
How Wealthy Investors Allocate Among Asset Classes

IssueM Articles
“Structured” annuities and exchange traded funds (ETFs) have proliferated in recent years as a kind of Goldilocks investment for people who want exposure to stocks and are willing to give up some of their potential reward for partial protection against risk of loss.
Now AIG, the giant annuity manufacturer, and Milliman Financial Risk Management, have taken elements of structured Registered Index-Linked Annuities (RILAs) and of Defined Outcome ETFs (a series issued by Innovator Capital Management and subadvised by Milliman) into “Advanced Outcomes Annuities,” a suite of variable annuities issued by American General Life, an AIG company.
Like RILAs, these funds use pairs of put and call options to capture part of the performance of an equity index. The indexes in these funds are the price-only versions (no dividend yield) of the large-cap S&P 500, the tech-heavy NASDAQ-100, the Russell 2000 small-cap index and the global MSCI EAFE.
Along with downside protection, an investor in these funds enjoys the tax-deferral of an annuity and the liquidity of an ETF. While the funds have specific start dates and term lengths (six months, one year or six years), their prices change daily and investors can enter or leave when they want or need to.
Like B-share variable annuities, the Advanced Outcomes Annuities are sold through broker-dealers by commission. Their fees resemble the fees of B-share products. They have surrender fees (7% in year one), annual contract fees (1.25%) and fund fees (0.99%). They also have an optional guarantee against long-term loss.
Prospective investors in these funds should be aware that AIG signaled in October 2020 that it plans to divest or spin off its life and retirement businesses, including annuities. MetLife made a similar move in 2016 when it created Brighthouse Financial. AIG declined to comment on what that might mean for contract holders.
The latest funds
The most recent flight of Advanced Outcomes Annuity offerings include five one-year funds, two six-month funds, and two six-year funds. During each term, the funds are priced daily. Investors can jump into and out of the funds to create their own durations, but their performance will vary depending on the fund’s prices when bought and sold.
“Each fund has its own target payout profile, each has its own upside target and downside protection target. These are managed like registered index-linked or structured annuities. But our product is not a RILA, it’s a variable annuity,” Adam Schenck, managing director, Head of Fund Services at Milliman FRM, said in an interview.
The amount of the investor’s money that is used to buy options on one of the indexes depends in part on the performance of the “collateral fund” into which most of the money is invested. Most of the collateral fund is invested directly or indirectly in fixed income investments.
One year crediting term funds:
Six-month crediting term:
Six-year crediting term
Bryan Pinsky, president, Individual Retirement, AIG Life & Retirement, said these products were designed in part on the basis of feedback from financial advisers. That feedback led to the “Capture-Reset-Reinvest” feature for liquidity. It also led to three crediting methods:
“As we talked to advisers, we heard loud and clear their desire for flexibility. Because of the nature of the funds, the duration can be whatever they want it to be. The six-month strategy lets them capture gains and reset more frequently,” Pinsky told RIJ. “It brings Milliman’s expertise from the Innovator Defined Outcome ETFs into AIG’s tax-deferred wrapper.”
AIG also adds optional guarantees that stop the total possible loss over six years at either -10% or -20%.
© 2022 RIJ Publishing LLC. All rights reserved.
A fictional Florida couple’s agony throbs at the heart of “The Baby Boomer Dilemma: An Expose of America’s Retirement Experiment,” a new film about America’s retirement financing woes. The movie ends with the wife weeping tears of regret and recrimination because her husband failed to opt for a pension or buy an annuity.
Yes, an annuity. In Doug Orchard’s Ken Burns-ish documentary, an A-list of US retirement experts take turns telling the back-story of retirement financing in the US since World War II before finally converging on a fairly strong endorsement of income annuities.
By the end of this 85-minute cautionary tale, some viewers might want to run out and, like Tom Hegna, buy a dozen annuities. It’s no wonder that financial advisers are renting this film and showing it to groups of middle-aged prospects. (The film can be downloaded for $29.99.)
Orchard visited the subject of retirement in an 2018 film on the national debt (“The Power of Zero”). Here he taps into a network of professors, annuity industry people, former regulators and others who understand (and in some cases helped create) the products and the policies that have shaped retirement financing in the US.
Readers of RIJ over the past decade may recognize some of the commenters. Respected academics Moshe Milevsky, Olivia Mitchell, Brigitte Madrian appear here, along with the late David Babbel of Wharton. Two Nobel economist/entrepreneurs, Robert Merton and William Sharpe, offer their views.
Former officials, whistleblowers and authors also adorn the cast. There’s a former Comptroller General of the US, an attorney who blew the whistle on bankers who fleeced a pension plan, a former president of the National Association of Insurance Commissioners, and congressman Michael Gallagher (R-WI).
Tex Benna
We even meet Tex Benna, the reputed “father of the 401(k).” Ambling about his grassy horse farm near Philadelphia, Benna explains his discovery of a subsection of the Internal Revenue Code–(401(k)–that would permit the tax-deferred, private-sector defined contribution savings plans that tens of millions of American workers participate in today.
As the movie warms towards annuities, people who frankly love annuities take center stage. We meet celebrity retirement speaker and author Tom Hegna on an Arizona golf course (and in his kitchen with his spouse, Laura). In a office in Des Moines, amid foot-high stacks of reports-to-be-read and items-to-be-filed, we find Sheryl Moore, founder of annuity consulting firm Wink, Inc., whose life goal is to “rebrand annuities” in a positive way. I know several of these experts; I could tell that the filmmaker knows how to draw people out.
Alternately back and forth between interviews with these well-known retirement mavens, Orchard tries to simplify and condense the tumultuous history of defined benefit pensions, 401(k)s, and Social Security. People with no prior knowledge of this history—the prequel to our world today—may strain to catch some of the references.
We hear about the rise and fall of corporate pensions. Olivia Mitchell covers the history of the modern private pension from the wage controls of World War II to the failure of Studebaker’s plan in 1963, to the passage of the Employee Retirement Income Security Act of 1974, to the underfunded public pensions of today.
Moshe Milevskly
The 401(k) defined contribution plan has of course succeeded the pension as the primary employer-sponsored tax-favored retirement savings vehicle. These plans have helped Americans save trillions of dollars for retirement, Benna tells us, but at the cost of exposing innocents to the risks of the stock market. If there’s a heavy in this film, it’s the 401(k).
The film doesn’t dispel a viewer’s doubts about the state of Social Security. We learn about the program’s financing crisis in 1980s, George W. Bush’s push in the early 2000s to partially “privatize” the program, and the shortfall in funding that it might face in 2034. (Critics harp on the idea that Social Security’s future liabilities are “unfunded.” But our government has “print on demand” money. It doesn’t need to pre-fund future expenses, nor should it.)
The film also makes passing references to esoteric phenomena like “sequence-of-returns risk” and “mortality credits.” Each of these hard-to-unpack topics might sustain its own movie, and maybe its own six-part Ken Burns epic. Orchard keeps up a swift pace—maybe too swift for the average viewer.
In the final section of the film, the conversation shifts subtly from big picture public policy matters to individual annuities. “Annuities” are positioned as a solution to the dilemma posed by the disappearance of defined benefit plans and the lack of provisions in most 401(k) plans for converting savings to retirement income.
Here you will meet people who rave about annuities. Hegna, pausing between putts, explains that he owns 11 different annuities. Babbel says that he owns 14 annuities, half of them still growing tax-deferred and half of them switched on and delivering monthly income. We learn that Moore wants her tombstone to reflect her lifelong quest to redeem the reputation of annuities and save America’s elderly from poverty.
Sheryl Moore
Economists, Milevsky tells us, tend to disagree on every possible matter except one. They all believe that annuities are a good idea for retirees. He urges 65-year-olds to put 20% to 60% of their savings into a lifetime income annuity. Mitchell suggests carving out 10% of 401(k) the savings at retirement to buy an annuity that starts paying out at age 80.
We don’t learn too many details about annuities as specific financial products. Orchard’s film doesn’t name the many kinds of annuities, or describe their different purposes. It doesn’t distinguish between the types of advisers and agents who sell them or between the types of life insurers that issue them. That’s a wise choice of the filmmaker, because the details are devilish—and eye-glazing.
“The Baby Boomer Dilemma” collapses some 75 years of retirement policy history into less than an hour and a half of cinema. And it all collapses on the head of one unfortunate 62-year-old driver’s exam official in Florida, who appears to have lost half his family’s savings in a stock market crash.
The movie’s finale reminded me of the ending of the Pulitzer Prize-winning 1949 drama, The Death of a Salesman. Willy Loman, only 63, has just killed himself. His widow, Linda, sobs: “I made the last payment on the house today. Today, dear. And there’ll be nobody home. We’re free and clear. We’re free. We’re free.”
The Lomans lost hope prematurely, and I wanted to reassure the desperate housewife of this film: “It’s not so bad. Your husband can work five more years and get a bigger Social Security benefit. Your stocks will bounce back by then. Roll with it.” As the film’s title points out, Baby Boomers don’t face a retirement tragedy. They just face a dilemma.
© 2022 RIJ Publishing LLC. All rights reserved.
To become eligible to market their products to retirement savers in the UK—who have some half a trillion pounds ($680 billion) in their “pension pots”—private equity (PE) fund managers are considering lowering their annual expense ratios, Bloomberg reported.
But the PE firms may want bigger performance bonuses in return.
As the UK government pushes for more retirement savings to be invested into alternative assets—infrastructure, affordable housing, technology firms, illiquid products—both the government and the private equity firms have reasons to compromise.
Buyout firms say they might reduce their usual 2% management fees if they can keep their performance-related payouts, which are contingent on meeting return targets, according to the Department for Work & Pensions, the UK’s equivalent of our Labor Department.
Fees on target date funds, into which retirement savers can be defaulted (in both the US and UK) are currently capped at 0.75%. The government is asking for public comment on whether a performance fee could exceed that cap. One model being considered would see the buyout firms get 30% of any profits, instead of the usual 20%.
If they reduce their expense ratio, private equity firms could get more access to the UK’s pool of defined contribution retirement savings. That pool, the savings of millions of workers, grew 45% to 471 billion pounds between 2015 and 2020, according to the Pensions Policy Institute. Such accounts, equivalent to 401(k)s, represent the savings of millions of workers.
Resolving the level of fees “is one of the last major operational or structural issues for DC investment into private markets,” said James Monk, head of Defined Contribution Investment at pension consultants Aon Plc.
Private equity supporters say their products would help investors diversify their portfolios while investing more in the “real economy.” But pension fund trustees wonder if a performance fee can be fairly calculated for investors.
“Members will come in, go out, have different asset values, different contribution structures,” said Stephen Budge, partner at pension advisers Lane Clark & Peacock. “How do you make sure members are fairly charged for the performance they have received?”
Abrdn Plc (formerly Standard Life Aberdeen Plc), Legal & General Group Plc and Phoenix Group Holdings Plc are expected to roll out private market products should the rules be relaxed, Bloomberg reported.
Some DC pension plans already include private market strategies as investment alternatives. NEST, the public-option defined contribution plan, appointed BNP Paribas SA to run a private credit portfolio in 2019.
Last summer, NEST began seeking private equity partners to help the firm invest 1.5 billion pounds in private assets by 2024. Partners Group Holdings AG’s Generations Fund has around $1 billion in DC assets invested in private assets.
© 2022 RIJ Publishing LLC.
For the first time in its 100-year history, TIAA is offering its guaranteed lifetime income solutions to the corporate 401(k) retirement plan market through the “TIAA Secure Income Account.” Until now, TIAA has offered those services mainly through 403(b) plans at non-profits and academia.
“Now, private-sector companies can provide employees with TIAA’s unique, pension-like guaranteed income for life as part of their retirement plan,” according to a release from TIAA president and CEO Thasunda Brown Duckett.
TIAA was founded as a teacher’s retirement fund in 1918, it was funded largely with grants from Pittsburgh steel magnate, financier, and philanthropist Andrew Carnegie.
The TIAA Secure Income Account is a deferred fixed annuity that offers a predictable, steady stream of guaranteed income for life in retirement. Plan participants’ contributions are guaranteed to grow over time and are protected from losing value no matter what the market does. The account is fully cashable during employees’ working years and fully portable to another 401(k) plan or rollover RIA,
Employees can choose—but are not required—to turn some or all of their savings into monthly income paychecks for life when they stop working. They also have the opportunity for more growth and higher amounts of income the earlier and longer they contribute because of the unique way TIAA shares profits with its individual clients.
Lifetime income payments may also increase once people are in retirement, which can help offset the effects of inflation. In 2022, for example, many currently receiving income from TIAA fixed annuities are enjoying a 5% increase in their lifetime income payments—the largest bump in 40 years.
TIAA’s 2021 Lifetime Income Survey found that more than 70% of workers say they would choose to work for, or stay with, a company that offers access to guaranteed lifetime income in retirement compared to one that doesn’t.
The TIAA Secure Income Account is specifically designed to be a Qualified Default Investment Alternative, which means the account can serve as an allocation in a managed account or target-date fund and that participants can be defaulted into it when they enroll in a plan.
Plan sponsors can automatically direct plan participants to a product with principal protection, guaranteed growth, low volatility and lifetime income with potentially increasing payments. Employees who choose to annuitize will not pay any expenses or commissions.
Lifetime income solutions turn simple savings accumulation vehicles into true retirement investing and payout plans,” said Colbert Narcisse, TIAA’s Chief Product and Business Development Officer, in the release.
The TIAA Secure Income Account is available through the defined-contribution investment-only distribution channel overseen by Nuveen, TIAA’s asset manager. It is the first in a series of innovative lifetime income solutions TIAA plans for a variety of retirement savings vehicles, including employer-sponsored and individual IRAs.
Nuveen, TIAA’s asset manager and a provider of “outcome-focused investment solutions,” will provide investment management expertise. For more information, please visit www.tiaa.org/secure-income
© 2020 RIJ Publishing LLC. All rights reserved.
American Life & Security, a Nebraska-based, B++ rated fixed indexed annuity (FIA) issuer that got new life in 2018 after asset manager Vespoint LLC bought control of its owner, Midwest Holding, will offer the Goldman Sachs Xenith Index to owners of its FIA contracts, according to a release.
Vespoint aims to capitalize on the “convergence” of the insurance and asset management businesses, according to a November 2021 investor presentation. “The insurance industry is archaic; Midwest is here to help,” their website said.
Midwest Holding describes itself as a technology-enabled, services-oriented annuity platform. Midwest designs and develops in-demand life and annuity products that are distributed through independent distribution channels, to a large and growing demographic of US retirees. Midwest Holding went public on NASDAQ in December 2020 and has a market capitalization of about $78 million.
Midwest “originates, manages and transfers these annuities through reinsurance arrangements to asset managers and other third-party investors. Midwest also provides the operational and regulatory infrastructure and expertise to enable asset managers and third-party investors to form, capitalize and manage their own reinsurance capital vehicles,” the Midwest website says.
“We are a unique cross-disciplinary team of insurance, technology and investment professionals building innovative businesses at the intersection of insurance and technology,” according to a release.
Midwest Holding has assembled the machinery to execute that strategy: a fixed annuity issuer, a reinsurer in a regulatory haven (Seneca Re in Vermont), 1505 Capital, a registered investment advisor, and a cloud-based policy administration system, m.pas, according to its website.
The group’s latest announcement involves its licensing agreement with Goldman Sachs for the Xenith index, which uses macro-regime asset allocation. According to Goldman Sachs’ paper on the index:
The Goldman Sachs Xenith Index is designed to provide exposure to a diversified portfolio that adjusts its exposure between five underlying assets… depending on whether a monthly Growth Signal is signaling a rising economic growth or a decreasing economic growth environment. In a rising growth environment, higher exposure will be allocated to equities and copper than in a decreasing growth environment and, in a decreasing growth environment, higher exposure will be allocated to fixed income and gold than in a rising growth environment.
Regardless of the growth regime, the basket will always provide a constant exposure to the Commodity Curve Component… the Index is also subject to a volatility control mechanism that adjusts the exposure of the Index to the Underlying Assets in order to achieve a predefined volatility target of 5%, subject to a leverage cap of 125%.
“Instead of relying purely on the S&P 500 Index for exposure to US equities, the index employs an intraday overlay that can reduce equity exposure based on intra-day trading ‘signals.’ As a result, the strategy incorporates real-time market movements, in addition to other factors, in its rules-based methodology,” a Midwest Holding release said.
Depending on the prevailing market regime, the Goldman Sachs Xenith Index also provides commodity exposure by switching between copper and gold based on anticipated economic growth.
Midwest Holding recently announced the closing of a majority ownership sale of a consolidated reinsurance facility to a subsidiary of ORIX Corporation USA (ORIX USA). Under the terms of the agreement, a subsidiary of ORIX USA purchased approximately 70% of Seneca Incorporated Cell, LLC 2020-01 (SRC1), a Midwest consolidated reinsurance cell.
Midwest established SRC1 in early 2020 as the first reinsurance cell of Seneca Re, a Vermont domiciled captive reinsurance company. SRC1 has reinsured premium from its sister insurance company and Midwest subsidiary, American Life & Security Corp. ORIX Advisers, LLC, another subsidiary of ORIX USA, will be the manager of the assets underlying SRC1’s reinsurance obligations going forward, replacing Midwest’s asset management arm, 1505 Capital LLC.
© 2022 RIJ Publishing LLC.
Multigenerational wealth transfer is one of the most significant factors affecting the high-net-worth (HNW) and ultra-high-net-worth (UHNW) segment—its impact in the coming decades is set to increase substantially.
Shifting wealth into next-gen’s hands will reward firms that are able to sustainably establish advisory relationships with younger clients in the years to come, according to Cerulli’s latest report, “U.S. High-Net-Worth and Ultra-High-Net-Worth Markets 2021: Evolving Wealth Demographics.”
Cerulli projects that wealth transferred through 2045 will total $84.4 trillion—$72.6 trillion in assets will be transferred to heirs, while $11.9 trillion will be donated to charities. Greater than $53 trillion will be transferred from households in the Baby Boomer generation, representing 63% of all transfers.
Silent Generation households and older stand to transfer $15.8 trillion, which will primarily take place over the next decade. $35.8 trillion (42%) of the overall total volume of transfers is expected to come from high-net-worth and ultra-high-net-worth households, which together only make up 1.5% of all households.
As a result, firms that can remain on the cutting edge of complex planning and wealth structuring tactics will be invaluable to clients as taxation becomes a more pressing worry. According to the research, grantor trusts (77%) are far and away the most common way to increase the tax-efficiency of wealth transfer events among HNW practices, followed by spousal lifetime access trusts (54%) and strategic gifting (46%).
“As taxes become an increasingly pressing regulatory issue among legislators, wealth managers will need to keep a pulse on the latest developments at the state and federal levels,” said Chayce Horton, an analyst at Cerulli.
As transfers lead to changes in family dynamics as well as engagement preferences, financial services providers across the wealth spectrum must adapt their business models. “Winners of walletshare will need to be prepared for changes to their business model and to evolve with the needs of a younger demographic,” said Horton. According to the research, family meetings and regular communication (81%) is considered the most-effective wealth transfer planning strategy by HNW practices, followed by educational support (59%), and organized succession planning (31%).
To improve relationships across generations, Cerulli recommends making family events a regular part of the advisory process. “Extending interfamily relationships to involve the entire range of stakeholders rather than just the current controllers of that wealth will create a greater sense of responsibility and inclusion among heirs that will help in the likely case that more complex discussions about management of the family’s wealth occur in the future,” said Horton.
© 2022 RIJ Publishing LLC.
Louis S. Harvey, the founder of Dalbar, a kind of J.D. Power for the financial services industry, analyzed stock market history and found that since 1940 US equities have always recovered, even in real terms, within five years of any crash.
He uses that finding—which might surprise a few people—as the basis for a portfolio asset allocation strategy that he’s now sharing with the world.
In a recent white paper, Harvey asks, Is an “Arbitrary Asset Allocation” more efficient than a “Prudent Asset Allocation.” By “arbitrary,’ he means setting a ratio of stocks and bonds according to an investor’s current risk tolerance and then rebalancing the portfolio back to the same ratio if the winds of volatility drive it off course.
By “Prudent Asset Allocation” Harvey means something different. His prudent approach involves two buckets. The first bucket should contain enough safe (“preservative” or “protection”) assets to cover cash needs (in excess of expected income) for the next five years.
The second bucket, including the rest of the client’s investable money, goes into growth assets. Once a year, the preservative bucket gets replenished with gains, if needed, from the growth bucket. The rolling five-year buffer, like the shadow of an eclipse crossing the landscape, moves one year forward.
“We said, let’s examine every possible combination in history to find the maximum recovery period for stocks—the longest it ever took for equities to recover their pre-crash value—and it came out to about 4.9 years,” Harvey told RIJ recently. “In the worst case scenario, if you have a diversified portfolio, you are more than likely to recover your losses in five years or less.”
Born in Puerto Barrios, Guatemala in 1942, Harvey emigrated to the US with a degree in physics from the University of the West Indies. He started Marlborough, MA-based Dalbar in 1976. Dalbar surveys financial services providers, establishes benchmarks for quality, publishes syndicated research and gives out awards. Harvey based the “Prudent Asset Allocation” technique on his own experience as an investor.
Here’s how it works:
“The procedure is intended to continuously deplete the Preservative assets at a rate that is slower than the growth of the growth class,” Harvey writes. “When market conditions are favorable, Growth assets are used to replenish the Preservative class,” the white paper said. “Favorable conditions are considered to be any time except immediately following a decline, before a full recovery is achieved.”
Stocks have always rebounded
Louis S. Harvey
The Prudent method is grounded in Harvey’s finding that stocks have crashed less often and their prices have bounced back faster than a lot of loss-leery investors tend to assume or imagine. According to his back-testing exercises, the S&P 500 Index fell 10% or more in only eight calendar years since 1940 (see chart below) and took no more than five years to recover the loss.
Ipso facto, an investor should be able to maximize returns and keep anxiety far away—a sustainable armistice between greed and fear—by hoarding enough cash to avoid a forced sale of depressed assets for up to five years and stretching for growth with the rest.
Before you run to your spreadsheets to prove that this two-bucket approach is an illusion (because a balanced fund performs the same as two one-asset funds), or purely behavioral (i.e., prevents panic-selling) or impossible to prove (because no two plans will ever perform identically), or rife with market-timing issues, remember that Harvey isn’t claiming that the Prudent method optimizes a portfolio. He’s saying that it outperforms the popular Arbitrary method and relieves stress.
Back-testing the Prudent allocation method vs the Arbitrary allocation method over the score of years from 2001 to 2020, Harvey found that his strategy beat an arbitrary portfolio of 60% stocks (S&P 500 Index) and 40% bonds (10-Year Treasuries) and found:
“The arbitrary method is not focused on what’s changing in the market place, or in the investor’s personal circumstances,” Harvey said. Instead, “We suggest that you have an annual schedule unless there’s an extraordinary event—such as the market going berserk. If it’s significant, go back and revisit your asset allocation.”
Good for decumulation or accumulation
Harvey’s approach is intended to work for people of all ages, in either the “accumulation stage” before retirement or the decumulation stage” after retirement. “People at older ages, who no longer have an earned income, can substitute their Social Security income for earned income and perform exactly the same calculation. It is most applicable in the decumulation stage, but also in the appreciation stage,” he said.
“When you look at society, you can see that so many people are in both stages. You can’t reasonably draw a line between the two. So many people are working and receiving retirement income at the same time. The same principle applies, regardless of how old you are, even if the numbers change.” [I assume that Harvey would recommend dealing separately with tax-favored accounts and not incorporating them into the Prudent method until after retirement.]
“If you have millions of dollars, you might need to hold only two or three percent of your net worth to cover the next five years. The method is also totally fluid; it’s just a function of your net cash needs,” he added. In other words, the more total savings you have, relative to your need for excess cash each year, the easier it is to run this strategy, and vice-versa.
The Prudent method accommodates almost any selection of growth assets. “It doesn’t have to be stocks,” Harvey said. “If you feel comfortable with alternative assets or options, go ahead and use them. You can make that determination yourself. The amount of risk you take will depend on your personal preference or gut and skill. Using risk ‘appetite’ to determine asset allocation, without segmentation, without consideration of income needs, is a cruel waste.”
Harvey acknowledges, without apology to the bucketing-skeptics, that the Prudent method is a kind of bucketing or time-segmentation. “It’s 100% supportive of time segmentation. One of our goals was to make it real simple. Using expressions like ‘bucketing’ or ‘time-segmentation’ can make it sound complicated. But any advisor and many individuals can implement it without rocket science.”
In calling for a rolling five-year window of safety, however, the Prudent method differs from retirement bucketing strategies that consist of, for example, four five-year buckets from age 65 to 85. In that strategy, each bucket’s assets grow for five, 10, or 15 years before they’re sold and the proceeds swept into the active spending bucket. The Prudent strategy calls for a rolling five-year buffer of safe assets.
“The bottom line of Prudent asset allocation is to have the confidence of knowing that over the next five years, you don’t have to worry about market conditions,” Harvey told RIJ. “It changes the character of your approach to risk, and it generally means that you can put more money into growth assets.”
© 2022 RIJ Publishing LLC. All rights reserved.
LGIM America (Legal & General Investment Management America), a registered investment adviser (RIA) specializing in designing and managing investment solutions across active fixed income, index, multi-asset and liability driven investment in the US market, today announced the launch of five new mutual funds.
The funds are designed for distribution through the defined contribution plan market in the US. LGIM America’s flagship fund, Legal & General Retirement Income 2040 Fund, focuses on “retirement income and investment solutions that help retirees make the right spending decisions throughout their retirement journey,” the company said in a release today.
Details of the five funds, which are offered only to institutional investors, include:
The Legal & General Retirement Income 2040 Fund is composed of the four funds listed below. Its goal is to provide current income during the early and middle-years of retirement while ensuring capital is not exhausted prior to the fund’s terminal date.
The Legal & General Global Developed Equity Index Fund seeks to provide investment results that, before fees and expenses, track the performance of the MSCI World Index.
The Legal & General Cash Flow Matched Bond Fund seeks current income through the management of investment grade credit with a final maturity between zero and five years. The Fund does not have a specific target for its average duration. The Fund’s portfolio is laddered by investing in fixed income securities with different final maturities so that some securities age out of the zero- to five-year maturity range during each year.
The Legal & General Long Duration US Credit Fund aims to maximize total return through capital appreciation and current income. It primarily invests in investment-grade fixed income securities with an average portfolio duration that is within 10% of the Fund’s benchmark, the Bloomberg Long Duration US Credit Index.
The Legal & General US Credit Fund looks to maximize total return through capital appreciation and current income. It primarily invests in investment-grade fixed income securities with an average portfolio duration that is within 10% of the Fund’s benchmark, the Bloomberg Capital US Credit Index.
“These Funds are part of a larger retirement income solution initiative and complete our retirement income strategy, which is designed to bring investors through the early- to middle-years of retirement. Within the first several months of 2022, we anticipate completing a long-life strategy, which is the longevity piece of our solution and designed to support individuals into their later years of retirement,” the release said.
© 2022 RIJ Publishing LLC. All rights reserved.
DPL Financial Partners, the insurance purchasing platform for Registered Investment Advisors, has partnered with Avantis Investors and Security Benefit Life on the design of a new, no-commission, fixed indexed annuity contract availability only to DPL customers.
The contract, Security Benefit Life’s ClearLine fixed indexed, will feature the Avantis Barclays Volatility Control Index, created by Eduardo Repetto and Pat Keating of Avantis Investors.
A total return index, its performance of the Avantis Barclays Volatility Control Index includes the dividend yield of the underlying companies.
(Many indexed annuities now offer bets on price return indices that don’t include dividends. Since options on those indices tend to be cheaper than options on total return indices, issuers can set afford to higher caps on their performance. Whether a higher cap on a price-return index will beat a lower cap on the total-return version of the same index, it’s impossible to predict.)
In a release, Avantis Chief Investment Officer Eduardo Repetto said, “FIAs can complement an existing allocation of equity and fixed income. FIAs offer risk mitigation, like fixed income, while diversifying the driver of returns away from bond yields. I think this structure can help advisors improve their clients’ portfolios, in particular during these times of extremely low bond yields.”
Security Benefit’s ClearLine Annuity, designed by DPL with Security Benefit, also offers a lifetime income rider with a 2% annual increase on income.
The average American worries a lot: about COVID mutations, potential blitzkrieg in eastern Ukraine, and the rising prices of gas and groceries. That’s in addition to the baseline “It’s-always-something” problems that they wake up to each morning.
In the financial realm, more than 75% of Americans believe the markets will be “very volatile” in 2022, according to the 2021 Q4 Quarterly Market Perceptions Study from Allianz Life. Two out of three American fear that a COVID-driven recession ad almost three-fourths fear worry about an imminent loss of purchasing power.
Another 64% of those surveyed say their income isn’t rising as fast as their expenses. The same percentage worry about tax increases. In Allianz Life’s other findings:
Allianz Life conducted an online survey, the 2021 Q4 Allianz Life Quarterly Market Perceptions Study, in December 2021 with a nationally representative sample of 1,004 respondents age 18+.
Lincoln Financial Group has elevated a new retirement plan participant website, featuring “intuitive navigation” and “innovative tools to help participants plan for and achieve income in retirement,” according to a Lincoln release this week.
The new mobile-adaptive design provides “a simple and secure digital experience” including “a clear picture of where they are on their paths to retirement” and making it easy to “increase contributions.”
“Through our newly redesigned site, participants can access personally relevant information and streamlined plan transactions — all designed to drive positive outcomes,” said Sharon Scanlon, senior vice president of Customer Experience, Producer Solutions and Retirement Plan Services Operations at Lincoln Financial Group.
“Through research, user analytics and usability testing, this new digital experience is designed to help meet the evolving needs, wants and expectations of plan participants, and help them save for and work toward the retirement they envision.”
The pandemic has inspired almost 80% of US workers to reevaluate their finances, career and retirement, according to Lincoln Financial Group’s 2021 Retirement Power study. Lincoln’s new participant site features include:
“My Target” tool: This personalized digital calculator helps participants estimate their retirement income and determine if they are on track for retirement.
Investments: New, easy-to-understand investment graphs help participants understand where their money is allocated and how their account has grown over time.
My Next Steps: This feature shows participants how to improve retirement readiness.
Mobile-Enabled Navigation: Participants can now manage their account anytime, anywhere with a mobile adaptive design, while ongoing investments in cybersecurity help keep plan and participant information secure.
The new platform also features a content hub with videos, articles and tools to educate participants, as well as single sign-on access to Lincoln WellnessPATH, an online financial wellness solution.
(c) 2022 RIJ Publishing LLC. All rights reserved.
MassMutual is now active in what RIJ calls the “Bermuda Triangle” business. There’s no reason why a strategy that’s been productive for publicly traded life insurers can’t work for a big mutual company. And, since buying Great American, MassMutual sells fixed indexed annuities—a key input of the triangle play.
This week, the 160-year-old giant mutual insurer helped launch Martello Re Limited, a licensed Class E Bermuda-based life and annuity reinsurance company. A consortium of MassMutual, Centerbridge Partners, Brown Brothers Harriman, and Hudson Structured Capital Management Ltd. capitalized Martello Re with equity of $1.65 billion.
Centerbridge, an alternative asset manager, and Barings—MassMutual’s own $300 billion investment arm—will act as asset managers for Martello Re, “providing access to extensive public and private asset origination and underwriting capabilities across all asset classes.”
Roger Crandall, chairman, president and CEO of Massachusetts Mutual Life Insurance Co.
MassMutual, based in Springfield, MA, and its subsidiaries will initially reinsure approximately $14 billion of general account liabilities with Martello Re and also enter into a flow arrangement to reinsure new business. Both transactions are expected to close in February 2022 and have received regulatory approval.
By reinsuring those liabilities in Bermuda, MassMutual will likely see a big drop in its required surplus, which means it will suddenly have perhaps hundreds of millions of dollars freed-up for new uses. Many publicly traded life insurers are spending their “released capital” on share buybacks. It’s not clear what a mutual insurer, which has policyholders rather than shareholders, might do with such a windfall.
Martello Re “will initially focus on providing MassMutual and its subsidiaries with reinsurance capacity on current product offerings, after which it will offer its services selectively to other top insurers in the life and annuity space,” according to a release.
All three corners of the Bermuda Triangle strategy are here: A life insurer that gathers lots of fixed-rate and fixed indexed annuity premiums each year; a well-capitalized reinsurer in a jurisdiction with a GAAP accounting regime; and an alternative asset manager that originates customized private credit instruments.
In the first half of 2021, MassMutual sold $1.7 billion worth of fixed-rate annuities, $618 million worth of fixed indexed annuities (FIAs) and $553 million of payout annuities (immediate income annuities, deferred income annuities, and structured settlements) in the US, according to LIMRA. In May 2021, MassMutual paid $3.5 billion for Great American, a well-established FIA builder. In the first half of 2021, MassMutual and Great American combined for $1.85 billion in sales of FIAs—enough to rank fifth in FIA sales overall.
In the strategy, the life insurer sells annuities, then reinsures the liabilities (releasing priceless surplus capital as a result) and sends the money to the alternative asset manager for deployment. The asset manager lends that money to credit-starved businesses (currently underserved by banks), using its financial engineering skills to turn those loans into sophisticated assets with a variety of risk/return profiles.
Some of those assets—collateralized loan obligations, senior tranches of mortgage backed securities—are held by the original life/annuity company. But the asset managers are also feeding an enormous global demand from endowments, family offices, corporations and other insurance companies who can no longer get the yield they need by buying plain-vanilla corporate bonds in the public markets.
What’s confusing is that life insurers appear in different roles at different times in this drama—sometimes as the targets of acquisition, as clients of alt-asset managers, often as purchasers of exotic risk-managed products, and sometimes as part of a holding company that brings the whole business under one roof—thus enjoying all sorts of synergies, efficiencies and, sometimes, conflicts of interest.
Martello Re will be led by CEO Dennis Ho, a 22-year industry veteran and life actuary who most recently founded Saturday Insurance, an online insurtech platform. Prior to founding Saturday, Ho held a range of other leadership roles including CEO for Longitude Re, Managing Director at BlackRock Solutions, and Head of US Life Insurance Solutions at Deutsche Bank.
Martello Re will be overseen by a Board of Directors made up of investors and Martello Re’s CEO. The initial members of the Martello Re Board of Directors will include Chairwoman Ellen Conlin from MassMutual and Michael Baumstein of Barings, Matthew Kabaker and Eric Hoffman from Centerbridge, Jeff Meskin and Taylor Bodman from Brown Brothers Harriman, and Mr. Ho.
Following MassMutual’s announcement, AM Best commented, “The credit ratings of Massachusetts Mutual Life Insurance Company and its life/health subsidiaries, remain unchanged following the Jan. 12, 2022, announcement that it has launched a licensed Class E Bermuda-based life/annuity reinsurance company, Martello Re Limited (Martello Re).”
© 2022 RIJ Publishing LLC. All rights reserved.
During a Zoom conference last fall on the future of defined contribution (DC) plans, I used the “Chat” function to chat up another attendee. Sidebar conversations during webinars are wrong, apparently—like passing notes in class. I might have lost my seat at the conference because of it.
But I wanted to make contact with that other attendee, Catherine Reilly. She’s the director of Retirement Solutions at Smart, the recently established US branch of a substantial defined contribution retirement plan recordkeeper in Britain called Smart Pension.
In the UK, Smart runs a $2.7 billion, 80,000-employer “master trust.” That’s the British version of Pooled Employer Plans (PEP), the multiple-employer plan design enabled by the SECURE Act of 2019. In the US since October 2020, Smart’s “recordkeeping solutions and retirement income solutions are purpose-built for PEPs,” according to its website.
With US headquarters in Nashville, Smart is moving fast. With capital from JP Morgan, Barclays, Natixis, Chrysalis, and Legal & General Group plc, Smart has just bought Stadion Money Management, a managed account provider, and is partnering with Finhabits, a provider of bilingual (Spanish/English), smartphone-mediated financial services.
For RIJ, Smart is interesting because it aims to reduce the often clunky process of accessing 401(k) savings in retirement to a few thumb strokes on a smartphone or key strokes on a laptop, while also helping retirees bucket their savings into short-term, medium-term and long-term money.
Historically, US recordkeepers have performed this critical function reluctantly, inefficiently or not at all. But without it, they’re just giving retired participants a reason to roll their money over to an (expensive) brokerage IRA. “The retirement income feature keeps people in the plan,” Smart’s US CEO Jodan Ledford told RIJ in an interview. “This optimizes their ability to preserve their base.”
The ‘grout in the mosaic’
Jodan Ledford, CEO of Smart USA
Ledford is responsible for growing Smart in the US. He already has a track record here. In his last job, he grew Legal & General’s US asset management business seven-fold, to $210 billion. Despite his British-sounding name, he’s an American. He tends to describe Smart’s services in metaphors.
“I like to use the term, mosaic,” he said in the interview. “In a pooled employer plan, for instance, the investment manager, the recordkeeper, and the plan administrator would be the pieces of the mosaic, and we could be the ‘grout.’ Or we could be the pooled plan provider that selects the other pieces.
“We will likely partner with recordkeepers to offer PEPs. Or we could be the 3(16) TPA (the third-party administrator, with fiduciary responsibilities). What we don’t provide is the 3(38) role (the asset manager with fiduciary responsibility for managing the investments in the plan).
“Say, for instance, that we approach a large registered investment advisor (RIA) or broker-dealer with financial advisers who serve small business plans. We say, ‘You can be the 3(38) fiduciary and select the funds.’ The RIA tells its advisers, ‘Here’s a new pooled employer plan. We have a system that lets you sign up the small business clients in less than hour.’ It lets the RIA or the broker-dealer do more business with small plans,” Ledford said.
“We could also partner with a recordkeeper, or with a large pension risk transfer company,” he added. “They could say to their corporate client, ‘If you liked our annuity for your defined benefit plan, why not use this retirement income system for your defined contribution plan?’”
Smart sees existing asset managers and recordkeepers held back by older technology systems that hinder them from providing what people now take for granted: fast, easy onboarding of new clients; personalized solutions; and scheduling of customized money transfers from any plan account to any bank.
The SECURE Act made it legally easier to aggregate many small plans into a single large plan (a PEP) that a large asset manager or recordkeeper could, in theory, administer for much lower expenses than individual small firms currently pay. But those large service providers don’t necessarily have the integration tools (e.g., the Application Programming Interface or API software) necessary to fill in the communication gaps between lots of unrelated clients and partners—like participants’ banks. Smart (and its competitors) aim to furnish some of those tools.
No annuity feature—yet
These tools will allow Smart to help retirees take systematic withdrawals from their 401(k) plans. Reilly, the Smart executive in charge of Retirement Solutions, told RIJ that Smart’s “decumulation platform” will give retirees “the flexible access of an IRA” while their money stays in the 401(k) plan.
Catherine Reilly, director of Retirement Solutions, Smart USA
“It’s a guided journey into retirement,” said Reilly, whose varied career has included stints as a McKinsey consultant in Helsinki, overseeing State Street Global Advisors’ $70 billion target date fund suite, and senior fellow at the Defined Contribution Institutional Investment Association. “You can set up a paycheck or move money around. It might be most closely related to a managed account.” [Under US labor law, managed accounts, along with target date funds, are Qualified Default Investment Alternatives into which the payroll deferrals of new, auto-enrolled participants can be automatically deposited.]
Smart uses a time-segmentation or bucketing approach, dividing income distribution into four periods:
The current product doesn’t incorporate the option to purchase an annuity, but it may eventually allow for the purchase of a deferred income annuity (DIA) for guaranteed income in old age. Legal & General sells immediate annuities in the UK, but according to Reilly, won’t be marketing annuities through Smart. Instead, the Smart platform calculates a “sustainable income” for every year of retirement up to age 80.
“Monthly payments can be set up, and you can always change them or make flexible withdrawals,” Reilly said. The system suggests an asset allocation, but the payments, once set, won’t automatically adjust or rebalance in response to market volatility.
“In the US, the recordkeeping industry has struggled to issue paychecks. Sometimes the recordkeeper is the problem. Sometimes plans just weren’t designed for retirement income payments,” Ledford told RIJ.
Replicating UK success
How does Smart get paid? “If we provide recordkeeping services, it can be basis points, flat dollar, or mix of both. Flat dollar is popular now,” Ledford said. “In the PEP-only model, we’d charge basis points. Either way, we’re trying to provide the service at a cost point that’s not a barrier to entry. In the small market today, according to the benchmarking we see, a small plan pays about 260 basis points (2.6%) a year in fees. We want the cost to be under 100 bps (1.0%) all-in.”
In the US, Smart hopes to repeat its successes serving retirement plans in the UK, Ireland, and Dubai. In the UK, it’s a major provider of a defined contribution “master trust”—the UK equivalent of a pooled employer plan in the US—serving more than 80,000 employers in Britain and 900,000 participants whose plans have £2 billion ($2.74 billion) under management.
Smart’s recent acquisition of Stadion adds a ready-made chunk of US business. Stadion provides personalized managed account services to some 4,000 retirement plans with $2.3 billion in the US. Stadion serves as the fiduciary that chooses the funds and designs the glide paths for the managed accounts.
Smart’s partnership with Finhabits will give it access to the Latinx community in the US, where there are an estimated 4.65 million Hispanic-owned small businesses, many of them lacking retirement savings plans.
What obstacles might Smart face in the US? So far, it seems to bill itself as a retirement jack-of-all-trades, refusing “no job, big or small.” That’s a key that could unlock a lot of doors. One potential speed bump: Prospective clients in the US might wonder if they have to hire at least some of Smart’s partners—like JP Morgan, Stadion and Legal & General—in a bundled solution. But Reilly said, “By buying Smart you’re not committing to any of our partners.”
Another possible hitch: Smart could be misgauging the way retired Americans tend to use their 401(k) money. In fact, many of them tend not to start taking money out of their retirement plans until the government forces them to at age 72. Distributions are taxable, and so not to be taken lightly. Investment advisers often tell clients to spend tax-deferred money last.
In the managed account market, it will certainly face competition from providers like Morningstar and Edelman Financial Engines. But the managed account market is big. According to Cerulli Associates, “The top nine DC managed account providers comprised more than $400 billon in DC assets and the vast majority of DC recordkeepers now partner with at least one managed account provider.” Smart may end-run that traffic by specializing in helping big asset managers and recordkeepers address the burgeoning PEP market—the kind of market Smart appears to have mastered in the UK.
© 2022 RIJ Publishing LLC. All rights reserved.
An article in yesterday’s Wall Street Journal helps explain why so many alternative (alt-) asset managers have been acquiring or establishing life insurers, reinsurers, and/or blocks of fixed annuities.
WSJ explains that big institutions, desperate for higher yield than they can get from bonds in the public markets, are bringing boatloads of cash to asset managers and asking for the custom private credit instruments–insurance-linked securities, leveraged loans, mortgage-backed securities, collateralized loan obligations–that those asset managers create.
These instruments often involve bespoke loans to below investment-grade borrowers; the asset managers use securitization and long maturities to immunize credit risk with an ‘illiquidity premium’ and ‘tranches’ of varied risk.
“Funds that make such loans now control about $1.2 trillion, nearly twice the capital they had five years ago,” the WSJ said. “‘We think this market dwarfs the alternatives market,’ Apollo CEO Marc Rowan said in the story, which added, “The figure could be as great as $40 trillion, he said. Apollo manages about $340 billion of credit investments, much of them private.”
One source of money that asset managers use to write these high-return loans are the proceeds of the sales of fixed annuities by life insurers to risk-averse American retirees and near-retirees. Apollo, through its parent, Athene Holding, was one of the first, if not the first, to see annuity assets (which many life insurers have been eager to unload due to stress from low interest rates on bonds) as raw material for risky loans.
We now have major asset managers like Apollo, Blackstone, and KKR owning or affiliated with large issuers of fixed annuities, including Athene, F&G, and Global Atlantic, respectively. They enhance margins by reinsuring the annuity liabilities in jurisdiction with easier capital requirements, like the Bahamas, Arizona or Vermont. They claim to be doing a good deed by infusing more capital into the annuity business; perhaps in the short run they are.
I have written about this phenomenon from the annuity end, calling it the ‘Bermuda Triangle strategy.’ The WSJ article explains it from the institutional investor end. When I talk to practitioners of this strategy, they claim to be solving the low-yield problem for clients in good faith. What is concerning are not so much the practices of pioneers of this business.
More concerning are the ‘me-too’ players–smaller johnny-come-lately asset managers who want some of those billions flowing from desperate institutional investors. They are hastily buying tiny life insurers, setting up offshore reinsurers, and reducing the transparency of their assets. I’m not the only one concerned; so is Moody’s. The NAIC is paying some attention to this, but not enough.
Less of this might be happening, IMHO, if much of the annuity industry had not already morphed into a quasi-investment industry. But that’s a longer story.
The field of retirement finance can sometimes seem hyper-specialized and remote from everyday life. But almost every major popular issue in the US contains at least an element or theme related to retirement policy.
Today’s edition of Research Roundup is evidence of that. Overlaps between retirement and “machine learning,” human decision-making, monetary policy, and immigration are central to the five academic papers we feature this month.
Here are questions and issues that these papers answer or address:
Machine learning (ML, aka artificial intelligence) involves chips and software that imitate human decision-making, only faster and at greater scale. The possible applications of ML in financial services are endless—but still largely unrealized.
A research team at two big universities has been exploring the use of ML technology to help investors build better portfolios, both during their careers and during retirement. ML could lead to mass-customization of portfolios, they believe, and to smarter target date funds (TDFs).
Jonathan Parker
The team, including Jonathan A. Parker and Aaron Goodman of MIT, along with Victor Duarte and Julia Fonseca of the University of Illinois at Urbana-Champaign, published its findings in a new paper, “Simple Allocation Rules and Optimal Portfolio Choice over the Lifecycle” (NBER Working Paper w29559).
The paper concludes that current TDF design leaves investors under-weighted in equities during retirement. A typical TDF in today’s market might call for an equity allocation of 50% or less at age 65 and after (and some people believe TDFs should hold zero equities at retirement). The authors’ ML analysis recommends 60% equities would provide more disposable spending in retirement. “The average optimal share in equity declines linearly to about 60% at retirement, after which it is roughly constant,” they write.
“We think TDFs do well in the first half of life, but are too conservative in the second half of life,” Parker told RIJ recently. According to the paper, “While TDFs may lead households to avoid worse mistakes, because they impose the same portfolio on everyone of the same age, there is scope for substantial improvement—2% to 3% of consumption—from more individualized financial advice or from more customized TDFs.”
The heart of the paper, however, is its exploration of ML’s applicability to fund design, financial advice, and robo-advisor platforms. The authors see ML enabling a mass-customization process where ML-driven software might annually tweak the asset allocations of smart TDFs in response to changes in client-specific variables, such as “non-traded labor income risk, home ownership and mortgages, health and mortality risks, pension income, family dynamics, liquidity needs, and taxes.”
“We’re building a ‘Game of Life,’ and asking an algorithm to play it,” Parker said. “It would be simple to encode this into a robo-advisor, with the goal of maximizing the average return and minimizing the variants.” Instead of a software “recipe” for successful investing, the investor gets a “trained apprentice” who thinks like a human advisor (more or less).
“You could develop a TDF that doesn’t condition on age, but instead on the state of the market,” Parker told RIJ. “This methodology, could be embedded in advisors’ desktops or online for people to play with.”
Parker stressed that the equity allocation of a retirement portfolio would be higher than for non-retirement accounts, because of differences in investment horizons. An appropriate equity allocation for young adults saving in taxable accounts for down payments on homes might be as low as 30%, but as high as 90% in a tax-deferred retirement savings account.
Reviewing data from some 70,000 401(k) plans for the 2009 to 2019 decade, a team of researchers at Harvard recently tried to find correlations between the average equity allocations in plans and the demographics of the plans.
Mark L. Egan and Alexander MacKay of Harvard Business School and Hanbin Yang from Harvard University published their findings in a December 2021 paper, “What Drives Variation in Investor Portfolios? Evidence from Retirement Plans” (NBER Working Paper 29604).
The team found that average equity allocations were higher in plans with relatively more wealthy and college-educated participants, and lower in plans with relatively more older and minority participants.
These differences were associated with different levels of risk aversion and different beliefs about the financial market. “Wealthier and more educated investors tend to have more optimistic expectations about the market,” the paper said. “Older investors, retirees, and minorities tend to have more pessimistic expectations about market returns.” Variation in beliefs and risk aversion explain 52% of the variation in equity exposure, the investigators concluded.
The differences in these attitudes varied by industry. “Investors who work in riskier sectors, as measured by the equity beta of their sector, tend to have more optimistic beliefs,” the paper said.
“Investors from the most optimistic sector, Real Estate, expect the market return to be 40% higher than investors from the least optimistic sector, Accommodation and Food Services.” Investor beliefs also appeared to depend on past market returns, and on the recent financial performance by their employers. They became “more optimistic about the stock market following strong financial performance from their employer.”
Optimism and low risk-aversion didn’t always go together. “Investors in the Information Sector have the highest equity allocations but are only in the 60th percentile in terms of investor expectations of market returns,” the paper said. The authors found no significant correlation between a plan’s demographics and the number of equity funds the plan offers.
Perhaps reflecting the so-called wisdom of crowds, the investment returns expected by the plan participants proved highly accurate. “The average expected return over our sample is 11.50%,” the authors noted. “The compound annual growth rate (CAGR) of the S&P 500 over the period 2009-2019 was 11.22%.”
Do low interest rates help or hurt the economy?
As the Federal Reserve contemplates a modest tightening in 2022—by tapering its bond purchases and raising interest rates perhaps three times—observers wonder if such inflation-fighting moves might trigger a stock market correction or a credit crisis. It has happened before.
In a new NBER paper, four European economists review past financial crises and ask: Should a central bank deviate from its objective of price stability to promote financial stability? The short answer is: Yes and no.
“The effect of monetary policy on financial stability is ambivalent,” write Frederic Boissay of the Bank of International Settlements, Fabrice Collard, of the Toulouse School of Economics, Jordi Gali, of Spain’s Centre de Recerca en Economia Internacional, and Cristina Manea of the Deutsche Bundesbank.
“On the one hand, loose monetary policy can help stave off financial crises. In response to the Covid–19 shock, for example, central banks swiftly lowered interest rates and acted as a backstop to the financial sector. These moves likely prevented a financial collapse that would otherwise have exacerbated the damage to the economy,” they write.
“[But] discretionary monetary policy actions, such as keeping policy rates too low for too long and then unexpectedly and abruptly raising them toward the end of an investment boom, can lead to a financial crisis.
“The financial sector is paradoxically more fragile when the central bank commits itself to backstopping the economy.” Why? Because such backstopping “eliminates the negative wealth effects associated with financial crises, raises the capital stock, which makes the credit market more vulnerable, and slows down the downward adjustment of capital that would be necessary to eliminate the existing imbalances,” the paper said.
“On the other hand, empirical evidence shows that, by keeping their policy rates too low for too long, central banks may entice the financial sector to search for yield and feed macro-financial imbalances.”
A new study from researchers in the US and Brussels yields the behavioral-finance insight that participants are more likely to opt out of a plan when confronted with decisions they don’t like.
That was one of the findings in “Choice Overload? Participation and Asset Allocation in French Employer-Sponsored Savings Plans.” NBER Working Paper 29601), by James Poterba (MIT economist and president of the National Bureau of Economic Research) and two Belgian economists.
“French employers have wide discretion in structuring employee saving plans. All plans must offer medium-term investments, which cannot be accessed for five years. Employers may also offer long-term investments that cannot be accessed until retirement,” the paper said.
“When plans include a long-term option, participation is lower than when the plan offers only more liquid medium-term investments. The presence of a long-term saving option also reduces the take-up of the plan’s default investment allocation, which must include a long-term component,” it continued.
“One interpretation of the findings, consistent with the theory of choice overload, is that some employees are unwilling to forego the liquidity of the medium-term option but find it costly to make an active election when they opt out of the default, and therefore choose not to participate in the plan at all.”
The authors noted that, because French workers still get most of their retirement income from the national pay-as-you-go pension (similar to Social Security but more generous), they rely relatively less on their defined contribution plan savings (though most participate). “French firms have more discretion in setting match rates than their US counterparts,” the paper said, “in part because the stakes are lower and most retirement income is provided through a public pay-as-you-go pension system.”
In areas where more low-education immigrants have entered the US workforce, the chance that US-born elderly will be able to live in their own homes goes up, according to new research from Kristin F. Butcher of Wellesley College, Tara Watson of Williams College, and Kelsey Moran of MIT.
In the NBER working paper 29520, “Immigrant Labor and the Institutionalization of the US-Born Elderly,” the three academics report that immigration provides “an abundance of less‐educated labor that can substitute for the elderly individual’s (or their family’s) labor…, potentially shifting the choice of technology for elderly care‐giving away from institutions. Immigration affects the availability and cost of home services, including those provided by home health aides, gardeners and housekeepers, and other less-educated workers, reducing the cost of aging in the community.”
More specifically, “a 10 percentage point increase in the less-educated foreign-born labor force share in a local area reduces institutionalization among the elderly by 1.5 and 3.8 percentage points for those aged 65+ and 80+, a 26-29% effect relative to the mean,” they write.
“The estimates imply that a typical U.S-born individual over age 65 in the year 2000 was 0.5 percentage points (10%) less likely to be living in an institution than would have been the case if immigration had remained at 1980 levels.” But benefits for the elderly come at the expense of lower pay for certain workers.
“Commuting zones with high predicted levels of immigration have lower wages among the less‐educated workforce and increased employment of health and nursing aides. We see similar impacts for other less‐educated occupations that may support home‐based care, such as housekeepers and gardeners,” the paper said.
“Home health aides are especially likely to see positive employment effects, and nursing home aides also experience effects depending on the specific measure. Licensed practical nurses have wage reductions but do not have employment increases, suggesting a reduction in labor demand. Registered nurses command higher wages and have, if anything, lower employment levels when immigration is higher.”
© 2022 RIJ Publishing LLC. All rights reserved.
If the global financial crisis (GFC) of the mid-to-late 2000s and the COVID crisis of the past couple of years have taught us anything, it is that Uncle Sam cannot run out of money. During the GFC, the Federal Reserve lent and spent over $29 trillion to bail out the world’s financial system, and then trillions more in various rounds of “unconventional” monetary policy known as quantitative easing.
During the COVID crisis, the Treasury has (so far) cut checks totaling approximately $5 trillion, often dubbed stimulus. Since the Fed is the Treasury’s bank, all of these payments ran through it—with the Fed clearing the checks by crediting private bank reserves. (To see the original version of this article, go to levyinstitute.org.)
As former Chairman Ben Bernanke explained to Congress, the Fed uses computers and keystrokes that are limited only by Congress’s willingness to budget for Treasury spending, and the Fed’s willingness to buy assets or lend against them—perhaps to infinity and beyond. Let’s put both affordability and solvency concerns to rest: the question is never whether Uncle Sam can spend more, but should he spend more.
If the Treasury spends more than received in tax payments over the course of a year, we call that a deficit. Under current operating procedures adopted by the Fed and Treasury, new issues of Treasury debt over the course of the year will be more-or-less equal to the deficit.
Every year that the Treasury runs a deficit it adds to the outstanding debt; surpluses reduce the amount outstanding. Since the founding of the nation, the Treasury has ended most years with a deficit, so the outstanding stock has grown during just about 200 years (declining in the remainder). Indeed, it has grown faster than national output, so the debt-to-GDP ratio has grown at about 1.8% per year since the birth of the nation.
If something trends for over two centuries with barely a break, one might begin to consider it normal. And yet, strangely enough, the never-achieved balanced budget is considered to be normal, the exceedingly rare surplus is celebrated as a noteworthy achievement, and the all-too-common deficit is scorned as abnormal, unsustainable, and downright immoral.
First the good news. The government’s “deficit” is our “surplus”: since spending must equal income at the aggregate level, if the government spends more than its income (tax revenue), then by identity all of us in the nongovernment sector (households, businesses, and foreigners) must be spending less than our income. Furthermore, all the government debt that is outstanding must be held by the nongovernment sector—again, that is us. The government’s debt is our asset.
Since federal debt outstanding is growing both in nominal terms and as a percent of GDP, our wealth is increasing absolutely and relatively to national income. Thanks Uncle Sam!
But the dismal scientists (economists) warn that all this good news comes with a cost. Deficits cause inflation! Debt raises interest rates and crowds out private investment! Economic growth stagnates because government spending is inherently less efficient than private spending! All of this will cause foreigners to run out of the dollar, causing depreciation of the exchange rate!
With two centuries of experience, the evidence for all this is mixed at best. Deficits and growing debt ratios are the historical norm. Inflation comes and goes. President Obama’s big deficits during the GFC didn’t spark inflation—indeed, inflation ran below the Fed’s target year after year, even as the debt ratio climbed steadily from the late 1990s to 2019.
The initial COVID response—that would ultimately add trillions more to deficits and debt—did not spark inflation, either. (Yes, we’ve seen inflation increasing sharply this year—but as I noted, the evidence is mixed and many economists, including those at the Fed, believe these price hikes come mostly from supply-side problems.)
Interest rates have fallen and remained spectacularly low over the past two decades. Anyone looking only at those 20 years could rationally conclude that interest rates appear to be inversely correlated to deficits and debt.
While I do believe there is a theoretically plausible case to be made in support of that conclusion, the point I am making is that the evidence is mixed. And if you were to plot the growth rate of GDP against the deficit-to-GDP ratio for the postwar period, you would find a seemingly random scatterplot of points. Again, the evidence is mixed at best.
Finally, the dollar has remained strong—maybe too strong for some tastes—over the past 30 years in spite of the US propensity to run budget deficits, and even trade deficits for that matter. Both of these are anomalies from the conventional perspective.
So, while there are strongly held beliefs about the negative impacts of deficits and debt on inflation, interest rates, growth, and exchange rates, they do not hold up to the light of experience. When faced with the data, the usual defense is: Just wait, the day of reckoning will come! Two centuries, and counting.
Levy Institute Senior Scholar L. Randall Wray is a professor of economics at Bard College.
© 2022 The Levy Institute. Reprinted by permission.
In another attempt to undermine faith in Social Security (‘Should You Count on Social Security?’), economist Andrew Biggs mixes up the value of social insurance and defined contribution retirement savings accounts.
What do I mean by that? In the 1970 dark comedy about WWII, ‘Catch-22,’ Jon Voigt as quartermaster of a B-25 bomber base near Italy reveals that he sold the flight crews’ parachutes to capitalize a company he’d created. He stuffed the empty parachute sacks with certificates of company stock.
Social Security is like the parachutes, and 401(k)s are like the stock. They serve different purposes. Insurance by definition pays off during insurable events; Social Security pays off in the event that you live past a certain age or are disabled. All US workers pay taxes for it, they get credit for it on a database, and the gov’t guarantees that they will get what they earned–in case of the insured event.
Jon Voigt (left) and Martin Balsam in the film ‘Catch-22’.
The cost of Social Security is low (relative to private annuities) because almost all American workers contribute, not everyone experiences the insurable event, and the government runs the program at cost. Armed with Social Security, Americans can afford to worry less about a market crash during the five-year “red zones” before and after they retire. They can also worry less about longevity risk, market risk, and inflation risk.
Importantly, workers can afford to risk more money on stocks because they know those other financial risks (which stocks don’t cover) will be covered by Social Security. Without Social Security, most people would need to invest more of their 401(k) contributions in bonds. I contest Biggs’ characterization of Social Security contributions as taxes (i.e., an expense), 401(k) contributions as savings (investments), and Social Security money as a transfer from strapped workers to pampered retirees. I believe this plays a shell game with the facts.
Payroll contributions to Social Security are savings, in effect, and the workers and retirees that Biggs pits against each other are the same people at different times of their lives. Biggs concedes that there won’t be a big fiscal crisis when the Social Security trust fund is empty, but still manages to compare the program unfavorably to DC plans (without mentioning the massive annual federal tax expenditure to incentivize retirement savings or market crashes or the cost of bailouts).
Sure, you might be able to invest for yourself ‘better than the government can.’ But you can’t insure yourself against market, sequence, interest rate, inflation and longevity risk more efficiently than Social Security can. And, by the way, Social Security’s critics often denigrate its “unfunded” nature; in fact, Boomer contributions to Social Security exceeded the program’s cost for decades. The Boomer burden has been pre-funded. (In 2034, when the Boomers’ decades of excess contributions may finally be exhausted, about half of them will already be dead.)
Biggs would have you believe that there’s a zero-sum game between workers and retirees, between taxes and investment, and between the public sector and the private sector. This supposed zero-sum game is not reality. In 2021, about a trillion dollars was deducted from paychecks for SS tax and a trillion ended up in the bank accounts of Social Security beneficiaries. The banking system saw no big change in reserves or lending capacity as a result. Consumption rose. The elderly lived independently. Don’t let the pundits confuse you. Don’t trade your retirement parachute for paper. We need Social Security and employer-sponsored retirement savings plans.
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