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End of forced annuitization creates product vacuum in UK

Posted on January 22, 2015 by Editorial Staff -

With only three months to go before annuitization becomes optional for retirees from British defined contribution (DC) plans, European asset managers are thinking a lot about affordable products that might help retirees tap their savings, according to Cerulli Associates’ European Defined Contribution Markets 2014 report.

But they haven’t gotten very far in developing those products. “Widely accessible drawdown or equity income strategies are still a ‘work in progress’ for Europe’s investment managers,” a Cerulli release said.

A 2013 ruling by the Chancellor of the Exchequer ended the UK’s policy of requiring most DC participants to annuitize any unspent tax-deferred savings by age 75, effective this spring. Most people bought their annuities from the “preferred provider” chosen by their DC plan providers, rather than shop for more competitively priced contracts in annuity exchanges.

That ruling has triggered a big drop in the percentage of asset managers who say their plans will offer period-certain or life annuities from preferred providers in the future. Only 8.3% of managers surveyed intended to do so. About one in five managers said their plans offer those types of annuities today.

The Cerulli report covered the opinions of DC asset managers with combined pension assets of more than $1.4 trillion. “Affordable drawdown products” was their biggest concern. Cerulli surveyed the managers in September 2014.

The end of forced annuitization doesn’t mean that retirees will stop buying annuities entirely, said Cerulli’s European research director, Barbara Wall. “This is a notable decline, but the annuity is far from dead,” she said in the release.

“Many retirees in the United Kingdom and on the Continent will still want some certainty of income. For many that will make annuitization attractive. Swiss retirees do not have to annuitize, for example, but most still choose to do so.”

Optional annuitization is also being discussed in the Netherlands. “Continental asset managers will be eyeing the whiteboards of their UK rivals when it comes to retirement phase products,” the Cerulli release said.

Pershing to roll out enhanced DC platform for plan distributors

Posted on January 22, 2015 by Editorial Staff -

Hoping to attract broker-dealers, investment advisors and registered investment advisors (RIAs) who want to expand their defined contribution retirement plan business, Pershing LLC, a unit of BNY Mellon, says it will roll out a new Retirement Plan Network solution during the first quarter of 2015.

The Retirement Plan Network is “an open-architecture platform that allows advisors to connect to independent recordkeepers, hold assets in custody, and to leverage an integrated suite of investment products, retirement plan tools and practice management solutions,” according to a Pershing release.

The opportunity for growth in the DC business is significant, Pershing noted. Currently at about $6.6 trillion, DC assets are expected to increase by five to six percent per year through 2019, Pershing said. Rollover IRA assets are expected to exceed $11.5 trillion by the end of the decade, as investors change jobs or retire and roll money out of DC plans.

The Retirement Plan Network is intended to give advisors access to:

Independent recordkeepers, including Allen, Gibbs & Houlik, L.C.; Aspire Financial Service; Benefit Consultants Group; DailyAccess Corporation; July Business Services; and Sentinel Benefits & Financial Group.
A variety of managed investment models featuring mutual funds, stable value funds and exchange-traded funds (ETFs).
Tools and solutions that can be used to create proposals, view plan investments, conduct investment reviews, facilitate IRA rollovers, select recordkeepers and access plan sponsor and participant education materials.

In one lifetime, median U.S. age will jump from 28 years to 42

Posted on January 22, 2015 by Editorial Staff -

The president and the 114^th Congress should focus in the next two years on addressing the needs of an America whose average age continues to rise, according to a call-to-action from the 18,000-member American Academy of Actuaries.

“A concerted national strategy on policies to support systems such as retirement security and lifetime income, health care and long-term care for the elderly, and public programs such as Social Security and Medicare, is long overdue,” the organization said in a recent release.

“The demographic transition of proportionately greater numbers of Americans entering retirement, coupled with increased longevity, or life expectancies… will compound the fiscal challenges to both private systems and public programs in the years to come,” the release said.

The U.S. median age in 2015 will be 37.8, up from 28.1 in 1970, and will rise to 42 in 2045, the actuarial organization said, citing U.S. Census Bureau estimates.

To address the needs created by an aging population, the administration and Congress should:

Address solvency concerns of key public programs like Social Security and Medicare to ensure that they are sustainable in light of changing demographics. The Academy also urges action to allow the disability trust fund to continue to pay full scheduled disability benefits during and beyond 2016.
Evaluate and address the risk of retirement-income systems not providing expected income into old age, especially in light of increasing longevity. The Academy’s Retirement for the AGES initiative provides a framework for evaluating both private and public retirement systems, as well as public policy proposals.
Encourage the use of lifetime-income solutions for people living longer in retirement. The Academy’s Lifetime Income initiative supports more widespread use of lifetime-income options.
Improve the governance and disclosures regarding the measurements of the value of public-sector (state/municipal) employee pension plans. The Academy’s Public Pension Plans Actuarial E-Guide provides information on the nature of the risks and the complex issues surrounding these plans.
Evaluate the relative health level of older Americans and those with disabilities, and assess the ability of Medicare and other public and private programs to meet those needs. The Academy is conducting an examination of the drivers of health care costs; Medicare, Medicaid, and private-sector payment and delivery system reform; quality of care metrics; and other issues through its Health Care Cost/Quality of Care initiative.
Explore solutions to provide for affordable long-term care financing, and address caregiver needs and concerns through public and/or private programs.
Address the impact of delayed retirement, either voluntary or through future retirement age changes, on benefit programs, as well as the needs it may create with increased demand for early retirement hardship considerations and disability income programs.

Let’s Concentrate on Recordkeeping

Posted on January 15, 2015 by Kerry Pechter -

Two days before last Christmas, New York Life became the latest big service provider to quit the world of defined contribution recordkeeping, when it sold its 401(k) plan services business (1,400 plans, $42 billion in assets in 2013) to ManuLife’s John Hancock division for an undisclosed sum.

The pace of consolidation in the DC business, which tends to run in cycles, has accelerated lately. In April 2014, mega-bank JP Morgan decided to sell its retirement plan services business (856 plans, $171 billion in assets) to Great-West Financial. Overall, there were 13 major industry moves last year, according to Fred Barstein of NAPA.Net.

Declining profits drive some companies to sell, while a quest for scale drives others to buy. But observers cite other factors, some familiar and some new: Litigation and regulation, technology expenses, the rise of indexing and target date funds, the “commoditization” of recordkeeping and the undertow of Boomer savings from 401(k) s to IRAs.

“Recordkeeping seems to go through these waves of consolidation every 10 to 12 years,” said long-time retirement industry watcher Nevin Adams of NAPA.Net. “Each time, everybody says, ‘This is it; one more wave and we’ll be down to a handful of large, national providers.’ Then things quiet down, time passes and we repeat the process.”

The immediate impact is that a concentrated industry—a mere 20 providers administer almost 90% of America’s DC savings—is likely to get more concentrated. In the long run, some predict—and hope—that we’re headed toward a new, more transparent era of paying for plan administration directly with flat fees rather than indirectly through asset-based fees, but it’s still too early to tell.

A game of concentration

The DC recordkeeping business, like the banking, insurance and mutual fund businesses to which it is a handmaid, consists of a few superstars and thousands of role players. That was true even before the 2013-2014 round of consolidation got started.

The chart at the right (data from PlanSponsor magazine, June 2014) shows the top ten providers. In terms of overall assets ($1.3 trillion) and numbers of participants (16.6 million), Fidelity Investments has a commanding lead. Its pursuers included one giant rival fund complex (Vanguard), five big insurance companies, two mega-banks and a global HR consulting firm (Aon Hewitt).

Even before two top-ten players merged last spring, when Great-West bought JP Morgan’s retirement plan business, this business was concentrated. Fidelity alone controlled about a third of the assets. The top 10 accounted for 68% of the assets ($5.6 trillion), 58% of the participants and virtually all of the large plans. The top 20 control over 80% of the assets, 80% of the participants and half the 740,000 plans.

If that sounds like oligopoly, it merely reflects the concentration of employment in the U.S., where Fortune 500 companies traditionally employ about half of American workers and countless mid-sized and small companies employ the rest. The smaller DC recordkeeping companies focus on those smaller companies; Paychex, the payroll administration firm, administers the most plans, with 64,000.

This small world got even smaller in 2014, which ended with Toronto-based ManuLife’s John Hancock unit buying New York Life’s recordkeeping business ($42 billion in assets, 1.03 million participants, at the end of 2013). John Hancock now has $135 billion in plan assets, 2.5 million participants and 55,000 plans (second highest in U.S.). That deal followed the JP Morgan/Great-West deal, and two 2012 moves that saw Hartford sell to MassMutual and Aegon to fold its Diversified Retirement business into its Transamerica Retirement Solutions.

High costs and low margins drive firms out

There were micro and macro reasons behind all this activity. At the micro level, it made sense for New York Life to stop pouring money into new proprietary technology for its fussy large-plan clients, especially when it wasn’t capturing a lot of rollovers from its 401(k) plans. By reinsuring John Hancock’s in-force life insurance business, New York Life also expanded its capacity to issue more deferred income annuities, a fast-growing product niche that it dominates.

It also made sense for John Hancock to broaden its business by adding New York Life’s bundled (asset management and recordkeeping) large plans (1,600 plans averaging 640 participants and $26 million in assets per plan) to its mass of unbundled (using third-party administrators) smaller plans (55,000 plans averaging only 37 participants and $1.84 million per plan). The deal also helped broaden ManuLife’s business internationally.

But what macro trends are driving consolidation in DC administration? RIJ talked to a number of people in the business and got a variety of answers. The short answer was “shrinking profit margins” on the one hand and a reach for economies of scale on the other. The longer answer included a lot of specific reasons why some players are cashing in their chips while others are doubling down.

“Recordkeeping costs a lot, it’s complicated and, done properly, it’s relatively low-margin,” NAPA.Net’s Adams, a former editor of PLANSPONSOR magazine and executive at the Employee Benefit Research Institute, told RIJ. “Eventually it gets to a point where asset managers who were hoping for an expanded asset management opportunity aren’t getting as much of that opportunity as they thought they would and get tired of trying to keep up with the required investments in technology and people.”

A company’s ability to control the costs of recordkeeping, which means holding down the costs of technology, is apparently critical to its survival. Some companies build their own proprietary information systems, others buy systems and others outsource the heavy data lifting.

For those who build or buy, years of customization and piece-meal updates can result in an inefficient, expensive and ultimately unsustainable “Frankenstein’s monster” of a system, according to Peter Littlejohn, direct of strategic partnerships at InspiraFS, a Pittsburgh-based recordkeeper.

“Very few people make money in recordkeeping,” he said in a recent interview. “You make money on the investments. But when unit costs are going up because of customization, and regulation adds new compliance costs on the banks, and revenue from asset-based fees goes away, and you can’t control a larger percentage of the client’s wallet,” it doesn’t make much sense to stay in the business.

Revenue from asset-based fees is currently under pressure. Observers agree that new Department of Labor regulation on fee disclosure, the “excessive fee” litigation by the Schlichter law firm and others, perhaps coupled with rising competition from index funds and ETFs, has hurt margins by raising costs for some recordkeepers and making participants and plan sponsors much more conscious of fees.

“The 408(b)(2) plan disclosure regulation and the 404a-5 participant disclosure regulation were costly for recordkeepers—particularly initially, but also on an ongoing basis,” said Fred Reish, the well-known ERISA attorney at Drinker, Biddle & Reath. “In addition, 408(b)(2) regulation heightened awareness of recordkeeping fees and the revenue sharing they received and, as a result, probably negatively impacted their ability to price plans.

“Also, the DOL regulatory agenda includes the possibility of a ‘guide’ for 408(b)(2) disclosure, which would be expensive. Another example is the anticipated proposed regulation on projecting retirement income on participant statements. While that would likely be very helpful to the 401(k) industry, it will be expensive for the recordkeepers.”

James Holland, an independent fiduciary at MillenniuM Investment and Retirement Advisors in Charlotte, NC, thinks that fee disclosure requirements are having a gradual but persistent effect in driving down fees.

“The disclosure document traditionally provided minimal information, so nobody read them,” he told RIJ. “But now, you can see on the statement that you paid $2,000 in fees last year. So, after maybe the eighth time you’ve seen it, you mention to your colleague Jane that you paid $2,000 and she says, I only paid $200. Everyone was expecting an earthquake from fee disclosure, but I see the industry building toward a Malcolm Gladwell-type ‘tipping point.’”

Holland believes that the business model that involves covering the cost of administration by charging high asset-based fees on the investments is doomed. If so, firms that relied on it will leave the recordkeeping business. “Revenue-sharing is about to become a thing of the past, so some are shedding the administrative parts of their business to focus on other areas where they can make more money,” he said

Small company owners, whose core business is plan design and administration, like rural folk who see the summer crowd come and go, say they are accustomed to turnover among big companies who enter the recordkeeping business as a path to large asset pools without considering the risks or the complexities. Since these same big companies often underprice them to capture plan administration business, the small company owners aren’t very surprised when the venture fails.

“Insurance companies and brokerages tend to go in and out of the business over the years,” said Lawrence Starr, president of Qualified Plan Consultants Inc. in West Springfield, Mass. “When they aren’t in it, they think it’s an easy business and see all those dollars that they can capture. When they are in the business, somebody in the actuarial department figures out that their internal return on investment is not high enough and decides the company would be more profitable if it invested that money in, say, Greek reinsurance. So they get out.

“Five or ten years later, somebody in the company says, ‘Why aren’t we in that business? We ought to be; look how much money we can make.’ By that time, everyone previously involved in that business is gone, along with all the institutional memory as to why they got out in the first place. So, they decide to get back in somehow. And the cycle starts all over again. When two companies at different points in the above cycle get together… Whoosh! You get consolidation. I’ve watched this cycle now for over 30 years. It is as predictable as the sun rising in the morning.”

“Every insurance company has said, ‘There’s gold in them thar hills—let’s throw up a tent and bring in a lot of money,’” said Jeff Feld, a CPA and principal at Alliance Pension Consultants in Chicago. “The approaches they all took were different. Some retrofitted their annuity or life insurance people and tried to adapt them to retirement plans. Making money was easy because there was so much fat in the system. But, as in any maturing space, people eventually start to scrutinize the costs. The inability to make easy money is driving out those with less than ideal models and sending business to those with more ideal models.”

“Fee disclosure was the straw on the camel’s back, as it removed the ability to bundle services,” said Mark Fortier, who has held senior retirement plan positions at AllianceBerstein and State Street Global Advisors. “But on the service side of the 401(k) business, the [consolidation] trend had been ongoing for decades. Thin margins and the need for ongoing and large investment in technology and people has been the long-term driver.”

“Asset retention has been the elusive ‘Holy Grail’ for years as well, since it can turn thin to negative margins into positive. Another factor is risk. Insurers in particular have liked the service business because it is lower risk and requires less capital than, say, the variable annuity business. However, class action lawsuits that sweep in service providers remind them that it is not riskless.”

The elephant-in-the-room might simply be the fact that assets are steadily leaving the 401(k) system and going into retail IRAs, noted Littlejohn. That hurts recordkeepers that don’t have a strong rollover business; and if they don’t have one, they have little reason to build one. “When there’s outflow, you lose both the recordkeeping fee and the asset management fee. If your unit costs were too high on the institutional side, it’s not going to be any cheaper on the retail side,” he told RIJ.

Distributors may also be driving consolidation in recordkeeping. In a recent blogpost, NAPA.Net’s Fred Barstein divided the retirement plan providers into direct-sold firms (Vanguard and Fidelity) and advisor-sold firms, and said that as advisors are reducing the number of plans they do business with to “five or six” from “20 or more,” and that those five or six need expertise in serving plans of all sizes.

“The question now is whether the consolidation heats up,” he wrote. “Will those without a secure seat at the advisor sold DC table (defined by the ability to serve multiple markets and plan types) seek to acquire smaller fish?”

“The 401(k) industry is a maturing industry. It’s not uncommon for maturing industries to consolidate and to compete on price,” said Reish. “With the increased competition on price—as well as the ongoing focus that the Department of Labor and court cases have placed on costs—it’s not surprising that the smaller, more marginal recordkeepers are having difficulty competing—particularly when you consider the need for ongoing capital investment to keep up with other providers.”

Who will remain?

So who will stay in the recordkeeping business? According to Littlejohn, we can assume that the leading target date fund companies will stay in the recordkeeping business, because the certification of TDFs as qualified default investment alternatives in DC plans ensured that they will always earn asset-based fees in their plan administration business. A list of the top TDF providers, from a 2014 Morningstar report, overlaps quite a bit with the top DC recordkeeper list. (Voya was ranked twelfth and Great-West fourteenth on the Morningstar list.)

Vanguard and Fidelity, which market themselves directly to plan sponsors rather than through advisors or brokers, have, in addition to economies of scale and strong TDF offerings, strong IRA platforms for capturing rollovers. Vanguard has the added advantage of being the low-cost indexing leader at a time when low-costs and indexing are in ever-increasing demand.

Other firms, for one reason or another, dominate specific niches. Aon Hewitt, as a benefits consultant, and Xerox HR Services, a unit of the technology firm, serve the same large firms with the core businesses and their recordkeeping business. Each has an average of over 10,000 participants in their plans. TIAA-CREF has a secure niche in the educational market (part of the non-profit 403(b) plan market). Among the insurance carriers, OneAmerica (through its Paychex unit), Voya, Principal, John Hancock, Nationwide and MassMutual have tens of thousands of small and mid-sized plans.

In the long run, those with the greatest scale will endure, said Larry Kiefer of DST Systems, the IT firm. “I think size will matter in the end,” he said. ERISA attorney Tom Clark, who thinks the fee litigation has had a big impact on recordkeeping firms, agrees. “Those who invested in technology to get economies of scale and efficiencies will win,” he told RIJ. “Those who used revenue sharing to prop up their primary business and even secondary businesses will not win.”

“Consolidation will continue,” said Littlejohn. “Recordkeepers without fund families will also go out.” Reish said, “I suspect that the largest providers will be the consolidators and the smallest, most entrepreneurial recordkeepers will do relatively well. But that leaves the recordkeepers that are in middle in terms of size. They may be the most exposed and, therefore, the most likely to decide to sell.”

What Are We Betting On?

Posted on January 15, 2015 by Mohamed A. El-Erian -

When I consider the prospects for the global economy and markets, I am taken aback by the extent to which the world has collectively placed a huge bet on three fundamental outcomes: a shift toward materially higher and more inclusive global growth, the avoidance of policy mistakes, and the prevention of market accidents. Though all three outcomes are undoubtedly desirable, the unfortunate reality is that they are far from certain – and bets on them without some hedging could prove exceedingly risky for current and future generations.

The first component of the bet – more inclusive global growth – anticipates continued economic recovery in the United States, with a 3% growth rate this year bolstered by robust wage growth. It also assumes China’s annual growth rate will stabilize at 6.5-7%, thereby enabling the risks posed by pockets of excessive leverage in the shadow-banking system to be gradually defused, even as the economy’s growth engines continue to shift from exports and public capital spending toward domestic consumption and private investment.

Another, more uncertain assumption underpinning the bet on more inclusive growth is that the eurozone and Japan will be able to escape the mire of low growth and avoid deflation, which, by impelling households and businesses to postpone purchasing decisions, would undermine already weak economic performance. Finally, the bet assumes that oil-exporting countries like Nigeria, Venezuela, and especially Russia will fend off economic implosion, even as global oil prices plummet.

These are bold assumptions – not least because achieving these outcomes would require considerable economic reinvention, extending far beyond rebalancing aggregate demand and eliminating pockets of excessive indebtedness. While the US and China are significantly better placed than others, most of these economies – in particular, the struggling eurozone countries, Japan, and some emerging markets – would have to nurture entirely new growth engines. The eurozone would also have to deepen integration.

That adds up to a tough reform agenda – made all the more challenging by adjustment fatigue, increasingly fragmented domestic politics, and rising geopolitical tensions. In this context, a determined shift toward markedly higher and more inclusive global growth is far from guaranteed.

The second component of the collective bet – the avoidance of policy mistakes – is similarly tenuous. The fundamental assumption here is that the untested, unconventional policies adopted by central banks, particularly in advanced countries, to repress financial volatility and maintain economic stability will buy enough time for governments to design and deliver a more suitable and comprehensive policy response.

This experimental approach by central banks has involved the conscious decoupling of financial-asset prices from their fundamentals. The hope has been that more buoyant market valuations would boost consumption (via the “wealth effect,” whereby asset-owning households feel wealthier and thus more inclined to spend) and investment (via “animal spirits,” which bolster entrepreneurs’ willingness to invest in new plant, equipment, and hiring).

The problem is that the current economic and policy configuration in the developed world entails an unusual amount of “divergence.” With policy adjustments failing to keep pace with shifts on the ground, an appreciating dollar has assumed the role of shock absorber. But history has shown that such sharp currency moves can, by themselves, cause economic and financial instability.

The final element of the world’s collective bet is rooted in the belief that excessive market risk-taking has been tamed. But a protracted period of policy-induced volatility repression has convinced investors that, with central banks on their side, they are safe – a belief that has led to considerable risk-positioning in some segments of finance.

With intermediaries becoming reluctant to take on securities that are undesirable to hold during periods of financial instability, market corrections can compound sudden and dramatic price shifts, disrupting the orderly functioning of financial systems. So far, central banks have been willing and able to ensure that these periods are temporary and reversible. But their capacity to continue to do so is limited – especially as excessive faith in monetary policy fuels leveraged market positioning.

The fact is that central banks do not have the tools to deliver rapid, sustainable, and inclusive growth on their own. The best they can do is extend the bridge; it is up to other economic policymakers to provide an anchoring destination. A bridge to nowhere can go only so far before it collapses.

The nature of financial risks has morphed and migrated in recent years; problems caused by irresponsible banks and threats to the payment and settlement systems have been supplanted by those caused by risk-taking among non-bank institutions. With the regulatory system failing to evolve accordingly, the potential effectiveness of some macro-prudential policies has been undermined.

None of this is to say that the outlook for markets and the global economy is necessarily dire; on the contrary, there are notable upside risks that could translate into considerable and durable gains. But understanding the world’s collective bet does underscore the need for more responsive and comprehensive policymaking. Otherwise, economic outcomes will remain, as former US Federal Reserve Chairman Ben Bernanke put it in 2010, “unusually uncertain.”

NAFA Throws a Hail Mary on QLACs

Posted on January 15, 2015 by Kerry Pechter -

Baffled. That’s how I felt after reading the letter that the National Association for Fixed Annuities has apparently sent to the Treasury Department asking that indexed annuities receive so-called QLAC status. George Bostick and Mark Iwry, the Treasury officials to whom the letter was addressed, are probably going to feel something similar.

The letter, which was signed by NAFA president and CEO Kim O’Brien and vetted by a respected authority on indexed annuities, isn’t likely to be persuasive. It just doesn’t make a whole lot of sense. Here’s a link to the letter. You can decide for yourself.

There are good reasons why deferred indexed annuities and variable annuities won’t ever be qualified longevity annuity contracts (QLACs). The QLAC regulations that the Treasury Department announced last year were intended to solve a specific problem: Near-retirees and retirees couldn’t use qualified money to buy deferred income annuities whose income streams started after age 70½. Why? Because DIAs are illiquid, and owners had no way to take required minimum distributions (RMDs) from them.

Deferred VAs and FIAs don’t suffer from that problem. As currently sold, they produce income through guaranteed lifetime income riders (GLWBs). Unless they’re annuitized—which never happens—they stay liquid. A person who buys them with qualified money doesn’t have to break the contract to comply with the RMD rule. So those products don’t need the regulatory relief that qualified DIAs needed. The QLAC rule specifically excludes annuities that have cash value.

Since the letter doesn’t mention DIAs or GLWBs at all, it’s hard to tell exactly what NAFA’s reasoning is. Maybe it wants Treasury to let its members sell FIAs that, like DIAs, require a commitment to annuitization by age 85. If they do, the letter doesn’t say so. (O’Brien received an interview request from RIJ, but responded, in real time, that “I am out this week.”)

Instead of talking about DIAs, NAFA focuses on declared rate deferred annuities and deferred variable annuities. “Fixed annuities with a set interest rate are eligible to be qualified longevity annuity contracts (QLACs), but fixed annuities with an indexed rate are not,” the first paragraph of the letter said.

That isn’t true—“declared rate deferred annuities,” which are safe accumulation vehicles like CDs, have nothing to do with the QLAC rule. NAFA also attacks variable annuities as unworthy of QLAC status because they’re risky, without acknowledging that it’s the reliance on the liquid GLWB riders (complex, non-standardized riders) to create income that makes the QLAC rule irrelevant to both FIAs and VAs, as currently sold.

Not entirely trusting my own interpretation of the letter—the tax and annuity fields are landmined with Rumsfeldian “unknown unknowns”—I emailed copies to three people on whom I rely on for their annuity expertise. They were as baffled by the letter as I was. “Though NAFA in this letter establishes that an FIA provides a substantially equal lifetime income payment to the contract owner,” one wrote back, “it does not address one fundamental requirement of the regulations, irrevocability of the qualified assets being used to fund the QLAC.”

This letter sounds like a “Hail Mary” pass, and it is. Liquidity is the main selling point of deferred annuities that produce income through GLWBs, and no annuity product can have liquidity and QLAC status at the same time.

NAFA isn’t responding to questions, so we don’t know exactly what they’re thinking. O’Brien referred me to three NAFA members, but they haven’t responded either. The other person whom I know worked on the letter declined to comment. Since the letter is already public, they may prefer to let it speak for itself. And it does. As one of my readers wrote, “There is only one opportunity to make a good first impression and they may have blown it. Their only chance is to follow up with an appropriate product.”

MetLife sues FSOC over “SIFI” designation

Posted on January 15, 2015 by Editorial Staff -

MetLife has filed a civil suit against the Financial Stability Oversight Council in U.S. District Court, District of Columbia, contesting the FSOC’s designation of the giant publicly-held global insurance company as a non-bank “systemically important financial institution” or (SIFI).

The SIFI designation is both a curse and a blessing. It raises capital requirements and other profit-reducing restrictions on designated companies to make them safer, because their failure could jeopardize the entire U.S. financial system. On the positive side, it implies that the company will never be allowed to fail.

MetLife has long argued that the SIFI restrictions are designed for banks, and are inappropriate for insurance companies, however large, because their risks are fundamentally different from banks, and because insurers are already tightly regulated by the individual states in which they do business.

Prudential Financial and AIG are the only other insurers to have been designated as SIFIs by the FSOC.

The lawsuit claims that “The traditional business of life insurance in which MetLife engages differs dramatically from the traditional business of banking. In general, banks borrow short term and lend long term—for example, by taking liquid, short-term deposits and wholesale funding and investing in illiquid long-term assets, such as commercial loans.

“In contrast, life insurers generally write long-term policies and invest premium dollars in long-term assets to make good on those obligations when they come due…. Because life insurers do not depend as banks do on short-term deposits and short-term wholesale funding, they are not subject to the “run” risks (and corresponding liquidity crises) to which banks are subject.”

On the issue of the damage that the SIFI designation could do to MetLife as a business, the lawsuit says, “An empirically-based estimate shows that the annual consumer cost of applying additional capital requirements to nonbank SIFI and thrift-owning insurers could be as great as $8 billion, depending on the capital requirements applied…. In particular, it has been estimated that imposing bank-centric capital requirements on MetLife would require the Company to raise its capital reserves by tens of billions of dollars, ultimately harming consumers.”

GAO recommends changes to “automatic rollover” practices

Posted on January 15, 2015 by Editorial Staff -

Reflecting a concern among some legislators about “leakage” from defined contribution plans and its potential damage to individual retirement security, the U.S. Government Accountability Office (GAO), made public a research report in late December, “401(K) Plans: Greater Protections Needed for Forced Transfers and Inactive Accounts.”

GAO found that when small (under $5,000), forgotten or neglected accounts held by former employees are forced out of 401(k) plans and rolled over to IRA custodial accounts, the IRAs tend to lose value over time because the returns from the safe investments that, by law, the forced-out assets must be placed in.

GAO also discovered that a plan can force out an account with a balance of, for instance, $20,000 if less than $5,000 is attributable to contributions other than rollover contributions.

GAO recommended that Congress consider amending current law to permit alternative default destinations for plans to use when transferring participant accounts out of plans, and repealing a provision that allows plans to disregard rollovers when identifying balances eligible for transfer to an IRA.

Among other things, GAO also recommends that DOL convene a taskforce to explore the possibility of establishing a national pension registry. DOL and SSA each disagreed with one of GAO’s recommendations, but GAO said it maintains the need for all its recommendations.

In its research, GAO reviewed policies regarding forced transfers of inactive accounts in six countries policies in six countries, including the U.K., Australia, Switzerland, the Netherlands, Denmark and Belgium.

Officials in two countries told GAO that inactive accounts are consolidated there by law, without participant consent, in money-making investment vehicles. Officials in the United Kingdom said that it consolidates savings in a participant’s new plan and in Switzerland such savings are invested together in a single fund.

In Australia, small, inactive accounts are held by a federal agency that preserves their real value by regulation until they are claimed. In addition, GAO found that Australia, the Netherlands and Denmark have pension registries, not always established by law or regulation, which provide participants a single source of online information on their new and old retirement accounts.

Independent advisors will manage more than wirehouses by 2019: Cerulli

Posted on January 15, 2015 by Editorial Staff -

The combined asset market share of the independent advisory channels will surpass the wirehouse marketshare in the next 5 years, according a new report, Advisor Metrics 2014, from Cerulli Associates, the Boston-based global analytics firm.

“More than two-thirds of advisors indicate they would prefer the independent broker/dealer, registered investment advisor, or dually registered models if they decided to leave their current firms,” said Cerulli associate director Kenton Shirk in a release.

Advisors like the flexibility, autonomy and economics of being independent, Shirk said. “Payouts are higher and advisors become responsible for their own overhead decisions. Independent advisors can build long-term enterprise value.”

The Advisor Metrics 2014: Capitalizing on Transitions and Consolidation report focuses on advisor trends and consumer information, including market sizing, advisor product use and preferences, and advice delivery, Cerulli said.

“Many independent broker/dealers and custodians have sufficient scale to offer broad and deep service offerings,” said Shirk, noting that access to practice management resources, financial planning support, and investment research—where wirehouse advisors used to have an edge–are now readily available to independent advisors.

Cerulli expects the wirehouse and independent broker-dealer channels to lose “significant asset market share” to RIAs and dually-registered advisors over the next five years.

Another longevity reinsurance deal for Prudential Retirement

Posted on January 15, 2015 by Editorial Staff -

Prudential Retirement, a unit of Prudential Financial, announced this week that it will reinsure the longevity risk of eight pension plans managed by Rothesay Life Limited and its affiliates. The transaction marks Prudential Retirement’s fifth longevity reinsurance deal since 2011 with Rothesay Life and the second in the past six months, according to a release.

The transaction covers longevity risk associated with pension liabilities of $450 million (about 288 million Pounds Sterling) for some 25,000 retirees and deferred members in the U.K.

In August 2014, Prudential announced a $1.7 billion (about 1 billion Pounds Sterling) transaction covering 20,000 annuitants. The Rothesay transactions followed Prudential’s agreement in July to reinsure $27.7 billion of longevity risk associated with BT Pension Scheme liabilities.

Security Benefit adds high-dividend stock index to fixed indexed annuity

Posted on January 15, 2015 by Editorial Staff -

Security Benefit Life has added one-year and two-year interest crediting options based on the BNP Paribas High Dividend Plus Index (HD Plus Index) to its Total Value Annuity (TVA), the company announced this week.

The HD Plus Index is made up of high-dividend stocks, chosen through a “rules-based” strategy that adds “yield-enhancement” and “risk-reduction” overlays to a dividend-focused stock portfolio, according to Security Benefit.

Every month, the HD Plus Index tries to buy stocks it expects to pay strong, consistent dividends. On average, the HD Plus Index is comprised of 75 to 80 highly liquid, non-financial U.S. stocks. The Index also aims for a targeted volatility rate of 6%—about half the S&P500’s historical volatility—through actively adjusted cash exposure.

Illinois Mandates Workplace Retirement Plans

Posted on January 8, 2015 by Kerry Pechter -

After several years of fitful steps toward the establishment of mandatory state-sponsored IRAs by legislatures in a handful of “blue” states, one of those states—Illinois—has finally closed the deal. Its Secure Choice Savings Program was signed into law this week.

How the law will affect the market for retirement plan services in Illinois remains to be seen. Now that private-sector employers with 25 or more full-time employees must offer access to a retirement plan by June 1, 2017 (and workers must be defaulted into it), the question arises: Will employers comply by hiring private-sector service providers or simply use the new state-sponsored investment trust?

Brian Graff, head of the American Society of Pension Professionals and Actuaries, has expressed confidence, at least in reference to a similar program in Connecticut, that private sector providers will outcompete the state-sponsored program. “I guarantee that they will,” he told RIJ at the statehouse in Hartford, Conn., last March.

But it’s also possible that most employers will do the minimum that the new law obligates them to do, and merely tweak their payroll administration systems to allow automatic deferrals into the funds in the state-sponsored IRA. In that case, there would be little uptick in demand for private plan services.

That’s the business side of the story. On the policy side, state legislators Sen. Daniel Biss and Rep. Barbara Flynn Currie, who sponsored the Illinois Secure Choice Savings Program (SB2758), and lame-duck Governor Pat Quinn, the Democrat who signed it, will probably be satisfied if the bill achieves its goal of expanding retirement plan coverage in their state. Employers with fewer than 25 employers are encouraged but not required to use Secure Choice. Workers can opt-out of participation if they wish.

The Illinois Secure Choice Savings Program had support from some 60 labor-related and retirement-related groups in Illinois, including the Illinois Asset Building Group, the Heartland Alliance, the Woodstock Institute, the Sargent Shriver National Center on Poverty Law, SEIU Healthcare, and AARP Illinois.

Efforts to create similar state-sponsored retirement plans have been underway for some time in other Democratic-majority states, like California and Connecticut, where initiatives that help labor are most likely to get legislative traction. The federal government, with its MyRA and Auto-IRA programs, has made efforts of its own toward improving retirement plan coverage in the U.S., where only about half of full-time workers have access to a 401(k)-like program at any given time.

Retirement savings mandates, much like the employer mandates in the Affordable Health Care Act, have been controversial. Critics of such plans have variously said that they do too much or too little. Free marketers say they create redundant bureaucracies, crowd out private sector providers, and heap new costs on employers.

On the other side of the political divide, liberals say the plans’ default deferral rates are too low (3%, in Illinois’ case) to produce nest eggs big enough to generate adequate income in retirement and that they fall short by not requiring firms with less than 25 employees to offer plans. Despite the criticisms, the chronic low pension coverage in the U.S.—analogous to the incomplete health insurance coverage—has kept such efforts alive.

According to SB2758, all employers in Illinois must offer the program by June 1, 2017, if they have:

Operated for at least two years

At least 25 employees

No existing employer-based retirement plan

Unless their employers offer an employer-based plan, employees will be automatically enrolled in the state plan; however, they may opt out. All accounts will be pooled together and will be managed professionally.

There will be a 3% deduction from Secure Choice participants’ pay to be put into an IRA; however, participants will be able to adjust the percentage of their earnings that is set aside. Participants also can select an investment option from those the Illinois Secure Choice Savings Board makes available to them.

Employers participating in Secure Choice will be required to provide an open enrollment period at least once a year to allow employees who opted out of the program to enroll in it. This will be the only annual chance such employees have to do so, unless their employer allows them to do so earlier than that.

Employers that do not offer their own retirement plan and fail to offer Secure Choice will be subject to a penalty equal to either:

$250 for each employee for each calendar year or portion of a calendar year during which the employee neither was enrolled nor had opted out of it; or

For each calendar year beginning after the date a penalty has been assessed regarding an employee, $500 for any portion of that calendar year during which such an employee continues to be unenrolled without having opting out.

The Illinois Secure Choice Savings Board will oversee the program. Four of the board’s seven members will be appointed by the governor: two with expertise in retirement savings plan administration or investment, or both, and one each representing participating employers and enrollees.

Trial Date Set for “Excessive fee” Suit against Boeing

Posted on January 8, 2015 by Kerry Pechter -

Unless the parties settle before then, the lawsuit of Spano v. Boeing, one of the first “excessive fee” cases brought by retirement plan participants against a large American employer and retirement plan sponsor, will go to trial next spring—eight years after it was initially filed.

A May 20, 2015 trial date in U.S. District Court in East St. Louis was set after Boeing’s attorneys’ motions for summary judgments were either denied or partially denied last December 30, according to a report on The Fiduciary Matters blog by ERISA attorney Thomas E. Clark, Jr. this week.

“This decision reflects the pendulum that has clearly swung in the participants’ favor in recent years…,” Clark writes, noting that no one would have expected such a trend when Spano v. Boeing was filed. “Betting a dollar that a decision such as this would be likely someday would have been a waste of a perfectly good dollar.”

The fact that Spano v. Boeing has been allowed to proceed to trial is consistent, however, with a recent wave of legal judgments and decisions that have discredited common business practices in retirement plans—practices that in many cases resulted in participants paying high and in some cases even non-competitive prices for services they thought were free.

One of those practices is revenue sharing. It involves offering of mutual fund share classes with high fees in order to subsidize the cost of administering plans. In several class-action suits by participants against plan sponsors and plan providers in recent years, judges and juries have decided that sponsors and providers that practiced revenue sharing were violating the sponsors’ responsibilities to operate the plans solely in the interests of the participants.

The cases and related decisions haven’t outlawed revenue sharing. But they have shined light on it, showed that it is prone to conflicts of interest, and inspired plan sponsors to look for cheaper, more transparent and more fiduciary-minded ways to cover plan administration costs. That trend, in turn, has squeezed profit margins in the 401(k) service provider business and is said to be a factor in the recent decisions by some companies to sell their retirement plan services units.

In Spano v. Boeing, plan participants charged that:

Until 2006, Boeing selected and retained mutual funds as plan investment options that charged excessive investment management expenses and that Boeing used them to “funnel” excessive Plan recordkeeping and administrative fees to State Street/CitiStreet via revenue sharing.
The Small Cap Fund provided additional revenue sharing fees to State Street/CitiStreet and charged its investors 107 basis points per year in fees, which was grossly excessive, in order to benefit Boeing’s corporate relationship with State Street/CitiStreet.
Boeing failed to monitor and remove an imprudently risky concentrated sector fund, i.e. the Technology Fund, and instead retained this fund for the purpose of benefiting its corporate relationship, rather than for the sole benefit of the Plan Participants.
The Boeing Company Stock Fund incurred excessive fees and held excessive cash, impairing the value of the Plan assets. With regard to this fund, Plaintiffs also allege that Defendants failed to remedy the resulting transaction and institutional drag.

High Valuations Carry a Cost: Prudential

Posted on January 8, 2015 by Kerry Pechter -

The U.S. may be addicted to low interest rates, relying on them to prop up asset prices and feeling nervous about the potential pain of withdrawal. But at least industry executives are not entirely in denial about the problem. A new release from Prudential Financial speaks candidly—and soberly—about it.

The release reflected views expressed by panelists at the firm’s 2015 Global Economic and Retirement Outlook discussion. They expect “uneven” global growth, “prolonged volatility” and a continuation of the status quo in the stock and bond markets as long as interest rates stay low. (The quotes below come from the release.)

“Bond yields have stayed low after the end of quantitative easing for a simple reason: bond demand is very strong, and bond supply is modest. Strong demand and modest supply means high prices in any market, and leads to low yields for bonds,” said Ed Keon, managing director of Quantitative Management Associates, Prudential’s economic research unit.

“In the short run, stocks can continue to perform well as low interest rates support higher-than-normal valuations, but higher valuations carry a long-term cost,” he warned. “Eventually expected returns of stock and bond portfolios might be lower than historical norms, creating challenges for many investors.”

The chief investment officer of Prudential Fixed Income, Mike Lillard, agreed with the conventional wisdom that Fed chairperson Janet Yellen isn’t likely to raise rates suddenly or sharply and will be guided by data on the strength of the economy.

“June would be my liftoff date for a rate hike from the Fed, but they will do it very slowly and patiently. If the economy begins to soften, however, they will stop to avoid sending us into another recession,” said Lillard. “They are going to be highly data dependent, and at the end of the day, our expectation is that they won’t be able to get short term rates very high.”

Quincy Krosby, a Prudential market strategist, warned that the recent slide in oil may not be as beneficial as Fed members make it out to be. “While consumer spending may have increased in the United States, the Fed needs to worry more about what lower energy prices mean globally. It could be signaling a decrease in demand in places like China, Europe, and Japan, which could lead to decreased production and job cuts in the energy sector,” said Krosby.

“Taking that into account, the Fed also has to keep in mind that when rates rise, something always breaks. There’s no telling what asset class may start the ball rolling, but it can’t come as a surprise. That said, it has been the velocity of the oil price plunge that caught markets off guard. Consumers, however, are net beneficiaries of lower prices.”

John Praveen, chief investment strategist for Prudential International Investments, cautioned that divergent monetary policies from central banks are likely to lead to volatility in the coming year and that current and future geopolitical risk cannot be dismissed.

“The start of quantitative easing in Europe and possibly Japan will allow for greater expansion in those markets compared to the United States, yet any unforeseen risks could derail that proposition,” Praveen said. “Europe was supposed to be on an upswing in 2014, but [Russian President Vladimir] Putin’s actions held any potential rally in check. With such interconnected global economies, any geopolitical or major risk can hold everything back.”

Sri Reddy, head of full service investments with Prudential Retirement, suggested that a prolonged low-growth, low-yield environment might even present a silver lining for his division—if it encourages defined contribution participants to start thinking outside the box for retirement income solutions.

As participants look for new options, “things like automatic enrollment plans, auto escalation options, and enhanced defined contribution plans need to become more of an industry norm to secure retirement income for today’s workers,” he said. Prudential Retirement sells a product that would fill the bill: IncomeFlex, a series of target date funds for the defined contribution plan market that come pre-wrapped with lifetime income riders.

A 100-150 bps rise in rates would help life insurers: Fitch

Posted on January 8, 2015 by Editorial Staff -

The rating outlook for the U.S. life insurance industry is stable for 2015, according to Fitch Ratings. In addition, the fundamental sector outlook is stable. Fitch’s outlook considers the industry’s very strong balance sheet fundamentals, strong liability profile, and stable operating performance.

But Fitch also expressed “ongoing concerns” over the impact of persistent low interest rates that “will pressure interest margins and reserve adequacy in 2015.” Fitch expects relatively stagnant earnings growth in 2015 due to a moderate decline in interest margins, which will offset growth in fee and underwriting income.

Fitch forecasts “modest improvement” in the macroeconomic environment, which should allow life insurers to sustain recent improvement in industry balance sheet fundamentals and financial performance. Fitch expects credit-related investment losses in 2015 to remain below pricing assumptions and historical averages based on strong corporate bond fundamentals and further improvement in the real estate market.

Fitch expects reported statutory capitalization, which exceeds both pre-crisis levels and rating expectations, to be sustained over the coming year driven by retained earnings, various capital management initiatives, and modest growth in in-force business. Further, Fitch continues to view the industry’s liquidity profile as very strong.

Concern over equity market risk tied to legacy variable annuity (VA) guarantees has decreased due to improved equity market conditions in recent years, but is expected to remain a drag on profitability over the near term. Longer-term, Fitch remains concerned about tail risk associated with VA guarantees, which could cause a material hit to industry earnings and capital in unexpected, but still plausible, severe stress scenario.

Fitch believes that a rise in interest rates by 100 bps to 150 bps could have positive implications for our sector outlook for U.S. life insurers. Conversely, if interest rates decline to levels seen in 2012 and stay there much beyond 2015, Fitch would likely change the outlook to negative based on weakened earnings profile and anticipated capital impacts associated with reserve strengthening.

Year-end shift into ETFs is a ‘contrary indicator’: TrimTabs

Posted on January 8, 2015 by Editorial Staff -

Investors were pouring record sums into U.S. equity exchange-traded funds in the traditionally slow holiday season, according to TrimTabs Investment Research.

“The buying frenzy suggests the U.S. stock market will keep stumbling into the New Year,” said David Santschi, CEO of TrimTabs. “ETF investors tend to buy high and sell low, so their actions are generally an excellent contrary indicator.”

In a research note, TrimTabs explained that $45.4 billion went into U.S. equity ETFs in December, surpassing the previous monthly record of $44.6 billion in September 2008. The inflow of $90.1 billion in the fourth quarter smashed the previous quarterly record of $72.2 billion in the third quarter of 2008.

“U.S. equity ETF flows are not the only cautionary sign for the short term,” noted Santschi. “A wide range of sentiment measures suggests the bullish camp has become extremely crowded. We advise investors to be less aggressive on the long side now.”

U.S. seeks public comment on asset management risks

Posted on January 8, 2015 by Editorial Staff -

The Financial Stability Oversight Council voted unanimously in December to seek public comment regarding potential risks to U.S. financial stability from asset management products and activities. This document describes what the FSOC is looking for.

The Council seeks input from the public until February18, 2015 about potential risks to the U.S. financial system associated with liquidity and redemptions, leverage, operational functions, and resolution in the asset management industry.

“Asset management is a vital segment of the financial services sector, with a high degree of diversity in investment strategies, corporate structures, regulatory regimes, and customers,” the FSOC said in a release. “The Council is issuing this notice in connection with its ongoing evaluation of asset management products and activities, building on work carried out by the Council over the past year regarding potential risks to U.S. financial stability.”

Earlier in 2014, the Council’s Deputies Committee hosted a public conference on the asset management industry and its activities. At the conference, practitioners – including CEOs, treasurers, and risk officers – as well as academics and other stakeholders discussed a variety of topics related to the industry.

The Council subsequently directed staff to undertake a more focused analysis of industry-wide products and activities to assess potential risks associated with the asset management industry. Members of the public are encouraged to submit comments, and all comments provided to the Council will be available on www.regulations.gov.

Gene Steuerle wins TIAA-CREF’s Samuelson Award

Posted on January 8, 2015 by Editorial Staff -

C. Eugene Steuerle has won the 19th annual TIAA-CREF Paul A. Samuelson Award for Outstanding Scholarly Writing on Lifelong Financial Security, in recognition of his 2014 book, Dead Men Ruling: How to Restore Fiscal Freedom and Rescue Our Future.

The Samuelson Award is given each year “in recognition of an outstanding research publication containing ideas that the public and private sectors can use to maintain and improve Americans’ lifelong financial well-being,” a TIAA-CREF release said.

“My thesis is quite simple,” Steuerle writes in the book, which RIJ reviewed in June. “In recent decades, both parties have conspired to create and expand a series of public programs that automatically grow so fast that they claim every dollar of additional tax revenue that the government generates each year.

“They also have conspired to lock in tax cuts that leave the government unable to pay its bills. The resulting squeeze deprives current and future generations of the leeway to choose their own priorities, allocate their own resources, and reach for their own stars. Those generations are left largely to maintain yesterday’s priorities.”

The book, a pointed criticism of the policies of both Republican and Democratic administrations over the past three decades, prescribes a reallocation of resources toward investment in children and financial education, and a workforce strategy that recognizes the talent and potential of older workers.

The award is named after Nobel Prize winner Paul A. Samuelson in honor of his achievements in the field of economics, as well as for his service as a CREF trustee from 1974 to 1985. The Samuelson Award winner is selected by a panel of distinguished judges composed of TIAA-CREF Institute fellows and previous award winners. This year’s panel includes these professors of economics, finance or business:

James Choi, Yale University
Eric Johnson, Columbia University
Brigitte Madrian, Harvard University
Jonathan Reuter, Boston College
John Rust, Georgetown University

The TIAA-CREF Institute presented the award in Boston on January 3, 2015, during the annual meeting of the Allied Social Science Associations.

The Fed Sets Another Trap

Posted on January 8, 2015 by Stephen S. Roach -

America’s Federal Reserve is headed down a familiar – and highly dangerous – path. Steeped in denial of its past mistakes, the Fed is pursuing the same incremental approach that helped set the stage for the financial crisis of 2008-2009. The consequences could be similarly catastrophic.

Consider the December meeting of the Federal Open Market Committee (FOMC), where discussions of raising the benchmark federal funds rate were couched in adjectives, rather than explicit actions.

In line with prior forward guidance that the policy rate would be kept near zero for a “considerable” amount of time after the Fed stopped purchasing long-term assets in October, the FOMC declared that it can now afford to be “patient” in waiting for the right conditions to raise the rate. Add to that Fed Chair Janet Yellen’s declaration that at least a couple more FOMC meetings would need to take place before any such “lift-off” occurs, and the Fed seems to be telegraphing a protracted journey on the road to policy normalization.

This bears an eerie resemblance to the script of 2004-2006, when the Fed’s incremental approach led to the near-fatal mistake of condoning mounting excesses in financial markets and the real economy. After pushing the federal funds rate to a 45-year low of 1% following the collapse of the equity bubble of the early 2000s, the Fed delayed policy normalization for an inordinately long period. And when it finally began to raise the benchmark rate, it did so excruciatingly slowly.

In the 24 months from June 2004, the FOMC raised the federal funds rate from 1% to 5.25% in 17 increments of 25 basis points each. Meanwhile, housing and credit bubbles were rapidly expanding, fueling excessive household consumption, a sharp drop in personal savings, and a record current-account deficit – imbalances that set the stage for the meltdown that was soon to follow.

The Fed, of course, has absolved itself of any blame in setting up the US and the global economy for the Great Crisis. It was not monetary policy’s fault, argued both former Fed Chairmen Alan Greenspan and Ben Bernanke; if anything, they insisted, a lack of regulatory oversight was the culprit.

This argument has proved convincing in policy and political circles, leading officials to focus on a new approach centered on so-called macro-prudential tools, including capital requirements and leverage ratios, to curb excessive risk-taking by banks. While this approach has some merit, it is incomplete, as it fails to address the egregious mispricing of risk brought about by an overly accommodative monetary policy and the historically low interest rates that it generated. In this sense, the Fed’s incrementalism of 2004-2006 was a policy blunder of epic proportions.

The Fed seems poised to make a similar – and possibly even more serious – misstep in the current environment. For starters, given ongoing concerns about post-crisis vulnerabilities and deflation risk, today’s Fed seems likely to find any excuse to prolong its incremental normalization, taking a slower pace than it adopted a decade ago.

More important, the Fed’s $4.5 trillion balance sheet has since grown more than fivefold. Though the Fed has stopped purchasing new assets, it has shown no inclination to scale back its outsize holdings. Meanwhile it has passed the quantitative-easing baton to the Bank of Japan and the European Central Bank, both of which will create even more liquidity at a time of record-low interest rates.

In these days of froth, the persistence of extraordinary policy accommodation in a financial system flooded with liquidity poses a great danger. Indeed, that could well be the lesson of recent equity- and currency-market volatility and, of course, plummeting oil prices. With so much dry kindling, it will not take much to spark the next conflagration.

Central banking has lost its way. Trapped in a post-crisis quagmire of zero interest rates and swollen balance sheets, the world’s major central banks do not have an effective strategy for regaining control over financial markets or the real economies that they are supposed to manage. Policy levers – both benchmark interest rates and central banks’ balance sheets – remain at their emergency settings, even though the emergency ended long ago.

While this approach has succeeded in boosting financial markets, it has failed to cure bruised and battered developed economies, which remain mired in subpar recoveries and plagued with deflationary risks. Moreover, the longer central banks promote financial-market froth, the more dependent their economies become on these precarious markets and the weaker the incentives for politicians and fiscal authorities to address the need for balance-sheet repair and structural reform.

A new approach is needed. Central banks should normalize crisis-induced policies as soon as possible. Financial markets will, of course, object loudly. But what do independent central banks stand for if they are not prepared to face up to the markets and make the tough and disciplined choices that responsible economic stewardship demands?

The unprecedented financial engineering by central banks over the last six years has been decisive in setting asset prices in major markets worldwide. But now it is time for the Fed and its counterparts elsewhere to abandon financial engineering and begin marshaling the tools they will need to cope with the inevitable next crisis. With zero interest rates and outsize balance sheets, that is exactly what they are lacking.

Stephen S. Roach, former Chairman of Morgan Stanley Asia and the firm’s chief economist, is a senior fellow at Yale University’s Jackson Institute of Global Affairs and a senior lecturer at Yale’s School of Management. He is the author of the new book Unbalanced: The Codependency of America and China.

RIJ Takes a Vacation

Posted on December 17, 2014 by Kerry Pechter -

Data Connection