Archives: Articles

IssueM Articles

Fed’s Bubbles to Slaughter Middle Class

Posted on March 17, 2013 by Michael Pento -

When central bankers dedicate their existence to re-inflating asset bubbles, it shouldn’t at all be a surprise to investors that they eventually achieve success. Ben Bernanke has aggressively attempted to prop up the real estate and equity markets since 2008. His efforts to increase the broader money supply and create inflation have finally supported home prices, sent the Dow Jones Industrial average to a record nominal high and propelled the bond bubble to dizzying heights.

The price of any commodity is highly influential towards its consumption. This concept is no different when applied to money and its borrowing costs. Therefore, one of the most important factors in determining money supply growth is the level of interest rates. The Federal Reserve artificially pushed the cost of money down to 1% during the time frame of June 2003 thru June 2004. It is vitally important to note that these low interest rates were not due to a savings glut; but were rather created by central bank purchases of assets. This low cost of borrowed funds affected consumers’ behavior towards debt and was the primary reason for the massive real estate bubble.

Today, the Fed Funds rate has been pushed even lower than it was in the early 2000’s. In addition, unlike a decade ago when the Fed held the overnight lending rate at 1% for “just” one year, the central bank is in the process of pegging short-term rates at near zero percent for what will amount to be at least seven years. However, this time the primary borrower of the central bank’s cheap money isn’t consumers as much as it is the Federal government. Mr. Bernanke has already increased the monetary base by over $2 trillion since the Great Recession began in late 2007, which has helped cause the M2 money supply to grow by $3 trillion–an increase of 40%!

Therefore, it isn’t such a mystery as to why there are now partying down on Wall Street like it is 1999; and we are once again amused with anecdotes of real estate buyers making millions flipping homes.

But all this money printing has not, nor will it ever, restore the economy to long-term prosperity. Despite the Fed’s efforts to spur the economy, GDP growth increased just 1.5% during all of 2012 and grew at an annual rate of just 0.1% during Q4 of last year. The future doesn’t bode much better. This year consumers have to deal with higher taxes, rising interest rates and record high gas prices for March. Don’t look for exports to rescue the economy either. Eurozone PMIs are firmly in contraction territory and Communist China is busy dictating the growth rate of the economy by building more empty cities—clearly an unsustainable and dangerous economic plan.

This means that the Federal Reserve will keep interest rates at record lows for significantly longer than the time it took to construct any of its previous bubbles. Also, the central bank will take years to reduce its $85 billion per month pace of monetary base expansion back to neutrality. Meanwhile, surging money growth will continue to force more air into the stock, real estate and bond markets for several years to come.

The ramifications for investors and the economy will be profound. Not only will the economy move gradually toward a pronounced condition of stagflation, but, more importantly, the bubbles being created by the Fed will be far greater and more devastating than any other in history. Equity and real estate prices are already stretched far beyond what their underlying fundamentals can support. But they are nothing compared with the distorted valuations being applied to U.S. sovereign debt. The bursting of the bond bubble will be exponential worse than the deflation brought on by the NASDAQ and real estate debacles. It is sad to conclude that the middle class is set up to get slaughtered even worse than they did when the previous two bubbles burst.

The economy is heading for unprecedented volatility between rampant inflation and deflation courtesy of Ben Bernanke’s sponsorship of the $7 trillion increase in new Federal debt since 2008. Investors need to plan now while they still have time before the economic chaos begins.

Michael Pento is president and founder of Pento Portfolio Strategies.

Montana Tax Strikers and Me

Posted on March 17, 2013 by Editor Test -

When I was a cub reporter covering the U.S. District Court in Billings, Montana, I encountered a cabal of men from Whitefish—a small town near Glacier Park in the northwest corner of the state—who called themselves Tax Strikers.

These strict Constitutionalists, vaguely associated with the home-grown militias that were popular at that time, had mailed an open letter to the federal judge—a rangy, stern, red-haired former Republican Congressman—in which they declared the illegality of the income tax and their intention not to pay it.

In Montana at that time, such eccentrics lived under almost every rock and tree. The sprawling, majestic state was an unofficial asylum for non-conformists from the crowded East. With all that open space, their anti-social tendencies easily went unnoticed.

The Unabomber, for example, once lived in a cabin near Lincoln, Montana.

So, when the Tax Strikers issued their manifesto, the effect was as momentous as the fall of a Ponderosa pine in a National Forest with no one around to hear. The federal judge ignored it. He ignored a follow-up letter and a third one as well.

Out of frustration at their inability to provoke a response, the would-be revolutionaries turned desperate. They threatened to take a mailman hostage. The court reluctantly stirred. One of the assistant U.S. Attorneys wrote up a complaint. A U.S. marshal drove to Whitefish to serve a summons.

While writing a check last week for my 2012 federal income taxes, I couldn’t help remembering those militant Tax Strikers from Whitefish. Unlike them, I am not bitter about the income tax. I’ve made my peace with it. Here’s why.

I’ve accepted the idea that the main purpose of the federal income tax is to control inflation. Federal tax—but not state or local tax—extinguishes money that would otherwise stay in circulation and drive up prices.

Wait—there’s a method to my madness. Contrary to conventional wisdom, it seems, spending comes before taxes, not the other way around. I’ve learned this from reading American history.

Before, during and after the Revolution, a variety of governmental bodies spent paper currency into existence. Recognizing the inflationary potential for such a policy, they arrangd to pull some of money back out of circulation each year by levying taxes that were payable in that currency.

Here’s one revealing anecdote. In 1766, the late treasurer of colonial Virginia, John Robinson, was found to have taken paper money tax receipts that he was officially required to burn and instead permanently “loaned” the cash to his friends among Virginia’s elite. The ensuing scandal briefly threatened to undermine the legitimacy of the colonists’ protests against England’s hated Stamp Act.[i]

Here’s another, more famous example. To fight the Revolutionary War, the Continental Congress issued a lot of bonds and paper money to pay for supplies and salaries. After the war, the government had to find a tax revenue stream in order to redeem the bonds. It did. It wrested the right to tax imports and exports away from the states.

Many people were unhappy with that arrangement, even though the new national government assumed the states’ war debts. But Alexander Hamilton, the first U.S. treasurer, had the epiphany that the central government would be helpless if it had to beg for revenue every time it needed money to pay for the things Congress had already voted to pay for.[ii]

What difference does it make if spending precedes taxes, or vice-versa? Either way, when the government spends more, it has to tax more, right? That’s true. But the sequence makes a big difference. If spending comes first, the government has lots of muscle, and the main purposes of federal taxes are to keep inflation down and to reassure bondholders.

If taxes came first, the government would perpetually be at the mercy of anti-tax activists, which was the case before Hamilton came along. (And is the case today, to some extent; witness the Fiscal Cliff and the Debt Ceiling crises.) Call me crazy, but I take comfort in the belief that my taxes help reduce inflation and reinforce the value of the dollar. It makes paying them less painful.

Here’s another way to look at: If Uncle Sam really needed to squeeze income taxes out of us in order to guarantee an uninterrupted flow of checks to military contractors, Social Security recipients, and featherbedding bureaucrats throughout the land, we would surely find ourselves facing a more aggressive Internal Revenue Service and harsher penalties for tax evasion.

And more aggressive judges. The U.S. District judge in Billings could afford to humor the Whitefish Tax Strikers, at least temporarily, in part because he knew that the country didn’t really need their income taxes. As for the Tax Strikers, they eventually appeared in federal court, looking surprisingly sheepish. I’m not sure what happened to them after that. Maybe they became survivalists.

[i] Einhorn, Robin L. American Taxation, American Slavery: Chicago, 2006.

[ii] Chernow, Ron. Alexander Hamilton: Penguin, 2004.

Stable Value Funds: Performance to Date – Part II

Posted on March 17, 2013 by David Babbel and Miguel Herce -

In Part I of our performance review of stable value investment funds (SVIF), we utilized mean-variance analysis in forming optimal asset allocations for six asset classes, including long-term government bonds, long-term corporate bonds, intermediate-term government/credit notes, large stocks, small stocks, and money markets.

We found that when SVIF were added to the mix, the efficient frontier was significantly improved, and that several asset classes were no longer included in any of the portfolios along the efficient frontier. We also used the Sharpe Ratio and the Sortino Ratio to compare the reward-to-risk ratios of the various asset classes, and found that SVIF scored the highest among all asset classes, and by a substantial margin.

Although widely used, the mean-variance framework and the performance ratios associated with it have serious limitations. Strictly speaking, their use is justified under conditions that are not even closely met in the real world.

Over the past 50 years, volumes have been written in the economic and financial literature on modifications to the mean-variance model, either based on different assumed utility shapes or on more realistic assumptions on return distributions, in an effort to address the deficiencies of the approach while retaining some of its attractive attributes.[1]

Stochastic dominance analysis

A powerful technique was developed in the 1970s to remedy the problems of mean-variance approaches. It is known as Stochastic Dominance (SD), and its validity depends on no particular asset return distribution nor any particular utility function.[2]

Stochastic Dominance comes in various degrees. First-degree stochastic dominance (FSD) imposes only one preference restriction—investors prefer more wealth to less wealth. If an asset class exhibits first-degree dominance over another asset class, it should be preferred by all investors, regardless of whether they are risk seekers, risk neutral, or risk averse, in any degree.

If an asset class exhibits second-degree dominance (SSD) over another asset class, it should be preferred by all who are risk-averse, in any degree. However, investors who are risk seekers or risk neutral may or may not prefer it.

Third-degree dominance (TSD) is for investors who prefer positive skewness of asset returns, and fourth-degree (4SD) takes into account the aversion most investors have for extreme return distributions, where positive and negative outcomes are just as likely.

The table below presents the SD results among the seven asset classes in our study, based solely on historical returns. Only the SVIF historical returns distribution dominates two asset classes in the stochastic dominance sense up to the fourth degree; none of the other asset classes dominates SVIF.

We see that SVIF stochastically dominated money market investments by the first-degree and by any higher degree as well. Consequently, any investor who preferred more wealth to less wealth should have avoided investing in money market funds when SV funds were available, irrespective of risk preferences.

However, over the longer time period beginning in 1973, SVIF did not dominate money market investments by the first-degree, yet they did dominate by second-degree and higher. This suggests that for investors with any degree of risk aversion, however slight or strong, SVIF should be preferred to money market investments.

Although SVIF failed to dominate intermediate-term government/credit notes by the first degree, they dominated by the second and higher degrees. This result is a direct consequence of the fact that positive intermediate-term bond returns during the period of our study were never large enough, relative to corresponding SVIF returns, to make at least some risk-averse investors prefer the riskier intermediate-term bond investment. When our time period of analysis was extended to 1973, the same dominance was maintained.

These results are remarkable. Not surprisingly, there is no stochastic dominance of any one traditional class over another; indeed dominance is rarely encountered among asset classes. Accordingly, it was surprising to find that SVIF dominated two of the major traditional investment classes.

Multi-period optimization analysis

Multi-period investment theory was developed decades ago in response to the drawbacks of single-period models such as the CAPM and others. Contributors to the theory and developers of investment models based on it included such luminaries as Paul Samuelson (MIT), Nils Hakansson and Hayne Leland (Berkeley), Steve Ross (Yale) and Gur Huberman (Columbia), among others.

Here we provide only an intuitive sense of its underpinnings and insights. Multi-period investment theory has been dubbed the Turnpike Theorem, and for a good reason. Consider the fastest way to drive from point A to point B, located a few miles distant. Generally, the most direct way along local roads is the quickest if the distance is short (assuming that a turnpike does not already connect the two points).

However, if point B is a long way from point A, say 20 or more miles, it might be faster to travel out of your way to connect to a turnpike or freeway, exit as close as possible to point B, and travel the rest of the way on local roads. This turnpike alternative generally becomes more and more attractive as the distance between point A and point B increases, and is almost certainly the preferred path to follow (if speed of arrival is of primary importance) when the distance exceeds a hundred or so miles.

Similarly, in multi-period investment theory, if one’s investment decisions are guided by a single-period optimization model such as the CAPM, among many others, the resulting wealth accumulation in the long run is very likely to be significantly lower than if one were to follow a dynamic investment model.

Dynamic models based on the theory are designed to maximize the investor’s expected utility of wealth where risk is measured by the degree of utility diminishment incurred from investing in risky assets. The economists referenced above uncovered a particular class of power utility functions that is consistent with maximizing long-term wealth for any level of risk aversion. Portfolios based upon such utility functions are known as turnpike portfolios.

One of the nicest features of such long-term investment models is that they are consistent with myopic behavior. In other words, if you invest this period according to the model, your behavior will be consistent with investing in a way that maximizes long-term wealth. However, if you follow investment models based on maximizing alternative utility of wealth functions or otherwise, you will do worse.

In this review we won’t rehearse the considerable safeguards we underwent in designing and implementing the dynamic model to assess asset performance.[3] Instead, we will simply present some representative results from which asset performance can be evaluated.

We derive the optimal asset allocations for each quarter based on the quarterly returns joint distribution across all asset classes considered from the prior 80 quarters. This length of time is sufficient to incorporate two or more business cycles, providing robust estimates. We use the full joint empirical return distribution of alternative investments in order to determine optimal wealth allocations that depend on the risk aversion parameter of the investor.

All moments of the joint distribution (e.g., mean, variance, skewness, kurtosis, etc.) are taken into account. The expected returns for the next quarter are derived from market data, but in the case of equities, the risk premium is an input reflecting the investor’s expectations. From this joint distribution, we apply the turnpike utility function to derive those asset allocations consistent with long-run maximization of utility of wealth.

Two fairly typical sets of outcomes are presented below. Each optimal asset allocation will depend on the investor’s level of risk aversion, ranging from 1 to 75 (logarithmic, or only slightly averse, to extremely risk intolerant), and across a variety of assumed annual equity risk premia on large stocks ranging from 2.5% to 5.5%.

Consistent with past research, we consider a risk index of 5 to be fairly moderate, although recent research suggests that the average risk aversion in the population is considerably higher, ranging from 20 to 45.

The figure below, for the first quarter of 2010, reveals that, with the exception of a very small proportion of long-term government bonds for moderate risk aversion levels when the large stocks premium is 5.5% per year, only small stocks and SVIF are relevant in the optimal portfolios, irrespective of the level of risk aversion.

As expected, SVIF represent a larger fraction of the optimal portfolio as risk aversion increases. Also as expected, a larger equity premium increases the proportion of small stocks in the optimal portfolio for any given risk aversion level.

Optimal Portfolio Weights

Next we show optimal portfolios for the third quarter of 2008, again using data for the 80 quarters that precede it. The figure below shows the optimal portfolio weights for selected values of the risk parameter, and selected large stocks expected annual risk premiums.

Optimal Portfolio Weights 2

Even though expected returns across all asset classes were significantly different from those used in calculating the 2010 optimal weights, we observe roughly similar optimal allocations, with small stocks and SVIF being the only significant investment classes, except for a small fraction of long-term government bonds at higher large stocks premiums.

This pattern of optimal portfolios being comprised largely of SV and small stocks is not that uncommon, it turns out, when expected returns are based on historic spreads and current yields. In fact, in our three separate studies, we found these portfolios to be the norm, but with interesting occasional exceptions.[4]

The analyses we have conducted to date conclude that, for moderately and highly risk-averse investors, SVIF are, under reasonable yield curve assumptions, a major component of an optimal portfolio, to the exclusion of money market funds and the near exclusion of intermediate-term bonds.

Since their inception in 1973, SV funds have undergone several severe tests. They survived the market fallout from the OPEC cartels, the severe stock market declines of 1973-4, 2000-2002, the interest rate spikes of the early 80’s, the stock market crash of 1987, the liquidity and credit spread crisis of the late 90s, the plummeting interest rates of the 21^st century, economic booms and deep recessions, the terrorist challenges to financial markets in 2001, and countless other daunting circumstances. With very few exceptions, they appear to have weathered the recent financial crisis of 2007-8.

Concluding remarks

In Part I and Part II of our brief review, we found that despite the different focus of the three performance evaluation methodologies used, the results we obtained under each analysis reinforced each other in the sense that SVIF outperformed some of the alternative investments we considered across one or more dimensions.

Whether SFIV will be appropriate for your clients will depend on their levels of risk aversion, liquidity needs, and other elements of their asset portfolios. If a determination is made that SVIF could be a valuable element of their portfolio, an assessment of providers will need to be made.

David F. Babbel, professor emeritus, The Wharton School, Univ. of Pennsylvania, is a Senior Advisor to CRA (Charles River Associates) and leader of its Insurance Economics practice. Miguel A. Herce, Ph.D., is a Principal at Charles River Associates.

[1] Either of two strong assumptions can be used to justify reliance on the mean-variance approaches, and the CAPM in particular, to portfolio composition. If investor preferences (utility) can be accurately mapped by a quadratic function (which has a shape similar to the cross section of a dome, indicating that more wealth is preferred to less, but at a diminishing rate as wealth increases, and beyond some point of wealth attainment, less wealth is preferred to more wealth at an increasing rate of repugnance for wealth), or if asset returns can be adequately characterized by a Normal distribution, then the basic mean-variance models including CAPM are supported.

[2] The economic foundations and mathematical support for the stochastic dominance criteria and implementation are given by Haim Levy, Stochastic Dominance: Investment Decision Making under Uncertainty, 2^nd Edition, Springer, 2010.

[3] Our previous studies were published in the Working Papers Series of the Wharton Financial Institutions Center website (Babbel and Herce, 2007-#21, 2009-#25, 2011-#1). http://fic.wharton.upenn.edu/fic/papers.html The 2011 study features our most advanced implementation of the dynamic investment model.

[4] A thorough review is in Babbel and Herce, 2011, at: http://fic.wharton.upenn.edu/fic/papers/11/p1101.htm

Morningstar publishes 2012 Global Fund Flows report

Posted on March 14, 2013 by Editor Test -

“Despite ongoing worldwide economic uncertainty, the global fund management industry grew at a 3.9% organic growth rate in 2012. Excluding money market funds, USD 565 billion flowed into mutual funds during the year,” said Morningstar’s latest Global Fund Flows Report, which measures mutual fund assets in Australia, Canada, Europe, Japan and the U.S.

“These massive inflows, though, fell short of 2009 and 2010, which saw inflows of USD 746 billion and USD 672 billion, respectively,” the report said. “Moreover, the average management fee that the industry gathers from investors has fallen dramatically since 2007 due to the cyclical shift to fixed-income products and a secular inclination toward less expensive funds.”

“The prevailing global trend in 2012 was investors’ hunger for yield and quest for the perceived safety of fixed-income funds. Worldwide, fixed-income funds gathered USD 535 billion in 2012, or nearly 95% of long-term net inflows,” said Syl Flood, product manager, investment research for Morningstar.

The report also showed:

U.S. fixed income is by far the largest long-term global category, with nearly USD 2 trillion in assets under management (AUM). U.S. investors contributed USD 199 billion of the category’s USD 227 billion total inflow in 2012. The PIMCO Total Return fund is the world’s largest actively managed strategy, with USD 442 billion in assets (including assets managed for institutional clients).
In 2012, interest from cross-border investors propelled funds in the U.S. fixed-income category to a 47% organic growth rate. Many of the most popular offerings are tended by U.S.-based managers, including AllianceBernstein, Muzinich, Neuberger Berman and PIMCO.
While 78% of worldwide mutual fund and exchange-traded fund (ETF) AUM still resides in actively managed funds, passive products captured 41% of estimated net flows—USD 355 billion—in 2012. With the exception of Australia and New Zealand, index funds grew faster than actively managed funds in every geographic region during the year.
Newer funds—those without a three-year track record—captured 87% of worldwide inflows in 2012.
Vanguard and PIMCO took in 16% and 18%, respectively, of worldwide long-term mutual fund inflows in 2012.

The report examines each key market in detail, analyzing flows by attributes such as broad asset class, Morningstar category, and fund group, as well as new fund launches and the active versus passive dynamic in each market. The commentary encompasses the 71 domiciles in which Morningstar tracks fund flows, accounting for USD 20.7 trillion in assets, and touches on the USD 1.9 trillion ETF universe tracked by Morningstar, when applicable.

Western & Southern introduces ‘SmartStep’ fixed annuity

Posted on March 14, 2013 by Editor Test -

W&S Financial Group Distributors, Inc., the wholesale distributor of annuities and life insurance for Western & Southern Financial Group’s member insurance companies, has introduced a new single premium deferred annuity, SmartStep.

The product is aimed at the many Americans who are “sitting on the sidelines” with their money invested in short-term paper, waiting for rates to rise, W&S said in a release.

SmartStep offers four years of guaranteed rates: an initial rate set by the company at the time of issue, followed by three years of stepped-up rates. At the end of the guaranteed period, the contract will be credited with an annual renewal rate set by the company.

Contracts without a return of premium guarantee receive the initial rate in year one, the initial rate plus 40 basis points in year two, the initial rate plus 80 basis points in year three, and the initial rate plus 120 basis points in year four.

Contracts with a return of premium guarantee receive the initial rate in year one, the initial rate plus 15 basis points in year two, the initial rate plus 30 basis points in year three, and the initial rate plus 45 basis points in year four. A floor interest rate of 0.50% (1% in New York) is guaranteed for the life of the contract

The SmartStep SPFA also features:

An optional return-of-premium guarantee on surrender. (The cost of the guarantee is lower interest rate step-ups in contract years two through four.)
Optional annuitization for single or joint annuitants.
A guaranteed death benefit.
Provisions for limited access to free withdrawals.
A 7% surrender penalty for years one through three, 6% for year four, 5% for year five, 4% for year six and zero percent after.
A minimum premium of $20,000.
Contract availability for issue ages 18 through 89.

Western-Southern Life Assurance Company, Cincinnati, and National Integrity Life Insurance Company, Goshen, New York, both offer SmartStep. Both are units of Western & Southern, which is rated AA+ (Very Strong) by Standard & Poor’s.

Financial tremors shake Poland’s retirement pillars

Posted on March 14, 2013 by Editor Test -

Poland is struggling to maintain two shaky retirement “pillars” for its citizens: a first pillar similar to our Social Security system and a newer, voluntary pillar whose assets are invested in professionally-managed funds.

To help reduce a general budget deficit, the government has already had to divert contributions away from the second pillar, a defined contribution plan whose Polish acronym is OFE, to the Pay-As-You-Go first pillar, whose Polish acronym is ZUS.

The nation’s Labour and Social Policy Ministry is currently consulting the finance, economy and treasury ministries, the Social Security Institution (ZUS), the National Bank of Poland, the Polish Financial Supervision Authority (KNF) and the Warsaw Stock Exchange (WSE). Executives at Aviva and ING are also weighing in.

Since the financial crisis, the establishment of a viable second pillar has been hindered by fact that the ZUS fell into deficit. In 2011, the mandatory contribution to the OFE was cut to 2.3% from 7.3%, with the remaining 5% was sent to the ZUS. The OFE contribution rate has since risen to 2.8% in 2013 and is set to increase to 3.5% by 2017. Their accumulations in OFE funds are expected to provide 20-25% of a final pension for Poles.

The transfer helped reduce the government’s overall budget deficit, which the European Union has ordered it to reduce. But the diversion of money away from the OFE has negative implications for bank deposits, equity prices and ultimately Poland’s economy.

Pawel Pytel, chief executive of Aviva Pension Fund Management Company, said the OFE money should remain invested on the capital markets, and not get swallowed by the ZUS, whose deficit is projected to nearly double by 2020.

“Future taxes and employee contributions will have to rise to secure the first pillar’s liabilities,” Pytel told IPE.com. “We can generate better returns than the current ZUS indexation, and, from a client’s view, it’s safer if there are two sources of financing future pensions.”

A further shift of funds to the ZUS from the OFE would require the OFE’s fund management companies to sell off assets, potentially lowering securities prices. In any case, there will be less money flowing into the OFE, since participants approaching retirement are expected to make progressively smaller contributions.

“There will be huge implications for the capital markets and Poland’s GDP,” said Grzegorz Chłopek, president of the board and chief executive at ING PTE, if money is drained from the OFE investment funds.

He predicted reduced bank liquidity, less co-financing of infrastructure projects, a smaller market for IPOs and SPOs on the Warsaw Stock Exchange, and problems for the bond market. “After several years, we will see a deep recession due to lack of stable long-term capital enabled for borrowers,” he said.

DC fee disclosure has little impact: LIMRA

Posted on March 14, 2013 by Editor Test -

Half of defined contribution (DC) participants still do not know how much they pay in plan annual fees and expenses, a proportion that appears unchanged by the implementation of fee disclosure regulations in 2012, according to LIMRA, the Life Insurance Marketing Research Association.

LIMRA surveyed DC plan participants before and after plan participants received information about their plans’ fees and expenses to determine how effective the disclosure statements were and how participants would react.

Prior to receiving disclosure notices, 50% of participants said they did not know how much they paid in fees and expenses; the same portion did not know subsequent to receiving the notices.

“The disclosure notices — or the discussion of them — did seem to improve the knowledge of those who believed they didn’t pay any fees or expenses,” said Alison Salka, corporate vice president and director of LIMRA Retirement Research.

“There are nearly 75 million workers who participate in defined contribution plans in the United States. Our study found that 22% of participants believed they didn’t pay fees and expenses after receiving disclosure notices, compared with the 38% in our first survey, prior to disclosures going out.”

The study found that many participants overestimated the amount of fees and expenses they pay in their DC plans. Forty-two percent of participants believe they pay 10% or more — with over a quarter of participants believing they paid 25% or more in fees and expenses.

On average, DC plan fees and expenses range between 1-2 percent, depending on the size of the plan and the participants’ allocation choices. LIMRA’s study found that less than one in three participants who thought they knew how much they paid estimated their fees and expenses to be under two percent.

The survey found that 7 in 10 participants who said they knew they paid fees and expenses believed those fees and expenses to be reasonable, similar to what LIMRA found in its survey prior to the disclosure notices being sent

“There was much speculation on how consumers would respond to the disclosure notices, yet our consumer surveys and discussions with plan service providers indicate that there has been limited reaction to learning about their fees and expenses,” noted Salka.

Fidelity the target of new lawsuits over float income in 401(k) plans

Posted on March 14, 2013 by Editor Test -

A putative Class Action Complaint was filed in the United States District Court for the District of Massachusetts last week, accusing Fidelity Management and Trust Company and others of fiduciary breaches over its handling of float income, according to press reports.

The suit was filed by participants in 401(k) plans from Bank of America, EMC Corp. and Safety Insurance Co., and it contains similar allegations to another suit, filed in the Boston federal court February 5, by current or former participants of plans from Hewlett-Packard Co., Delta Air Lines Inc. and Avanade Inc., a subsidiary of Accenture.

The February 5 suit was filed for Timothy Kelley (an ex-participant in the Avanade and Hewlett-Packard 401(k) plans) and Jamie Fine (a participant in the Delta 401(k) plan), but class action status is being sought on behalf of all Fidelity 401(k) participants, not just participants in the Avanade, Delta and HP plans.

According to the February 5 complaint:

Fidelity caused certain of the Plans’ assets to be deposited on an interim basis in interest-bearing accounts before it invested or disbursed monies as directed by the Plans’ participants. Income earned on or derived from the Plans’ assets while invested in such accounts is “float income.” The float income was an asset of the Plans under ERISA. Fidelity exercised discretion and control over the investment of the Plans’ assets in such accounts and over the collection and allocation of float income. Accordingly, Fidelity was a fiduciary for the Plans with respect to the float income. As a fiduciary, Fidelity was prohibited from dealing with the float income for itself or for the benefit of another and was required to deal with that float income with prudence and unflagging loyalty. Fidelity did not. Instead, it engaged in prohibited transactions and breached its fiduciary duty in two distinct ways.

First, Fidelity used float income to pay itself trust and record-keeping fees above and beyond the fees authorized in the trust agreements between the Plans and Fidelity. Thus, Fidelity engaged in repeated self-dealing transactions and breaches of duty in violation of § 406 and § 404 of ERISA whenever it paid itself float income.

Second, Fidelity remitted float income into the mutual fund options selected by the Plans’ participants without crediting the amount of that float income to the contributions made by Plans or the Plans’ participants. This had the effect of disseminating the value of the float income generated by the Plans’ assets to all of the investors in the mutual fund, and substantially diluting the value of the float income received by the Plans and the Plans’ participants. Thus, Fidelity engaged in repeated transactions for the benefit of others and breaches of duty in violation of § 406 and § 404 of ERISA whenever it invested float income into its mutual funds.

Both float-income suits refer to a March 2012 opinion of a judge in U.S. District Court in Kansas City, Mo., in a lawsuit by plan participants against ABB Inc., Cary, N.C., and Fidelity. The judge ruled that Fidelity had “breached its fiduciary duties” in the use of float income, and ordered Fidelity to pay the plan $1.7 million. Fidelity is appealing the decision.

“Our practices are in compliance with ERISA and DOL guidelines,” Jennifer Engle, a Fidelity spokeswoman, told Pensions & Investments magazine. “We believe that the practices described in the lawsuit are consistent with the law and fair to all parties and that we provide valuable services to 401(k) clients for whom Fidelity serves as a record keeper and trustee.”

When the Empire Didn’t Strike Back

Posted on March 14, 2013 by Martin Hutchinson -

Benn Steil’s excellent new study The Battle of Bretton Woods (Princeton, 2013) focuses on the 1944 global monetary conference as a struggle between its two principal protagonists, the U.S. Treasury’s Harry Dexter White, and Britain’s celebrity economist, Maynard Lord Keynes.

Even Steil, an American who has considerable sympathy with Keynes, is quite clear that he lost, playing a bad hand poorly. To this British-born columnist with less sympathy for Keynes’ bizarre economic beliefs, his Bretton Woods performance was not merely a defeat, it was a historic disaster.

Britain went into the Bretton Woods negotiations with an unfounded belief in the goodwill of Franklin Roosevelt’s administration. Churchill had, a few years earlier, described the U.S. Lend-Lease arrangements as “the most unsordid act in the whole of recorded history.”

In reality the Lend-Lease arrangements of 1940-41 were designed to leave Britain as close to insolvency as possible while she wore out her economy and people in a life-and-death struggle that had little relevance to particular British interests.

Keynes himself had been notably uninvolved in the British economic successes of the 1930s, but had been brought back into influence only at the outbreak of war, when Chamberlain’s pacific free-market approach to Britain’s needs seemed discredited.

He was philosophically opposed to the centerpiece of British 1930s policy, the Imperial Preference agreements of 1932, which had finally ended the unilateral trade disarmament of 1846-1932 and imposed a modest 10% tariff on imports to the Empire and Dominions to combat the tariffs of 50% and more imposed by Britain’s trading partners, notably the United States under the 1930 Smoot-Hawley tariff.

Keynes was also philosophically opposed to private-sector bankers, refusing to negotiate a possible post-war loan with Wall Street, which would have greatly increased his bargaining power at Bretton Woods. He apparently failed to perceive that Britain’s interests coincided in many respects with Wall Street’s, since both groups wanted to avoid a post-war financial system dominated by the public sector bureaucrats of Washington.

Finally, Keynes was opposed to the pre-World War I Gold Standard, and also to a floating exchange rate system, typically wanting a system in which exchange rates would be determined by a superior group of public sector mandarins. He also favored a new currency, “bancor,” which the mandarins could create through the IMF, which would prevent a repeat of the deflation of the 1930s.

On the American side, White (who we now know was an active Soviet agent) and his boss Treasury Secretary Henry Morgenthau were convinced that much of the U.S. misery in the 1930s had been due to British and French “competitive devaluation,” so they were determined to establish a system of fixed exchange rates.

White (who was unpleasant and intellectually misguided, but not corrupt) also believed that the Soviet economic system was the wave of the future, to which we were all converging – perhaps not as lunatic a belief in the middle of World War II as it seems today – and so was determined to help that convergence along as far as he could.

He therefore wanted Imperial Preference dismantled, a fixed gold/dollar exchange rate system that gave the U.S. dollar primacy as the only reserve currency, and a World Bank/IMF that could lend money but not create it. He opposed Keynes’ “bancor,” since that would weaken the position of the dollar and effectively act as a hidden subsidy from the U.S. (the only fully solvent economy) to everyone else.

A negotiator with Britain’s true economic interests at heart would not have allowed chimerical new schemes of international finance to dominate the conference, but would have focused on Britain’s three crucial interests:

The preservation of Imperial Preference
The largest possible post-war loan
Permission for an immediate sterling devaluation similar to the 30% fall which became inevitable in 1949

Imperial Preference had proved its value in the 1930s, in allowing a modest reciprocal arrangement against the still gigantic American tariffs, so that British manufacturers had a chance in Empire, Dominion and later Commonwealth markets of competing against U.S. products that had built huge efficiencies of scale behind their high tariff wall.

Britain would have had its own free-trade area that was well designed to balance its raw-material-poor manufacturing and service economy. Joining the European Economic Community would have been superfluous and indeed obviously economically counterproductive.

When Keynes came to focus on Britain’s postwar loan, in 1945, he concentrated fanatically on the interest rate, demanding an interest-free loan instead of the 50 years at 2% that was on offer. In consequence he obtained a loan of only $3.5 billion instead of the $5 billion Britain needed—with conditionality of restoring full convertibility of sterling in July 1947, an impossibly early date.

A better negotiator would have opened negotiations with Wall Street, securing a $5 billion commitment, which appeared to be available, and then negotiated with the U.S. Treasury only for a top-up, sufficient to carry Britain through to 1950 or so, when private markets would be functioning properly again.

Finally, since both sides were determined to abandon a true gold standard (because of its automaticity and deflationary nature), Keynes should have pressed for floating exchange rates (which Britain almost introduced in 1952 by the “Robot” scheme, but alas wimped out of). At a minimum a good negotiator would have insisted on a 1949-style devaluation immediately.

As for the World Bank and IMF, a good negotiator would have avoided setting up these useless bodies altogether. Without (until 1968 with Special Drawing Rights) the ability to create Keynes’ bancor, they did nothing useful to solve Britain’s dollar shortage problem in the post-war years.

Moreover, once they got going they provided and have continued to provide subsidized competition to London merchant banks, which in the pre-1914 Gold Standard world had made a very good business out of providing advice and arranging loans for the world’s emerging markets.

With sterling freely convertible at a floating exchange rate after, say, 1950 there was no reason why the merchant banks could not have resumed this business, driving out their domestically-oriented and undercapitalized U.S. cousins who had gained a position in the business in the 1920s.

The merchant banks would have had a much larger fee income, and would thereby have been saved from the depredations of the 1986 “Big Bang” while emerging markets would have received advice that helped rather than hindered their development—and far fewer opportunities for the local elites to siphon off loan monies.

The drawbacks of Keynes’ approach were recognized by clear thinkers at the time. Leo Amery, Secretary of State for India, wrote in a Cabinet memo: “We must be free to take whatever measures we think necessary to the safeguard of our own production, to develop Imperial Preference, to use our bargaining power with foreign countries, and to strengthen that wonderful monetary instrument the sterling system. We must enter into no international commitments which in any way limit that freedom.”

White and Morgenthau became notorious in 1944-45 by their “Morgenthau Plan” which would have stripped Germany of industry, thereby leaving Soviet tanks a clear run to the Channel ports. They didn’t get to implement that one—but by the Bretton Woods Agreement, with the aid of the vain and foolish Keynes, they did just about as much damage to the British economy, damage that lasted until exchange controls were lifted in the early days of Margaret Thatcher.

Martin Hutchinson is the author of “Great Conservatives” (Academica Press, 2005). This article appeared unabridged at prudentbear.com.

Distribution of Wealth in the U.S.

Posted on March 13, 2013 by Editor Test -

Where the Wealth Is

Posted on March 13, 2013 by Kerry Pechter -

Despite the fines they’ve paid, their high fees and their resistance to a fiduciary standard, the so-called wirehouses—Merrill Lynch, Morgan Stanley, Wells Fargo, UBS, etc.—still control the lion’s share of professionally managed wealth in the U.S.

While employing only about 16.3% of all advisers and brokers, the wirehouses direct the investment of about 41.1% of the $27.3 trillion that’s “addressable” by advisors in the U.S. according to the latest report from Boston-based Cerulli Associates.

Asset managers—including mutual fund manufacturers—must therefore include wirehouses in their distribution strategies, even though, as Cerulli notes, they “have raised the cost of doing business through higher platform placement fees and more expensive revenue sharing agreements.”

That situation is changing, but only at the margins, said the proprietary report, titled, “The State of U.S. Retail and Institutional Asset Management 2012.” Wirehouse assets shrank by 0.3% from 2011 to 2012, as many advisors fled or got laid off in the wake of the financial crisis, taking some of their clients along.

Components of U.S. Asset Market

(Investment vehicles with the most assets, with highest dollar amount at the top)

Institutional separate accounts

Open-end mutual funds

Money markets

Hedge funds

Collective trust funds

ETFs

Subadvisory: Mutual funds

Fixed annuities

Variable insurance trusts

Subadvisory: Retail separate accounts

Closed-end mutual funds

Open program retail separate accounts

Non-traded REITs

Model retail separate accounts

ETNs

Source: Cerulli Quantitative Update: The State of U.S. Retail and Institutional Asset Management 2012.

Where are they going? The advisor-distribution channels that grew the most in 2012 were the RIA (Registered Investment Advisor) channel (assets up 14.7%) and the overlapping “dually registered” channel (up 19.1%), whose advisors are both FINRA-registered brokers and SEC-registered investment advisors. But those two channels combined handle only about 20.1% of total AUM and 14.9% of advisors, according to Cerulli, and they’re highly fragmented.

State the financial union

The main point of the Cerulli report is to show the size and strength of the various advisor-led distribution channels. “The report is meant to be a ‘state of the union’ of domestic markets,” its author, Cerulli associate director Tyler Cloherty told RIJ this week.

“Asset managers are asking, ‘What are our distribution options? How large are they? Are they growing or shrinking?’ We’ve seen that the RIA and the dually-registered advisor channel are growing faster than any other part of the market,” he said. “So asset managers might want to tailor their products to the needs of those two segments of the distribution marketplace,” he added.

But the proprietary report—RIJ saw only excerpts—offers a detailed snapshot of the institutions and the products where most of America’s investments are held. (Cerulli estimates that U.S. invested assets may be worth as much as $36 trillion, with only about three-quarters of that “addressable” by asset managers and advisors.)

According to the Flow of Funds Accounts of the U.S., March 7, 2013, personal financial assets in the U.S. at the end of 2012 was $50.13 trillion, and “household net worth—the difference between the value of households’ assets and liabilities—was about $66.0 trillion at the end of the fourth quarter of 2012, $1.1 trillion more than at the end of the third quarter.”

That wealth isn’t evenly distributed. According to “An Analysis of the Distribution of Wealth Across Households,” a July 17, 2012 report by the Congressional Research Service, 34% is in the hands of the richest one percent of Americans and the richest 10% hold almost three-quarters of it.

“The share of wealth held by the top 10% of wealth owners grew from 67.2% in 1989 to 74.5% in 2010. Declines occurred in the remaining 90% of households. The share of total net worth owned by households in the 50th to 90th percentile of the wealth distribution fell from 29.9% in 1989 to 24.3% in 2010, and the share of households in the bottom half fell from 3.0% to 1.1%,” the report said.

The Cerulli report also looked at how U.S. financial wealth is divided among different investment products. Institutional separate accounts and open-end mutual funds are the by far two biggest categories, with about $13.8 trillion between them. Both saw minor asset shrinkage in 2012 after three years of double-digit growth.

The two fastest-growing categories in 2012 were “model retail separate accounts” and “open program separate accounts, but both started from a very low base compared with open-end mutual funds and institutional separate accounts.

One of the main takeaways from the Cerulli report: Asset managers need to fine-tune their sales approach if they want to shift some of their resources from the wirehouse advisors to the RIAs and dually-registered advisors.

“These advisors operate their own independent practices,” Cloherty told RIJ. “They don’t have as much institutional support as an advisor at a wirehouse like UBS or Merrill Lynch. To get that kind of technology or research support they have to buy it themselves. Consequently, they may need more support from their asset manager partners in terms of macroeconomic research or marketing support.”

A change in pitch

The shift from wirehouse to RIAs and dually-registered advisors also involves a shift from the suitability standard to the fiduciary standard, and that has an impact on how asset managers and their wholesalers make their pitches.

“The asset managers are all moving toward the consultant approach, where they frame the macroeconomic environment and show try to show their customers where their product fits into their strategic outlook. It’s distinct from the commission-based formula where you say, ‘Here’s the product, buy our product,’” Cloherty said.

“In the fee-based arena, the salesperson or wholesaler needs more quantitative ability. He or she needs to move away from the mindset of, ‘I need to create sale activity.’ Now that intermediary is an advisor and a fiduciary.”

Despite their bad publicity and high fees, the wirehouses still have a grip on investors because of their strong brands and long-term relationships with clients, Cloherty pointed out. The wirehouses also benefit from the fact that most clients don’t understand how advisors get paid or what ethical standards they observe.

“Clients tend to separate their relationships with their advisors from their opinions about the firm. A client might say, ‘I’ve read about XYZ wirehouse acting in ethically dubious ways. But I know my advisor down at the local office would never do anything that wasn’t in my interest,’” he told RIJ.

“People don’t understand the difference between a fiduciary or a suitability standard. Clients have no idea how their advisors are compensated. They don’t understand how the firm’s proprietary products might harm them, and they don’t understand the pressure on wirehouse advisors to push the products that the wirehouse underwrites.

The link between underwriting and the suitability standard is strong. “That’s why you see so much lobbying against the fiduciary standard. It would blow up the way [the wirehouses] do business,” Cloherty said.

“The wirehouses still have brand recognition, but they are under pressure. Some of the clients are drifting away because they see the firms’ names in the paper every day. A bigger factor is that advisors are leaving the wirehouses because they don’t like forcing products down people’s throats.”

But the confusion about ethical standards apparently doesn’t end there, Cloherty added. “As advisors leave the wirehouses and move to the independent channel, they tell their client, I’m a fiduciary now. The client says, ‘I thought you were always a fiduciary.’”

More chatter about ‘defined ambition’ plans in the UK

Posted on March 7, 2013 by Editor Test -

The UK’s pension minister, who has proposed a “defined ambition” approach to retirement funding that would spread longevity and investment risk among plan providers and plan participants, says the private sector might need public help in underwriting the guarantees that such plans would entail.

Speaking at a joint OECD/Pension Institute conference on defined contribution, Steve Webb said that a government-backed DC protection fund could be the best way to allow for cheap guarantees due to the “challenges” posed by the solvency requirements for private sector approaches.

“If we are going to have financial guarantees, they have got to be backed,” Webb told a joint OECD/Pensions Institute conference on DC, guarantees and risk sharing yesterday. “Backing through solvency is very, very expensive.”

He said individual banks had discussed with his department how best to achieve guarantees and that the Department for Work & Pensions (DWP) had been examining both the possibility of private and quasi-government solutions – the latter of which, he said, were potentially more able to provide security “cheaply.”

Speaking at the same event, the chairman of the National Employment Savings Trust (NEST) Lawrence Churchill praised the proposed DC Pension Protection Fund (PPF), which Webb has described as a “smoothing fund” for participant outcomes.

He appeared to view greater risk sharing as a possible route, telling attendees: “We do need a better solution than merely transferring all of that risk onto those who don’t understand it.”

But Tim Jones, chief executive of NEST, noted that NEST had considered introducing a level of guarantee, but decided against it. He appeared to favor higher contributions by members rather than guarantees. He said it was important for “people to put more money in and to put that extra money to harder work.”

Cerulli surveys global DC trends

Posted on March 7, 2013 by Editor Test -

Global defined contribution (DC) assets should reach US$13.7 trillion by 2016, according to the latest report from Cerulli Associates. By then, Australia will be the third-largest market after the United States and the United Kingdom.

In other Cerulli findings:

The United Kingdom is the only market with assets in excess of US$1 trillion that is expected to have double-digit growth. Asia ex-Japan shows immense potential with Korea and Taiwan registering the strongest growth rates across the region. China, Hong Kong, and Thailand are expected to grow more than 10%.

Europe has the greatest immediate potential for growth. The region is forecast to have more than US$6.8 billion in assets under management in 2013. The United Kingdom and the Netherlands have the greatest potential, but Poland also offers huge opportunities. Managers can tap growth in disparate markets, but local knowledge, language skills, and after-sales service are needed to access the addressable assets. While it is possible to identify common themes, much also depends on a country’s regulatory environment and investment heritage.

“Performance is considered an important attribute by most European trustees and consultants, but low fees act as a trump card in competitive tenders in Italy,” says Barbara Wall, director at Cerulli Associates. “In Germany it is steadiness of returns and a coherent investment strategy that win. In the Netherlands and the Nordic region expertise in proven alpha niches is a competitive advantage, whereas in France it is an association with an insurance company that holds sway.”

In other findings:

In the United States, United Kingdom, and Latin America, consultants are the most important gatekeepers. In contrast, their role is less significant in Asia and continental Europe, where banks and insurance companies are the primary gatekeepers. Auto-enrollment in the United Kingdom opens the door to platforms, which will be particularly appealing to employers keen to outsource complex and time-consuming processes.
In the United States, as income from defined benefit schemes dwindles, consultants’ interests in DC plans clashes with retirement specialist advisors. Advisors are moving up-market from small plans and have developed fee-for-service models. Cerulli research indicates that there are more than 3,000 specialist advisors in the United States, of which about 600 teams demonstrate consultant-like characteristics. Opportunities for consultants in Brazil, meanwhile, are likely to mushroom as rules on international investing are liberalized.
Pressure on fees is one trend that is close to being universal. Most of the investors polled in the Nordic region, the United Kingdom, and the Netherlands told Cerulli the crisis has prompted them to negotiate fees more vigorously. These same interviewees also said they were prepared to share extra returns with managers who could deliver stable performance. Continuity in returns was the common requirement and a key to new business.

US at rear of peloton in retirement security: Natixis

Posted on March 7, 2013 by Editor Test -

The United States ranks 19th worldwide in the retirement security of its citizens, according to a new annual index compiled by Natixis Global Asset Management (NGAM), the world’s 13^th largest investment management firm.

The Natixis Global Retirement Index gauges how well retired citizens live in 150 nations, based on measures of health, material wellbeing, finances and other factors. The study was released today by the NGAM Durable Portfolio Research Center, which conducts research on risk management, asset allocation and other investment issues.

Though the U.S. is the world’s biggest pension market, it lags behind less-affluent nations on measures of income and health, according to the index. While the U.S. leads the world in per-capita health spending, individuals are still responsible for a portion of this expense.

Western European nations with universal health care and retiree social programs dominate the top of the rankings, taking the first 10 spots. Norway is first overall, followed by Switzerland, Luxembourg, Sweden and Austria. Australia is the highest-ranked non-European country, followed by Israel and Canada. The U.S. finished ahead of the United Kingdom, but trailed the Czech Republic and Slovakia.

Demographic challenges
Like many other nations, the U.S. is grappling with significant demographic change, including a rapidly aging population, rising life expectancy rates and declining birth rates. Globally, the number of people aged 65 or older is on track to triple by 2050, when the ratio of the working-age population to those over 65 in the U.S. is expected to drop from 5-to-1 to 2.8-to-1.

According to a recent Senate report, the U.S. faces a retirement savings deficit of $6.6 trillion, or nearly $57,000 per household. As a result, 53% of American workers 30 and older may be unprepared for retirement, up significantly from 38% in 2011.

Only half of all workers have access to employer-sponsored plans, and those who do participate often make the common mistakes of saving too little or investing too much in lower-returning products.

The Natixis Global Retirement Index is a composite index that combines 20 indicators grouped into four major categories: health; material well-being; quality of life in retirement; and finances.

CoreData Research, a London-based financial research firm, captured data from a variety of sources, calculated a mean score in each category and combined the category scores for a final overall ranking of 150 nations.

The categories, and the subjects they comprise, are:

Health: Per-capita health spending, life expectancy, the availability of physicians and hospital beds per 1,000 citizens, and the level of noninsured health spending. (Sources: World Bank’s Development Indicators, 2012; World Health Organization)
Material well-being: Per-capita income, income inequality and unemployment. (Source: World Bank)
Finances: Old-age dependency (the ratio of retirees to workers), inflation, interest rates, taxation level and bank nonperforming loans. (Sources: World Bank, United Nations)
Quality of life: The level of happiness and satisfaction of citizens, as well as the quality of the climate and environment. (Sources: Gallup World Poll 2012; Environmental Performance Index 2012)

New FIA from ING U.S. offers living benefit and deferral bonuses

Posted on March 7, 2013 by Editor Test -

ING U.S. has launched the ING Lifetime Income single premium deferred fixed annuity, issued by ING USA Annuity and Life Insurance Company (ING USA).

ING U.S. currently offers an in-plan guaranteed income investment option for 401(k) participants as well as a series of retirement income planning and education resources for ING Financial Partners’ financial advisors.

“ING USA’s new deferred fixed product rewards those who have the ability to postpone their income withdrawals, by stepping up their future available income withdrawal amount. If their needs shift, the individual can access a portion of the funds along the way although this will result in reduced future income withdrawal amounts,” said Chad Tope, president of ING U.S. Annuity and Asset Sales.

The ING Lifetime Income annuity offers two deferral bonus opportunities. If income payments are deferred for five years, the available income withdrawal amount is boosted by 150%. With a ten-year deferral, the available income withdrawal amount gets a guaranteed boost of 225%.

Another potential growth feature is linked to changes in the S&P 500® Index. If the S&P 500 Index is higher at the end of a contract year than at the beginning, the available income amount increases by this percentage subject to an annual cap on the amount of this increase. The index cap is currently 6% and is fixed for the life of the contract. ING may declare a different index cap in the future for new contracts.

While there is upside potential, the income amount will not be decreased as a result of a decline in the S&P 500 over the course of the year. The step up benefit and index-linked growth increase the benefit value, which is used to determine the income withdrawal amount only and do not increase the contract’s account value.

The income amount has the potential to grow until lifetime income withdrawals start, at which point the amount is locked in and the income withdrawals will continue for an individual’s lifetime, or the lives of two spouses if there are joint owners. An optional death benefit grows in a similar way, providing protection for beneficiaries and helping with legacy planning.

Forethought Launches ‘ForeRetirement’ VA

Posted on March 7, 2013 by Editor Test -

The life insurance unit of Houston-based Forethought Financial has launched the ForeRetirement variable annuity with “daily benefit options.” The contract, which marks the company’s first entry into the VA market since acquiring The Hartford’s annuity business, is available in B, C and L shares.

ForeRetirement will be distributed in partnership with national, regional and independent broker/dealers, as well as banks. It has been approved in 49 states and the District of Columbia, covering all jurisdictions where Forethought Life Insurance Company issues variable annuity business.

The contract’s “Daily Lock Income Benefit” guarantees lifetime withdrawals for retirees as a percentage of the benefit base, which can grow through favorable investment performance. The benefit captures new contract value highs on a daily basis, known as “step-ups,” to age 90, with a minimum deferral bonus of 6% simple interest credited until the 10^th contract anniversary or the first withdrawal if sooner.

Contract owners who elect the income benefit can also elect the “Legacy Lock” death benefit option. It allows contract owners to provide beneficiaries with death benefit proceeds at least equal to the amount of premium invested. The death benefit will not reduce for withdrawals, unlike traditional annuity death benefits, as long as the benefit’s requirements and guidelines are met.

Two Dollar Fallacies

Posted on March 7, 2013 by Martin Feldstein -

The United States’ current fiscal and monetary policies are unsustainable. The US government’s net debt as a share of GDP has doubled in the past five years, and the ratio is projected to be higher a decade from now, even if the economy has fully recovered and interest rates are in a normal range.

An aging US population will cause social benefits to rise rapidly, pushing the debt to more than 100% of GDP and accelerating its rate of increase. Although the Federal Reserve and foreign creditors like China are now financing the increase, their willingness to do so is not unlimited.

Likewise, the Fed’s policy of large-scale asset purchases has increased commercial banks’ excess reserves to unprecedented levels (approaching $2 trillion), and has driven the real interest rate on ten-year Treasury bonds to an unprecedented negative level. As the Fed acknowledges, this will have to stop and be reversed.

While the future evolution of these imbalances remains unclear, the result could eventually be a sharp rise in long-term interest rates and a substantial fall in the dollar’s value, driven mainly by foreign investors’ reluctance to continue expanding their holdings of US debt. American investors, fearing an unwinding of the fiscal and monetary positions, might contribute to these changes by seeking to shift their portfolios to assets of other countries.

While I share these concerns, others frequently rely on two key arguments to dismiss the fear of a run on the dollar: the dollar is a reserve currency, and it carries fewer risks than other currencies. Neither argument is persuasive.

Consider first the claim that the dollar’s status as a reserve currency protects it, because governments around the world need to hold dollars as foreign exchange reserves. The problem is that foreign holdings of dollar securities are no longer primarily “foreign exchange reserves” in the traditional sense.

In earlier decades, countries held dollars because they needed to have a highly liquid and widely accepted currency to bridge the financing gap if their imports exceeded their exports. The obvious candidate for this reserve fund was US Treasury bills.

But, since the late 1990’s, countries like South Korea, Taiwan, and Singapore have accumulated very large volumes of foreign reserves, reflecting both export-driven growth strategies and a desire to avoid a repeat of the speculative currency attacks that triggered the 1997-1998 Asian financial crisis. With each of these countries holding more than $200 billion in foreign-exchange holdings – and China holding more than $3 trillion – these are no longer funds intended to bridge trade-balance shortfalls. They are major national assets that must be invested with attention to yield and risk.

So, although dollar bonds and, increasingly, dollar equities are a large part of these countries’ sovereign wealth accounts, most of the dollar securities that they hold are not needed to finance trade imbalances. Even if these countries want to continue to hold a minimum core of their portfolios in a form that can be used in the traditional foreign-exchange role, most of their portfolios will respond to their perception of different currencies’ risks.

In short, the US no longer has what Valéry Giscard d’Estaing, as France’s finance minister in the 1960’s, accurately called the “exorbitant privilege” that stemmed from having a reserve currency as its legal tender.

But some argue that, even if the dollar is not protected by being a reserve currency, it is still safer than other currencies. If investors don’t want to hold euros, pounds, or yen, where else can they go?

That argument is also false. Large portfolio investors don’t put all of their funds in a single currency. They diversify their funds among different currencies and different types of financial assets. If they perceive that the dollar and dollar bonds have become riskier, they will want to change the distribution of assets in their portfolios. So, even if the dollar is still regarded as the safest of assets, the demand for dollars will decline if its relative safety is seen to have declined.

When that happens, exchange rates and interest rates can change without assets being sold and new assets bought. If foreign holders of dollar bonds become concerned that the unsustainability of America’s situation will lead to higher interest rates and a weaker dollar, they will want to sell dollar bonds. If that feeling is widespread, the value of the dollar and the price of dollar bonds can both decline without any net change in the holding of these assets.

The dollar’s real trade-weighted value already is more than 25% lower than it was a decade ago, notwithstanding the problems in Europe and in other countries. And, despite a more competitive exchange rate, the US continues to run a large current-account deficit. If progress is not made in reducing the projected fiscal imbalances and limiting the growth of bank reserves, reduced demand for dollar assets could cause the dollar to fall more rapidly and the interest rate on dollar securities to rise

Martin Feldstein is professor of economics at Harvard University and president emeritus of the National Bureau of Economic Research.

They Just Don’t Get It

Posted on March 7, 2013 by Editor Test -

At the ASPPA/NAPA 401(k) Summit in Las Vegas this week, you could hear a lot of defensive anger at the government and at academics for their efforts to shrink the tax expenditure for retirement savings or kill it entirely.

A cynic might accuse the retirement industry of biting the hand that feeds when it attacks Uncle Sam, since tax deferral is the mother’s milk of the business. But occupants of the House-that-ERISA-Built are not unjustified when they say that bureaucrats and Ivory Tower experts—my epithets, not theirs—don’t get it.

Here’s the disconnect. To certain policy kibitizers, Ivy League professors and reportedly the White House, some of the $50 billion to $70 billion that the government “spends” each year to incentivize Americans to save for retirement is wasted on upper-income DC plan participants who would have saved for retirement anyway.

These mainly liberal policymakers and academics would prefer to cap the tax break for well-to-do participants at 28% (compared with the maximum of 39.6%) and use some of the tax expenditure to help undersavers save more and/or to extend the availability of workplace retirement plans to the currently underserved half of the working population.

ASPPA (American Society of Pension Professionals and Actuaries), which lobbies on behalf of plan advisors and service providers, is particularly upset about last years’ “Danish” study, published by the National Bureau of Economic Research. In it, academics with excellent credentials produced evidence that tax incentives have little positive impact on the mass of participants.

What don’t the policymakers and academics understand? They don’t get that the 401(k) industry, like the beer industry or the fast food industry or the arts or the “gaming” industry, relies on its largest customers and contributors for a disproportionate amount of its revenues.

The biggest contributors to 401(k) plans cover a disproportion of the plan expenses (unless perhaps the plan has a flat administrative fee). And small business owners, the wealthiest of whom who can save almost $20,000 in taxes each year by contributing the maximum to their plans, are the ones who often decide whether to sponsor a plan for employees or not.

These are the people whom the retirement industry wants to incentivize—not to save more per se, but to support the 401(k) business. The industry wants to reward these crucial customers more. It understandably drives the industry nuts to hear New England professors and Beltway theorists proposing to reduce the incentives for high rollers. They’ll just take their chips someplace else.

But if the policymakers live in a utopian fantasy to some extent, so does the 401(k) industry. Its fantasy is that auto-enrollment and auto-escalation and behavioral tricks will propel the mass of participants to retirement with accounts fat enough to replace (along with Social Security) as much as 85% of their peak salaries every year from age 65 to age 90.

Of course they want people to save more—for the same reason that Starbuck’s wants you to drink more lattes. AUM drives their business. But only a slim minority of plan participants will ever save enough to finance a long retirement, let alone finance a rising share of their health care costs and legacies for their kids. Most people are going to need insurance products, as a component of overall savings, to help themselves and society deal with the cost of rising longevity.

Besides the rivalry between these utopian visions, another rivalry manifested itself at the ASPPA/NAPA Summit. That’s the rivalry between those who see the reform activities of the Department of Labor and the actions of plaintiff’s attorneys (the legal equivalents of short-sellers) as an opportunity and those who see them as threats.

It’s the rivalry between entrenched retirement interests, which desperately want to hold onto the increasingly-hard-to-justify extra 50 bps they’ve been surreptitiously charging participants for years, and the smaller service providers who hope to use the new climate of transparency and fee competition to steal business from the profiteers. It will be interesting to watch the game play out.

Cutting Longevity Tail Risk Down to Size

Posted on March 7, 2013 by Kerry Pechter -

Longevity tail risk is expensive, regardless of who has to finance the beast. Save for it, hedge against it, or pool it, it can be a heavy burden for individual retirees, for pension plans and even for national governments to bear.

Uncertainty about life spans is an age-old problem for which a bunch of new solutions have been suggested lately. One of the most recent proposals comes from a team of actuaries at Milliman, the global consulting firm.

In Longevity Plan, a white paper published last month, Milliman actuaries describe a design for a mini defined benefit plan that a plan sponsor could tuck inside a defined contribution plan like a donut tire in the trunk of a car.

Running parallel to a DC plan, this new type of plan would resemble a DB plan. But it would be cheaper and less risky than a traditional DB plan because accrual wouldn’t start until age 45 or so and payouts wouldn’t start until age 80 or 85.

This “unit-accrual design” is still just a concept, not a product. But the authors of the white paper think the only thing that prevents it from widespread adoption is an outdated ERISA regulation against delaying pension payouts past age 65.

“Everyone’s talking about this and lots of new products has been proposed,” said Bill Most, a Milliman principal who worked on the paper with principals Zorast Wadia and Daniel Theodore and consulting actuary Danny Quant.

“But we don’t need new products, we need changes from government. And the results will hopefully give us something that employers might embrace. We’re not kidding ourselves. We don’t deny that there’s a lot of bad faith toward defined benefit plans. But from a cost perspective, this makes sense.”

How it works

Milliman offers the following example for how such a plan would work. The plan sponsor would start contributing to a fund on behalf of an employee when the employee reaches age 45, and stop contributing at age 65. The pension would pay out about two-thirds of the participant’s final salary at age 80.

If the employee died after retiring but before age 80, a lump sum death benefit of three times the pension would be paid. If a married employee died after starting payments, the spouse would receive a 75% continuation.

The plan would be much cheaper than a traditional DB plan, and not merely because of the long deferral period. Because of the career plateau effect, salary paths after age 45 become much less variable. Also, the distribution of life expectancies after age 80 is narrower than at age 65. Less variability means lower risk and therefore lower cost for the underlying fund.

How much lower? According to Milliman, it would cost an employer about 10% of pay for a lifetime pension paying out two-thirds of final salary starting at age 65, with a 75% spousal continuation. The same pension based on career-average earnings would cost about 6.5% of pay.

But under Milliman’s longevity plan, the cost for the final-salary pension, including death benefit and spousal continuation would drop to 2.9% of pay. Without the death benefit, the plan would cost 2.4% of pay; without the death benefit or spousal continuation, the cost would drop to 2.1% of pay.

Between retirement age and age 80, the employee would presumably rely on Social Security and either systematic withdrawals from the defined contribution plan account or rollover IRA, or perhaps on a 15-year period certain annuity purchased with tax-deferred assets or personal savings.

Outside perspective

The Milliman actuaries don’t pretend that these concepts originated with them, as outside observers pointed out to RIJ. “All of the actuarial consulting firms have got some of their so-called ‘thought leaders’ imagining the ideal pension plan that combines the best of all worlds and universes,” said Moshe Milevsky, professor at York University in Toronto.

Milevsky wonders who will underwrite such plans. “Most of these ideas have been thrashed in the academic pension and economics literature, which few practitioners ever read. In general, I think everyone agrees that retiring with a ‘random variable,’ which is the amount of money in your DC plan, isn’t the way to finance a random lifetime. We all need more certainty. But who is going to provide that certainty? Who will back it?”

Wade Pfau, Ph.D., who is about to begin teaching advisors about retirement income planning at the American College in Bryn Mawr, Pa., likes the Milliman proposal. “I generally think that deferred income annuities (DIAs) have a lot of potential for helping to reduce longevity risk at a reasonable cost. That is what this proposal is about,” he told RIJ.

“[Milliman] takes the discussion in an interesting direction by talking about how to get something more sustainable for employers. One issue about DIAs, though, is that there are not currently any inflation-adjusted versions. Even a small difference between actual and assumed inflation can make the real value of future spending quite different than planned after 20 years of compounding.”

Currently, plan sponsors could not put the Milliman concept into practice even if they wanted to. Pension regulations, written decades ago to protect plan participants, don’t allow the deferral of defined benefit payouts past age 65.

“They’ve relaxed certain rules related to required minimum distributions starting at age 70½, but they have not made changes in the terms of defined benefit plans,” said Zorast Wadia. “If you’re no longer working, you must begin payments from a defined benefit plan no later than age 65. If you’re still working past age 65, they won’t force you to take benefits. But ERISA won’t let the company purposely delay payments beyond 65 if you’re retired.”

Milliman believes, as many retirement income experts now do, that self-insuring for retirement is too expensive, and that it’s going to take a revival of some form of defined benefit pension with mortality pooling to finance longevity tail risk.

“It’s not even disputable [that people will be able to save enough for a retirement of us to 30 years],” said Most. “It’s not going to happen, though 401(k) pp will tell you differently. Even if you save a substantial amount, you still don’t know when you’re going to die.”

The Research Points to Annuities

Posted on March 5, 2013 by Editor Test -

The four scholarly papers that are summarized below aren’t exactly suitable for summer beach reading, I’ll admit. But for any advisor who wants to explore the rationale for including a guaranteed income product in their clients’ retirement plans, they could be described as page-turners. In case you overlooked them last week when they were included among our selection of the Best Retirement Research of 2012, here they are again.

A Utility-Based Approach to Evaluating Investment Strategies

Joseph A. Tomlinson, Journal of Financial Planning, February 2012.

In exploring the often-overlooked “utility” or insurance value of annuities, this actuary and financial planner ventures where few others care to tread. He rejects the popular notion that an annuity represents a gamble with death. “Immediate annuities are often viewed as producing losses for those who die early and gains for those who live a long time, whereas I am portraying no gain or loss regardless of the length of life,” he writes. “This is an issue of framing or context. If one thinks of an annuity as providing income to meet basic living expenses, both the income and the expenses will end at death.” He also asked 36 people how much upside potential they would require—i.e., how much surplus wealth at death—to justify a retirement investment strategy that carried a 50/50 risk of depleting their savings two years before they died.

Spending Flexibility and Safe Withdrawal Rates

Michael Finke, Texas Tech University; Wade D. Pfau, American College; and Duncan Williams, Texas Tech. Journal of Financial Planning, March 2012.

The “4% rule” is a needlessly expensive way to self-insure against longevity risk, this paper suggests. “By emphasizing a portfolio’s ability to withstand a 30- or 40-year retirement, we ignore the fact that at age 65 the probability of either spouse being alive by age 95 is only 18%. If we strive for a 90% confidence level that the portfolio will provide a constant real income stream for at least 30 years, we are planning for an eventuality that is only likely to occur 1.8% of the time,” they write. They also show that a mixture of guaranteed income sources and equities burns hotter and more efficiently than a portfolio of stocks and bonds: “The optimal retirement portfolio allocation to stock increases by between 10 and 30 percentage points and the optimal withdrawal rate increases by between 1 and 2 percentage points for clients with a guaranteed income of $60,000 instead of $20,000.”

A Framework for Finding an Appropriate Retirement Income Strategy

Manish Malhotra, Income Discovery. Journal of Financial Planning, August 2012.

No two retirees have exactly the same needs, and advisors need a process for finding the best income strategy for each client. The author has created a framework that advisors can use to tackle this challenge. His framework includes two “reward metrics” (income and legacy) and three “risk metrics” (probability of success, the potential magnitude of failure, and the percentage of retirement income safe from investment risk). “Using this framework, advisers can incorporate a variety of income-producing strategies and products, and decisions about Social Security benefits, into their withdrawal analyses—lacking in much of the past research focused purely on withdrawals from a total return portfolio,” Malhotra writes.

An Efficient Frontier for Retirement Income

Wade Pfau, Ph.D. September 2012 (Published as “A Broader Framework for Determining an Efficient Frontier for Retirement Income.” Journal of Financial Planning, February 2013.

Just as there’s an efficient frontier for allocation to risky assets during the accumulation stage, so there’s an efficient frontier for allocation to combinations of risky assets and guaranteed income products in retirement, this author proposes. He describes “various combinations of asset classes and financial products, which maximize the reserve of financial assets for a given percentage of spending goals reached, or which maximizes the percentage of spending goals reached for a given reserve of financial assets” and asserts that “clients can select one of the points on the frontier reflecting their personal preferences about the tradeoff between meeting spending goals and maintaining sufficient financial reserves.”

Data Connection

Lists*