Archives: Articles

IssueM Articles

Is It Time to End Tax Deferral?

Posted on July 30, 2015 by Kerry Pechter -

Blame it on tax deferral.

Like a park ranger who blocks the road to a million acres of resource-rich wilderness and warns loggers and the miners that they shall not pass, the Labor Department’s Phyllis Borzi is standing in front of the $7.2 trillion in America’s IRAs and telling commission-driven brokers and agents: Back off!

The chief of the Employee Benefit Security Administration is doing it because of tax deferral. The government has hundreds of billions of dollars worth of tax expenditures invested in IRAs. Tax deferral is supposed to help Americans’ retirement accounts grow faster and fatter. The DOL doesn’t want to see its investment consumed by unnecessary commissions and fees.

(You may believe that most of those commissions and fees aren’t useless at all, and that they pay for products and services that enhance investors’ and retirees’ financial security. The DOL doesn’t appear to share that belief.)

Notice that the government has no beef with the treatment of taxable accounts. The trillions of dollars in those accounts are up for grabs. But retirement accounts are different. The DOL evidently thinks that as long as the money in rollover IRAs remains tax-deferred, it should be as closely regulated as the money in ERISA-regulated plans (whence almost all of it came).

Ergo, DOL proposal haters, be careful what you wish for. An argument against the spirit of the proposal is an argument for ending tax deferral for retirement savings. If you want to keep tax deferral, it might make sense to accommodate some of the DOL’s concerns.

A nest of ambiguities

We tend not to see the situation in those terms because the role of tax deferral has been fogged over with ambiguities.

Tax deferral means different things to different people. Not everybody agrees that tax deferral is a subsidy. Not everybody believes that tax deferral should achieve a public policy goal. Not everyone believes that tax deferral is a “tax expenditure,” or even that such a phenomenon as tax expenditures exist.

The nature of the rollover IRA is also ambiguous. Is it a personal pension fund—a kind of trust accounts—or is it like any other retail brokerage or mutual fund account, aside from the nuisances of penalties for early withdrawal and required minimum contributions at age 70½? Answer: It’s both.

The purpose of the 401(k) itself is ambiguous. Created by the private sector, it was first seen as a tax management device, then as a supplemental savings plan, then as a replacement for defined benefit pensions, and now as a de facto incubator for retail rollover IRA accounts. The government didn’t create the phenomenon and never had a clear goal for it, so why should it care to regulate it more closely?

Because of tax deferral.

There’s a good reason why we don’t recognize the tax deferral on savings as a direct federal subsidy. In the UK, they encourage savings differently. The government directly credits the participant’s retirement account with an amount equal to the tax reduction. Here, we get a tax refund, which we don’t necessarily have to save. There’s no government-funded sleeve in our retirement accounts. So when the DOL says it wants to regulate our IRAs, we can accurately say, “But it’s our money.”

A modest proposal

It would seem, then, that everyone is right—and wrong. The DOL has a legitimate claim that rollover IRA money should be regulated like an ERISA plan, and the financial services industry has an equally legitimate claim that rollover IRA money should be treated the same (except for the penalty before 59½ and the RMDs at 70½) more like other retail money. Hence the battle. (The hearings on the conflict-of-interest proposal start August 10 in Washington.)

All I am saying here is that, the more strongly and successfully the industry presses its case, the easier it will be for enemies of the $100 billion annual tax expenditure for retirement savings to say: Go ahead, brokers, have your way with rollover IRAs, and even 401(k)s for that matter. But you have to give up tax deferral. A subsidy without rules is a recipe for moral hazard. You can’t have it both ways.

This strikes me as the issue at the heart of the current controversy—the issue we duck and dodge, while pretending that it’s all about “advice.” Perhaps it’s time to reconsider tax deferral, and replace it with tax-free withdrawals from retirement accounts. Think how much simpler life might be.

FINRA Sides with Brokers against DOL Proposal

Posted on July 30, 2015 by Kerry Pechter -

FINRA, the securities industry’s in-house watchdog, is urging several changes in the Department of Labor’s proposed “fiduciary rule” for retirement accounts, including a change that would create a single “best interest standard,” based on current securities laws, for both retirement and non-retirement accounts.

The recommendation was one of several that FINRA (Financial Industry Regulatory Agency) made in a 21-page letter sent to the DOL on July 17 in response to the DOL’s request for comments on the proposal. It is posted in the public comments section of the DOL’s website.

Many of FINRA’s recommendations are consistent with those made by other members of the industry that it both serves and polices. In its letter, FINRA asked the DoL to clarify its best interest standard, or “BICE,” and to “harmonize” the standard of conduct for commission-paid brokers and fee-based advisors, in addition to harmonizing it for retirement and non-retirement accounts.

Otherwise, the proposal’s “fractured approach will confuse retirement investors, financial institutions, and advisers,” said the FINRA letter. The letter provided the chart below to show that the DOL proposal would create the potential for six different sets of rules for any product a financial advisor might offer:

FINRA Chart DOL Proposal comment 7-15

FINRA also asked the DOL to eliminate the proposal’s requirement that financial institutions maintain public web pages, updated at least quarterly that:

“show the direct and indirect material compensation payable to the Adviser, Financial Institution and any Affiliate for services provided in connection with each Asset (or, if uniform across a class of Assets, the class of Assets) that a plan, participant or beneficiary account, or an IRA, is able to purchase, hold, or sell through the Adviser or Financial Institution, and that a plan, participant or beneficiary account, or an IRA has purchased, held, or sold within the last 365 days, the source of the compensation, and how the compensation varies within and among Asset classes.”

In addition, FINRA called for the limit that the DOL wants to place on the range of assets that financial institutions can sell to IRA owners. The current version of the proposal defines the permitted assets as:

“bank deposits, CDs, shares or interests in registered investment companies, bank collective funds, insurance company separate accounts, exchange-traded REITs, exchange-traded funds, corporate bonds…, insurance and annuity contracts (both securities and non-securities), guaranteed investment contracts, and equity securities” but not “any equity security that is a security future or a put, call, straddle, or any other option or privilege of buying an equity security from or selling an equity security to another without being bound to do so.”

Price-fixing suit names Goldman, 21 other primary Treasury dealers

Posted on July 30, 2015 by Editorial Staff -

In a federal class-action lawsuit, Boston’s public employees pension fund has accused 22 large financial institutions of using their privileged positions as primary dealers of U.S. government debt to manipulate the Treasury auction market and boost their own profits at investor’s expense.

All of the institutions entrusted with underwriting and distributing Treasury debt—Bank of America’s Merrill Lynch unit, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JPMorgan Chase, UBS and 14 others—were named in the suit, which State-Boston Pension Fund filed July 23 in U.S. District Court, Southern District of New York.

The State-Boston Pension Fund manages $5.4 billion for more than 20,000 active and more than 14,000 retired employees of all city departments and agencies as well as the School Department, the Boston Redevelopment Authority, the Boston Housing Authority, the Public Health Commission, and the Boston Water & Sewer Commission.

The suit was filed about a month after Bloomberg News reported that the U.S. Department of Justice (DOJ) was investigating possible misconduct in the $12.7 trillion Treasury market, where primary dealers operate with little oversight and where tiny fluctuations in spreads represent millions of dollars gained or lost.

The plaintiffs linked the alleged manipulation with the similar manipulation of the benchmark LIBOR (London Interbank Order Rate) in 2012. The Treasury “conspiracy ultimately collapsed around the time DOJ secured a plea agreement from UBS Securities Japan Co. Ltd. in connection with its investigation of LIBOR in or around December 2012—a scandal involving similar manipulative conduct that would ultimately engulf several of the same Defendants, their parents, or affiliates,” the State-Boston suit said.

The suit claims that traders at the 22 firms conspired via Internet chatrooms and text messages to widen their spreads, or profit margins, on trades of government debt. Primary dealers typically sell government securities “short” prior to a Treasury auction, and then cover their positions by buying debt instruments from the U.S. Treasury.

Sharing information on order flow before the auction, the suit said, the traders agreed to charge investors such as pension funds and other investors a slightly higher, “supra-competitive” price for Treasury bills, notes and bonds, then conspired to pay a slightly lower, less competitive price on their own purchases from Treasury.

Because the prices and yields that are set during the Treasury auction become the benchmarks for prices in related markets, the effects of the manipulation included mis-pricing of Treasury futures and options, the lawsuit said. The New York law firm of Labaton Sucharow represents the plaintiffs.

According to the suit:

Using “electronic methods of communication, Defendants’ Treasury securities traders employed a two-pronged scheme to maximize the spread between their short positions in the when-issued market and their acquisition costs of obtaining Treasury securities at Treasury Department auctions.

“First, Defendants’ traders agreed to artificially inflate the prices of Treasury securities in the when-issued market through coordination of bid-ask spreads. Defendants communicated with each other during the when-issued market to ensure that prices of when-issued Treasury securities would stay at supracompetitive levels.

However, because Defendants are primary dealers—and thus were required to bid at Treasury Department auctions—Defendants, individually and collectively, generally maintained short positions in the when-issued market. Defendants needed to be able to cover these positions profitably. Thus, they needed to fix the prices at which they bought Treasury securities from the Treasury Department.

And that’s exactly what Defendants did. Defendants coordinated their bidding strategies at the Treasury Department auctions to artificially suppress the prices they would pay for their bids. This had the effect of benefiting the short positions they maintained in the when-issued market by allowing Defendants to cover their positions with low-cost Treasury securities purchased at auction.

By artificially increasing the spread between prices of Treasury securities in the when-issued market and at auction, Defendants were able reap supracompetitive profits— essentially shorting (selling) Treasury securities artificially high in the when-issued market and then buying them at artificially low prices in the Treasury Department auction to cover their short positions.

Through Defendants’ unlawful conduct, they were able to keep the spread between when-issued and auction prices at supracompetitive levels that would otherwise not have been possible in a competitive market.”

The lawsuit seeks class-action status on behalf of investors in Treasury securities, including futures and options, from 2007 to 2012, and unspecified triple damages.

Reuters sought responses from the primary banks named in the suit but said it did not receive any.

Switcheroo: New FIA credits benefit base, not account value

Posted on July 30, 2015 by Editorial Staff -

Fidelity & Guaranty Life, the Baltimore-based insurer that was purchased by Harbinger Capital from Old Mutual plc in 2011, has a new fixed indexed annuity designed to provide income payments for retirees, called FG Retirement Pro.

F&G described the product as unique in allowing the “benefit base” (the notional amount guaranteed minimum withdrawal benefit’s monthly payment gets calculated), rather than the account value, to grow through an interest crediting mechanism determined by the appreciation of equity index options.

Meanwhile, the account value (the cash value of the contract) grows by an annually declared fixed interest rate. In states that allow it, the contract also offers an optional 7% premium bonus that vests over time, a 13% cap on annual point-to-point increases in the benefit base, and an income multiplier (200% for single annuitants and 150% for joint annuitants) for contract owner who become ill.

Asked to comment on this type of product design, a consulting actuary who is not familiar with the product offered this observation by e-mail:

“The cost of a GLWB [to the issuer] is somewhat proportional to the gap between the cost of the withdrawal path vs. the account value/surrender path. A proxy for the withdrawal path is the benefit base (BB), although the true cost is the present value of the withdrawal income and the exercise probabilities.

“Some products have tried to manage this gap by having the BB grow in some way that is related to interest crediting. For example, there is “stacked” BB crediting consisting of a constant plus credited interest. Basically, it is good to keep the BB and the AV from diverging too much.

“With hedge budgets being fairly low, it may be that BB growth based on credited interest is generally, on average, lower than a competitive fixed roll-up rate. If F&G has become aggressive on hedge budgets/interest crediting, the gap between a fixed roll-up and this may be narrow.

“With roll-ups where they were, step-ups were a rarity. They had minimal financial impact. If the case is that the AV and the BB both grow by credited interest, then there never would be a step-up; however, that would have minimal financial impact.

“On the surface, this F&G product seems to add nothing for the customer (unless I am missing something) except some simplification by eliminating a much misunderstood roll-up rate.”

“The design of FG Retirement Pro puts strong indexing opportunity into the income feature. The product’s “innovation lies in its income potential,” said Brian Grigg, vice president of annuity distribution at FGL. Any agent who has sold indexed annuities clearly understands the upside potential of index credits tied to a well-known index, such as the S&P 500. FG Retirement Pro takes it to the next level and builds a benefit base on indexing. And, the caps have the potential to be very strong.

“The competitive arena for FIAs for many years now has been with income. Early versions provided a fixed roll-up rate as a way to grow a benefit base. FG Retirement Pro combines the fixed rate with the potential of a higher overall roll-up rate through indexed interest credits to the benefit base.”

FG Retirement Pro is available for sale immediately. A call requesting comment from FGL was not returned by deadline.

The SoA’s new logo is “impossible”

Posted on July 30, 2015 by Editorial Staff -

As part of an overall brand refresh, the Society of Actuaries (SOA) has adopted a new logo. The logo design is based on the Penrose “impossible triangle,” which itself was partly inspired by the famous drawings by M.C. Escher that employed ambiguous shadows and perspectives to depict objects that couldn’t exist in three-dimensional space.

The SoA says, however, that the new logo represents infinity, like a Mobius strip, which some people believe is the original inspiration for the ancient symbol of infinity, ∞. According to one source, if “a line is traced around the Penrose triangle, a three-loop Mobius is formed.”

“The infinity symbol communicates how the organization is continually evolving to provide forward-thinking research, education and opportunities for our community and the professionals within it,” the SOA said in a release.

“ The shield represents a foundation, bound by a set of principles, that advances the interests of our profession and cultivates outstanding, trusted professionals. The Penrose triangle (impossible triangle), among other mathematical related symbols, served as inspiration. The logo is blue, a color of trust.”

The new logo will be featured on SOA.org and in the organization’s magazine, The Actuary.

“The SOA brand is changing, though our principles endure as we serve the public, advance the profession, credential and educate actuaries, and build strong actuarial communities,” said SOA President Errol Cramer, FSA, MAAA, in a statement. “This brand refresh reflects the essence of the SOA. We are trusted to advance knowledge through actuarial research. We are trusted to nurture and educate our candidates.”

The SOA’s ancestry can be traced to the formation of the Actuarial Society of America in 1889. When the ASA merged with the American Institute of Actuaries in 1949, the SOA was born. The SOA will continue to use its traditional seal for official documents.

When entertaining ideas for a new logo, the SOA surveyed members and other audiences on the messages and brand identity. The brand campaign was developed by the SOA and an outside vendor. The SOA Board of Directors approved the new logo in October 2014.

Time for Boomers to rebalance: Fidelity

Posted on July 30, 2015 by Editorial Staff -

Fidelity Investments’ latest quarterly analysis of its 401(k) accounts and Individual Retirement Accounts (IRAs) showed that the bull market that started in 2009 has made Boomers richer on paper—but perhaps more heavily allocated to equities than they should be.

In a report released this week, Fidelity shared these statistics:

Account balances. The average 401(k) balance dipped slightly at the end of Q2 to $91,100 from $91,800 at the end of Q1, and is nearly flat from the end of Q2 2014 average of $91,000. However, IRA balances increased to $96,300 at the end of Q2, up from $94,000 at the end of Q1 and $92,500 one year ago.
Contributions. Individuals and their employers remain committed to saving in 401(k) accounts and total contribution rates are reaching record levels. The average 12-month total savings amount, which combines employee contributions and employer contributions (such as a company match), increased from $9,840 at the end of Q1 to $10,180 at the end of Q2 – the first time the total savings amount has surpassed $10,000. The average IRA contribution dipped to $2,690 at the end of Q2 from $3,150 at the end of Q1, primarily due to the significant number of people making contributions to their IRA in Q1 to meet the IRS tax deadline.
401(k) loans. While average balances have increased over the past several years, higher savings balances could be contributing to increased loan activity among 401(k) account holders. While the percentage of people initiating a loan (10.1%) and the percentage of loans outstanding (21.9%) have remained steady over the last several quarters, the average 401(k) loan amount continues to increase. For the previous 12 months, the average loan amount reached $9,720 at the end of Q2, up from $9,630 at the end of last quarter and $9,500 a year ago.

Many Boomers top-heavy on stocks

While a rising stock market is one reason the average 401(k) balance is up 50% in the last five years, this has led to an increased percentage of equities within many 401(k) accounts, which can add increased exposure to the negative impact of a market downturn.

Many older 401(k) account holders, including Baby Boomers close to retirement age, had stock allocations higher than those recommended for their age group.

Fidelity compared average asset allocations to an age-based target date fund and found 18% of people 50-54 had a stock allocation at least 10 percentage points or higher than recommended, and for people ages 55-59, that figure increased to 27%.

An additional 11% of people ages 50-54 had 100% of their 401(k) assets in stocks, while 10% of people ages 55-59 had all of their 401(k) assets in stocks.

Would the DoL Proposal Deny Advice to the Masses?

Posted on July 23, 2015 by Kerry Pechter -

The financial services industry’s most common criticism of the Department of Labor’s conflict-of-interest proposal has been that middle-class Americans would lose access to valuable advice about retirement investing if the proposal were enacted in its current form.

Several financial services trade associations mentioned this possibility in the reports they submitted to the DoL during the public comment period on the proposal, which ended this week. The cost of all the disclosures required by the proposal, said the Bank Insurance & Securities Association:

“Will require enormous effort on the part of financial service providers, at great expense. Conceivably, this could force all but the largest financial institutions to leave the retirement plan and IRA business, inhibiting the ability of average investors to obtain the advice they require.”

But is that true? Would the Labor proposal backfire, and ruin an imperfect but functional market for advice in a quixotic attempt to purify it? Or is the industry’s concern for the average investor mainly just a talking point, tailored to neutralize the DoL message and gain public sympathy?

The jury’s still out. A review of the comments on the DoL/EBSA website, and a look at related reports and studies, suggest that the proposal in its current form would be highly disruptive. In the UK, advisor numbers dropped by almost 25% after most commissions were banned.

But the proposal may not as disruptive to the delivery of advice per se as to the delivery of products. The advisors who will be most affected will be those who are directly involved in the sales and distribution of high-cost mutual funds and variable annuities; these are products that don’t sell themselves, and which require the incentives that the DoL clearly targets. The proposal may or may not limit a client’s access to advice; it would almost certainly limit an advisor’s access to clients.

The economics of advice

Part of the economic argument against the DoL proposal is the assumption that vendor financing—mainly in the form of manufacturer-paid commissions on the sale of mutual funds and annuities—helps drive the provision of financial services to middle-class people who wouldn’t actively seek or pay for advice alone.

According to this line of thinking, if you encumber the commission-model with over-regulation, advisors will move to the fee-based model that, almost by definition, caters primarily to people with enough wealth to make a percentage of assets-under-management arrangement attractive for the advisor.

“If, as we predict, the proposed rule will cause all compensation models to move to one-size-fits-all pricing, advisors are likely to determine that they cannot afford to work with small clients,” wrote Scott Stolz, president of the Raymond James Insurance Group, in his comment to the DoL.

In support of that idea, he pointed to a hypothetical client with a $25,000 IRA. “Assuming a common asset charge of 1%, advisors are unlikely to enter into a fiduciary relationship that requires essentially a 24-hour a day, seven-day-a-week care for just $250 a year.”

Even if the advisor charges a commission, it still wouldn’t be enough, Stolz argued. First of all, “the compression of commissions and trails… will provide compensation to the advisor roughly equal to the $250 he or she would receive under a fee-based agreement,” and the advisor “will most likely not serve the client because the costs and liability [entailed by the BIC standard] will likely exceed the compensation received.”

Defenders of commissioned sales also argue that one-time commissions on product sales can be cheaper in the long-run than asset-based fees that are assessed every year. But it’s difficult for a layperson to make apples-to-apples comparisons in such cases, because products often entail their own automatic annual fees, and an asset-based fee might cover financial planning services that commissions don’t.

Will ‘robos’ fill the gap?

Even assuming that middle-class investors are disenfranchised by regulations that discourage commission-based sales, they increasingly have the option of seeking investment advice online. Robo-advisors like Wealthfront, Betterment and others, as well as traditional B2C providers like Vanguard and Fidelity, along with advisors who adopt a hybrid model that blends in-person and automated advisory services, are confident that they can pick up the slack.

In his official comment to the DoL proposal, submitted this week, Rob Foregger, the co-founder of robo-advisor NextCapital, wrote, “The emergence of low-cost, automated services will directly help alleviate the concerns of decreased access to advice.

“In general, digital advice firms target those investors who may be underserved by traditional advisors. With the increased adoption rate of new technology, access to automated financial advice will only continue to grow and ultimately benefit lower-income investors.”

At the recent InVest conference in New York, executives from robo-advice firms praised the DoL proposal. One even suggested that the DoL timed its proposal to take advantage of the robo-advice phenomenon. Secretary of Labor Tom Perez mentioned the availability of Wealthfront and other robo-advisors when asked in a House subcommittee hearing about the potential for an advice-gap to open up in the wake of a hard-line DoL rule.

No advice gap in fiduciary states

In one of the few academic studies on this topic, Michael Finke of Texas Tech University and Thomas Langdon of Roger Williams University looked for evidence that holding agents to a fiduciary standard changes the composition of their client base—shifting it away from the middle-class—but they couldn’t find any.

“The [financial services] industry is likely to operate after the imposition of fiduciary regulation in much the same way it did prior to the proposed change in market standards that currently exist for brokers,” they wrote in their 2012 paper, “The Impact of the Broker-Dealer Fiduciary Standard on Financial Advice.”
Exploiting the fact that some states already impose a fiduciary standard on advisors, Finke and Langdon surveyed advisors in states with and without the standard to see if there was a significant difference in the average incomes of their clients.

“We find no statistical differences between the two groups in the percentage of lower-income and high-wealth clients, the ability to provide a broad range of products including those that provide commission compensation, the ability to provide tailored advice, and the cost of compliance,” they wrote.

Those findings are compromised, however, by the fact that the research was sponsored in part by the fi360, the Financial Planning Association and the Committee for the Fiduciary Standard, all of which have come out in favor of tougher standards for brokers and agents. But the data speaks for itself.

Impact of RDR in UK

In the UK, a similar proposal did in fact have a disastrous effect on advisors. After the 2008 financial crisis, authorities in the UK conducted an examination of brokerage practices, called Retail Distribution Review (RDR), and a few years later the government outlawed third-party commissions on many annuity and investment products.

At the time, many observers feared that middle-class people would be “disenfranchised” in terms of access to financial services as a result. In a sense, it did. A June 2013 study by consultants at the Cass Business School of City University London found that between 2011 and 2013, the number of advisors in the UK dropped to 31,000 from 40,000.

“The overwhelming view of most of our interviewees was that… RDR would lead to a polarization and fragmentation of the advisory market,” the Cass report said. “The consequence of this will be a reduction in the number of mass-market IFAs [independent financial advisers], which may create a ‘guidance gap’ where many consumers may find themselves without independent financial advice, despite still having a demand for it.”

But, the report continued, “Despite the concerns raised by some or our interviewees about the unattractive nature of the market for financial advice in an RDR world, 69% of the advisers in our survey suggested that they would be retaining 75% to 99% of their clients, while 17% stated that they would retain 100% of their clients.”

People were already moving away from the commission-based model anyway, the report said: “Sophisticated, computer- and financially-literate investors are already gravitating to internet solutions where fees are transparent and low. The awareness of ETFs, fundamental indices and similar ‘economical’ products is increasing exponentially.”

Metered advice

Few commenters on the DoL proposal have asked a fairly obvious question: Why can’t registered reps simply charge middle-class clients an hourly fee for advice, like fee-only planners, and avoid the conflict created by third-party compensation?

One advisor did in fact raise this issue in a comment to the DoL. “There is much talk in the media that registered reps believe that small clients, and some have even said mass-affluent clients, will not have access to advice if reps are not allowed to charge commissions on IRA,” wrote Jonathan Phelan of Algonac, Michigan.

“Apparently their feeling is that RIAs will not service such clients and the reps have no other way to earn money on a client’s IRA than a commission. Why couldn’t the reps or the RIAs simply charge an hourly or flat fee for services for such clients instead of a commission or percentage of assets under management? I know there are plenty of RIAs, including myself, that are willing to charge hourly fees. Why are registered reps unable or unwilling to do that?”

One often-heard answer is that investors would rather have a commission deducted from their purchase premium or an expense ratio deducted from their account value, than write out a relatively modest check for an hour of advice or pay a flat fee for the creation of an investment plan. Indeed, investors generally don’t question an advisor’s right to earn a commission. But surveys show that they don’t necessarily know when the advisor is receiving a commission, or whether the commission might be distorting the advice. Therein lies the problem that the DoL hopes to address.

Clearly, the government and the financial services industry have divergent ideas about what’s best for middle-class savers. Industry advocates say that the DoL proposal is a solution in search of a problem. The government says that too many investors—IRA owners in particular—are over-paying for financial products and services. The search for a shared vision of the future has proven elusive.

In the Fiduciary Fight, Key Players are Biting Off as Much as They Can Chew

Posted on July 23, 2015 by Will Trout -

Amidst the summer lull, the Department of Labor (DoL) has issued Field Assistance Bulletin 2015-02, a clarifying document that aims to open the door to the broader use of annuities within defined contribution (DC) plans.

While annuities have been allowed within DC plans for some years, a lack of guidance as to fiduciary obligations post-sale has tempered sponsor enthusiasm. The bulletin explains that while sponsors are considered under fiduciary obligation at the time of annuity selection and at each periodic review, they will not be held to this standard in the case of specific purchases by a participant or beneficiary.

This distinction is important in that it grants significant protection to sponsors, but the DoL leaves significant wiggle room as to the frequency of required reviews.

Clearly, published reports of the pending insolvency on an issuing insurer would trigger the need for a review. Otherwise, the degree of diligence that must be exercised by the sponsor post-selection will need to be evaluated on a case by case basis: First by the plan sponsor, presumably, and then by the DoL.

This may be a best-effort solution to an irreconcilable problem, but such a measured response by the DoL is unlikely to eliminate what it describes as “disincentives for plan sponsors to offer their employees an annuity as a lifetime income distribution.” Plan sponsors have little incentive, in any case, to assume the risks of offering annuities when these are readily available for purchase outside the pre-tax space, and so the DoL will need to aim higher.

What is noteworthy here is not so much the narrow scope of the little noticed bulletin, or its limited reach, but the degree to which it signals an acceleration of DoL efforts to clean up the DC business. To a large degree, this acceleration reflects a heightened jockeying for position among regulators and other industry actors with an interest in guiding reform. The recent Supreme Court case of Tibble vs. Edison International, which affirmed the nature of the fiduciary responsibility of plan sponsors to participants on an ongoing basis, appears to have brought issues of power and control to a head.

The latest guidance from DoL attempts to boost clarity around sponsor obligations pursuant to the sale of annuities. This guidance is important because to date, regulatory attention has fallen disproportionately on the accumulation side of the DC business. Helping participants to successfully manage the payout function is a noble and (as I discuss in my recent report on de-accumulation) challenging goal. Time is of the essence if the US is to forestall a doomsday scenario of retirees outliving their savings.

At the same time, it is important to keep in mind that economics are not the only consideration driving the DoL push. Rather, the newfound urgency underscores the Department’s desire to put its imprimatur on an issue that is being tackled by multiple actors (e.g. Treasury; the SEC, which announced last month its compliance-focused ReTIRE Initiative; and lobbying groups such as SIFMA and NAIFA) and from multiple standpoints. In particular, a torrent of litigation (the capstone of which was the Tibble vs. Edison verdict) appears to be shifting decision power to the courts.

Legal actions are also shining a spotlight on fees. This presents a cart-before-the-horse problem for DoL, in that excessive fees are an issue that a uniform fiduciary standard is supposed to address. Having assumed the mantle of defined contribution crusader, the DoL risks falling behind events. The pressure on DoL will only become more acute as we enter the twilight of the Obama administration.

The upshot? Look for a wave of bulletins and other forms of guidance from the DoL, particularly in the wake of the upcoming August hearings. While the fiduciary debate to date has gotten less attention than it deserves, it will rise to the top of the political agenda this fall, despite resistance from industry lobbyists. Indeed, given the weight of the government and private sector entities (among them the AARP) behind reform efforts, the end result may actually have teeth.

Today’s Dark Lords of Finance

Posted on July 23, 2015 by Alexander Friedman -

In his Pulitzer-Prize-winning book, Lords of Finance, the economist Liaquat Ahamad tells the story of how four central bankers, driven by staunch adherence to the gold standard, “broke the world” and triggered the Great Depression. Today’s central bankers largely share a new conventional wisdom – about the benefits of loose monetary policy. Are monetary policymakers poised to break the world again?

Orthodox monetary policy no longer enshrines the gold standard, which caused the central bankers of the 1920s to mismanage interest rates, triggering a global economic meltdown that ultimately set the stage for World War II. But the unprecedented period of coordinated loose monetary policy since the beginning of the financial crisis in 2008 could be just as problematic. Indeed, the discernible effect on financial markets has already been huge.

The first-order impact is clear. Institutional investors have found it difficult to achieve positive real yields in any of the traditional safe-haven investments. Life insurers, for example, have struggled to meet their guaranteed rates of return. According to a recent report by Swiss Re, had government bonds been trading closer to their “fair value,” insurers in America and Europe would have earned some $40-$80 billion from 2008 to 2013 (assuming a typical 50-60% allocation to fixed income). For public pension funds, an additional 1% yield during this period would have increased annual income by $40-50 billion.

Investors have responded to near-zero interest rates with unprecedented adjustments in the way they allocate assets. In most cases, they have taken on more risk. For starters, they have moved into riskier credit instruments, resulting in a compression of corporate-bond spreads. Once returns on commercial paper had been driven to all-time lows, investors continued to push into equities. Approximately 63% of global institutional investors increased allocations in developed-market equities in the six months prior to April 2015, according to data from a recent State Street survey – even though some 60% of them expect a market correction of 10-20%.

Even the world’s most conservative investors have taken on unprecedented risk. Japan’s public pension funds, which include the world’s largest, have dumped local bonds at record rates. In addition to boosting investments in foreign stocks and bonds, they have now raised their holdings of domestic stocks for the fifth consecutive quarter.

These allocation decisions are understandable, given the paltry yields available in fixed-income investments, but the resulting second-order impact could ultimately prove devastating.

The equity bull market is now six years old. Even after the market volatility following the crisis in Greece and the Chinese stock market’s plunge, valuations appear to be high. The S&P 500 has surpassed pre-2008 levels, with companies’ shares trading at 18 times their earnings.

As long as the tailwinds of global quantitative easing, cheap oil, and further institutional inflows keep blowing, equities could continue to rally. But at some point, a real market correction will arrive. And when it does, pension funds and insurance companies will be more exposed than ever before to volatility in the equity markets.

This overexposure comes at a time when demographic trends are working against pension funds. In Germany, for example, where 20% of the population is older than 65, the number of working-age adults will shrink from about 50 million today to as few as 34 million by 2060. Among emerging markets, rapidly rising life expectancy and plunging fertility are likely to double the share of China’s over-60 population by 2050 – adding roughly a half-billion people who require support in their unproductive years.

If the combined effect of steep losses in equity markets and rising dependency ratios cause pension funds to struggle to meet their obligations, it will be up to governments to provide safety nets – if they can. Government debt as a percentage of global GDP has increased at an annual rate of 9.3% since 2007.

In Europe, for example, Greece is not the only country drowning in debt. In 2014, debt levels throughout the eurozone continued to climb, reaching nearly 92% of GDP – the highest since the single currency’s introduction in 1999. If pensions and governments both prove unable to provide for the elderly, countries across the continent could experience rising social instability – a broader version of the saga playing out in Greece.

The new Lords of Finance have arguably been successful in many of their objectives since the financial crisis erupted seven years ago. For this, they deserve credit. But, when an emergency strikes, large-scale policy responses always produce unintended consequences typically sowing the seeds for the next full-blown crisis. Given recent market turmoil, the question now is whether the next crisis has already begun.

MetLife launches retail QLAC

Posted on July 23, 2015 by Editorial Staff -

MetLife’s Guaranteed Income Builder deferred income annuity (DIA) is now available as a qualifying longevity annuity contract (QLAC) for individual clients, the publicly-held insurance giant announced this week.

In late May, MetLife introduced a similar annuity, called Retirement Income Insurance, for the retirement plan market. The institutional product offers unisex pricing, while the retail product offers higher payouts for men than women because of women’s higher average life expectancy, all else being equal.

In an interview with RIJ, Elizabeth Forget, executive vice president of MetLife Retail Retirement & Wealth Solutions, said that the product would be distributed through MetLife’s affiliated Premier Client Group affiliated advisors as well as its “traditional third-party distributors,” such as broker-dealers.

The product isn’t planned to be distributed by insurance agents via state-regulated insurance marketing organizations, in part because, unlike the broker-dealers, they don’t necessarily assume responsibility for assuring the suitability of each sale, she told RIJ.

Asked if she thought that the Department of Labor’s fiduciary proposal, if enacted in its current form, might favor the sale of fixed annuities, Forget said, “The proposal differentiates between fixed and variable annuities, but it’s hard to translate what the proposed rule will mean in certain instances.” Under the current proposal, sellers of variable annuities would have to meet a new, more stringent standard of conduct by signing a “Best Interest Contract” (BIC) with the client.

QLACs help protect against the risk of outliving one’s savings. But, like several other insurers that market QLACs, MetLife is positioning its QLAC as a tax-reduction tactic. By purchasing a QLAC, IRA owners can exclude up to 25% of their tax-deferred savings (but no more than $125,000) from the calculation of their required minimum distributions until age 85, thus potentially lowering their annual tax bill by 25% for up to 14 years. Taxable annual distributions from the rest of their tax-deferred savings must begin in the year after the year the owners reach age 70½.

“By allowing clients to defer payments from their IRAs, Guaranteed Income Builder as a QLAC gives them a significant level of flexibility to manage both their assets and tax obligations—further enhancing their ability to retire with confidence,” Forget said in a release.

Lockheed Martin’s $62 million ERISA settlement approved

Posted on July 23, 2015 by Editorial Staff -

Chief U.S. Judge Michael Reagan of the Southern District of Illinois has given final approval for a $62 million settlement in favor of Lockheed Martin employees and retirees in their suit against their employer, the plaintiffs’ law firm said in a release this week.

The eight-year-old case, Abbott v. Lockheed Martin, alleged excessive fees in two of Lockheed Martin’s 401(k) plans, as well as imprudent management of certain investment options offered to employees, according to the St. Louis firm of Schlichter, Bogard & Denton.

Jerome Schlichter, the firm’s managing partner, specializes in leading class action suits against 401(k) plan sponsors and providers on behalf of plan participants and retirees, often focusing on their failure to protect participants from high investment or recordkeeping fees, in violation of their fiduciary duties under the Employee Retirement Income Security Act of 1974.

“The settlement is the largest ever for a case of this kind against a single employer,” observed Thomas E. Clark Jr. of the Wagner Law Group. Lockheed Martin’s plan, with over $27 billion in assets and 180,000 current and former employees, is the fifth largest 401(k) in the United States.

The plaintiffs had charged that Lockheed Martin, a defense contractor, invested plan participants’ retirement savings in funds that charged excessively high fees, diminishing returns. They also claimed that Lockheed Martin allowed excessive recordkeeping fees, and allowed too much of participants’ assets to be held in low-yielding money market funds.

Lockheed Martin denied the allegations and said it followed the law and that the fees were reasonable. The case was originally scheduled for trial in the Southern District of Illinois last December, but the parties reached a settlement just before then.

Schlichter said his firm also recently won a unanimous 9-0 decision in the United States Supreme Court on behalf of employees and retirees of Edison International in their 401(k) plan, which is the first 401(k) excessive fee case decided by the Supreme Court.

Fred Reish et al comment on DOL proposal’s impact

Posted on July 23, 2015 by Editorial Staff -

If enacted in its current form, the Department of Labor’s fiduciary (or “conflict-of-interest”) proposal would have “a significant impact on the sales practices of insurance agents and brokers, according to a new report from attorney Fred Reish and colleagues at the law firm of Drinker Biddle.

Under the current language of the proposal, insurance advisors would have to comply with the existing exemption (PTE 84-24) in order to be earn manufacturer-paid commissions on sales of fixed annuities to IRA owners and 401(k) plan participants, but must meet a new “best interest” or “BICE” standard on sales of variable annuities to IRA owners.

Sales of variable annuities, which are securities and insurance products, are regulated by the SEC and FINRA. Sales of fixed annuities—fixed deferred, fixed income, and fixed indexed annuities—are regulated by the states as insurance products.

One insurance company executive speculated at the recent IRI regulatory conference that, if the fiduciary bar is set higher for variable annuities, fixed annuities would have an advantage in the IRA market.

That could have a big impact on annuity sales. Recent estimates show that the amount of savings in IRAs, including traditional and rollover IRAs, now exceeds $7 trillion. Sales to IRA owners currently account for a large share—nearly half for some products—of overall annuity sales.

There’s some overlap between the BICE and PTE 84-24 standards, and some important differences. Under both standards, advisors have to act in the best interest of the client when selling to IRA owners. But the BICE rule requires advisors and clients to enter into a contract in which the advisors pledge to make their sales recommendations “without regard” to their own remuneration.

The phrase “without regard” is receiving particular scrutiny by critics of the proposal. In its public comment on the DOL proposal, the Insured Retirement Institute, which advocates for the interests of the annuity industry, said “the definition of the term “Best Interest” in the Proposed Amendment to PTE 84-24… should be revised to make clear that advisers and financial institutions must always put their clients’ interests first, but would not be required to completely disregard their own legitimate business interests.”

Participants still not focused on income: Cerulli

Posted on July 23, 2015 by Editorial Staff -

Systematic withdrawal products, provided by asset managers, are considered the “most attractive retirement income sales option during the next five years” in the retirement plan space, according to The Cerulli Edge (Retirement Edition), published by Cerulli Associates.

Cerulli asked asset managers, broker-dealers and insurance companies what income product they thought would sell best to plan sponsors and participants. Forty-one percent said “asset management-only” products, 18% named hybrid products such as variable annuities, and 14% said insurance-only products such as deferred income annuities.

The asset management products might include “dividend drawdown selections that involve the asset manager’s ability to create a product enabling the individual to withdraw a certain amount based on the investments of the underlying product,” Cerulli analysts observed.

“Instead of waiting for the request for a retirement income product, asset managers need to have their foot in the door with two types of products: one in which the insurance company manages a component and one without, in case opportunity knocks,” analysts suggested.

Behavioral issues, as opposed to financial or legal liability issues, may be the biggest obstacles to the introduction of income products in workplace retirement plans, Cerulli noted. Most participants have not yet made the conceptual leap from looking at the account balances in absolute terms to looking at them as the present value of a life annuity or annuity-like income stream.

“The movement away from defined benefit plans to defined contribution has placed a significant portion of the retirement savings burden on employees, without really transferring the investment knowledge, risk management, or know-how that should accompany it,” states Shaan Duggal, research analyst at Cerulli, in a release.

“Most plan participants lack basic information about what their account balance means in terms of retirement income. As more Baby Boomers approach retirement, the issue of ongoing income, especially to pay for healthcare, assumes added urgency.”

Approximately 80% of respondents to their annual plan participant survey indicate that when checking their account statements, they consider the investment performance or their account balance to be the most important information, Cerulli’s newsletter said.

“Those in the 60-69 age range appear to pay the most attention to projected retirement income, but in the aggregate, this is not the case,” the release said.

Cerulli research shows that the majority of 401(k) participants report checking their balances on a quarterly or monthly basis, indicating a reasonable level interest in the growth of their retirement account.

“There should be a concerted effort to change the mindset of the average saver. Accumulating a sizable balance and achieving high investment return on a yearly basis are beneficial, but if that balance doesn’t match the projected retirement expenses, there will likely be a shortfall,” Duggal said.

Financial Engines, Betterment will leverage new Social Security data

Posted on July 16, 2015 by Editorial Staff -

Financial Engines, the managed accounts provider will incorporate the Social Security Administration’s new Social Security data file in the Financial Engines Social Security planner. The data file was introduced at the White House Conference on Aging this week.

The transferable data file contains the information found in users’ Social Security benefit statements regarding the amount they can expect to receive in Social Security each month in retirement. Financial Engines introduced its Social Security planner to the public at no charge in June 2014.

Retirement plan participants with access to Financial Engines’ Social Security planner through their employer can generate a personalized retirement income plan, based on Financial Engines’ patented Income+ methodology.

The comprehensive plan includes multiple income sources, such as part-time work and pensions, and shows how retirement savings in a 401(k) or IRA can be converted into income to help defer claiming Social Security to maximize benefits.

Betterment, the automated investing service that manages $2.4 billion for 98,000 customers, said it too would update its advice engine to use newly available Social Security data, the robo-advice firm announced at the White House Conference on Aging this week.

Betterment will integrate the information—a digital version of the information in their monthly Social Security benefit statement—into RetireGuide, an advice engine that informs customers whether or not they are “invested correctly for a comfortable retirement.”

RetireGuide builds a savings and investing plan that encompasses all of an investor’s accounts, including those with other providers, and his or her spouse’s holdings. It uses Betterment’s globally diversified portfolio of index-tracking ETFs and asset allocation advice.

AXA’s UK pension fund uses longevity swap

Posted on July 16, 2015 by Editorial Staff -

In a swap deal with The Reinsurance Group of America (RGA), French insurance group AXA has insured the longevity risk on about half its UK defined benefit (DB) pension fund’s liabilities, IPE.com reported.

RGA will now take on £2.8bn ($3.9bn) worth of longevity in a swap deal arranged via the pension fund’s sponsoring insurer employer.

Reinsurance companies only deal with banks and insurance firms, with the pension fund able to leverage against its sponsor’s place in the market.

The longevity swap will now form part of the £3.6bn pension fund’s asset portfolio, with RGA providing income to the fund to protect it from the risk that its 11,000 participants will live longer than expected.

AXA becomes the fifth UK insurer to arrange longevity swaps for its own DB plan, as the UK market as a whole has hedged £53.4bn worth of longevity liabilities.

Insurers will be subject to additional capital requirements when Solvency II kicks in later this year, requiring companies to shore up longevity within their books and their own pension funds.

The AXA longevity swap is the first of 2015 after the £25.4bn record level of swaps seen in 2014. Last year also saw the first scheme access the reinsurance market without an intermediary firm – with Aviva aiding its pension fund to access the market directly.

This allows pension funds to save on costs and benefit from better pricing by avoiding price averaging, which occurs when intermediary insurers or banks engage with several reinsurers to spread credit and counterparty risks, as well as exposure limits. Four of the five deals in 2014 used this process.

Last July, the BT Pension Scheme dealt directly with the Prudential Insurance Company of America by setting up its own insurance company in a £16bn longevity swap.

Towers Watson, which advised the BT scheme and went on to create an insurance cell for smaller pension funds to access the market, also advised the AXA pension fund.

Conversions of pensions to lump sum payments are banned

Posted on July 16, 2015 by Editorial Staff -

In an unexpected move last week, the IRS and Treasury Department acted to ban the commutation of pension annuities into lump sums, asserting that a liquidity option would inevitably result in a reduction of the guaranteed monthly payout.

“If a participant has the ability to accelerate distributions at any time, then the actuarial cost associated with that acceleration right would result in smaller initial benefits, which contravenes the purpose of § 401(a)(9),” the agencies said in Notice 2015-49.

The new amendments to existing regulations “provide that qualified defined benefit plans generally are not permitted to replace any joint and survivor, single life, or other annuity currently being paid with a lump sum payment or other accelerated form of distribution.”

As background, the agencies wrote: “A number of sponsors of defined benefit plans have amended their plans to provide a limited period during which certain retirees who are currently receiving joint and survivor, single life, or other life annuity payments from those plans may elect to convert that annuity into a lump sum that is payable immediately. These arrangements are sometimes referred to as lump sum risk-transferring programs because longevity risk and investment risk are transferred from the plan to the retirees.”

“Under the regulations, a defined benefit pension plan cannot permit a current annuitant to commute annuity payments to a lump sum or otherwise accelerate those payments, except in a narrow set of circumstances specified in the regulations, such as in the case of retirement, death, or plan termination.”

Risk-transfers that were arranged before July 9, 2015 would not be affected by the ruling.

Investments + Annuities = Healthy Retirement

Posted on July 15, 2015 by Kerry Pechter -

Some Americans have saved so much for retirement that they don’t need an annuity, while many others have saved so little that they can’t afford to tie up any of their money in an annuity. In between, however, are millions of retirees who could probably “maximize their utility” by holding a mix of investments and annuities.

Two recent articles by major retirement researchers offer fresh ammunition to advisers who believe that a combination of annuities and investments (sometimes separately, and sometimes within the same bundled product) could give many of their clients the most income and the most peace-of-mind in retirement.

Mark Warshawsky’s paper is called “Government Policy on Distribution Methods for Assets in Individual Accounts for Retirees Life Income Annuities and Withdrawal Rules.” Meanwhile, the prolific Wade Pfau and Michael Finke have co-authored an article, “Reduce Retirement Costs with Deferred Income Annuities Purchased Before Retirement” in the July issue of the Journal of Financial Planning.

Although they both advocate annuities, these two articles approach the retirement financing problem differently. Warshawsky think it would be good public policy to prescribe a ladder of immediate annuities, plus investments, to retirees in general. Pfau-Finke demonstrate that buying a deferred income annuity, up to 20 years before retirement, can buffer a retired couple’s longevity risk and market risk.

But both articles offer useful starting points for advisers who are curious about embedding a guaranteed income product into their clients’ retirement portfolios. The articles will appeal to advisers who aren’t satisfied with the 4% withdrawal rule, and who doesn’t want to fudge the risks of retirement by simply assuming that their clients will live to the average age and experience average market returns.

Annuity lamination plus investments

A blend of life annuities and withdrawals from an investment portfolio is recommended as the best policy not just for individual retirees but also as an exit strategy for participants in financially challenged public employee pensions, according to the paper by Warshawsky (right), which was published by the Mercatus Center at George Mason University.

Warshawsky’s name should be familiar to retirement mavens. A former Assistant Secretary of the Treasury official and director of retirement research at Towers Watson, he wrote Retirement Income: Risks and Strategies (MIT Press, 2011). He recently founded ReLIAS LLC, a retirement consulting firm. Mark Warshawsky

In the new paper, Warshawsky works toward his conclusions about the advisability of a hybrid annuity-systematic-withdrawal de-accumulation plan by first comparing Bengen’s famous 4% rule (perhaps the most-analyzed rule-of-thumb in financial history) with the purchase of a joint-life immediate annuity with a 50% continuation of the benefit for the surviving spouse.

In isolation, each method has significant drawbacks, Warshawsky found. The 4% solution fails to protect fully against longevity risk; the immediate annuity fails to protect against inflation risk. So he recommends a compromise: Retirees should put part of their money in a ladder of annuities and the rest in a diversified investment portfolio.

In an interview with RIJ, Warshawsky said he envisions the ladder as “a sequence of purchases of immediate life income annuities.” That, along with a “fixed percentage distribution from investment portfolio provide the flow of income to the retired household. The specifics of the sequencing and the percentage) would be customized to the preferences, goals and resources of each retired household.”

Warshawsky is aiming at public policy recommendations, not just for individuals but also for the legions of workers in underfunded local public pensions. He advises cash-strapped municipalities to resolve their crushing pension liabilities with lump-sum buyouts that would be invested for each participant in a “structured account.”

The lump sum would not be for the full present value of the pension, but something more affordable for the municipality. As for the structured account, it would be a “mix of systematic withdrawals from a dynamic portfolio of a mix of asset types, and gradual laddered purchases of immediate life annuities.”

Dedicate half your bond allocation to a DIA

While Warshawsky leans toward immediate annuities as the raw material for his partial annuitization strategy, other researchers have been looking at the use of a newer type of lifetime income generator: the deferred income annuity, or DIA.

Writing in the July issue of the Journal of Financial Planning, Pfau, a professor at The American College, and Finke (left), who teaches at Texas Tech University, try to calculate whether, or under what circumstances, a 65-year-old couple could lower their cost of retirement at age 65 by substituting a DIA for half of their portfolio’s bond allocation.

Michael Finke The authors use a lot of computing power to test this proposition under a wide range of possibilities: 50,000 different ages of death for the second-to-die; 50,000 sequences of asset returns; a DIA purchase date at age 45, 55 or 62; and 11 different overall stock allocations, from zero to 100%. The DIA is a joint-life contract with a 10-year period certain and a return-of-premium benefit if neither spouse survives to the income start date.

The tables they generated, which are reprinted in the journal, showed that the savings from using the DIA peaked when it was purchased at age 45, when the allocation to the DIA was 35% to 45% of the original assets, and when the total cost of retirement was high (i.e., when longevity was great and market returns were unfavorable). The maximum savings was about 11%.

In other words, the insurance did exactly what it was supposed to do: protect against calamity (long life, poor returns). It had the least value—in hindsight, as it were—when the owners had short lifespans, enjoyed bull markets, and maintained either a very high or very low allocation to stocks.

“A short-deferral DIA can be a valuable complement to a conventional portfolio withdrawal strategy,” Finke and Pfau conclude. “Similar to the benefit of allocating bonds to single premium immediate annuities, this analysis shows that a short deferral DIA that provides lifetime income can lower the cost of funding retirement by softening the financial blow of a long lifetime or poor market returns.

“The tradeoff is lower wealth for retirees who do not live as long; however, this loss is reduced by the return of premium if the client dies before income begins and the 10-year period certain feature.”

RetirePreneur: Laurence Kotlikoff

Posted on July 15, 2015 by Jenna Gottlieb -

What I do: I’m an economics professor at Boston University and I have conducted research on financial reform, personal finance, tax issues, Social Security, healthcare, pensions, saving, and insurance and other topics. I’m also the president of Economic Security Planning Inc., a company that makes and markets life-cycle personal financial planning software tools that determine how much households should spend and save and how they can safely raise their living standards in a host of ways, including optimizing Social Security benefit collection and retirement account contributions and withdrawals. Larry Kotlikoff preneur block

Who my clients are: Everyone in the country is a potential client. We target households directly and we also work with financial planners. We’re don’t market or advertise financial products. We license our software to individuals starting at $40 per license, and $200 for financial advisors.

My business model: Worry first about quality, second about glitz, and third about sales. Fortunately, I’m well paid by Boston University, so I’ve never had to rush products to market to meet personal bills.

Where I came from: I received my B.A. in Economics from the University of Pennsylvania in 1973 and my Ph.D. in Economics from Harvard University in 1977. From 1977 through 1983, I served on the faculties of economics of the University of California, Los Angeles and Yale University and spent a year working for the President’s Council of Economic Advisors. I joined BU in 1984.

My latest book: My 17^th book is “Get What’s Yours—the Secrets to Maxing Out Your Social Security Benefits.” It’s co-authored with personal financial columnist Philip Moeller and PBS NewsHour correspondent Paul Solman. Social Security is incredibly complicated and playing your cards right can mean tens of thousands of extra dollars. The book is a guide to getting every dollar of benefits you’ve paid for, while avoiding Social Security’s myriad gotchas.

My run for president: Politicians from both parties are slowly but surely driving our country broke. Our bureaucracy rivals that in Russia. We need to fix, for real and for good, our healthcare, Social Security, tax, and banking systems. In 2012, I laid out postcard length reforms at www.thepurpleplans.org hoping the presidential candidates would consider them. When politics-as-usual prevailed, I ran for president on the online Americans Elect platform. Unfortunately, after five months, the sponsors of this third party movement called it quits, which ended my candidacy. Running for president was a big step for an academic with little name recognition. I felt I owed it to my kids and all of our country’s children to reveal our nation’s true and truly desperate fiscal condition and how I and other economists think things should be fixed.

My entrepreneurial spirit: I got into economics because it uses theory and data to resolve real-world economic problems, whether at the level of the globe, the country, the household or the individual. My entrepreneurial spirit comes from a lot of places. But it’s primarily from the desire to help people and make economics relevant. Most economists spend their lives describing economic mistakes. I think my profession needs to prescribe economic solutions.

What I see ahead for retirement income: The baby boom generation is woefully ill-prepared for what may be tremendously long retirements. This is thanks to the demise of defined benefit plans, failure to join and contribute to defined contribution plans, the failure to save enough on one’s own, and the fact that Social Security, Medicare, and Medicaid are all broke on any reasonable present value calculation.

For its part, the financial industry is far too focused on selling expensive risky financial products. It sets replacement-rate saving targets that are miles too high and then lures people into buying high-yield, but also high-risk and high-fee, securities to make “their” target. There is little real interest in helping people safely raise their living standards. This is why I started my company and produce, with my dedicated colleagues, the software we sell.

The best retirement income plan for most people: Economists have worked on personal financial planning for over a century, starting with Yale’s Irving Fisher. Fisher properly explained that people want to smooth their spending power over time—good times and bad times. We economists call this consumption smoothing. It underlies every aspect of the theories of saving, investment, and insurance. In the retirement area, people need spending targets that are sustainable and ways to raise their living standards with no risk. These include working longer, downsizing homes, moving to states with lower taxes, getting Social Security’s best deal, considering Roth conversions, timing retirement account withdrawals—and the list goes on.

My view on robo-advisors: I obviously believe in the power of expert financial planning software to do enormous good. But quick and easy software is generally quick and dirty. People need to take planning their finances as seriously as dealing with their health. No one is looking for a three-minute annual health checkup; we need to be equally wary of quick software programs that are simply fancy sales tools. There is a huge conflict of interest in selling financial products and offering financial advice. This is why my company sells no products, recommends no one’s products, and takes no advertising. Our software also provides no investment advice. Instead, we do what I think all financial software should do, namely show clients how different types of investments and current spending behaviors will affect the level and spread of their future living standards and then let the client decide how to invest. Robo-advisors don’t solicit the large numbers of the inputs needed to produce intertemporal living standard risk-reward frontiers. Nor do they have the consumption-smoothing technology to make these calculations. I’d personally be very wary of anyone or anything telling me how to invest if they can’t show me the possible living standard implications—upside and downside with all factors, including all future taxes, taken into account.

My thoughts on the DoL fiduciary proposal: I think it’s appropriate—especially if the conveyor of investment advice is also selling financial products or otherwise benefiting from the amount and type of his/her client’s investments. In my view, there is financial advice/education/suggestions and then there are product sales. Providing both involves a huge conflict of interest; if you are going to do so, better you should do so in the role of a fiduciary.

My retirement philosophy: I think people should work as long as possible, smooth their living standard through time, take advantage of the many safe ways to raise their living standard, and not count on their risky investments paying off. This is the basis for my company’s product line.

Britain’s Exchequer Mulls an End to Tax Deferred Savings

Posted on July 15, 2015 by Kerry Pechter -

Britain’s Tory government got rid of one of the relics of the English “nanny state” when it ended mandatory annuitization of tax-deferred savings, effective last April. But apparently that was just one of its ideas for shaking up the retirement system like a dice cup.

In his summer budget, released last week, Britain’s chancellor of the exchequer said that the government would study the possibility of taxing most retirement contributions and allowing retirees to withdraw their incomes tax-free.

That’s how Individual Savings Accounts (ISAs) currently work in the UK, and it’s the way savings are taxed in another part of the old British Empire—in Australia’s “Superannuation” plan. It’s similar to the way Roth IRAs and Roth 401(k)s work in the U.S.

Ironically, in the U.K. a conservative wants to roll back tax deferral, while only the liberal Obama administration has dared to mention it in the U.S. In both countries, most of the tax subsidy for savings, which amounts to about $100 billion a year, goes to the highly-compensated, who can afford to take full advantage of it. Some of that money comes back to the government later, when distributions are taxed.

Chancellor of the Exchequer George Osborne said that any changes to the tax system “would aim to encourage people to save more for retirement,” the Financial Times reported. Advocates of the changes say that it would simplify an overcomplicated system.

A Times columnist, Chris Giles, praised the idea in today’s paper, but raised concerns. “A switch would add some complications to the tax treatment of employer contributions to the remaining defined benefit pension schemes,” he wrote.

“A switch would also take years to implement because pension savings which have already attracted tax relief would still be liable to taxation when it is received. More importantly, the move to abolish tax relief on pension contributions would bring forward huge amounts of tax revenues, flattering the public finances by possibly in excess of £40bn ($60bn) a year.”

According to the 2015 Budget document:

Possible Roth-style savings. “The government is… consulting on whether there is a case for reforming pensions tax relief to strengthen incentives to save, offering savers greater simplicity and transparency, or whether it would be best to keep the current system. The government is interested in views on the various options [ranging] from a fundamental reform of the system (for example moving to a system which is “Taxed-Exempt-Exempt” like ISAs and providing a government top-up on pension contributions) to less radical changes (such as retaining the current system and altering the lifetime and annual allowances).”

Easier transfers. “The government will consult before the summer on options aimed at making the process for transferring pensions from one scheme to another quicker and smoother, including in relation to any excessive early exit penalties. If there is evidence of such penalties, the government will consider imposing a legislative cap on these charges for those aged 55 or over.”

Secondary market for annuities. “The government wants existing annuity holders to have the freedom to sell their annuity income. The government will set out plans for a secondary annuities market in the autumn, and agrees with respondents to the recent consultation that implementation should be delayed until 2017 to ensure there is an in-depth package to support consumers in making their decision.”

Fixed tax-break on savings. “The government is committed to supporting savers at every stage of their life. From April 2016 the government will deliver a major reduction in the level of tax on savings with the introduction of the Personal Savings Allowance, which will exempt the first £1,000 of savings income from tax for basic rate taxpayers and the first £500 for higher rate taxpayers.”

Reaction from UK pensions sector

A shift in the taxation of pensions could have far-reaching effects on the British retirement industry, according to media reports. “By treating pensions more like ISAs, the changes would further erode the distinction between retirement savings and regular investments,” the Times reported.

“That could open the market up to investment houses including BlackRock and digital platforms such as Hargreaves Lansdown, which are already set to benefit from new pensions freedoms.”

The UK pensions industry expressed alarm over the news of the possible change. In an article in The Actuary, benefits consultant Hymans Robertson warned that “such a move would increase costs for defined benefit schemes, resulting in up to 250 closing in the next nine months, cut defined contribution pension pot sizes and ‘potentially lead to a collapse in retirement savings.’”

The retirement industry in the UK is still digesting the termination of mandatory annuitization, a move that has halved the sale of individual income annuities in half. The investment industry, meanwhile, is dealing with the impact of Retail Distribution Review, which capped fund management charges and banned commissions on many products sales.

Phil Loney, chief executive of Royal London, Britain’s biggest mutual life and pensions group, questions the plan. “Long-term saving is better served by giving people tax relief upfront,” he told the Times.

He suspected that Osborne budget was an attempt to bring in a windfall of tax revenues now instead of later. “You kick tax relief 30 years hence and you make a significant impact on the budget today,” he said.

The 2015 budget proposal also raised taxes on dividend income, treating it as ordinary income. It would also reduce the amount of money that high earners could defer to retirement accounts by one pound for every two pounds they earn over £150,000. The maximum deferral is currently £40,000 ($62,526). The deferral would drop to a minimum of £10,000 for those earning £210,000.

On another front, the Association for British Insurers reported that British retirees are exercising the new access to their money that the end of mandatory annuitization has given them. Almost a quarter of a million payments worth £1.8 billion were made to about 85,000 customers from retirement accounts in April and May, according to new figures published today by the Association of British Insurers.

In the same period £1.3 billion was put in to buying nearly 22,000 regular income products, with over 50% of this going into income drawdown (systematic withdrawal) products rather than annuities. In 2012, when annuity sales were at their peak, over 90% of the total value of sales were annuities. Less than 10% of total sales were income drawdown sales.

In a press release, Huw Evans, director general of ABI, said this week: “We strongly welcome a full review of how to strengthen the tax incentives to help people save more for their retirement. Pension providers share the Chancellor’s concern that Britain isn’t currently saving enough and have been calling for this review for some time. We will be keen to actively contribute to this consultation, including highlighting the risks of a workplace ISA replacing pensions.”

Northwestern Mutual offers dividend-paying QLAC

Posted on July 15, 2015 by Editorial Staff -

Northwestern Mutual has launched a QLAC (qualified version) of its deferred income annuity, which gives policyholders a chance of rising income in retirement through the accrual of dividends—the same steady dividend that the mutual insurer has been paying its life insurance policyholders since 1872.

The new product is the QLAC version of the insurer’s Select Portfolio Deferred Income Annuity (Portfolio DIA). It works the same way the non-QLAC version works: In exchange for a lower guaranteed payout than a conventional DIA would offer, the policyholder benefits from Northwestern Mutual’s dividend, which will be 5.6% in 2015. The dividend accrual is the key to this product.

The annuity owner gets a partial dividend at first, but it rises during the deferral period, eventually reaching the full amount. Each year, the owner can choose either to use the dividend to buy more income or he or she can take it in cash. The dividend is paid out every year, eventually diminishing in amount because income distributions gradually reduce the base on which the dividend payout is calculated.

“You get prorated into the dividend,” said Greg Jaeck, director of Annuity Product Development at Northwestern Mutual. We try to protect our existing policyholders. If we were to give new policyholders the full dividend from the start, the current policyholders would be subsidizing the new policyholders.”

What you get, surprisingly, is a contract that reproduces some of the features—and a bit of the complexity—of the variable-annuity-with-guaranteed-lifetime-withdrawal-benefit rider that was so popular between 2006 and 2011, but one that uses a fixed income annuity chassis instead of a mutual fund chassis.

Instead of a roll-up in the benefit base and step-ups in the account value, the Select Portfolio DIA offers the dividend. Where the VAs, in some cases, allowed optional cash distributions (up to a point) that didn’t necessarily affect the guaranteed minimum payout, the Select Portfolio allows the policyholder to spend or reinvest take any portion of the dividend. Policyholders who choose the deferral period death benefit option can also change the terms of their contract if they wish.

All this flexibility is great, but it makes it difficult to assess this product’s value proposition without very close study. Essentially, it entails a bet that Northwestern Mutual will keep paying a healthy dividend, that the dividend will grow as prevailing interest rates rise, and that this product will produce more lifetime income, with more liquidity, than a straight fixed-payment DIA would.

Let’s consider a hypothetical. Northwestern Mutual’s product literature (see illustration below; click to enlarge) offers the example of a 50-year-old man who pays a $250,000 premium (the minimum is $10,000) for a life contract with a 10-year period certain and a return-of-principal death benefit during the deferral period. He plans to retire at age 65. [For a QLAC, maximum premium would be $125,000; assume that all the numbers in the example are halved.]

In this hypothetical, the policyholder has a guaranteed minimum annual income at age 65 of $14,720. That’s about half of the guaranteed rate he would receive if he bought a straight deferred income annuity with the same specs, according to the calculator at immediateannuities.com. Not so great, you might say.

But the picture looks better when you include the dividends. According to the illustration, the compounding of principal, interest and dividends over a 15-year deferral period would generate an estimated income of $31,465 at age 65. In this case, the policyholder has chosen to take $10,000 in cash and $21,465 as guaranteed income. Total income peaks between ages 85 and 90.

The liquidity of the product is quite unusual. “If the policyholders need access to some or all of the dividend, they can take 100% in cash, prior to cash date,” Jaeck told RIJ in a phone interview. He added that the dividend, which could be expected to grow if interest rates grow and the insurer’s profits rise, also provides protection from interest rate risk. “We often hear the question, ‘Do I have to lock in a rate?’ With this product, you’re not locking in a rate.”

Northwestern Mutual’s first DIA, issued in 2012, was only for qualified money, so a QLAC fits into its business plan. So far, about 75% of the company’s deferred income annuity sales were made with qualified money and 25% with non-qualified. “We have a 19% market share, and we’re second in DIA sales in the career channel,” Jaeck said. “According to LIMRA, we did $113 million in the first quarter of 2015 and $146 million in the fourth quarter of 2014. MassMutual did $53 million in the first quarter of this year and $95 million in fourth quarter of last year.”

QLACs were made possible by Treasury Department rulings in 2014 that resolved an obstacle to the use of tax-deferred money to purchase a deferred income annuity with an income start date after age 70½. The problem was that owners of qualified accounts have to start taking annual distributions from those accounts at that age.

But, a year ago, Mark Iwry, an assistant Treasury Secretary, announced that people could buy deferred income annuities with a start date after age 70½ and defer required distributions (and the taxes due on them) on the premium amount until they began receiving the money. They could wait to begin receiving the money until as late as age 85. Treasury restricted the purchase premium of a QLAC to the lesser of $125,000 or 25% of an individual’s tax-deferred savings.

Data Connection

Lists*