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SEC: VA closures, buybacks send wrong message

Posted on November 8, 2012 by Editorial Staff -

In late 2011, when word first trickled out that some life insurers might try to de-risk their books of variable annuity business by encouraging owners of contracts with rich riders to exchange them for less risky new ones, observers wondered how the SEC might react.

Similar concerns arose last summer after the decision by several of the largest VA writers to block new contributions to contracts that were purchased a few years ago, when living benefits were rich.

The carriers involved in the closures included Allianz, AXA, John Hancock, MetLife, Prudential and Transamerica, according to Morningstar’s third-quarter variable annuity update.

[Last week, the Associated Press reported that Hartford Financial Services Group has offered some of its annuity clients cash for their contracts. “We are making this offer because high market volatility, declines in the equity markets and the low interest rate environment make continuing to provide the Lifetime Income Builder II rider costly to us,” Hartford said in a Securities and Exchange Commission filing last Thursday. CEO Liam McGee said during a conference call on Friday that the offer will be made to annuity holders that make up almost 45% of the net amount at risk on the contracts.]

The SEC has since taken notice of the situation, according to an attorney who is a consultant to life insurers. One of its responses has been to approach the major insurers and ask them to answer eight questions about the prospectuses of the contracts that were closed to subsequent contributions, or sub-pays, and whether they had properly disclosed their right to shut off contributions. The SEC delivered the questions orally, but asked for written answers, the attorney said.

Both of these issues—the exchanges and the closures—were addressed by Norm Champ (below right), the director of the SEC’s Division of Investment Management, in a speech at the ALI CLE (American Law Institute-Continuing Legal Education) 2012 Conference on Life Insurance Company Products in Washington, D.C. on November 1.

In prepared remarks, Champ articulated the same concerns that a few VA distributors voiced months ago. He urged life insurers to prevent the current situation in the future by risk-testing their products more thoroughly before marketing them to the public.

“The [SEC] staff has noted that several recent filings announced companies’ decisions to stop accepting additional purchase payments on outstanding contracts,” Champ said. “In most cases, the affected contracts were those with a living or death benefit that appears to have been too generous for the issuing insurer to maintain in a sustained environment of low interest rates and volatile equity markets.

“These actions may have surprised some investors who had hoped to fund their retirement income over time through ongoing purchase payments, including established automatic purchase plans.

“Regardless of whether any or all of the companies had effectively reserved the right to suspend payments, one has to question the message this course of action sends to investors in these products generally. I fear the message might read something like this: ‘Here is the deal we are offering you, unless we find out later that we miscalculated, in which case you may have to go elsewhere to build annuity value and possibly pay a surrender charge on your investment with us on your way out.’ ”

On the question of life insurers offering to exchange new contracts for existing contracts with rich benefits, Champ said:

“Several issuers of variable annuities, again generally those with generous living benefits, have recently made exchange offers for newer contracts that do not feature those benefits. Some insurers have also offered inducements, such as cash bonuses, to contract owners who surrender their contracts or terminate living benefit riders.

“These actions raise questions about the suitability of both the original transaction and the exchange, where the original transaction was perhaps premised on the value and importance of the living benefits and the exchange removes or reduces those same benefits.

“A careful consideration of the risks associated with the design of any product could assist in avoiding the scenarios playing out now. Going forward, the Division urges you to keep in mind steps you may have to take in the future to limit your risk, think through how this affects your customers, and consider how you can make your customers aware of the risks they may face with the product you are selling them.”

The eight questions that the SEC sent to variable annuity issuers asked them to identify the contracts that were being closed to new payments and to identify the specific prospectus language that supported the closure, and whether the decision to block new contributions had been vetted by an attorney. The questions also sought to identify the exact dates when the products were sold and the dates when prospectus language was added.

Asked what might occur if the prospectus didn’t support the closures, the attorney said, “The SEC could bring an action against the company that had no contractual right to do it. There could be fines, and if the prospectus was false and misleading, and if the SEC can show that it was willful, the fines can go up.”

In other comments, Champ noted that the Investor Advisory Committee, created by the Dodd-Frank Act, had recently published its first recommendations on the general solicitation in Rule 506 of Regulations D offerings. This year’s JOBS Act requires the SEC to lift the ban on general solicitation and advertising in Rule 506 private placements. The ban had confined hedge funds and private equity firms to promoting securities only to “accredited investors,” such as wealthy investors and institutions.

The Insured Retirement Institute issued a press release Monday praising Champ for a part of his speech where he favored the development of a summary prospectus for variable annuities. Champ noted that a recent financial literacy study showed that investors liked the mutual fund summary prospectus.

In a release Monday, IRI President and CEO Cathy Weatherford said, “We are encouraged by Director Champ’s remarks and agree with his optimism that a variable annuity summary prospective would benefit investors by providing better information. “There remains a strong demand by investors for clear and concise variable annuity information. IRI research shows that 95% of investors prefer a shorter paper summary prospectus. As it stands today, the length of the full prospectus—in and of itself—is a barrier to investor education and informed decision making.

Sampling the Breakfast Buffett at NAPFA

Posted on November 8, 2012 by Editor Test -

It’s safe to say that most if not all of the advisors attending the NAPFA East conference in Baltimore admire Warren Buffett, the “Oracle of Omaha.” So when Buffett biographer Alice Schroeder rose to give the first keynote address Wednesday morning, the Hilton ballroom grew hushed.

Schroeder shared her insights into Buffett’s investing style, and I’ll relate those comments in a moment. First, let me pass along Schroeder’s investment tips.

“The great growth industry of the 21^st century will involve risk management and risk mitigation,” she said. “I don’t mean derivatives. I mean insurance. I mean esoteric businesses like staffing companies—businesses that take the risk of having employees off of other companies’ balance sheets. Risks are going to grow, but the sophistication of handling risks will grow even faster.

“The second big trend, and one that’s underrated by economists, is what’s happening in the digital scientific world. If you hang with West Coast venture capitalists, you will find out that all of us will soon have 3-D printers that will let us do things like design our own shoes and make them at home. Someone has already designed an artificial intelligence doctor that diagnoses more accurately than a human doctor.

“You should be short ‘stuff,’ she said. “Be short on the people who make Hummel china, and the stores that retail that kind of stuff. The generation behind us, those who are 35 and under, they don’t want stuff. They don’t want antiques or art. Younger people have digital collections, like photographs, apps, games, and they want disposable furniture and clothes. Just as our 19^th century robber barons hauled old stuff back from Europe, people in Shanghai will be carting home old stuff from the U.S. Your grandmother’s good china will be going to China.”

‘Warren likes cash’

Getting back to Buffett: I haven’t read Schroeder’s bestseller about the great investor, “The Snowball: Warren Buffet and the Business of Life” (Bantam, 2008). So I can’t say if it improved on Roger Lowenstein’s masterpiece, “Buffett: The Making of an American Capitalist,” (Random House, 1995) which revealed how Buffett had a huge cash hoard when the DJIA dropped to 577 at the end of 1974, and took full advantage of what turned out to be historic bargains.

But Buffett clearly allowed Schroeder almost unlimited access for this authorized biography, so she had ample opportunity to observe him up close. She described his ability to shut out distractions, his brown-on-brown corner office like the “inside of a cuckoo clock,” his belief that “valuation is the ultimate protection against risk” and that “you don’t have to worry about the future if you don’t overpay for an asset.”

What impressed Schroeder most was Buffett’s attitude toward cash. Her conclusions were consistent with Lowenstein’s.

“Most money managers are under pressure not to hold cash, because it doesn’t earn anything. But Warren likes cash. He likes having it around him. He would bathe in cash. He thinks of cash as a call option on every asset class, with no strike price and no expiration date. The premium for the option might be high or low, depending on the interest rate, but that doesn’t matter to him.

“Berkshire Hathaway currently has $47 billion in cash, and Warren feels like he has a huge cash option on whatever happens in the economy. Everyone wants to know where the economy is headed. But an investor’s real goal, he thinks, is to exempt yourself from it and make it not matter. He wants to be in a position to take advantage of any economy. He never wants to feel like he’s corralled. He’s the only person I ever knew who has thought about cash in quite that way.”

Election hangover

Schroeder’s upbeat attitude was just the tonic that NAPFA advisors seemed to need Wednesday morning. Judging by a random sampling of opinions, few of them were celebrating the Obama victory. The people I spoke to would rather have watched the bubble economy deflate than see it kept afloat with stimulus and bailouts that, they bleakly suspect, will lead to higher taxes, inflation and slower growth.

And then, of course, there’s the buzz-killing fiscal cliff, “sequestration” and the expiration of the Bush tax cuts.

One advisor was thumbing through the e-mail on his smartphone screen and sipping his first coffee of the day. I asked him to tell me the most pressing issue on his mind, investment-wise, given that the Democrats had retained the presidency and the Republicans still dominated the House.

His biggest challenge, he said, will be to protect his clients from the impact of the coming inflation. The trillion-plus dollars sitting in excess bank reserves at the Fed will eventually be loaned out, he believes, and inflation will follow.

What about bonds, I wanted to know. When bondholders start demanding better returns on government debt, he said, the prices of existing bonds will fall. Boomers’ savings will evaporate just as the cost of living soars. And prices will inevitably soar, he said, because the Chinese will soon be paying their workers much more and passing the costs on to us.

For inflation protection, he has adopted what he calls a “Depression era strategy.” He’s begun recommending utilities to his clients. More specifically: he likes those trendy master limited partnerships that own gas transmission lines.

But wait. If the Great Depression was characterized by deflation, I asked, why use a Depression strategy against inflation? “Do you remember the ’70s?” he asked rhetorically. He expects a return of stagflation, that limbo of rising energy costs and falling corporate profits that made the 1970s a dead zone for equity investors.

The most, or I should say, the only positive note that I heard about the election outcome was sounded by an advisor from Rochester, N.Y., who seemed to be glad that the Affordable Care Act won’t be repealed. It will make it easier for some of her clients to retire before age 65, she said, because the universal mandate will make individual health insurance policies cheaper.

Of course, we may never know just how painful it would have been to let the financial crisis run its course, and to let the zombie banks and inefficient automakers die a more or less natural death. I imagine that the Oracle of Omaha, with his $47 billion war chest, would have emerged from the wreckage that much richer.

Fees will soon rise on several VA contracts: Morningstar

Posted on November 7, 2012 by Editor Test -

Variable annuity carriers filed 106 annuity product changes in the third quarter of 2012, making for an active period according to Morningstar’s third-quarter annuity product update. This compares to 168 new filings during the second quarter of 2012 and 40 in Q3 of last year.

Morningstar took notice of the fact that some VA carriers are eliminating add-on payments, also known as subsequent payments or “sub-pays.” The carriers who recently limited additional investment dollars into existing contracts and benefits include Allianz, AXA, MetLife, John Hancock, Prudential and Transamerica.

New York Life re-entered the individual VA market after a long hiatus, Morningstar said, referring to the firm’s Income Plus product. The product was issued as a variable annuity with an optional guaranteed minimum income benefit rider and as a deferred income annuity.

Product changes that Morningstar said were in the “pipeline” included:

In October Allianz is raising the fixed percentage step up to 6% from 5% on the Income Protector GLWB. The simple interest is credited quarterly before the first withdrawal (or age 91). The change applies to new sales.
Fees will increase on six different Genworth benefits to 1.25% on December 3rd.
Jackson National is dropping the joint option on its LifeGuard Freedom 6 Net and Flex benefits effective Oct. 15. This applies not only to new contracts but also to existing contracts that do not have the option elected. Jackson is also eliminating the bonus credits on contracts, which range from 2% to 5%. In addition, the Perspective Advisors II and Perspective Rewards VA contracts are closing.
John Hancock is closing multiple contracts effective October 15th: Venture Opportunity A-Series, Venture Opportunity A-Share (national & NY), Venture Opportunity O-Series, Venture 4 (national & NY) and Venture (national & NY) In addition, purchase payment restrictions were added to multiple JH Venture contracts on October 15th.
Lincoln filed changes to the Lincoln ChoicePlus and American Legacy Fusion contracts. The fee for SmartSecurity Advantage will increase from 65 bps to 85 bps (single) or 85 bps to 100 bps (joint). In addition the withdrawal percentages for Lifetime Income Advantage 2.0 will change, though new age bands were not specified. The changes are effective in December 2012.
Nationwide is launching a new I-share contract (Destination Income) on November 15th. The fee is 70 bps and it carries a lifetime withdrawal benefit (100 bps).
Protective is increasing the fee for Protective Income Manager to 1.20% (1.30% under the RighTime option) effective December 10th. SecurePay R72 is closing, to be replaced by a new SecurePay benefit with a different roll-up percentage that was not specified in the supplemental filing.
On October 1st Pacific Life will increase fees on multiple versions of its CoreIncome Advantage benefits. Fees increases ranged from 10 to 20 bps.
The RiverSource Accumulation Protector Benefit (multiple versions attached to different contracts) fee increases to 1.75% on October 20th.

VA closures, buy-backs send wrong message: SEC

Posted on November 6, 2012 by Kerry Pechter -

In late 2011 and early 2012, when it first became known that variable annuity issuers might try to de-risk their books of business by offering to exchange existing rich contracts for less risky ones, some close observers wondered how the SEC might react.

Last summer, the decision by several of the largest issuers to block new contributions to variable annuity contracts that were purchased a few years ago, when living benefits were rich, raised similar concerns.

Both of these issues were addressed by Norm Champ (right), the director of the SEC’s Division of Investment Management, in a speech at the ALI CLE (American Law Institute-Continuing Legal Education) 2012 Conference on Life Insurance Company Products in Washington, D.C. on November 1.

In prepared remarks, Champ articulated the same concerns that a few VA distributors voiced many months ago. He urged life insurers to prevent the current situation in the future by risk-testing their products more thoroughly before marketing them to the public. He did not, however, mention taking any action against the practices.

“These actions may have surprised some investors who had hoped to fund their retirement income over time through ongoing purchase payments, including established automatic purchase plans.

On the question of life insurers offering to exchange new contracts for existing contracts with rich benefits, Champ said:

In other comments, Champ noted that the Investors Advisory Committee, created by the Dodd-Frank law, had recently published its first recommendations on the general solicitation in Regulation D Rule 506 offerings. This year’s JOBS Act requires the SEC to lift the ban on general solicitation and advertising in Rule 506 private placements. The ban had confined hedge funds and private equity firms to promoting securities only to “accredited investors,” such as wealthy investors and institutions.

That study “provides grounds for optimism that a variable annuity summary prospectus, if designed and implemented effectively, could provide better disclosure for investors in your products,” Champ said. “The framework that was designed for mutual funds — that is, the provision of key information in a summary prospectus, together with online delivery of the statutory prospectus and paper delivery upon request — may provide a useful model for improving the disclosure that variable annuity investors receive.

“I know, and appreciate, that the industry has worked hard to try to adapt the mutual fund summary prospectus in a way that is workable for variable annuities. That effort involves difficult decisions about how to adequately convey to investors and financial advisors the terms of complicated products, with a wide variety of benefits, risks, and costs. Like you, we are committed to making improvements in the important area of helping variable annuity investors to make informed investment decisions. Investors in variable annuities deserve our best efforts on this important initiative.”

In a release Monday, IRI president and CEO Cathy Weatherford said, “We are encouraged by Director Champ’s remarks and agree with his optimism that a variable annuity summary prospective would benefit investors by providing better information. “There remains a strong demand by investors for clear and concise variable annuity information. IRI research shows that 95% of investors prefer a shorter paper summary prospectus. As it stands today, the length of the full prospectus—in and of itself—is a barrier to investor education and informed decision making.

“Only 17% of investors reported reading any part of the full prospectus in 2012. And even among those that have, they are only reading a small fraction of the full prospectus, which often times can be between 150 to 300 pages long. The research is clear that now is the time for a summary prospectus to facilitate more informed decision-making. That is why IRI remains committed and resolved to work with the SEC to ensure that relevant, clear and concise information, via a variable annuity summary prospectus, is made available to investors.”

U.S. economy will improve regardless of election results, consultant says

Posted on November 5, 2012 by Editor Test -

It doesn’t much matter whether Barack Obama or Mitt Romney wins the presidential election. The more interesting question is how well the Tea Party will fare, says Robert Wescott, head of Washington, DC-based Keybridge Research.

Wescott’s comments were reported by IPE.com.

If the Tea Party makes a strong showing, its views will likely influence a Romney presidency strongly, “as Romney would feel beholden to the ultra-conservative end of his party and would be forced to appoint a number of cabinet members with Tea Party credentials and support,” Wescott said.

But Tea Party aside, the differences between Obama and Romney are far less pronounced than the election rhetoric suggests, Wescott says.

“Like Romney, Obama intends to address the deficit and like Obama, Romney has no wish to indiscriminately slash spending and risk putting the economy back in recession,” he said.

Regardless of the election outcome, the economist believes US policymakers will find a way to avoid the ‘fiscal cliff,’ in which $600 billion (€463bn) in tax increases and budget cuts are scheduled to take effect automatically by the end of this year.

Neither Democrats nor Republicans want this to happen, and both parties agree in large part on how to avoid the fiscal cliff, Wescott said.

“There is just a 5% chance the fiscal cliff will really bite,” he added. “I expect that two-thirds of the automatic budget cuts will be slashed and that we’ll ultimately have cuts of approximately 1-1.5% of GDP in 2013 – a percentage that will still allow the economy to grow at a reasonable rate.”

“The American economy is doing better than people tend to think,” he said. “The housing market, in particular, is rebounding much more strongly than many people realize. Housing starts are up, and the demand for new mortgages is so great that banks are having to hire scores of new loan officers to process applications.

“We’re already seeing the positive effects of the housing rebound on construction and anything to do with housing – from furniture to appliances. And then, of course, there is also a positive psychological effect. People who see the value of their house go up are more willing to spend their money.”

Wescott cited the chemical sector as one of the most exciting areas in the US economy right now. “The price of natural gas in the US dropped to just $1.80 per million BTUs – that is very low, indeed, considering the price is $15 per million BTUs in Asia and $10 in Europe. Plus, we have just added 100 years to the proven reserves in terms of shale gas. As a result, we are seeing a revival of manufacturing in the industrial core, driven by cheap gas.”

Investors would do well to focus on the US housing sector and related businesses, and, “from an investor standpoint, I’m also upbeat about anything to do with the chemical industry – from plastic bags to fertilizer,” he said.

CFP board chairman resigns

Posted on November 5, 2012 by Editor Test -

Alan Goldfarb, chairman of the Certified Financial Planner Board of Standards, and two members of the CFP’s Disciplinary and Ethics Commission have resigned, the CFP board announced last week.

The board of directors was informed of the resignations during a special October 31 meeting. They elected the 2012 chair-elect, Nancy Kistner CFP, to fill the remainder of Mr. Goldfarb’s term. She will continue to chair the board of directors through December 31, 2013.

The CFP Board became aware of broad allegations that members of the board and other volunteers may have violated provisions of the CFP’s Standards of Professional Conduct, the CFP said in a release. The nature of the allegations wasn’t disclosed.

A special committee made up of public board members with no ties to the financial services industry was then appointed by the board to look into the matter. The committee retained outside counsel to investigate and report its findings.

Goldfarb and the two others, who were not named, resigned after being presented with the outside counsel’s findings and after being told that there would be proceedings against them under CFP Board’s Disciplinary Rules and Procedures.

In an October 30 letter to the board, CFP professionals and the public, Goldfarb wrote, “I am certain that this was a misunderstanding, and I welcome the opportunity to engage in good faith the CFP Board’s enforcement process consistent with its Disciplinary Rules and Procedures.”

ING Financial Partners to help advisors grow their decumulation business

Posted on November 5, 2012 by Editor Test -

ING Financial Partners, the broker-dealer of ING U.S., has launched a new practice management program to help financial advisors grow the retirement income side of their business.

The program, which rolled out in early October, is available to more than 1,400 financial advisors in the ING Financial Partners Network, according to an ING release. Marcia Mantell, a retirement income consultant, has helped develop the program.

The program includes pre-approved pre-retiree and retiree seminars, educational materials with action plans, online tools and a structured framework that financial advisors can follow with their clients.

The scripted, 20-minute seminars address relevant topics, including health care, longevity risk, budgeting, lifetime income and financial risks. They are organized into modules that offer flexibility and enable customization for each audience’s needs.

If a client is concerned about health care, a financial advisor can start with the pre-retiree seminar that focuses on Medicare and potential health care costs.

The program also provides a resource guide for financial advisors and detailed training sessions, along with advice on identifying likely clients. A study by the ING Retirement Research Institute found that 86% of consumers say they need help determining how long their savings will last in retirement.

Can 401(k) Plan Balances Predict the Presidential Race?

Posted on November 5, 2012 by Editor Test -

A study of 401(k) plans nationwide by FutureAdvisor, the Seattle startup that specializes in giving free financial advice to young 401(k) participants, shows that plan balances in blue (Democratic-leaning) states tend to be higher than balances in red (Republican-leaning) states.

Over the past four years, median balances in blue states have remained at least 25% higher than median balances in red states, the study showed. In 2012, the median blue state balance was about 32% higher than the median red state balance, the group said.

In 2008, for instance, the median retirement account balance nationwide was just over $21,000. But in blue states it was $23,000 while in red states it was about $17,000.

Since 2008, median account balances nationwide have dropped and recovered by about the same percentage. “American retirements are in much better shape than they were four years ago,” said Bo Lu, president of FutureAdvisor, which advises on about $4 billion in savings and recently received $5 million in private equity from Sequoia Capital, according to techcrunch.com.

Through crisis and recovery, blue state plans have maintained their advantage over red state plans in terms of plan balance. That was somewhat counter-intuitive, Lu acknowledged, in view of the conventional wisdom that wealthier people are more inclined to vote Republican.

If the pattern holds true in the 2012 election tomorrow, the FutureAdvisor findings suggest an advantage for Democrats. That’s because 401(k) balances in swing states, whose electoral votes are considered still in play, tend to be higher than the national average. Those states are Colorado, Iowa, Florida, New Hampshire, North Carolina, Ohio, Virginia, and Wisconsin.

“As a group, the eight swing states are in general wealthier than the national average,” FutureAdvisor said, in a study released last week. “Five out of the eight report 401(k) average account balances that are higher than the national average. In addition, seven out of the eight report balances higher than the median among plans in red states. Only Florida falls below the median among red states.”

Did FutureAdvisor mean to suggest that its study indicates an Obama advantage? Lu wouldn’t venture farther than his data, which shows that “swing states skew wealthy.” Lu admitted that his data set was limited to 401(k) participants. Since only about half of American workers are covered by workplace retirement plans, the study isn’t representative of the wealth or voting patterns of all Americans voters.

FutureAdvisor’s findings do however support a claim made a few years ago by Columbia University political scientist Andrew Gelman, in his book, Red State, Blue State, Rich State, Poor State: Why Americans Vote the Way They Do (Princeton, 2008).

Rich individuals tend to vote Republican and Democrats are disproportionately supported by the less affluent, Gelman had observed. Yet wealthier states—like California and New York—have been voting Democratic, while poorer states—like Mississippi and Louisiana—are now reliably Republican.

“For decades, the Democrats have been viewed as the party of the poor, with the Republicans representing the rich,” wrote Gelman and others in a 2007 article in the Quarterly Journal of Political Science. “Recent presidential elections, however, have shown a reverse pattern, with Democrats performing well in the richer ‘blue’ states in the northeast and coasts, and Republicans dominating in the ‘red’ states in the middle of the country and the south.”

Gelman said this trend isn’t necessarily a puzzle. “Within an ‘upscale’ area that supports the Democrats, the more ‘upscale’ voters are still likely to vote Republican,” he wrote. “If we had to pick a “typical Republican voter,” he or she would be an upper-income resident of a poor state, and the “typical Democratic voter” would conversely be a lower-income resident of a rich state.”

So why, as he puts it, is “individual income… positively correlated with Republican voting preference, but average state income is negatively correlated with aggregate state presidential voting for Republicans”?

“These are not mutually exclusive relationships,” Gelman wrote. “We find that income matters more in ‘red America’ than in ‘blue America.’ In poor states, rich people are much more likely than poor people to vote for the Republican presidential candidate, but in rich states (such as Connecticut), income has almost no correlation with vote preference.

“We can understand the state average income effect as one of context. The Mississippi electorate is more Republican than that of Connecticut; so much so that the richest segment of Connecticutians is only barely more likely to vote Republican than the poorest Mississippians. In poor states, rich people are very different from poor people in their political preferences. But in rich states, they are not.”

Does this mean that wealthy Democrats empathize more with the poor in their states than wealthy Republicans do? Gelman doesn’t address that question, but James K. Galbraith and J. Travis Hale did in an October 22 Reuters op-ed article, “The Rich, the Poor, and the Presidency.”

They suggest, somewhat cynically, that “spatial segregation” is greater in wealthy blue states than in poor blue states. In other words, the wealthy blues are more insulated from their poor neighbors in states like Connecticut than in states like Mississippi.

“While income inequality, measured between persons or households, is higher in Mississippi than in Connecticut, spatial segregation is greater in Connecticut. That is, in Mississippi, rich and poor tend to live quite near each other, inside the same towns, counties and school districts, while in Connecticut, which is a well-known mosaic of wealthy and working-class towns, they don’t,” they write.

“And that means that in local politics, at least, Connecticut’s rich and the poor are often not in direct political conflict. They don’t live in the same towns, sit on the same school boards, argue quite so much over zoning or local property taxes. So conflicts rooted in class (and also in race) tend to be muted. None of this makes it easier for the poor to be Republican. But it does make it a bit easier for the well-to-do to be Democrats; it weakens their class politics, at least at the national level.”

As evidence, Galbraith and Hale point out that the majority of the least spatial-segregated states (South Dakota, North Dakota, Montana, West Virginia, Kentucky, Iowa, Vermont, Mississippi, Nebraska, Arkansas, Oklahoma, Wyoming, Louisiana, Idaho, Maine, Alabama and Alaska) mostly vote Republican.

Conversely, they say, the most spatially-segregated states (New York, Connecticut, Massachusetts, California, New Jersey, Maryland, Washington, Virginia, Pennsylvania, Illinois, Florida, Hawaii, Arizona, Minnesota and Delaware) mostly vote Democratic.

The authors also point out that the rich and poor are the most geo-polarized in the most populous states, which should give the Democrats an Electoral College advantage. “While the fifteen most geo-polarized states have 253 electoral votes,” they write, “the seventeen least polarized states have only 86.”

Suppressed Report Discredits “Supply-Side” Economics

Posted on November 5, 2012 by Editor Test -

A recent report from the Congressional Research Service suggests that “supply-side economics”—essentially, the idea that tax cuts pay for themselves by stimulating business activity—isn’t supported by historical evidence.

The report, dated September 14, was posted on the CRS website for private use by members of Congress and their staff, but was withdrawn two weeks later after Republican lawmakers objected to several aspects of it, the New York Times reported last week.

According to the Times, the economist who wrote the report, Thomas L. Hungerford, has donated $5,000 to the Obama campaign or the Democratic Party, but the report was an official publication of the non-partisan CRS, not a work of opinion.

The summary of the report said:

Throughout the late-1940s and 1950s, the top marginal tax rate was typically above 90%; today it is 35%. Additionally, the top capital gains tax rate was 25% in the 1950s and 1960s, 35% in the 1970s; today it is 15%.

The real GDP growth rate averaged 4.2% and real per capita GDP increased annually by 2.4% in the 1950s. In the 2000s, the average real GDP growth rate was 1.7% and real per capita GDP increased annually by less than 1%.

There is not conclusive evidence, however, to substantiate a clear relationship between the 65-year steady reduction in the top tax rates and economic growth. Analysis of such data suggests the reduction in the top tax rates have had little association with saving, investment, or productivity growth.

However, the top tax rate reductions appear to be associated with the increasing concentration of income at the top of the income distribution. The share of income accruing to the top 0.1% of U.S. families increased from 4.2% in 1945 to 12.3% by 2007 before falling to 9.2% due to the 2007-2009 recession.

The evidence does not suggest necessarily a relationship between tax policy with regard to the top tax rates and the size of the economic pie, but there may be a relationship to how the economic pie is sliced.

A 2011 report from the CRS by two other authors came to similar conclusions, saying that:

Potentially negative effects of tax rates on economic growth have been an issue in the debates about whether to extend the 2001-2003 income tax cuts, whether to increase taxes to reduce the deficit, and whether to reform taxes by broadening the base and lowering the rate.

Initially, it is important to make a distinction between the effects of policies aimed at short-term stimulation of an underemployed economy and long-run growth. In the short run, both spending increases and tax cuts are projected to increase employment and output in an underemployed economy. These effects operate through the demand side of the economy. In general, the largest effects are from direct government spending and transfers to lower-income individuals, whereas the smallest effects are from cutting taxes of high-income individuals or businesses.

Long-run growth is a supply-side phenomenon. In the long run, the availability of jobs is not an issue as an economy naturally creates jobs. Output can grow through increases in labor participation and hours, increases in capital, and changes such as education and technological advances that enhance the productivity of these inputs.

Historical data on labor participation rates and average hours worked compared to tax rates indicates little relationship with either top marginal rates or average marginal rates on labor income.

Historical studies on top U.S. marginal tax rates often refer to the tax rate but omit the income threshold to which the top rate applies. The chart below, from the Econometrics Laboratory Software Archive, compares the top marginal tax rate with the income threshold (expressed as a ratio of the top income threshold and the average income) between the years 1913, when the federal income tax was created, to 2008.

Russell Up Some Income

Posted on November 4, 2012 by Kerry Pechter -

As an advisor, you know that it’s sometimes hard to dissuade wealthy retirees from over-spending. A client might insist on burning through 10% a year, even after your Monte Carlo projections demonstrate that he’s flirting with long-term disaster by doing so.

“The four percent rule?” one advisor recently moaned. “I have trouble enforcing the 14% rule.” As for introducing the concept of “annuity” into the plan to reduce longevity risk… Well, that’s a conversation that few fee-based advisors, or their clients, want to have.

So, given the sensitivity around this topic, there’s obviously room in the marketplace for new ways to rivet your clients’ attention on safe spending rates, annuities and mortality without confusing them or scaring them half to death.

That is essentially what the Seattle-based asset manager Russell Investments is trying to do with a program that it rolled out about a month ago to advisors at Lincoln Investment Planning, based in Wyncote, Pa., and Cambridge Investment Research in Fairfield, Iowa.

It’s called the Russell Retirement Lifestyle Solution. An advisor feeds his clients’ data—age, assets, and income needs, etc.—into a web-based, interactive income planner. The tool spits out a “funded ratio” that, like the funded ratio of a pension plan, tells the advisor and the client whether the portfolio is on track to provide income for life.

Here’s where annuities enter the picture: If the funded ratio drops to 100%, it signals to the clients that they will have just enough money left in 10 years to buy an income annuity that can protect them from a late-life diet of Friskies and Fancy Feast. In a sense,, it uses clients’ own dread of annuitization to discourage them from over-spending.

Phill Rogerson (right), Russell’s managing director for consulting and product, calls it “a quick, direct way for advisors to calculate a client’s funded ratio in the context of a fairly sophisticated strategy.”

The catch is that client and advisor have to be willing to commit all or most of their investable assets to the program and to a Russell fund-of-funds that uses Russell’s “Adaptive Investing” technique—aka dynamic asset allocation, or reverse asset-rebalancing—to buffer downside risk. Since dynamic asset allocation is inherently conservative, and since the program employs mortality pooling only as a last resort, this approach might appeal more to clients whose legacy motive is greater than either their desire for growth or their need for current income.

Calculating the ‘funded ratio’

Russell’s Rod Greenshields (below, left), a consulting director for Russell’s advisor-sold products, recently led RIJ through a demonstration of the Lifestyle Solution’s online planner. Like other web-based income planners, it has data entry boxes, dynamic sliders, colorful bar charts and handy comparison tools.

What’s different is that, instead of using Monte Carlo projections to calculate the success rate of a certain annual withdrawal percentage from a certain level of assets over a certain number of years, the tool measures success by whether the client’s funded ratio is above or below 100%.

Funded ratios over 100% mean three things. First, that clients can meet their spending goals with systematic withdrawals for 10 years. (It’s a rolling 10-year period, and the funded ratio is recalculated every six to 12 months.) Second, that they’ll have enough money at the end of 10 years to fund a life annuity that will cover their expenses for the rest of their lives. (Russell regularly re-calculates the cost of the annuity.) Three, that they can afford to invest in equities.

A funded ratio under 100% means that it’s time for a course correction. Clients can make it positive again either by retiring later, spending less in retirement, or eventually buying a life annuity, which, at the expense of liquidity, allows them to take advantage of the so-called “survivor’s credit” that comes from mortality pooling.

Meanwhile, inside the planning tool, Russell’s “Adaptive Investing” re-allocates assets in a Russell fund-of-funds in response to changing market conditions. A kind of financial gyroscope, it protects the funded ratio by moving money from bonds to stocks when the funded ratio rises and from stocks to bonds when the funded ratio falls.

That’s not especially new. Russell first developed the strategy in the 1990s for a Japanese pension fund. The technique itself is a cousin of Constant Proportion Portfolio Insurance, or CPPI. Prudential Financial uses a modified version of CPPI to mitigate the risks of its Highest Daily variable annuity living benefit.

“We borrowed a couple of things from the pension world that have relevance for individuals,” Greenshields told RIJ. “First, we adopted the concept of using a funded ratio to communicate the health of the plan. Second, we recognized that pension plans focus on the capacity to bear risk. In the retail market, advisors tend to focus on assessing risk in terms of willingness to tolerate market volatility. But that doesn’t map to the real risk in retirement.

“In pension plans, they focus on the capacity to bear risk. That works for the individual too,” he added. “By saying that the investor with a surplus [above the 100% funded ratio] can bear more market risk, you’re shifting the focus from risk tolerance to risk capacity. The funded ratio is a great proxy for that. The higher their funded ratios, the more they can expose themselves to market risk.”

“We like the funded ratio because it captures a lot of information, and it shows investors where they stand,” Rogerson told RIJ in. “The tool is direct and straightforward and produces a personal funded ratio and proposal in 10 minutes.”

The funded ratio is really just a different way of expressing a retirement spending limit. The numbers that are used to generate the funded ratio could be used to generate a safe spending rate. Greenshields told RIJ that Russell’s calculations translate into a safe spending range that varies roughly from about 3% at age 55 or 60 to 8% at age 80.

At its heart, the Retirement Lifestyle Solution is a systematic withdrawal plan with a chip inside. More importantly for advisors, it provides a narrative that can help re-frame the difficult running-out-of-money conversation to make it simpler and less scary.

“We believe that if we provide the advisor with information about the ‘point of no return,’ then they can change the conversation,” Greenshields told RIJ. “As clients get closer to that line, they may have to lower their spending, at least temporarily.”

Though Lifestyle Solution isn’t meant to be pro-annuity—Russell is a $152 billion fund company, albeit one owned by Northwestern Mutual—it puts the life annuity option on the table. By introducing annuitization as a kind of remedy for over-spending, it also demonstrates, perhaps unintentionally, that life annuities enable retirees to spend more.

Third-party thoughts

One advisor told RIJ that he welcomed the Russell program because it facilitates a frank conversation that many clients would prefer to avoid. “The conversation needs to be had,” said Tom Forst of Lincoln Investment Planning. “We thought this was a unique way of starting the conversation. It provides clarity. It’s a unique way of framing the situation.”

“It’s a unique discipline for retirement planning. The current tools are: Manage it yourself; Use variable annuities with living benefits; or Self-insure. This provides a discipline that allows the client to invest in a managed portfolio, but gives them an ‘airbag’ that allows them to reallocate their portfolio if the market turns against them. In this case, the airbag is all about taking a breath and re-looking at the process.”

Denver-area advisor Phil Lubinski noted that he already uses a similar technique when discussing retirement income. But he suggested that Russell might be providing an important service for advisors who don’t have the time or inclination to do all the necessary calculations on their own.

“On every review I do a ‘stress test’ that involves telling the client what their current withdrawal rate is,” said Lubinski, who originated the time method behind Wealth2k’s Income for Life Model (IFLM). “If it goes over 6%, then I tell them that there is more stress on the portfolio than I am comfortable with—particularly if they hope to leave a legacy. Obviously, if the client is 88 years old, then the 6% isn’t as critical.”

The Russell method “has great psychological value and creates a floor in the mind of the client,” he added. “I just can’t imagine having to go through all these elaborate calculations that Russell is doing.”

Wade Pfau, Ph.D., who writes extensively about decumulation, blogged about the Russell program and raised a question about the merits of dynamic asset allocation. “I haven’t seen the math behind this part, but I do wonder about the implications that one is buying high and selling low when overfunded,” he told RIJ. “I wonder if the asset return assumptions guiding this part of the analysis account for mean reversion or whether they are independent and identically distributed. Mean reversion would work the other way, suggesting to reduce the stock allocation as the overfunding level grows.”

Commenting on Pfau’s blog, Crowley, Texas-based advisor Jason Hull found two potential weaknesses in the Russell approach. First, that dynamic asset allocation may not do a perfect job of market timing during a crisis, and second, that the client might be better off actually buying an income annuity instead of merely keeping the annuity option open.

“It just seems a little risky to think that you can catch the timing if your asset base is shrinking to know when to buy the annuity,” Hull wrote. “Remember, we hate to sell losers because of the endowment effect. Better, to me, to remove that temptation altogether.”

Greenshields defended dynamic asset allocation. He believes that, while asset-rebalancing suits the accumulation phase, reverse asset-rebalancing better suits the decumulation phase. as well as asset-rebalancing suits the accumulation phase. He also pointed out that it works well in slowly declining equity markets, similar to what occurred in 2007 and 2008.

“In investors’ memories, the financial crisis seems to have happened in a matter of weeks or days,” he said. “It seemed like everything was going off a cliff at once. But it didn’t happen all at once. There were seven quarters in a row that the equity markets registered a loss.” Buying-the-dips can make sense during a rising equities market, he noted, but buying into a market that’s falling is a losing game. That’s especially true for retirees, he said, who should be more concerned about minimizing losses than maximizing gains.

“Our strategy says, if you’re in equities and equities get punished, back off the equity exposure. Over those seven quarters [in 2008-2009], our strategy would have been to go to fixed income and cushion the fall. You give up the quick snap back, but there’s no free lunch. That’s a reasonable trade-off during retirement. If we knew that the market was going to snap back in the next quarter, our strategy wouldn’t make sense.”

Back to the future

Retirement Lifestyle Solution isn’t entirely new for Russell. It represents the evolution of Russell’s LifePoint Retirement Distribution Funds, which were launched about five years ago. Those were funds-of-funds that paid out a predictable but not guaranteed income over a 10-year period and used dynamic asset allocation to keep the account value from straying off course.

LifePoint Funds, like other payout funds launched, fell victim to a number of adverse factors. They faced bad timing (the financial crisis), a fairly narrow focus (they were purely product-based solutions) and they lacked transparency (their risk management method was a bit of a “black box”).

But the LifePoint Funds live on as the investment vehicle for Russell Retirement Lifestyle Solution, which takes the earlier product, puts it inside a planning tool and adds a dashboard indicator—the funded ratio. All of which makes the funds more transparent, easier to explain and, presumably, easier to market.

“It’s very similar under the hood to what we did with LifePoint,” Greenshields told RIJ.

“We developed software for it, but that never went anywhere. The underlying mathematical algorithms are similar in principle, in terms of doing optimization process.”

The new strategy is being put to the test right now, as Lincoln Investment Planning and Cambridge Investment Research roll it out to their advisors. Cambridge is the ninth largest independent broker-dealer in the U.S., with about 2,000 advisors and annual revenue of almost $400 million. Lincoln’s 850 advisors manage $19 billion for about 250,000 customers nationwide.

“It’s up to our reps to embrace it, and they haven’t had time yet,” Forst told RIJ. “We just started training on October 1, and we don’t expect to see significant sales or movement of assets until next year.”

Russell already has commitments from three other broker-dealers to use the Retirement Lifestyle Solution, Rogerson said, and the firm has plans to use it in defined contribution space, where it would compete against programs such as Financial Engines’ Income+ and Dimensional Fund Advisors’ recently-launched Managed DC. Said Greenshields, “We are actively pitching this to DC clients.”

Producers like American Funds, iShares, and Jackson National: Cogent

Posted on November 4, 2012 by Editor Test -

American Funds, iShares, and Jackson Nation Life enjoy the strongest “personal connection” with financial advisors who sell their mutual funds, ETFs and variable annuities, respectively, according to Boston-based Cogent Research.

The results were announced in Cogent’s Advisor Touchpoints 2012, a proprietary report based on a survey of 1,741 retail investment advisors in all major distribution channels. Survey participants were required to have an active book of business of at least $5 million, and offer investment advice or planning services to individual investors.

When asked to identify the mutual fund company with which they feel the “strongest connection,” 16% of mutual fund producers named American Funds. More than a third (37%) of ETF producers identified iShares as their favorite ETF company and 24% of variable annuity sellers said Jackson National was their favorite provider of VAs.

“Trust and familiarity, built up with advisors over many years, has and will continue to sustain these market leaders against the onslaught of competition,” said Linda York, Cogent’s research director. “For Jackson National, which overtook Prudential this year on this measure, it is proof that building a strong connection with advisors can actually propel a company to the top.”

Cogent also asked advisors who don’t currently sell a company’s products to name firms with which they feel personally connected, since the answer indicates what they are likely to sell in the future. Five percent of non-users named J.P. Morgan Funds, 9% named PowerShares, and 11% named Jackson Life indicated that they feel more connected to these firms than their current providers.

According to Cogent, Jackson ranked the highest in personal connection in the national and independent channels, and among advisors with $100 million or more in assets. Jackson led all VA providers in client activity, with 65% of advisors saying they had received a Jackson external wholesaler visit within the past three months, and 73% saying they had received a Jackson internal wholesaler phone call within the past six months.

“Best Personal Connection with Advisors”
Mutual fund providers		ETF provider		Variable annuity providers
1.	American Funds	1.	iShares	1.	Jackson National
2.	Franklin Templeton Investments	2.	PowerShares	2.	Prudential
3.	BlackRock	3.	State Street/SPDR;	3.	MetLife
4.	J.P. Morgan		First Trust (tie)	4.	AIG/SunAmerica;
5.	Fidelity;	4.	Vanguard		VALIC (tie)
	OppenheimerFunds;	5.	ProShares;	5.	Nationwide Financial
	PIMCO (tie)		WisdomTree (tie)
Source: Cogent Research Advisor Touchpoints^TM 2012

Too Big to Handle

Posted on October 31, 2012 by Editor Test -

In the discussion of whether America’s largest financial institutions have become too big, a sea change in opinion is underway.

Two years ago, during the debate about the Dodd-Frank financial-reform legislation, few people thought that global megabanks represented a pressing problem. Some prominent senators even suggested that very large European banks represented something of a role model for the United States.

In any case, the government, according to the largest banks’ CEOs, could not possibly impose a cap on their assets’ size, because to do so would undermine the productivity and competitiveness of the US economy. Such arguments are still heard – but, increasingly, only from those employed by global megabanks, including their lawyers, consultants, and docile economists.

Everyone else has shifted to the view that these financial behemoths have become too large and too complex to manage – with massive adverse consequences for the wider economy. And every time the CEO of such a bank is forced to resign, the evidence mounts that these organizations have become impossible to manage in a responsible way that generates sustainable value for shareholders and keeps taxpayers out of harm’s way.

Wilbur Ross, a legendary investor with great experience in the financial services sector, nicely articulated the informed private-sector view on this issue. He recently told CNBC,

“I think it was a fundamental error for banks to get as sophisticated as they have, and I think that the bigger problem than just size is the question of complexity. I think maybe banks have gotten too complex to manage as opposed to just too big to manage.”

In the wake of Vikram Pandit’s resignation as CEO of Citigroup, John Gapper pointed out in the Financial Times that “Citi’s shares trade at less than a third of the multiple to book value of Wells Fargo,” because the latter is a “steady, predictable bank,” whereas Citigroup has become too complex.

Gapper also quotes Mike Mayo, a leading analyst of the banking sector: “Citi is too big to fail, too big to regulate, too big to manage, and it has operated as if it’s too big to care.” Even Sandy Weill, who built Citi into a megabank, has turned against his own creation.

At the same time, top regulators have begun to articulate – with some precision – what needs to be done. Our biggest banks must become simpler. Tom Hoenig, a former president of the Federal Reserve Bank of Kansas City and now a top official at the Federal Deposit Insurance Corporation, advocates separating big banks’ commercial and securities-trading activities. The cultures never mesh well, and big securities businesses are notoriously difficult to manage.

Hoenig and Richard Fisher, the president of the Federal Reserve Bank of Dallas, have been leading the charge on this issue within the Federal Reserve System. Both of them emphasize that “too complex to manage” is almost synonymous with “too big to manage,” at least within the US banking system today.

George Will, a widely read conservative columnist, recently endorsed Fisher’s view. Big banks get a big taxpayer subsidy – in the form of downside protection for their creditors. This confers on them a funding advantage and completely distorts markets. These subsidies are dangerous; they encourage excessive risk-taking and very high leverage – meaning a lot of debt relative to equity for each bank and far too much debt relative to the economy as a whole.

Now these themes have been picked up by Dan Tarullo, an influential member of the Board of Governors of the Federal Reserve System. In an important recent speech, Tarullo called for a cap on the size of America’s largest banks, to limit their non-deposit liabilities as a percentage of GDP – an entirely sensible approach, and one that fits with legislation that has been proposed by two congressmen, Senator Sherrod Brown and Representative Brad Miller.

Tarullo rightly does not regard limiting bank size as a panacea – his speech made it clear that there are many potential risks to any financial system. But, in the often-nuanced language of central bankers, Tarullo conveyed a clear message: The cult of size has failed.

More broadly, we have lost sight of what banking is supposed to do. Banks play an essential role in all modern economies, but that role is not to assume a huge amount of risk, with the downside losses covered by society.

Ross got it right again this week, when he said: “I think that the real purpose and the real need that we have in this country for banks is to make loans particularly to small business and to individuals. I think that’s the hard part to fill.”

He continued, “Our capital markets are sufficiently sophisticated and sufficiently deep that most large corporations have plenty of alternative ways to find capital. Smaller companies and private individuals don’t have really the option of public markets. They’re the ones that most severely need the banks. I think they’ve kind of lost track of that purpose.”

Hoenig and Fisher have the right vision. Tarullo is heading down the right path. Ross and many others in the private sector fully understand what needs to be done. Those who oppose their proposed reforms are most likely insiders – people who have received payments from big banks over the past year or two.

Quote of the Week

Posted on October 30, 2012 by Editor Test -

New York Life expands retail annuity team

Posted on October 30, 2012 by Editor Test -

Matt Grove, head of New York Life’s annuity business, circulated a message to his LinkIn network on September 26 saying that the mutual insurer, which dominates sales of income annuities in the U.S., is expanding its retail annuity team and has two high profile positions to fill.

According to Grove’s note, New York Life is looking for someone to lead its variable annuity product management team and a second person to lead strategic development for the annuity business.

The variable annuity position involves “managing the product development life cycle for our $2.5 billion per year variable annuity business,” Grove wrote. “An ideal candidate would have experience developing variable annuity products and working with the extended product development team—including pricing, technology, legal and marketing personnel—to successfully launch products.”

The person who fills the planning job “would be responsible for leading strategy development, planning and execution, and also helping to transform the annuity business from a set of functional silos into a true P&L. An ideal candidate would have prior experience in a similar role in the annuity industry,” Grove wrote.

Gender has little effect on IRA asset allocation: EBRI

Posted on October 30, 2012 by Editor Test -

Men and women differ in many ways, but they do not allocate the assets in their individual retirement accounts (IRA) very differently, according to a new report from the Employee Benefit Research Institute (EBRI).

While gender has little impact on IRA asset allocation, other factors do, the EBRI says. People of either sex who are relatively older, who have relatively higher account balances, or who own a rollover IRA had, on average, lower allocations to equities, according to the report.

Traditional IRAs that originated from rollovers had the lowest percentage of assets in equities (at 41.3%), the highest in money (12.8%) and the highest in bonds.

Roth IRA owners had the highest share of assets in equities (59.1%) and balanced funds (15.5%). They were also much more likely to have 90% or more of their account invested in equities than owners of the other IRA types. IRA owners who also were 35 to 44 years old or had balances under $10,000 were more likely to have more than 90% in equities.

As of year-end 2010, about 46% of all IRA assets were in equities, 20% in bonds, 11% in balanced funds, 9% in money, and 15% in “other” investments, EBRI said.

Generally, as account balances increased, the percentages of assets in a combination of equities (owned directly or through mutual funds) and balanced funds (including target-date funds) decreased, while the percentage in fixed income and “other” assets increased.

Equity allocations were highest for those ages 25 to 34 with the largest account balances and lowest for young IRA owners (under age 35) with account balances under $10,000.

“Those under age 45 were much more likely to use balanced funds than were older IRA owners, and those under age 35 with balances less than $25,000 had particularly higher allocations to balanced funds,” noted Craig Copeland, EBRI senior research associate and author of the report. “This shift follows the standard investing ‘rule of thumb’ that individuals should reduce their allocation to assets with high variability in returns (equities) as they age.”
© 2012 RIJ Publishing LLC. All rights reserved.

Economy grew faster but business investment fell in Q3 2012: Prudential

Posted on October 30, 2012 by Editor Test -

The latest economics assessment from Prudential global equity strategist John Praveen shows that:

Although the rate of GDP growth remains below trend, a recovery in consumer and government spending helped the U.S. economy improve in Q3 2012. U.S. GDP grew at an annualized rate of 2% in Q3 after growing at a rate of 1.3% in Q2 and 2% in Q1. GDP growth in Q3 was slightly better than market expectations of 1.8% growth. On an annual basis, GDP rose 2.3% YoY after 2.1% in Q2.

Consumer spending (1.4%), government spending (0.7%) and housing (0.3%) drove Q3 GDP growth. Government spending had declined in the previous eight quarters. Residential construction remained “solid.”

Inventories (-0.4%), trade (-0.2%) and business investment spending (-0.1%) all receded in Q3. A drought-related decline in farm inventories subtracted -0.4% from Q3 GDP.

Other details included:

Consumer spending rose 2% QoQ annualized in Q3, improving from 1.5% in Q2, and added 1.4% to Q3 growth after a 1.1% contribution in Q2. There was a strong recovery in durable goods (8.5% after -0.2%) and non-durable goods (2.4% after 0.6%) spending. However, services spending, the largest component of consumer spending, growth slowed to 0.8% from 2.1%.
Government spending reversed several quarters of declines, rising 3.7% in Q3 after -0.7% in Q2 and added 0.7% to Q3 growth. The reversal in government spending was primarily driven by an increase in federal national defense consumption spending which jumped 15.2% after falling -2.1% in Q2. While there was also a modest increase in non-defense spending, the increase in defense spending was the primary driver of the sharp increase in federal spending in Q3. By contrast, state and local spending edged down modestly.
Housing added 0.3% to Q3 growth with residential investment surging 14.4% in Q3 after 8.4%, albeit from a low base. The strength in residential investment is consistent with the upward trend in housing starts in recent months.
Business investment spending remained weak for the fourth consecutive quarter, suggesting that more businesses are putting projects on hold ahead of the fiscal cliff. Business investment spending declined -1.3% in Q3 after growing 3.6% in Q2 and 7.5% in Q1, and reduced -0.1% from Q3 GDP growth. Spending on equipment and software was flat, while investment in structures fell -4.4%.
Trade was a drag on growth with net exports reducing -0.2% from Q3 GDP growth. Exports declined -1.6% after rising 5.2% in Q3, while imports edged down -0.2% after rising 2.8% in Q2.

Looking ahead, Praveen expected U.S. GDP growth to slow to around 1.8% in Q4.

On the plus side, “Consumption spending is likely to remain solid due to support from lower energy prices and the recent gains from equity markets,” the report said. “GDP growth is also likely to get a boost from a rebound in farm inventories which were on drag on Q2 and Q3 GDP. Housing is also likely to remain solid with interest rates lower and housing activity remaining solid.”

On the negative side, “business investment spending is likely to remain weak in Q4 despite healthy corporate cash levels due to concerns about the ‘fiscal cliff’ and how it will be resolved once the U.S. Presidential election is over. Trade is likely to remain a drag with slower global growth and Europe in recession.”

Financial Engines cites growth of its Income+ program

Posted on October 30, 2012 by Editor Test -

Income+, the decumulation strategy that Financial Engines offers to its managed account customers, now has more than 50 signed contracts representing $79 billion in assets from over 900,000 retirement plan participants, the company announced earlier this month. Of those numbers, $30 billion is already under management and 340,000 employees are already enrolled.

The San Francisco firm’s announcement coincided with the Third Annual Retirement Income Summit, held October 10 in New York and co-hosted by Financial Engines and the Pension Research Council of The Wharton School of the University of Pennsylvania.

Launched in January 2011, Income+ is described by Financial Engines “as the first retirement income solution designed specifically for 401(k) plans. Income+ helps protect participants from big losses before retirement and generates steady monthly payouts that can last for life.”

Participants who use the Financial Engines managed account program, Professional Management, which costs each participant up to 60 basis points a year depending on account size, do not need to pay extra to use Income+.

“Income+ …can create the kind of safe but flexible spending from their investment accounts that is needed in this new reality,” said Financial Engines president and CEO Jeff Maggioncalda in a statement.

Income+ does not involve the purchase of an annuity. According to Financial Engines’ website, retirees who want an income guarantee can purchase an annuity. Under Income+, employees maintain full control of their assets and the timing of their withdrawals, can cancel the program at any time, and can choose when to start or stop payouts.

The annual Retirement Income Summit offers a collaborative forum for academics, policy makers, and large employers to facilitate new programs that help retirees create income that can last for life.

Government, policy makers and key executives from nearly 30 large employers representing a cross-section of industries attended the invitation-only event. Of the sponsor participants, more than half were from Fortune 500 companies.

Speakers at the Summit included:

Michael Davis, Deputy Assistant Secretary of the U.S. Department of Labor
Mathew Greenwald, president and CEO, Mathew Greenwald and Associates
J. Mark Iwry, Senior Advisor to the Secretary of the Treasury and Deputy Assistant Secretary for Retirement and Health Policy
Jason Scott, managing director, Financial Engines Retiree Research Center
Richard Shea, partner, Covington & Burling and Pension Research Council advisory board member
John Shoven, director, Stanford Institute for Economic Policy Research
Panelists from Citigroup, The Home Depot and other large plan sponsors

Stock Split

Posted on October 30, 2012 by Knowledge@Wharton -

The stock markets climbed all summer, and were nearing record highs before the Dow Jones Industrial Average fell 243.36 points [recently], down almost 4% from a five-year peak. Yet even before the drop, many investors didn’t trust the rally.

“This is the most disliked rally I can ever remember,” Charles Rotblut, vice president of the Chicago-based American Association of Individual Investors, said last week, referring to the recent stock run up, which ended abruptly after a string of dismal third quarter earnings reports.

Washington gridlock—including speculation about the upcoming Presidential election, stubborn unemployment and the stalemate in Europe—were making investors uncertain, Rotblut notes.

Weekly surveys of the sentiments of the Association’s 150,000 members (with the option to pick “bearish,” “bullish” or “neutral”) have revealed bullish outlooks to be below average for 28 of the past 29 weeks. Bond allocations among surveyed members have been above average for more than three years.

Many investors are frustrated with low yields, they don’t have confidence in the market and they are worried about “another shoe dropping,” Rotblut says. “And nobody counts how many people have just checked out of the market,” he adds. “They tend to just very quietly move away.”

Wharton professors disagree about which way stock markets are headed and whether investors should be in or out. Some have pulled their own investments out of equities and don’t plan to return. Others say bearish investors are hurting themselves by withdrawing at the worst possible time and missing out on the market’s upside.

Chris Goolgasian doesn’t need surveys to tell him how retail investors feel about the stock market these days. As head of the U.S. portfolio management and investment solutions group for Boston-based State Street Corp., he meets regularly with brokers and advisors who manage individual client portfolios. In as many as 80 meetings since April, they have all said the same thing: How do I get my clients out of cash and bonds? “This is repeated at every meeting,” Goolgasian notes. “These advisors are meeting clients who are extremely bearish.”

Investors have moved about $2 trillion into cash and fixed income since the financial crisis, Goolgasian says. And despite a number of indicators that suggest the market today is “a fairly low risk environment,” many retail investors “don’t want to hear it. Money flow weekly is still out of equity funds and into bonds and cash.”

Investors who have swapped equities for bonds have “exchanged nominal safety for a real loss,” Goolgasian points out. “They are getting ‘safety’ in their accounts in that they are not seeing volatility…. But they are going to suffer real losses because the bonds and cash they bought are earning less than the inflation rate.”

Institutional investors are less likely to divest from equities, given spending goals that can’t be met with bonds earning 1.5%, Goolgasian notes. Individual investors, on the other hand, are suffering from a number of ‘isms’: “Pessimism about the job market, skepticism about the equity rally and cynicism about our political leaders and their ability to pull us out of this.”

Many investors pulled their money out of the market in 2008 and haven’t come back, scared of volatility and still reeling from the drama of the Flash Crash in 2010. That’s been a mistake, according to Wharton finance professor Jeremy Siegel. Even factoring in Tuesday’s drop, the market’s value has doubled since March 2009. Volatility has eased. For equity investors, Siegel sees sunny days ahead.

“The public unfortunately lags [behind] what’s going on in the market,” says Siegel, noting that rank-and-file investors tend to be bullish at the top of the market and bearish when the market is about to recover. “It is not unusual for the public to miss the first half to two-thirds of a bull market. Then they get in at the end, and they ride it down.”

To sophisticated market watchers, the fact that most retail investors are staying out of the market right now is actually a positive indicator, since history shows that public flows in and out of the market are usually badly timed, Siegel says. “I still think this bull market definitely has room to run,” he notes. “I can easily see stocks up another 20% to 30% from these levels in a year or two.”

Wharton finance professor Franklin Allen holds the opposite view—as well as opposite investments. “I don’t have much in the stock market at all anymore,” notes Allen, who describes himself as risk-averse. “It’s in Treasuries and real estate.”

Allen says he doesn’t know why the stock market is as high as it has been lately, and wonders if it’s a bubble. The recent rally may have more to do with quantitative easing by the Federal Reserve (QE3) than a positive economic outlook, he notes.

Despite low returns on bonds and Treasuries, Allen says he wouldn’t go back into the market unless equity prices dropped by about 30%. “If you think the market is going to drop, then zero [return] is better than minus-20,” Allen points out. “That’s the perspective that people who are pulling out are using.”

Wharton finance professor Richard J. Herring says the market outlook remains uncertain. “It is hard to imagine earnings continuing to grow since they are already at an historical high relative to GDP, and the economic outlook is tepid at best,” he notes. “Many experts believe this is a market pumped up by QE3 and little else.”

Market volatility over the past few years may be keeping investors away, Herring suggests. “Although we are now back to about where we were in 2006, it has been a horrifying ride, and some investors bailed out at precisely the wrong time because they were terrified it could go still lower.”

A crisis of confidence?

Confidence in the markets has been damaged in a variety of other ways, with a number of incidents causing individual investors to wonder how well they are being protected by institutions such as the Securities and Exchange Commission, Herring adds.

“The Madoff scandal, MF Global, the flash crash, the software error at Knight Capital, the NYSE settlement with the SEC over information sold preferentially to a program trader, the bizarre spectacle of the Facebook IPO and scandals at several major banks all have undermined the confidence of individual investors that they can be treated fairly,” he says. “It seems like a game rigged against [them].”

This is costly to society, because it means that less capital will be available for risk-taking and the liquidity of markets will diminish, Herring notes. “Although many overlook the point, we should realize that confidence in the markets is an enormously valuable public good. If investors trust that they will be treated fairly, they will be much more likely to place their savings in marketable instruments, and both the quality and quantity of capital formation will be improved.”

About 46% of American households held investments in stocks or stock funds at the end of 2011, down from 53% in 2001, according to the Investment Company Institute, a Washington, D.C.-based association of U.S. investment companies.

“We have seen outflows from domestic mutual funds since 2007,” says Investment Company Institute senior economist Shelly Antoniewicz. Yet she says it would be wrong to suggest that investors are simply running away from stocks. “We don’t think that investors are fleeing” domestic equity markets, she adds. “We think of it as diversification.”

For example, from the beginning of 2007 to August 2012, a total of $196 billion flowed out of domestic mutual funds and exchange traded funds. During that same period, $361 billion went into international equity mutual funds and ETFs, which “more than offsets all the flows out of domestic equity,” Antoniewicz says out.

Investors are also putting more money into products such as target date funds and hybrid mutual funds, which contain a mix of equities and bonds, she adds. During the first nine months of 2012, for example, $45 billion flowed into hybrid mutual funds, up from $30.7 billion for the year 2011 and $23.7 billion in 2010.

With two bear markets in the past decade, the willingness to take risk has gone down across all age groups, Antoniewicz notes. “Even within age groups, people are a little more risk averse. They are more conscious about diversifying.”

A general malaise

Reticence to invest in stocks may also reflect “just a general malaise and a growing distrust for essentially all of our institutions,” says Olivia S. Mitchell, a Wharton professor of business economics and public policy and executive director of Wharton’s Pension Research Council. A Gallup poll in June, for example, found that only 21% of Americans have confidence in banks, down from 60% in 1980.

“The other thing you see over and over again is that people today are extremely pessimistic,” Mitchell adds. Worries include the U.S. economy, the looming fiscal cliff, continuing turmoil in Europe and a slowing economy in China. “If China’s growth is tapering off, what does it mean for the rest of the world? People are skeptical,” she notes.

Mitchell cites the latest Chicago Booth/Kellogg School Financial Trust Index, a quarterly survey of public attitudes toward financial institutions, which found that only 15% of those surveyed said they trusted the stock market, and 47% said it was likely to drop 30% or more in the next 12 months.

Her daughters, both in their 20s, echo public sentiment, Mitchell says. They argue that there’s no point in putting money in their 401ks because they could lose it, and if they put it in the bank, they won’t earn enough to beat inflation, “so they might as well spend it.” It’s not exactly what Mitchell wants to hear: Long term, that approach translates into having to save more, consume less and most likely delay retirement.

Mitchell herself pulled out of the stock market entirely in 1999, investing her pension in Treasury Inflation-Protected Securities (TIPS) instead. “And I’ve made more money investing in TIPS between 1999 and today than if I had invested in the stock market,” she says. “Since the year 2000, the market hasn’t performed very well.”

The problem now is that TIPS are paying negative returns, and she is reluctant to put all of her money in real estate. “I don’t think there is any easy answer except work longer, save more and spend less,” Mitchell suggests.

Most middle class households probably held too much of their investments in stock anyway, notes Wharton business economics and public policy professor Kent Smetters, which is why he is “not too upset” with the apparent trend away from equities. “Stocks should not be the main workhorse vehicle for basic retirement needs,” Smetters says. “Bonds should be used for basic retirement and stock for goals where falling short is more acceptable to the household.”

Smetters recommends that portfolios include bonds, TIPS and some stocks, but adds a caveat: “People should not use the expected return on stocks when estimating how much saving they need,” he says. “They should use a bond yield to adjust for risk. That forces them to save but also better manages risk.”

The Fed’s Exit Strategy

Posted on October 29, 2012 by Editor Test -

Exit from this regime [quantitative easing] could prove difficult. In particular, some observers worry that the expansion of the Federal Reserve’s balance sheet could ultimately prove inflationary. If that were the case, then I would regard the costs as exceptionally high.

Fortunately, I am confident that such fears are misplaced. That is because we now have the ability to pay interest on excess reserves (IOER). This means we can keep inflation in check regardless the size of our balance sheet. If the recovery got underway in earnest and credit demand surged, we could slow down the rate of credit creation by raising the interest rate we pay on excess reserves.

Banks wouldn’t lend out funds at lower rates than what they can earn from holding reserves with us. As a result, a hike in the IOER would raise the level of interest rates throughout the economy and this would dampen any expansion of credit. Our ability to pay interest on excess reserves is an essential tool that we can use to avoid future inflation problems.⁴

We are mindful of the fact that there could still be confusion about how exit will take place. This could increase financial market volatility. To reduce this risk, the FOMC has published a set of exit principles. These principles lay out a roadmap about how exit is likely to occur:

First, the end of reinvestment of maturing securities;
Second, an increase in short-term interest rates, and,
Third, the gradual sale of mortgage backed securities to shrink the magnitude of excess reserves in the system and ultimately to restore the Fed’s balance sheet to a predominately all-Treasury portfolio.

A degree of humility is appropriate given the lack of experience as to how markets will respond when economic conditions eventually cause investors to anticipate exit. When asset purchases are anticipated to end or when asset sales begin to be anticipated, this will affect term premia in ways that cannot be precisely predicted in advance. That said, I do expect the repricing will prove manageable. We will seek to communicate so as to avoid generating sharp shifts in term premia and in long-term interest rates. Also, we will play close attention to ensure that financial institutions are managing their interest rate risks appropriately.

The third set of costs is the impact of higher short-term rates on the Federal Reserve’s earnings and balance sheet when exit occurs. When we ultimately raise short-term interest rates, this will squeeze the Fed’s net interest margin. Also, when the Fed sells long-term assets, there is some prospect for losses on these sales depending on the level of long-term interest rates at the time when such sales occur. This means that the Fed’s earning could fall sharply or even turn negative in a given year. We look at this issue very closely to understand the risks here.

The good news is that a very large proportion of our liabilities—those associated with currency outstanding—has no interest cost. This mitigates the risk of a sharp net interest margin squeeze. Moreover, our analysis shows that the cumulative income generated over the period in which the balance sheet has been unusually large is likely to exceed normal levels under a wide range of scenarios.

In my view, while the costs are real and need to be carefully evaluated, they pale relative to the costs of not achieving a sustainable economic recovery. A failure in that regard would lead to widespread chronic unemployment. Not only would that be tragic for millions of people, but it also would generate chronic shortfalls in the nation’s potential output and fiscal capacity. Relative to the costs outlined above, the benefits from avoiding such an outcome seem overwhelming.

The SmartNest Back-Story

Posted on October 24, 2012 by Editor Test -

Last March, David H. Deming, a convivial former JPMorgan managing director, gave a slide presentation about Managed DC, Dimensional Fund Advisor’s new managed account program for defined contribution plans, during the Retirement Income Industry Association’s spring meeting at Morningstar headquarters in Chicago.

Managed DC appeared ready-to-launch. Deming, then the CEO of Dimensional Retirement, passed out business cards and invited a journalist to call him for a detailed interview about the program, which is based on software called SmartNest that was developed about six years ago by Nobel Prize-winning economist Robert C. Merton. (See today’s RIJ cover story.)

But subsequent phone calls and e-mails to Deming later that spring went unreturned, and by September it emerged that Deming had been ousted from DFA, for unknown reasons. He had left Austin, Texas, where DFA is based, and moved to Oyster Bay, New York, where according to the networking website LinkedIn, he now has a financial advisory firm, D. H. Deming & Co.

Over the summer, DFA chairman David Booth had replaced Deming with Michael Lane, 45, a DFA vice-president. Unlike Deming, who arrived at DFA in 2009 when it bought the patented SmartNest software, Lane has long had a close working relationship with Booth.

Lane’s most recent title, according to LinkedIn, was “vice president, Office of the Chairman,” where his job description was “work[ing] with the chairman on strategic global initiatives.”

“I’ve been around DFA for 18 years, and I’ve been an employee for eight years,” Lane told RIJ a few weeks ago. “I’ve been working on long-term strategic initiatives, including how to provide a better, more integrated lifetime experience for plan participants. David Booth asked me two months ago if I would take over as head of Dimensional SmartNest, and take it from an interesting solution to getting it out into the market.”

A 1989 political science graduate of the State University of New York at Binghamton, Lane started in the financial services business as a registered rep at Equitable Life. He spent seven years at AEGON Financial, rising to president of Advisor Resources, then served as vice-president of advisor distribution at TIAA-CREF.

Asked if Deming’s non-homegrown status at DFA was linked to his sudden departure, Lane told RIJ: “I would couch it… I’ve been around the firm for a long time—almost 20 years. There is some value in knowing all the people in the firm, in having worked outside and inside the firm, and in knowing how to get things done here.”

The story of how DFA came to own SmartNest is an interesting one, though the details remain elusive.

SmartNest was originally the property of Integrated Financial Limited, a hedge fund firm that Merton—a co-founder of the Long-Term Capital Management hedge fund whose spectacular crash and bailout in 1998 was chronicled in Roger Lowenstein’s best-selling book, When Genius Failed—started in 2002 with a team from JPMorgan. The team included Deming, a former JPMorgan managing director, as well as Robert Mendoza, a former vice-chairman of JPMorgan, and Peter Hancock, a former CFO of JPMorgan. Merton himself had been a senior advisor to and managing director of JPMorgan Chase from 1999 to 2001, according to Reuters.

In January 2007, Integrated Financial merged with another financial advisory firm, Marakon Associates, which was co-founded in 1978 by Jim McTaggart, to form a new company called Trinsum Group. Merton became chief science officer and McTaggart became CEO. In a press release, Trinsum described itself as a firm that creates “breakthrough solutions by combining the science of finance, the discipline of management and the art of advice.” It boasted of offices in seven cities, from Singapore to New York to Zurich.

“Trinsum Group, will integrate advisory services previously accessible only through the use of multiple providers,” a company press release said. “By offering an integrated approach, Trinsum Group will fill the gap between management consulting and investment banking for objective, real-world advice steeped in financial science.”

The release continued, “The new company will serve top management of large corporations on issues relating to strategy, execution, organic growth, M&A, productivity and organization. The firm also plans to add a strategic risk management practice in early 2007. In addition, Trinsum Group will offer sophisticated investors a range of investment vehicles, and will continue to develop next-generation financial products such as SmartNest, a pension management solution that addresses deficiencies associated with traditional defined-benefit and defined-contribution plans.”

But, like a lot of other financial firms during the 2008-2009 period, Trinsum failed, or the Integrated Financial-Marakon merger failed, for reasons that aren’t immediately clear. According to Crain’s New York Business, Trinsum Group’s creditors filed for liquidation in July 2008, and Trinsum filed for Chapter 11 bankruptcy in 2009.

In its filing, Trinsum reported liabilities of $15.8 million and assets of $1.2 million—“$1.1 million of which is listed as the value of a patent for an investment management software program called SmartNest.”

So DFA appears to have plucked SmartNest from a burning ship; the collapse of Trinsum led to two years of lawsuits and appeals that appear to have been dismissed or denied. Deming accompanied SmartNest to DFA, stayed on as CEO of Dimensional Retirement/SmartNest for three years or so, and then left suddenly last summer. The ball is now in Lane’s hands.

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