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Experts with Unrealistic Expectations

Posted on November 15, 2012 by Editor Test -

The CEOs of many of the largest U.S. financial services companies sent an open letter to President Obama and Congress on October 18, urging them to resolve the “fiscal cliff” problem quickly and rein in the nation’s deficit spending.

“We urge you to work together to reach a bipartisan agreement to avoid the fiscal cliff and take concrete steps to restore the United States’ long-term fiscal footing,” they wrote.

Signers of the appeal, which was written on the letterhead of the Financial Services Forum, included Steven Kandarian of MetLife, John Strangfeld of Prudential, John Stumpf of Wells Fargo, Lloyd Blankfein of Goldman Sachs, Jamie Dimon of JP Morgan Chase and 10 other CEOs.

In asking Washington officials to “avoid the fiscal cliff,” the executives presumably meant avoiding the currently scheduled reversion to Clinton-era tax rates on income, capital gains and dividends, as well as an automatic $120 billion-a-year cut in discretionary spending known as “sequestration.”

In the same letter, however, the CEOs asked the president and Congress to “restore the nation’s long-term fiscal soundness by negotiating policies that will produce a stabilization and then downward trend in the ratio of federal debt to GDP over the medium term.”

But, as New York Times columnist Paul Krugman recently pointed out, those two wishes are in conflict. At best, it sounds like a recommendation to “kick the can down the road.” The Congressional Budget Office has forecast that avoiding the fiscal cliff—that is, failing to raise taxes and lower spending—would contribute to unsustainable growth in the federal debt.

The request from the CEOs resurrects supply-side economic thinking, a dead theory that says lower income taxes lead to tax revenue-enhancing growth. That thinking has been called “voodoo” and “zombie” economics. It has been disavowed by some of its original proponents. There’s no grand bargain that can simultaneously soften the impact of the cliff in 2013 and lead to smaller deficits.

The letter exaggerates the impact of the fiscal cliff. “Sequestration” would eliminate only 3% of next year’s budget; that’s a bump in the road, not a precipice. In its latest assessment, the Congressional Budget Office said, “If all of that fiscal tightening occurs, real GDP will drop by 0.5% in 2013… That contraction of the economy will cause employment to decline and the unemployment rate to rise to 9.1% in the fourth quarter of 2013. After next year, by the agency’s estimates, economic growth will pick up, and the labor market will strengthen…”

That’s not ideal. But it’s not catastrophic. It would be more dangerous in the long run to avoid the cliff, according to the CBO. “In years beyond 2022, rising deficits under the alternative fiscal scenario [which assumes that the Bush tax rates and other measures are maintained indefinitely] would lead to larger negative effects on GDP and GNP and to larger increases in interest rates,” the CBO report said. “Ultimately, the policies assumed in the alternative fiscal scenario would lead to unsustainable federal debt.”

It’s wishful thinking to believe that the country can have gain without pain. And it’s disingenuous for the CEOs of major financial services companies—who can easily afford the haircut they’ll take when the Bush tax rates expire—to imply that we can.

A Man Without a Plan

Posted on November 15, 2012 by Robert Shiller -

During the United States’ recent presidential election campaign, public-opinion polls consistently showed that the economy – and especially unemployment – was voters’ number one concern. The Republican challenger, Mitt Romney, sought to capitalize on the issue, asserting: “The president’s plans haven’t worked – he doesn’t have a plan to get the economy going.”

Nonetheless, Barack Obama was reelected. The outcome may reflect the economy’s slight improvement at election time (as happened when Franklin Roosevelt defeated the Republican Alf Landon in 1936, despite the continuing Great Depression). But Obama’s victory might also be a testament to most US voters’ basic sense of economic reality.

Economic theory does not provide an unambiguous prescription for policymakers. Professional opinion in macroeconomics is, as always, in disarray. Because controlled experiments to test policy prescriptions are impossible, we will never have a definitive test of macroeconomic measures.

Romney had no miracle cure, either, but he attempted to tap into voters’ wishful-thinking bias, by promising to reduce the size of the government and cut marginal tax rates. That would work if it were true that the best way to ensure economic recovery were to leave more money on the table for individuals. But the electorate did not succumb to wishful thinking.

The idea that Obama lacks a plan is right in a sense: nothing he has proposed has been big enough to boost the US economy’s painfully slow recovery from the 2007-9 recession, nor to insulate it from shocks coming from Europe and from weakening growth in the rest of the world.

What Obama does have is a history of bringing in capable economic advisers. Is there anything more, really, that one can ask of a president?

And yet US presidential campaigns generally neglect discussion of advisers or intellectual influences. Although a president’s advisers may change, one would think that candidates would acknowledge them, if only to suggest where their own ideas come from; after all, realistically what they are selling is their ability to judge and manage expertise, not their own ability as economists. This time, too, however, there was no mention by name of any deep economic thinker, or of any specific economic model.

Obama originally had a wonder team of economic advisers, including Lawrence Summers, Christina Romer, Austan Goolsbee, and Cass Sunstein. But they are gone now.

Today, the most powerful economic adviser remaining in the White House is Gene Sperling, head of the National Economic Council, the agency created by President Bill Clinton in 1993 to serve as his main source of economic policy (somewhat shunting aside the Council of Economic Advisers). Because this position does not require Congressional approval, the president may appoint whomever he wants, without having his choice raked over the coals in the US Senate. That is why Obama could appoint the highly talented but politically unpopular Summers, the former president of Harvard University.

Sperling is not nearly so well known as Summers. But his record of influence in government is striking; indeed, he has been at the pinnacle of economic-policymaking power in the US for almost a decade. He was the NEC’s deputy director from its beginning in 1993 until 1996, and its director from 1996 to 2000. Obama reappointed him as head of the NEC in January 2011.

His 2005 book, The Pro-Growth Progressive, contains many ideas about how to make the economy perform better. None is grandiose, but together they might help substantially. Some of these ideas found their way into the American Jobs Act, which might have had some real impact had Congress passed it in 2011.

The AJA embodied some of what Sperling describes in his book: subsidies for hiring, wage insurance, and job training, as well as support for education and early learning. Moreover, the AJA would have offered some balanced-budget stimulus – the kind of stimulus that would boost the level of economic activity without increasing the volume of government debt.

But the public, despite its concern about unemployment, is not very interested in the details of concrete plans to create more jobs. Sperling is just not very visible to the public. His book was not a best seller: in commercial terms, it might be better described as a dud.

Sperling is fundamentally different from the typical academic economist, who tends to concentrate on advancing economic theory and statistics. He concentrates on legislation – that is, practical things that might be accomplished to lift the economy. He listens to academic economists, but is focused differently.

At one point in his book, Sperling jokes that maybe the US needs a third political party, called the “Humility Party.” Its members would admit that there are no miraculous solutions to America’s economic problems, and they would focus on the “practical options” that are actually available to make things a little better.

In fact, Americans do not need a new political party: with Obama’s reelection, voters have endorsed precisely that credo of pragmatic idealism.

Traitor VIX

Posted on November 15, 2012 by Kerry Pechter -

Is the variable annuity industry coming or going? Will life insurers, after taking losses in the financial crisis, retreat into the comfort zone of the law of large numbers? Or have they learned enough about derivatives to stay at the Wall Street gaming tables?

One of the best places to look for straight answers to those questions, I’ve found, is the Equity-Based Insurance Guarantees conference hosted each fall by Toronto options expert K. (Ravi) Ravindran and the Society of Actuaries. The eighth annual EBIG meeting, held this week in Chicago, drew 195 actuaries and quants, up from 110 in 2005.

These perennial meetings help bring insurance company actuaries up to speed on derivatives and give banks and consulting firms a chance to tout their options expertise. Goldman Sachs, Deutsche Bank, Barclays, BNP Paribas and Credit Suisse represented Wall Street. Consultants included Milliman, Tower Watson and Aon Benfield. Actuaries and IT folks from Transamerica and Pacific Life shared front-line war stories.

The experts’ answers to all three questions posed at the top of this story were “Yes.” Some insurers are staying in the game; they’re now hearing that the safest way forward is to put investors in volatility-controlled funds. Many have left the game; they’re learning that the risks buried in their existing blocks of business might still come back to haunt them.

While listening to the presentations—most of whose content, including terms like contango and backwardization, sailed far over my head—a couple of questions nagged at me. First, the design and maintenance of VA products is getting more complex and more expensive; is that a smart idea? Second, could the industry be gearing up to “fight the last war”? In a world ruled by Dodd-Frank and Solvency II, will market volatility be the biggest danger?

At this juncture, life insurers face a greed-fear quandary vis-à-vis VAs. The Fed’s open-ended financial repression policy argues in favor of hunkering down. But the presence of a huge and hungry market for guaranteed income products argues in favor of forging ahead.

Indeed, opportunity continues to knock. “There’s a disconnect in the marketplace,” said Matt Zimmerman, who sells Milliman’s volatility-control hedge program. “VA providers are pulling back, but financial advisors and investors are clamoring for guaranteed income riders. One of the wirehouses, for instance, has massive demand coming on, and they want to add certain insurers to their shelf, but those insurers don’t have the capacity to take on that business.”

How to proceed—safely

Companies that plan to keep selling variable annuities with guaranteed income riders will most likely require contract owners to invest some or all of their premia in volatility-controlled funds. That was a major takeaway from the conference.

“The whole mantra is volatility-controlled funds and managed volatility funds,” said Ravindran in his opening comments on Monday. “It’s been of interest for a few years, but more writers are focusing on that, and you’ll be hearing a lot about that here.”

Those volatility-controlled funds, such as the TOPS funds that are now used by several insurers to manage the risks of variable insurance products, shift risk from the insurer to the investor. In the past, when an insurer hedged a VA, it held the options on its own balance sheet. That design led to losses during the financial crisis. In new “low-vol” funds, the funds themselves—i.e., the contract owners—hold the derivatives.

“It’s a two component approach—volatility management and capital protection,” said Milliman’s Zimmerman, whose firm designed the dynamic hedging strategy in the TOPS funds.

“The volatility component involves buying inverse exchange-traded futures contracts, based on a major index, such as the FTSE, NASDAQ or Nikkei, and targeting about 10% volatility,” Zimmerman said. The capital protection strategy involves buying a five-year rolling equity put for each subaccount, which replicates a five-year rolling maturity put option on the portfolio. (See RIJ’s December 2011 story on “Airbag-Equipped Annuities.”)

“That strategy would be too expensive on its own, but it isn’t as expensive when you couple it with volatility management,” he added. “There’s a little over $1 billion in those funds now, and that will increase with launches next May. We think that employing protected accounts will become the norm for this market.” It remains to be seen, however, whether those low-vol funds are able to capture enough upside to keep advisors and clients happy.

How to stop the bleeding

What about the life insurers that are retreating from VAs? If they have a large legacy block of contracts with generous riders, their worries aren’t over. They still face market risk, longevity risk, and policyholder behavior risk on their guarantees.

Longevity risk is a major wild card, said Tim Paris of Ruark Insurance Advisors. He recommended that companies look into reinsurance for the longevity risk in their legacy blocks. While reinsurers have largely left the VA market, he said, coverage for the longevity risk component is available.

“Variable annuity mortality doesn’t follow the standard mortality tables,” Paris said. “People who elected the death benefit ratchet had 20% higher than average mortality, but people who elected a rich living benefit had 20% lower mortality. Those selection effects were magnified by policy size. A policy of $250,000 or more tended to be the smart money; the smaller policies were not quite as savvy.”

The month-to-month fluctuations in mortality among VA owners can be significant—and ill timed, Paris said. “We looked at monthly mortality as a percentage of Ruark’s [proprietary] mortality tables over 84 months and found them to be as low as 50% of average and as high as 170% of average. We saw similar numbers across eight or nine insurance companies. That’s a lot of volatility.

“What matters even more is the interaction of this pattern with the net amount at risk at any given time,” he added. “If you hit 50% of expected mortality when the excess benefit was $1 billion, you’d make money. But if you hit 170% when the amount at risk was $1 billion, you’d have lost even more.”

Policyholder behavior is even less predictable than mortality rates. So far, no clear pattern has emerged in the utilization rate of the income guarantees. “Over the next couple of years, we’ll see a lot of GMIBs (guaranteed minimum income benefits) reaching the end of the accumulation period,” Paris said. “We’ll learn a lot about policyholder behavior then.”

Addressing another legacy block issue, executives from Transamerica—which has offered to buy back in-the-money riders from contract owners as a way of trimming excess risk from its VA block—described the difficulty of building and maintaining a system that can accurately assess the risks in a large block of VA contracts with living benefit riders.

“A barebones variable annuity is a complicated set of derivatives. Just to price one policy you’re talking about hundreds of variables,” said an IT executive at Transamerica, which has about 700,000 VA policies worth $55 billion. “As I dug into the products, I was shocked at the various forms of risk.”

Aside from modeling risks, those systems also have to generate reports that senior executives can readily interpret and act on. That’s a significant task in itself. “Having information systems that funnel information upward and consolidate data in a decision-friendly way is increasingly important, because C-suite managers are more involved [in the VA business segment] at this point,” said Cornelia Spiegel of Deutsche Bank.

‘The only game in town’

“Should we de-risk or focus on growth? That’s the big question,” said Spiegel, in an overview of the cross-currents in the VA market. “On the one hand, you have 10,000 boomers turning 65 each day, and a generation of 107 million coming in after them. Seventy percent of their assets are in retirement related products.

“On the other hand, we have capacity constraints,” she added. “The product is still complex. Reserving is expensive. Interest rates are low. What is a comfortable level of sales? It’s a challenging balance. In the long run the industry outlook is positive, especially as we roll out new products, and as long as we can insulate ourselves from the risks in the legacy books.” Asked if optimism about the VA market was truly justified, she said, “No other product gives you principal protection and lifetime income. It’s the only game in town.”

Quote of the Week

Posted on November 8, 2012 by Editor Test -

ABB ordered to post $50m bond due to 401(k) violations

Posted on November 8, 2012 by Editor Test -

In the latest order involving Fidelity Investments and ABB’s conduct in the ABB 401(k) Plan, U.S. District Court Judge Nanette Laughrey ordered ABB to post a $50 million bond to protect ABB employees and retirees, the plaintiff’s attorney said in a press release. According to the release:

The company was ordered to post the bond within ten (10) days while it appeals a $50 million judgment against it and Fidelity Investments, which was previously entered. This judgment found ABB and Fidelity to have used employees’ retirement assets for their own benefit, in violation of the Federal law which protects the safety of 401(k) retirement assets.

Jerome Schlichter, of the St. Louis law firm of Schlichter, Bogard, & Denton, LLP, said in a statement:

“The Court required a $50 million bond to protect the retirement assets of ABB employees and retirees after Fidelity and ABB were ruled to have used them for their own corporate interests. These were assets of the employees and did not belong to Fidelity or ABB. The Court also made clear that Fidelity and ABB are liable for additional damages if they continue to use ABB employees’ retirement assets for their own benefit.”

ABB was also ordered previously to reform the 401(k) plan and to put out a request for proposals to replace Fidelity Investments as recordkeeper of the 401(k) plan; to monitor recordkeeping costs and negotiate for reasonable costs; to stop using Fidelity to provide its corporate services while using Fidelity as the employees’ 401(k) plan recordkeeper; to choose investments with low expenses; and to manage the 401(k) plans solely for the benefit of employees and retirees, not for its own benefit. The Court also ordered Fidelity to avoid taking income earned by the employees’ and retirees’ assets for its own purposes.

The Court also stated that is “does not believe ABB is likely to succeed on appeal” and that any additional damages to the employees and retirees from violations “can be remedied with a monetary award and additional attorney’s fees.”

Lack of Social Security savvy will be costly: BMO

Posted on November 8, 2012 by Editor Test -

Many American retirees risk losing a significant amount of retirement income because they poorly understand their Social Security benefits, according to a new report from the BMO Retirement Institute.

The report, “Retirees Not Maximizing Social Security Retirement Benefits,” showed that many retirees are taking their benefits too early and aren’t aware of options and strategies that may raise their benefits.

While 91% of respondents to a BMO survey understood that waiting longer increases the monthly amount they will receive, almost half admitted they are currently collecting or planning to collect before full retirement age, the report said. Couples are particularly vulnerable since a claim impacts both for their combined lifespan and can significantly affect spousal and widow benefits.

The report also revealed several factors that influence when people begin taking Social Security:

Too many decisions: Since so many decisions take place at retirement it appears that too many options can result in confusion and paralysis, pushing many people to take Social Security early by default.
Lack of knowledge: Half of Americans (52%) are not knowledgeable about general strategies to maximize Social Security benefits and 62% have not actively looked for information. Sixty percent have not discussed their Social Security decision with anyone.
Doubts about Social Security: More than 80% of Americans doubt Social Security’s viability, even though the program is solvent well into the 2030s.

Spousal benefit: Almost half (49%) of those surveyed say they lack knowledge about spousal benefits and 56% are uninformed about widow benefits. Under Social Security rules, a person can receive up to 50% of a spouse’s benefit and a widow can receive 100% of a deceased spouse’s benefit.

To view a copy of the full report, please visit: www.harrisbank.com/retirementinstitute.

Retirement insecurity rose from 2007 to 2010, academics say

Posted on November 8, 2012 by Editor Test -

The National Retirement Risk Index (NRRI) rose to 53% in 2010 from 44% in 2007, according to the Center for Retirement Research (CRR) at Boston College. The ongoing tracking of the NRRI by the CRR is sponsored by Prudential Financial.

The Index calculates the percentage of U.S. households at risk of falling short of maintaining their pre-retirement standard of living in retirement, based on their projected replacement rates (their retirement income as a percentage of pre-retirement income).

As of 2010, the latest report shows, more than half of today’s households will fail that test, even if they work to age 65 and annuitize all of their financial assets, including the receipts from a reverse mortgage on their homes.

The financial crisis contributed to an already difficult situation for many pre-retirees, the CRR study shows, through “the combined effect of poor investment returns, lower interest rates, and the continuing rise in Social Security’s Full Retirement Age.” The report also showed that:

The length of retirement is increasing [because] the average retirement age hovers at 63 and life expectancy continues to rise.
Median 401(k)/ IRA balances for households approaching retirement were only $120,000 in 2010, according to the Survey of Consumer Finances.
Asset returns in general, and bond yields in particular, have declined over the past two decades so a given accumulation of retirement assets will yield less income.
The decline in interest rates through its impact on annuity prices worsens the NRRI. A retiree with $100,000 will receive $492 per month from an inflation-indexed annuity when the real interest rate is 3% compared to $413 per month when it is 1.5%. (The NRRI assumes that retirees will annuitize financial assets, 401(k) balances, and home equity.)

Celent: Stop gaming the system

Posted on November 8, 2012 by Editor Test -

A new report from Celent, the global research firm, uses unusually blunt language in calling for more probity in financial services, saying that “the global economy is not set up simply for the financial industry to benefit from, and if necessary, sacrifice.”

The October 31 report, Malpractice in Capital Markets: Changing the Organizational Blueprint, by Celent’s Anshuman Jaswal, adds that, “If anything, it is the industry that is set up for the economy to meet its requirements and goals. The service-centered focus of the financial markets has to be restored. This is something that has been lost in the last few decades.”
The report found that:

“The events leading to the financial crisis were not outlying occurrences.” It was believed that the global financial crisis was caused in part by the repeal of the Glass-Steagall Act and the resulting tendency on part of large financial conglomerates to engage in high levels of speculation using complex derivatives. But the Libor-rigging case and similar instances show that there have been ongoing instances of market manipulation in the last couple of decades and the events leading to the financial crisis were not outlying occurrences.

“The systemic occurrence of market manipulation have negated the earlier idea that… corruption was only at the large corporate level and did not affect the layperson as much.” The recent case filed in New York by a group of US homeowners against the Libor-fixing banks possibly illustrates how the systemic corruption actually affected people in all parts of the society and was not confined to just one part of the economy or one country.

“A siloed approach for encouraging ethical employee behavior” may be to blame. If firms want to incentivize ethical behavior, they have to make it an essential part of employee induction and training and also remunerative practices. Trading firms should create proper safeguards to ensure employees know what the limits of risk-taking are.

Organizational malpractices shouldn’t “compromise the very economies firms are a part of.” Financial market participants have been making efforts in this area, but these have focused on fire-fighting and preparing for upcoming regulatory requirements.

The argument for a zero tolerance policy has its roots in the grassroots support for action against financial institutions in the leading global economies, especially in the US and Europe. The Occupy movement in the US and the Spanish Indignants movement show the general public’s displeasure at the way the financial crisis came about and was dealt with.

“The global repercussions have been severe.” Even though the crisis unfolded in a select band of developed nations, 5% and 10% of the population of some developing countries may have gone back into poverty due to the economic effect of the crisis in those countries. Growth rates for China and India have still not recovered and are following a lower trajectory.
The crisis undid the good work of the previous two decades in a number of the poorer countries around the world and made the situation more difficult for citizens of the US and the nations in the European Union.

Further changes have been recommended, including looking at the size of financial institutions worldwide. Accountability and transparency can suffer when an institution is very large. If banks and other large financial institutions were smaller, regulators could monitor them more efficiently. But this is not a simple trade-off and requires further research.

“The financial industry needs to change its psychological blueprint,” and prevent overwhelming domination by certain groups of individuals, perhaps by hiring different types of individuals and reviewing the places or institutions they are hired from.

Firms have to put checks and balances in place to encourage and incentivize healthy practices. Self-regulation by organizations must go beyond normal risk mitigation. The industry needs to understand the impact that malpractice and corruption have on not-so-obvious stakeholders and society at large.

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.

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