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The Bucket

Posted on November 28, 2013 by Kerry Pechter -

New York Life reports 2013 annuity sales

New York Life experienced strong third quarter gains in sales of life insurance, annuities and mutual funds, as well as an increase in agent new-hires in the first nine months of 2013, the company said. Career agents gathered 10% more whole life insurance premia and 11% more annuity premia in the period, compared with the same period in 2012.

For the second consecutive year, the company also reported an 8% increase in its dividend payout to participating policyholders. The total payout increased $109 million over the prior year, to $1.43 billion in 2014. The company said it has paid a dividend every year since 1854.

Individual recurring premium life insurance sales through agents were up 12% through the third quarter compared with the same period in 2012.

New York Life’s sales of single premium immediate annuities and the company’s deferred income annuity, Guaranteed Future Income Annuity, increased 17% through the third quarter compared with the same period in 2012. Total annuity sales through all channels have increased 36% compared with the first nine months of 2012, the company said.

Sales through New York Life Direct, including sales through AARP, increased by 5% over the same period last year. New York Life has been the exclusive direct provider of life insurance to AARP members since 1994 and of lifetime income annuities to AARP members since 2006.

Sales of its MainStay family of mutual funds increased by 78% to a record $22.47 billion through the third quarter, year over year. New York Life’s operations in Mexico (Seguros Monterrey New York Life) saw 10% sales growth in the first nine months of 2013, compared with the same period in 2012.

MassMutual sells record $3 billion of annuities in 2013

Massachusetts Mutual Life Insurance Company has sold over $3 billion of annuities year to date, exceeding prior full-year sales, the Boston-based company said in a release. The total reflects sales across MassMutual’s full suite of fixed, variable, and income annuities.

Sales of the MassMutual RetireEase Choice flexible premium deferred income annuity contributed to the increase, the company said. The product, which allows individuals to buy personal pensions years in advance of their retirement date, is available for direct purchase through the Fidelity Investments website.

MassMutual also attributed sales growth to its “Sound Retirement Solutions” retirement income planning framework. Based on the company’s research into the outcomes of various retirement strategies, the SRS framework shows how guaranteed income streams can help cover a retiree’s critical living expenses.

On Nov. 4, MassMutual announced that its board had approved the company’s largest dividend payout in the company’s history. The payout to eligible participating policyowners for 2014 was about $1.49 billion, up more than $100 million from the 2013 estimated payout and based on a 7.10% dividend interest rate. MassMutual said it has paid dividends to eligible participating policyowners since the 1860s.

Financial strength ratings for MassMutual (and subsidiaries C.M. Life and MML Bay State Life) are: A.M. Best Company, A++ (Superior); Fitch Ratings, AA+ (Very Strong); Moody’s Investors Service, Aa2 (Excellent); and Standard & Poor’s, AA+ (Very Strong). Ratings are as of 11/13/2013 and are subject to change.

[The dividend interest rate is not the rate of return on the insurance policy. Dividends have an investment component, a mortality component and an expense component. Dividends for any given policy are influenced by policy series, issue age, gender, underwriting class, policy year and policy loan rate and changes in experience.]

Towers Watson hires former MetLife executive Edward Root

Edward Root has been hired as a senior pension risk analyst by Towers Watson, the global consulting firm. He will join the firm’s Stamford, Conn.-based North American retirement business, which advises plan sponsors on pension plan risk management strategies.

Root had been vice president and head of U.S. pensions at MetLife, where he was responsible for its multibillion-dollar pension risk transfer annuities business. Previously, he was a senior vice president and actuary at Transamerica. Root began his professional career as a pension actuary at Towers Perrin.

Root received a B.S. degree in mathematics from California State University at Sonoma and an M.B.A. in finance from the University of Southern California.

Jackson National notes rising sales of Elite Access VA

Jackson National Life, a unit of the U.K.’s Prudential plc, reported sales and deposits of $20.7 billion in the first nine months of 2013, up 5.4% year over year. Total sales included $15.5 billion in variable annuity sales, the company said in a release.

The $15.5 billion (up from $15.3 billion in 2012) included almost $3 billion in sales (up from $630.1 million in 2012) of Elite Access, a VA designed for tax-deferred investment in alternatives for accumulation. Sales of Perspective variable annuities, which offer lifetime income benefits, dipped.

Jackson’s sales of fixed index annuities totaled $1.3 billion, up from $1.2 billion in the first nine months of 2012. Fixed annuity sales were $679.6 million, down from $713.5 million in 2012.

In the first nine months of 2013, Jackson issued $1.1 billion of institutional products, up from $440.5 million in the first nine months of 2012. Jackson participates in the institutional market (guaranteed investment contracts, medium-term notes and funding agreements) on “an opportunistic basis.”

Curian CapitalLLC, Jackson’s asset management subsidiary, generated deposits of $2.1 billion during the first nine months of 2013, up 11.1% over 2012. Assets under management in Curian’s core business increased to $10.3 billion as of September 30, 2013, up from $8.9 billion at year-end 2012.

As of November 13, 2013, Jackson had the following strength ratings: A+ (superior) from A.M. Best, AA from Standard & Poor’s, AA from Fitch Ratings, and A1 from Moody’s Investors Service Inc.

Fidelity 401(k) plan accounts now average $84,300

This year’s rising stock market has helped boost the average balance in 401(k) plan accounts provided by Fidelity Investments to a record $84,300 at the end of the third quarter of 2013, an increase of 11.1% from a year prior, Fidelity said in a release.

Employees who were continuously active in their 401(k) plan over the last 10 years saw their average balance rise 19.6% to $223,100 during the past 12 months. For pre-retirees age 55 or older who have been active in their plan for 10 years or more, the average balance is $269,500.

Fidelity also found that one in three participants now uses a professionally managed investment option, such as a target date fund or a managed account.

At the end of the third quarter of 2013, one third (33.1%) of 401(k) participants overall and 55% of “Gen Y” participants (aka “Millennials” under age 30) had all of their plan assets in a target date fund.

Fidelity has seen a more than three-fold increase in the portion of plan sponsors offering managed accounts to their employees since the third quarter of 2009 and in the number of participants using them. Assets in retail managed accounts have more than doubled since then.

Fidelity offers “Plan for Life,” which furnishes advice to plan participants via phone, web, smartphones or tablets and in person.

Guardian declares dividend for life policyholders

Guardian Life Insurance Company of America announced that its board had approved payment of $776 million in dividends to the company’s individual life policyholders in 2014. The dividend interest rate will be 6.25% in 2014, the company said in a release.

Quote of the Week

Posted on November 21, 2013 by Kerry Pechter -

Asia’s appetite for alternatives on the rise: Cerulli

Posted on November 21, 2013 by Kerry Pechter -

Growing appetite for alternative investments will likely drive institutional outsourcing across Asia, according to Cerulli Associates. This could spell good news for managers that offer alternatives as options in variable annuity products.

In a new report, Institutional Asset Management in Asia 2013, Cerulli forecasts that total assets in the region will continue to grow between 2013 and 2017 and hit $17 trillion by 2017. Private equity, commodities, hedge funds, and other alternative investments could play a large role in that.

The report, which examines Asia’s institutional landscape and outsourcing opportunities for external managers, found that allocations to alternatives still remain small at most institutions, often accounting for less than 10% of their overall portfolios. However, these allocations are said to be increasing steadily.

Investable assets of Asian institutions topped $10 trillion for the first time in 2012, rising 9.6% year-over-year. Stronger increases are expected from Southeast Asia, as institutions in those markets are relatively underdeveloped and are growing their assets from low bases.

“Managers that start engaging institutions early, even when the latter are not ready to allocate to alternatives, will stand a better chance of winning mandates when an institution is ready to invest,” says Cerulli senior analyst Chin Chin Quah, an author of the report.

Additionally, deregulation is welcome news to some institutions. China has been at the forefront with a series of deregulations, especially for insurers. This past June, insurers have been allowed to set up fund management units to offer mutual funds to retail and institutional investors.

Indexed annuity sales soar in 3Q 2013

Posted on November 21, 2013 by Kerry Pechter -

Indexed annuities had record-breaking sales for the third quarter at $10 billion. Indeed, production was up more than 9% when compared to the previous quarter, and up more than 15% when compared with the same period last year, according to Wink’s 65^th Sales & Market Report.

Allianz Life prevailed as the leading issuer of indexed annuities with a 12.91% market share, while Security Benefit Life and American Equity maintained their positions as the second and third-ranked companies in the market. Great American and Aviva rounded out the top five, respectively.

Wink’s report consisted of 42 indexed annuity carriers, representing 98.4% of indexed annuity production.

Indexed life sales came in at $328 million for the third quarter with 48 insurance carriers participating in the ranking, representing 95.1% of production.

Pacific Life maintained its leadership in indexed life sales, with a 13.51% market share. Aegon came in second place in the market, while AXA Equitable, National Life Group, and Minnesota Life rounded-out the top five companies, respectively.

Allianz Life launches Signature 7 FIA, a companion to Core Income 7

Posted on November 21, 2013 by Kerry Pechter -

Allianz Life has launched the Signature 7, a fixed indexed annuity with three index options—the S&P500, the Russell 200 and Barclays U.S. Dynamic Balance Index—as well as a fixed interest option. There’s a seven-year surrender period.

Signature 7 offers an annual reset that locks in earned interest each year. The annuity is available to Allianz Preferred broker-dealers, insurance marketing organizations. It is approved in 41 states.

This is an accumulation stage product, not an income product. Like most FIAs, it’s designed for retail investors who are looking for a safe return that’s higher than they can get from fixed income products. Although the product is described as intended for broker-dealers, the seven-year surrender period may be longer than many broker-dealers would like to sell.

The Signature 7 offers a monthly sum crediting strategy and a spread of 1.7% on the Barclays index. Any return above 1.7% will be credited to the policy on the anniversary in this index.

The new product complements Allianz’s recently launched Core Income 7 annuity, which has a guaranteed lifetime withdrawal benefit option. With the Signature 7 annuity, a policyholder must annuitize to receive lifetime income.

A model for investing Social Security funds in stocks

Posted on November 21, 2013 by Kerry Pechter -

Some observers have suggested investing a portion of Social Security trust fund assets in equities. An existing retirement plan for railroad workers offers a model for how that might be done, according to a new brief from the Center for Retirement Research at Boston College.

The Railroad Retirement program, which holds $23 billion in assets, bears some similarity to Social Security. An act of Congress in 2001 allowed the railroad fund to start investing in equities, and the fund has encountered and overcome some significant risks associated with equity management since then.

The Social Security trust, which currently holds $2.7 trillion in U.S. Treasury obligations, would need to accomplish two things to follow the Railroad Fund’s lead, according to the brief, written by CRR research economist Steven A. Sass.

The Railroad Fund implemented an automatic mechanism to respond to financial shocks. It adjusts the amount of payroll taxes dedicated to the plan based on whether the pension fund’s total assets are up or down. Social Security could create a similar mechanism, according to the brief.

“The Railroad Retirement ratchet adjusts tax rates based on the ratio of Trust Fund assets to annual benefit outlays, averaged over the previous 10 years. The adjustments are designed to keep that ratio within a target band of four to six times outlays. The ratchet raises taxes should the ratio fall below four, and cuts taxes should it rise above six. These adjustments are based on the slow-moving 10-year average of the ratio of assets to outlays because both management and labor sought to avoid sharp year-to-year changes in tax rates,” the brief said.

To limit politically motivated meddling in their fund, the railroads established a trust independent of Congress, the National Railroad Retirement Investment Trust. Social Security could do something similar. To limit manager risk, the Social Security trust could “specify the share of Social Security assets to be invested in equities, say 40%, and then direct those assets to be invested in a broad market index, such as the Russell 3000 or the Wilshire 5000,” Sass wrote.

Net VA flow ebbs to $1.5 billion in 3Q 2013: Morningstar

Posted on November 21, 2013 by Kerry Pechter -

If the variable annuity market were a large dance hall, you might see a dynamic confusion of sweaty couples streaming on and off the crowded floor, some spinning to the music under the glitter ball and others flopping into folding chairs along the wall.

Some are changing partners. A few have slipped out the fire exit for a change of scenery, or headed home. The dancers number almost the same as always—but a subtle ennui in the air suggests that this venue is no longer the hippest in town.

Or, to dispense with obsolete metaphors, you could say that the variable annuity sales statistics for the first three-quarters of 2013 are contradictory and difficult to interpret. Assets under management reached an all-time high. But net flows have reached what may be a 10-year low. Publicly held companies still dominate this market, but they’ve played musical chairs with the top-ten list.

“Shifts in market share this year have been massive,” wrote Morningstar VA analyst Frank O’Connor in his third quarter and year-to-date sales report, issued yesterday. “Former market leaders Prudential and MetLife were down a whopping 44.3% and 37.1%, respectively,” while Lincoln National sales were up 47%, SunAmerica/VALIC (now American General) was up 34.8%, AEGON/Transamerica was up 59%.

Jackson National, which has diversified its VA offerings with the no-living-benefit Elite Access product, was the top seller by a large margin, with $5.2 billion for the quarter and $15.5 billion for the year. Relative to 2012, Elite Access sales have risen more than four-fold so far this year, to $2.77 billion.

Despite the ongoing turmoil in the industry—evidenced by the departures, the de-risking, the dropouts, the buy-backs and the launch of complex structured or buffered products—consumers and advisers are still evidently looking for an all-weather retirement income tool. By no means have they abandoned variable annuities.

In the third quarter of 2013, gross new sales were $34.7 billion, down 5.9% from the previous quarter ($37 billion) and down 3.2% from the year-ago quarter ($35.9 billion). Through the first nine months of this year, sales totaled $106 billion, a 3.1% drop from the same period in 2012. “Absent a significant bump in sales activity in the fourth quarter, full year 2013 sales are expected to be down 2-3% from 2012 sales of $143.4 billion,” O’Connor wrote.

Although sales were slightly down on an industry basis, the shifts in market share this year have been massive. Former market leaders Prudential and MetLife were down a whopping 44.3% and 37.1%, respectively, as those carriers put the brakes on VA sales. The net flows figure was extremely low, at about $1.5 billion in the third quarter and $4 billion for the year so far. But Morningstar characterized the net flow as surprisingly good, given the cash drain from older and/or run-off blocks (like Hartford’s) and from group annuities like TIAA-CREF.

“Though low, net flow remains in positive territory despite the heavy bleeding, which is no mean trick and in some respects perhaps a blessing in disguise to the extent the cash outflow represents a reduction in risk assets,” Morningstar noted.

Sales of variable annuities without income benefits, which are sold for the long-term benefits of tax deferral and tax-deferred trading, were strong in the third quarter. With or without living benefits, variable annuities are still the only product where an investor can put virtually any amount of after-tax money for tax-deferred growth.

“Jefferson National’s Monument Advisor, a flat fee product aimed at the RIA market, has seen quarterly sales almost double in the past year. Jackson National’s Elite Access VA, focusing on alternative based investment strategies and offering no benefit guarantees, has nearly tripled quarterly sales in the past year. Another example is Midland National’s LiveWell VA, where sales, while small in the context of the product sales of major players, increased almost 500% in the third quarter relative to the 3rd quarter of 2012,” Morningstar said.

Most of the traditional variable annuity sales leaders or their parents have been stock companies: AXA, AIG (American General, SunAmerica/VALIC), AEGON/Transamerica, Jackson National (Prudential plc), Lincoln National, ManuLife (John Hancock), MetLife and Prudential Financial. ING, AEGON/Transamerica. Nationwide, ranked 13^th in VA AUM, was a stock company but went private.

That makes sense, because their shareholders expect equity-like gains and the only way to get those is by taking risks—which in the 2000s meant equity-linked insurance products. Now that they’ve been whipsawed by equity volatility and an interest-rate drought, it’s not yet clear where they will look next for strong profits.

Not every stock company jumped on the VA bandwagon. Principal (which has less than $8 billion in VA assets under management), Protective, Genworth Financial, and Allianz Life of North America, either purposely chose to stay out of the business of writing puts on the equity markets or just decided to focus on other businesses. Nationwide has

The big mutual companies make up most of the second-ten leading VA issuers. Members of this group include Pacific Life, Thrivent Financial, New York Life, Ohio National, Northwestern Mutual, Minnesota Life, Massachusetts Mutual and Guardian. Together, they sold roughly as much VA product in the third quarter as Jackson National, the distant leader, sold alone.

More than two-thirds of variable annuities sold are of the B-share type, which carries an up-front of commission of 5% or more for the intermediary. Many sales were driven by both rich customer benefits and rich advisor incentives, and the risks as well as the direct cost of sales was high.

The issuer earns back the commission through the mortality-and-expense risk fees paid by the contract owner at least through the surrender period. Those fees may be tied to the account value, which is tied to the stock market, which makes the issuer dependent on steady or rising equity values both to fund the income guarantee (especially if deferral bonuses are promised) and to recoup the deferred acquisition costs (DAC). When equity values dropped in 2008, companies had to set aside higher reserves for potential losses on DAC.

Variable annuity issuers now face the challenge of trying to offer new equity-linked insurance products with lifetime income benefits to Boomers without exposing themselves again to high levels of market and longevity risk. They’re doing that by requiring the investor to share the market risk, often by requiring investors who want living benefits to allocate their premiums to low-volatility mutual funds.

These new risk-shared variable annuity products may in fact sell in significant quantities to Boomers, who will remain amenable to combo-products that offer downside protection and upside potential. But a return to the VA sales boom of the mid-2000s would probably require a return to the peculiar naïveté of the mid-2000s—which doesn’t seem likely anytime soon.

A Fool for a Client?

Posted on November 21, 2013 by Kerry Pechter -

Jerry Schlichter, the St. Louis plaintiff’s attorney whose multi-million-dollar federal class action lawsuits have revealed the vulnerability of 401(k) plan sponsors and providers to “excessive fee” complaints, has struck again.

In this case, the plan sponsor and the full-service plan provider is MassMutual.

The complaint was filed in U.S. District Court in Boston on November 5. The plaintiffs are participants in the MassMutual Thrift Plan, a 14,800-member, $1.7 billion group annuity. The defendants are members of the plan’s Investment Fiduciary Committee and Plan Administrative Committee, as well as Mass Mutual CEO Roger Crandall.

Excessive fees are at the heart of the complaint, as they have been in Schlichter suits against Fidelity, Ameriprise and CIGNA. The suit charges, in essence, that MassMutual enriched itself at the expense of the participants by hiring its own Retirement Services division to steering their savings mainly into MassMutual funds (and a guaranteed-return fund in its general account) when the company should have, as a plan sponsor and a fiduciary, made less expensive, non-proprietary options available.

If you love irony, this almost seems like a case of people suing themselves for moving too much money from one pants pocket to another. On the other hand, it’s hardly a laughing matter.

The defendant in this case, as in a recent Schlichter case against Fidelity, is both the plan provider and the sponsor. Depending on how you choose to look at it, MassMutual’s plan either chose to eat its own cooking or, alternately, it compelled its employee-participants to shop at the company store.

What was business-as-usual yesterday is apparently actionable today. (The fact that the MassMutual Thrift Plan is a “group annuity” isn’t necessarily significant, we are told. According to the complaint, the return on the plan’s fixed interest account assets is set for six months at a time; otherwise, the plan has no insurance features. The lawsuit specifically questions an 85-basis point risk charge on assets in the fixed interest account.)

ERISA aficionados are tracking the story. On his blog, Tom Clark, an ERISA consultant (and former Schlichter law firm attorney) didn’t take sides; he called the suit a wake-up call for customers of MassMutual Retirement Services:

“Plans that use MassMutual as a provider or advisors who recommend MassMutual services and products… should use this as an opportunity to review your plan’s relationship with MassMutual.

This is only a complaint and no one can predict with any certainty how it will turn out. But that being said, if any of the specific allegations found in the complaint could apply to your plan, you have now been put on notice to investigate.

This can include asking for more information, re-reviewing your 408(b)(2) disclosures and agreements, or benchmarking your plan’s fees. These tasks should obviously focus on analyzing any investments in your plan and ensuring that any fees paid are reasonable and necessary.”

The complaint accuses MassMutual of layering extra fees on top of the fees charged by fund subadvisors, that its funds weren’t as inexpensive as Vanguard’s, and that MassMutual was charging its own participants more than MassMutual charged outside institutional clients.

Vanguard appears in the role of curve-wrecker in this lawsuit. The plaintiffs compare the costs of MassMutual’s target date fund offerings unfavorably to similar Vanguard products, with the former costing up to 85 basis points but the latter costing as little as 17 bps.

(But that comparison may be a case of apples-and-oranges. According to Morningstar, MassMutual’s TDFs are either partly or entirely actively managed, while Vanguard’s are mainly or entirely funds-of-index-funds. The federal judge in this case may end up deciding whether the added expense for active management is “reasonable” in the context of an ERISA retirement plan.

[BrightScope gives the MassMutual Thrift Plan a rating of 74 out of 100; that’s above the peer group average but well below best-in-class. Morningstar notes that MassMutual’s retail TDFs are on the pricey side.]

If nothing else, this case suggests that, like the person who serves as his own lawyer and has a fool for a client, a full-service plan provider might think twice before hiring itself to be the provider for its own corporate plan. Even when intentions are impeccable, questions about self-dealing can’t help but arise. As for intentions, the plaintiffs go for the throat by alleging that the MassMutual CEO directly profited, via bonuses linked to MassMutual’s bottom line, from the economics of the plan.

The stickiest wicket in the complaint may be the charge that participants were paying for plan expenses even though the “Plan document” states “that all expenses of establishing and administering the plan including expenses with respect to the group annuity contract and fixed income agreement shall be borne by the employer as a further contribution to the plan.” If true, this alludes to a broader question that the 401(k) system as a whole has yet to answer: What to tell the millions of participants who believe their plans are “free”?

The Hangover

Posted on November 20, 2013 by Kerry Pechter -

Have annuity manufacturers turned the corner? Have they regrouped and repaired and retooled enough to make another strong bid for domination of the Baby Boomer retirement market?

Or have “bad liabilities” and low interest rates forced them to downsize their ambitions? And if so, what will that mean for distributors and for the Boomers themselves?

Questions like those simmered under the cordial surface of the American Council of Life Insurance meeting a few weeks ago in New Orleans—a city that, like the life insurance business, is still recovering from disaster. On the one hand, there are reasons to believe that the worst may be over.

Life insurer stocks have risen by about 40% in 2013, on average. The bull market in equities—itself a by-product of low interest rates—has kept variable annuity subaccounts values high and unlocked some of the insurers’ reserves for deferred acquisition charges.

Insurers have withdrawn, de-risked, re-designed, “bought back” and shut off new contributions to old, problematic annuities and introduced an array of new products that carry less risk and require less capital. Bitter medicine has been swallowed—witness Prudential’s recent $1.7 billion pre-tax charge for adjusted lapse-rate assumptions and AXA Equitable’s costs in trying to buy back in-the-money living benefits.

But annuity issuers—some more so than others—aren’t out of the woods yet. Many have big blocks of in-force variable annuity business that were priced with expectations of higher interest rates and lower lapse rates than we’ve seen. General account revenues have been trending down, a result of persistent low interest rates. Sales of new variable annuities are not benefiting as much from rising stock values as they once did.

Given the big variations in life insurers’ experience in (and responses to) the financial crisis, a one-size-fits-all interpretation of the VA market probably doesn’t exist. But, it appears that, for some companies, binging on sales of generous variable annuities and other products during the boom has led, since the financial crisis, to a kind of hangover.

While it’s easy to say so in hindsight, at least one industry analyst who presented at the ACLI conference believes that things might have turned out better if the VA industry had reacted more pragmatically to the shift from non-qualified to qualified premiums that started in 2002.

At the ACLI conference

That analyst, Colin Devine of C. Devine & Associates, worries that some of the liabilities assumed over the past decade will be millstones around the necks of certain life insurers for a long time.

“Bad assets you can sell. Bad liabilities you’re stuck with forever,” said Devine in an interview with RIJ after the conference. He thinks those liabilities will diminish, though not destroy, life insurers’ capacity to meet the Boomers’ retirement needs.

“I don’t think there’s enough capacity in the industry as it stands today to service the Boomer need for longevity protection,” Devine said. “For one thing, the opportunity is so big. The second piece is the life insurers’ legacy liabilities.

“Whether it’s variable annuities, long-term care (LTC) or no-lapse guarantee universal life, these liabilities similar to the old non-cancelable own-occupation individual disability income polices sold back in the’80s and ’90s will stay around a long time, consume a lot of capital and deliver a low return. Many insurers may find a meaningful portion of their reserves and capital will be committed to supporting these underachieving liabilities and not be available to fund new growth opportunities.”

Another long-lasting problem, he said, has been the decline in general account yields. Life insurers have to make long-term assumptions when they price certain products, like annuities. A significant level of liabilities on insurers’ books today was priced with the assumption that incoming premiums would be invested at much higher rates of return than insurers are able to earn today.

While there may be some ability to adjust for this in terms of the cost of insurance charges and policy dividends, insurers are still feeling their margins being squeezed. Low rates can also adversely impact lapse assumptions (as investors seek better opportunities), which in turn can hurt mortality/morbidity experience, according to Devine.

“Nobody’s crippled, but they are constrained in leveraging the Boomer market opportunity,” he said.

In its own way, the financial crisis and the low rate environment may have changed certain life insurers’ attitudes toward equity market risk almost as dramatically (though less visibly) the way 9-11 changed the way the airline industry handles airport security risk.

Today, it no longer matters whether life insurers should have assumed lower lapse rates or if demutualized companies took too much equity market risk in pursuit of higher returns on equity. Going forward, there are new questions: Having been bitten once by equity risk, will life insurers be doubly shy? And if they are too cautious, how will that affect product design, profitability and competitiveness in the face of challenges from private-equity firms or fund companies, which also want to manage a chunk of the Boomer retirement savings?

A sticky wave of qualified money

Devine’s presentation at ACLI was called “Lots of Opportunities, Lots of Challenges. Looking Ahead at the U.S. Life Insurance Industry.” He was upbeat on the asset side but downbeat on the liability side. “Because of their low lapse rates, it is going to take not quarters, not years, but decades to run down these closed blocks,” he said. In its latest earnings call, Prudential said it has adjusted its VA lapse assumption to 6% per year from 9%.

While higher equity prices help insurers recover VA acquisition costs faster and unlock some reserves, low interest rates are pushing down on lapse rates (and raising reserve requirements) by making the 5% to 7% (of the benefit base) annual payouts of those products look very good by comparison.

If VA issuers calculated that contract owners who delayed income until the end of the deferral period—10 years, for many contracts—wouldn’t live long enough to drain their account values and start dipping into insurers’ pockets, they may have been banking on overly-optimistic equity market expectations and high lapse rates.

Starting in 2002, a reversal occurred: more premium started coming from qualified money than non-qualified money. That meant that more policyowners probably bought their contracts for the lifetime income, and would likely hold onto their contracts until they died.

“In 2000, 60% of VA sales were non-qualified. Let’s look at today: 60% of sales come from tax-deferred money. People are buying them in their IRAs. For the past 10 years they’ve been buying the contracts for retirement income, not tax deferral. All the VA issuers have known this. They have watched the percentage of their deposits that are tax qualified steadily rise,” Devine said.

But the implications of that switch for lapse (and pricing) assumptions were not sufficiently heeded, he suggested. “People who bought VAs with non-qualified money might just let it sit there and never use their living benefit. Nobody stepped back and re-thought their pricing assumptions as the percentage of purchases using qualified funds began to rise.

“Some insurers continued to assume these products would get exchanged every six or eight years [as surrender periods expired]. But qualified customers are different. It’s not a matter of if the tax-qualified buyer will start taking withdrawals; it’s a matter of when. You know that by age 70½ they will have to start taking required withdrawals because that is when the tax code mandates that must begin required minimum distributions or RMDs.”

The mutual insurers and a couple of public life insurers—Protective and Principal, notably, which at mid-year 2013 held only about $11 billion and $7.2 billion in VA separate account assets, respectively—largely sat out the VA arms race, but others “chased sales, even though it was obvious that people bought their living benefits with the full extent of using them,” said Devine.

A more sanguine view

Other observers, however, prefer to focus on the positive. Consulting actuaries at companies like Milliman and Ruark, who get paid to help insurers out of jams like these, take a more sanguine view than Devine, a former equity analyst.

“I don’t necessarily agree that products were ‘mispriced,’” said Tim Paris, CEO of Ruark Insurance Advisors. His company studies lapse rate data and works on reinsurance deals for life insurers with burdensome VA blocks.

“Even before the financial crisis, the manufacturers understood that the cost of the guarantee would be affected by policyholder behavior and surrender rates,” Paris told RIJ. “But they said, ‘We need to make certain assumptions. We’ll do our best.’ Now it looks like it hasn’t turned out the way they might have hoped.

“As we’ve seen since 2008 and 2009, policyholder behavior is turning out to be a lot different from what was anticipated. Directionally, the surrender rates are a lot lower than they used to be, and lower than what companies would have expected.”

Milliman has played a big role in the engineering of managed-volatility portfolios, which reduce VA manufacturers’ equity risk exposure by building equity risk dampeners into the separate accounts themselves. VA issuers like Ohio National and Securian can now afford to bring living benefit riders with rich deferral bonuses to market because they require contract owners to use those portfolios if they want those riders. The crisis has produced that and other product innovations.

“My view is that the life insurance industry will find ways to benefit significantly from the Baby Boomer demographic trend. Looking for a silver lining, the financial crisis taught the life insurance industry that it is critical that guaranteed products are manufactured in a sustainable way,” Milliman principal Ken Mungan told RIJ.

“The industry has made tremendous progress in improving product design and risk management to create VAs that meet customer needs with significantly lower risk profiles. Bit by bit, VA writers are applying the knowledge that they have gained to the management of the in-force as well. It will take longer to make changes to the in-force vs. new products, but I think those efforts will pay off.”

“In my mind, the lesson of the last five or six years, for variable annuities, is that these products may be trickier to deal with than was first hoped. That has spurred creativity in the development of products that meet the challenge of longevity risk management. And that’s a good thing,” Paris said.

Necessity has in fact sparked an explosion of actuarial creativity in the annuity product sector since the financial crisis. Fixed indexed annuities sprouted GLWBs. New York Life launched a new kind of deferred income annuity and sparked a flurry of fast-follower products. AXA Equitable, MetLife and others introduced buffered accumulation products. Jackson National introduced an accumulation-stage VA specializing in alternative investments. Executives at other firms say they are looking for products that don’t require much capital, like life insurance/life annuity hybrids. There’s not a lot of talk about selling equity market protection.

What’s next

Asked to speculate on the future of the VA business in the U.S., Paris said, “The issue of longevity risk management is only going to get bigger. It could be that we will see less focus on capital markets guarantees and more focus on longevity protection.

“With VAs, there was so much emphasis on a bundled product. But there’s another school of thought, and we’re beginning to hear more about this, that it would be reasonable for the life insurers to just stick to covering the longevity risk and not get involved in the investment risk,” he said.

“It’s analogous to the debate between buying universal life insurance and buying term life and investing the difference. Maybe the bundled solution isn’t the way to go. The fact that we’re seeing all these deferred income annuities is some indication of that. Handling longevity risk is what life insurance companies are uniquely qualified for,” Paris added.

Why were the publicly held companies so much more aggressive in VA pricing and asset gathering? “In the mid-2000s, our shareholders told us they wanted equity-type returns, and we went into the equity markets to get them,” a product chief at a major publicly-held life insurer said in a press briefing recently. The S&P Life Index more than doubled between September 2003 and the end of 2007. After dropping steeply in 2008, it has rallied, recovering about two-thirds of its 2003-2007 gains.

Paris was asked if he saw a link between demutualization in the 1990s and the risk-taking that publicly held life insurers engaged in just before the financial crisis, and if the risk-taking was a bad idea. He said it was too soon to tell.

“There’s no question that if you want the higher returns, you have to take more risk. Which means you’re going to have more volatility,” he said. “But we may look back 40 years from now and see that, although there were zigs and zags along the way, and periods when [those companies] may have had to put up a lot of reserves, they did get a 15% return, and that may be more than the returns of a company that just stuck to selling term life insurance.

“Yes, we’ve seen massive changes in the last few years. It may very well have lasting effects on the life insurance companies. But no matter how severe the crisis was, the truth is that these products will stay in force for decades, and we don’t know yet what will happen. It’s still very early.

“Of all the GLWB products that have been sold since the mid-2000s, and among all of the companies whose capacity you’re concerned about, not one has yet paid a claim to a GLWB policyholder. Even contract owners who are taking income are still just withdrawing their own money. None of them have exhausted their own money.”

Which Bubbles Will Burst Worst?

Posted on November 15, 2013 by Martin Hutchinson -

This week the hedge fund SAC was fined $1.8 billion, and will revert to running Steve Cohen’s family money only—still a big job, since he’s worth some $8-9 billion. This raises the question of which forms of investment will be exploded by the next market downturn, just as were subprime mortgages and complex securitizations by the 2008 unpleasantness. Guessing what the next downturn will look like and which forms of wealth will suffer permanent rather than temporary diminution in value is the most important task facing investors as we approach the top of the current bubble.

After the 2000 bubble burst, the value downturn was almost entirely in equities, and a tiny subset of equities at that. While the main share indexes declined less than 50%, and were above their previous peaks within six years, the Nasdaq is still thirteen years later more than 20% below its 2000 peak of 5,048, a loss of more than 40% when inflation is taken into account.

For individual companies, the decline was more comprehensive. Microsoft (Nasdaq:MSFT) and Cisco (Nasdaq:CSCO) are both more than a third below their 2000 highs, even though their assets and profits are much greater than they were in 2000. Some companies have had much steeper falls; the switchgear specialist JDS Uniphase (Nasdaq:JDSU), valued well over $100 billion in 2000, now has a stock price of little more than 1% of its high, even though the company’s operations remain solidly profitable and its P/E ratio is still elevated at 45 times earnings. Finally, a few companies that had taken excessive advantage of easy money and easy ethics went outright bankrupt, the most prominent being Enron, WorldCom and Global Crossing.

Other types of asset saw only a modest downturn after 2000. Emerging market stocks had already been beaten down in 1997-98, so the 2000 crash saw only a hiccup in the beginnings of recovery. The hedge fund that had sold all its tech holdings in March 2000 and reinvested in Russia and Indonesia would have truly deserved its management’s exorbitant fees. Gold and silver too were close to their bottom in 2000, and would prove an excellent investment over the next decade.
For small investors, here’s a tip. It’s true most of the time, but it’s overpoweringly, Biblically true at the top of a bull market: the best investment going forward is not the best-performing fund among a broad family of mutual funds, based on 1-year, 3-year and 5-year track records, but the worst-performing fund, which is almost certainly close to a cyclical low and will shortly rebound sharply.

The next time around in 2007-08 the casualty list was quite different. There were no significant losses in the tech sector, other than stock market declines that were mostly made up when the market recovered. Again, emerging markets were little affected—the world central banks’ policies of ultra-easy money soon reflated their balloons. U.S. house prices declined, by as much as 50% in some over-inflated markets, but real estate in general suffered only modest losses—General Growth, the shopping center operator that went bust in 2009, was soon refloated. General Motors and Chrysler filed for bankruptcy, but those bankruptcies, like the frequent bankruptcies in the airline sector, reflected long-term lack of profits rather than any bursting bubble.

The biggest permanent losses of value were suffered in three areas: housing bonds and the associated securitizations, the financial sector and the PIIGS of southern Europe. All three losses were directly linked to excesses of the preceding bubble. Lending practices in the home mortgage sector had deteriorated to unsustainable levels, largely owing to government encouragement by housing legislation and the Fed, and that bubble had been further encouraged by the practice of securitization and associated derivatives games. The result was a bust that had been inevitable, but was made much worse by government and Wall Street malfeasance.

The financial sector’s losses were largely a spin-off of the losses in the housing sector, but strictly reflected a bubble of easy money and unsound derivatives innovation rather than the housing bust directly. Credit default swaps in particular were poorly managed, dominated by rent-seeking trading practices, and should have caused a lot more damage than they were allowed to (if they had caused more damage in 2008, they would not still be around to plague us in 2014-15).

Finally, the losses in peripheral Europe resulted from the unsound self-deluding structures surrounding the establishment of the euro and the admission of Greece to the EU. Greece, in particular, had been allowed to become a subsidy junkie and had driven its living standards up to unsustainable levels. Its GDP per capita needed to halve, and it could do not do so within the euro without intolerable levels of deflation. Interestingly, the Baltic states, also ahead of themselves in living standards in 2007, were able to solve their problems through deflation alone—the living standards excesses were less than Greece’s and the internal discipline was much better. The other PIIGS: Ireland, Italy, Spain, Portugal, and now Slovenia, had only a mild version of Greece’s problem, so only a bearable deflation and possibly a modest debt write-off should see it solved.

The sectors self-destructing this time round will be those showing most excesses in this bubble, which are not the same as the excesses of the two previous bubbles. Housing is unlikely to cause another major problem directly, at least in the United States, because it hasn’t recovered far enough, although the bloated and overblown London housing market, where prices are now above those of 2007, seems certain to crash. Most emerging market countries have managed their finances much more carefully than Western countries, so are unlikely to see more than modest problems, although every year this bubble lasts will increase the numbers of emerging markets that get into difficulties—the temptation to spend the money being thrown at them is too great. Finally, commodity prices have fallen back a long way from their 2011 peaks; unless that bubble reflates rapidly it is unlikely to cause much trouble—the underlying driver of strength, growth in emerging markets relative to developed ones, is a long-term trend that is not going away.

Having listed assets that won’t suffer a meltdown when the current bubble bursts, it is a melancholy fact that the list of assets that will melt down is much longer.
First, there are the assets located in the BRIC economies of Brazil, Russia, India and China. Far too much money has poured into these economies, drawn by their likely future wealth, but also by the foolish theory of BRIC domination perpetrated by Jim O’Neill of Goldman Sachs. These economies are already showing their cracks, but there’s much more to come. The Batista bankruptcy in Brazil is the first of many; both the consumer debt and government sectors in that ill-run country are hugely overblown and due for a credit crunch similar to that suffered in the 1980s.

In Russia, trouble will accompany an oil price collapse, caused by the plethora of new energy sources currently being developed; with oil at $40-50 a barrel, a perfectly reasonable long-term expectation, Russia’s fiscal and economic position is hopeless. In India, the economy is already showing signs of strain; it’s most likely that fiscal and economic collapse, accompanied by a major balance of payments crisis, will be Congress’s legacy to its successor in spring 2014, a poor recompense for the bright, reformist outlook Congress inherited at its unjustifiable election victory in 2004. Finally, China’s bank bad debt problem is now sufficiently large as to swallow even its $3.4 trillion of international reserves. The four BRICs may well have good long-term prospects, but they are due to suffer a grisly and costly decade before re-embarking on the road to prosperity.

The BRICs are only the tip of the cracking iceberg of bubble credit, albeit a very large one. The U.S. junk bond market has prospered in the last few years with credit standards weaker even than in 2006-07 and interest rates at unsustainably low levels. When interest rates rise, holders of junk bonds will suffer gigantic losses, many of which will be unrecoverable as the underlying borrowers collapse in turn.

U.S. Mortgage REITs, which buy long-term mortgage bonds, financing themselves in the repo market, will be a medium-sized casualty, with losses somewhere under $1 trillion, as short-term and long-term interest rates rise, collapsing their capital structures as bond prices decline. Their death will also kill off the repo market, which is rather more serious, as all kinds of entities depend on it for their short-term liquidity excesses and shortages.
To return to where we opened, hedge funds will also collapse, as their investment returns become heavily negative, their funding dries up and the legal vultures close in, as they have on SAC. The hedge fund and private equity sectors have grown far larger than is justified in a non-bubble economy; their return to their proper size will inevitably involve large losses for their investors. It’s another bubble; therefore it must burst.

There will also be collapses in the too-big-to-fail bank sector. Here the losses and bailout of 2008 have made them more cautious, although they still employ trading desks that are far too large and aggressive for the genuine businesses of the banks. However in the last few months, governments have discovered the political joy of zapping big banks with penalty after penalty, mostly relating to malfeasances that should by now have passed beyond the five-year statute of limitations. A financial system cannot survive continual looting raids by regulators and trial lawyers, out of proportion to any losses directly caused. At some point, one of the majors will find itself unable to attract either further capital or funding and will fail. That failure will drag the other largest banks with it, since they all have similar legal liabilities and are hopelessly intertwined. Only medium-sized banks may survive, since the politicians and lawyers have not yet targeted them to the same extent.

The tech sector, spared in 2008, will crash again this time. The hopelessly over-optimistic valuations given to the likes of Twitter and Facebook will collapse, as Internet advertising revenues prove finite, while teenage and young adult fashions move on from Facebook membership and tweeting to some other activity. This particular part of the movie we have seen before; it will involve only modest credit losses, but a substantial number of ex-billionaires will be created.

A wholly new credit crash will come in the area of college debt, which recently passed $1 trillion as students hocked themselves to the eyeballs to pay for overpriced college courses. With college courses now available for free or close to it over the Internet, much of the college infrastructure, and college debt infrastructure, is hopelessly overpriced malinvestment and will have to be liquidated. The process will be both painful and to the intelligentsia wholly unexpected.

Finally, government bonds are themselves a bubble, which will inevitably burst. However only Japan’s public debt is large enough in terms of the country’s GDP to cause a bursting bubble in the next year or two. U.S., British and most EU public debt is still within historical norms in terms of GDP, although the accompanying deficits often aren’t. My crystal ball is thus clouded on whether the public debt bubble bursts this time around, or whether reflationary policies cause it to grow further, becoming an unimaginably damaging centerpiece of a collapse around 2020. Either way, when it goes it will take the entire banking system with it, because of the Basel regulatory structure’s incredibly foolish zero-weighting of public debt in calculating capital needs.

As you can see from the above discussion, the universe of assets whose price will collapse in the next downturn is considerably better populated than the collection of assets whose price won’t collapse. It is only a question of time, and if you asked me to guess, I’d put the collapse’s onset in the fourth quarter of 2014.

The Uncertain Future of Central Bank Supremacy

Posted on November 15, 2013 by Mohamed A. El-Erian -

History is full of people and institutions that rose to positions of supremacy only to come crashing down. In most cases, hubris – a sense of invincibility fed by uncontested power – was their undoing. In other cases, however, both the rise and the fall stemmed more from the unwarranted expectations of those around them.

Over the last few years, the central banks of the largest advanced economies have assumed a quasi-dominant policymaking position. In 2008, they were called upon to fix financial-market dysfunction before it tipped the world into Great Depression II. In the five years since then, they have taken on greater responsibility for delivering a growing list of economic and financial outcomes.

The more responsibilities central banks have acquired, the greater the expectations for what they can achieve, especially with regard to the much-sought-after trifecta of greater financial stability, faster economic growth, and more buoyant job creation. And governments that once resented central banks’ power are now happy to have them compensate for their own economic-governance shortfalls – so much so that some legislatures seem to feel empowered to lapse repeatedly into irresponsible behavior.

Advanced-country central banks never aspired to their current position; they got there because, at every stage, the alternatives seemed to imply a worse outcome for society. Indeed, central banks’ assumption of additional responsibilities has been motivated less by a desire for greater power than by a sense of moral obligation, and most central bankers are only reluctantly embracing their new role and visibility.

With other policymaking entities sidelined by an unusual degree of domestic and regional political polarization, advanced-country central banks felt obliged to act on their greater operational autonomy and relative political independence. At every stage, their hope was to buy time for other policymakers to get their act together, only to find themselves forced to look for ways to buy even more time.

Central banks were among the first to warn that their ability to compensate for others’ inaction is neither endless nor risk-free. They acknowledged early on that they were using imperfect and untested tools. And they have repeatedly cautioned that the longer they remain in their current position, the greater the risk that their good work will be associated with mounting collateral damage and unintended consequences.

The trouble is that few outsiders seem to be listening, much less preparing to confront the eventual limits of central-bank effectiveness. As a result, they risk aggravating the potential challenges.

This is particularly true of those policymaking entities that possess much better tools for addressing advanced economies’ growth and employment problems. Rather than use the opportunity provided by central banks’ unconventional monetary policies to respond effectively, too many of them have slipped into an essentially dormant mode of inaction and denial.

In the United States, for the fifth year in a row, Congress has yet to pass a full-fledged budget, let alone dealt with the economy’s growth and employment headwinds. In the eurozone, fiscal integration and pro-growth regional initiatives have essentially stalled, as have banking initiatives that are outside the direct purview of the European Central Bank. Even Japan is a question mark, though it was a change of government that pushed the central bank to exceed (in relative terms) the Federal Reserve’s own unconventional balance-sheet operations.

Markets, too, have fallen into a state of relative complacency.

Comforted by the notion of a “central-bank put,” many investors have been willing to “look through” countries’ unbalanced economic policies, as well as the severe political polarization that now prevails in some of them. The result is financial risk-taking that exceeds what would be warranted strictly by underlying fundamentals – a phenomenon that has been turbocharged by the short-term nature of incentive structures and the lucrative market opportunities afforded until now by central banks’ assurance of generous liquidity conditions.

By contrast, non-financial companies seem to take a more nuanced approach to central banks’ role. Central banks’ mystique, enigmatic policy instruments, and virtually unconstrained access to the printing press undoubtedly captivate some. Others, particularly large corporates, appear more skeptical. Doubting the multi-year sustainability of current economic policy, they are holding back on long-term investments and, instead, opting for higher self-insurance.

Of course, all problems would quickly disappear if central banks were to succeed in delivering a durable economic recovery: sustained rapid growth, strong job creation, stable financial conditions, and more inclusive prosperity. But central banks cannot do it alone. Their inevitably imperfect measures need to be supplemented by more timely and comprehensive responses by other policymaking entities – and that, in turn, requires much more constructive national, regional, and global political paradigms.

Having been pushed into an abnormal position of policy supremacy, central banks – and those who have become dependent on their ultra-activist policymaking – would be well advised to consider what may lie ahead and what to do now to minimize related risks. Based on current trends, central banks’ reputation increasingly will be in the hands of outsiders – feuding politicians, other (less-responsive) policymaking entities, and markets that have over-estimated the monetary authorities’ power.

Pushed into an unenviable position, advanced-country central banks are risking more than their standing in society. They are also putting on the line their political independence and the hard-won credibility needed to influence private-sector behavior. It is in no one’s interest to see these critical institutions come crashing down.

Sign of the times: Fidelity adds short duration bond funds

Posted on November 14, 2013 by Kerry Pechter -

Fidelity Investments said it has expanded its line-up of short duration bond mutual funds for investors and financial advisors with the launch of three new products: Fidelity Limited Term Bond Fund, Fidelity Conservative Income Municipal Bond Fund and Fidelity Short Duration High Income Fund (Advisor and retail share classes.)

The three new short duration bond funds are managed with varying degrees of credit and interest rate exposure, from primarily investment grade to below investment grade and with weighted average maturities between six months to five years, Fidelity said in a release.

Fidelity, based in Boston, manages $1.9 trillion, including about $890 billion in fixed income assets.

Vanguard tops mutual fund flow charts in October

Posted on November 14, 2013 by Kerry Pechter -

U.S.-equity mutual funds enjoyed their highest monthly inflow since January, gathering $10.5 billion in October 2013. International-equity funds did even better—leading all category groups with inflows of $12.2 billion, according to Morningstar, Inc.

Total mutual fund inflows, at $17.8 billion for the month, were tempered by continued outflows from taxable- and municipal-bond funds tempered overall inflows. Morningstar estimates net flow by computing the change in assets not explained by the performance of the fund.

Vanguard gathered just over $6 billion in the quarter ($60 billion YTD) to lead all fund companies. American Funds, PIMCO, Columbia and Janus all saw outflows of more than $10 billion each.

Highlights from Morningstar’s report on mutual fund flows:

Active U.S.-equity funds had strong monthly inflows for only the third time in 2013, failing to fulfill expectations of a “great rotation” into active strategies after years of passive-fund flow dominance.
But outflows from active equity funds are only $15.3 billion for the year to date, compared with outflows of $131.5 billion in 2012.
Foreign large blend was the top category for inflows; equity categories took the top three spots in terms of inflow by category.
October was the first month since March that bank loan, nontraditional bond, or world bond did not lead all categories in flows, and the first time in more than a year that the bank-loan category wasn’t in the top five.
Inflation-protected bond funds lost $4.8 billion in October. The average fund in the category has lost 5.9% year to date.
Vanguard dominated inflows at the provider level in October, collecting new $6 billion overall and inflows of $2.1 billion for Vanguard Total Stock Market Index Fund.
Vanguard’s market share of mutual fund assets stands at 17.5%, up from 15.6% three years ago. American Funds’ market share has fallen to 10% from 12% over the same period. PIMCO’s share has dropped to 5.1 percent after peaking at 6.1 percent in late 2012.

Click here for more information about Morningstar Asset Flows.

Hedge fund managers’ eyes are bigger than customers’ budgets: E&Y

Posted on November 14, 2013 by Kerry Pechter -

Hedge fund managers who survived the financial crisis are focusing on growth beyond their original business models, but investors don’t intend to buy multiple products from one manager, according to Ernst & Young’s 7th annual global hedge fund market survey.

One hundred hedge fund managers who manage a combined US$850 billion and 65 institutional investors with AUM of $715 billion and over US$190 billion allocated to hedge funds participated in the EY survey, called “Exploring Pathways to Growth.”

Strategic priorities for hedge funds, changes in revenues and costs, technology, headcount, outsourcing and shadowing, and the future of the hedge fund industry were topics covered in the survey.

The growth ambitions of managers may not be matched by sustained investor appetite,” said Art Tully, EY’s Global Hedge Fund Services co-leader said in a release.

Besides investing in new strategies and products, hedge fund managers are developing non-traditional distribution networks and channels. Managers with less than US$10 billion under management are budgeting for 15% growth in 2013. But 72% of investors expect to maintain current allocation levels.

Two in three hedge fund managers reported an increase in revenues over the past year as performance improved and assets grew, the survey showed. But only half of managers saw improvements in margins. One in three managers said margins declined and another 10% noted margins remained unchanged. Meanwhile, costs rose.

“European managers appear to have a tight control over their costs and anticipate the greatest increase in margins,” said Julian Young, EY’s Europe, Middle East, India and Africa Hedge Funds Leader. “This is probably because they are managing costs by outsourcing, refraining from shadowing and offering less complex strategies.”

Cost increases were reported by one-third of European managers, 58% of Americans and three out of four Asians. But Asian hedge fund managers have been the most successful in raising capital and thereby growing revenue. Margins have improved as a result.

A majority of hedge fund managers continue to fully “shadow,” and the cost of shadowing is high. Hedge funds fully shadow across a range of functions to mitigate the risk of error, and indirectly to provide a contingency plan, if needed. They shadow more in the front office, where sensitivities to error are greatest and timely resolution of errors is critical to avert adverse consequence and reputational risk. It is not surprising that the survey highlights that the majority of hedge fund managers continue to fully shadow. What is surprising is that a growing percent of managers have developed stronger relationships with fund administrators and are paring down full shadows, granting partial oversight to the fund administrator.

Investors agree that the front office is most important, but are more discriminating than managers in what they deem important to shadow. Trade reconciliation and investment valuation are most important, while a number of back-office functions, including partner/shareholder accounting and investor reporting are not. Yet, nearly half of hedge funds fully shadow these latter functions.

When asked what conditions are needed to reduce shadowing, some managers cited a higher level of integration with their administrators. Others admit that they would need agreement among all their investors that they could stop.

More DB sponsors intend to off-load risk

Posted on November 14, 2013 by Kerry Pechter -

More defined-benefit plan sponsors are “formalizing steps to de-risk” their plans, in part because interest rates and equity prices have been moving higher, according to a new survey by Towers Watson and Institutional Investor Forums.

Employers are interested in offering lump-sum buyouts to former employees. A majority of plan sponsors with DB plans still open to new hires said they intend to offer a pension to all employees five years from now.

The survey found that three-fourths (75%) of respondents either have implemented, are planning to, or are considering developing formal “journey” plans to de-risk their DB plan.

A journey plan details actions a plan sponsor will take to de-risk its pension plan once certain trigger points have been reached. Forty two percent of respondents had a journey plan in place before this year; 8% implemented a plan this year.

“Pension plan sponsors remain under tremendous pressure to reduce the financial liabilities of their DB plans,” said Michael Archer, leader of the client solutions group for retirement, North America at Towers Watson.

“Many employers see [lump-sum payments and annuity purchases] as the most viable option to lower their DB burdens and a significant number are planning to take action in the next year or two.”

The impact of the DB plan on financial statements (69%), the impact of the DB plan on company cash flow (58%) and the general cost of the plan (41%) were the most commonly cited factors that led to the development of a formal de-risking plan.

Lump-sum payments remain attractive. The survey found that 28% of respondents are either planning to offer lump-sum payments to former employees next year or are considering doing so in 2015.

That is in addition to the 39% of respondents who did so in 2012 or indicated they were doing so this year. Lump-sum offers are especially appealing to companies whose ultimate objective is to transfer all of their pension obligations.

“We continue to see interest in companies offering lump-sum buyouts to vested former employees who have not yet retired. The success of these programs in 2012 will help drive a significant amount of activity over the next several years,” said Matt Herrmann, leader of retirement risk management at Towers Watson.

“The low interest rate environment coupled with moderate funded status levels limited the options for many plan sponsors over the past several years. However, if the recent improvements in funded status continue, de-risking activity could be strong for the foreseeable future.”

DB plans still open to new hires are largely expected to still be open five years from now, the survey showed. Among the 30% of respondents with DB plans open to new hires, more than 70% expect to offer a DB plan five years from now. Three-fourths of companies with closed plans expect at least some current participants to still be accruing benefits five years from now.

Among other findings from the survey:

DB Plan Funding policy:48% of respondents have not recently changed the amount they plan to contribute to their plan; 23% still contribute the minimum required; 21% have increased their planned contribution.
Investment management:Respondents prefer to focus on risk reduction, not higher returns; 78% plan to increase their focus on risk in the next 2 to 3 years rather than seeking higher returns. Interest is growing in alternative investments and long-dated fixed income.

The Towers Watson/Institutional Investor Forums survey, U.S. Pension Risk Management – What Comes Next, was conducted in June and July of 2013, and includes responses from 180 U.S. companies that sponsor at least one non-bargaining defined benefit program.

The ‘haves’ have retirement plans; the ‘have-nots,’ not so much

Posted on November 14, 2013 by Kerry Pechter -

Among the complex causes of the retirement savings “crisis” in the U.S., the most obvious and important one may be the fact that less than half of working Americans even have the option of deferring part of their paychecks into a saving plan at work.

Only 48.6% of the 156.5 million Americans who worked in 2012 were employed by a company or union that sponsored a pension or retirement plan, but that overall number of workers included not just full-time workers but also the self-employed, part-time workers, those younger than 21 and older than 64, according to an analysis by the Employee Benefit Research Institute of U.S. Census data.
Considering only full-time, full-year wage and salary workers ages 21–64, 60.4% worked for employers sponsoring a plan, and 53.5% of the workers participated in a retirement plan. Most public-sector workers (71.5%) participated in a retirement plan at work, while only 39.1% of private sector workers did so.

People who are most likely to lack sufficient other financial resources in retirement are those least likely to have access to a plan. White, male, well-educated, healthy and married full-time workers are more likely to have access than non-whites, women, single people, the less educated and the less healthy. Geographically, lack of a qualified plan is more likely in the South and West than in the North and East.

Those in rural occupations like farming, fisheries or forestry are also less likely to be covered by a plan. Public employers are most likely to be covered by a plan, but taxpayer-supported public employee retirement plans have been under attack in many parts of the U.S. It increased after the drop in equity prices and interest rates caused or amplified those plans’ underfunded status.

The number of U.S. workers participating in an employment-based retirement plan rose to 61.6 million in 2012 from 61.0 million in 2011. The percentage participating dropped to 39.4% of the workforce in 2012 from 39.7% a year earlier, according to an Employee Benefit Research Institute analysis of U.S. Census data.

Stock market returns and the labor market tend to drive participation EBRI noted. The bull market of the late 1990s, for instance, boosted participation, while the financial crises of the 2000s dampened participation.
EBRI senior research associate Craig Copeland said 2013 would be like 2012, with “a potential for a slight increase.”
The full report, “Employment-Based Retirement Plan Participation: Geographic Differences and Trends, 2012,” is published in the November EBRI Issue Brief, available online at www.ebri.org

FINRA Talks a Good Game

Posted on November 14, 2013 by Kerry Pechter -

Until FINRA published “A Report on Conflicts of Interest” recently, some of us could only guess at the specific opportunities, incentives and temptations to abuse their positions of trust that registered reps contend with in the course of serving the typically under-informed retail brokerage customer.

Now there’s no need to rely on the imagination. The Financial Industry Regulatory Authority’s 44-page report (which one commentator called a stunt designed to further FINRA’s candidacy as the future self-regulatory authority for all financial intermediaries, including fee-only advisors) spells them out. If seamier details exist, we’d have to send the children from room.

Talk about disclosure. The report urges broker-dealer managers, for instance, to be especially watchful for unsuitable sales by brokers who are approaching thresholds for bonuses—bonuses presumably set by the managers themselves. If this report fell into the hands of consumer activists, it might impact brokerages as much as Upton Sinclair’s 1906 expose, “The Jungle,” impacted the meatpacking industry. That’s an exaggeration, but not a huge one.

Most brokers and their organizations are undoubtedly scrupulous. And life is full of conflicts. But if the end-customer ends up paying, directly or indirectly, for sales incentives or revenue-sharing whose purpose is simply to drive volume, that’s hard to justify. Customers patently don’t like what they see (or don’t see, since conflicts by nature have to be hidden). That’s why Vanguard, with its tiny fees and salaried phone representatives, manages $1.8 trillion in assets, netting $60 billion so far this year and a league-leading $6 billion in October alone.

But back to the report. The second sentence of the first paragraph is a sockdolager. “While the existence of a conflict does not, per se, imply that harm to one party’s interests will occur,” it calmly said, “the history of finance is replete with examples of situations where financial institutions did not manage conflicts of interest fairly.” The word “replete” represents a much bigger concession to critics than the traditional “few bad apples” defense ever allowed.

“This report…” the unidentified author writes a few lines later, “emphasizes that firms should do more to manage and mitigate conflicts of interest in their businesses.” We’ve entered mea culpa territory here. The report goes on to mention the many ways that brokers can take advantage of their possession of much more information than most customers will ever have.

Below are references in the report to potential conflicts of interest. (Heaven help the customer whose broker is just shy of a sales threshold.)

“…complex products are sold to less knowledgeable investors, including retail investors.”
“The incentive to increase revenue from product sales by using distribution channels… may not have adequate controls to protect customers’ interests.”
“Pressure to prefer proprietary products to the detriment of customers’ interests.”
“Revenue sharing or other partnering arrangements with third parties.”
“An incentive to favor products with higher commissions because these produce larger payouts. “
“Churning practices, that may be motivated by a desire to move up in the compensation structure and, thereby, receive a higher payout percentage.”
Biased “recommendations as a registered representative approaches the threshold necessary for admission to a firm recognition club (e.g., a President’s Club or similar).”
A temptation “to hire an associated person in spite of a poor regulatory history, if they believe that the individual can boost firm profitability.”
“Incentive for the registered representative to recommend the fund that pays a [higher Gross Dealer Concession] to enhance his compensation.”
“Conflicts, such as their role as a market maker; their trading in a principal capacity; the existence of multiple share classes of a recommended mutual fund; and their receipt of revenue sharing payments.”
“Incentives for hiring personnel to fill a position with a potentially ethically compromised individual in order to meet a hiring target.”
“FINRA remains concerned about the number of firms willing to hire associated persons with problematic disciplinary histories.”
“The increased sale of complex products to retail investors who may struggle to understand the features, risks and conflicts associated with these products.”
“Loosening controls… may exist around a product’s distribution, or incrementally changing existing product features to make the product available to a broader range of investors.”
“Conflicts arise where a manufacturer or its affiliates play multiple roles in determining a product’s economic outcome.”
“An index calculation agent may have discretion in how it calculates the value of an index it uses in a complex product, including, potentially, the authority to change the calculation methodology.”
“The funds for which a firm receives revenue-sharing payments often will be placed on a ‘preferred’ list of funds the firm offers.”
“Proprietary products and revenue sharing arrangements may involve significant financial incentives for firms to favor these products over others.”
“Although registered representatives do not share in the revenue sharing payments directly, they still may favor funds on preferred lists, because of training the issuer provides or because the mechanics of order processing are, in some cases, easier for funds on the preferred list.”
“When ‘the distributor basically acts as a “co-manufacturer’ [it] may have incentives to incorporate features such as high selling concessions or potential higher returns at the cost of a riskier product structure.”
“A clear conflict would exist if a registered representative who is also registered as an investment adviser or advisory representative recommends that a customer purchase a mutual fund that is subject to a front-end sales load and, shortly thereafter, recommends that the customer move those mutual fund shares into an investment advisory account that is subject to an asset-based advisory fee.”
“Key liquidity events [such as when an investor rolls over her pension or 401(k)] may heighten conflicts of interest because of the large sums of money that may be involved. …Firms have a strong incentive to gather assets.”
“[In a ‘net trade’], a market maker, after having received an order to buy a security, purchases the security from another broker-dealer or customer and then sells it to the customer at a different price.”

One person’s conflict-of-interest is another person’s synergy, and at least some of these synergies help make the financial services industry the wonderfully profitable business that it is. The conflicts are fundamental parts of a business model that a fiduciary standard would probably destroy.

Personally, I don’t favor a fiduciary standard for brokerage reps. It’s well intended but, under the timid (or radical, depending on your view) proposal currently on the table, unenforceable. It puts an unfair burden on sales people who are mostly trying to make a living, not practice a profession. Only the self-employed can readily exercise the discretion that fiduciary behavior demands. Buyers simply need to be reminded that when they enter a brokerage, they should beware.

Driven by VA de-risking, managed-vol funds grow

Posted on November 7, 2013 by Kerry Pechter -

There’s nothing volatile about the flow of assets into funds that use managed volatility strategies, according to a report from Strategic Insight. The flow has been strong and steady—largely because of the ongoing flight from risk by issuers of variable annuities.

Assets in funds in this not-very-well-defined category reached $200.1 billion by mid-2013 after rising to $153.9 billion at year-end 2012 from $30.9 billion at year-end 2006, an annualized growth rate of 31%. About 64% of the assets, or $127.9 billion as of mid-year 2013, were in variable annuity separate accounts and the rest in mutual funds.

Mutual funds held just $72.3 billion, or 36% of managed volatility assets, even though MV funds outnumbered variable annuity portfolios by 229 to 180. After the financial crisis and the huge equity price drop, VA issuers realized they had given contract owners too much ability to take risk under the lifetime income guarantee and sought to reduce their exposure.

THey did it by raising fees, limiting the investment options in new contracts, requiring clients who chose a lifetime income guarantee to put some or all of their money in managed volatility portfolios, requiring larger bond allocations, or some combination of those moves. Some companies stopped selling variable annuities entirely because the risks embedded in their existing VA books of business required so much capital.

Strategic Insight recognizes two categories of managed volatility strategies: “tail risk managed” and “low volatility,” with 248 funds ($149.2 billion) and 161 funds ($51.0 billion), respectively. Tail-risk managed funds predominate in VAs—in both assets and number of funds. Low volatility funds are more likely to be mutual funds.

The growth of managed volatility in the retail fund space is also being shaped by the new “alternative” investment styles, along with managers who are new to the retail fund business. The number of managed volatility players has grown to 101 on August 31, 2013 from just 12 in 2006.

The alternatives market includes hedge fund-type strategies that fall within Strategic Insight’s definition of managed volatility. For example, risk parity is a low volatility strategy and many individual portfolios include low volatility management mechanisms.

“The retail fund space has become a fertile market for new concepts and the proliferation of a wide variety of managed volatility designs,” the release said.

Cincinnati voters opt to reform, not replace, an underfunded public pension

Posted on November 7, 2013 by Kerry Pechter -

“Issue 4,” a ballot initiative that would have frozen Cincinnati’s public employees pension plan and offered new employees a 401(k)-style retirement system, was defeated on Tuesday, with 78.4% of about 55,500 voters opposing it. Elsewhere in the U.S., similar initiatives have succeeded.

Cincinnati voters apparently reacted negatively to a part of the proposed initiative that would have required the city on the Ohio River to pay off the pension’s $862 million in promised benefits over just 10 years while phasing in the new defined contribution system.

Supporters of the initiative said that a DC plan would relieve the city and its taxpayers of the burden of large annual required pension contributions. They also argued that the initiative would remove the pension from manipulation by elected officials. They had accused City Council of choosing not to fully fund the program over the last 10 years.

About 3,500 active and 4,500 retired city employees are covered by the municipal pension fund on the ballot. Cincinnati’s policemen and fireman have separate pensions, according to Gary Greenberg, spokesman for Cincinnati for Pension Reform, which collected over 8,000 signatures to put the initiative up for a vote.

Both mayoral candidates and all members of Cincinnati City Council opposed the measure, as did many business and labor groups. Opponents argued that the accelerated, 10-year payoff proposal would have meant higher taxes, cuts in city services or both during that period.

The precise wording of an initiative can have a big effect on behavior in the voting booth, and Issue 4’s advocates had contested the original wording. Earlier this year, they sued over the Hamilton County Board of Elections’ first proposed description of the initiative. The case went to the Ohio Supreme Court and the language was modified, but the final language included a reference to the city’s need to raise taxes or cut services to fulfill the amendment.

Chris Littleton, campaign manager for Cincinnati for Pension Reform, wasn’t sure whether the pension reform committee would try again for a voter-approved charter amendment. “One thing’s for sure, “We have absolutely zero faith that the politicians who put us into this mess will pull us out of it,” he told the Cincinnati Enquirer. “Not fixing it is not an option. What are we going to do, let Cincinnati go bankrupt?”

Ohio Auditor David Yost told reporter Jim Pilcher, “Elections don’t change the math that Cincinnati is facing. The pension crisis in Cincinnati is not going to go away, and it will never be easier to fix than it is right now.” It only gets harder from here, and the numbers only get bigger.”

The board overseeing the city’s retirement system had previously voted to recommend a freeze in cost-of-living adjustments for current and future retirees, a increase in the city’s annual payments into the plan to as much as $45 million, and a $30 million lump-sum contribution from the parking lease fund into the municipal pension fund.

The Issue 4 initiative was similar to other proposals in several other U.S. cities. Pension reform initiatives have been approved in San Jose, Calif., San Diego and Phoenix. Last month, the mayors of five California cities filed to have a pension-reform initiative placed on the statewide ballot there.

MetLife and ING benefit from Romanian pension growth

Posted on November 7, 2013 by Kerry Pechter -

Romania’s compulsory second-pillar (defined contribution) pension funds have surged in size and profitability this year, largely because of an increase in the contribution rate to 4% from 3.5% of gross wages, according to IPE.com.

MetLife and ING both manage collective retirement fund assets in that market, and stand to benefit from the growth. MetLife bought the Romanian insurer Alico from AIG in 2010 and acquired Aviva’s Central and Eastern European business (CEE) in 2012. MetLife now manages about one-sixth of the Eastern European nation’s second-pillar assets.

Dutch insurance giant ING, with the biggest Romanian DC fund by assets and membership, recorded the highest profit so far this year, of RON146.7m (€33.1m). As of the end of June, total profits in the second pillar grew 43% y-o-y to RON440.4m (€99.3m).

Romania’s retirement system has three components or “pillars”: a tax-funded entitlement program, a mandatory employer-based program funded with individual contributions, and a voluntary workplace savings program. (In the U.S., Social Security, employer-sponsored plans and personal savings are sometimes referred to as our pillars.)

The total net asset value of the eight second-pillar funds totaled RON12.8bn (€2.9bn), a y-o-y rise of 45.6% and participation grew to 5.95 million, a 3.2% increase, according to the country’s pension regulator, the Private Pension System Supervisory Commission (CSSPP).

“Out of the RON4bn increase in net assets, 73% represents the contributions directed to the second pillar, and the difference (RON1.05bn) is explained by the investment performance of the funds,” said Catalin Ciocan, executive secretary of the Romanian Private Pension Funds Association.

“The total performance since the system’s inception remains very strong: the funds posted a net annualized average return of 11.7%, meaning a net gain (net assets minus gross contributions) of RON2.28bn since their inception in 2008,” he added.

Current legislation for the second pillar entails yearly increases in the contribution rate. Since 2008, the national DC plan has been mandatory for those up to age 35 but voluntary for those ages 35 to 45. The government has not yet finalized the 2014 budget.

“The most important action to support the continuation of these very good results would be to increase the contribution rate to 4.5%, and we are waiting for official confirmation from the government,” Ciocan said.

The weighted annual average return rose over the year from 6.2% to 10%, according to CSSPP. The gain was helped by heavy investment in state bonds—an average 76% as of the end of September—whose prices rose significantly this year.

In the case of the smaller, third-pillar pension fund system, in operation since 2007, assets grew by 35.2% to RON750.1m and membership by 8% to 305,796 as of end September.

Returns for the balanced funds rose to 9.6% from 5.3%, and those for the higher-risk dynamic funds to 10.5% from 5.3%. The total profits of the 10 funds grew by 7.8% to RON22.4m as of end June.

New York Life reports 2013 annuity sales

MassMutual sells record $3 billion of annuities in 2013

Towers Watson hires former MetLife executive Edward Root

Jackson National notes rising sales of Elite Access VA

Fidelity 401(k) plan accounts now average $84,300

Guardian declares dividend for life policyholders

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