Archives: Articles

IssueM Articles

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.”

A Few Words of Advice for You Advisors

Posted on March 5, 2013 by Editor Test -

Lightyears ago, when the Great Boom was a toddler and I knew bupkis about financial services, a Merrill Lynch broker called and invited me to invest my savings with her. I felt flattered, which tells you how many lightyears ago that was.

We chatted. She happened to own a Fiat Spider. I had owned a Fiat Sport Coupe! The next thing you know, I owned a few hundred shares in a Health Sciences mutual fund and a few hundred more in an Information Sciences fund. The rest of my money went into a new concept called a Money Market fund.

My relationship with Merrill Lynch was brief and unremarkable. The Dow was then hovering at an all-time high of 3,500 or so. I was nervous. Even my broker thought that the bull market was too good to last. So I liquidated those assets and put the money down on a little brick row-home.

Flip forward a few years. My wife and I had accumulated enough savings to start investing again. We consulted our friends and, just to play it safe, turned our assets over to my wife’s former roommate, a recently licensed broker at a brokerage whose brand no longer exists.

Ignorance was bliss—until our first statement arrived. I noticed that our account had taken a 5% haircut—though at the time I had not yet heard the word “haircut” in any but a tonsorial context—and phoned the ex-roommate. Surely, I said, there’d been a mistake. Fees or expenses hadn’t been mentioned during our sole interview with her.

No mistake, she said cheerfully. That’s how it works; didn’t I understand how it works? No, I didn’t. Welcome to the big city, she said, adding just a tiny schmear of irony to her good cheer. I protested. That seemed to sadden her, though not in the way I’d hoped it would.

Memories of these experiences came rushing back to mind recently while I was reading an excerpt of a new report about advisors and clients from Boston-based Cerulli Associates and Phoenix Marketing. (Not to be confused with The Phoenix Companies.)

The report, titled Retail Investor Advice Relationships 2012: Meeting Investor Needs Post-Crisis, described a state of affairs in the advice industry today that echoes my encounter with the Merrill Lynch agent so many years ago. For instance:

“In many cases, especially for younger households, these sessions [between clients and advisors] would have little focus on long-term accumulation portfolios as these investors are more interested in saving for short to intermediate goals such as home ownership or funding a wedding.”

That captures my former self perfectly. And the Merrill Lynch agent, for her part, handled me with the kind of light touch that Cerulli and Phoenix recommend.

“An important part of understanding the advice process is realizing that many investors consider it a temporary need,” the report said. “Rather than engaging in an ongoing comprehensive financial planning engagement, many investors would prefer the opportunity to have periodic check-ins with advice providers regarding their overall financial position.”

The Merrill Lynch broker treated me exactly that way. If she hadn’t dropped out of finance, I might have remained her client. Her behavior toward me was in line with Cerulli’s description of an advisor who takes the long view regarding client acquisition:

“Providers interested in establishing trust relationships with younger investors should consider being able to provide basic, but personalized, financial planning guidance for these clients. Simply having a representative qualified to speak for few minutes on the choices a client faces with financial topics such as life insurance or mortgages could go a long way toward strengthening client relationships.”

Another section of the Cerulli-Phoenix report was also spot-on in describing at least one of the elements of my run-in with my wife’s former roommate. I may have been clueless about the terms of our relationship, but apparently many people are. As we implicitly did, most people assume that a broker puts their interests ahead of his or her own.

“Nearly two-thirds of investors who identify having a commission-only relationship with their provider also indicate that the provider is obligated to operate under a fiduciary standard,” the Cerulli-Phoenix report said. “Households in commission relationships largely believe that their advisor must put their best interests first.”

Back then, I don’t think we even understood how commissions work. My wife’s ex-roommate, of course, was simply doing her job—which she turned out to be very good at—and following the suitability standard. One irony of the situation was that while we assumed that no harm (or haircuts) could come to us if we invested with her, she must have assumed that friends and family would help jump-start her business.

At the time, the situation was awkward. We weren’t sure how to handle it. So our money, some of it in trust accounts for our children, remained with her for 15 years. But she eventually lost us as a client. Now part of our money is in a rollover IRA at a do-it-yourself no-load fund company and part is in a 403(b) account with TIAA-CREF.

Our disenchantment with our treatment under the suitability standard happens to be something else that the Cerulli report warns advisors about:

“In Cerulli’s opinion, trying to cling to business models that allow for ongoing conflicts of interest holds the industry back from making true advances that would ultimately rebuild investor trust and advance the industry overall,” the report said.

“Firms that continue to operate solely on a suitability standard basis must be ready to answer client questions as to how they ensure clients are being served, and potentially lose clients if the public comprehension spreads about how the various standards impact client relationships.”

Emphasis added.

Vanguard closes Wellington Fund and a bond fund to some customers

Posted on March 5, 2013 by Editor Test -

Vanguard’s oldest fund—Wellington Fund—and its Intermediate-Term Tax-Exempt Fund have stopped accepting new accounts from financial advisor or institutional clients, but will remain open to additional purchases from those clients, the direct no-load fund company announced this week.

Retail clients may continue to establish new accounts and make additional purchases without limitation, however, a Vanguard release said, adding that the funds may open if the situation changes.

The action was taken to “ensure that [the funds’] investment advisors can continue to effectively manage the portfolios,” said Vanguard CEO Bill McNabb. “Our commitment is to protect the interests of the funds’ current shareholders.”

Over the years, Vanguard has often restricted cash inflows to maintain fund assets at levels that don’t compel fund managers to buy suboptimal investments. Currently, seven Vanguard funds are closed to most new accounts:

Admiral Treasury Money Market Fund
Federal Money Market Fund
High Yield Corporate Fund
Convertible Securities Fund
Capital Opportunity Fund
PRIMECAP Core Fund
PRIMECAP Fund

Wellington Fund, Vanguard’s oldest mutual fund and the fund industry’s largest balanced fund, with $68 billion in assets, invests approximately 65% of its assets in stocks and the remaining 35% in investment-grade corporate bonds, with some holdings in U.S. Treasury, government agency, and mortgage-backed securities.

As substitutes, Vanguard offers its Balanced Index Fund and Vanguard STAR Fund. Both invest about 60% of their assets in equities. STAR Fund is a fund of 11 actively managed Vanguard stock and bond funds.

The $39 billion Vanguard Intermediate-Term Tax-Exempt Fund is Vanguard’s largest municipal bond fund and the largest tax-exempt fund in its category, according to Lipper Inc. The fund invests in high-quality muni-bonds and has an average duration of five years.

As substitutes, the company suggested its Limited-Term Tax-Exempt Fund, which has an average duration of 2.4 years, or its Long-Term Tax-Exempt Fund, which has an average duration of 6.1 years.

Vanguard also said it will add to its low-cost bond offerings with a Vanguard Emerging Markets Government Bond Index Fund and ETF Shares by the end of the second quarter of 2013.

The expense ratios for the ETF, Investor, Admiral, and Institutional Shares will range from 0.30% to 0.50% (as shown in the table below). The average emerging markets bond fund features an expense ratio of 1.21% (source: Lipper, as of December 31, 2012).

The fund will assess a purchase fee of 0.75% on all non-ETF Shares to help offset the higher transaction costs associated with buying emerging markets bonds.

Four Share Classes of Vanguard Emerging Markets Government Bond Index Fund
	Minimum Initial Investment	Estimated Expense Ratios	Purchase Fee
Investor Shares	$3,000	0.50%	0.75%
Admiral Shares	$10,000	0.35%
Institutional Shares	$5,000,000	0.30%
ETF Shares	—	0.35%	—

“Emerging markets bonds have presented low correlations with domestic and developed market bonds, and have the potential to add value for certain risk-tolerant investors holding an otherwise broadly diversified portfolio,” said Vanguard CEO Bill McNabb in a release.

Vanguard Emerging Markets Government Bond Index Fund offers “low-cost exposure to a sizable and growing portion of the international fixed income universe” while incurring higher risk than to the average international bond fund.

In early February, Vanguard announced plans for a Total International Bond Index Fund, which along with the new fund, represent the company’s first international fixed income offerings for U.S. investors.

The fund will use a new target benchmark—the Barclays USD Emerging Markets Government RIC Capped Index. It features approximately 540 government, agency and local authority bonds from 155 issuers. As of January 31, 2013, the top three country holdings were Russia (13.8%), Brazil (10.6%), and Mexico (8.5%). The fund will invest solely in U.S. dollar denominated emerging market bonds.

AnnuityRateWatch.com launches GLIB calculator

Posted on March 5, 2013 by Editor Test -

Annuityratewatch.com, Inc. has expanded its suite of fixed annuity analysis software to calculate the highest Guaranteed Lifetime Income Benefit for prospective annuitants.

With an input of the annuitant’s age, premium, state of residence and the year in which they would like retirement income to begin, the GLIB Calculator solves for the highest income payment.

The software calculates all the possible combinations of over 250 annuity products combined with more than 100 riders to find the product and rider that provides the highest income payout for that individual.

The calculations include increasing, inflation adjusted, joint, and enhanced payout values. The GLIB Calculator’s detailed reports include a “Payout by Age” report, which shows the impact of deferral before commencing income payments. The “Detailed Ledger” report shows a complete income scenario including how contract values are affected by the associated cost of Lifetime Income Riders.

The GLIB Calculator can be found at annuityratewatch.com and is available for license to broker-dealers, banks, insurance distributors, investment advisors and brokers.

Odd new online game lets you “play” the market

Posted on March 5, 2013 by Editor Test -

You’ve heard the one about the two hunters trapped by an angry bear. When Hunter One calmly switches from boots to running shoes, Hunter Two says, “What good is that? You can’t outrun the bear.” The first replies: “I don’t have to. I just have to outrun you.”

A new online game allows people to practice that principle in the world of investing. Called Invoost and produced by a social gaming startup of the same name, the game gives players a chance to profit from the market regardless of if it goes up or down. Invoost players compete against one another in stock trading tournaments that can last from one hour to two weeks.

Players are able to interact with one another through the social gaming functions. Invoost provides real-time market data on four of the world’s largest markets: Eurostoxx 50, FTSE 100, Ibex and NASDAQ 100. Every open market hour more than 30 hourly, daily and weekly tournaments are being played, Invoost said in a release.

Players pay an entry fee to enter the tournament and receive $10,000 virtual dollars to trade with real stock market data. At the end of the tournament the player with the best portfolio return will win a cash prize ranging from $10 to $10,000.

As one early-adopter put it, “Playing Invoost has given me a new perspective on the stock market. I can win money by being the best in a tournament, not by whether the market goes up or down. Those are odds I like!”

Flood into foreign equities bodes ill: TrimTabs

Posted on March 5, 2013 by Editor Test -

An estimated $55.1 billion poured into global equity mutual funds and exchange-traded funds in January and February, the biggest two-month inflow on record, according to TrimTabs Investment Research.

“Bulls should be concerned” that in-flows into foreign stock funds have been so heavy this year, said David Santschi, TrimTabs CEO. “Big inflows from fund investors often occur near market tops.”

Global equity mutual funds and exchange-traded funds received an all-time record $34.4 billion in January, according to TrimTabs note to clients. While inflows subsided to $20.1 billion in February, last month’s inflow was still the second-highestsince October 2007.

“It’s remarkable that U.S. investors are convinced the grass is greener offshore even though global equities have been underperforming,” said Santschi. “The average U.S. equity fund is up 6.2% so far this year, more than double the average global equity fund’s 2.4% gain.”

TrimTabs reported that U.S. equity mutual funds and exchange-traded funds issued $5.9 billion in February, down from $32.0 billion in January. Bond mutual funds and exchange-traded funds issued $17.2 billion in February, down from $33.5 billion in January.

“Inflows into U.S. stocks slumped dramatically last month,” said Santschi. “But global equity funds raked in more than $1 billion daily in fresh cash, and inflows didn’t slow much as the month progressed.”

The previous two-month record for inflows into global equity mutual funds and ETFs was $49.1 billion in January and February of 2006 amid growing enthusiasm over investments in emerging markets and China, in particular, TrimTabs said.

Stable Value Funds: Performance to Date – Part I

Posted on March 3, 2013 by David Babbel and Miguel Herce -

Stable Value Investment Funds (SVIF) are offered in almost half of all defined contribution (DC) plans in the USA, with more than $800 billion dollars worth of assets under management. Historically, they have been one of the two most popular asset classes for people enrolled in such plans.

Unlike stocks, bonds, and many other asset classes, they are generally not susceptible to large fluctuations in value, but accrue attractive interest over time while providing necessary liquidity at book value. Therefore, they may be especially suitable as people approach retirement and are also useful after retirement.

Their stable value allows a person to transition into retirement without any late-inning unwelcome market surprises that can devastate a retirement plan. After retirement, for those plans that allow participants to retain a portion of their assets in SVIF, the availability of funds at book value is important when extraordinary expenses are incurred.

In three related studies[1] conducted over the past seven years, we have examined SVIF performance relative to six other major asset classes, including U.S. large stocks, small stocks, long-term government bonds, corporate bonds, intermediate-term government and corporate bonds, and money market funds.

Our evidence suggests that going back to their inception in 1973, SVIF have dominated two (and nearly three) major asset classes based on a historical analysis and that they often occupy a significant position in optimal portfolios across a broad range of risk aversion levels.

We discuss the factors that contributed to stable value’s remarkable performance and whether it can continue to maintain it into the future. Our various studies used three methods to examine historical performance:

Mean-variance analysis
Stochastic dominance analysis
An enhanced multi-period utility analysis

In Part I of this report, we will briefly discuss the mean-variance results. Part II will summarize the performance results using the other methods.

What are Stable Value funds?

SVIF offer principal protection and liquidity to individual investors, and steady returns that are competitive with intermediate-term bond yields. However, over ensuing one-to-three-month intervals, the guaranteed rate of return moves much more slowly than intermediate-term bond yields.

This is achieved by having a process that allows the provider to smooth market volatility through amortizing gains and losses over the duration of the portfolio. This smoothing is effected through the rate re-set mechanism and insulates against day-to-day volatility. Consequently, SVIF provide investors with positive returns of very low volatility. This combination of bond-yield-like returns and low volatility generates contract or book value accounting of the investment.

The underlying investment portfolios of SVIF are comprised of high quality, short maturity corporate and government bonds, mortgage-backed securities, and asset-backed securities. In all but a few pre-specified circumstances, investors in SVIF are able to transact (make deposits, withdrawals, transfers) at book or contract value, which is deposits plus accrued interest, less any past withdrawals.

While SVIF do not require a set holding period but provide full access to the participant’s principal and accumulated interest, they are subject to the general restrictions within the overall plan. For example, many plans restrict participants from the direct transfer to a competing short-duration bond or money market fund by requiring that money transferred out of SV be first invested in a non-competing (e.g., stock or long-term bond) fund for a short period such as 30-90 days to eliminate arbitrage.

This rule, together with the fact that plan participants do not act in concert regarding the allocation of their funds, allows the investment contract protections to be provided for a fraction of what it would cost if interest arbitrageurs dominated the pool and were revising their allocations aggressively.

Mean-variance analysis

From an investor’s viewpoint, SV funds operate like a passbook savings account. They accrue interest at a pre-specified crediting rate that is generally updated every one to three months to slowly incorporate changing market conditions. Below are compared the relative yields of stable value and money market funds in the stressful post-crash period.

SVIF also fared well over a longer time period. The SVIF returns shown are net of all fees. Note that over the twenty-one-year period shown below, there were only two brief intervals lasting a month or two each when the money market fund average yield exceeded the stable value average.

Despite shortcomings, the mean-variance approach is a popular analytical tool and provides useful insights into the ability of SV investments to dominate other asset classes.

The historical record provides evidence that, even as stand-alone investment, SV funds have been superior in the mean-variance sense to money market and intermediate-term government/credit bond funds.

Based solely on historical returns, when included in optimal mean-variance portfolios, SV funds contribute significantly to the portfolio, to the exclusion of money market, intermediate-term government/credit bonds, long-term corporate bonds and even large stocks.

In other words, optimal mean-variance portfolios based on past data contain only SV funds, long-term government bonds and small stocks in proportions that naturally vary with the expected return (or, alternatively, the expected volatility) of the optimal portfolio.

(Looking forward, we would expect long-term government bonds to be excluded from the set of efficient portfolios because their historical returns benefitted from a significant drop in yields, producing huge capital gains. We cannot expect such a significant drop in yields going forward, so their future returns relative to other investment classes cannot benefit from the capital gains.)

For example, over the past 23 years, from January 1989 through January 2012, SV returns exhibited both a higher mean and lower volatility than either money market or intermediate-term government/credit bond returns. This feature can be seen in the figure below, where we plot two efficient frontiers, one including all seven asset classes in our study and one that excludes the value-weighted SV (VW-SV) funds. The plot extending back to 1973 looks about the same.

While not shown here due to space constraints, we observed that no optimal mean-variance portfolio along the efficient frontier included money market instruments, intermediate-term bonds or long-term corporate bonds. Not even large US stocks were included. We also observed that SV funds predominated in the lower portion of the expected return range, where one would conventionally anticipate seeing money market and intermediate-term bond investments.

The Sharpe ratio, commonly used in performance measurement, measures excess return per unit of risk. It measures how well an investor is compensated per unit of risk taken. Higher ratios denote greater return for the same level of risk.

The Sortino ratio focuses more on the downside risk. It is based on the Sharpe ratio, but penalizes for only those returns that fall below the target return, which in our case is the average riskless rate of return over the period of analysis. It gives the actual rate of return in excess of the risk-free rate per unit of downside risk.

The Sharpe and Sortino ratios for quarterly net return data from 1989-2011 are reported in the table below.

	Large Stocks	Small Stocks	Long-Term Corporate Bonds	Long-Term Government Bonds	Intermediate-Term Gov’t/Credit	Stable Value	Money Market
Mean	2.21%	3.27%	1.99%	2.15%	1.38%	1.41%	0.87%
Std. Deviatn	8.19%	11.68%	4.78%	5.46%	1.84%	0.38%	0.59%
Sharpe Ratio	0.16	0.20	0.23	0.24	0.29	1.69	N/A
Sortino Ratio	0.24	0.33	0.44	0.46	0.52	25.77	N/A

Note that the Sharpe ratio values for five of the asset classes are mostly clustered together, but that for SV it is about six times greater than the highest of the other asset classes. This pattern is even more pronounced for the Sortino ratio. The extremely high ratio for SV funds results from the fact that throughout the period under consideration, the risk-free rate exceeded the SV credited rate only for only a few months and by small amounts. Hence, there were only a few, small observations that factored into the denominator.

The Value Proposition, Challenges and Future Prospects

The positive evidence shown above also holds true over the entire 40-year period of existence for traditional and synthetic forms of SVIF. It raises two questions: What has been the value proposition that allowed these returns to be achieved? Should we expect this kind of performance over the future?

The value proposition has two facets. On the asset side, some of the return above money market yields comes from investing at durations sufficient to capture the term premium that has been traditionally available. The funds also are able to take on a very small amount of credit and convexity risk and thereby gain additional spread. They also invest in some less liquid securities and Guaranteed Investment Certificates (GIC), which provide higher spreads than the most liquid assets.

The first two of these factors help explain why SV returns have generally outpaced money market yields, but do not explain why they also have outpaced intermediate-term government/credit returns. For that we must turn to the liability side of fund management.

On the liability side, the contribution to performance derives from behavioral finance factors. SVIF have contingent liquidity that FASB and GASB define as “benefit responsive.” From the point of view of participants, SV has liquidity similar to money market funds. Banks, insurers or other financial institutions that issue the investment contracts take on the transfer/liquidity risk as well as the investment/market risk that everyone will not withdraw at the same time, since the underlying portfolio has to be less than contract value to cause the investment contract to make up the difference.

SV providers mitigate their risk largely by being astute at predicting and underwriting participant behavior. Providers know that SV investors tend to use less liquidity than they think they need. They know that the vast majority of participants, because of tax penalties, equity wash requirements that inhibit interest rate arbitrage, and simple investor inertia, tend to leave their money in stable value options for a fairly long time. Providers are willing, therefore, to guarantee a fixed rate for a traditional GIC or a minimum zero percent crediting rate each quarter for a synthetic GIC. This allows “wrap” providers to offer their guaranties at lower prices than otherwise would be the case.

Going forward, SVIF will need to be able to continue earning term premia, liquidity premia, and credit spreads while investors will need to continue to behave as they have over the past 40 years for it to continue to be a widely sought investment vehicle for accumulation and decumulation.

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] 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 These studies provide references to the literature that explain the details.

Ten Questions about Quantitative Easing

Posted on February 28, 2013 by Nouriel Roubini -

Most observers regard unconventional monetary policies such as quantitative easing (QE) as necessary to jump-start growth in today’s anemic economies. But questions about the effectiveness and risks of QE have begun to multiply as well. In particular, ten potential costs associated with such policies merit attention.

First, while a purely “Austrian” response (that is, austerity) to bursting asset and credit bubbles may lead to a depression, QE policies that postpone the necessary private- and public-sector deleveraging for too long may create an army of zombies: zombie financial institutions, zombie households and firms, and, in the end, zombie governments. So, somewhere between the Austrian and Keynesian extremes, QE needs to be phased out over time.

Second, repeated QE may become ineffective over time as the channels of transmission to real economic activity become clogged. The bond channel doesn’t work when bond yields are already low; and the credit channel doesn’t work when banks hoard liquidity and velocity collapses. Indeed, those who can borrow (high-grade firms and prime households) don’t want or need to, while those who need to – highly leveraged firms and non-prime households – can’t, owing to the credit crunch.

Moreover, the stock-market channel leading to asset reflation following QE works only in the short run if growth fails to recover. And the reduction in real interest rates via a rise in expected inflation when open-ended QE is implemented risks eventually stoking inflation expectations.

Third, the foreign-exchange channel of QE transmission – the currency weakening implied by monetary easing – is ineffective if several major central banks pursue QE at the same time. When that happens, QE becomes a zero-sum game, because not all currencies can fall, and not all trade balances can improve, simultaneously. The outcome, then, is “QE wars” as proxies for “currency wars.”

Fourth, QE in advanced economies leads to excessive capital flows to emerging markets, which face a difficult policy challenge. Sterilized foreign-exchange intervention keeps domestic interest rates high and feeds the inflows. But unsterilized intervention and/or reducing domestic interest rates creates excessive liquidity that can feed domestic inflation and/or asset and credit bubbles.

At the same time, forgoing intervention and allowing the currency to appreciate erodes external competitiveness, leading to dangerous external deficits. Yet imposing capital controls on inflows is difficult and sometimes leaky. Macroprudential controls on credit growth are useful, but sometimes ineffective in stopping asset bubbles when low interest rates continue to underpin generous liquidity conditions.

Fifth, persistent QE can lead to asset bubbles both where it is implemented and in countries where it spills over. Such bubbles can occur in equity markets, housing markets (Hong Kong, Singapore), commodity markets, bond markets (with talk of a bubble increasing in the United States, Germany, the United Kingdom, and Japan), and credit markets (where spreads in some emerging markets, and on high-yield and high-grade corporate debt, are narrowing excessively).

Although QE may be justified by weak economic and growth fundamentals, keeping rates too low for too long can eventually feed such bubbles. That is what happened in 2000-2006, when the US Federal Reserve aggressively cut the federal funds rate to 1% during the 2001 recession and subsequent weak recovery and then kept rates down, thus fueling credit/housing/subprime bubbles.

Sixth, QE can create moral-hazard problems by weakening governments’ incentive to pursue needed economic reforms. It may also delay needed fiscal austerity if large deficits are monetized, and, by keeping rates too low, prevent the market from imposing discipline.

Seventh, exiting QE is tricky. If exit occurs too slowly and too late, inflation and/or asset/credit bubbles could result. Also, if exit occurs by selling the long-term assets purchased during QE, a sharp increase in interest rates might choke off recovery, resulting in large financial losses for holders of long-term bonds. And, if the exit occurs via a rise in the interest rate on excess reserves (to sterilize the effect of a base-money overhang on credit growth), the ensuing losses for central banks’ balance sheets could be significant.

Eighth, an extended period of negative real interest rates implies a redistribution of income and wealth from creditors and savers toward debtors and borrowers. Of all the forms of adjustment that can lead to deleveraging (growth, savings, orderly debt restructuring, or taxation of wealth), debt monetization (and eventually higher inflation) is the least democratic, and it seriously damages savers and creditors, including pensioners and pension funds.

Ninth, QE and other unconventional monetary policies can have serious unintended consequences. Eventually, excessive inflation may erupt, or credit growth may slow, rather than accelerate, if banks – faced with very low net interest-rate margins – decide that risk relative to reward is insufficient.

Finally, there is a risk of losing sight of any road back to conventional monetary policies. Indeed, some countries are ditching their inflation-targeting regime and moving into uncharted territory, where there may be no anchor for price expectations. The US has moved from QE1 to QE2 and now to QE3, which is potentially unlimited and linked to an unemployment target. Officials are now actively discussing the merit of negative policy rates. And policymakers have moved to a risky credit-easing policy as QE’s effectiveness has waned.

In short, policies are becoming more unconventional, not less, with little clarity about short-term effects, unintended consequences, and long-term impacts. To be sure, QE and other unconventional monetary policies do have important short-term benefits. But if such policies remain in place for too long, their side effects could be severe – and the longer-term costs very high.

Prudential Enters DIA Space with All-Bond VA

Posted on February 28, 2013 by Editor Test -

Having noticed the success that other life insurers have had in selling deferred income annuities (DIAs), Prudential Annuities has rolled out a new offering designed to compete in that product category.

The new product is a variable annuity with a living benefit called Prudential Defined Income. It invests all client assets in a long-duration bond fund, held in a separate account, and offers an annual compound 5.5% roll-up in the benefit base for every year the client delays taking an income stream.

For instance, a 65-year-old man could invest $100,000 and begin taking an annual lifetime income of $8,540 ten years later. That amount is based on a 5% payout rate for a 65-year-old and an income base of $170,814 ($100,000 compounded at 5.5% for 10 years.)

That payout rate is much less than the payout rate from the leading deferred income annuity, New York Life’s Guaranteed Future Income product. According to New York Life, it would allow a single man who invested $100,000 at age 65 to take an income of more than $12,000 at age 75.

The Prudential product offers more liquidity, however. Subject to a surrender fee (for seven years, starting at 7%), the Prudential investor could access the money in his account. The New York Life investor could not access his money during the deferral period. His beneficiaries would receive a cash refund, however, if he died during the deferral period. A refund of unpaid principal is also paid at death.

The Prudential product offers a return of premium death benefit (net of withdrawals and fees) during the deferral period and a return of the remaining account value, if any, if death occurs after income payments begin.

Prudential’s deferred income offering is available to policyowners ages 45 to 85, and requires at least a $25,000 premium. All assets are invested in the AST Long Duration Bond Portfolio. The income benefit and the roll-up are not optional; they are part of the contract. The policyholder cannot drop the benefit.

The all-in annual costs are 2.74%, including a mortality and expense risk fee of 95 basis points, investment fees of 84 basis points, a Defined Income benefit charge of 80 basis points and an administrative fee of 15 basis points.

Advisors and potential investors should take note that the payout rate from the Prudential Defined Income annuity is based on the client’s age when he or she purchases the contract, not when he or she begins taking income. The payout rates of most variable annuities with living benefits are typically based on the age at which income is first taken.

Bruce Ferris, senior vice president of sales and distribution for Prudential Annuities, said this practice gives the company a better idea of what its future liability will be—even though it cannot know exactly when each client will begin taking income.

“One of the difficulties in designing variable annuities is that we’re still in the early stages of understanding client behavior or behavioral finance, regarding when they will take income or restart income. This helps us significantly in pricing a product that allows for a higher level of initial income than our Highest Daily Lifetime Income rider, but without the opportunity of the Highest Daily feature,” Ferris told RIJ.

“The annuity space is book-ended at one end by the single premium immediate annuity, which offers the highest level of initial income, and at the other end by the variable annuity with a guaranteed lifetime income benefit, which offers upside opportunity. Our new product resides somewhere in the middle. We wanted to combine the features and benefits of both,” he added.

“[New York Life, Guardian Life] have become leaders in the deferred income annuity space, which was once called ‘longevity insurance,’ and they’ve brought out products with terrific market appeal. [With Prudential Defined Income] we’re bringing another version of that.”

Pacific Life announces new pension de-risking product

Posted on February 28, 2013 by Editor Test -

Pacific Life has added a new product, Pacific Secured Buy-In, to its suite of “pension de-risking” products, the Newport Beach, Calif., company said in a release.

The product is intended to enable plan sponsors “to de-risk their pension obligations and stabilize their corporate balance sheets and income statements without affecting plan termination, said Richard Taube, vice president, Institutional & Structured Products for Pacific Life. He recommended it “for plan sponsors who want to de-risk… without recognizing settlement losses.”

Pacific Secured Buy-In allows the plan sponsor to transfer all future obligations to Pacific Life by converting its plan to a Pacific Transferred Buy-Out contract at any time and at no cost, the release said.

Pacific Life’s risk-transfer products also include Pacific Insured LDI, a “guaranteed alternative to best-efforts liability-driven investing strategies.” Launched last year, it guarantees plan sponsors a match between plan assets and plan liabilities without requiring an up-front payment like a buy-in or buy-out product, and without triggering settlement losses.

Europe evaluates incentives for working longer and subsidies for saving more

Posted on February 28, 2013 by Editor Test -

European pension policies should promote “active aging,” using a “modern tax and benefit system” to incentives for longer participation in the labor market, said László Andor, European Union’s commissioner for employment social affairs and inclusion.

Speaking at a conference on tax issues for pensions in Brussels, Andor referred to the last year’s Pensions Adequacy Report, which stressed that increasing working life would be key to pension adequacy in the future.

“This requires active aging strategies, investments in life-long learning of all age groups, the adaption of workplaces to the needs of older workers and new forms of labor-force participation,” he said.

The tax system could incentivize active participation in the labor market until the statutory retirement age is reached, or even beyond that stage, he said, adding that “it may be necessary to increase taxation in other areas, such as value-added taxes, green taxes and property taxes” to offset the reductions in taxes on earned income.

The commissioner conceded that tax increases, if not properly designed could backfire, and that shifting taxation from labor to other sources might affect the financing of social protection.

“This is a risk particularly in countries where social protection is primarily based on social insurance contributions,” he said. “However, the financing of social protection could be preserved by earmarking a portion of revenues for this purpose, as done for instance by Germany for VAT.”

Andor also stressed that, as part of the EU’s plans to cut costs, member states will have to look at the cost of promoting funded second and third-pillar pensions through tax exemptions and other subsidies.

“They will have to examine whether fiscal incentives offered to pension savers and to pension funds yield enough value in terms of pension provision,” he said. “They will also have to consider whether similar or better results can be achieved through other or complementary means.”

The key argument for subsidies through tax exemptions, according to Andor, is that second and third-pillar schemes are voluntary. Therefore, economic incentives are necessary to motivate employers and individuals to defer consumption into the future and build extra entitlements through complementary savings, he said.

“Yet, even with high subsidies, it has been impossible in some member states to raise coverage above 50%,” he added, noting that some authorities were now trying the regulatory approach of auto-enrolment instead.

Public authorities might need to look at the idea of mandatory private pensions, he noted. “Making it mandatory need not mean we abolish or even reduce fiscal incentives,” he said. “But it would mean we have more room to consider how much we subsidize and with which distributional profile.”

Small plan participants pay as much as 1.97% in annual fees

Posted on February 28, 2013 by Editor Test -

If the average 401(k) small plan participant is earning an investment return of 6% a year, he or she is losing about 25% of that to fees. For the average large plan participant, the fee bite on a 6% return would be about 16%.

That’s based on the latest data from the 13th Edition of the 401k Averages Book, which shows that the average total plan cost for a small retirement plan (up to 50 participants and $2,500,000 in assets) is 1.46% (down slightly from 1.47% over the past year), with a range of .38% to 1.97%. For a large retirement plan (1,000 participants/$50,000,000 assets), the average total plan cost is 1.03%, down from 1.08% over the past year.

Investment expenses for small plans declined to an average of 1.37% from 1.38% while the large plan average investment expense declined to 1% from 1.05%. The Department of Labor’s 408(b)(2) disclosure regulations were cited as putting downward pressure on fees.

Although “401k fees have been trending down over the years, the Department of Labor’s fee disclosure regulations helped bring a great deal of attention to 401k plan fees,” said Joseph Valletta, co-author of the 401k Averages Book.

The average target date fund expense in a large plan is .98%, while the balanced fund average is 1.12%. The average target date fund expense for a small plan is 1.37%, while the balanced fund average is 1.45%.

The 13^th Edition separates the costs of target date funds from the costs of traditional balanced and risk-based funds for the first time. Published since 1995, the 401k Averages Book is available for $95.

Debate continues over capping 401(k) tax break at 28%

Posted on February 28, 2013 by Editor Test -

The executive director/CEO of the American Society of Pension Professionals & Actuaries (ASPPA), Brian H. Graff, issued a statement rebutting a recent suggestion from a Brookings Institution scholar that the federal budget deficit could be reduced by $40 billion over 10 years by reducing the maximum tax break on retirement plan contributions at 28%.

The suggestion was made by the Brookings Institution Karen Dynan in her essay, “Proposal 6: Better Ways to Promote Saving Through the Tax System,” which was part of a report from Brookings’ Hamilton Project, “15 Ways to Rethink the Federal Budget.” Her proposal has been favored by the Obama Administration.

There’s been a rising chorus of academic and governmental voices suggesting that at least part of the annual “expenditure” on retirement plan tax deferral (estimated at $50 billion to $70 billion by the Center for Retirement Research at Boston College) is wasted because it offers incentives to wealthy people who would save even without the incentive.

Under the “28% cap” proposal, a small business owner in the 39.6% marginal tax bracket would reduce his federal income taxes by a maximum of $14,000 on a maximum deferral of $50,000 into a 401(k) plan, rather than the potential $19,800 tax savings under current law.

Only adjusted gross income over $400,000 for single filers ($425,000 for heads of households and $450,000 for couples filing jointly) is taxed at the highest marginal rate, and only about one percent of Americans earn that much. But many of them, some would argue, are business owners who base their decision to sponsor or not sponsor a retirement plan on the size of the tax benefit to themselves.

ASPPA CEO Brian H. Graff is in that camp. He has publicly maintained that incentivizing savings isn’t the only benefit of the tax break for high earners. It also incentivizes high-earning small business owners to sponsor a retirement plan in the first place, he has argued. Reduce their benefit, and they’ll shut down their plan or never start one in the first place. In his latest prepared statement on the topic, Graff said:

“Brookings Hamilton Project has proposed placing a 28% cap on the ‘rate at which deductions and exclusions related to retirement saving reduce a taxpayer’s income tax liability.’ Because the tax incentive for retirement savings is a deferral, not a permanent exclusion, the proposal would more accurately be described as double taxation of contributions to retirement savings plans for anyone with a marginal tax rate of over 28%.

You won’t expand coverage by penalizing small business owners for offering a 401(k) plan. Retirees already pay ordinary income tax on distributions from retirement savings plans. If this proposal went through, a small business owner in the 39.6% bracket would pay an 11.6% tax on contributions made to the 401(k) plan today, and pay tax again at the full rate when they retire.

The Hamilton Project paper acknowledges that individuals subject to this double taxation may decide to put their savings somewhere other than in the 401(k) plan. What it fails to acknowledge is when that double-taxed person is a small business owner and it no longer makes sense for the owner to have a 401(k) plan, that owner probably won’t offer a 401(k) plan to the employees, either.

ASPPA strongly supports expanding coverage through proposals such as automatic enrollment IRAs. But we think those proposals should be a step up for workers who have no access to workplace retirement savings. Not a step down for workers that had a 401(k) plan before their employer got hit with a double tax on their own 401(k) contributions. ”

Dynan’s proposal includes the following recommendations:

Cap the rate at which deductions and exclusions related to retirement saving reduce a taxpayer’s income tax liability at 28%
Increase the tax credit that small businesses can take for startup pension plan expenses.
Establish an automatic IRA program.
make the saver’s credit refundable and easier to understand
Remove obstacles to firms establishing expanded savings platforms that would allow employees to save for both retirement and nonretirement purposes.

Life and annuity companies will face reckoning in 12-14 months: Conning

Posted on February 28, 2013 by Editor Test -

A new report from Conning on the global insurance industry suggests that the life and annuity sector continues to be plagued by three main problems: a slow economy, low interest rates, and regulatory advancement.

The 70+ page proprietary report, titled “U.S. and Global Insurance Industry Outlook: Economic, Capital Markets, and Regulatory Challenges Continue—Nothing to Be Gained by Waiting for Things to Get Better,” makes the following points about the life and annuity business:

The life and annuity sector has more asset leverage than the property-casualty and health sectors and “a more uniform national perspective as opposed to significant variability in product and market characteristics at the state level.”
The low interest rate environment has a negative effect on investment income and on policyholder behavior, and exacerbates the mismatch of asset and liability durations.
Performance margins are hurt by relatively low sales of discretionary products and spread compression of investment yields compared with guaranteed credited rates.
Companies continue to seek ways to de-risk interest rate exposures and income guarantees, but the extended environment with little near-term chance for reversion to “normal” levels makes this increasingly problematic.
Falling surrender rates are increasing the effect of net spread compression and forcing increases in statutory reserves.
Operating margins on net premiums are half pre-financial crisis levels.

According to report, “life and annuity products may be seen as discretionary purchases that may be broadly constrained in times of financial stress. Individual annuities, both fixed and variable, will continue their decline in premium from shifting policyholder behavior, while indexed annuities and group annuities are doing well.”

Regulatory challenges are affecting solvency and risk management approaches, investment and hedging capital charges, reserving for contingencies and policyholder behavior, and distribution strategies.

Major differences “between regulators and companies on the degree of conservatism in reserving may swing toward the regulators’ position if the low interest rate environment is seen as extending beyond the next couple of years,” the report said.

Strategies pursued by life insurance companies include:

Increased divestitures of blocks of business and noncore operations (including bank and savings and loan affiliates).
Aggressive investment in infrastructure improvements.
Alternative distribution strategies and more focused market approaches
Broader ranges of investment alternatives.

As for companies that are adopting a “wait and see” attitude, the report said that strategy might work if normal conditions return in the next 12 to 14 months, but not if “sluggish conditions” and “intensifying regulatory challenges” persist.

The Best Retirement Research of 2012

Posted on February 28, 2013 by Kerry Pechter -

The retirement financing challenge is a worldwide phenomenon. Almost every advanced nation has its Boomer generation, its massive debt and its rising retiree-to-worker ratio. Many emerging nations have no safety net at all for their aged. Governments, companies, families and individuals from Singapore to Honduras, from Germany to Australia, all feel the pain.

Not surprisingly, the search for solutions to this complex demographic, political and financial problem has elicited a river of academic research. Each year, social scientists use the latest survey techniques and mathematical models to illuminate different aspects of the problem and to test potential solutions.

For the second consecutive year, Retirement Income Journal is honored to bring some of the leading English-language research in this area to your attention. We asked researchers to identify their favorites among the research that they first read during 2012 (even it did not appear in published form until 2013). They recommended the 16 research papers that we describe below (with some links to webpages or pdfs).

Here you’ll find research that emanates from Croatia, Denmark and Germany, in addition to the U.S. There’s research from at least 20 different universities. There are papers that apply to advisors of individual clients and to sponsors of institutional retirement plans. There’s research for annuity issuers and for distributors of annuity products. At least one paper calls for a major change to U.S. retirement policy. As a group, the papers shed light on many of retirement financial challenges that individuals, financial services providers, and governments face today.

A Utility-Based Approach to Evaluating Investment Strategies

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

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.

Should You Buy an Annuity from Social Security?

Steven A. Sass, Center for Retirement Research at Boston College, Research Brief, May 2012.

In a financial version of “The Charlie’s Angels Effect,” Social Security went from misbegotten child to Miss USA last year. Returns on low-risk investments were lower than the step-up in Social Security income that comes from postponing benefits to age 66 or even 70. It thus made more sense for a 62-year-old retiree to delay Social Security and consume personal savings than to hoard his own cash and claim Social Security benefits. “Consider a retiree who could claim $12,000 a year at age 65 and $12,860 at age 66—$860 more,” the author writes. “If he delays claiming for a year and uses $12,860 from savings to pay the bills that year, $12,860 is the price of the extra $860 annuity income. The annuity rate—the additional annuity income as a percent of the purchase price—would be 6.7% ($860/$12,860).”

Lifecycle Portfolio Choice with Systematic Longevity Risk and Variable Investment-linked Deferred Annuities

Raimond Maurer, Goethe University; Olivia S. Mitchell, The Wharton School, University of Pennsylvania; Ralph Rogalla, Goethe University; Vasily Kartashov, Goethe University. Research Dialogue, Issue 104, June 2012. TIAA-CREF Institute.

Deferred income annuities—often purchased long before retirement—are in vogue. To offset the risk that a medical breakthrough could lift average life expectancies, annuity issuers could raise prices. But that would suppress demand. The authors of this study propose a “variable investment-linked deferred annuity” (VILDA) that might solve that problem. The owner would assume the risk of rising average life expectancy by agreeing to a downward adjustment in the payout rate should average life expectancy rise. In return, he would enjoy a lower initial price. Access to such a product, perhaps through a 401(k) plan, could increase the annuity owner’s income at age 80 by as much as 16%, the researchers believe.

Retirement Income for the Financial Well and Unwell

Meir Statman, Santa Clara University and Tilburg University, Summer 2012.

In this paper, the author of What Investors Really Want calls for a mandatory, universal workplace-based defined contribution plan in the U.S. that would make Americans less dependent on Social Security for retirement income. “It is time to switch from libertarian-paternalistic nudges to fully paternalistic shoves,” the author writes. He argues that automatic enrollment, which has been shown to increase 401(k) participation, is not strong enough a measure to make a difference in the amount of retirement savings available to most people. He recommends tax-deferred private savings accounts similar to 401(k) and IRA accounts but mandatory and inaccessible to account owners before they reach retirement age.

Harmonizing the Regulation of Financial Advisers

Arthur B. Laby, Rutgers University. Pension Research Council Working Paper, August 2012.

In this paper, a law professor analyzes the debate over harmonized standards of conduct for advisors. On the problem of principal trading, he writes, “Any broker-dealer that provides advice should be required to act in the best interest of the client to whom the advice is given [but] imposing a fiduciary duty on dealers is inconsistent, or not completely consistent, with the dealer’s role. A dealer’s profit is earned to the detriment of his trading partner, the very person to whom the dealer would owe a fiduciary obligation.” He identifies three obstacles to harmonization: the difficulty of analyzing its costs and benefits, the presence of multiple regulators, and the question of whether advisors should have their own self-regulatory organization.

A Framework for Finding an Appropriate Retirement Income Strategy

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

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.

How Important Is Asset Allocation To Americans’ Financial Retirement Security?

Alicia H. Munnell, Natalia Orlova and Anthony Webb. Pension Research Council Working Paper, September 2012.

Asset allocation may be important when it comes to building a portfolio, but “other levers may be more important for most households,” according to this paper. “Financial advisers would likely be of greater help to their clients if they focused on a broad array of tools—including working longer, controlling spending and taking out a reverse mortgage,” the authors write, claiming that decisions in these areas can have a bigger impact on retirement savings than merely transitioning from a typical conservative portfolio to an optimal portfolio. “The net benefits of portfolio reallocation for typical households would be modest, compared to other levers,” they write. “Higher income households may have slightly more to gain.”

The Revenue Demands of Public Employee Pension Promises

Robert Novy-Marx, University of Rochester; Joshua D. Rauh, Stanford. NBER Working Paper, October 2012.

The cost of fully funding pension promises to state and local government workers is startlingly large, according to these authors. Assuming that pension assets earn only a risk-free real return of 1.7% (the yield of TIPS in 2010) and that each state’s economy grows at its 10-year average, government contributions to state and local pension systems would have to rise to 14.1% of own-revenue to achieve fully funded systems in 30 years, the authors say, or $1,385 per household per year. “In twelve states, the necessary immediate increase is more than $1,500 per household per year, and in five states it is at least $2,000 per household per year,” they calculate, adding that a switch to defined contribution plans would cut the pension burden dramatically.

What Makes Annuitization More Appealing?

John Beshears, Stanford; James J. Choi, Yale; David Laibson, Harvard; Brigitte C. Madrian, Harvard; and Stephen P. Zeldes, Columbia. NBER Working Paper, November 2012.

When offered an annuity or a lump sum at retirement, many defined benefit plan participants choose the lump sum. While this behavior obeys the principle that “a bird in the hand is worth two in the bush,” it can be shortsighted for healthy people who need to finance a long retirement. How can policymakers help cure this form of myopia? These researchers surveyed DB plan participants and found them more willing to choose annuitization if they could annuitize part of their savings instead of 100%, if their annuity income were inflation-adjusted, and if they could receive an enhanced payment once a year, in a month of their own choosing, rather than identical amounts every month.

Home Equity in Retirement

Makoto Nakajima, Federal Reserve Bank of Philadelphia; Irina A. Telyukova, University of California, San Diego. December 2012.

The retirement savings crisis notwithstanding, many older Americans reach the end of their lives with too much unspent wealth, rather than too little. Some academics call it “the retirement savings puzzle.” The authors of this study think they’ve solved the mystery. Much of the unspent wealth is home equity, they believe. “Without considering home ownership, retirees’ net worth would be 28% to 53% lower,” they write. A number of homeowners tap their home equity by downsizing, purchasing reverse mortgages or simply neglecting to invest in home maintenance as they get older. But retired homeowners rarely downsize unless an illness or death of a spouse occurs, the study says.

Active vs. Passive Decisions and Crowd-Out Retirement Savings Accounts: Evidence from Denmark

Raj Chetty, Harvard University and NBER; John N. Friedman, Harvard University and NBER; Soren Leth-Petersen, University of Copenhagen and SFI; Torben Heien Nielsen, The Danish National Centre for Social Research; Tore Olsen, University of Copenhagen and CAM. National Bureau of Economic Research, December 2012.

Are tax subsidies the best way to encourage retirement savings? Not in Denmark, say these authors. “Each [dollar] of tax expenditure on subsidies increases total saving by one [cent],” they write, because 85% of Danish retirement plan participants are “passive savers” who ignore tax subsidies. If employers simply put more money into retirement plan participants’ accounts, it would do much more to raise retirement readiness, the authors assert, finding that every additional [dollar] added by employers enhances savings by 85 cents. Though their study is based on Danish data and Danish currency, the authors suggest that the results cast doubt on the effectiveness of America’s $100-billion-a-year tax expenditure on retirement savings.

Wealth Effects Revisited: 1975-2012

Karl E. Case, Wellesley College; John M. Quigley, University of California, Berkeley; Robert J. Shiller, Yale University. NBER Working Paper Series, January 2013.

Changes in housing wealth have a much bigger effect on consumption than changes in stock market wealth, the authors assert. During the housing boom of 2001-2005, the value of real estate owned by households rose by about $10 trillion, and “an average of just under $700 billion of equity was extracted each year by home equity loans, cash-out refinance and second mortgages,” the authors write. In 2006-2009, real estate lost $6 trillion in value, reducing consumption by about $350 billion a year. “Consider the effects of the decline in housing production from 2.3 million units to 600,000, at $150,000 each. This implies reduced spending on residential capital of about $255 billion,” they note. The paper builds on a 2005 paper by these authors, which remains the most downloaded article on the B.E. Journal of Macroeconomics website.

Optimal Initiation of a GLWB in a Variable Annuity: No Arbitrage Approach

Huang Huaxiong, Moshe A. Milevsky and Tom S. Salisbury, York University. February 2013.

Most owners of variable annuities with in-the-money guaranteed lifetime withdrawal benefits (GLWBs) should activate their contract’s optional income stream sooner-rather-than-later and later-rather-than-never, these authors recommend. “The sooner that account can be ‘ruined’ [reduced to a zero balance] and these insurance fees can be stopped, the worse it is for the insurance company and the better it is for the annuitant,” they write, noting that even the presence of a deferral bonus or “roll-up” feature in the product doesn’t justify postponing drawdown. With over $1 trillion in GLWB contracts in force, the paper suggests, the behavior of contract owners will have major implications for them and for the annuity issuers.

Empirical Determinants of Intertemporal Choice

Jeffrey R. Brown, University of Illinois at Urbana-Champaign; Zoran Ivkovic, Michigan State University; Scott Weisbenner, University of Illinois at Urbana-Champaign. NBER Working Paper, February 2013).

Croatia’s bloody war of independence from Yugoslavia in the 1990s yielded a natural experiment in behavioral finance. To save money from 1993 to 1998, the Croatian government began indexing pensions to prices instead of wages. After the war, the courts ordered the government to reimburse pensioners for the reduction. In 2005, about 430,000 Croatians were offered either four semi-annual payments—totaling 50% of the nominal amount owed—or six annual payments—totaling 100% of the nominal amount owed. Seventy-one percent chose the first option. “As one might expect,” the authors write, “those with higher income and wealth were more willing to accept deferred payment from the government.”

The Online 401(k) offers $200 for successful leads

Posted on February 21, 2013 by Editor Test -

As a publicity stunt, the Online 401(k), a low-cost provider of retirement plan services to the very smallest of small businesses, is offering a $200 reward for any lead that results in a sale.

“By instituting the referral incentive, we are hoping to debunk common myths about retirement plans and help Americans at businesses of all sizes effectively save for their retirement,” the company said in a release.

Only about 8% of small businesses with between two and 20 employees offer any type of retirement savings plan to their employees. The Online 401(k) is hoping the new referral program will be an incentive for concerned citizens to direct their friends and family that work for small businesses to its affordable, easy-to-use retirement plan.

“Small businesses are the least likely to offer a 401(k) plan to their employees,” says Chad Parks, CEO and founder of The Online 401(k). “By offering this program, we hope more small businesses will realize there are plans out there designed for them and their employees. Combined with the fact that the government wants to pay us to save, we hope the light bulb will go off.”

The Online 401(k) offers plans that are web-based and flat-fee: The company offers four retirement plan options, which conform to ERISA contribution limits:

Single(k): Designed for a single proprietor business, it allows a maximum investment of up to $50,000 per individual.
Starter(k): Serves businesses that have between one and 100 employees. It allows for a maximum savings potential of up to $5,000 per year or $6,000 for employees who are 50 or older.
Express (k): A low-cost 401(k) for a business with up to 50 employees. There is a maximum investment potential of up to $50,000 per individual.
Custom(k): Designed for a business with up to 50 employees, there is a maximum investment potential of up to $50,000 per business.

The referral reward program applies to anyone who refers a business to the firm that eventually results in an opened plan. The program comes on the heels of the company’s cross-country road trip in 2012 to publicize the lack of retirement savings in America that will eventually be turned into a documentary called “Broken Eggs Film: The Looming Retirement Crisis in America.”

Quote of the Week

Posted on February 21, 2013 by Editor Test -

Data Connection

Lists*