate, and individual income taxes fit together and how to reduce the use of tax arbitrage to game the system.

The Government We Deserve is a periodic column on public policy by Eugene Steuerle. A former deputy assistant secretary of the Treasury, he is an Institute fellow and the Richard B. Fisher Chair at the nonpartisan Urban Institute.

 

Anecdotal Evidence: Football and Financial Ads

It’s football season so I’m catching a few games on TV, which means seeing commercials for financial service providers. E*Trade’s re-“tire”-ment story was the funniest of the lot. A bearded man in a cardigan, slightly resembling Julius Irving and palming a goblet of red wine, addresses the camera from his wood-paneled study, where full-size automobile tires are mounted trophy-style on the walls.

In the space of 15 seconds, he creates about eight or 10 puns using the word “tire” before recommending E*Trade as a retirement partner. If you’re not prepared for it, and you like puns—which E*Trade’s target audience may or may not—it’s unexpectedly funny. That spot was paired with a similar one in which a tailor puns on the word “vest,” as in in-“vest”-ment. There’s also a Benedict Arnold spot that exploits the word “trade” (as in traitor).

For absurdity, these spots almost match GEICO’s recent Marco Polo ad, in which the “real” 14th century Marco Polo wades into a backyard swimming pool and, speaking in Italian, tries unsuccessfully to convince kids who are busy playing “Marco Polo” that the real Marco Polo is right in front of them.

Why anybody would custody his or her retirement savings at a discount brokerage, it’s difficult to say. The biggest joke of all is the one E*Trade plays on its prospects by offering a $600 reward for new signups. You must deposit between $250,000 to $499,999 at E*Trade to qualify for that reward, according to the fine print. Unfortunately, other companies have copied this type of click-bait teaser. The DOL, which now regards rollover recommendations as fiduciary acts, might frown on it. 

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Pacific Life engaged in a bit of slap-water, if not slap-stick, comedy with a commercial during either the Arkansas-Ole Miss game or the Ohio State-Wisconsin game last Saturday. The 30-second spot featured the montage of PacLife’s trademark humpback whales, breaching, fin-slapping and lob-tailing in the ocean as usual. This time, however, each emphatic slap coincided with the crash of percussion instruments in a marching band. It was an efficient, humorous merger of brand-reinforcement and football.

Northwestern Mutual’s commercial airing last Saturday wasn’t new, but it remains noteworthy for its messaging. The voice-over and graphics emphasize the point that smart retirement planning often requires the use of both investments and insurance products in combination, and that Northwestern Mutual specializes in bringing the two together. I don’t know of any other retirement company that makes that pitch so explicitly. The commercial also depicts a very attractive mixed-race couple. The husband is white, the wife African American. The message may be: We’re a modern, hip company; not the “Quiet Company” your father or grandfather knew.

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Inside the first section of my Sunday newspaper last weekend, I saw Wells Fargo Bank’s full-page ad. The headline said, “Moving forward to make things right.” This is part of the mega-bank’s damage-control campaign amidst its ongoing 17-month reputational train wreck.

“We have eliminated product sales goals for our Retail Banking team members who serve customers in our bank branches and call centers…, the ad copy said in part. “We have provided full refunds to customers we have already identified and we’re broadening our scope of work to find customers we may have missed.”

Banking services are sticky, Americans have short memories and the strength of the Wells Fargo brand (Boomers may remember the Wells Fargo song from “The Music Man”), so the company may survive its current troubles: the resignation of CEO/chairman John Stumpf, a $185 million federal fine and a 24% decline in its stock price since mid-2015 (when the city of Los Angeles announced its action against the bank for pressuring its employees to create millions of phony new accounts for clients in order to meet aggressive sales goals).

Since the financial crisis, ownership of Wells Fargo stock has made its senior managers and others very rich. Just before the financial crisis, the stock reached a high of $30 before plunging to less than $9 in March 2009. It peaked at almost $58 in mid-July 2015, when Los Angeles announced its action.  

Despite those widely publicized revelations, the bank’s stock held most of its value for another year. As recently as six weeks ago, the share price was $50.55. Then came the Consumer Financial Protection Bureau’s announcement of a $185 million fine in early September. Since then the price has slumped to $44.71 (as of October 14). That, added to Stumpf’s unsatisfying appearance before a Senate committee, forced him to retire.

The drop in the Wells Fargo share price may or may not last, and may depend as much on the impact of the DOL fiduciary rule as on reactions to the phony accounts fiasco. But the incident exemplifies the conflict-of-interest that publicly-held companies inevitably struggle to manage. Their mandate to put shareholders’ interests ahead of customers’ interests can breed incentives that lead to abuse. Such conflicts may become harder to manage, and create new legal exposures, under the DOL rule.  

© 2016 RIJ Publishing LLC. All rights reserved.