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Global Economy ‘Frustratingly Fragile’

In a new “Economic and Investment Outlook,” the Vanguard Investment Strategy Group assesses the future of the global economy, and its forecast—notwithstanding yesterday’s drop in the Dow Jones Average—isn’t all bad.

Given the “structurally lower population growth” and removal of “the consumer-debt-fueled boost to growth between 1980 and the global financial crisis,” Vanguard’s team of economists considers the anticipated 2% growth rate for the U.S. to be about as good as can be expected.

You can find a copy of the full report here. The main points are summarized below: 

Global economy: Structural convergence

World economic growth will remain frustratingly fragile. As in past versions of Vanguard’s Economic and Investment Outlooks, we view a world not in secular stagnation but, rather, in the midst of structural deceleration. Vanguard’s non-consensus view is that the global economy will ultimately converge over time toward a more balanced, unlevered, and healthier equilibrium, once the debt-deleveraging cycle in the global private sector is complete.

Most significantly, the high-growth “Goldilocks” era enjoyed by many emerging markets over the past 15 years is over. We anticipate “sustained fragility” for global trade and manufacturing, given China’s ongoing rebalancing and until structural, business-model adjustment occurs across emerging markets. We do not anticipate a Chinese recession in the near term, but China’s investment slowdown represents the greatest downside risk to the global economy.

The growth outlook for developed markets, on the other hand, remains modest, but steady. As a result, the developed economies of the United States and Europe should contribute their highest relative percentage to global growth in nearly two decades. Now at full employment, the U.S. economy is unlikely to accelerate in 2016, yet is on course to experience its longest expansion in nearly a century, underscoring our continuing view of its resiliency.

Indeed, our long-held estimate of 2% U.S. trend growth is neither “new” nor “subpar” when one both accounts for structurally lower population growth and removes the consumer-debt-fueled boost to growth between 1980 and the global financial crisis that began in 2007. Our interpretation fully explains the persistent drop in U.S. unemployment despite below-average economic growth.

Inflation: Secular deflationary bias waning

As we have discussed in past outlooks, policymakers are likely to continue struggling to achieve 2% core inflation over the medium term. As of December 2015, however, some of the most pernicious deflationary forces (commodity prices, labor “slack”) are beginning to moderate cyclically. Inflation trends in the developed markets should firm, and even begin to turn, in 2016. That said, achieving more than 2% core inflation across developed markets could take several years and will ultimately require a more vibrant global rebound.

Monetary policy and interest rates: A ‘dovish tightening’ by a lonely Fed

Convergence in global growth dynamics will continue to necessitate and generate divergence in policy responses.

The U.S. Federal Reserve is likely to pursue a “dovish tightening” cycle that removes some of the unprecedented accommodation exercised due to the “exigent circumstances” of the global financial crisis. In our view, there is a high likelihood of an extended pause in interest rates at, say, 1%, that opens the door for balance-sheet normalization and leaves the inflation-adjusted federal funds rate negative through 2017.

Elsewhere, further monetary stimulus is highly likely. The European Central Bank (ECB) and Bank of Japan (BoJ) are both likely to pursue additional quantitative easing and, as we noted in our 2015 outlook, are unlikely to raise rates this decade. This view is another potential factor that could result in a pause for the federal funds rate this business cycle.

Chinese policymakers have arguably the most difficult task of engineering a “soft landing” by lowering real borrowing costs and the real exchange rate without accelerating capital outflows. The margin of error is fairly slim, and policymakers should aggressively stimulate the economy this year in an attempt to stabilize below-target growth.

Investment outlook: Still conservative

Vanguard’s outlook for global stocks and bonds remains the most guarded since 2006, given fairly high equity valuations and the low-interest-rate environment. We continue to view the global low-rate environment as secular, not cyclical.

Bonds. The return outlook for fixed income remains positive, yet muted. In line with our past outlooks, our long-term estimate of the equilibrium federal funds rate remains anchored near 2.5% and below that of the Fed’s “dot plots.” As a result, our “fair value” estimate for the benchmark 10-year U.S. Treasury yield still resides at about 2.5%, even with a Fed liftoff. As we stated in our 2015 outlook, even in a rising-rate environment, duration tilts are not without risks, given global inflation dynamics and our expectations for monetary policy.

Stocks. After several years of suggesting that low economic growth need not equate with poor equity returns, our medium-run outlook for global equities remains guarded, in the 6%–8% range. That said, our long-term outlook is not bearish and can even be viewed as constructive when adjusted for the low-rate environment. Our long-standing concern over “froth” in certain past high-performing segments of the capital markets has been marginally tempered by the general relative underperformance of those market segments in 2015.

Asset allocation. Going forward, the global crosscurrents of not-cheap valuations, structural deceleration, and the exiting from or insufficiency of near-0% short-term rates imply that the investment environment is likely to be more challenging and volatile. Even so, Vanguard firmly believes that the principles of portfolio construction remain unchanged, given the expected risk–return trade-off among asset classes. Investors with an appropriate level of discipline, diversification, and patience are likely to be rewarded over the next decade with fair inflation-adjusted returns.

© 2015 The Vanguard Group, Inc.

“Roll-in” deal signed by Retirement Clearinghouse

Everyone talks about rollovers. You may be less familiar with “roll-ins,” a still-new counter-trend championed mainly by a single firm, Retirement Clearinghouse, LLC, of Charlotte, NC.  

The firm’s efforts to popularize 401k-to-401k transfers appeared to bear fruit this week, when Alliance Benefit Group of Illinois (ABGI), a record-keeper and third-party administrator for employer-sponsored retirement plans, announced that it has engaged Retirement Clearinghouse to give its participants access to “managed portability” solutions—that is, to help them roll tax-deferred savings from previous plans or IRAs into their current plans. 

Retirement Clearinghouse identifies itself the “only independent portability solutions provider that consolidates retirement assets into active 401(k) accounts.” In a release, the firm said it has consolidated more than $3.17 billion in retirement savings accounts as of November 30, 2015.

The CEO of Retirement Clearinghouse, formerly called RolloverSystems, is former MassMutual executive Spencer Williams. He and Tom Johnson, formerly of MassMutual and New York Life, have spent years promoting their roll-in vision, which they believe serves public policy as well as commercial goals. Robert L. Johnson, the billionaire who founded Black Entertainment Television and sold it to Viacom in 2001, owns Retirement Clearinghouse.

Under the partnership, ABGI will educate participants about the benefits of consolidating their retirement savings in their current employers’ plans. If a plan participant decides to consolidate, Retirement Clearinghouse will “locate, transport and consolidate” their retirement savings accounts in their ABGI plan. “Consolidation specialists” in Retirement Clearinghouse’s call center will work with plan participants, sponsors and record-keepers to find participants’ accounts in previous employers’ plans, and move all balances into their current plans. The service is free to participants, ABGI said. 

Peoria, Ill.-based ABGI provides recordkeeping, administration and investment consulting services for employer-sponsored retirement plans in 40 states, with the heaviest concentrations in Illinois, Indiana, Iowa, Missouri and Wisconsin. The firm specializes in designing and servicing participant-directed 401(k), 403(b)(7), 457(b) and other qualified retirement plans. ABGI also acts as administrator for non-qualified retirement plans, interfaced payroll services and Health Savings Accounts.

Research commissioned by Retirement Clearinghouse and conducted by Boston Research Technologies has shown that “despite the difficulty of the consolidation process, 83% of Millennials, 83% of Generation-Xers and 78% of Baby Boomers would roll accounts into their current plans using a service provided, and paid for, by employers.”

Retirement Clearinghouse has promoted its “roll-in” process as an answer to an issue created by the surge in the number of small, abandoned accounts created when people who’ve been auto-enrolled into a retirement plan change jobs. The “managed portability” service offers them an alternative to common practice of cashing out the accounts, which can delay and undermine their accumulation of retirement savings.

© 2016 RIJ Publishing LLC. All rights reserved.

Raymond James adjusts the bar for index annuities

Raymond James, the national broker-dealer and a leader in index annuity sales, issued new requirements this week for the index annuities that its Insurance Group will approve for distribution by its registered representatives, effective January 29, 2016.   

The new requirements include:

  • Upfront commissions will not exceed 5%.
  • Any additional compensation afforded by the product will be paid in year two or in the form of a trail for the life of the contract.
  • Initial surrender charges must be less than 10%, unless the contract provides a return of premium guarantee that is effective upon the contract start date.
  • Carriers must remove crediting options, such as monthly average and monthly cap strategies that investors often misunderstood or rarely use.

In the bulletin, Raymond James said it may limit availability of certain indices within the crediting options to “avoid those that are overly complex or fail to align with the positioning of the product.”

The implications of these new standards are, according to the bulletin:

  • Any product that does not meet these requirements will be closed to new purchases, but will remain available for additional deposits (where applicable) for current contract holders.
  • Certain longer-term products will be removed largely due to the surrender charges. Many of these are older products are not often purchased, as newer (and often more appealing) products have been made available.
  • Many of the existing products will be modified to fit these guidelines. Modifications include: Removing certain crediting strategies, including monthly average and monthly cap; Removing certain index options that may be non-traditional or overly complex in nature
  • Commission schedules will change, but total compensation to the financial advisor is essentially flat.

“It is likely that additional products will be launched throughout the year as we work with carriers to build new products that meet investor objectives,” the bulletin said.

© 2016 RIJ Publishing LLC. All rights reserved.

New MetLife indexed variable annuity has shorter surrender period

MetLife has added a new Shield Level Selector indexed variable annuity that gives investors the option to choose a three-year surrender period instead of the six-year period in the Shield Level Selector product that was issued in 2013..

A copy of the product prospectus is available here.

Both products are designed to offer more growth potential than a fixed indexed annuity while offering a downside buffer that can limit losses to varying degrees in the event of downturn. The new version allows investors to surrender the contract without a penalty after only three years.

The marketplace apparently demanded the change. “We heard feedback from advisors that their clients are seeking not only the opportunity for market growth with downside protection, but also the flexibility to adapt to changing conditions,” said Elizabeth Forget, executive vice president of MetLife Retail Retirement & Wealth Solutions, in a release. “With Shield Level Selector 3-Year, advisors now have access to an additional tool to develop customized solutions for their clients.”

 © 2016 RIJ Publishing LLC. All rights reserved.

Record buyouts and buyback bode ill: TrimTabs

A record $1.41 trillion in cash was committed to buy U.S. public companies and repurchase shares in U.S. public companies in 2015, TrimTabs Investment Research reported this week.

“Last year’s volume easily surpassed the previous record of $1.27 trillion in 2007,” said TrimTabs CEO David Santschi. “It’s not surprising that corporate America turned more to financial engineering as revenue and profits stagnated.”

Cash takeovers reached $682 billion in 2015, smashing the previous record of $448 billion in 2007, TrimTabs reported in a research note. Previous interim peaks in 1999 and 2007 both coincided with major market tops.

U.S. companies also announced share repurchases of $725 billion in 2015, second only to the $810 billion notched in 2007.

“The merger boom is a longer-term negative signal for U.S. equities,” said David Santschi, chief executive officer at TrimTabs. “Stock performance tends to deteriorate after periods of heavy merger activity, which is what we saw in the second half of last year.”

The largest cash mergers last year included Dell’s agreement to buy EMC using $46.2 billion in cash, Anthem’s $45.0 billion all-cash offer for Cigna, Berkshire Hathaway’s $32.4 billion all-cash offer for Precision Castparts, and Charter Communications’ $28.3 billion all-cash bid for Time Warner Cable.

© 2016 RIJ Publishing LLC. All rights reserved.

Tales from the Annuity Frontier

The term “efficient frontier” usually refers to Harry Markowitz’ famous scatter chart, which is often used to show the optimal investment portfolio for any risk-free interest rate. But in recent years the same concept has been used to illustrate the optimal investments-to-annuities ratio in an income-generating retirement portfolio.

Moshe Milevsky and Peng Chen are considered the first to have framed “product allocations” in this way, but others have followed. In November, the Society of Actuaries published two reports by Wade Pfau, Joe Tomlinson and Steve Vernon that, in effect, plots the relative risks and returns of various annuity/investment strategies.

One report evaluates deferred income annuities (DIAs) and the second evaluates Qualified Longevity Annuity Contracts (QLACs), as ways to add a lifetime income element to defined contribution plans. Although the reports are designed to educate plan sponsors, they establish basic principles that advisors and individual retirees can use.

Brief summaries of these reports can be found below. Anyone who wants to take a deep dive into these rich reports can download them here and here.

A quick look at QLACs

The first of the two analyses (“Phase 3” of the five-part “Optimal Retirement Income Solutions for Defined Contribution Plans” developed by the Stanford Center on Longevity and the Society of Actuaries) is called “Using QLACs to Design Retirement Income Solutions.”

QLACs are still quite new. Several retail versions were issued in 2015, mainly by insurers that already built DIAs, which are non-qualified and have fewer restrictions. Purchased with up to 25% of an individual’s qualified savings (to a maximum of $125,000), QLACs allow owners to remove longevity tail risk while deferring their required minimum distributions on the QLAC premium beyond age 70 1/2  (until as late as age 85).

The efficient frontier chart below is based on the hypothetical case of a single female, age 65, with $250,000 in qualified savings. Represented here are the median real average incomes from a variety of income strategies, including systematic withdrawals (fixed percentage and by RMD percentage), full and partial use of single premium immediate annuities (SPIAs), and the purchase of fixed or inflation-adjusted life-only QLACs for income starting at age 85, with either a 100% spend-down of assets between ages 65 and 85 or a systematic withdrawal plan across the entire lifespan. The median income (x-axis) includes Social Security of about $17,000 per year. The QLAC-plus-20-year-spend-down strategies are represented by black circles.

Efficient frontier for QLACs

The chart shows that strategies using QLACs and a distribution of the remaining savings (invested in up to 100% equities) between ages 65 and 85 offer the optimal combinations of income and shortfall risk. Partial annuitization with SPIAs offer almost as much safety but less income, while QLACs coupled with a SWP of other assets over the whole lifetime offers almost as much income but less safety. All three annuity-linked strategies outperform the pure SWP strategies.

If the client wants to make sure that there’s a smooth transition from his pre-QLAC income to his QLAC income (starting at age 85) the researchers recommend putting 20% of savings in the QLAC instead of 15% and withdrawing about 3% to 4% of savings over the entire life expectancy rather than over the 20 years between ages 65 and 85.

It’s worth noting that age 85 is the maximum QLAC start date. Income can be taken earlier, albeit with reduced tax benefits. Note also that the QLACs are life-only. QLACs with death benefits before the income start date or cash refunds after the income start date would offer less monthly income but greater security for survivors. 

Using DIAs in the red zone

In Phase 4 of the study, entitled “Strategies to Protect Retirement Income Before Retirement,” Vernon, Pfau and Tomlinson weigh the merits of fixed-payout DIAs—contracts, in this case, that are purchased either five or 10 years before the retirement/income start date—as protection against sequence of returns risk (the risk of a ruinous market crash within five years of retirement). As in their Phase 3 analysis, the conclusion favors the use of life-only annuities.

One of their examples involves a 55-year-old couple with $300,000 in combined savings. As you can see from the efficient frontier chart below, the riskiest solutions (lower left) are those that keep all money invested (in a target date fund or a 65/35 balanced fund) for life after age 55. The variable annuity with a GLWB (4.5% payout at age 65; no deferral bonuses) isn’t much better.

Annuity frontier chart

But adding an annuity to the portfolio increases the expected median annual income and lowers the risk of a shortfall at the same time. While 100% life-only annuitization offers the highest income with the least chance of shortfall, the chart shows that partial annuitizations (red crosses and blue crosses) can serve as compromises for people who want to preserve some liquidity. 

Note that, probably because of the relatively short time periods involved, it doesn’t make much difference whether the couple “ladders” their investments in the DIA or if they keep their money invested in a TDF or a 65/35 portfolio before fully investing in a DIA. But note that, because of its heavier tilt to equities, a 65% stock portfolio outperforms the TDF when used in conjunction with a partial annuitization.       

Individual client applications

Both of these studies are aimed at acquainting plan sponsors with the available options for adding annuities to defined contribution plans. But few plan sponsors have yet shown a big interest in doing so. With people changing jobs every few years, the employee-employer bond is only weakening. Plan sponsors have also made it clear that until the Labor Department gives them an explicit “safe harbor” option—protecting them from liability in the case that their annuity provider fails—they’ll resist the use of “in plan” annuities that involve long-term relationships with life insurers. 

A fifth and final phase of the SOA’s “Optimal Retirement Income Solutions for Defined Contribution Plans” study is expected this spring. A similar study focusing on the needs of retail clients is planned for the future, an SOA spokesman said.

Phases 3 and 4 should be useful in their current version for individual advisors who want to serve mass-affluent clients. The case studies here reflect the needs of plan participants, many of whom will fall into the mass-affluent demographic. These are the “constrained” or “orange zone” clients that Canadian advisor/author Jim Otar has talked and written about.

More so than either the wealthy (who can self-insure) or the poor (the 50% of Americans with no investments), mass-affluent retirees will need a combination of delayed retirement, partial annuitization and/or home equity release (through downsizing or reverse mortgages) in order to maintain a satisfactory lifestyle. These two analyses by Pfau, Vernon and Tomlinson illuminate the potential of QLACs and DIAs to maximize retirement income and minimize longevity risk.  

© 2015 RIJ Publishing LLC. All rights reserved.

Opportunity Knocks on the 2016 Door

In my 2014 end-of-year commentary, I forecast a 19% loss in 2015 for U.S. stocks, as measured by the S&P 500, when in fact the S&P actually earned a positive 1.4% return, so I was wrong. 2015 was disappointing, but not as bad as I thought it would be. The total U.S. stock market was down 1%. Other asset classes weren’t so lucky, especially precious metals and commodities. 

My fickle finger of gloom was misdirected in 2015; it should have pointed at other asset classes. But I’m repeating my forecast for a 19% loss in 2016, in stark contrast to Wall Street’s 7% to 11% gain forecast. U.S. stock market fundamentals have deteriorated with lower dividend yields and higher price/earnings ratios, especially if you consider the effects of stock buybacks.

We’re entering 2016 with a frothy and expensive stock market that begs to be humbled. I don’t think it can dodge a bullet two years in a row. [This is an abbreviated version of the Surz report. You can find the full version, including all of the charts, here.]

Winners and losers in 2015 and the 5 years ending 2015

U.S. stocks. As in 2014, large-cap stocks led the way in 2015, with large-cap growth stocks performing best, earning 10.5%. By contrast, small-cap growth companies lost 15%. The S&P 500 returned 1.4%, exceeding the total market’s 1% loss. On the sector front, healthcare fared best, earning 7%. By contrast, energy stocks lost 25.5%, and materials lost 14%. In a repeat of 2014, it was another bad year for infrastructure companies, and a good year for technology, both IT and medical.

The collapse of energy stocks this year and last year has been the big story. Energy stocks plummeted in the second half of 2014 and continued to decline in 2015 as oil prices crashed, due in large part to increased supply from fracking operations in the U.S. Crude oil ended 2015 at $38 per barrel, which is less than the cost of exploration in several countries like Brazil and the UK. Consequently oilrigs have been shut down as have pricier shale regions including Eagle Ford in Texas and Bakken in North Dakota.

OPEC is employing a strategy of putting oil producers out of business, at least temporarily. OPEC is increasing oil supply in the face of decreasing prices, a strategy that may be good for consumers in the short run, but can’t be good in the long run. Lower prices increase consumption, so we use more of a commodity that has a limited supply. The day that this supply is used up has drawn closer, as has the day that energy prices rebound.

Larger companies have performed best over the past five years, especially large cap growth stocks. Healthcare and consumer discretionary companies have performed best. Infrastructure stocks – materials and energy – have performed worst. Surz sector returns for 2015

Foreign stocks. Looking outside the U.S., foreign markets earned 1%% in 2015, exceeding the U.S. stock market’s 1% loss and exceeding EAFE’s 0.5% return because, unlike the U.S., smaller companies performed best. Japan and Europe have seesawed over the years, thriving in 2013, suffering in 2014, and winning again this year. Canada was the worst performing country with a 20% (in $US) loss.

Over the past five years, foreign market returns of 5% per year have lagged the U.S.’s 11% per year appreciation, but exceeded EAFE’s 4% return. Europe and Japan have had the best performance, earning 8% per year. By contrast, Latin American markets have lost 3% per year. Unlike the U.S., value stocks have fared best over the past 5 years, earning twice as much as growth stocks, 7.5% versus 3.5% for growth.

The future: Winners and losers forecast for 2016

In “Searching for Alpha in Heat Maps,” published in early April 2013, I showed how heat maps could be used to profit from momentum effects. I then published my forecasts each quarter and momentum effects “worked,” with winners continuing to win and losers continuing to lose.

So now I’ll offer forecasts for the first quarter of 2016 using heat maps. A heat map shows shades of green for “good,” which in this case is good performance relative to the total market. By contrast, shades of red are bad, indicating underperformance. Yellow is neutral.

The table below is the U.S. heat map for the year ending December 31, 2015. We see that the best performing market segments are mostly in the healthcare sector and the large cap growth style. These would be the stocks to bet on if you want to make a momentum bet. Of course you could make a contrarian bet that these sectors will not do well.

Surz 2015 Heat Map

As for underperforming segments, energy and materials stocks are the place to look, especially smaller companies in these sectors. Many quantitative managers employ momentum in their models, buying the “green” and selling the “red.” Fundamental managers use heat maps as clues to segments of the market that are worth exploring, for both momentum and reversal potential.

Moving outside the U.S., the healthcare sector and the small cap growth style thrived in 2015, while energy stocks in all countries and styles have suffered, as has Canada.

The Past: The 90-year history of the U.S. capital markets

In forecasting the future, it helps to understand the past. Those who are unaware of the mistakes of the past are more likely to repeat them. In the final section of this report, I provide a longer-term 90-year history of stocks, bonds, T-bills and inflation.

There are many lessons to be learned from this history. Here are a few:

  • T-bills paid less than inflation in 2015, earning 0.1% in a 1.3% inflationary environment. We paid the government to use their mattress, as we have for the past ten years, with a 1.21% return in a 1.85% inflationary environment.
  • Bonds were more “efficient,” delivering more returns per unit of risk than stocks in the first 45 years, but they have been about as efficient in the most recent 45 years. The Sharpe ratio for bonds is 0.48 versus 0.34 for stocks in the first 45 years, but the Sharpe ratio for both is the about the same in the more recent 45 years. Both stocks and bonds have returned about 0.32% per unit of risk.
  • Average inflation in the past 45 years has been more than twice that of the previous 45 years: 1.83% in 1926-1970 versus 4.09% in 1971-2015.
  • Bonds returned 2% above inflation in the first 45 years, and that doubled to above 4% in the past 45 years.
  • Stock market volatility was much higher in the 20-year period 1926-1945 than it has been since. Volatility subsided from 20-35% down to 15% in the most recent 70 years.
  • By contrast, bond markets have become more volatile, more than doubling in the most recent 45 years to 9.23%, versus 4.52% in the first 45 years.

© 2016 PPCA Inc.

More Boomers + fewer advisors = robo-advice?

With financial advisors retiring as fast as Boomers, it’s little wonder that robo-advisors and related “digital advisory solutions” have sprung up to fill the growing gap between the supply of retirement planning advice and the potential demand for it.  

This trend apparently has been underway for some time. The number of U.S. financial advisers fell for the fifth straight year as the industry suffers a continuing wave of retiring veteran advisers, according to a report this week by the Boston-based research group Cerulli Associates.

There were roughly 285,000 financial advisers in 2014, a 1.9% drop from 2013, according to Cerulli. The industry has lost more than 39,000 advisers, roughly 12%, since peaking at 325,000 advisors in 2008.

The decrease held steady from 2013, when adviser headcount also fell by 1.9%, but researchers say attrition through retirement will continue to shrink the industry. Nearly half of all financial advisers are over the age of 55. Over the next decade, Cerulli expects nearly 100,000 more brokers to retire.

Cerulli’s data comes from surveys of 7,000 advisers across banks, brokerages, insurers and other investment firms. The research firm has tracked adviser population figures since 1992.

Only two types of advisors—registered investment advisors (RIAs) and “hybrid advisers”—saw their sales force increase in recent years. RIAs are independent wealth managers who collect fees as a percentage of client assets. Hybrid or dually-licensed advisors collect fees on a client’s assets as well as commissions on securities trades. Cerulli Associates’ Kenton Shirk said he expects the numbers of RIAs and hybrid advisors to continue growing over the next five years.

© 2015 RIJ Publishing LLC. All rights reserved.

‘The Big Short’ Is No Tall Tale

“The Big Short,” the just-released film based on Michael Lewis’ nonfiction bestseller about the 2007-2008 mortgage bond meltdown, doesn’t blame the financial crisis on Fannie Mae or Freddie Mac. Or Bill Clinton or on the community activists at ACORN, as several histories of the Great Recession do.

This reality-based drama instead blames the crisis mainly on stupidity, herd-mentality and moral hazard among Wall Street bankers and traders. Neither the book or the movie has a hero, only winners—the raffish hedge fund types who got nine-figure rich by convincing complacent bankers to take the other side of a very large bet against mortgage-backed securities. 

To the extent that the movie divines the ultimate source of the global financial crisis, its Patient Zero is Lewis S. Ranieri. If you have a long memory, you may recall that Ranieri was the legendary Salomon Brothers bond trader who invented mortgage securitization during the topsy-turvy 1980s. He played a big role in Lewis’ first book, Liar’s Poker.   

But what of Fannie Mae and Freddie Mac, the government-sponsored entities (GSEs) whose purchases of subprime mortgages were central to the crisis? A lot of smart people believe that overzealous government lending policy, mediated by the GSEs, caused the crisis. In Fragile by Design, for instance, their excellent 2014 book on the crisis, Charles Calomiris of Columbia and Stephen Haber of Stanford pin the tail on a “political bargain” between the big banks and the Association of Community Organizations for Reform Now, or ACORN. 

Their version of the crisis, which has wide currency, goes like this: In the 1990s, big banks wanted to merge. ACORN’s activists, armed with the 1977 Community Redevelopment Act (CRA), threatened to torpedo the mergers unless the banks channeled $850 billion in credit through community organizations and committed an “additional $3.6 trillion in CRA lending to underserved areas or low-income communities” between 1992 and 2007.

The activists then pressured Congress to mandate Fannie and Freddie to buy the sub-prime loans made to credit-unworthy individuals or in depressed communities. The GSEs bundled up the loans, divided the bundles by seniority, and marketed the tranches with the highest seniority to global institutions at triple-A prices. Soon the big banks got involved, and their demand for sub-prime loans took on a momentum of its own. Mortgage bond fever became the 21st century version of tulipmania.

An equally persuasive book, Black Box Casino, by Robert S. England, supports this version of the story. England traces the crisis to 1992 legislation, known as the “GSE Act,” which gave Fannie Mae and Freddie Mac too much autonomy and lending power with too little oversight. In England’s telling, the nitro and the glycerin that produced the crisis were first combined at Fannie and Freddie when Congress mandated them to commit most of their lending to poor people while setting their capital requirement for MBS at a mere 0.45% (a 222 to one leverage ratio) and insuring their liabilities.

“Congress basically created the framework for what would become the world’s two largest hedge funds,” England wrote.

It is this version of the story that “The Big Short” rejects, largely by ignoring it. Instead, Lewis paints a scenario where a trifecta of fraud, ignorance and stupidity in the financial industry pumped an otherwise garden-variety housing boom into an epic catastrophe. (Though slightly didactic, the movie does a particularly good job of dramatizing the anxieties of dealmakers, including the ironic moment when the Big Shorters realized that a successful bet on the end of the financial system might never pay off.)  

Having read The Big Short, and lots of other books and scholarly articles that support its version of the crisis, I find its anti-banker version of the crisis more credible than the anti-government version. The idea that community activists had the power, even with allies in the government, to blackmail huge banks seems preposterous. It contradicts much of what I’ve seen first hand. 

For instance, in my own community during the 2000s, I saw cornfield after cornfield replaced by the printed circuits of tract mansions. In my own mailbox, I received an endless series of glossy, four-color junk mail solicitations for pre-approved six-figure loans with no money down and three-figure monthly payments. Clearly, something rotten was afoot.

If the government were in fact forcing money into poor neighborhoods, I would expect to have seen low-income housing projects blossom, and observed homeowners replace renters in poor and middle-class neighborhoods.  But the opposite occurred. We saw the construction of thousands of McMansions on rural land and a rise in renter-occupied houses in middle-class urban neighborhoods.

Indeed, in the small city where I used to live, real estate brokers were buying up rowhouses and renting them to poor people. (My once 100% owner-occupied rowhouse neighborhood deteriorated in this way.) We eventually moved to the country. In my new neighborhood, one large home has stood empty for five years because the doctor-nurse couple who owned it, along with two other homes, defaulted on their loan).

Government policies or rules may well have provided conditions necessary for the crisis to germinate, but they were not sufficient. Common sense dictates that the crisis also required the massive exploitation of the loopholes by those who had the most to gain from exploiting them. That would be the mortgage brokers and asset securitizers.

Tellingly, Calomiris and Haber reveal in Fragile by Design how the original low-income housing program morphed into a McMansion program. Once Fannie Mae and Freddie Mac enabled the lowering of mortgage underwriting standards, those lower standards “applied to everyone,” they wrote.

Thus, by 2006, “46% of first-time home buyers put down no money at all, and the median first-time buyer put down only 2% of the purchase price… The result [of such “inconceivably lax” rules] was the rapid growth of mortgages with high probabilities of default.” Had lending been confined to the poor, we wouldn’t have had nearly as big a boom—or as big a bust.

© 2015 RIJ Publishing LLC. All rights reserved.

Vanguard keeps dominating fund flows

Is it the ultra-low expense ratios? The Internet-friendly direct sales model? The focus on passive investing? The lack of conflicts of interest in its inimitable ownership structure, which sprang from Jack Bogle’s head 40 years ago?

No one knows for sure.  

But statistic-junkies know this: Through the end of November, Vanguard mutual funds received more net inflows than the next nine mutual fund companies combined. According to Cerulli Associates, the source for all data here, Vanguard is also the top retail mutual fund manager, with $2.33 trillion under management and a 20% industry market share.

Funds sponsored by the Malvern, PA-based fund company received $139.3 billion in the first 11 months of 2015 and $7.87 billion in November. The next nine companies received about $118.7 billion in the first 11 months and about $6.7 billion in November.

Four of the top five funds in flows in November were Vanguard funds: the Total International Stock Index Fund, the Total Bond Market II Index Fund, the Total International Bond Fund Index and the Total Stock Market Index Fund. The remaining top-five fund (in third position) in November was the PIMCO Income Fund.

Vanguard’s strength, as reflected by Cerulli’s data, is clearly in its market-wide index funds, that form the core of many investment strategies, to which more specialized “satellite” funds are typically added for diversification. (The underlying funds in the asset allocations of the leading robo-advisor, Betterment, are Vanguard index funds.)

Thanks to several big equity index funds, Vanguard is the top equity fund advisor, with assets of $1.26 trillion. Its Total Stock Market Index Fund had the most flows in November, with $1.02 billion, and it had five of the top six funds in terms of net inflows YTD: the 500 Index fund, Total Stock Market Index fund, Mid-Cap Index fund, Institutional Index fund and Small-Cap Index fund.

As of the end of November, Vanguard was also the top manager of taxable bonds ($518.3 billion, 19.5% market share) and tax-exempt municipal bonds ($122.2 billion, 21% market share). In the taxable category, its Total Bond Market II fund had the highest flows in November ($1.29 billion) and its Total International Bond Index fund has the highest flows YTD ($19.3 billion). In the tax-exempt category, its Intermediate-Term Tax-Exempt bond fund had the highest flows in November ($435.7 million) and YTD ($3.81 billion).

© 2015 RIJ Publishing LLC. All rights reserved.

RIJ’s 20 Top Events for 2016

AICPA Advanced Personal Financial Planning Conference, January 18-20, 2016, Bellagio, Las Vegas, NV. 

 

T3 (Technology Tools for Today) Advisor Conference, February 10-12, 2016, Marriott Harbor Beach Resort, Fort Lauderdale, FL

 

Morningstar Institutional Conference, March 3-4, 2016, JW Marriott Desert Ridge Resort and Spa, Phoenix, AZ.

 

Society of Actuaries, 2016 Investment Symposium, March 14-15, 2016. New York Marriott Downtown.

 

NAPA 401(k) Summit, April 17-19, 2016, Music City Center, Nashville, TN.

 

IMCA Investment Consultants Conference, February 1-2, 2016 Sheraton New York Times Square Hotel, New York

 

IRI Marketing Summit, March 20-22, 2016, PGA National Resort and Spa, Palm Beach Gardens, FL

 

IMCA 2016 Annual Conference Experience, April 17-20, 2016, Hyatt Regency Orlando, Orlando, FL

 

Money Market Institute, 2016 Annual Convention, April 20-21, 2016, Marriott Marquis, Washington, DC. 

 

FPA Retreat 2016, April 25-28, 2016, The Wigwam, Phoenix, AZ.

 

SOA/LOMA LIMRA Secure Retirement Institute Retirement Industry Conference, May 4-6, 2016, The Westin Copley Place, Boston, MA.

 

69th CFA Institute Annual Conference, May 8-11, Palais des Congres de Montreal, Montreal, Quebec, Canada. 

 

SOA Life & Annuity Symposium, May 16-17, 2016, Nashville, TN. 

 

  

Boulder Summer Conference on Financial Decision Making, May 22-24, 2016, St. Julien Hotel, Boulder, CO.

 

NAIFA Congressional Conference, May 24-25, 2016, Washington, D.C.

 

Morningstar Investment Conference, June 13-15, 2016, McCormick Place, Chicago, IL.

 

Vision: IRI Annual Meeting 2016, September 25-27, 2016, Broadmoor, Colorado Springs, CO

 

Money Market Institute 2016 Fall Solutions Conference, October 18-19, 2016, The Westin Copley Place, Boston, MA. 

  

 

 

 
 

Here come the new Boomers (sans Beatles)

Here’s a look at six of the strongest financial trends among Millennials and a preview of what to expect from Millennials in 2016, courtesy of Northwestern Mutual:

There will be an influx of Millennials in the workforce. According to the Bureau of Labor Statistics, in 2016 Millennials will represent the largest generational segment. They will have more disposable income as they reach management positions.

Millennials are socially conscious investors. Socially-conscious funds play to Millennials’ inclination to “give back.” In 2001, investment in these models totalled $3.1 trillion; by 2014 this had jumped to $6.6 trillion.

Weddings will become even more expensive. In 2014, the average price of a wedding rose to $31,213, a 4% increase from 2013, according to The Knot’s annual survey. Many couples already choose to wed later due to student loan debt and unstable financial situations.

The average student loan debt will continue to increase. As of 2015, U.S. students carry $1.2 trillion in debt. In 2014, average loan debt was $28,950, up 2% from 2013, among 70% of students who graduated. Student-loan debt helps explain the number of Millennials living at home and the tendency among young adults to delay home-buying. TheMintGrad.org, Northwestern Mutual’s online resource for Millennials, offers tools to help pay down student debt

Millennials will skip the gym, but not the exercise. Wellness remains a top priority among Millennials, with 88% saying they exercise. But a Mintel survey shows that 72% of Millennials say gym memberships are too expensive. So they have been cutting their gym expenses and instead paying for community exercise programs, fitness apps, classes and other nontraditional workouts.  

Millennials travel, but spend less per trip.  Millennials are willing to make sacrifices, like forgoing hotel stays for hostels, to cut down travel expenses. According to a Yahoo! Travel Survey, 68% of Millennials are more likely to spend less than $1,000 per trip versus 33% of the population surveyed who said they would spend $1,000 to $4,999 on a vacation.

“Millennials tend to follow their hearts,” says Emily Holbrook, director of the young personal market at Northwestern Mutual. “Their financial decisions are reflective of their personal values, beliefs and lifestyles.”

© 2015 RIJ Publishing LLC. All rights reserved.

Stick to a Plan? Few Retirees Do: Hearts & Wallets

Advisors preach “safe withdrawal rates” to their retired clients, but many retirees ignore strict financial guidelines and spend erratically. And it’s not uncommon for retirees to designate the same pot of money for legacies and longevity insurance—a practice that keeps their would-be heirs in suspense.

These insights and many more are revealed in two new studies by the research firm Hearts & Wallets. The studies are Funding Life After Work: Impact of Parenthood & Wealth Transfer on Retirement Solutions for Baby Boomers and Portrait of U.S. Household Wealth.

Funding Life After Work explores a variety of Boomers’ attitudes about money that might interest advisors, including:

  • Sources of income in retirement
  • Decisions about whether to tap into capital
  • Sources of advice
  • Robo-advisors
  • Most important financial needs

The study found, for instance, that many retirees practice a “chunk or nothing” spending pattern, consuming from 0% to 9% or more of principal annually rather than drawing down savings at sustainable rates. This behavior is thought to spring from a conflict between shame about spending capital and a desire to do so, or to occur among parents who worked longer than non-parents to provide for their children’s education.

Parent traps

The Portrait of U.S. Household Wealth study focuses on 5.2 million households ages 53–70 with $500K to $5 million in investable assets who control about $10 trillion of the estimated $21 trillion in total Boomer savings. 

Hearts & Wallets surveyed three consumer groups that make up 82% of these households and control 84% of the assets. The groups are “Non-Parents” (1.8 million households with no children who have about $3.5 trillion), “Parents Spend All” (1.0 million households headed by parents who plan to spend all their assets in retirement and have about $1.7 trillion), and “Parents Leave Inheritance” (1.5 million households headed parents who plan to leave a legacy and have about $3.1 trillion.

“Parents who plan to leave a legacy aren’t necessarily more generous than those who plan to spend it all,” Laura Varas, Hearts & Wallets co-founder and principal, said in a press release. They like to say that they’re putting money aside for their children, but simultaneously they see that money as a potential emergency fund for themselves, if they need it.  

Consciously or unconsciously, this form of double-think serves a purpose. “To them, leaving an inheritance is the ultimate insurance policy,” Varas said. “They may plan to leave only a couple of $100,000 or so, but having that goal reins in their spending and guides their retirement funding decisions.” It also has a downside, she added: “They could afford to be a little less frugal and risk averse if they had sources of advice or solutions that acknowledged this fear.”

The “Parents Leave Inheritance” is primarily concerned with how much money they have and the location of important documents and paperwork, the studies found. The “Parents Spend All” group expresses equal concern for their children, but worries that a pre-determined inheritance might make children irresponsible. Retirees without children have a different problem altogether: they tend to worry about not having anyone to help them when they become frail.

“Non-parents more often say they are unsure who will help them when they become infirm. It’s not so much about the money, but about having a trusted caretaker to take them to the doctor and help with bill-paying. Parents often see children in these roles,” Varas said.

Income, advice and needs

All segments express frustration with the low-interest rate environment that forces them to take more financial risk than they would like to. Even if they own annuities, they may be unsure about when to take annuity income or how annuities affect their Required Minimum Distributions (RMDs).

In other findings: Boomers look to advisors, accountants or estate planners for answers. Finding the right professional is challenging for them, especially given their perception that advice will be “free.” Good advisors continue to encounter the mistrust generated by advisors who didn’t meet clients’ expectations. Few older investors even know about “robos.”

In terms of financial services, the survey participants wanted help with investment selection, optimizing income and minimizing taxes, charitable giving and estate planning, and long-term care expenses. The “Parents Spend All”and “Non-Parents”groups were equally interested in income and tax optimization solutions, because of their low wealth transfer needs and willingness to spend principal. A clear majority of those surveyed said they are willing to pay someone to tell them how much they can afford to spend and to advise them on tax-smart charitable giving and estate planning. 

© 2015 RIJ Publishing LLC. All rights reserved. 

American Financial sells LTCI book to focus on FIAs

American Financial Group, Inc., has completed its sale of United Teacher Associates Insurance Company and Continental General Insurance Company, which contain almost all of its run-off long-term care insurance business, to HC2 Holdings, Inc.  

The deal “allows us to provide continued focus on our [fixed and fixed-indexed] annuity business,” said Craig Lindner, AFG’s co-CEO. “The sale is expected to create between $110 and $115 million of excess capital for AFG by mid-2016 (due to the timing of tax benefits to be received), in addition to the $700 million of excess capital reported at September 30, 2015.”

HC2 paid approximately $15 million in proceeds. AFG may also receive up to $13 million of additional proceeds from HC2 based on the release of certain statutory reserves of the legal entities sold by AFG.

To obtain regulatory approval for the transaction, AFG agreed to provide up to $35 million of capital support for the insurance companies, on an as-needed basis to maintain specified surplus levels, subject to immediate reimbursement by HC2; this agreement expires five years after closing. In exchange for this agreement, AFG received warrants to purchase two million shares of HC2 common stock.

In the first quarter of 2015, AFG recorded an after-tax non-core loss of $105 million in connection with this transaction; an additional after-tax non-core loss of up to $10 million may be recorded after closing, reflecting updated valuations of expected proceeds to be received and net assets disposed.

Due to a significant tax benefit from the sale, AFG expects to receive total after-tax proceeds of $110 to $115 million from the transaction (including the tax benefit but before any potential future proceeds).

With the completion of this sale, AFG will retain only a small block of 1,700 polices totaling approximately $33 million of reserves.

Philip Falcone, HC2’s chairman, president and CEO, said in a release, “We believe this acquisition provides a strong base on which to grow our insurance vertical and also offers further diversification for HC2.”

© 2015 RIJ Publishing LLC. All rights reserved.

Retirement assets dip to $23.5 trillion in 3Q2015: ICI

Total U.S. retirement assets were $23.5 trillion as of September 30, 2015, down 4.3% from the end of June, according to just-released data from the Investment Company Institute.

The new estimate of $24.5 trillion for June reflects a slight downward revision based on new information. Retirement assets accounted for 34% of all household financial assets in the United States at the end of the third quarter of 2015.  

Assets in individual retirement accounts (IRAs) totaled $7.3 trillion at the end of the third quarter of 2015, a decrease of 4.8% from the end of the second quarter. Defined contribution (DC) plan assets fell 4.1% in the third quarter to $6.5 trillion. Government defined benefit (DB) plans—including federal, state, and local government plans—held $5.0 trillion in assets as of the end of September, a 3.9% decrease from the end of June. Private sector DB plans held $2.8 trillion in assets at the end of the third quarter of 2015, and annuity reserves outside of retirement accounts accounted for another $1.9 trillion.

Defined contribution plans

Americans held $6.5 trillion in all employer-based DC retirement plans on September 30, 2015, of which $4.5 trillion was held in 401(k) plans. In addition to 401(k) plans, at the end of the third quarter $504 billion was held in other private-sector DC plans, $842 billion in 403(b) plans, $255 billion in 457 plans, and $426 billion in the Federal Employees Retirement System’s Thrift Savings Plan (TSP). Mutual funds managed $3.5 trillion, or 54%, of assets held in DC plans at the end of September.

Individual Retirement Accounts (IRAs)

IRAs held $7.3 trillion in assets at the end of the third quarter of 2015, down 4.8% from the end of the second quarter of 2015. Forty-seven percent of IRA assets, or $3.4 trillion, was invested in mutual funds.

Technical notes

The Investment Company Institute’s total retirement market estimates reflect revisions to previously published data. Revisions to the Financial Accounts of the United States, published by the Federal Reserve Board, resulted in a substantial downward revision to assets of annuities held outside of retirement plans for the past 10 to 15 years, with smaller revisions going back to 1992; and minor, mostly upward, revisions to estimates of 403(b) plan and IRA assets at life insurance companies from 2007 through 2015:Q2.

In addition, newly released U.S. Department of Labor (DOL) Form 5500 data for 2013 were incorporated, resulting in slight downward revisions to DC plan assets (both the “401(k) plans” and the “other private-sector DC plans” categories) and private-sector DB plan assets beginning in the first quarter of 2013.

The reported assets of federal pension plans for the first, second, and third quarters of 2015 are adjusted for U.S. Treasury financing activities undertaken in anticipation of hitting the legal limit on federal government borrowing. These actions have reduced the amount of Treasury securities reported on the balance sheet of federal government DB plans, an effect that we anticipate will be fully reversed in the fourth quarter of 2015.

© 2015 Investment Company Institute.

The Perils of Fed Gradualism

By now, it’s an all-too-familiar drill. After an extended period of extraordinary monetary accommodation, the US Federal Reserve has begun the long march back to normalization. It has now taken the first step toward returning its benchmark policy interest rate—the federal funds rate—to a level that imparts neither stimulus nor restraint to the US economy.

A majority of financial market participants applaud this strategy. In fact, it is a dangerous mistake. The Fed is borrowing a page from the script of its last normalization campaign—the incremental rate hikes of 2004-2006 that followed the extraordinary accommodation of 2001-2003.

Just as that earlier gradualism set the stage for a devastating financial crisis and a horrific recession in 2008-2009, there is mounting risk of yet another accident on what promises to be an even longer road to normalization.

The problem arises because the Fed, like other major central banks, has now become a creature of financial markets rather than a steward of the real economy. This transformation has been under way since the late 1980s, when monetary discipline broke the back of inflation and the Fed was faced with new challenges.

The challenges of the post-inflation era came to a head during Alan Greenspan’s 18-and-a-half-year tenure as Fed Chair. The stock-market crash of October 19, 1987—occurring  only 69 days after Greenspan had been sworn in—provided a hint of what was to come. In response to a one-day 23% plunge in US equity prices, the Fed moved aggressively to support the brokerage system and purchase government securities.

In retrospect, this was the template for what became known as the “Greenspan put”—massive Fed liquidity injections aimed at stemming financial-market disruptions in the aftermath of a crisis. As the markets were battered repeatedly in the years to follow—from the savings-and-loan crisis (late 1980s) and the Gulf War (1990-1991) to the Asian Financial Crisis (1997-1998) and terrorist attacks (September 11, 2001)—the Greenspan put became an essential element of the Fed’s market-driven tactics.

This approach took on added significance in the late 1990s, when Greenspan became enamored of the so-called wealth effects that could be extracted from surging equity markets. In an era of weak income generation and seemingly chronic current-account deficits, there was pressure to uncover new sources of economic growth.

But when the sharp run-up in equity prices turned into a bubble that subsequently burst with a vengeance in 2000, the Fed moved aggressively to avoid a Japan-like outcome—a prolonged period of asset deflation that might trigger a lasting balance-sheet recession.

At that point, the die was cast. No longer was the Fed responding just to idiosyncratic crises and the market disruptions they spawned. It had also given asset markets a role as an important source of economic growth. The asset-dependent economy quickly assumed a position of commensurate prominence in framing the monetary-policy debate.

The Fed had, in effect, become beholden to the monster it had created. The corollary was that it had also become steadfast in protecting the financial-market-based underpinnings of the US economy.

Largely for that reason, and fearful of “Japan Syndrome” in the aftermath of the collapse of the US equity bubble, the Fed remained overly accommodative during the 2003-2006 period. The federal funds rate was held at a 46-year low of 1% through June 2004, before being raised 17 times in small increments of 25 basis points per move over the two-year period from mid-2004 to mid-2006. Yet it was precisely during this period of gradual normalization and prolonged accommodation that unbridled risk-taking sowed the seeds of the Great Crisis that was soon to come.

Over time, the Fed’s dilemma has become increasingly intractable. The crisis and recession of 2008-2009 was far worse than its predecessors, and the aftershocks were far more wrenching. Yet, because the US central bank had repeatedly upped the ante in providing support to the Asset Economy, taking its policy rate to zero, it had run out of traditional ammunition.

And so the Fed, under Ben Bernanke’s leadership, turned to the liquidity injections of quantitative easing, making it even more of a creature of financial markets. With the interest-rate transmission mechanism of monetary policy no longer operative at the zero bound, asset markets became more essential than ever in supporting the economy. Exceptionally low inflation was the icing on the cake—providing the inflation-targeting Fed with plenty of leeway to experiment with unconventional policies while avoiding adverse interest-rate consequences in the inflation-sensitive bond market.

Today’s Fed inherits the deeply entrenched moral hazard of the Asset Economy. In carefully crafted, highly conditional language, it is signaling much greater gradualism relative to its normalization strategy of a decade ago. The debate in the markets is whether there will be two or three rate hikes of 25 basis points per year—suggesting that it could take as long as four years to return the federal funds rate to a 3% norm.

But, as the experience of 2004-2007 revealed, the excess liquidity spawned by gradual normalization leaves financial markets predisposed to excesses and accidents. With prospects for a much longer normalization, those risks are all the more worrisome. Early warning signs of troubles in high-yield markets, emerging-market debt, and eurozone interest-rate derivatives markets are particularly worrisome in this regard.

The longer the Fed remains trapped in this mindset, the tougher its dilemma becomes—and the greater the systemic risks in financial markets and the asset-dependent US economy. It will take a fiercely independent central bank to wean the real economy from the markets. A Fed caught up in the political economy of the growth debate is incapable of performing that function.

Only by shortening the normalization timeline can the Fed hope to reduce the build-up of systemic risks. The sooner the Fed takes on the markets, the less likely the markets will be to take on the economy. Yes, a steeper normalization path would produce an outcry. But that would be far preferable to another devastating crisis.

Stephen S. Roach, a former chairman of Morgan Stanley Asia and the firm’s chief economist, is the author of Unbalanced: The Codependency of America and China (Yale University Press, 2014).

© 2015 Project Syndicate.

Damage Assessment: Who’s Hurt by New Fiduciary Rule?

The perennial wave of rollovers from 401(k)s to IRAs won’t be thwarted by the Department of Labor’s soon-to-be-issued “conflict of interest rule,” but the rule could foil some of the existing synergies in the IRA business, according to the latest issue of the Cerulli Edge, Retirement edition.

In the report, analysts at Cerulli Associates, a global consulting firm, said that they believe the proposed rule, which would extend the DOL’s jurisdiction over retirement plans to include retail rollover IRA accounts, will “be implemented with only minor revisions in spring 2016.”

And even though the DOL has made clear that it would rather see less money migrating from relatively low-cost, closely regulated 401(k) plans to potentially higher-cost retail IRA accounts, Cerulli doesn’t think that’s likely. The firm expects the rollover tsunami to keep rising. By 2020, it estimates the annual volume of rollovers will reach $517 billion.

“Tsunami” in this case is justified hyperbole. As more Boomers reach retirement age or leave their employers, more of them roll their employer-sponsored plan accounts to IRAs. Rollover IRA assets, now at about $7.3 trillion, exceed the assets in defined contribution plans.

Cerulli cited two reasons why the rollover wave will continue unabated: First, the big broker-dealers whose advisors have largely switched to a fee-based, fiduciary compensation model already, so their most important advisor-client relationships won’t necessarily change.

Second, most 401(k)s aren’t set up for flexible distributions, so retirees are virtually forced to roll assets over to IRAs. “Just 21% of large plan sponsors report having adopted an in- plan guaranteed income product,” Cerulli reported. “Only 10% of plans allow participants to take ad hocpartial distributions.”

Uneven impact

The DOL proposal will hurt some financial industry players, leave some more or less alone, and have a mixed effect on others, according to Cerulli. It’s difficult to isolate the likeliest points of pain, however. That’s because advisors often wear multiple hats (insurance and investments), broker-dealers have mixed business models (commissions and asset-based fees), and properly licensed and certified intermediaries can act as planners at one moment, brokers at another and insurance agents at another. Here’s how Cerulli expects the new “playing field” to unfold:

Insurer-owned broker-dealers: They could get hurt the most, Cerulli says. Their business model—where advisors often sell proprietary products like variable annuities on commission—is inherently conflicted. Insurer-owned B/Ds  faced problems even before the DOL’s campaign to reform the IRA rollover industry began.     

Firms with existing client relationships: Plan participants tend to stick with the provider they know. Depending on the size of the plan, that provider might be a registered rep, an insurance agent, a recordkeeper, or a full-service provider like Fidelity or Vanguard. It’s no coincidence that Fidelity, the largest plan provider, is also the largest IRA provider, with 14.7% ($1.1 trillion) of the IRA market. (Fidelity’s “Bring Us Your Old 401(k)s” ads seem to be everywhere.)

Wirehouses: As registered investment advisors, most wealth managers at wirehouses (Merrill Lynch, Morgan Stanley, UBS, Wells Fargo) are already fiduciaries, so they already comply with the DOL’s anticipated new rule. Also, their high net worth clients (>$250k in investable assets) tend not to purchase commissioned products, which DOL believes are inherently conflicted. “Cerulli believes that large-balance investors and rollovers will be the least impacted by the new rules because these investors will value holistic advice on their entire portfolio,” the report said.  

Advisors at broker-dealers affiliated with investment banks that underwrite securities: “To be a fiduciary, these B/Ds must ensure that investors receive best execution or the most favorable price on any securities they purchase. It should be noted that this largely applies to buying individual equities or bonds,” the Cerulli bulletin said. In other words, investment banks might have difficulty pressuring their broker-dealers to push their issues.   

Advisors or broker-dealers that receive revenue-sharing payments from companies that provide products on their shelves: “A key source of revenue for many B/Ds is revenue sharing from product manufacturers, which is another potential conflict of interest, albeit for the B/D rather than the advisor. Seeking client acknowledgment of revenue sharing may be yet another pain point for advisors,” according to Cerulli.

Recordkeepers: “Many recordkeepers provide IRA education while participants still have assets within defined contribution plans to help facilitate rollovers,” Cerulli’s report said. “While investors may be getting the consultation they seek in these scenarios, the proposed Department of Labor Conflict of Interest Rule has the potential to change this dynamic with more stringent regulation of the IRA rollover process.” The DOL has said publicly, however, that generic rollover information by recordkeeper call center operators won’t be considered to be advice under the forthcoming rule.

US Total Retirement Market

Editor’s note: In the discussion over the details of the conflict-of-interest proposal and its disruptiveness for broker-dealers, the context of the rule is often lost or obscured. For instance, it’s been said, somewhat opaquely, that the DOL wants to “expand the definition of fiduciary.” Essentially, the DOL wants to change an antiquated definition of fiduciary status that allows some broker-dealer reps to be refs and players at the same time—that is, to serve as trusted, objective advisors to retirement plans and also use the plans as sources of retail rollover prospects. 

The DOL hopes to end this game, especially when a client’s costs go up as a result. The ultimate goal is to reduce the costs that retirement investors pay.  The DOL focus on costs rankles the retail financial industry because it appears to imply that their services add no value. Retirement industry leaders have also claimed that, as a practical matter, brokers will sell far fewer 401(k) plans to small businesses if there’s no potential for them to secure future retail business. 

Some broker-dealers believe that the DOL rule will chill the sale of all commissioned products, including income annuities and the hot-selling fixed indexed annuities. If that happens, they have argued, the DOL initiative will backfire by eliminating services for middle-income clients (who are the primary purchasers of commissioned products) and reducing the availability of guaranteed income products.

The industry resents the “one size fits all” solution to conflicts-of-interest in the IRA world that the DOL appears eager to impose. Rather than make surgical changes to its rules, the DOL chose to use a blanket approach and require advisors who want to make inherently conflicted transactions—sell on commission, accept revenue sharing, or sell proprietary securities—to sign a legally-binding Best Interest Contract (BIC) and promise to act in the sole interest of the client.  Many in the rollover industry have found the BIC requirement to be, in their words, “unworkable.” But the IRA business is so varied and complex that anything other than a principles-based solution may have been impractical.   

The DOL proposal does make at least one surgical change to the regulations. It distinguishes variable annuities from fixed annuities, making sellers of VAs on commission subject to the BIC pledge requirement while allowing fixed annuities to continue to be sold under an existing indulgence (i.e., “exemption from prohibited transaction”). As a result, selling VAs may be more difficult going forward. But it may not matter much: VA sales are shrinking anyway.

© 2015 RIJ Publishing LLC. All rights reserved.

Fed hike will have “no immediate impact” on insurers: A.M. Best

In a new briefing, entitled “Insurers Hope Fed Move a Sign of Things to Come,” the rating agency A.M. Best said, “The Federal Reserve’s first interest rate increase in nearly a decade does not symbolize a ‘lift off’ scenario for interest rates. Subsequent moves by the Fed will involve an uncertain and measured approach with multi-year rate increases following what had been an unprecedented monetary easing.”

The briefing said:

“A.M. Best sees no immediate impact to its view of the U.S. property/casualty, life or health insurance industries, or any individual rating units as a result of the 0.25% increase in the Federal Funds Rate. While the overall industry has been juggling falling portfolio yields and limited reinvestment opportunities, life/annuity companies in particular have also been facing spread compression. In the short-term, the Fed’s rate hike will primarily impact the shorter end of the interest rate term structure, which doesn’t impact insurers with predominantly longer-term bond holdings. This initial move also doesn’t ease the pain for older spread-based products with higher guaranteed crediting rates.

“Although investment portfolio yields would eventually benefit from any increasing interest rate scenario, A.M. Best is more watchful of the increased credit risk accumulating for the industry from its effort to attain higher investment returns.

“Overall, however, a continued measured rise in rates is a net positive for the life/annuity industry as product spreads improve, investment portfolio yields increase, and other side benefits accrue to the industry, such as having a positive impact for those carriers with underfunded pension plans.”

In a second briefing, entitled “Rating Outlook Remains Stable For U.S. Life/Annuity Industry But Challenges Persist,“ said A.M. Best “is maintaining its stable outlook on the U.S. life/annuity industry for 2016, supported by the benign credit and interest rate environments and in the face of various challenges, in particular, the overall economic climate and its potential impact on interest rates, and, to a lesser extent, credit risk.”

“The life/annuity industry has seen absolute and risk-based levels of capitalization improve. In addition, asset impairments remain low and operating performance is up modestly as compared with 2014,” the briefing said.  

But the assessment was mixed. “Slow premium growth for life products, driven in part by the industry’s inability to effectively access the middle market, remains an industry-wide dilemma, and when coupled with low interest rates, leads to moderate revenue and operating earnings,” A.M Best said.

“A shift to a negative outlook could result from an overall negative transition in the U.S. economy, which, for example, could drive a sudden spike in interest rates. In addition, a material increase in credit risk resulting in investment impairments would also potentially drive an unfavorable change in outlook.”

© 2015 RIJ Publishing LLC. All rights reserved.

Seniors’ home equity reaches $5.76 trillion

An estimated $147 billion increase in the aggregate value of homes owned by seniors drove their share of home equity to $5.76 trillion, according to the National Reverse Mortgage Lenders Association.  

The new figures boosted the NRMLA/RiskSpan Reverse Mortgage Market Index (RMMI) to a record in Q3 2015 of 200.19, from 195.42 in Q2, even though mortgage debt held by seniors increased slightly, to $1.46 trillion from $1.45 trillion during that period. 

The Q3 numbers are based on data from the 2013 American Community Survey and the Federal Reserve’s Z.1 Release to estimate the value of aggregate senior home equity underlying the RMMI.

“The recalibrated index uncovered something we didn’t expect to see, which was that senior housing values outperformed the general population. In metro areas hard hit by the Great Recession, for example, senior home values were more resilient to declines. It’s great news for seniors who are considering tapping their housing wealth to support their retirement planning,” said NRMLA President and CEO Peter Bell in a release.

© RIJ Publishing LLC. All rights reserved.