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The Best & Worst TDF Performers

Rising equity markets helped generate strong returns during 2012 and early 2013. Experiencing more volatility, TDFs with equity rich glide paths, tactical overweighting, emerging market and real estate exposure fared particularly well last year. The defensive funds and those focused on real returns lagged, but it is important to review these funds on a risk-adjusted basis over a longer time period.

As noted in the 7/15/13 release by the Center for Due Diligence (CFDD) on TAA: Prudent, Generally Accepted & Diversified, a surprisingly large number of mainstream TDF managers, including T. Rowe Price, are now using a tactical element. Given the increased interest in tactical asset allocation, the CFDD’s white paper on TAA & ERISA Plans was specifically designed to provide an analytic framework for evaluating these complex strategies.

TDFs have diversified via international equity and foreign bonds in recent years. The Morningstar survey noted that TDFs with significantly different allocations and geography delivered somewhat similar results during 2012, but that will not be the case in 2013. In spite of this diversification, the average TDF generated a 13.1% return during 2012, not far from the 16.0% generated by the S&P 500.

Recognizing that few managers add attribution value beyond asset class selection, the flows into passive TDFs exceeded active funds for the first time during 2012. TDF fees continue to fall and while active funds still hold a 68% market share, that market share is down from 85% in 2006.

Bolstered by recordkeeping platforms and brand, Fidelity ($157 billion in TDF assets), Vanguard ($124 billion) and T. Rowe Price ($80 billion) remain the dominant mutual fund providers of TDFs. The big three held a 75% market share at the end of 2012, but that is down from 83% at the end of 2006.

Declining from 48% in 2006 to 32% at the end of 2012, most of the decline in market share was experienced by Fidelity. The increased use of CITs, mediocre performance and the trend towards open architecture contributed to the decline in Fidelity’s market share.

The Fidelity Direct and Fidelity Advisor platforms are quite different, but both offer robust non-proprietary TDF flexibility. Indeed, Fidelity Direct includes the vast majority of TDFs as part of their standard offering, including Vanguard and T. Rowe. Vanguard and the American Funds do, however, appear to be missing from the Fidelity Advisor platform.

Looking at the 2015 vintage, Fidelity’s absolute and risk adjusted returns were average or below during 2012, particularly the Index series. The somewhat conservative glide path and commodity allocation are no doubt taking a toll. Fidelity is the only one of the big three with a commodity allocation and while it was ill-timed, smart allocations could be muted by conservative glide paths during periods of rising equity markets. Unlike the Freedom Series, the Index series does not use High Yield, Emerging Market Debt or REITs. Despite average volatility, Fidelity’s TDF performance did not improve much during the first half of 2013.

From an absolute performance standpoint, T. Rowe, TIAA-CREF, Principal, Great West and John Hancock led the 2012 charge. T. Rowe Price, TIAA-CREF and Principal were also among the top performing TDFs over the trailing three-year period calendar period. Vanguard’s growth rate was the highest among the “big three” last year and while most TDF managers experienced organic growth during 2012, the smaller funds generated the highest growth rates.


TDF managers with more than $1 billion in assets experiencing robust growth during 2012 included John Hancock, up 43%, JP Morgan, up 51%, and Great West, up 71%. TDF Managers with less than $1 billion experiencing robust growth included MFS, up 49%, PIMCO, up 127%, Invesco, up 57%, and Allianz, up 149%. Interestingly, these four firms lack recordkeeping platforms and use different strategies.

2012 was a good year for most TDF managers, but six of the TDF series tracked by Morningstar experienced negative growth, including Alliance Bernstein, DWS and Putnam. Given their less than stellar performance, attribution value and lack of scale, these TDFs should be monitored more closely. While we aren’t sure about their other asset allocation solutions, Putnam’s TDF performance has been particularly poor over the trailing 1, 3 & 5 year periods.

American Independence, Columbia, OppenheimerFunds and Goldman Sachs shuttered their TDFs in 2012, primarily due to a lack of scale. Goldman Sachs is, however, positioning to leverage the market for custom solutions and turmoil in the fixed income markets.

As noted in the lead copy, the first half of 2013 was very different from the 2012 results. The TDF managers are also diverging. US equities performed well during the first half of 2013, but US bonds, foreign bonds, TIPS and commodities all ended in the negative column for the year-to-date period ending 6/30/13.

As noted by Jon Chambers, Principal, Schulz Collins Lawson Chambers, “Those advocating heavy bond allocations may be fighting yesterday’s battle. Asset allocation is about balancing risk, not avoiding it, something that is impossible.” Indeed, the inevitable end of quantitative easing and the record outflows from US bonds during June are reminders that equity and longevity risk are not the only risks facing TDF investors. For more on fund flows and asset class performance, see the CFDD’s DC Plan & TDF Statistical Supplement. 


TDF performance varies by vintage. Given the impact of rising interest rates, the long-dated funds fared better than the short-dated funds for the period ending 6/30/13. In other words, the most risk-averse investors came up short.
Based on the lowest cost share class TDF in Morningstar’s mutual fund database—which does not include funds of funds, target-risk funds & CITs—the average TDF in the 2015 vintage was DOWN 1.4% for the quarter, up 2.1% for the year-to-date June period and up 8.0% for the trailing year. In sharp contrast to the average target date fund, the S&P 500 was UP 2.9% for the quarter, up 13.8% for the year-to-date period and up 20.6% for the trailing year.

When comparing TDF performance, it is important to note that Morningstar’s database does not separate the “to” and “through” funds. This is a serious limitation because these funds have different objectives. As noted previously, comparing funds with different objectives is like comparing apples to oranges.

Given that different strategies and wide ranging glide paths make performance comparisons difficult, we have identified the “to” and “through” funds and added a column with the 2015 vintage equity exposure as of 12/31/12. To assist with risk adjusted performance comparisons, we have added a column with standard deviation for the trailing 1, 3 and 5 year periods. Going forward, the CFDD will separate the “to” and “through” TDFs. We will also include CITs. Based on the Morningstar data, the SSgA Target Retirement CIT actually outperformed T. Rowe Price, the top-ranked TDF manager, with far less volatility.

T. Rowe Price was the top performing TDF for the trailing 1, 3 & 5 year periods in Morningstar’s mutual fund database. The American Funds, MassMutual and TIAA-CREF also placed among the top five for the trailing 1 & 3 year periods. Contrastingly, Putnam was the only manager among the bottom five for all the periods shown. Unlike T. Rowe Price & Vanguard, Fidelity was the only one of the top three managers that failed to place among the top five for any of the time periods. They also avoided the bottom five for the same time periods.


As you might expect, the top performing TDFs—particularly T. Rowe Price—were accompanied with high standard deviation. In other words, these funds may suffer the most if the equity markets tank. By focusing on dividend paying securities, the American Funds Group was the sole exception, i.e., they delivered top decile performance over the trailing 1- and 3-year periods with low standard deviation.

© 2013 Center for Due Diligence. Used with permission.

The Bucket

Fear of markets exceeds fear of death: Nationwide  

Americans are more afraid of investing in equities than of losing their jobs, public speaking or dying. Many would rather use a website for financial planning than meet with an investment professional, according to a new Nationwide Financial/Harris Interactive survey.

According to the “Fear of Financial Planning” survey, of the 783 potential investors over the age of 18 who had at least $100,000 in investable assets, 62% are scared of investing in the stock market, while 58% fear death, 57% fear public speaking and 37% fear losing their jobs.

More than one in two millennials and nearly half of generation X (58% and 48%) turn to websites before financial advisors for help with financial planning. However, 78% of retirees and 61% of high-net-worth investors (those with $250,000 or more in investable assets) use a financial advisor as their top resource for financial planning needs.

The survey also found 83% of respondents are afraid of another financial crisis, while 72% are concerned about unmanageable health care costs and 71% worry they won’t be able to pay for their children’s education.

Nearly four in five of Millennials and generation Xers (77% and 78%, respectively) fear not enjoying the lifestyle they want in retirement, and two-thirds (66% of millennials and 65% of generation X) fear not retiring at all.   

Harris Interactive conducted the survey online in the U.S. on behalf of Nationwide Financial from March 26 – April 3, 2013. Participants included 783 Americans ages 18 and older with a minimum of $100,000 in investable assets.  

Spain uses social security reserves for extra summer pensions

The Spanish government has tapped into the Social Security Reserve Fund for the third time to pay extra summer pension payments, and is expected to do so again later this year, according to a report by IPE.com.

Angel Martínez-Aldama, director of the country’s investment and pension fund association (INVERCO), said that prime minister Mariano Rajoy’s government took €3.5 billion from the reserve fund in June to pay extra summer pensions. According to the Labour Ministry, the reserve fund is now worth €59.3bn, equivalent to 5.65% of gross domestic product.

Although the Spanish social security system faces severe shortfalls due to high unemployment, Martínez-Aldama said this use of the reserve fund is in line with its initial goal. “There is nothing abnormal about tapping into the fund,” he said. “That is precisely the reason why the fund was launched in the first place, back in 2000.”

But Martínez-Aldama conceded that tapping into the reserve fund for extraordinary payments could lead to “some problems” in the future if the country’s economy does not improve. “However, the economy seems to be improving slightly,” he said.

The government, led by José María Aznar, launched the reserve fund to offset future shortfalls at Spanish pension plans.

Martínez-Aldama said that the reserve fund was supposed to make 14 payments in total this year to pay pensions. While one payment is made each month to finance Spanish pension incomes, two additional payments are expected to be made twice this year to cover extra needs.

New York Life Retirement Plan Services adds two plans

Retirement programs for AMC Entertainment, Inc. (AMC) of the Kansas City metro area, and Dead River Company of South Portland, Maine, have appointed New York Life Retirement Services as their plan provider.

The defined contribution and defined benefit plans of energy provider Dead River Company – totaling $52 million in assets – transitioned to the New York Life platform in mid-April. AMC, a movie cinema operator, is expected to convert its defined contribution and non-qualified plans in August, with a defined benefit plan to transition shortly thereafter.  

Both AMC and Dead River Company will be supported by New York Life’s Manufacturing, Materials, & Retail industry practice service team.

New York Life administers $47 billion in assets in 408 mid- to large-plans with more than 1.2 million participants, as of June 30, 2013.

Is your retirement outlook sunny or cloudy? New mobile app from Transamerica will do the forecast   

Transamerica Retirement Solutions’ new free mobile app, the Retirement Outlook Estimator, allows users to enter specific criteria and then estimates the probability that they will reach their retirement savings goals, the company said in a release.

Four weather forecast icons are used to indicate the retirement outlook: sunny, partly sunny, cloudy, or rainy. The app also provides alternative saving rate scenarios that could produce better outcomes.

The app calculates outlooks based on retirement account balances, contribution rates, investment style, and other retirement income sources. It also incorporates a Social Security income estimate. Information entered on the mobile device is saved, allowing users to edit their goals and savings whenever they would like and provides for a continuously updated retirement outlook. Facebook users can share the app.

For plan sponsor clients and their participants, Transamerica offers an online tool called Retire OnTrack. Along with the Retirement Outlook Estimator, Retire OnTrack offers customized strategies and outcomes, personalized progress reports, and communications intended to keep employees focused on retirement savings.

T. Rowe Price Group reports 2Q 2013 results

T. Rowe Price Group, Inc., had net revenues of $854.3 million, net income of $247.8 million, and diluted earnings per common share of $.92 in the second quarter of 2013, the Baltimore-based financial services firm said in a release.

In the second quarter of 2012, net revenues were $736.8 million, net income was $206.8 million, and diluted earnings per common share was $.79 in the second quarter of 2012.

Investment advisory revenues for the second quarter of 2013 were up $109.7 million to $739.7 million from the comparable 2012 period, as average assets under management increased $86.8 billion, or 16%.

Assets under management decreased by $3.4 billion since March 31, 2013, to $614.0 billion at June 30, 2013, including $379.5 billion in T. Rowe Price mutual funds distributed in the United States, and $234.5 billion in other managed investment portfolios.

Results for the first half of 2013 include net revenues of nearly $1.7 billion, net income of $489.7 million, and diluted earnings per share of $1.83, up $.29 per share from the comparable 2012 period. Assets under management have increased $37.2 billion from the end of 2012 as market appreciation and income of $41.9 billion was slightly offset by net cash outflows of $4.7 billion.

T. Rowe Price said it remains debt-free with cash and sponsored portfolio investment holdings of nearly $2.7 billion. The firm currently expects total capital expenditures for property and equipment for 2013 to be approximately $125 million, which will be funded from operating resources.

Market appreciation and income of $4.6 billion was more than offset by net cash outflows of $8.0 billion during the second quarter of 2013. The majority of the net cash outflows were concentrated among a small number of large institutional and intermediary clients that changed their investment objectives or repositioned their strategy allocations.

From an investment performance standpoint, 78% of the T. Rowe Price mutual funds across their share classes outperformed their comparable Lipper averages on a total return basis for the three-year period ended June 30, 2013, 83% outperformed for the five-year period, 81% outperformed for the 10-year period, and 62% outperformed for the one-year period.

In addition, T. Rowe Price stock, bond and blended asset funds that ended the quarter with an overall rating of four or five stars from Morningstar account for 79% of the firm’s rated funds’ assets under management. The firm’s target-date retirement funds continue to deliver very attractive long-term performance, with 100% of these funds outperforming their comparable Lipper averages on a total return basis for the three- and five-year periods ended June 30, 2013.

© 2013 RIJ Publishing LLC. All rights reserved.

SunGard names key trends in retirement plan services

SunGard, the global technology company, has identified six key trends that are impacting retirement record keepers and plan sponsors:

  1. Retirement record keepers are seeking managed services offerings to help control costs, scale the business efficiently, and simplify and streamline retirement plan administration in order to compete.  
  2. As advisors play a larger role in individuals’ retirement planning, retirement administrators will invest in data, analytics and productivity tools to help advisors enhance service to participants.  
  3. Retirement plan administrators will look to provide standardized fiduciary, compliance and reporting solutions to help reduce the cost of compliance and help employers meet their increased responsibilities amid continued regulatory change.
  4. With the majority of Americans unprepared to fund their retirement, providers are placing a higher priority on offering retirement readiness support, including income projection tools and guaranteed income products.   
  5. As baby boomers retire, record keepers and advisors will seek growth through innovation by engaging younger participants via mobile and social media channels, while also leveraging these channels to reach smaller and micro markets.
  6. Larger retirement plan providers will look globally to achieve growth in new markets such as Latin America, Asia and the Middle East.

© 2013 RIJ Publishing LLC. All rights reserved.

Two senior SEC attorneys join Kirkland & Ellis

Kirkland & Ellis LLP announced today that former U.S. Securities and Exchange Commission (SEC) Enforcement Director Robert Khuzami has joined the firm as a partner in the global Government, Regulatory and Internal Investigations Practice Group. Khuzami, who led the SEC’s Enforcement Division for four years, will be based in  Washington, D.C. and New York. 

During Khuzami’s tenure at the SEC, the Enforcement Division filed its highest rate of cases, in fiscal years 2011 and 2012. He created nationwide prosecution units to concentrate on the high-priority areas of investment advisers and private funds, large-scale trading and market abuse, mortgage and other structured products, bribery of foreign officials under the Foreign Corrupt Practices Act (FCPA), and municipal securities and public pensions.

Senior SEC official Kenneth Lench will also join Kirkland as a partner in the global Government, Regulatory and Internal Investigations practice. Lench, who will leave the agency at the end of July, has headed the Structured and New Products Unit within the SEC Enforcement Division since January 2010 and will be based in Washington, D.C.

Lench spent 23 years at the SEC, where he most recently was Chief of the Structured and New Products Unit. That unit created by Khuzami in 2010 as a specialty group of more than 45 professionals nationwide focusing on abuses in markets for complex securities, including asset-backed securities and derivatives.

© 2013 RIJ Publishing LLC. All rights reserved.

Prudential’s challenge to SIFI status heard

A confidential hearing was held this week before the Financial Stability Oversight Council on Prudential Financial’s challenge of its designation as a systemically important financial institution.

A Treasury statement acknowledged the hearing but did not identify the challenger at the hearing, which, by rule, is confidential. Prudential, however, was the only one of three nonbanks to challenge the June 3 decision by the FSOC, the identity of the company was obvious. The FSOC now has 60 days to make a final determination regarding the company.

Last week, the FSOC said it has advanced MetLife to “Stage III” — the last stage before designation as a nonbank systemically significant financial institution. MetLife said later that day that it would challenge such a designation.

Prudential announced July 2, the deadline, that it would challenge its designation as a SIFI and seek a hearing. That same day, American International Group and GE Capital announced that they had accepted such a designation, the first non-banks to do so.

© 2013 RIJ Publishing LLC. All rights reserved.

UK ponders ‘Defined Ambition,’ a path from DB to DC

Britain’s Department for Work & Pensions continues to entertain ideas for a nationwide collective defined contribution investment fund in the UK that would employers to pool their defined benefit pension budgets into a “centralized vehicle” that deliver pensions based on performance.

This fund would aim for a target participant benefit of 1/80th of salary per year of service, based on a combined employer/employee contribution of 20% of salary. The fund is part of a new employer-sponsored retirement savings initiative in the UK known as “defined ambition,” unveiled last November, as a potential alternative to defined benefit plans.

Last month, DWP minister Steve Webb expressed an interested in a collective pool of savings. Participants would have notional, not personal, accounts in such a pool, and would have rights rather than ownership to an accrued benefit at retirement.

This week, a partner at the consulting firm of Barnett Waddingham, Danny Wilding, said that introduction of a “basic” collective defined contribution (CDC) system in the UK would not cause a “massive” legislative burden to the government. The collective model is “the horse [the DWP] should be backing initially,” he said.

“You then calculate the target benefit of 1/80th of salary for each year of service,” Wilding said. “You value that on some pre-agreed actuarial basis, and then you look at the aggregate value of all of those target benefits and compare them with your collective fund.” Such an improved DC model would be preferable to “DB-lite,” as certain reforms to the defined benefit system have been called.     

Defined Ambition is based on the idea of shifting some of the investment risk that a DB plan sponsor currently shoulders onto the plan participants, while preserving the concept of a lifetime income.

If the collective fund were only able to meet 90% of the target, Wilding said, then members would only see 90% of the proposed benefits. But if the fund were able to deliver higher benefits, the additional income could also be distributed among members. The type of CDC currently used in the Netherlands imposes benefits cuts if funds are falling short of promised payments, allowing the scheme to recover, without the promise of a bonus during bull markets.

According to Wilding, single large employer could operate a standalone fund, but that smaller employers should probably seek out industry-wide or other collective arrangements. “As long as the employers agreed on the criteria up front – agreed the target benefits, and these targets benefits are valued for the purpose of pooling – then there is no reason why employers shouldn’t work together on this,” he said. Any future change would require agreement across all employers.

© 2013 RIJ Publishing LLC. All rights reserved.

Law Professor Goes Postal

While Retirement Income Journal was publishing its story on 401(k) fee litigation (“Measuring You for an ERISA Suit,” June 26), a Yale Law School professor apparently went postal and mailed letters to thousands of plan sponsors warning them that their investment fees were too high and hinting at dire consequences.

Dozens of plan sponsors subsequently picked up their smartphones and called their plan advisor or their ERISA attorneys, setting off an ever-widening ripple of anguish that culminated in indignant responses from the leaders of associations that represent the retirement industry. BrightScope, whose 401(k) fee data the professor used in his analyses of plan fees, denied complicity with him.

Samples of the signed letters sent by Ian Ayres, the law professor, are available here. Yale Law School reportedly confirmed their existence to media outlets. Ayres’ voicemail box was full when I called his number. He hasn’t answered an email I sent.

On the Internet, however, I obtained a draft of relevant research by Ayres and Quinn Curtis, a professor at the University of Virginia Law School. Its tone wasn’t nearly as provocative as the letters supposedly were. Its conclusions, while interesting, shouldn’t surprise anyone familiar with the ongoing debate about whether some 401(k) participants are paying too much plan services, through hidden investment fees, and that the fees substantially reduce their retirement accumulations over the course of their careers.   

The undated monograph, “Measuring Fiduciary and Investor Losses in 401(k) Plans,” still in draft form, claims to be the “first study to measure, within a unified framework, the relative costs investors of limited investment menus, fund- and plan-level expenses, and investor allocation mistakes.”

In short, Ayres and Curtis tried to identify and weigh the causes of poor participant returns: faulty plan design and excess fees (“fiduciary losses”), or participant errors in portfolio choice or trading (“investor error”).

To me, this would seem almost as difficult a task as determining, after scooping a bucket of water from the Mississippi River at New Orleans, whether that water originated from the Missouri, Ohio, Arkansas or Red Rivers, or perhaps even from Lake Itasca in northern Minnesota. But that’s what regression analysis is supposedly all about.

After sifting through the paper, I extracted these salient quotes:

  • “Fiduciary losses are smaller than investor losses on average, comprising 7.7% (68 basis points) of optimal excess returns compared to 13.3% (116 bps) for investor losses.”
  • “We also decompose [fiduciary] losses into the relative proportion of losses which come from excessive fees and from insufficient diversified allocations, and find that excess fees represent more than 60%.”
  • “Taken together, these losses consume about 20% of the optimal risk premium.”
  • “While adding index fund options would benefit most plans, eliminating poor choices would also be a powerful palliative, and our regressions suggesting elimination of poor funds might be a more effective strategy than adding good ones.”
  • “If fiduciaries adapt their menus to accommodate well-understood investor behavioral biases, investor outcomes may be improved.”
  • “Large plans have lower fiduciary losses than small plans, but there is substantial variation in plan quality independent of plan size.”
  • “The results of this study suggest that improving fiduciary decision-making may prove a more tractable problem than educating millions of investors, particularly in light of fiduciaries’ duty of prudence.”
  • We find evidence that a substantial majority of funds could reduce total losses by (i) offering additional lower-fee index funds, (ii) not offering funds with high fees.”

Shocking would be the wrong word to describe these results and recommendations, if I’m interpreting the paper accurately. It comes to the common-sense conclusions that more plans should include more index funds and that it will be a lot easier to try to change the behavior of a relatively limited number of plan sponsors than to try to educate millions of participants. Not much controversy there.

The authors of the paper briefly visit the highly charged issue of revenue-sharing. They compare plans where sponsors pay directly for plan services with those where the cost of services is built into the fund fees. 

They found that “the amount of direct compensation is associated with an increase in the fraction of index funds offered. Fee loss is also lower as direct compensation to investment advisors increases. The number of funds in the plan is also decreasing in direct compensation, an interesting result in light of the finding… that plans with more funds are associated with higher investor losses.”

Again, no surprise. You would expect an inverse relationship between revenue-sharing and index funds. Overall, the Ayres-Curtis paper seemed to have something reasonably useful to say. It would be a shame if its substance is lost in the furor over Ayres’ evidently unreasonable letter.   

© 2013 RIJ Publishing LLC. All rights reserved.

SPIAs Are Slow to Pay Off: Kitces and Pfau

A new research paper from two well-known investment experts concludes that only people who live much longer than average are likely to benefit from owning an immediate annuity, and that an inflation-adjusted annuity works better than a fixed annuity.

The article also defies conventional wisdom by suggesting that an investor’s allocation to equities should rise in retirement, not fall. 

One of the authors, Michael Kitces, has never been a fan of annuities—his high net worth audience can afford to self-insure against longevity risk. But his co-author, Wade Pfau of the American College, has built a reputation on research showing the advantage of income annuities for retirees—even for those who wanted to maximize their bequests. For Pfau, the paper suggests an abrupt change of heart.

RIJ asked Pfau if the paper was a repudiation of his former support for income annuities. In an email, he wrote, “I wouldn’t go that far. It is going to be easy to misinterpret this one, because it was specifically responding to studies which showed SPIAs in too optimistic of a light. SPIAs still provide unparalleled longevity protection and still have a role. Also, we are revising now by exploring more with regard to the magnitude of failure, which is also going to help SPIAs. We will need to revise the article a bit in that regard.”

In their new paper, the two analysts test the wisdom of putting half your money in an single-premium immediate annuity at retirement and the other half in stocks. Their calculations show that many people—especially if they don’t live longer than average—would be better off starting out with half their money in stocks and half in bonds, and then gradually reducing their bond allocation over time.

The authors agree, however, that people who live a very long time will benefit from buying a SPIA with half their money at retirement, and that those who buy an inflation-adjusted SPIA will benefit the most.

 “For those who materially outlive life expectancy, SPIAs do continue to show a valuable benefit to improving retirement income sustainability and real SPIAs fare better in such a ‘longevity hedge’ role than nominal SPIAs. However, the required time horizon for real SPIAs to make a meaningful contribution is significant—long enough that only a small percentage of retirees are likely to reach the benefit point, and the crossover takes even longer to achieve given today’s low return environment,” the paper said.  

“Most prior studies which indicated a benefit of partially annuitizing a retirees portfolio were actually showing the benefits of a bucketed liquidation strategy that spends down fixed assets first and allows the household equity allocation to rise, not a benefit of the SPIA itself, especially in scenarios that do not extend materially beyond life expectancy.”

The paper recommends higher equity allocations in retirement, not lower. “Not only are declining equity glidepaths potentially harmful, but that surprisingly rising equity glidepaths are actually beneficial,” the authors write.

“The primary scenarios where SPIAs should be used are specifically those were the intent is to hedge significant longevity beyond life expectancy, where SPIAs and their mortality credits simply provide an unparalleled fixed-income-equivalent return. In the remaining scenarios for most retirees, though, the more effective way to improve retirement outcomes is simply to implement a rising equity glidepath.”

Some in the annuity world may find this paper provocative, and not in a good way. Annuities can be viewed through an “investment” frame or an “insurance” frame. This paper seems to evaluate them mainly as investments. Annuities never do make sense as investments; their value shows up mainly as a hedge against extreme aging. Hedges are expensive, but insuring against longevity risk is thought to be cheaper than hoarding against it.   

The paper focuses on life-only annuities. That may be a bit of a straw man. Many people who buy annuities buy life-with-period-certain annuities that are guaranteed to pay out most or all of the principal to somebody, if not the original owner. It would be interesting to see what would happen if the authors considered life-with-period-certain contracts.

There’s a lot of implicit faith in equities here; people who don’t believe that stocks always pay off in the long run may question the authors’ belief in the wisdom of rising equity allocations in retirement. The paper also doesn’t appear to acknowledge that the severe pain of running out of money in extreme old age, in addition to the probability, adds weight to the value of life annuities.

© 2013 RIJ Publishing LLC. All rights reserved.

Closer to Where You Belong

Everyone knows where the variable annuity business has been. First came the boom, then the bust. Then, in no particular order, came the de-risking, the buy-back offers and the industry shakeout. But where will the VA business go next? That question is a lot harder to answer.

Interviews with VA product managers at life insurers who remain “committed” to the variable annuity business show little consensus. They each experienced the financial crisis in a different way, and they all face the future with different strategies.   

They agree, however, that variable annuity isn’t going away. It will continue to be a go-to vehicle for tax-deferred accumulation. And demand will continue to exist for the “optional income” that GLWBs provide.

But, even after interest rates normalize, several industry leaders believe, the VA is likely to concede shelf space to other income vehicles, like deferred income annuities (DIAs), fixed indexed annuities (FIAs) and single-premium immediate annuities (SPIAs).

Clearly, product diversification will increase. It’s something that was probably inevitable, with or without the financial crisis. Close observers of the Boomer retirement phenomenon have always said that decumulation is more complex than accumulation. Retirees need customized combinations of income and investment products, not one-size-fits-all remedies. So, while getting to this point hasn’t been easy, annuity issuers might be a step closer to where they belong.   

Here, in their own words, is what some prominent annuity product managers told us about the directions of their businesses:

Bruce Ferris, head of sales and distribution, Product Management and Marketing, Prudential Annuities

“To paraphrase Mark Twain, the rumors of our death are greatly exaggerated. The answer to questions about the value of variable annuities is: Compared to what? Given the capital market backdrop today, what other choices do investors and advisors have? The demand for our products and services, for guaranteed retirement income, has only continued to increase.

“A recent LIMRA survey showed that there are 42.5 million retirees today and that there will be 64 million in 2025 and more in 2050. For years we talked about the pig in the python. It’s no longer the pig. It’s the python. There’s a dislocation of supply, but that lack of supply only spells opportunity for companies with the right skill sets and the right capitalization.

“We’re a young industry. We’ve learned a lot. We’ve gone through big challenges. We’ve weathered the storm. Now it’s up to us to deal with the capital markets environment. We have no control over it and we don’t know how long it’s gong to last. But, at Prudential, we see opportunity. We have a diversified growth strategy in responding to consumer needs.

Bruce Ferris“It’s more challenging than ever for individual investors to meet their needs in retirement. The golden rule of 4% withdrawal no longer applies. There are some who now say that the rate at which you can withdraw from a balanced portfolio without risk of running out of money may be as low as 2.8% a year. So when I hear people say that VAs aren’t as good as they were, I acknowledge that. But I also say that they are better than some of the alternatives, such as systematic withdrawal or fixed income or laddered bonds.

“The feedback we get from the distribution is that they are interested in continuity of supply and good solution sets. What’s most concerning to them is that the insurer will sell a product up to its capacity limit and then go to the sidelines. To that, I point to our track record of uninterrupted supply. We’ve changed products but we haven’t withdrawn them without providing a replacement solution. That’s the great thing about the new Prudential Deferred Income (PDI) product.

“One thing that’s important to our future is to respond more nimbly to capital market changes. The product development cycle is six to nine mons, when you consider the state regulatory filings. With the PDI, we can respond virtually immediately to changes in capital market scenarios, up or down. That allows us to maintain supply and manage risk. We determine the withdrawal rates based on the contract issue age, so we’re not as exposed to client behavior in terms of when they exercise income.”

 

Liz Forget, head of individual annuity sales at MetLife

“We’re still in the VA business, but sales this year will be lower than in 2012, which were lower than in 2011. We’re comfortable with the risks of the product that we’re selling today, however, and we like the demographics. You’re seeing an industry at an inflection point. People are trying new ideas. All of us are trying to feel our way around, anticipating what the next decade will bring, wondering how we can be relevant, how the guarantees will be manifested and what people will want. The arms race wasn’t good for our industry. It was one-size-fits-all; if you wanted an annuity it had to be a variable annuity with a guaranteed lifetime withdrawal benefit.

Elizabeth Forget”We’re spending a lot of time on product development. We’re trying to create a better balance of products sales. The variable annuity dwarfed everything else; we would like to see a better balance. The Shield product is a new focus. We’ve refreshed our SPIA. Rates are creeping up a bit, so there’s more marketing effort around that.

“We’ve launched a non-lifetime living benefit on a variable annuity. It’s aimed at the mid-50s investor as opposed to the 65-year-old investor. It says, ‘Here’s a guarantee that will get you to retirement, and then you can decide whether to use it for income. We’re selling it as a ‘bridge’ to retirement. MetLife invented longevity insurance; we’re now refreshing our product. In its current form, it’s not a modern product. If you look at the New York Life DIA, it has income acceleration features; you can pick the age at issue. We like that market, and we’re still selling the old one. But we’re modernizing it.

“Instead of hawking product features, we need to focus on how people understand these solutions. If you combine the GAB with the DIA, for instance, you can get a heck of a lot more income for life. We have the broadest distribution of anyone in the market. We have a 5,000-member career agent force, which generates a big percentage of our sales. We’re in every channel in the third-party business, including unique relationships with Primerica and Fidelity that gives us a wide reach.

“What have we learned from the financial crisis? The industry got the fact right that clients want guaranteed income for life. From an innovation and creativity standpoint the industry has responded well. I think that the crisis taught people to re-evaluate pricing and to anticipate what increased regulation will do to reserve requirements and hedging costs. But the retirement mega-trend is still out there. People need to insure a portion of their assets and only insurance companies can help them do that.”

 

Eric Henderson, senior vice president of life insurance and annuities, Nationwide Financial

“Today you’re seeing capacity constraints, mainly because of low rates, and we don’t know if that will change much in the future or not. But you will see more balanced [product] portfolios. That’s what we’re doing here. In the past, the vast majority of sales involved the variable annuity with the guaranteed lifetime withdrawal benefit. Today, we’re seeing immediate annuity sales growing faster than VAs, and we’re getting into the indexed annuity space, which we think will be a significant growth area for us. We’re seeing faster growth in the sales of variable annuities without living benefits. So our mix of business has shifted considerably.

Eric Henderson“Risk management isn’t only about making a product that’s less risky for the insurer, it’s also about selling other products whose risks are uncorrelated with the first product. [In terms of lifecycle, mortality/longevity insurance hybrids] We’ve got a couple of products that focus on the ‘income replacement’ story in test right now, and another design that’s not quite ready for market testing. But it will be awhile before we bring something to market.

“Our mutual ownership structure has allowed us to take a long-term view. In 2012, when we made some product changes because rates dropped, we knew that our sales would drop as a result, and we were OK with that. The distribution said, ‘you’ll be hurt,’ and we knew we would be, but we’ll be there in the long run, and that has turned out to be true. The distribution partners now understand.”

 

Dan Herr, vice president, Product Management, Annuity Solutions, Lincoln Financial Group

“Yes, we gained market share in variable annuities over the last year, but a lot of that had to do with shifts in the marketplace that gave us a stronger benefit than we had in the past, relative to others. Jackson National had pulled back the terms of their joint-life rider and we hadn’t. But we made adjustments to correct that in May. We don’t manage according to market conditions, and we don’t want to make hard rights or lefts. We want to grow the business on our terms and we try to manage the products that way.

“Guaranteed lifetime income is our industry’s franchise. The living benefits business will continue, but the spectrum of income products will change and grow. We don’t see any product as a silver bullet. We’ve seen, for instance, the growth of the deferred income annuity. We don’t have a product like that right now but it is certainly on our radar. We’ve had tremendous success with the i4Life variable annuity. That’s one of our biggest differentiators. That provides our value in the marketplace. We’ve been able to avoid the arms-race mentality. Unlike the living benefit, the i4Life [variable income annuity] is a pure income feature and it’s priced accordingly.

“We’re very confident around our assumptions for that product, as we are with all of our products. The payouts are far more certain than in the WB; there’s much less noise around them. Every month, we know how it can adjust. Of our VA sales, about 15-20% are i4Life and the rest are the WB. There’s just more certainty with the i4Life. We’ve had outside consultants help us with utilization studies on the living benefit. We’ve always understood that there’s a segment of contract owners that will never use it.

“We’ve been offering the fixed indexed annuity since our merger with Jefferson Pilot. About half of our FIA sales are with a GLWB rider. We’re not in a scale-back mode on the FIA, but we’re also not looking to compete against the new companies [Guggenheim Partners and Athene Holdings] that are trying to purchase new business. Our strategy has been to take a disciplined approach and sell on our terms.

“Some time back we introduced a long-term care annuity combo [where interest on deferred fixed annuity assets pays for long-term care insurance and the annuity assets finance a large deductible if the insurance is exercised]. We’re still trying to grow the distribution of that business. We also have a feature on the variable annuity that accelerates the payout for long-term care expenses.

“It’s been a long haul getting approval through the states, but we expect that business to grow. It’s for retirees who have covered their income needs. The assets are there if you need them for long-term care coverage. It’s not use-it-or-lose-it like regular long-term care insurance. It’s just repositioning assets.

“We always look for opportunities to partner with key distributors. We had a fixed indexed annuity relationship with Primerica and when the opportunity came to partner with them on variable annuities, we took it. In May we launched our ChoicePlus variable annuity through Chase Bank. That’s our first time distributing variable annuities through them.”

 

Richard Moran, former head of retirement products distribution at Symetra

“Most of the carriers are stepping back and making a case for the features that sold the variable annuity 20 years ago, which were tax deferral, access to professionally-managed subaccounts and a death benefit. That no-GLWB product hasn’t sold tremendously well, with the exception of Jackson National’s products, because of their superior distribution and fund selection. But most carriers, not so much. The executives I talk to are not planning to get back into the VA business anytime soon. They view is as a long-in-the-tooth business. They see capital as best deployed elsewhere in the insurance company. They failed miserably at pricing the products. They simply didn’t account for the level of tail risk that the market showed them.

Richard Moran“Did the sales have to do with the high compensation? “Absolutely. Frankly, for some financial advisors, the level of commissions offered on the variable annuities motivated them to put them first and foremost in front of their clients. I don’t believe that’s the case for the majority of advisors. The overwhelming majority are clean sales, and most advisors care very much about their clients. What’s been challenging has been the level of complexity in the product. They’re difficult for even the diligent advisors to understand. Nonetheless, when a lot of advisors are looking around and see a 7% up front commission, that’s a lot of motivation for an advisor to introduce a variable annuity to a client.

“I do believe that [advisors and registered reps] are learning more about immediate annuities and that they are more willing to put those products in front of clients today. But Americans can’t look to annuities alone to generate income. The past dozen years have taught us that it’s silly to put all your money into one type of product. Looking forward, I see a more balanced approach. A component of your money might be in a fixed or variable annuity. But people will still be using a systematic withdrawal program from mutual funds. I think more people will gear their portfolio toward higher dividend-paying investments.

“A lot of folks are also recognizing that retirement income is partly about after-tax returns. People are forced to think through their drawdown strategies to minimize the tax drag. When the rich living benefits were available, there was a disproportionate amount of client portfolio dedicated to the variable annuity. It worked out OK, but there could have been a different set of circumstances where it didn’t. The clients who bought those products benefited enormously. At the peak of the crisis, they could have pulled the trigger and gotten a huge income stream off of them. But those living benefits are gone and they’re not coming back, and that will compel the advisor to work more closely with the client.”

 

Alison Reed, senior vice president, Product and Investment Management, Jackson National Life Distributors

“Going back to the pre-crisis era, Jackson National was always committed to a diversified book of business. We always had fixed, fixed indexed, and variable annuities and life insurance, and that provided us with great natural offsets from a hedging perspective. Going into the financial crisis, we were priced more appropriately than the competition was. Our pricing for insurance riders was in some cases 30 basis points higher, so we were in a better position to weather the changing market environment.

“Since the crisis, we’ve committed more resources to product innovation and product expansion. We’re still committed to our original products, but wanted to expand into new products like our Elite Access variable annuity. It’s less capital intensive than the living benefit product and it focuses on unique alternative investment options at a low price point for the retail market. We launched Elite Access in March 2012. Our total 2012 variable annuity sales were $19.7 billion, and in the last nine months of 2012, Elite Access sales were $1.35 billion. Through the first quarter of 2013, we had $835 million in Elite Access sales, so momentum is strong. We’re still selling more of the GLWB product, but we’ve found strong interest in Elite Access among the non-annuity producers. They can take the product and build a complete portfolio, with access to alternatives and risk-managed options at a lower price point. You see reps who may not have sold VAs with living benefits selling that product.

“At this point, we do not have a deferred income annuity product. A SPIA is part of our diversified portfolio, but because of the rate environment we’ve chosen not to focus on certain products. So far our distribution hasn’t had a strong interest in the DIA. We’re monitoring the market to see if that gets more traction, but we haven’t seen the traction we’d like to see. At the same time, sales of the variable annuity with living benefits remain a critical aspect of our success. We remain committed to the fixed indexed annuity market, but we have purposely not sold as much as we could or would like to, given the interest rate environment. We definitely like the business, but we’ve elected to lower our caps and guarantees so as not to increase sales.”

 

Cathy Weatherford, president and CEO, Insured Retirement Institute

“We’ve been through the ‘great reset.’ We’ve seen some companies exit the business that were at the top of the variable annuity leaderboard. We’re seeing the rebirth of the industry with brand new entrants like Forethought. They can benefit from some lessons learned, and they’re not carrying a legacy book. Others who were at the top of the leaderboard are retooling and recalibrating their products. There have been over 500 product changes over the last five quarters. This is definitely not the variable annuity business of the past. It’s a new industry with a larger shelf space as opposed to one or two products.

“Another new thing is the growth of Jefferson National, which came in with tax deferral for the client. I sat down with our new chairman [to be announced in September] yesterday. We talked about increasing and growing our identification and support with financial advisors. We’re providing education, research, practice management tools and client documents that FINRA has reviewed. Our members are asking us to be more engaged in advocacy. We have gone through an unprecedented era of regulatory activity. We’re seeing how the ongoing implementation of that regulation is affecting the balance sheets of our members. We want to be the objective voice that helps provide understanding about retirement in the mainstream media as well as the financial media. We’re very much at the front end of the next stage. We’re not there yet. It’s going to be a great industry to watch.”

 

Executive at mutual life company that sells both VAs and DIAs [speaking not for attribution]

“Among Boomer retirees and near-retirees, there are two income markets, not one. There’s a market for guaranteed income and there’s a market for optional income. The GLWB goes after the optional income market. It says, here’s a guaranteed income that you don’t have to take. But that option costs money to write. I’m a big believer that optional income is a need, and that a meaningful market will continue to exist for the lifetime withdrawal benefit, in whatever flavor it comes in. A significant portion of the market doesn’t need guaranteed income but does need optional income.

“In the VA/GLWB products, before the financial crisis, you saw under-pricing relative to the guaranteed market. Since the crisis, that under-pricing has rationalized to a new status quo that looks more like normal pricing. As that happens, we think, the relative values of immediate and deferred income annuities, the SPIA and the DIA, have increased significantly. Our average customer, who used to get 30% more income than a GLWB client, now gets closer to 50% more income.”

© 2013 RIJ Publishing LLC. All rights reserved.

The Pros Don’t Gamble; They Leverage

Smart investors, like Warren Buffett, make money by borrowing to invest in low-risk, low-return securities, like soapmaker stocks. Other people, who don’t have enough borrowing power to play the leverage game, can only generate profits by investing in riskier assets, like tech stocks.   

The sad irony for those are in the second group—which includes most of us, including many mutual fund managers—is that they don’t profit much from the risk they take. That’s because their collective demand for risky assets tends to drive up the prices of those assets, thus reducing their returns.

Those are two of the takeaways from a technical and challenging but otherwise intriguing recent research paper by Andrea Frazzini and Lasse H. Pedersen of AQR Capital Management and the Stern School of Business at New York University. AQR is an $83.7 billion Greenwich, Conn.-based firm that manages money for institutional investors and registered investment advisors. It was founded in 1998 by three Goldman Sachs financial engineers.

“A basic premise of the capital asset pricing model (CAPM),” Frazzini and Pedersen write, “is that all agents invest in the portfolio with the highest expected excess return per unit of risk (Sharpe ratio), and leverage or de-leverage this portfolio to suit their risk preferences. However, many investors—such as individuals, pension funds, and mutual funds— are constrained in the leverage that they can take, and they therefore overweight risky securities instead of using leverage… causing those assets to offer lower returns.” 

The paper goes on to answer the question: How does an arbitrageur exploit this effect? In the process, it makes a case for a strategy that the authors called “Betting against Beta,” or BAB. This involves, in part, creating a portfolio that is “long leverage low-beta stocks and that short-sells de-leveraged high-beta stocks.” The explanation of the authors’ long-short arbitrage strategy will soar over the heads of 99% of readers, but the paper is also studded with nuggets like these:

  • A portfolio that has a leveraged long position in 1-year (and other short-term) bonds and a short position in long-term bonds produces positive returns.
  • A leveraged portfolio of highly rated corporate bonds outperforms a de-leveraged portfolio of low-rated bonds.
  •  [Mutual funds and individual] investors hold portfolios with average betas above 1. On the other side of the market, we find that leveraged buyout (LBO) funds acquire firms with average betas below 1 and apply leverage. Similarly, looking at the holdings of Berkshire Hathaway, we see that Warren Buffett bets against beta by buying low-beta stocks and applying leverage.
  • Leveraged buyout funds and Berkshire Hathaway, all of which have access to leverage, buy stocks with betas below 1 on average… Hence, these investors may be taking advantage of the BAB effect by applying leverage to safe assets and being compensated by investors facing borrowing constraints who take the other side.
  • Individuals with low IQ scores hold higher-beta portfolios than individuals with high IQ scores.
  • Younger people, and people with less financial wealth (who might be more constrained) tend to own portfolios with higher betas.
  • The 1940 Investment Company Act places some restriction on mutual funds’ use of leverage, and many mutual funds are prohibited by charter from using leverage. A mutual funds’ need to hold cash to meet redemptions (in the model) creates a further incentive to overweight high-beta securities. Indeed, overweighting high-beta stocks helps avoid lagging their benchmark in a bull market because of the cash holdings.

The authors find that ordinary investors, without the ability to leverage, are in the same fix no matter where they look for added return. And when they do so, their net losses can create net gains for arbitrageurs with leverage who know how to capture them. The BAB strategy, these authors argue, wins in every asset class and in every market worldwide for those with “unconstrained” borrowing capacity.   

© 2013 RIJ Publishing LLC. All rights reserved.

Succession planning a challenge for advisors

Few financial professionals are fully prepared for succession, according to a new survey by Mathew Greenwald and Associates for broker-dealer Signator Investors, Inc., a unit of John Hancock Financial Network.

The survey also found that most advisors feel that the broker-dealer industry does a poor job helping with succession planning, even though nearly three-quarters of advisors prefer to join a broker-dealer with a succession planning platform.
Although many (56%) advisors have a disability plan, few have a completed succession plan or have an excellent estimate of their firm’s value. According to the survey:

  • Only 11% have completed a succession plan. About a third (34%) have started but not completed a plan, while 44% said they’ve thought about making a plan but not started one; an additional 12% haven’t even started thinking about creating a succession plan. 
  • Only one in ten has an excellent estimate of the value of their practice (10%), though 33% have what they consider to be a good estimate. More than four in ten say they have some sense of the value of their practice, but not a good estimate (44%), and an additional 12% say they do not have any idea how much their practice is worth. 

Why unprepared
While 81% of advisors surveyed believe the industry does not do a good job of helping representatives plan for succession, most admit that they themselves are roadblocks in planning for their succession. Fifty-five percent agree that they are too busy with their practice to think about succession planning, and 53% agree that they have procrastinated too much when it comes to this issue. 

The different channels of advisors surveyed – independent broker dealers, independent advisors/planners, and career agents – hold similar views toward and preparation for succession. The survey also showed that some of the advisors’ hesitation in planning may come from not knowing how they want to retire from their practice. For instance:

  • Only 20% are very certain about what they will do with their practice when they retire, though it appears few plan to retire all at once.  Many plan to reduce their practice activities before they retire (52%), and 42% currently have a plan in place to continue working with key clients (another 45% say they intend to create a plan to continue working with key clients).  Most either have a protégé now (30%) or are likely to hire one in the future (among those who do not have a protégé, 67% plan to hire one).  Sharing a philosophy with the protégé and working with them for a number of years are key considerations in hiring someone to take over their practice (important to 96% and 94% of advisors, respectively).

Lack of knowledge
Many advisors do not feel knowledgeable about the aspects of succession planning they consider to be most important.  This includes finding a successor, important to 85% of respondents, with 41% not feeling knowledgeable about it; obtaining a valuation of an investment business, which 83% feel is important, and 42% not knowledgeable; valuation of a fee-based business (72%, 49%); access to financing (71%, 60%); valuation of an insurance business (66%, 56%); and arranging third-party management of the transition (57%, 71%). In addition, at least seven out of ten responding advisors consider each of those issues to be a challenge for them.

Advisors cite a number of concerns in succession planning, including obtaining cash for their business (80%), maintaining relationships with key clients (70%), financing a transition (69%), annuitizing their business (69%), and bringing along a younger rep (66%). 

Client service is also a key consideration: 56% list leaving clients with a lower level of service as a concern, and another 47% agree that they do not believe they will be able to find someone who will service their clients as well as they do. 

Valuable forms of support
When presented nine services that a succession planning platform might offer, best practices for making a practice more valuable is by far the most popular with 79% of advisors interested in this service, though majorities are interested in each of the other tested services as well.

Two out of three advisors would be interested in receiving assistance in structuring an acquisition on either the buy or sell side (67%), assistance in designing and implementing a transition plan (67%), receiving support with a continuity plan (67%), or third-party evaluation of their entire practice (65%). 

Slightly fewer – roughly six in ten – would be very or somewhat interested in ongoing valuation (63%), financial support for the transaction (62%), or finding someone to purchase their practice (59%). 

Survey methodology
Conducted by Mathew Greenwald & Associates online, the survey represents responses from more than 500 financial professionals who were working either as a career agent, IFP/IFA, or independent broker dealer rep; planned to retire within 20 years; and had worked in the financial services industry for at least five years, owned at least half of their practice and generated at least $80,000 in gross income in the 12 months prior to the study.

© 2013 RIJ Publishing LLC. All rights reserved.

The Upside of Falling Bond Prices

Not only should retirement investors not worry about rising interest rates, writes Maine-based actuary Joe Tomlinson in a paper recently published at Advisorperspectives.com, “A rise in interest rates is actually good for retirement portfolios.”

In his timely and reassuring article, “Retirement Portfolios: Fears over Rising Rates are Overblown,” Tomlinson describes hypothetical owners of a Vanguard TIPS fund to show how, over a 25-year retirement, a rise in interest rates and a drop in fund value today actually gives the owners a higher income each year in retirement. Here’s his example:

Let’s consider a hypothetical couple who set aside $560,000 on March 31, 2013, to provide retirement withdrawals to supplement their Social Security income, with a goal of having that fund last 25 years. They decide to invest in the Vanguard TIPS [Treasury Inflation-Protected Securities] fund and work with their advisor to develop projections to set up a withdrawal schedule.

The projections use a yield after inflation of negative 0.84%, based on the March 31, 2013, 10-year TIPS yield of negative 0.64%, less 0.2% for expenses. They determine that pre-tax withdrawals of $20,000 annually (with increases each year for inflation) would last 25 years, based on the fund’s composition. 

Three months pass, interest rates increase and their quarterly statement shows they are off to a bad start. The fund has lost 7.34% (from the chart above), and their $560,000 has been reduced by $41,000 to $519,000. They decide to redo their projections and now use an updated yield of 0.28%.

They are pleasantly surprised to discover that, even though they are starting with $41,000 less, they now have projected money left over after 25 years. They determine that an increase in withdrawals of 7.5% to $21,500 is now consistent with the fund lasting 25 years.

Anyone nearing retirement long on bonds (I raise my hand) should find Tomlinson’s analysis comforting. But it sounds almost too good to be true. If the yield goes up, does that really help the current shareholder? (The fund’s posted yield on any given day is, according to Vanguard, its holdings’ average yield-to-maturity over the last 30 days.) According to Vanguard, it does—to the extent that the fund manager reinvests each day’s dividends at lower prices and higher yields. There’s a catch, of course. You have to hold the fund long enough so that your buying-the-dips strategy recovers your loss of principal. And that could take a while.

But Tomlinson’s investors have time. He’s not measuring success in terms of recovering principal in a hurry. He’s measuring success by the income potential (in years and dollars) of the bond fund assets over 25 years.

To see if I could replicate something akin to Tomlinson’s findings, I used a calculator at Yahoo.com that’s designed to answer the practical question: “How long will my money last with systematic withdrawals?” My hypothetical investor was a 65-year-old on the verge of retirement who owns 50,000 shares of Vanguard Total Bond Market Index Fund.

On January 1, 2013, this investor’s 50,000 shares were worth $553,000. On July 18, 2013, their market value was just $533,000, for a 3.6% decline. Over the same period, however, the fund’s yield had risen to 2.01% from 1.59%. (The fund’s annual expense ratio of 10 basis points is ignored here.)   

I plugged these numbers into the Yahoo calculator. My findings were a bit closer to a wash than Tomlinson’s. First I ran the numbers for the higher-principal, lower-yield scenario. According to the Yahoo calculator, if someone in the 25% tax bracket with $553,000 in a fund that earned 1.59% a year were to withdraw $1,667 a month (~$20,000/year) and increased the withdrawal each year by 2% to keep pace with inflation, the money would last 25.0 years and pay out a cumulative $647,705. Then I ran the numbers for the lower-principal, higher-yield scenario. All else being equal, someone with $533,000 and a 2.01% yield could withdraw $1,675 a month and see the money last 25.0 years for a cumulative payout of $649,941.

What if prices kept falling and yields kept rising? They would probably keep balancing out for the investor—at least, I presume, until his time horizon became shorter (roughly speaking) than the duration of the bond fund.

My results, like Tomlinson’s, suggest that the millions of near-retirees who own lots of shares of bond funds shouldn’t panic when they hear that bond yields are rising. So why does the media report on bonds so anxiously, with simultaneous wailing over low yields and falling prices? Maybe it’s because bond news is always either bad for somebody, depending on whether she owns individual bonds or bond funds, is accumulating or decumulating, and has a long or short time horizon. In Tomlinson’s article, he’s talking specifically about people who are decumulating over 25 years, and his findings seem to be mostly positive for them.

So far we’ve been talking about a systematic withdrawal strategy. Let’s not overlook the annuity option. If my hypothetical investor wants the highest possible income from his bond-invested savings for as long as he lives, he should price an income annuity for comparison.

In this case, an annuity might be better than a bond fund. According to immediateannuities.com, my hypothetical retiree could get the same income as his bond fund provided (about $1,667) from a joint and survivor fixed income annuity—with an installment refund to beneficiaries—for $350,000, leaving him 183,000 for growth, inflation protection, bequest funding, charity, travel or a long-term care annuity hybrid. Annuities aren’t necessarily the answer; there are as many ways to solve the retirement income puzzle as there are clients. These represent just a small sample.      

© 2013 RIJ Publishing LLC. All rights reserved.

Summit Business Media launches ThinkAdvisor.com

Summit Business Media has launched ThinkAdvisor.com, an enhancement of AdvisorOne.com. The makeover of the three-year-old site includes, beside a new name, a new, simplified site design and a greater focus on advisor needs, according to a Summit news release.

Like AdvisorOne.com, ThinkAdvisor.com will provide news, analysis and industry information, vendor resources, best practices and continuing education and access to professional reference publications. The new layout has been optimized for readability and multi-device support, including smartphones and tablets.

ThinkAdvisor.com also intends to offer access to live events, virtual tradeshows and webcasts, as well as The Academy, an interactive knowledge center.  

Matt Weiner, Group Publisher, said in a release, “By focusing content in four primary subject-matter channels—The Portfolio, Wealth, Retirement and The Practice—ThinkAdvisor.com offers new opportunities for sponsors to own a larger share of advisors’ workflows, spanning traditional and high-impact web advertising to content syndication, custom programs and lead generation.”

© 2013 RIJ Publishing LLC. All rights reserved.

As S&P 500 rises, so do U.S. equity inflows: TrimTabs

TrimTabs Investment Research reported today that U.S. equity mutual funds and exchange-traded funds have received $34.4 billion in July through Wednesday, July 17.  This month’s inflow is already the second-highest on record.

“The ‘great rotation’ so many pundits have been expecting may finally be getting underway,” said David Santschi, Chief Executive Officer of TrimTabs.  “Since the start of June, U.S. equity funds have taken in $34.2 billion, while bond funds have lost $77.3 billion.”

In a research note, TrimTabs explained that global equity funds were also receiving plenty of fresh cash.  Global equity mutual funds and exchange-traded funds have taken in $9.2 billion in July.

“The strong enthusiasm for equities should give contrarians pause,” said Santschi.  “Four of the ten largest inflows into U.S. equity funds occurred at the peak of the technology bubble in early 2000.”

TrimTabs also reported that outflows from bond funds have slowed dramatically.  Bond mutual funds and exchange-traded funds have redeemed $9.4 billion in July after losing a record $67.9 billion in June.

“The mere suggestion that the Fed would take away the liquidity punchbowl in the future prompted investors to dump bonds at a record pace,” said Santschi.  “While selling has subsided this month, what will happen when the Fed does more than just talk?”

© 2013 RIJ Publishing LLC. All rights reserved.

ETF liquidity mystifies advisors: Cerulli

Many advisors don’t understand the liquidity aspect of exchange-traded funds very well and need assistance in that area, according to new research from Boston-based analytics firm Cerulli Associates. Advisors understand the risks of ETFs and their role in portfolios much better.

Alec Papazian, associate director at Cerulli Associates, said in a release: “ETF sponsors view liquidity as the top growth challenge in 2013 as nearly two-thirds (63%) rated it as such.” 

The July 2013 issue of Cerulli Edge-U.S. Asset Management Edition examines retail educational strategies, focusing on whitepapers, ETF education, and organizational structure and staffing. 

“ETF risks and the use of ETFs in portfolio construction were ranked as the top two topics that advisors understood the best. Liquidity and trading ranked the lowest, suggesting these two topics should remain top of mind for providers when developing educational programs,” the release said. “Creating programs to meet educational needs of advisors across the spectrum of adoption and sophistication is a difficult task, but it will be necessary for some time.” 

ETF sponsors should focus on new advisors in order to further increase advisor adoption, Cerulli recommends. More advanced educational initiatives will help increase ETF allocations among advisors who already using ETFs. Sponsors should continue to educate advisors and clients on ETF basics.  

© 2013 RIJ Publishing LLC. All rights reserved.

Summit Business Media launches ThinkAdvisor.com

Summit Business Media has launched ThinkAdvisor.com, an enhancement of AdvisorOne.com. The makeover of the three-year-old site includes, beside a new name, a new, simplified site design and a greater focus on advisor needs, according to a Summit news release.

Like AdvisorOne.com, ThinkAdvisor.com will provide news, analysis and industry information, vendor resources, best practices and continuing education and access to professional reference publications. The new layout has been optimized for readability and multi-device support, including smartphones and tablets.

ThinkAdvisor.com also intends to offer access to live events, virtual tradeshows and webcasts, as well as The Academy, an interactive knowledge center.  

Matt Weiner, Group Publisher, said in a release, “By focusing content in four primary subject-matter channels—The Portfolio, Wealth, Retirement and The Practice—ThinkAdvisor.com offers new opportunities for sponsors to own a larger share of advisors’ workflows, spanning traditional and high-impact web advertising to content syndication, custom programs and lead generation.”

© 2013 RIJ Publishing LLC. All rights reserved.

Retirement Lengths, Withdrawal Rates and Failure Probabilities

The Bogleheads Forum is a great resource for investors, and in a recent discussion thread, user umfundi proposed/requested a new way to illustrate the results about sustainable withdrawal rates in retirement. I thought it seemed like an interesting way to express things, and since I have the resources to perform the necessary calculations, it seems like a pretty good topic for a post.

This is based on the idea behind the 4% rule. What percentage of your retirement date assets can you withdraw, and then adjust the amount of income provided by this initial withdrawal rate for inflation in subsequent years, and sustainably maintain these withdrawals throughout your entire retirement? The 4% rule is based on a 30-year retirement duration. But umfundi is essentially asking to see the results for all the different possible retirement durations in order to help coordinate one’s planning for different retirement lengths.

When we do this analysis, we naturally need to make some assumptions. I will use Monte Carlo simulations, which use computer power to extrapolate out hypothetical scenarios for future stock and bond returns. These simulated returns need to be tethered around some assumptions. Often the assumptions used to guide Monte Carlo simulations are historical averages, which include an inflation-adjusted average stock return of 8.6% for the S&P 500, and with intermediate-term government bonds, an inflation-adjusted return of 2.6%.

In the second figure, I will provide results for these assumptions, but I really think they are too optimistic when looking forward from today as interest rates are so low at the present. So the baseline assumptions I will use in the first figure below are assumptions that I think are more realistic and come from a very popular financial planning software program called MoneyGuidePro. With their assumptions, average inflation-adjusted stock returns are 5.5%, with 1.75% for bonds.

Two more assumptions we need are at the asset allocation to be used by the retiree, and the probability of failure that a retiree accepts for their strategy. For these figures, I will simply use a 40% stock allocation, which I think is within a reasonable ballpark for what many retirees will use (though of course everyone’s situation is different and 40% may not be a good idea for any particular reader). About the probability of failure, the whole purpose of these figures is to show what the sustainable withdrawal rates are for different probabilities of failure over different retirement lengths. So this is what is illustrated.

It is worth suggesting one more note about how these results can be used. Mainly, they are initial planning numbers about what might be a reasonable withdrawal rate in retirement. Real people, when using volatile assets like stock and bond mutual funds, will need to make adjustments to their spending over their retirement. They will not play a game of chicken in which they keep withdrawing the same amount as the portfolio plummets toward zero.

And so what the different probabilities of failure really mean is that someone using a higher probability of failure (which lets them use a higher withdrawal rate) is much more likely to have to make cuts to their spending throughout retirement. There is a trade-off here. Spending more today allows for more enjoyment in the early part of retirement, but a larger chance of having to make cutbacks in the future. People have to make their own decisions about how they feel regarding these trade-offs.

And so this brings us to our figures. This first figure is the one I would suggest spending the most time with, since I believe it has a more reasonable underlying assumptions about future market returns. We can look at this figure in different ways. For instance, moving horizontally, let’s consider a 4% withdrawal rate. The figure shows that 4% should work for 22 years with a 5% chance of failure, 24 years with a 10% chance of failure, 28 years with a 20% chance of failure, 32 years with a 30% chance of failure, and so on.

Another way to look at the figure is to follow one particular curve, such as the curve associated with a 10% chance of failure. With a 10-year retirement, a withdrawal rate of over 9% could be used, while for a 20-year retirement the withdrawal rate is about 4.8%. For a 30-year retirement the withdrawal rate is about 3.2%, and for a 40-year retirement the withdrawal rate is about 2.8%. For an early retiree planning a 60-year retirement, the withdrawal rate that can be expected to work with a 10% chance of failure is just above 2%.

A final way to look at the figure is to move vertically and to note how small increases in withdrawal rates can quickly result in higher failure rates. For instance, consider a  30-year retirement. With a 5% chance of failure, the withdrawal rate is just above 3%. If someone increases their withdrawal rate to 4%, the failure rate will be somewhere between 20% and 30%. With a 5% withdrawal rate, the failure rate is already 60%.

 

 

Now, I am also including the figure below based on historical averages without further comment, except to note that you can see outcomes are much more optimistic across the board, as this figure can be interpreted in the same way. I know some people really want to hold onto the belief that it is okay to use these historical average assumptions but I suggest that readers beware when making their retirement plans based on this second figure. I think the first figure is much more applicable.


© 2013 Wade Pfau. Used with permission.

New report from Fitch Ratings on interest rate climate

Fitch Ratings has released a special report that examines the challenging interest rate environment for U.S. life insurers. “While the recent uptick in interest rates has provided some relief to the industry, Fitch believes that the industry remains exposed to heightened interest rate risk,” the report said.

Fitch performed sensitivity analysis to look at the industry’s exposure to various interest rates scenarios. The scenarios, deemed The Good, The Bad and The Ugly, show that industry earnings are sensitive to future rate movements over a three-year projection period. A Fitch release described the scenarios as follows:

Good scenario

The Good scenario is a steady rate increase of 100 basis points per annum. This scenario is favorable across all major product lines and particularly interest-sensitive products such as fixed annuities, universal life and long-term care. Rising interest rates would have a positive impact on net investment income and interest margins and mitigate potential statutory reserve strengthening associated with asset adequacy testing. The interest rate environment thus far in 2013 is consistent with this scenario as the 10-year Treasury rate increased 74 basis points during the first six months of the year. Under this scenario, rating implications would be neutral to somewhat positive.

Bad scenario

The Bad scenario is level interest rates (from year-end 2012 levels) for three years. This scenario is unfavorable across all major product lines. Over the next two years, the impact of sustained low interest rates would limit earnings growth, but not have a meaningful impact on statutory capital. The impact on net investment income and interest margins will become more pronounced as the industry moves into the back half of the three-year projection period and beyond. Under this scenario, rating implications would be neutral over the near term but would turn negative if interest rates remain low much beyond 2014.

Ugly scenario

The Ugly Scenario is an interest rate spike of over 500 basis points, similar to that experienced in the late 1970s and early 1980s. This would have a more immediate negative earnings and capital impact due to heightened investment losses tied to asset sales needed to fund policyholder disintermediation associated with fixed annuities and other surrenderable liabilities. Under this scenario, rating implications would be negative.

© 2013 RIJ Publishing LLC. All rights reserved.

Allstate to sell Lincoln Benefit Life, exit fixed annuity business

A late-breaking release from Allstate read as follows:

The Allstate Corporation today announced a definitive agreement to sell its Lincoln Benefit Life Company to Resolution Life Holdings, Inc. for $600 million, thereby exiting the consumer segment served by independent life insurance and annuity agencies and reducing required capital in Allstate Financial by approximately $1 billion.

Allstate Financial will discontinue issuing fixed annuities at year-end 2013 and utilize third party annuity companies to ensure Allstate agencies and exclusive financial specialists continue offering a broad suite of protection and retirement products.

“This divestiture is one of many actions we have taken to strategically focus Allstate Financial and deploy capital to earn attractive risk-adjusted returns. This action also advances Allstate’s key priorities, including reducing exposure to spread-based business and interest rates,” said Thomas J. Wilson, chairman, president and chief executive officer of The Allstate Corporation.

Transaction details
Allstate has entered into a definitive agreement to sell LBL to Resolution Life for $600 million, generating cash proceeds, inclusive of tax benefits, of approximately $785 million. The transaction is expected to close by the end of the year, subject to customary regulatory approvals. The sale of LBL is estimated to result in a GAAP loss on sale in the range of $475 million to $525 million, after-tax, and a reduction in GAAP equity, including the impact to unrealized capital gains and losses, in the range of $575 million to $675 million. This transaction will result in a statutory gain of $350 million to $400 million, increase Allstate’s deployable capital by approximately $1 billion and reduce Allstate life and annuity reserves by $13 billion.

The business being sold had $341 million of premiums and contract charges, representing 15% of Allstate Financial’s 2012 total. Normal after-tax returns have averaged approximately 1% of transaction reserves.

As a result of this transaction, Allstate will not sell new life or retirement products through independent life insurance and annuity agencies. Allstate will continue to service in-force LBL business sold through independent life insurance and annuity agencies for a 12- to 18-month transition period, after which this business will be administered by Resolution Life.

Allstate Financial Annuity Strategy
Consistent with Allstate’s strategy to reduce its exposure to spread-based business, Allstate Financial will cease issuing fixed annuities at year-end 2013. Allstate agencies and exclusive financial specialists will serve their customers by continuing to offer a broad suite of life, retirement, savings, long-term care and disability products that are either issued by Allstate or provided by other companies.

“Allstate is committed to making the changes necessary to strengthen and grow the Allstate Financial business by focusing on life insurance sold through Allstate agencies and the worksite benefits market, where our competitive advantages generate profitable growth,” said Don Civgin, president and chief executive officer of Allstate Financial.

Lincoln Benefit Life
Based in Lincoln, Neb., LBL was founded in 1938 and acquired by Allstate in 1984. Lincoln Benefit Life products are sold through independent agents by means of master brokerage agencies, independent agents, and Allstate exclusive agencies in all states except New York, the District of Columbia, Guam and the U.S. Virgin Islands.

Resolution Life
Resolution Life Holdings, Inc. is a Delaware corporation established by British financial services investor, The Resolution Group. Its strategy is to acquire a number of life insurance businesses in the United States and focus on the needs of existing customers over the long run, rather than actively seeking new sales. Resolution Life is separate from Resolution Limited, a company publicly traded on the London Stock Exchange, which also was founded by The Resolution Group.

Lower-than-expected lapse rates led to VA charges: Moody’s

Variable annuity issuers underestimated the number of contract owners of variable annuities with living benefit riders who would surrender or “lapse” their contracts. Some life insurers have lost billions of dollars as a result, according to Moody’s Investors Service.

Moody’s June 24 report, “Unpredictable policyholder behavior challenges US life insurers’ variable annuity business,” refers to the “double trouble” created for VA issuers from the fact that the most expensive policyholders (those with “in-the-money” contracts where the benefit base is larger than the assets) are lapsing at a lower-than-expected rate while more profitable policyholders (those with “out-of-the-money” contracts) are lapsing at a higher than expected rate. 

According to Moody’s, annual lapse rates of VAs with living benefits dropped to the 2% to 3% range after the financial crisis, and have remained depressed.

“The impact can be especially costly to insurers, as more benefits will be paid out than priced for, while margins are compressed—at a time when hedging costs are increasingly expensive because of low/volatile equity market returns and low interest rates,” the report said.

Reserve charges of over $1 billion each have been incurred by AXA Equitable Life Insurance Co.  and ING US’s life insurance companies. MetLife took a charge of $752 million. John Hancock (IFS A1 stable), Sun Life Assurance Company of Canada (U.S.) and Prudential Insurance Co. of America took lesser charges, according to Moody’s.

Insurers adequately hedged equity market and interest rate risk exposure on their VA contracts, but policyholder behavior risk is virtually impossible to hedge for and can only be transferred through reinsurance, the Moody’s report said. “Hence, a company that has misestimated policyholder behavior may have little choice other than to recognize the adverse experience in its financials.”

Moody’s noted that it is still too early in the product life cycle of VAs with living benefits to predict how policyholders will use their benefits. It is unknown how many contract owners will annuitize their GMIB riders or convert GLWB riders to income streams.

“Policyholder behavior matters more [in variable annuities with lifetime income guarantees] than in a lot of insurance products,” said Neil Strauss, vice president, senior credit officer at Moody’s, who was an author of the report. “Mortality is more predictable because morbidity data is available right now. Here’s there’s a behavioral issue, and the exposure can change with changes in the environment. That makes this unique.”

Moody’s isn’t necessarily drawing negative conclusions about companies that are taking charges based on changing assumptions about lapse rates, he added. Nor do the changes in lapse rate assumptions constitute a financial emergency in Moody’s view.

“Companies have some flexibility in deciding when to account for a change [in lapse assumptions] and when to take a charge,” he added. “It’s a ball that can be kicked down the road. If policies go out-of-the-money, the lapse rates will be less of an issue. We’re not saying that companies have to take a charge now.  We’re not reducing ratings for companies that haven’t taken a charge. We’re just raising the issue.”

Strauss wasn’t sure how the recognized losses might affect a life insurer’s future appetite for issuing variable annuities with living benefits. “Companies that have taken a hit might say, ‘We’re clean and we can approach [the variable annuity business] with a fresh start.’ Others may say, ‘We learned our lesson and we’re never going back.’”

The entire report on the extent and implications of unpredictable VA contract lapse behavior is available for purchase at Moodys.com.

© 2013 RIJ Publishing LLC. All rights reserved.