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Dynamic Withdrawal Strategies Made Easy

In a new article in the Journal of Financial Planning, Morningstar researcher David M. Blanchett proposes two relatively simple ways for advisers to adjust their clients’ withdrawal rates during retirement to maximize long-term safety and income levels.

As he explains in the paper entitled “Simple Formulas to Implement Complex Withdrawal Strategies”:

“A growing body of research has noted that updating a retirement portfolio withdrawal strategy on a regular basis improves outcomes. Financial planners call this a ‘dynamic’ technique to retirement income, because the portfolio withdrawal amount adapts to ongoing expectations and actual experiences during retirement.

“This dynamic approach is in contrast to the static approach used in much of the existing literature on sustainable withdrawal rates. The static approach assumes that a retiree selects a withdrawal rate at retirement and subsequently increases the portfolio withdrawal amount to maintain a real level of consumption, regardless of portfolio performance, expected mortality, or the retiree’s changing needs.

“While the ability to account for new information makes dynamic withdrawal strategies theoretically superior, many financial planners and engaged retirees may find a dynamic withdrawal strategy difficult or impossible to implement given the sometimes complex software, tools, or processes that are needed to adjust portfolio withdrawal amounts at some regular interval.

Blanchett’s paper introduces two equations for implementing an efficient dynamic withdrawal strategy based on different expected time periods, portfolio equity allocations, the likelihood of achieving the goal, and fees (or alpha). As he puts it the paper:

  • The first formula, which is called the dynamic formula, determines the withdrawal percentage for a given target probability of success, portfolio equity allocation, expected retirement period, and fees (or alpha).
  • The second approach, which is called the RMD approach, is based on the IRS’ required minimum distribution (RMD) rule. This approach requires only an estimate of the expected retirement period. 

“A measure called the ‘withdrawal efficiency rate’ is used to determine the optimal inputs for distribution equations, as well as the relative efficiency of the formula approach,” the paper says. “Results indicated that life expectancy (median mortality) plus two years is a relatively efficient estimate for the expected retirement period and that 80% is a reasonable input for the probability of success. [Our] equations capture 99.9% of the relative efficiency of a far more complex methodology and represent a significant improvement over a static approach.”

© 2013 RIJ Publishing LLC. All rights reserved.

Allianz Life Launches FIA for Broker-Dealer Channel

Allianz Life Insurance Company of North America (Allianz Life), which built its indexed annuity business by distributing through the independent agent channel, has launched a fixed indexed annuity that it describes as the first FIA built by Allianz Life to appeal to the broker/dealer channel.

[An Allianz Life spokesperson was not available prior to deadline to explain how this product will appeal to broker-dealers more than other FIA contracts. Some FIAs are issued by companies with less than A strength ratings, which is a threshold for being accepted by broker-dealers. Allianz Life has an A rating from A.M. Best.]

The Allianz Core Income 7 Annuity is designed to offer a combination of downside protection, accumulation potential, a death benefit and lifetime withdrawal options. Its Core Income Benefit rider is automatically included at an additional cost of 1.05% of the contract’s accumulation value. It is available in 39 states, according to an Allianz Life release.

The lifetime withdrawal percentage automatically increases as early as age 45 and continues each year the customer waits to begin lifetime withdrawals. The longer the contract remains in the accumulation phase, the higher the income payment percentage will be during payout.

Customers can choose between one or more interest crediting allocations, which can be changed annually. They can earn fixed interest or can choose to base potential indexed interest on changes in several market indexes including the new Barclays US Dynamic Balance Index.

In addition to distribution through the broker/dealer channel, the Allianz Core Income 7 FIA will also be sold through field marketing organizations associated with the Allianz Preferred platform.

Starting at age 50, contract owners can choose either level payments for life or payments that have the potential to increase each year.

© 2013 RIJ Publishing LLC. All rights reserved.

Securian Offers “MyPath” VA Income Riders

Securian Financial Group has introduced a new group of four optional lifetime income riders on its MultiOption variable annuity contracts and has stopped selling its Ovation Lifetime Income II income riders and its Guaranteed Minimum Withdrawal Benefit, according to Dan Kruse, Securian’s second vice president and individual annuity actuary. The change was effective as of October 4.

“It was time for us to refresh our living benefit portfolio,” Kruse told RIJ in an interview. “We introduced Ovation two years ago, then we replaced it with Ovation II to recognize the lower interest rates. MyPath is less a statement on interest rates than a reflection of our desire to allow advisors to dial-in what each client needs.

“So many income riders are one-size fits all,” he added. “For those who want growth, we beefed up the roll-up. For those who want income, we allow higher withdrawal percentages. We have a less expensive option for those who want accumulation but still like the idea of a safety net. We are focused on putting business on the books that makes sense to us, and on the idea that we don’t have to be all things to all broker-dealers.”

The four income rider options are:

MyPath CoreFlex. This rider offers a six percent annual roll-up for 10 years (the deferral bonus is credited only in years when no withdrawals are taken) and requires investors to put at least 40% of their assets into managed-volatility funds. It costs 120 basis points a year (130 bps for joint contracts).

MyPath Ascend. This rider resembles CoreFlex, but offers a seven percent annual roll-up for 10 years and requires investors to put all of their assets into managed-volatility funds. It costs 140 bps (150 bps for joint contracts). Payouts for CoreFlex and Ascend are 4% (3.5% for joint contracts) for those under age 65; 5%(4.5%) from ages 65 to 74, 5.25% (4.75%) from ages 75 to 80, and 6% (5.5%) for ages 80 and above.

MyPath Summit. This rider offers no roll-up, but its payout rates are a quarter of one percent higher in every age band.  

MyPath Value. This product offers no roll-up and pays out a flat 4% of the benefit base each year for all ages, but has expenses of only 45 bps (55 bps for joint contracts).

“We’re not aiming at dominating the variable annuity market, but we want to be competitive with our key distribution partners,” Kruse told RIJ. [Those distribution partners are the semi-captive Securian Financial Network, Waddell & Reed, and independent broker-dealers; each partner accounts for about one-third of Securian’s variable annuity sales.

The allowable sub-accounts for MyPath Ascend, MyPath Summit and MyPath Value currently include:

  • Advantus Managed Volatility Fund (Securian proprietary fund)
  • AllianceBernstein Dynamic Asset Allocation Portfolio
  • Goldman Sachs Global Markets Navigator Fund
  • Ivy Funds VIP Pathfinder Moderate — Managed Volatility
  • PIMCO VIT Global Diversified Allocation Portfolio
  • TOPS Managed Risk Flex ETF Portfolio

© 2013 RIJ Publishing. All rights reserved.

A Roundup of RIIA’s Meeting in Texas

The thoroughfare named Bee Cave Road begins just west of downtown Austin, Texas, and snakes for eight miles through dusty suburbanized canyons until it reaches Dimensional Fund Advisors’ curvy blue office tower, where the Retirement Income Industry Association held its annual conference and awards gala last week.

RIIA, for those not familiar with it, is the Boston-based organization that takes a “view across the silos” of the retirement industry. Its modus operandi is to invite people from all segments of the industry—insurance and investment, manufacturing and distribution, institutional and retail—to meet and exchange ideas.

Much of RIIA’s activity lately goes into promoting its Retirement Management Analyst professional designation, and on refining the retirement income planning philosophy—“build a floor, then seek upside”—that informs the curriculum on which the designation is based.

The meeting at the headquarters of DFA—the $300 billion fund company that relocated from southern California to Austin a few years ago—featured a series of presentations on research into various issues and challenges relating to retirement. In case you couldn’t attend the meeting, here are a few synopses of the presentations:

A tool for mapping the retirement landscape, household by household. RIIA, Price Waterhouse Cooper, and Strategic Business Insights have collaborated to create an analytic tool that incorporates elements of RIIA’s 16-part segmentation of the retirement market, SBI’s MacroMonitor household financial survey data and PwC’s simulation modeling expertise (the Retirement Income Model) to produce both snapshots and dynamic views of “household balance sheets” at the individual household level or the demographic segment level. Advisors can use it to achieve a 360-degree view of their client’s finances, to benchmark them against their peers and to test a variety of future scenarios. Product manufacturers can use it to locate and measure market opportunities as well as for basic target market research. “No other organization is doing this,” Larry Cohen of SBI told RIJ. A report based on their work will be available to RIIA members in the future.

Losing our wits after age 60. In a sobering presentation about the way we will all eventually lose our wits, Michael Finke of Texas Tech University demonstrated that as we get older, our cognitive ability declines and with it our ability to make smart financial decisions. About 5% of Americans in their 70s, 24% of those in their 80s, and 37% over age 90 have dementia. An additional 16%, 29% and 39%, respectively, have “cognitive impairment.” Financial literacy peaks at age 49, Finke said, and the decline in cognitive ability begins at about age 60. The population age 65 and older is the only age group that is more likely to pay for financial services on a transaction basis than on a “comprehensive basis.”

The benefits of keeping a year’s worth of cash on hand. John Salter, professor at Texas Tech and wealth manager at Evensky & Katz Wealth Management talked about the value of cash in a retirement portfolio. He recommended having enough cash on hand to cover living expenses for one year. He also touted the benefits of a home equity standby line of credit as a secondary source of cash that can be used to take advantage of a sudden opportunity, for an emergency or to avoid selling depressed assets.  

Everyone’s retirement is financially unique. No two households have the same cost of retirement, according to Morningstar’s David Blanchett. A lot depends on the cost of stocks and bonds at the time you retire. The higher the Cyclically-Adjusted Price/Earnings (CAPE) level and the lower the bond yield at the time you retire, the lower your returns will be during retirement and, consequently, the more likely you will be to run out of money. The best news from his presentation was that median medical costs for retirees as a share of total expenditures is only about 5% of income at age 60, rising to between 11% (for low-income elderly) and 17%(for high-income elderly) at age 80. An unlucky five percent of elderly will see their medical spending spike above 40% sometime during retirement.

The advantage of using a retirement income advisor. In what was partly an advertisement for RIIA’s RMA designation, advisor Sean Ciemiewicz of San Diego gave an entertaining presentation about the differences between accumulation advisors and retirement advisers—the latter being more holistic, more thoughtful and far more conversant with the principles of behavioral finance.

The value of a rising equity path in retirement? RIIA’s annual Academic Thought Leadership Award this year went to Michael Kitces and Wade Pfau for their paper, “The True Impact of Immediate Annuities on Retirement Sustainability: A Total Wealth Perspective.” It will appear in the fall issue of RIIA’s Retirement Management Journal.

The paper challenges previous research that touted the long-range growth potential of buying a single premium immediate annuity with at least part of your retirement savings and putting the rest in stocks. Where earlier research suggested that the annuity yielded the benefits, this paper suggested that the results would have been just as good if bonds were substituted for the annuity. It was the equities that provided the growth, the authors say.

At first glance, this paper appears to suggest that investors should increase their equity allocation during retirement, and not buy annuities at all. Asset managers who hate annuities should enjoy hearing that; life insurers won’t.

But the paper only shows that if an investor divides his savings into safe and risky assets in retirement and then takes income only from the safe asset, the equity allocation will climb—only because the safe asset is shrinking.

Is that the same as a rising equity allocation? Some people might object and say that “a rising equity allocation” implies that the income-producing part of the portfolio has a rising percentage of equities.

Kitces and Pfau apparently have a newer paper that confirms the benefits of reducing the equity allocation to 30% at retirement and then increasing it by one percentage point a year over 30 years of retirement. As for debunking the value of annuities, the paper doesn’t do that either: it affirms that annuities offer unique protection against extreme longevity risk.

© 2013 RIJ Publishing LLC. All rights reserved.

 

 

FIA investor barred from New York insurance

New York Superintendent of Financial Services Ben Lawsky has ordered hedge fund impresario Philip A. Falcone barred from exercising direct or indirect control over the management, policies, operations, and investment funds of Fidelity & Guaranty Life Insurance Co. of New York (FGL-NY) or any other New York-licensed insurer for a period of seven years.

The order was a consequence of the Aug. 16 Securities and Exchange Commission (SEC) consent action against Falcone and Harbinger Capital Partners LLC.

Lawsky stated that the SEC settlement detailed admitted facts and wrongdoing that demonstrate serious issues “related to Mr. Falcone’s fitness to control the management, operations, and policyholder funds of a New York insurance company.”

At the same time, FGL-NY agreed to put in place a series of enhanced policyholder protections – modeled on those that other insurers owned by private equity firms and investment companies have established at the request of the New York State Department of Financial Services (DFS). 

These include maintaining risk-based capital levels (RBC Levels) at an amount not less than 450 percent and establishing a separate backstop trust account totaling approximately $18.5 million to provide additional protections to policyholders above and beyond the heightened capital levels if FGL-NY’s RBC levels fall below 450 percent.

Little more than one month ago Fidelity & Guaranty Life, a leading provider of fixed indexed annuities (FIAs), announced it was  going public through parent company Harbinger Group Inc. It filed a prospectus for a $100 million IPO. In 2011, HGI, which defines itself as a publicly traded diversified holding company, acquired Fidelity & Guaranty Life for $350 million. 

The agreement is in line with the agreements struck with Guggenheim Partners LLC and Apollo Global Management LLC this  summer as part of a package of policyholder and reserve protections in their acquisitions of annuity companies.

Lawsky has highlighted a spike in private equity firms and other investment companies moving into the annuity business and subpoenaed private equity firms, concerned that they have a more short-term oriented business model than traditional insurers, while they were buying annuity businesses. He wanted them to show they were focused on ensuring long-term security for policyholders by subjecting them to higher standards. The companies, including FGL-NY, will also have stronger disclosure and transparency requirements.

The August SEC action resulted in a civil penalty of $10.5 million and payments of more than $7.5 million against Falcone and the Harbinger defendants for improperly borrowing $113.2 million from two funds they advised, Harbinger Capital Partners Special Situation Fund (SSF) and Harbinger Capital Partners Fund.

Falcone prevented other SSF investors from making redemptions, and did not disclose the loan to investors for approximately five months; and granted favorable redemption and liquidity terms to certain large investors in HCP Fund who voted in favor of more restrictive redemption terms, and did not disclose these arrangements to the fund’s board of directors and the other fund investors, according to the consent order. 

Dealing with Auto-Enrollment’s Dilution Effect

It’s widely acknowledged that the policy of automatically enrolling employees in 401(k) plans by a default process can have a negative feedback effect.

By increasing enrollment, auto-enrollment inevitably increases the number of employees eligible for a matching contribution, if any, and in such cases can drive up employer costs.

Something’s got to give in such a situation, and a new research brief, written by Barbara Butrica and Nadia Karamcheva of the Urban Institute and published by the Center for Retirement Research at Boston College, explores what that something might be.

First, the authors describe the problem: While automatic enrollment increases savings for employees who would not have participated without it, those who would have participated even without auto-enrollment may end up saving less because auto-enrollment is associated with low default contribution rates and low employer match rates.

Plan sponsors who fear rising costs but still want to adopt an automatic enrollment strategy have four options, Butrica says:

  • Lower the match rate per dollar of employee contribution and/or lower the ceiling on the percent of contributions the company will match. These changes would reduce the per-participant match, allowing the company to address an increase in participation without raising total 401(k) costs.
  • Indirectly reduce its matching contributions by setting a default employee contribution rate below the level needed to obtain the maximum employer match. Participants could override the default and choose a higher saving rate; in practice, participants tend to stay where they are placed.
  • Offset higher match costs by reducing wages or other non-401(k) benefits.
  • Keep its compensation policies the same and simply allow total compensation costs to rise.

Auto-enrollment policies are still quite new and changes in design – such as more use of auto-escalation – could help solve the problems, the brief said.

© 2013 RIJ Publishing LLC. All rights reserved.

New York Life DIA wins innovation award from RIJ and RIIA

New York Life’s Guaranteed Future Income Annuity, a deferred income annuity (DIA) product that has altered the income product landscape since its introduction in 2011, received an award for product innovation from Retirement Income Journal at the Retirement Income Industry Association annual conference this week.  

New York Life managing director John Bonvouloir accepted the award from RIJ publisher Kerry Pechter on behalf of the insurer. RIJ also gave honorable mention to the Northwestern Mutual Life Select Portfolio Annuity, another DIA, and to Sun Life SunFlex Retirement Income, a variable income annuity available in Canada.

Shlomo Benartzi, author, professor and co-chair of the Behavioral Decision-Making Group at the UCLA Anderson School of Management, received RIIA’s 2013 Academic Thought chievement in Applied Research Award at the conference. Research Magazine/ThinkAdvisor sponsored the award.

In addition, Wade Pfau of The American College and Michael Kitces of Pinnacle Advisory Group received the RIIA 2013 Academic Thought Leadership Award for their research paper, “The True Impact of Immediate Annuities on Retirement Sustainability: A Total Wealth Perspective.” The award was sponsored by the Retirement Management Journal, which will publish the article this fall.

Jackson National, JP Morgan Chase, and Prudential also received awards at the RIIA conference in Austin.

© 2013 RIJ Publishing LLC. All rights reserved.

What do multinational companies think about retirement? Brussels bureaucrats want to know

PensionsEurope has created a new Multinational Advisory Group (MAG) to give large companies a say on pension issues. The Brussels-based group is speaking with several companies, in countries around the world, to join the group, according to a report at IPE.com.

The new group will advise PensionsEurope members on issues such as transparency, regulations, accounting standards, solvency requirements, governance, and education.

The shift from defined benefit plans to defined contribution is in part driving the new initiative, said Matti Leppäla, the chief executive at PensionsEurope, adding that large pensions need an outlet to discuss challenges and solutions. 

“This group will enable multinationals to have a place within PensionsEurope with the view to discussing these issues on a regular basis,” said Leppäla.

While the advice and input from the pensions would be valued, all policy decisions would remain within PensionsEurope, said Leppäla.

The group, which will meet twice a year in Paris, has attracted five pension plans, including Shell. The group is actively seeking additional companies.

“Once up and running, the multinationals within the group will meet to elect their own chair, who will hold the role for a period of two years, with the possibility of being re-elected at least once,” he said.

Established in 1981 as the European Federation for Retirement Provision,  PensionsEurope represents national associations of pension funds and similar institutions for workplace pension provision. It affiliates associations in 16 EU member states and five other European countries.

© 2013 RIJ Publishing LLC. All right reserved.

The global retirement puzzle remains unsolved: Mercer

Annuity products should factor more into global retirement plans as more countries and companies shift from defined benefit to defined contribution systems, according to Mercer.

But the trend toward DC has three major flaws, Mercer said. First, all the risks fall on individuals. Second, DC focuses on wealth accumulation rather than on retirement income. Lastly, nobody really knows yet what the best portfolio of income products for retirees is.

The 2013 Melbourne Mercer Global Pension Index (see Data Connection in today’s issue of RIJ), which measures the adequacy, sustainability and integrity of Australia’s pension system, included a section on the implications of DC plans replacing defined benefit plans.

“As countries grapple with rising life expectancies, increased government debt, uncertain economic conditions and a global shift to DC plans, there are still many lessons to be learnt and new solutions to be found, particularly for the post-retirement years,” said Dr. David Knox, a senior partner at Mercer and author of the research. He described the ideal features of retirement products:

  • Limited access to a lump sum benefit at retirement
  • Access to some capital for unexpected expenses and some spending flexibility
  • Income product for initial retirement (annuity or drawdown with adequacy and security)
  • Pooled insurance-type product with longevity protection (deferred annuity or pooled product from pension plan)
  • Structure that allows phased retirement – people continue working (part-time) while drawing on retirement savings

“Developing effective and sustainable post-retirement solutions has to be one of the most critical challenges for policy makers and retirement industries around the globe,” said Knox.

In Australia, the conversion of DC assets into sustainable retirement income remains a largely unresolved problem.

Australia’s system should consider increasing labor force participation among older workers, raising the minimum access age to get benefits from private pension plans, and removing legislative barriers to encourage more effective retirement income products, the report said.

© 2013 RIJ Publishing LLC. All rights reserved.

A Conspiracy against Public Pensions?

The media have publicized lots of academic research over the past few years about the way public sector defined benefit pensions face a multi-trillion-dollar shortfall and will be millstones around the necks of taxpayers in states and municipalities across America. 

But from the perspective of the folks running those pensions, the press has been a tool in a scare campaign conducted for the ultimate benefit of asset managers who’d like to wrest the management of the trillions of dollars in those plans from local governments.

The sense of siege among pension administrators found little public expression until two weeks ago when journalist David Sirota’s white paper entitled “The Plot Against Pensions,” was published by the Institute for America’s Future and instantly publicized by reporter Matt Taibbi in Rolling Stone magazine.

Since then, of course, the D.C. Shutdown and the baseball playoffs have absorbed most of the nation’s limited attention span. But we think it’s worth dwelling on this question for another news cycle or two: Is there a plot against pensions? Or are they just paranoid?

Two accused conspirers—economists Andrew Biggs of the American Enterprise Institute and Josh McGee of the Laura and John Arnold Foundation—told RIJ they think public pensions are obsolete retirement vehicles but deny a conspiracy.

On the other side, Joe Gimenez, a spokesman for Texas pensions, and a pension official in another state who asked for anonymity, admitted that pensions have problems but told us they’ve been sandbagged—ambushed unfairly by opponents who are camouflaging their strength. And they felt vindicated by the Rolling Stone article.

“I loved it, and I’m guessing that other people like me were dancing all over the place,” said the unnamed official. “It just punched them in the face. They were getting a free ride from the press. The [Sirota and Taibbi] articles had a few inaccuracies and wrong assumptions. But they may even the playing field a little.”

Under siege

Gimenez is a spokesperson for TexPERS, the association for all of the public pensions in Texas. (Unlike, say, CalPERS, it doesn’t manage pensions.) There’s been a coordinated effort around the country to generate negative research about public pensions, to educate anti-labor state legislators in states with underfunded pensions like Kentucky, Rhode Island, Louisiana and California, with the goal of passing legislation that will convert a states’ defined benefit public plans to defined contribution plans, he told RIJ.

TexPERS logo“You’re talking about basic politics,” he said. “People use certain situations to push certain agendas. There’s no doubt that that’s what’s happening here. TexPERS is on the alert and in constant communication with anybody who will listen to the politically-oriented threats to defined benefit plans in Texas.”

The apparent broad push against the public pension concept despite the relative health of many plans makes him wary. “The pension systems in Texas are by and large close to or at full funding. What’s happening in Rhode Island isn’t a problem here. But some people are automatically saying the DB system is broken. They make a blanket statement for all pensions systems and say we have to change them all to DC plans. They’re trying to create a top-down approach to pension reform. They say that without understanding the dynamics at the local level.”

“It’s a plot on the part of some people, and others are going along with it. If a plot can consist of a bunch of individual efforts, then absolutely it’s a plot. It’s a conspiracy of opportunism,” said the state pension official who asked not to be identified.

“I think it crosses over into a conspiracy when they start manipulating public perceptions and facts in order to move that money over,” the official added. “That’s what has happened. It’s easy to manipulate people. You get receptive audiences who are hurting. And the message is that moving [the public plans to defined contribution] will benefit you and lower your taxes. And that’s not true.”

TexPERS was so alarmed about the perceived stealth campaign that it published a document this year called “The Hostile Threat” to alert and mobilize its members, the various city and firefighter and policemen’s unions around the Lone Star State, from humid Houston on the Gulf Coast to arid Amarillo in the west. 

The document went so far as to name people and organizations it considered to be enemies: The Laura and John Arnold Foundation, the Texas Public Policy Foundation, the American Legislative Exchange Council (ALEC), the American Enterprise Institute, the Heritage Foundation, Charles and David Koch, and others.

“Many groups and individuals have put Defined Benefit plans for Texas public employees in their sights, erroneously claiming reform is needed and Defined Contribution plans are the only viable option,” the document said in part. “Many are true ideologues and only consistent presentation of facts can prevail to counter their misguided assertions. TEXPERS has been monitoring these hostile threats to DB plans and engaging in various public forums as necessary to thwart their efforts. We will succeed!”

The alleged conspirators

Two people named in “The Hostile Threat” document were Biggs (below left) and McGee (below right), of the conservative American Enterprise Institute and the Laura and John Arnold Foundation, respectively. The foundation, headquartered in Houston, is based on the fortune amassed by billionaire John Arnold (pictured below, with wife Laura), who started a hedge fund with money accumulated as an Enron trader.

Biggs, a former deputy commissioner at the Social Security Administration and a well-known Washington academic, has written several research papers arguing that the risk-free rate of return is the only legitimate way to discount the guaranteed obligations of a defined benefit pension.

Andrew BiggsIf they did use the risk-free rate—not the rosy 8% rate that many public pensions use—they’d see that they are deeply underfunded and putting future taxpayers in their states or communities on the hook for huge top-up contributions.

 “If this is a conspiracy, it’s not broad or deep. And I’m not in on it,” Biggs told RIJ this week. “A conspiracy requires conspiring, and I have no contact with any of these folks [such as the Arnold Foundation and the Koch brothers]. If it’s a conspiracy, where’s the Trilateral Commission?

“[I and the public pension administrators] just have different views on measuring pension liabilities. My attitude toward pension plans is that they’re exaggerating their funding health by understating their liabilities. If you’re looking at me and the Pew Center on the States [which published an influential study critical of public pensions] and Josh McGee, there are some similarities in our views on pensions, but we all have different angles on it.”

McGee, speaking for himself and the Arnold Foundation, also denied the conspirator label. “I’m a Democrat and have been one all my life,” he told RIJ. “The founders of our foundation were Obama supporters. So it’s a little strange to be pegged as right-wing. We have never coordinated with the Koch brothers or the American Enterprise Institute. I’ve not done anything behind anyone’s back. We’ve tried to be open. We’ve held public meetings. We are a private foundation. I can’t advocate. We must operate in a way that’s non-partisan.

“I want all employees to have a safe retirement,” he continued. “But we allow politicians to make promises that they don’t pay for. We saw the same behavior in the public sector that we saw in corporations that have since moved away from defined benefit plans: the companies borrowed from the pension funds to help their bottom lines.

Josh McGee“The public sector is doing the same thing. The model invites bad behavior and underfunding. On the labor market side, it has an accrual structure that puts people on an insufficient savings path. It’s a bad model. We need to improve both the funding and the labor market side. I’m not against providing workers with pensions. But it can’t be the case where they underfund and do significant harm.” McGee has proposed cash balance and hybrid DB/DC plans as well as DC.

Double standard

Public pension administrators claim that the defined benefit pension model is not obsolete or illegitimate. They admit that local officials have often chosen to skip their ARCs during good times (annual required contributions) and apply the funds to other purposes, but they say that doesn’t invalidate public pensions.

The see something disingenuous in the fact that many groups are bent on eliminating all public pension funds, even the many that are successful. The see additional evidence of bad faith in the odd failure of critics to apply the same standard to defined contribution plans that they apply to DB plans.

Defined contribution plans are doing an even poorer job at financing an adequate retirement income than DB plans, they say. DC participants face a huge amount of sequence of returns risk when they retire. Most participant accounts are tiny and deeply underfunded. The federal government is patently worried that U.S. taxpayers will be on the hook if millions of baby boomers don’t have enough DC savings to supplement Social Security. So why the obsession with the flaws of public plans?

“Public pensions have become a convenient but wholly undeserving scapegoat,” said Hank Kim, director of the National Conference on Public Employee Retirement Systems, in a release after the Sirota and Taibbi articles came out in late September.

“Retirement security is not only an issue for public plans but also for private plans,” Jimenez told RIJ. “If we are honest about the overall retirement income system in America, we have to acknowledge that we can’t just look at this whole thing as a just a public employee issue. It’s a broader issue. No matter where you’re employed, it’s a problem.

“We question that about [the protection of the] taxpayer. Fifty-two percent of the public employees in the U.S. don’t pay into Social Security. That’s from a GAO report. If you’re the City of Houston and you’re paying 18% of a public employee’s salary to his or her pension fund, you’re not paying the payroll tax for that individual. If they switch to a defined contribution plan, they will have to switch to Social Security. My point is that none of these groups take any of these considerations into account. They just want to slap on a top-down adjustment to how everybody else does it.”

Hidden agenda?

Members of the public pension community say they recognize that both public and corporate defined benefit pensions all over the world are converting to DC or experimenting with some sort of hybrid plan that balances risk between sponsors and participants.

But they see only one possible motive for what they perceive to be seemingly pervasive, persistent efforts–coordinated or not, but sharing an unnervingly similar dataset—to shift control of the funds out of the hands of elected officials and unions.

 “The mutual fund companies would benefit tremendously from having 401(k)-style investment options mandated by the states for the trillions of dollars of investments across the country,” Gimenez said. “They are looking to grow their market share among people who are forced all of a sudden to DC plans. By moving from defined benefit to defined contribution they get a larger base on which to collect fees.”

That view was seconded by another public pension official.

“Whenever anybody in the private sector sees an opportunity to compete for more business, they go after it. That’s OK. But we give people who manage money a green light to make a fortune at the expense of the people they manage money for. They get the cultural adulation. People say, ‘They’re so smart, they deserve the money,” the official said.

“On the positive side, this private sector urge to compete is healthy. On the not-so positive side, they vilify a structure [public pensions] that has worked well for a segment of the population. The fact is that they would love to put us out of business and take the business away from us. The people who are really energized about this right now are the defined contribution industry. They see the public plan money as a golden egg,” the official added.

Laura and John Arnold“I have very mixed emotions about that. If they truly ran the plans for the members’ benefit, that would be great. But they need to make money. That’s a fact of life. They way they run their plans is not for the individual’s benefit. The individual loses when everyone becomes an individual buying unit and there’s no group-buying power and no oversight. For the public plans to have reckoning is not a bad idea. But a total gutting doesn’t make sense.”

A neutral voice

In search of a neutral opinion on this issue, RIJ turned to someone who has worked in the nation’s capital on retirement issues for many years and knows people of every political stripe. We asked him if there is a plot against pensions. He answered on condition of anonymity.

 “As is often the case in Washington, the answer is both yes and no,” he said. “Andrew Biggs is not an agenda guy. While it’s easy to assume that John Arnold is a stalking horse for Wall Street, based on his background [as a trader at Enron], that’s not his goal, directly or indirectly.”

But, he continued, “there’s a mindset among conservatives—a common mindset, but that’s different from a conspiracy—that a DB pension is hard to sustain. They’re not surprised that there hasn’t been the appropriate level of responsible funding,” he said.

“That mindset gets mixed up with the overall conservative agenda, with its distrust and dislike of public employee unions. There are people at conservative think tanks whose goal in life is to destroy unions. So anything that damages the strength of the public employee unions must be good.”

© 2013 RIJ Publishing LLC. All rights reserved

To woo younger clients, New York Life halves its minimum DIA premium

New York Life, which sells 44% of the deferred income annuities (DIA) in the U.S., has decided to lower the minimum contribution to its flexible-premium DIA product, Guaranteed Future Income Annuity (GFIA), to 5,000 from $10,000, and to encourage workers in their late 30s and 40s to fund personal pensions with annual IRA contributions.  

“The average customer purchasing the GFIA with an initial premium of $5,000 is 48 years old, ten years younger than the overall average GFIA customer,” a New York Life release said. “The 48- and 58-year-old cohorts defer their income start dates to an average age of 66 and 67 respectively.”

New York Life sparked a virtual doubling of the relatively tiny income annuity market—tiny compared to the market for deferred variable annuities with living benefits—by introducing the GFIA in mid-2011. Since then, about eight other life insurers have launched DIAs and it is reported that another half-dozen more intend to follow.

Northwestern Mutual Life is the second-best selling DIA provider, with roughly a quarter of the market.

So far DIA sales, like income annuity sales, are largely a phenomenon of the mutual life insurers and their captive agents. Opinions differ on whether the product, which is not an investment product, will be marketed as enthusiastically by publicly-held issuers or independent advisers and agents.

Until New York Life introduced the GFIA, DIAs were mainly marketed as pure “longevity insurance” with no cash value. In that form, they typically didn’t pay out unless or until the annuitant reached age 85 (roughly the average life expectancy at age 65). They were positioned as the cheapest possible way to mitigate the financial risk of living to 90 or 100.

That product never got much traction in the market place, especially during the risk-on period of 2003-2008. In 2011, however, New York Life repositioned the DIA as a way for increasingly risk-off Boomers to buy a pension about 10 years in advance of retirement, and buy it at a discount, thanks to the delay between purchase and the income date. A predictable delay allows the issuer to invest farther out on the corporate bond yield curve, allows time for appreciation, and shortens the average payout period, all of which allows a higher income quote.     

By all accounts, the peace of mind that the fixed product delivers helps drive sales. When New York Life subsequently wheeled out a less risk-averse version of the product, which offered upside potential through exposure to equities during the deferral period in exchange for a lower guaranteed minimum payout on the start date, interest was relatively tepid.

The primary funding method for New York Life’s book of GFIA business, which has an average initial premium of $100,000, is via a rollover from another qualified plan. Only three percent of these policies have pre-set recurring contributions.

So far, the primary funding method for GFIA policies with an initial premium of $5,000 is through IRA contributions. One-fifth of these policies are funded with a pre-set, recurring annual contribution.

With the lower-premium product, New York Life is promoting a retirement income strategy based on 20 or 30 years of buying future income with IRA contributions or existing IRA assets, which, nationally, number in the trillions of dollars.

According to New York Life examples for life-with-cash-refund GFIA contracts:

  • A 48-year-old male purchases a GFIA with a $5,000 IRA contribution and continues to contribute $5,000 every year until he retires at age 66. He will then receive $9,622 a year for the rest of his life. 
  • A 37-year-old male purchases a GFIA with a $5,000 IRA contribution and continues to contribute $5,000 annually. When he retires at age 66, he will receive $20,667 annually for the rest of his life.  

Today, a man of 67 would have to pay about $308,000 to buy $21,000 in annual lifetime income with an installment refund. Were he to contribute $5,000 every year to a fund that earned an average of 4.3% a year, he would accumulate about $308,000 after 30 years.

The average purchaser of the GFIA today is age 58 and takes income nine years later, New York Life said. With a $100,000 contribution, such a contract owner would receive $11,427 a year for life, starting at age 67.  

Some advisors have been comparing the payouts from DIAs with the payouts from fixed indexed annuities (FIAs) with guaranteed lifetime withdrawal benefits and generous deferral bonuses and find the minimum payouts to be similar after similar deferral periods. FIAs typically sell through the independent insurance agent channel, however. But they are spreading to the bank channel, where they could eventually compete head-to-head with DIAs.

© 2013 RIJ Publishing LLC. All rights reserved.

America’s Endless Budget Battle

Perhaps investors are becoming inured to the United States’ annual debt-ceiling debacle, now playing out for the third year in a row. But, as the short-term antics become more routine, the risks of long-term dysfunction become more apparent – a point underscored by the shutdown of the federal government.

President Barack Obama is right to complain of blackmail. The US Congress cannot expect to use the threat of default – that is, a weapon of mass financial destruction – as a normal means of extracting concessions. Unfortunately, because Obama himself has established a history of making concessions in the face of congressional brinkmanship, the debt-ceiling debate has morphed into more than just a short-term political fight.

Increasingly, the battle over the US government’s debt ceiling reflects a deeper constitutional power struggle between the president and Congress. This struggle, if left unresolved, could profoundly weaken the government’s ability to make significant economic decisions in the future.

Of course, a breakdown in political civility would hardly make the US unique; all too many countries suffer some degree of political dysfunction. It would take some doing to match (or exceed) Italy’s record of governmental paralysis. But if Congress continues to hijack US economic policy, it bodes ill for the economy’s otherwise bright long-term prospects.

At least for now, the rest of the world has seemingly unbounded confidence – reflected in very low borrowing rates – in America’s capacity to put its house (of representatives) in order. No one can imagine that a country with so many unique economic advantages would risk such a damaging self-inflicted wound as default would cause.

But this time could be different. Obama needs to force his Republican opponents to blink, and there is no guarantee that they will. In the past, it was Obama who blinked, knowing that even if a catastrophic debt default was largely caused by congressional Republicans, he would likely absorb some of the blame in the next election. Now that re-election is behind him, Obama could be inclined to take more risks, with an eye toward securing his economic legacy.

What will that legacy be? Despite the federal government’s destructive impulses, the US economy is showing great resilience and looks set to become stronger. Of course, Obama would love to see this trend continue, as would almost everyone else. Unfortunately, a US debt default, even a technical one, would have unforeseeable consequences that could threaten the recovery.

Consider what happened when the Federal Reserve misplayed its hand with premature talk of “tapering” its long-term asset purchases. After months of market volatility, combined with a reassessment of the politics and the economic fundamentals, the Fed backed down. But serious damage was done, especially in emerging economies. If the mere suggestion of monetary tightening roils international markets to such an extent, what would a US debt default do to the global economy?

Much of the press coverage has focused on various short-term dislocations from counterproductive sequestration measures, but the real risk is more profound. Yes, the dollar would remain the world’s main reserve currency even after a gratuitous bout of default; there is simply no good alternative yet – certainly not today’s euro. But even if the US keeps its reserve-currency franchise, its value could be deeply compromised.

The privilege of issuing the global reserve currency confers enormous advantages on the US, lowering not just the interest rates that the US government pays, but reducing all interest rates that Americans pay. Most calculations show that the advantage to the US is in excess of $100 billion per year.

There was a time, during the 1800’s, when the United Kingdom enjoyed this “exorbitant privilege” (as Valéry Giscard d’Estaing once famously called it when he served as French President Charles de Gaulle’s finance minister). But, as foreign capital markets developed, much of the UK’s advantage faded, and had almost disappeared entirely by the start of World War I.

The same, of course, will ultimately happen to the dollar, especially as Asian capital markets grow and deepen. Even if the dollar long remains king, it will not always be such a powerful monarch. But an unforced debt default now could dramatically accelerate the process, costing Americans hundreds of billions of dollars in higher interest payments on public and private debt over the coming decades.

Ironically, the debt-ceiling fight is not really about debt. The Republicans are hardly debt hawks when they control things. The last Republican presidential candidate, Mitt Romney, and his vice-presidential running mate, Paul Ryan, campaigned in 2012 on a program that would likely have added trillions of dollars to the US debt over the next ten years, owing to tax cuts and increased defense spending. Rather, the debt-ceiling debate is about the size and reach of government.

Yes, the US should worry about its soaring public debt – and about the rising pension and health-care costs that loom large. Despite baseless politically motivated claims to the contrary, the academic research still overwhelmingly suggests that very high debt is a drag on long-term growth.

Of course, Americans should worry just as much about the quality of education and infrastructure – not to mention the natural environment – that they are leaving to future generations. But, above all, they need to leave a legacy of civil political decision-making. That essential feature of effective government is now at risk.

Kenneth Rogoff, Professor of Economics and Public Policy at Harvard University and recipient of the 2011 Deutsche Bank Prize in Financial Economics, was the chief economist of the International Monetary Fund from 2001 to 2003.

The Crone or the Elegant Lady?

People are entitled to their own opinions but not to their own sets of facts, the scholar-politician Daniel Moynihan famously said. Yet opinions often morph into beliefs, and beliefs can harden into perceptions and perceptions can become “facts.”

A collision of two versions of the “facts” about the government’s finances is part of what lies behind the current stare-down in Washington. (Let’s assume for the moment that the “fact” purveyors in D.C. believe what they say, and don’t say it just for effect.)

The competing realities are:

Reality I. The federal government is, and always has been, parasitic.

It is a cancer on the states, crippling them with unfunded mandates. It criminally sucks tribute from the private sector—the makers, not the takers—in two ways.

It confiscates honestly earned wealth from its owners through taxation. It crowds out private investment through excessive borrowing.  

It then sends these dollars to poor people, addicting them to dependency, after which the money vanishes, as if into a dumpster. The government feeds them because it wants their votes. But charity only extends their dependence. 

Always spending, never investing, the federal government falls farther and farther into debt… the interest and principal of which its citizens or their children or grandchildren will repay through higher taxes or the steady, stealthy dilution and debasement of their savings and income through inflation.

If we could only take the spendthrift’s checkbook away,  pay down the debt and balance the budget, the private economy would boom.

Reality II. The federal government (including the central bank) is our deep-pocketed friend. 

It has been the states’ rich Uncle Sam since the birth of the country, covering the bills and debts they can’t.  

Its various purchases, subsidies and “tax expenditures”—of weaponry or infrastructure or of the costs of retirement savings, health care and mortgages—disproportionately enrich those who are already well-off or favored.

By selling bonds to the public, it a) Puts excess savings to work, b) Recaptures dollars from our trading partners, c) Keeps taxes low and d) Gets the cash it needs to execute its lawful responsibilities. The Federal Reserve, through the banks, makes sure the private sector has enough cash and credit to operate smoothly. If the government runs a deficit, the private sector runs a surplus. 

In return for campaign contributions, it tends to under-tax the wealthy. It subsidizes the poor only enough so they can afford to work for low private-sector wages and still subsist. There has been persistent, intentional inflation, which drives up asset prices and, to a lesser extent, eases the burden of debt. Inflation is regrettable but preferable to deflation.

The standoff 

This is a fascinating contrast in worldviews. Looking from one set of “facts” to the other and back again is like studying one of those etchings where first you see the hook-nosed crone, then the elegant young lady.  

Is one of them accurate? Both? Neither?

Beats me. But I wasn’t born yesterday. As far as I can tell, the price of almost everything—a copy of the Times, a cup of coffee, a gallon of gas, a semester at college, a single-family home—has risen about tenfold since I graduated from high school. (The official CPI has risen only six-fold, interestingly. I suppose clothes and televisions are cheaper. And computers, by a large margin.)   

During that time, the assets of the Federal Reserve rose by about 40 times and the average price of large-cap stocks (35% of stocks are owned by one percent of the U.S. population) rose by a factor of 15 to 20 (depending on whether you start with the 1969 spike or the 1970 trough).

Over the same period, the average nominal income rose only about seven-fold. It has risen a mere five- or six-fold for the middle- and low-income groups but more than tenfold (and from a much higher base) for the top 5%. 

So how do these facts jive with the two sets of “facts” above? That’s hard to say. It may depend on how you’ve dealt with inflation. If you’ve stayed ahead of inflation (by owning assets and/or earning top dollar), you should probably call the free-spending government your friend, as much as it might hurt to do so. If you’ve fallen behind inflation, you’re pretty much out of luck.

© 2013 RIJ Publishing LLC. All rights reserved.

Why Retirees Should Choose DIAs over SPIAs

Retirement portfolios can be constructed from a mix of asset classes, including stocks, bonds and annuities. In the past, I’ve shown that retirees achieve some of the best outcomes by allocating a portion of those assets to single-premium immediate annuities (SPIAs). In this column, I extend my analysis to show that deferred-income annuities (DIAs) work even better than SPIAs, by providing more liquidity and better longevity protection at a lower cost.

This analysis is created in the context of the efficient frontier for retirement income, looking at the case of a 65-year-old couple and finding that a combination of stocks and SPIAs optimizes a retirement-income portfolio for a robust set of circumstances. That analysis, however, did not include DIAs within the universe of available investment choices. I’ve now remedied this.

DIAs offer longevity protection through a guaranteed income beginning at a future date, which lowers their cost relative to SPIAs. DIAs may be more attractive to clients who loath the loss of principal and liquidity implied by a SPIA purchase. When adding DIAs into the mix, the retirement income frontier expands. In my analysis, DIAs have pushed aside SPIAs as the product of choice for providing longevity protection.

Fundamentals of deferred-income annuities
For both DIAs and SPIAs, a lump-sum premium is paid today in return for a guaranteed income for life. The difference is that for the DIA, the guaranteed income does not begin until a later date. Another way to look at this is that a SPIA is a DIA with no deferral period.
The basic idea of “longevity insurance” is that a 65-year-old might purchase a DIA for which income begins in 15 or 20 years. Because the income is deferred, total lifetime payouts will be less and the cost of the annuity is lower. This provides longevity protection at a lower cost.

Recent research articles have shown that DIAs support a higher withdrawal rate more safely by creating a 20-year Treasury inflation-protected securities ladder with a DIA that starts payments after the 20 years. S. Gowri Shankar wrote about this strategy in A new strategy to guarantee retirement income using TIPS and longevity insurance in a 2009 issue of Financial Services Review, and Stephen C. Sexauer, Michael W. Peskin and Daniel Cassidy reconfirmed the idea with an article in the January/February 2012 issue of Financial Analysts Journal.

An important feature about DIAs, however, is that in their current form they do not provide full inflation protection. Inflation-adjusted DIAs exist, but the inflation adjustments do not begin until the date income is received, rather than the date that the premium is paid. Advisors and their clients are forced to assume a value for the future compounded inflation rate in order to try to calibrate the real value of the income the DIA will provide. Small differences between actual inflation and what is assumed can compound into big differences over a long deferral period.

Figure 1 illustrates this with an example of a 20-year deferral to the income start date. In this example, the advisor and client try to purchase a DIA that will meet the spending goal 20 years from now in inflation-adjusted terms. They assume inflation will compound at 2.1%. If actual inflation matches this, then the real value of the income will be exactly what the client desired. If inflation is less than assumed, then the real value of the income is even greater.

For instance, if inflation averages 1.6%, the DIA provides about 10% more than planned, and the client annuitizes 10% more assets than necessary. On the other hand, higher inflation reduces the real value of income. For instance, if inflation averages 3.3%, then the real value of the income provided by the DIA is about 20% less than the client’s goal. Advisors must be aware of this inflation risk when planning a DIA purchase.


One other risk for a DIA is the possibility that financial assets could deplete before the date that income begins, which would leave clients with a hole in their finances midway through retirement.

The efficient frontier for retirement income
I did not incorporate DIAs into my analysis when I last wrote about the efficient frontier for retirement income. It is worth a brief refresher about how that analysis worked. A more complete explanation can be found in my article from the February 2013 issue of the Journal of Financial Planning, A Broader Framework for Determining an Efficient Frontier for Retirement Income.

The basic idea is that a client envisions a lifestyle-spending goal for the remainder of his or her lifetime and seeks to find a retirement income strategy that meets that goal while also preserving liquidity for remaining financial assets. Failure to meet spending goals is quantified in terms of the how far spending fell below what was desired. This is different from the failure rate (the probability that financial assets will deplete, which is a popular measure in safe-withdrawal-rate studies), because it accounts for income from other guaranteed sources that would continue if financial assets were depleted.

The efficient frontier does not solely focus on avoiding financial wealth depletion. Instead, there is a tradeoff between two objectives: supporting lifestyle spending goals, and maintaining a buffer of financial assets. This buffer could be for a legacy or a reserve in the case of expensive health shocks, divorce, severe economic downturns or other contingencies. Clients must determine how much they value each objective and choose the appropriate balance between them.

My analysis is based on Monte Carlo simulations, giving us a distribution of outcomes for both of the financial objectives. To measure the potential upside of a strategy, I focus on how much spending would be feasible in unlucky circumstances with poor market returns and the value of the financial assets that would remain at death in the median case. The calculations are made on a survival-weighted basis, considering the probability of survival to all subsequent ages past the retirement age.

The resulting efficient frontier shows the allocations that support the largest buffer of remaining financial assets at death while still providing a given percentage of spending needs (or, alternatively, the highest percentage of spending needs that can be satisfied for a given reserve of financial assets). Any of the product allocations on the efficient frontier represents a potentially optimal point. Clients must make the final decision about which allocation is most optimal for them.

In my previous article, I showed that combinations of stocks and SPIAs provide the best opportunity to meet spending goals while preserving liquidity, even in circumstances with unfortunate market returns. Including bonds or variable annuities with guarantee riders led to suboptimal outcomes.

Incorporating DIAs into the efficient frontier
I added DIAs with deferral periods ranging from 5 to 25 years into the product mix. Though that is a lot of choices, I simplified the analysis in other respects so as to illustrate the appropriate deferral periods. My earlier analysis showed that stocks and SPIAs provide the most efficient results, but only if remaining financial assets are invested entirely in stocks. That may not be realistic for many clients. I tried to make this aspect more realistic by assuming that whatever is not annuitized will be maintained in a portfolio of financial assets rebalanced annually to a 50/50 stock/bond allocation.

Unlike the earlier mentioned research articles, I did not create bond ladders; bond investments are in mutual funds earning the underlying index returns. The only questions are how much to annuitize and what deferral length to use to best meet the retirement financial objectives when combined with withdrawals from a 50/50 portfolio.

Table 1 provides quotes obtained in early September 2013 from Cannex for a SPIA and for DIAs with deferral periods ranging from 5 to 25 years. These quotes are all joint and 100% survivor (which means that the same guaranteed income is provided until the death of the long-living member of the couple) for a 65-year old couple and are from the same issuer. The monthly income is fixed for the SPIA and DIAs with no inflation adjustments. I show the monthly income from a $100,000 premium along with the annual payout rate.

The final column shows the percentage of financial assets needed to meet one’s lifestyle spending goal in expectation terms in the first year that income is received. For instance, with a 4% withdrawal rate needed to meet one’s lifestyle goal, 68.6% of assets would be annuitized with a SPIA to meet the first year goal. In subsequent years, inflation will erode the value of the SPIA income, but withdrawals from remaining financial assets are used to make up the difference.

For another example, consider a 20-year deferral period. In this case, 18% of assets could be annuitized today, and this would provide the desired income precisely in year 20 if inflation compounds at 2.1% over those 20 years. (As discussed before, if actual inflation differs, there could be a shortfall or surplus in real terms.) The remaining 82% of financial assets could then be used with a systematic withdrawal strategy to cover spending goals over the next 20 years and make any needed income adjustments to achieve the desired inflation-adjusted spending in the years after that.

When sufficient financial assets remain, I assume that clients withdraw what is needed to meet their lifestyle spending goal after accounting for any annuity income. In cases when the annuity provided excess income in real terms (such as with lower realized inflation), I return any excess income to the financial portfolio.


I investigated the results for a scenario in which systematic withdrawals are taken from a 50/50 portfolio without any partial annuitization, as well as for the six possibilities in Table 1, in which partial annuitization is combined with systematic withdrawals from a 50/50 portfolio of remaining assets to make up any difference from the spending goal. For stock and bond holdings, I assumed investments are made in underlying indices for the S&P 500 and intermediate-term U.S. government bonds, each with a 0.2% administrative fee. Capital market expectations are aimed to better match current market conditions (including inflation-adjusted arithmetic returns for stocks and bonds of 5.7% and 0.9%, respectively, and inflation of 2.1%, with historical assumptions for volatility and cross-correlations).


The results are presented in Table 2. Spending shortfalls are shown as the percentage of the lifetime spending goal that could not be met, and financial assets at death are shown in inflation-adjusted terms for retirement date wealth of $100. Compared to the no- annuitization case, partial annuitization results in less shortfall on the downside, without impacting the legacy to a substantial degree.

Though partial annuitization causes financial assets to drop initially, ground is made up during one’s retirement through the contributions provided by the annuity products to reduce the subsequent drawdown from financial assets. In fact, at the median of the distribution, the financial legacy is larger for DIAs with at least 15 years of deferral, compared to the no-annuitization case.

DIAs improve the results beyond what is obtained with a straightforward SPIA. To minimize the spending shortfall in the above table, the deferral sweet spot is 10 or 15 years. A shorter deferral period leaves more time for inflation to erode the value of the annuity — and with more assets devoted to annuitization, less is available to make up the difference needed to meet spending goals.

With a longer deferral, the wait for income to begin becomes too long. Clients would increasingly find that their financial assets were depleted before the stage in which they receive their DIA income. A 10-year deferral, with income starting at age 75, provides the most downside protection for spending shortfalls.

The bottom line
DIAs expand the efficient frontier, providing clients a stronger opportunity to meet their financial objectives in retirement. In the case of a 65-year old couple with a 4%-of- retirement-date-assets spending goal for their portfolios, the results show that incorporating a DIA with a 10- to 20-year deferral period is more effective than using a SPIA. Relative to the non-annuitization case, shortfalls are substantially less on the downside with only a minimal impact on the financial legacy at death. Relative to a SPIA, a DIA secures better outcomes with more liquidity and the same longevity protection at less cost.

Wade  D. Pfau, Ph.D., CFA, is a professor of retirement income in the new Ph.D. program in financial services and retirement planning at The American College in Bryn Mawr, Pa. He is also the leading financial planning scientist for inStream Solutions.

Don’t underestimate the (well-educated) older worker, economist says

As the U.S. population ages, and as under-saved Americans postpone retirement, the average age of the domestic workforce is gently rising. That raises the question: Since older workers are assumed to be less productive than younger ones, can we generalize that an aging workforce be a less productive one?

It all depends, says economist Gary Burtless of the Brookings Institution, on whether or not the aging workers who delay retirement are well-educated. And it so happens—no surprise—that the more educated, more productive workers are the ones most likely to remain employed.

So we don’t need to worry that a graying trend will be accompanied by a decline in productivity. (It all makes sense. Early boomers and pre-boomers (1940-46) know that they are demography’s darlings: blessed to grow up just after the world emerged from chaos and destined to die just before chaos returns.)

“None of the indicators of male productivity suggest that older male workers are less productive than average workers who are between 25 and 59,” writes Burtless in a paper published by the Center for Retirement Research at Boston College.

“The expectation that older workers will reduce average productivity may be fueled by the perception that the aged are less healthy, less educated, less up-to-date in their knowledge, and more fragile than the young. While all these images of the elderly are accurate to some degree, they do not necessarily describe the people who choose or who are permitted to remain in paid employment at older ages.”

In a study published by the Center for Retirement Research at Boston College, Burtless reveals what he learned from the Census Bureau’s monthly Current Population Survey (CPS) files. He found facts about older workers that are both familiar and not so familiar:

  • The sheer size of the baby boom generation means that the number of Americans attaining age 60 each year is climbing steeply.
  • Labor force participation rates among adults between 60 and 74 have increased.
  • The share of all labor income earned by older workers has also soared in recent years because they have enjoyed faster wage gains than workers who are younger.  
  • A major reason is that older workers are now better educated compared with prime-age workers than in the past. In the past the gap in education between prime-age workers and older Americans was large. It is now much smaller.
  • At older ages there are major differences between the participation rates of highly educated and less educated groups.
  • In the early 1990s nearly 60% of 62-74 year-old men with doctoral and professional degrees were still in labor force.
  • Only 20% of male high school dropouts the same age remained in the workforce. The participation-rate gap was smaller for older women, but it was still sizeable.
  • There was a steady improvement in older Americans’ educational credentials over the past 25 years, both absolutely and in comparison to the qualifications of younger cohorts still in their prime working years. That improvement will be much slower between now and 2030.  
  • Older Americans who stay attached to the labor force after 62 are much more likely to have received schooling after high school.   
  • Compared with their prime-age counterparts, older workers now receive much better compensation than they used to. Workers younger than 50 have seen a modest decline in their relative annual earnings, but workers past 55 have enjoyed impressive relative earnings gains. Compared with the earnings of an average 35- to 54-year-old worker, the average worker between 65 and 69 has seen his or her earnings climb 30 percentage points.
  • Workers between 70 and 74 experienced a 28-percentage-point gain in their relative earnings.

Older workers are taking home an increasingly large share of the national pie, Burtless found. The share of male earnings received by 60- to 74-year-olds increased from 7.3% in 2000 to 12.7% in 2010. Among women earners, the share increased from 5.8% of total female earnings in 2000 to 11.7% of earnings in 2010.

The magnitude of these gains is partly explained by the rising share of older workers in the labor force, partly by their increasing levels of work, and partly by improvements in their relative earnings if they do work, he wrote.

“Even if employment and earnings patterns of older workers do not change during the next two decades, the share of all labor income received by older workers will continue to rise through about 2025. At their peak in importance, 60- to 74-year-old men will account for about 16% of male earnings and 60- to 74-year-old women for about 14.5% of female earnings,” the paper said.

© 2013 RIJ Publishing LLC. All rights reserved.

Inflation or deflation? It’s a toss-up

AXA Investment Managers say pension funds must be aware of the widening “duration mismatch” in their portfolios as a retiring membership clashes with the prevailing low-yield environment, IPE.com reported.  

In a paper on longevity, AXA said two trends – the low-yield environment and retiring baby boomers – were “superimposing” themselves on the coming problem posed by a globally aging population.

The research observed that the instinctive choice of many on retirement was to invest in fixed income, an approach at odds with current bond yields.

“In order to pay additional annuities in the short term, pension funds need to invest in higher-return assets such as equities or real estate,” it noted. “With increased pressure on the short-term horizon of their liability and a chase for yield that delivers in the longer term, pension schemes are caught in a duration mismatch that keeps widening as the new demographic steady-state, post baby-boom is getting closer.

“So changes in mortality tables and structures of age pyramids imply radical changes in the temporal profile of liabilities for public and private pensions alike, which must adapt their [asset-liability matching] strategic choices accordingly.”

The research recommended increasing equity exposures to “satisfy the need for higher shorter-term yields. Tilting the balance towards equities would hopefully compensate for depressed bond yields. This is a noteworthy move, as it departs from an old habit,” the paper said, noting UK pension funds are pursuing that strategy.

A rising dependency ratio in countries could lead to deflation among the developed nations, AXA added, pointing to past experience of rising old-age ratios in Japan.

“But an aging population could well turn into inflationary forces if an unsustainable rise in government debt led to its monetization,” it added. “When old-age dependency ratios reach the levels forecast by the UN in only a decade’s time, this would mean inflation next to zero or even turning into outright deflation.”

© 2013 IPE.com.

International Paper settles 401(k) fee case for $30 million

A tentative $30 million settlement has been reached in a seven-year-old 401(k) fee lawsuit involving International Paper Co., the plaintiffs’ attorneys announced in a release this week.

 The St. Louis law firm of Schlichter, Board & Denton, a specialist in class action lawsuits against large plan sponsors, said it reached a tentative settlement with International Paper Company in Pat Beesley, et al., v. International Paper Company, et al., Case No. 06-703, in the U.S. Federal Court for the Southern District of Illinois.

The settlement must be approved by an independent fiduciary and Chief Judge David R. Herndon before it becomes final.

The case, pending since September of 2006, involves allegations that the fiduciaries responsible for International Paper’s 401(k) plans “breached their duties resulting in excessive fees, treating the 401(k) plans differently from the company’s pension plan, and by imprudently selecting funds in the plans,” the release said.

In addition to the payment of $30 million, the settlement requires International Paper’s 401(k) plans to be monitored for four year and requires the company to put its recordkeeping out for bids, the release added.  

The International Paper defendants disputed the allegations in the case, contending that the Plans had been appropriately managed.

In addition to the settlement with International Paper, Schlichter recently settled an excessive fee case on behalf of Cigna employees and retirees for $35 million, said to be the largest settlement in an excessive fee case in history.

Schlichter has achieved settlements on behalf of employees and retirees of Caterpillar, General Dynamics, Bechtel, and Kraft Foods.  In 2012, he and his firm won a judgment against ABB and Fidelity of over $50 million in the only full trial of an excessive fee 401(k) plan lawsuit in U.S. history.

© 2013 RIJ Publishing LLC. All rights reserved.

Shedding Light on Shadow Reinsurance

Since 2002, life insurers have ramped up their use of “shadow reinsurers” as a way to reduce their taxes or capital requirements, write researchers at the London Business School and the Federal Reserve Bank of Minneapolis in an unpublished paper. 

Shadow reinsurers are defined in the paper as unauthorized affiliates of life insurers that are domiciled in places such as Bermuda, the Cayman Islands, South Carolina or Vermont, with looser capital requirements than the parent companies’ domiciles.

The savings from this practice may help reduce the cost and expand the supply of life insurance and annuities, but they may add risk to the life insurance industry, just as so-called shadow banks added to the systemic risk that crashed the global economy in 2008, according to authors Ralph S. J. Koijen and Motohiro Yogo.

Their study shows that the volume of shadow insurance grew from just $11 billion in 2002 to $364 billion in 2009, and has remained high:

“We estimate that total liabilities ceded by U.S. life insurers to shadow reinsurers was $364 billion at its peak in 2009, or 2.98 times the equity of the ceding companies,” they said. “At the end of 2012, it remains large at $363 billion or 2.52 times equity. We find that shadow insurance adds a tremendous amount of financial risk for the companies involved, which is not reflected in their ratings. When we adjust measures of financial risk for shadow insurance, risk-based capital drops by 49 percentage points for the median company, which is equivalent to three rating notches. Hence, default probabilities are likely to be higher than what may be inferred from their reported ratings. Our adjustments for shadow insurance implies an increase in the expected asset shortfall of $19 billion for the life insurance industry, which is a cost to the state guaranty funds (and ultimately taxpayers).”

If shadow reinsurance were banned, the authors predict that prices for insurance products would go up. “We find that insurance prices would rise by 1.2 percent for the average operating company. For an empirically realistic value of 11 for the demand elasticity, the market would shrink by 13.1 percent. This corresponds to $10.6 billion annually when aggregated across all the operating companies that are involved in shadow insurance,” their paper said.

Regulators have become concerned about the transfer of liabilities from one holding company insurer to another in order to free up capital.

Last June, the New York State Department of Financial Services, published a report, “Shining a Light on Shadow Insurance: A Little-known Loophole that Puts Insurance Policyholders and Taxpayers at Greater Risk.” The report was the result of a year-long investigation in to the hidden use of shadow reinsurance and its ability to make insurance companies look healthier than they are. According to the report:

“In a typical shadow insurance transaction, an insurance company creates a ‘captive’ insurance subsidiary, which is essentially a shell company owned by the insurer’s parent. The company then ‘reinsures’ a block of existing policy claims through the shell company — and diverts the reserves that it had previously set aside to pay policyholders to other purposes, since the reserve and collateral requirements for the captive shell company are typically lower. Sometimes the parent company even effectively pays a commission to itself from the shell company when the transaction is complete.

“This financial alchemy, however, does not actually transfer the risk for those insurance policies because, in many instances, the parent company is ultimately still on the hook for paying claims if the shell company’s weaker reserves are exhausted (‘a parental guarantee’).”

The National Association of Insurance Commissioners is also looking into the matter. According to the NAIC website, the group’s Financial Condition Committee has created a Captive and Special Purpose Vehicle Use SubGroup to:

“Study insurers’ use of captives and special purpose vehicles to transfer insurance risk, other than self-insured risk, in relation to existing state laws and regulations, and establish appropriate regulatory requirements to address concerns identified in this study. The appropriate regulatory requirements may involve modifications to existing NAIC model laws and/or generation of a new NAIC model law.”


© 2013 RIJ Publishing LLC. All rights reserved.