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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.

The Future of Variable Annuities

The variable annuity was one of the huge success stories of the 2003-2007 period. It attracted more than $1 trillion worth of assets. It made many broker-dealer representatives and independent advisors wealthy. It protected policyholders during the financial crisis.

But its internal design and its business model weren’t sustainable in the volatile, low-interest post-crisis world, even though its Boomer market hasn’t gone away. Most VA manufacturers have pulled back or pulled out. The future of the business is in question. 

What will the VA business look like in two to five years? RIJ recently posed that question to people who have advised the largest life insurance companies: a prominent finance professor, a reinsurance expert, Milliman actuaries, McKinsey consultants, and a pioneering product developer.

The big takeaway: The variable annuity product will live on, but its investment-related guarantees will not. Life insurers have lost most of their appetite for writing long-term puts on the equity markets. The VA will survive mainly as a vehicle for risk-managed funds and as a funding tool for life annuities. The good news is that Boomer demand for retirement income products and risk-reducing products isn’t going away.


Ken Mungan, Financial Risk Management Leader, Milliman.

“I think there will be less emphasis on guaranteed living benefits. GLB’s will still be available in the market. But insurers are more cautious now. Even when interest rates come back to more normal levels, there will always be a note of caution in the strength of the guarantees that insurers are willing to provide.

“There is also likely to be more diversification across a range of products, including VAs (with and without GLBs), DIAs [deferred income annuities], FIAs [fixed indexed annuities], SPIAs [single premium immediate annuities], and SPDAs [single premium deferred annuities]. An active focus on product diversification by the senior management teams of the insurers will tend to incrementally reduce VA sales. Companies are looking to be more than just VA writers. They’re looking to see what other products they should focus more on. Across the industry, I see more diversification by companies that were once happy to sell VAs alone.

“Insurers may use the VA to provide retirement-oriented investors with access to risk management [tools], instead of providing a guarantee. I see an interest among VA writers in a product that has no living benefit, but emphasizes the risk management in the funds. This provides access to risk management instead of access to guaranteed income. The product becomes a lot cheaper. The onus will be on the financial advisor and insurer to show the benefits of [this type of] risk management.”

 

Tim Paris, CEO, Ruark Insurance Advisors, Inc.

“When you look at the rider election rates on point of sale, it’s obvious that the guaranteed living benefits and death benefits have become vital to selling the product. But a lot of companies have lost [money] on the guarantee piece. We’ve seen $2 to $3 billion in charges against earnings across four companies due to changing lapse assumptions. To the extent that this lower level of lapse assumptions has become the new normal, it will affect [VA product] prices and features, which you would think will affect sales.

“In the next phase, we’ll see better management of the policyholder behavior risk, including lapse behavior risk, partial-withdrawal risk and non-elective risks. In 2008 and 2009 companies took big losses on capital markets risk. But over the last one or two years, the big losses have been attributable to policyholder behavior, both as they happen and as companies extrapolate the results to future policyholder beholder. A lot of companies now have a strong interest in actively managing those risks.

 “Our clients are direct writers of variable or fixed indexed annuities. Some participate in our experience studies, where they share granular policyholder behavior and we analyze the data and tease out the factors. Others hire us as a reinsurance broker. If it is structured properly, for instance, [reinsurance] companies are willing to reinsure in-the-money death benefits. We try to carve out each risk in isolation.

“Take the guaranteed minimum death benefit, for instance. The GMDB behaves a lot like classic life insurance, and companies want to manage the mortality risk in it. But mortality risk is volatile. There’s a noise in it on a month-to-month basis. That creates noise in the hedging program. We’ve placed reinsurance by carving the mortality risk out of the product. We don’t transfer the capital market risk to the reinsurer. It uses a life reinsurance structure. This is very bespoke kind of work that’s particular to each insurance company.

“Looking ahead, if there’s a way during the product development or risk management process to reinsure some of these [risks] in isolation, issuers will have some pricing validation and shareholders will have more confidence in what’s going on. To the extent that we can use the reinsurance, that may allow companies to get back into the business of gathering assets.”

 

Casey Malone, actuary, Milliman.

“The life insurers will be in the variable annuity business, but the living benefits may have run their course. They’ve been de-risked so much that even though the current benefits might be OK for the company, I’m not sure how much value they’re providing for the policyholders. The benefit that you’re getting isn’t worth the rider fee. It’s so expensive because companies have to pay hedge costs. Over the long-term, nobody really wins when the company pays hedge costs on a price-neutral bases. The client should look for the investments to be managed to a certain age, and then rely on the insurance company to take on the longevity risk protection. Insurance company shouldn’t be concentrated in market risk protection. It’s not a sustainable idea. It’s too expensive and it’s not necessarily in line with the policyholders’ interests.

“From the standpoint of the fees that you end up paying, the mortality and expense risk fee, the investment management fee and the rider charge, the drag on your account value and your potential upside is just too great. If interest rates were much higher, these products would become cheaper again, but then we’d end up right where we are now. Insurance companies aren’t set up to change their offerings that quickly. Those are just my thoughts. But there are quite a few life insurance companies that stayed out of living benefits, and I assume their management has a similar point of view.

“The GMWB tells a simple story at the point of sale. Being able to summarize the benefit in one sentence—‘You can have 5% for life’—makes it an easy sale. A lot of companies saw the living benefit as a sales inducement rather than the piece that they would make money on. That’s part of the difficulty of replacing them with another product. The story was so good.

“The deferred variable annuity is a good way to fund an immediate annuity or a deferred income annuity. It can allow people to lock in future income over time without putting their money in a fixed account. That’s an attractive idea. It addresses some of the concerns of the policyholder and it’s in line with the life insurers’ expertise. [As far as more issuers getting out of the VA business], I don’t think anybody would want to talk about it until it became a certainty. But it follows from de-risking. Eventually de-risking gets to the point where it makes sense to get out. It’s hard to sell a put to a policyholder. You’re becoming a derivative counterparty to your policyholder and that’s a different relationship from the one insurance companies are used to. I see the New York Life-type product [the deferred income annuity] as the way that we should go, and I hope that we do. But it’s hard to make a prediction.”

 

Chad Slawner, partner, McKinsey & Co.’s insurance practice

“Obviously a slew of carriers have exited the business, so there’s going to be quite a bit less supply. A lot of it has to do with required capital and capital market conditions, but I don’t see a return to anywhere close to the supply we saw in 2003-2007. There will be no return to multiple carriers selling $10, $15 or $20 billion a year. There isn’t the appetite on the balance sheet for that kind of supply. The demand is still there for retirement income solutions, and there have been some innovations around more floating type or looser guarantees. You’ll see carriers looking to participate in retirement outside of the variable annuity. There’s appetite for fixed annuities, and for insuring risks that aren’t financial. You could see carriers participating more heavily in the health area.”

“The variable annuity wasn’t really a longevity play in my mind. It was a financial markets guarantee. The SPIA is a good long-term solution for longevity risk but it hasn’t taken off with advisors.

“From a financial perspective, the life insurers didn’t do well during crisis. But they’ve been honoring their commitments. In 2009 and 2010, if you talked to advisors who sold variable annuities, they’ll tell you that the product worked as intended. The carriers can capitalize on that. The losses are what people in the press talk about, but if you talk to the executives who run these [annuity] businesses, many of them think a lot of this is just an accounting problem. So it’s premature to say that they’ve ‘blown it.’ On the other hand, they have no appetite to run into this kind of volatility again. Right now they’re trying to steer clear of tight financial guarantees. You see carriers shifting towards group protection products. The story is not over as far as life insurers participating in retirement.

“The variable annuity wasn’t really a longevity play in my mind. It was a financial markets guarantee. The SPIA is a good long-term solution for longevity risk but it hasn’t taken off with advisors.”

 

Guillaume de Gantes, partner, McKinsey & Co.’s insurance practice

“I agree with Chad. It’s very hard to see [life insurers] going back in. It will be much more about managing the in-force book. Companies that were more balanced in their approach, like Jackson [National Life] or Lincoln [Financial Group], will still be in the market. Then you have companies like Prudential and MetLife whose balance sheets are  big enough to keep them in the market. Companies with captive distribution have done better. Ameriprise, for instance, did well during the crisis and they are still active.

“We think mortality [life insurance] as a need is much less important for carriers than it used to be. You have social safety nets and two-income households. But longevity is growing fast. There’s a huge role for life insurers to play there, if not in providing variable annuity living benefits, then in insuring against health-related risks [that are linked to aging].”

 

Jerry Golden, founder and president, Golden Retirement Advisors.

“I was talking to a successful rep the other day who said that despite having significant AUM [assets under management], his ROA [return on assets] was relatively low. Although not a heavy annuity seller, he recounted a story of how he helped a client exchange a $1+ million VA contract from a company modifying its provisions.

“He went on to say how great these VA’s were great for new reps who don’t have any AUM built up. From a distribution perspective, as long as there’s a demand for risk protection or structured products, certain issuers will continue to manufacture.  My issue is that if the fully hedged cost were passed through in product pricing, and illustrations were complete, the product would lose a lot of its appeal. It gets back to distribution and the cost of distribution. When compensation is at historical rates, volatility is high and market interest rates are low, you have this vicious cycle if you try to maintain attractive floors.

“My view is that there is a market for these products, but with different kinds of designs. There will be a market for a low-cost accumulation product coupled with the purchase of guaranteed income—instead of the purchase of derivatives. ‘You buy the cow, not the milk.’

“The other product idea would have no third-party guarantee; the account is simply managed with the objective of putting a floor under your withdrawals. In that case, it’s all transparent: you, the investor, own the hedge position. You can see it. You know its value. And the withdrawal benefit is based on what the market can support, not on what competitors are doing. I happen to own such a product, through a managed account at a firm with expertise in hedging and reinsurance. It was managed for withdrawals to start in five years from the time I purchased it. Because the risks have increased since purchase, I own the increase in the hedge position, and I can either stay and make withdrawals, roll over to another account, or annuitize.  

“There will be a continuing demand [for VAs with living benefits] in the marketplace and companies will keep testing to see how they can lower the risk. But at some point the distribution will say, ‘These are not generous enough,’ and then the product may or may not die its own death. On the other hand, the distributors are looking for these types of structured products, so there will be pressure to keep something going.

For some carriers, the distributor will drive the decision, because if those carriers get out of the variable annuity business, they’ll be getting out of the third-party distribution business entirely. It will not be totally driven by what the manufacturer wants. Before a life insurer decides to get out of this business, it has to think about how that will change its distribution. So the death of the business won’t happen immediately, and it will be driven by the combination of factors affecting the distribution and the manufacturers. It’s going to be a challenge.”

 

Moshe Milevsky, Ph.D., York University.

“New companies are coming into the industry that weren’t exposed to this liability five years ago. They have a clean balance sheet and can offer new guarantees without the emotional and financial baggage. They didn’t sell these products. They didn’t ruin their reputations. A lot of these life insurance companies are still sitting on the sidelines.

“The Boomers still need help with their retirement. The rationale for this business, the justification for this business, is still there. In fact it’s stronger than it was before the financial crisis. And demand will continue to be there.

“People will always want to participate in the upside. ‘Safe’ sounds great when your neighbor is losing money [on risky investments]. But when your neighbor is making a lot of money, safe stinks.

“What I’m seeing now, much more than five years ago, is immense international interest in the subject of retirement income. Five years ago, I was getting my 95% of my invitations to talk about retirement [finance] from the U.S. Now, 70% of my invitations are coming from overseas. They’re struggling with [decisions about] what products people should be buying. I see this as a global issue. Any large, U.S.-based company should be looking overseas.”

© 2013 RIJ Publishing LLC. All rights reserved.

Reverse mortgage program under stress

To reduce the number of reverse mortgage borrowers who go into foreclosure because they can’t pay their property taxes or homeowner’s insurance, the Federal Housing Administration (FHA), which insures reverse mortgages, wants to require prospective borrowers to pass a financial assessment and possibly a credit check, the New York Times reported.

Nearly 10% of reverse mortgage holders are reported to be in default because they failed to make those payments, the Times said.

According to the news report, the House of Representatives approved the FHA’s plan but the Senate has not. If Congress doesn’t pass the measure, then, effective Oct. 1, another of the FHA’s reverse mortgage products could be eliminated, and the amount that people over 62 could borrow against their homes might drop by 10% to 15%.

This year the FHA already eliminated a type of reverse mortgage that allowed homeowners to borrow the maximum in a lump sum. Instead of eliminating another popular product, the FHA would prefer to detect and screen out applicants who are likely default on their loans, the Times said. The agency wants applicants to have adequate cash flow in excess of typical living expenses, property taxes, homeowners insurance, homeowner association dues (if any), utilities, taxes and other expenses. Credit scores might also be factored into a review.   

Risky borrowers might still qualify for a reverse mortgage if they agreed to place part of the loan proceeds in escrow for property taxes and insurance, either for as brief a period as two years or for as long as the entire expected duration of the loan. 

The agency also said it would like to cap the amount borrowers could pull out at 60% of the maximum sum for which they were eligible (or the amount needed to pay off their current mortgage, whichever was greater. Reverse mortgage borrowers must pay off their regular mortgage to obtain the reverse mortgage).

Today, using a so-called standard reverse mortgage, a 65-year-old could borrow about $226,800 (in cash or a line of credit) against a home worth $400,000, after various fees, according to ReverseVision Inc., a reverse mortgage software firm. Borrowers can also receive the money as lifetime income or income over a specific term.   

If, because of its own financial stress, the F.H.A. eliminated the standard mortgage, the “saver” reverse mortgage would be available. It has lower fees but would allow that hypothetical 65-year-old to borrow only about $194,800 against his $400,000 home, or 14% less, after all fees. Another “saver” option would also be available.

© 2013 RIJ Publishing.

The Bucket

EBRI reports results of policy forum

At “Decisions, Decisions: Choices That Affect Retirement Income Adequacy,” a recent policy forum hosted by the Employee Benefit Research Institute in Washington, D.C., the general topic was retirement readiness and the follow specific issues were addressed:

  • The impact of the sustained low-interest-rate environment on retirement savings and retirement income
  • The influences of the employer match in 401(k) plans
  • Suggestions on how to help plans and participants distribute their 401(k) savings, either through IRA rollovers, direct drawdown or income annuities.   

Findings presented at the policy forum, and published in the July EBRI Notes (online at www.ebri.org) included:

  • About 25% of Baby Boomers and Gen-Xers will run short of money in retirement if today’s interest rates are a permanent condition; the lowest-income group wouldn’t be affected.
  • The current interest rate environment, and its duration, will determine the types of fixed-income investments defined contribution plans offer, as well as the kinds of stable-value and target-date funds.
  • The slow economy has affected employer contributions to 401(k) plans. Of the plan sponsors that suspended their matches, many have restored them. A few employers have moved annual matching cycles but most provide a match with each paycheck.
  • The level of the match affects contribution levels in voluntary-enrollment 401(k) plans more than in automatic enrollment plan designs.
  • The adoption of automatic enrollment has not affected employer match behavior.
  • All but a few defined benefit (pension) plan participants who weren’t required to annuitize chose lump-sum distribution.
  • Plan design affects participant savings decision and post-retirement financial decisions.

EBRI-ERF holds at least two roundtable discussions per year, attracting plan sponsors, congressional and executive branch staff, benefit professionals and experts, and members from interest groups, labor, and academia. The next EBRI policy forum will be held Dec. 13, 2013, in Washington, D.C.

Patrick McAllister to lead Investment Strategy and Analytics at Lincoln

Lincoln Financial Group (announced that Patrick McAllister has joined the company as vice president and managing director of Investment Strategy and Analytics, effective today. In his new role, McAllister is responsible for Strategic Asset Allocation and Liability-Driven Portfolio Construction. He joins Lincoln Financial from Morgan Stanley, where he most recently served as executive director in the Global Capital Markets division.

Prior to joining Morgan Stanley in 2006, McAllister served as managing director of Equity Derivatives for Societe Generale. Previous positions also included serving as principal for Constellation Financial Management, and head of Quantitative Methods for Risk Management in the Capital Markets Group at First Union Corp., now Wells Fargo.

McAllister holds a doctoral degree and a bachelor’s degree in Economics from Stanford University. His articles have been published in the Journal of Banking and Finance, Annals of Operations Research, Journal of Economic Theory and Journal of Policy Modeling.

Transamerica to collaborate with MIT’s AgeLab

Transamerica and the Massachusetts Institute of Technology (MIT) AgeLab have entered into a long-term research partnership.

MIT AgeLab’s goal is to design, develop and deploy innovations that touch how the world’s aging population will live, work, and play tomorrow. The inventions and research focus on health and wellness, transportation and community, housing and home services, business and policy innovation, retirement and longevity planning, as well as innovations for work and the workplace.

Transamerica’s Individual Savings and Retirement (IS&R) division is leading the engagement with the MIT AgeLab. IS&R focuses on financial strategies and solutions that help people save for retirement, as well as protect their savings leading up to and throughout retirement. This critical phase of life is when the effects of aging can significantly impact the finances of those individuals and their families.

The MIT AgeLab research, white papers, and presentations will help frame how Transamerica and its business partners communicate with and advise their customers. Joseph F. Coughlin, Ph.D., who teaches policy and systems innovation at MIT, is the director and driving force behind MIT AgeLab. The lab is based within MIT’s School of Engineering’s Engineering Systems Division.

Employee Fiduciary now serves over 2,000 small and mid-sized 401(k) plans

Employee Fiduciary, LLC, an independent low-cost 401(k) recordkeeper and consultant specializing in small and medium-sized plans, said it now serves more than 2,000 plans with more than $2 billion in assets.   

“Employee Fiduciary set out nine years ago to disrupt and disprove the notion that smaller businesses must settle for expensive and inefficient 401(k) services,” the company said in a release. The firm has averaged 40% annual growth. 

Employee Fiduciary provides recordkeeping and administration services to smaller professional firms and high tech businesses that use Employee Fiduciary to help attract and retain talent by enhancing employee benefits.

CEO Greg Carpenter blogs about the 401(k) business at “The Frugal Fiduciary.”

The Principal releases plan to increase DC savings 

New research from the Principal Financial Group shows retirement plan participation rates increase by up to 70% when plans use automatic enrollment, automatic increases, online deferral changes or employer contribution. Retirement plans with at least two of those features have an average total participant savings rate of 11%, or more than twice the national average. 

To make the largest impact on savings, The Principal recommends:

  • Automatic enrollment for all employees at 6% deferral 
  • Automatic annual increases of at least 1% annually
  • Online deferral changes available to participants
  • Employer contribution or match

“Most Americans need to save in general between 11% and 15%, including employer contributions, over an entire working career to replace 85% of income in retirement. This new research identifies plan design features that can encourage employees to save at those higher levels,” said Jerry Patterson, senior vice president of retirement income strategy at The Principal. 

The Principal Retirement Readiness initiative, based on surveys of 25,000 sponsors, recommends a three-step approach to improvement: strategic measurement, meaningful plan design changes and goal-driven participant education.  

NEST shifts assets to U.S. from U.K.; hit with $2.1 million fraud

Britain’s National Employment Savings Trust (NEST) has lowered its exposure to UK investments markedly in the last year, with domestic holdings now only 30% of assets, down from nearly 50% last March. Publishing its annual report for the financial year 2012-13, the “public option” defined contribution plan said its default investment options, retirement date funds, performed as expected.

The fund also said NEST Corporation, the entity responsible for the day-to-day running of the fund, had been the victim of a $2.1 million fraud. Chairman Lawrence Churchill said the plans defenses had been strengthened since the £1.4m (€1.6m) payment had been uncovered. He added that, despite the money not coming straight from members’ pots, if the scheme were unable to recover the money, it might increase running costs.

“They have delivered above-inflation returns within our given risk budgets while protecting members from excessive volatility in uncertain conditions,” the report said. The 2021, 2040 and 2055 retirement date funds all saw double-digit returns. A member retiring in eight years saw investments grow by 12.2% over the year and by 10% since the fund was launched in August 2010. A member retiring in 27 years saw returns of 13.6% over the year.

Members with a greater risk appetite invested in the NEST Higher Risk Fund saw returns of 15.6%, only 1.1 percentage points above the Sharia-compliant fund. Those who opted for the lower-risk fund only saw returns of 0.4%, in line with the option’s benchmark return both last year and since the fund’s inception.

NEST has also significantly rebalanced its asset allocation away from the UK; instead, it increased investment in North America to 35.9%, its single largest regional exposure. A greater emphasis was also placed on Continental Europe, up nearly 3 percentage points to account for 18.4% of investments. Latin and South America remained the smallest identified region, with investments in the area nonetheless rising over the 12 months from 0.4% to 1.9% of total assets.

In other matters, NEST justified its decision to allocate 20% of its assets in growth-oriented funds to real estate as “reasonable” and essential to its mandate to offer above-inflation returns.  NEST appointed Legal & General Investment Management to a “property mandate,” thus helping NEST invest in UK property and a global real estate investment trust (REIT) index.

NEST CIO Mark Fawcett described the allocation as hedge against investment risk. “There is this strategic question as to how much we should have in real assets, and then there is this risk management question [on] relative attractiveness of other assets in the shorter term,” he told IPE.com. “About one-fifth in real assets – almost whichever way we run the models and crunch the numbers – that seems to be a reasonable position.” He explained that, in NEST’s view, real assets are a “good way of hedging some of that inflation risk” – with the fund seeking to outperform the UK consumer prices index (CPI).

© 2013 RIJ Publishing LLC. All rights reserved.

Legal Deception: The M&E Fee

When and how did it became acceptable for variable annuity issuers to pad their mortality and expense risk (M&E) fee to get the client to pay the sales commission (and then some) without realizing it? The back-story of the M&E subterfuge, it turns out, is a fascinating one. Especially because it helps explain the VA boom of the last decade and a half.

For those of you who don’t read VA prospectuses, the “mortality and expense risk” fee is one of the asset-based fees listed in the fee table of a VA contract. Technically, the fee protects the insurer against the risks that its mortality projections might be off or that the costs of servicing the contract might rise unexpectedly.

Sounds plausible. But the M&E fees vary widely among contracts. For instance, the M&E charge on the variable annuity with guaranteed lifetime withdrawal benefit sold directly to investors by Vanguard and underwritten by Monumental Life is 0.195%, with a 0.10% administrative charge. That’s 29.5 basis points, or $295 per $100,000 invested. Sounds reasonable.

If you look at the prospectus for the B-share of a typical VA sold through the independent advisor channel from the last few years, you find a much higher M&E. Picking three recent contracts at random, I find M&Es of 1.52%, 1.05% (with a 0.25% administrative charge), 0.95% (plus a 0.15%) and 1.55% (plus a 0.15% administrative charge). That’s $1,520, $1,300, $1,100 and $1,700 per year per $100,000 invested, respectively. (I include the administrative charge because its distinction from the M&E fee, as the term is loosely used, seems weak. Both are part of aggregrated, vaguely-defined costs.)

The M&Es of the B-share contracts (which represent two-thirds of variable annuity sales, according to Morningstar) are much bigger than that of the direct-sold contract because the B-share contract owner, in effect, is gradually reimbursing the insurance company for the 6% or 7% commission that the insurer paid the independent advisor or registered representative for making the sale.   

In practice, this fact is not disclosed. It’s unlikely that the advisor would tell the purchaser that this ostensibly painless arrangement exists, or that it would be cheaper in the long run for him or her to buy an “A” share variable annuity and pay the entire commission up front. Contracts do disclose of the merging of the M&E and the sales charge, but not in “plain English.” Here’s how three disclosures from three contracts read (italics added):

  • “The mortality and expense risk charge is expected to result in a profit. Profit may be used for any cost or expense including supporting distribution.”
  • “If the charge exceeds the actual expenses, we will add the excess to our profit and it may be used to finance distribution expenses or for any other purpose.”
  • “Any gain will become part of our General Account. We may use it for any reason, including covering sales expenses on the Contracts.”

The contracts do not explicitly say that the policyholder is reimbursing the insurer for the commission over time, or that the padded M&E fee may remain in place long after it has made the issuer whole.

Padding the M&E wasn’t always legal. It only became legal in 1996, when the National Securities Markets Improvement Act of 1996 (NSMIA) amended the Investment Company Act of 1940 to allow (among other things) insurers leeway to charge more for variable annuities.

Before 1997, deductions from variable subaccounts for insurance charges, including mortality and expense risk charges, were capped at 1.25% for variable annuities (0.90% for variable life products). Variable annuity issuers were also required to obtain an “exemptive order” before they could change any M&E fee. Administrative charges had to be “at cost.”

The NSMIA of 1996 changed that. After the amendment, the direct limit on insurance fees was removed, the exemption requirement was lifted, and insurance charges could be combined with other (such as administrative) charges that, in the aggregate, merely had to be “reasonable,” according to a 1999 analysis of the law by the Washington law firm of Sutherland, Asbill & Brennan. Such a loose standard sparked innovation and invited abuse.

(The NSMIA of 1996 was sponsored by Jack Fields Jr. [R-TX] and was part of a wave of deregulatory legislation that shaped today’s financial and telecommunications landscape. In the same year, the Glass-Steagall Act was “reinterpreted” to let bank holding companies earn up to 25% of their revenues from investment banking. The telecom industry was also deregulated that year. At the time, Republicans controlled both houses of Congress for the first time in 40 years. Robert Rubin of Goldman Sachs was Treasury Secretary under President Bill Clinton.)

As mentioned above, this change in the law helps explain the VA boom of the last 15 years, which has been characterized by new products, new features and rising prices—as well as the messy bust that followed. The Sutherland analysis noted that:

“By eliminating the regulatory “straightjacket” that for years constrained the design of variable contracts, the 1996 Amendments have permitted insurers to introduce new product features and designs and to charge consumers prices that are competitive with the fixed market. Pricing is now subject only to the constraint of new Section 26(e) of the 1940 Act and its requirement that total fees and charges under the variable insurance contract be ‘reasonable.’”

More to the point: “The primary effect of the Reasonableness Standard so far on VA contracts has been to facilitate the introduction of new product features (such as enhanced death benefits, guaranteed minimum income benefits, and bonus credits), since insurers can now charge what these product features are “reasonably” worth to consumers without being subject to arbitrary price limitations,” wrote the same Sutherland attorney in another analysis.

The rest is history. The deregulation of fees on variable annuities allowed the products to become more feature-laden, more attractive to registered representatives and more profitable. It enabled the issuers to pass along new manufacturing and distribution costs to the consumer. But the weight of those fees, and their necessary disguises, made variable annuities expensive, complex, and inherently deceptive. To rehabilitate the reputation of the product, we could start by ending the legal fraud of the M&E charge.

© 2013 RIJ Publishing LLC. All rights reserved.

Average IRA balances at Fidelity reach five-year high of $81,100

The average balance of seven million IRAs custodied at Fidelity Investments reached a five-year high of $81,100 at the end of tax year 2012, according to the Boston-based fund giant. The figure was 53% higher than the five-year low, registered in 2008

Total contributions to Fidelity IRAs have increased 7.5% from tax year 2008 to 2012, with the average IRA contribution reaching $3,920 in tax year 2012. Roth IRA conversion activity also jumped at the end of 2012 as tax law changes were debated, contributing to a 12% year-over-year increase.

The findings from Fidelity, the largest IRA custodian, highlight positive balance trends across all age groups despite even contribution levels (at right):

Fidelity average IRA balance 2012Total contributions to IRAs have increased every year since 2008, with a 3.1% increase over last year and a 7.5% increase over 2008. At the same time, the average contribution held strong at $3,920 for tax year 2012 (vs. $3,930 for tax year 2011).

Investors in their 60s continue to save the most in their traditional and Roth IRAs. For tax year 2012, these investors contributed on average $4,910 to Traditional IRAs and $4,840 to Roth IRAs. Full contribution rates with age breaks are as follows (below):

Fidelity average IRA contributions 2012As tax law changes were debated, Roth IRA conversions conducted by investors increased in 2012. In fact, there was a 12% year-over-year increase in Roth IRA conversions, and a 52% year-over-year surge for the month of December. Overall, Fidelity conducted more than 101,000 Roth IRA conversions with investors in 2012.  

 

 

 

 

© RIJ Publishing LLC. All rights reserved.

MetLife not ‘too big to fail’: CEO Steven Kandarian

MetLife, Inc. chairman, president and CEO Steven A. Kandarian issued the following statement this week after the company was notified by the Financial Stability Oversight Council (FSOC) that it had reached “Stage 3” in the process to determine whether MetLife would be named a non-bank Systemically Important Financial Institution or SIFI:

“We look forward to working with FSOC on the best way to fulfill its obligation to mitigate systemic risk.

“I do not believe that MetLife is a systemically important financial institution. The Dodd-Frank Act defines a SIFI as a company whose failure ‘could pose a threat to the financial stability of the United States.’ Not only does exposure to MetLife not threaten the financial system, but I cannot think of a single firm that would be threatened by its exposure to MetLife.

“The life insurance industry is a source of financial stability. Even during periods of financial stress, the long-term nature of our liabilities insulates us against bank-like ‘runs’ and the need to sell off assets.

“To be clear, I support prudent regulation of the life insurance industry. After all, we are financially liable for insolvencies through the state-based guaranty funds. What I do not support is a regulatory system that creates an unlevel playing field.

“If only a handful of large life insurers are named SIFIs and subjected to capital rules designed for banks, our ability to issue guarantees would be constrained. We would have to raise the price of the products we offer, reduce the amount of risk we take on, or stop offering certain products altogether.

“We look forward to working with FSOC on the best way to fulfill its obligation to mitigate systemic risk.”

MetLife, Inc. provides insurance, annuities and employee benefit programs to about 90 million customers in the United States, Japan, Latin America, Asia, Europe and the Middle East.   

© 2013 RIJ Publishing LLC. All rights reserved.

NEST shifts assets to U.S., absorbs €1.6 m fraud

Britain’s National Employment Savings Trust (NEST) has lowered its exposure to UK investments markedly in the last year, with domestic holdings now only 30% of assets, down from nearly 50% last March. Publishing its annual report for the financial year 2012-13, the “public option” defined contribution plan said its default investment options, retirement date funds, performed as expected.

The fund also said NEST Corporation, the entity responsible for the day-to-day running of the fund, had been the victim of a $2.1 million fraud. Chairman Lawrence Churchill said the plans defenses had been strengthened since the £1.4m (€1.6m) payment had been uncovered. He added that, despite the money not coming straight from members’ pots, if the scheme were unable to recover the money, it might increase running costs.

“They have delivered above-inflation returns within our given risk budgets while protecting members from excessive volatility in uncertain conditions,” the report said. The 2021, 2040 and 2055 retirement date funds all saw double-digit returns. A member retiring in eight years saw investments grow by 12.2% over the year and by 10% since the fund was launched in August 2010. A member retiring in 27 years saw returns of 13.6% over the year.

Members with a greater risk appetite invested in the NEST Higher Risk Fund saw returns of 15.6%, only 1.1 percentage points above the Sharia-compliant fund. Those who opted for the lower-risk fund only saw returns of 0.4%, in line with the option’s benchmark return both last year and since the fund’s inception.

NEST has also significantly rebalanced its asset allocation away from the UK; instead, it increased investment in North America to 35.9%, its single largest regional exposure. A greater emphasis was also placed on Continental Europe, up nearly 3 percentage points to account for 18.4% of investments. Latin and South America remained the smallest identified region, with investments in the area nonetheless rising over the 12 months from 0.4% to 1.9% of total assets.

In other matters, NEST justified its decision to allocate 20% of its assets in growth-oriented funds to real estate as “reasonable” and essential to its mandate to offer above-inflation returns.  NEST appointed Legal & General Investment Management to a “property mandate,” thus helping NEST invest in UK property and a global real estate investment trust (REIT) index.

NEST CIO Mark Fawcett described the allocation as hedge against investment risk. “There is this strategic question as to how much we should have in real assets, and then there is this risk management question [on] relative attractiveness of other assets in the shorter term,” he told IPE.com. “About one-fifth in real assets – almost whichever way we run the models and crunch the numbers – that seems to be a reasonable position.” He explained that, in NEST’s view, real assets are a “good way of hedging some of that inflation risk” – with the fund seeking to outperform the UK consumer prices index (CPI).

© 2013 RIJ Publishing LLC. All rights reserved.

Aria enhances its RetireOne contingent deferred annuity

Aria Retirement Solutions has announced an enhanced version of its contingent deferred annuity (CDA) product, RetireOne Transamerica II solution. A registration statement for the product was filed with the Securities and Exchange Commission May 15.

The product is designed for use by registered investment advisors (RIAs) and their clients who want to add longevity protection to a portfolio of mutual funds or exchange-traded funds without purchasing a variable annuity contract. A CDA—once known as a stand-alone living benefit, or SALB—lets RIAs add lifetime income rider insurance to clients’ portfolios without changing the tax treatment of the underlying investments. There’s no surrender fee for letting the coverage lapse.

Aria Retirement Solutions provides the technology platform for the product, Transamerica Advisors Life provides the lifetime income guarantee and a variety of low-cost fund managers provide the investments.

Like a lifetime income benefit in a variable annuity, a CDA guarantees an income for life by putting a floor under the amount of assets on which the client can base an annual income for life. The income amount is also determined by the client’s age (age 60 or later) when he or she initiates the guaranteed income stream.

 In Aria’s CDA, the income amount also depends on the 10-year Treasury rate. For instance, at today’s rates, a 65-year-old single client could take 4% of the guaranteed benefit base per year for life. At a rate of 7% or more, the client could take 5.5% per year for life.

Like variable annuities with living benefits, retail CDAs aren’t necessarily cheap. Counting the RIA management fee (1% to 1.5%), the management fees on the underlying funds and ETFs, and the insurance fees, the total drag on the insured investments can exceed 3% a year, depending on the risk of the investments being wrapped.

Aria CEO David Stone told RIJ that the CDA fees aren’t comparable to VA fees, because the client would be paying the RIA management fee anyway and the funds and the ETFs in the CDA are ultra-low cost. A typical retail variable annuity will charge about 2%-2.5% for the base annuity and the living benefit rider.  Throw in the fund fees and the all-in cost is frequently 3%-3.5%,” Stone said in an email.

“With our CDA, we just offer the insurance component, which can be as low as 65 bps after all breakpoints,” he continued. “If we combine the insurance with a portfolio of low cost ETFs, the all-in investment related costs can be 90-95 bps. So, essentially for the cost of an actively managed mutual fund, a consumer can get guaranteed income for life.  

“Of course, the fees can go up for portfolios with greater risk or higher fees or if the advisor wants to use the account to deduct their fees. But we believe the majority of advisors will look to keep the all-in cost (before the RIA fees) to between 90-150 bps.  Also note, we work with advisors who just assess a flat fee or charge much less than 1-1.5%.”

So far, Aria may be the only firm that markets CDAs to retail investors and their advisors. So far, market penetration of the still-novel product category has been slow. The product is not available in all states. 

RIAs can’t wrap Aria’s longevity protection around just any investment portfolio they like. They must choose from among products in the 16 asset categories available under the Aria contract. There’s a different cap on portfolio allocations for each asset class. The caps are as low as 5% for emerging market small equities or alternative assets and as high as 100% for balanced funds and investment grade bond funds.

Eligible investments are listed on Aria’s website, www.retireone.com. They include funds and ETFs from Dimensional Fund Advisors (DFA), iShares, Schwab, Vanguard, and others. The program offers nine investment “Profiles” or “Strategies.” Their risk levels vary and the fees correspond to the risks.  

According to the SEC filing, each eligible investment has a “Fund Factor,” which Aria defines as “the factor derived from the use of a proprietary algorithm that attempts to assess the relative risk associated with each Eligible Fund. The algorithm factors criteria such as market data, historical volatility and other measures of exposure.”

There are several fee options for advisors to choose from, depending on whether they want the insurance fee and the advisor’s fee to be taken from the guaranteed benefit base or from a separate cash account, and whether the RIA charges a management fee of 1% or 1.5% per year.

© 2013 RIJ Publishing.

Where to Get Old Variable Annuities Appraised

When variable annuities with living benefits had lavish payouts and low prices relative to their guarantees, Mark Cortazzo of MACRO Consulting Group in Parsippany, N.J., sold about half a billion dollars worth of them to his clients. Along the way, he and his staff assembled a huge database identifying the jewels and the clawbacks that were buried in hundreds of VA prospectuses.

Six years later, VA benefits are far less dazzling, and Cortazzo doesn’t guide as much of his client’s money into them. But the high-profile 40-something advisor, whose paneled conference room walls are studded with the framed covers of national magazines that have lionized him, isn’t letting that huge database go to waste. He’s used it to launch a new business venture called Annuity Review

At first glance, Annuity Review is a VA issuers’ worst nightmare. Its purpose is to prevent VA contract owners (and their advisors) from mistakenly surrendering contracts that they think might be worthless “swampland,” as he put it, but are actually hiding “oil reserves.” At a time when some VA issuers pray for high lapse rates so they can stop reserving and hedging for their rich old benefits, that’s not good news.

But Cortazzo (below), a New Jersey high school pole vault champion who still competes in the Masters division, insists that he’s not trying to do to VA issuers what hedge fund manager John Paulson did to mortgage-backed securities in 2008 or what financier George Soros did to the Thai baht in 1997.

Mark CortazzoHe says he merely wants to help contract owners realize the value of what they own. And he insists that, by helping VA contract owners get the most value from their contracts—through proper structuring and asset allocation—he’s actually helping the VA issuers.

The sad fact is that thousands of variable annuity contracts with complex riders were sold for large sums by intermediaries who didn’t understand them to investors who didn’t understand them. Many of those investors are now being advised on how to dispose of their contracts by fee-only advisors who don’t understand them either. Cortazzo sees a chance to do good and do well, and he’s offering his services for just $199.

“I think there’s a misconception about what we’re trying to do,” Cortazzo told RIJ recently. “We spend half of our time talking to clients about the basic structure of what they own. People come to us with joint riders where the spouse isn’t the primary beneficiary.

“Insurers think we’ll talk to contract owners and tell them to jack up the risk and maximize the protection. But we’re not trying to game the contracts. If I put a VA contract owner in emerging markets equities and the asset class goes down 50%, my client isn’t high-fiving me for maximizing the guarantee. He’s saying, ‘I just lost half my money!’”

In any case, he said, Annuity Review is just a flea on the back of the VA elephant; in-force VAs represent $1.7 trillion in assets (Morningstar, March 31, 2013).

Hidden assets

Annuity Review provides VA contract analysis services either directly to individual contract owners or to the financial advisors of contract owners. The basic charge is $199 for the first three contracts and $49 for each additional contract. He has provisions for free initial consultations and volume discounts for financial advisors with whom he has ongoing relationships. If he becomes the representative of record on the contract, he may also receive a trail commission from the issuer.

When working with fee-only advisors, Cortazzo can become the registered representative on the contract. He also signs non-compete agreements to assure financial advisors that he’s not going to steal their clients. “Our approach has been to focus on the RIA [registered investment advisor] community,” he said.

The fee-only or fee-based advisors who call Cortazzo are, as a rule, not the intermediaries who originally sold the VA contracts to their clients. Typically, a registered representative of a regional broker-dealer or wirehouse sold the contract to the client.  

A not unusual scenario is for an investor to have bought one or more VA contracts before the financial crisis. Post-crisis, the contract owner may have panicked and re-allocated to bonds within the contract. He or she might also have fired the rep who sold the contract and hired a fee-only advisor.

Unfortunately for the clients, Cortazzo said, the investor’s new fee-only advisor, not being familiar or even comfortable with insurance contracts, was likely to advise the client to surrender the contract (as soon as the surrender period expired) and perhaps roll the assets into a Roth IRA, paying taxes that further diminish the remaining VA account value.

Ignorance and inertia

“A half-dozen times, while reviewing a contract with a client and a fee-only advisor, I’ve heard an advisor say, ‘I have a number of other clients with the same product and I told them to get out of it.’ On literally every review with an advisor, I hear, ‘I didn’t understand these provisions.’ Imagine how much de facto de-risking is happening because fee-only advisors have that as their default recommendation?” Cortazzo told RIJ.

Some people, of course, might be better off letting the contract lapse and putting their money somewhere else. But if the living benefit on that contract was deep in the money—that is, if the account value was far below the guaranteed benefit base—or if it had a big death benefit, then the client may have been tossing away something of great financial value. Cortazzo hopes to prevent that tragedy with Annuity Review.

“The insurance companies have two great risk mitigators: ignorance and inertia,” he said. But he added that a client who works with Annuity Review may actually end up costing the insurers less money than someone who kept their contract and invested too conservatively.

 “We have a client whose guaranteed benefit base was higher than his account value, and all his money was in an intermediate-term bond fund. With interest rates where they are today, there’s no chance that his portfolio [will ever grow fast enough to cover the cost of the guarantee]. By putting him in a 70/30 stock/bond mix, we’re increasing the probability that the account will grow and the insurer will never pay him anything.”

Although Cortazzo doesn’t find the value propositions of today’s de-risked variable annuity contracts as alluring as earlier contracts, he still thinks VA living benefits are worthwhile from a behavioral finance point of view. They provide peace-of-mind for older investors who would otherwise pull their money out of equities at the first sign of a downturn.  

Cortazzo was asked if any VA issuers have complained about Annuity Review.

“We haven’t had any negative responses from insurance companies,” he said. “One insurer reached out to us to see what we thought about their product, and to ask if we could work with them on new product development. But our approach has been to focus on the RIA community.”

© 2013 RIJ Publishing LLC. All rights reserved.