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When rates rise, will bond fund owners bolt?

Posted on November 21, 2012 by Editor Test -

As bond funds continue to absorb assets and the Fed’s policy of suppressing long-term interest rates continues, some observers wonder if a bond bubble is building. They fret that if and when interest rates on new bonds begin to rise and depress the prices of existing bonds, bond fund owners might panic and make the problem worse.

In an essay in this month’s issue of the Journal of Financial Planning, Mark W. Riepe, CFA, president of Charles Schwab Investment Advisory in San Francisco, looked at the historical relationship between changes in interest rates and fund flows for intermediate-term (average maturity, four to 10 years) bond funds and for high-yield or “junk” bond funds from August 1992 to July 2012.

Riepe assumed that high-yield fund shareholders would be “more active and motivated by tactical considerations when deciding to get in or out of a fund” and that “the intermediate bond category is more likely to be populated by shareholders who have a longer-term, strategic mindset and seek diversification from stocks.” The correlation between fund outflows during rate hikes would likely be stronger in high-yield bond funds than in intermediate-term bond funds, he hypothesized.

Riepe constructed a series of monthly net asset flows for all mutual funds within the high-yield and intermediate-term categories between the dates listed above, using data from Morningstar. The data on individual funds were aggregated into category totals. The category totals were then correlated with the monthly returns of the Barclays Aggregate Index (for intermediate bond) and the Barclays U.S. Corporate High Yield Index (for high yield).

The data confirmed Riepe’s expectations. They showed that the high-yield category had a positive net cash flow in only 8 of the 64 months when there was a negative total return to the high-yield index, for a 0.53 correlation between returns and net cash flows over the 20-year period. For intermediate bond fund flows, the correlation was only 0.10, though it reached 0.53 when rates rose over a three-year period in the early 1990s. (See chart from Journal of Financial Planning below.)

“High-yield investors, I suspect, will be the quickest to pull the trigger and redeem shares if rates rise… On the other hand, high-yield returns are not driven solely by interest rate movements. High-yield returns have been correlated with equity returns in the past. If rising rates are accompanied by rising stock prices, flows may be modest,” Riepe wrote.

For intermediate-term bond funds, demographics may dampen flows. “If rates increase month after month, as in 1994, some outflows [from intermediate-term bond funds] appear to be likely,” he said. But given boomers’ age and conservatism, he expected them to largely stick with their core bond fund choices even if rates rise.

Easy Does It

Posted on November 21, 2012 by Editor Test -

Two years ago, a leading life insurance executive told RIJ that his company could weather ultra-low interest rates for about five years. Yesterday, in a speech in Manhattan, Fed chairman Ben Bernanke reiterated his intention to keep rates low until at least 2015.

Bernanke told members of the New York Economic Club that his policy is justified by the “headwinds,” such as weakness in housing, bank lending, and public sector expenditures, that the U.S. economy still faces four years after the nadir of the financial crisis.

As for the so-called “fiscal cliff” (an expression rendered memorable by chiasmus, a figure of speech evident in the reversal in “cliff” of the “f” and “c” sounds in “fiscal”), Bernanke said that the goal of long-term deficit reduction would be best served by avoiding big spending cuts and tax increases in 2013.

“Fortunately, the two objectives are fully compatible and mutually reinforcing,” Bernanke said. “Preventing a sudden and severe contraction in fiscal policy early next year will support the transition of the economy back to full employment; a stronger economy will in turn reduce the deficit and contribute to achieving long-term fiscal sustainability.

“At the same time, a credible plan to put the federal budget on a path that will be sustainable in the long run could help keep longer-term interest rates low and boost household and business confidence, thereby supporting economic growth today.”

Low rates to continue even after recovery

In his speech, Bernanke explained the rationale behind his policy of buying mortgage-backed securities, which lifted prices in that sector this fall:

“Our purchases of MBS, by bringing down mortgage rates, provide support directly to housing and thereby help mitigate some of the headwinds facing that sector. In announcing this decision, we also indicated that we would continue purchasing MBS, undertake additional purchases of longer-term securities, and employ our other policy tools until we judge that the outlook for the labor market has improved substantially in a context of price stability.

Although it is still too early to assess the full effects of our most recent policy actions, yields on corporate bonds and agency MBS have fallen significantly, on balance, since the FOMC’s announcement. More generally, research suggests that our previous asset purchases have eased overall financial conditions and provided meaningful support to the economic recovery in recent years.

In addition to announcing new purchases of MBS, at our September meeting we extended our guidance for how long we expect that exceptionally low levels for the federal funds rate will likely be warranted at least through the middle of 2015. By pushing the expected period of low rates further into the future, we are not saying that we expect the economy to remain weak until mid-2015; rather, we expect—as we indicated in our September statement—that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.In other words, we will want to be sure that the recovery is established before we begin to normalize policy.

Rationale for buying Treasuries

A footnote to the published text of Bernanke’s speech noted specifically that his policy of purchasing Treasuries helps reverse the flight to Treasuries from riskier assets.

“One way in which our asset purchases affect the economy is through the so-called portfolio balance channel. Because different classes of financial assets are not perfect substitutes in investors’ portfolios, changes in the supplies of various assets available to private investors may affect the prices and yields of those assets.

“Thus, the Federal Reserve’s purchases of Treasury securities, for example, should raise the prices and lower the yields of those securities; moreover, as investors rebalance their portfolios by replacing the Treasury securities sold to the Federal Reserve with other assets, the prices of those other assets should rise and their yields decline as well.

“An increase in our asset purchases may also act as a signal that we intend to pursue a persistently more accommodative policy stance than previously thought, thereby lowering investors’ expectations for the future path of the federal funds rate and putting additional downward pressure on longer-term interest rates.”

MetLife’s VA Sales are Missed

Posted on November 21, 2012 by Kerry Pechter -

At $54.3 billion, sales of all types of annuities were down 10% in the 3Q 2012 from the same period in 2011. As of September 30, annuity sales totaled $166.1 billion, down 8% year over year, according to LIMRA’s third quarter 2012 U.S. Individual Annuities Sales survey.

LIMRA research director Joe Montminy attributed the decline to the Fed’s low-interest policy. “Protracted low-interest rates have impacted all lines of the annuity business, causing manufacturers to reassess their exposure among various product lines,” he said.

“The sustained uncertain economic environment has many companies implementing conservative risk management strategies in an effort to prudently manage their business,” he added.

Variable annuity sales in the third quarter totaled $36.6 billion, down 8% from the same period in 2011. Year-to-date, VA sales were $112 billion, a decline of 7% from the prior year. The top 20 issuers accounted for 93% of sales. LIMRA’s report represents data from 95% of annuities issuers. (See LIMRA chart below.)

The decline in VA sales doesn’t so much reflect lack of demand as lack of capacity on the part of issuers. Having been torched for an estimated $3 billion in losses on broken hedges during the financial crisis, according to Deutsche Bank, VA issuers are searching for ways to accommodate more Boomer retirement risk without capsizing themselves.

Some companies are keeping hedge costs down on new products by using volatility-controlled funds as mandatory investment choices for contract owners who buy guaranteed lifetime withdrawal benefit riders. Other firms have their hands full hedging the risks on the billions of dollars worth of VA products they’ve already sold.

The impact of their latest strategies may not be felt until next year. “While leading VA writers have announced they are making adjustments to their book of business, LIMRA believes the total impact of these decisions has not fully reached the market,” the LIMRA release said.

The difference is MetLife

About 80% of the $9 billion difference in 3Q YTD VA sales between 2011 and 2012 can be accounted for by the drop in MetLife sales alone. The company had announced its intention to moderate sales this year after leading all VA issuers in 2011 with $28.4 billion.

MetLife has sold $14.1 billion for the year, as of September 30. That was a large number, of course, and represented more than 10% of all sales this year. But in the first nine months of 2011, MetLife sold $21.2 billion.

In 2011, MetLife’s VA sales soared on the increased generosity of its GMIB Max product. Then the company reduced the benefits in the face of Fed low-interest policy, and this year MetLife CEO Steven Kandarian said the insurer would limit its 2012 VA sales to $18 billion to reduce risk.

At the time, some observers wondered if the pursuit of high sales and the subsequent pullback were parts of a deliberate long-range strategy by MetLife. But it may not have been. As one MetLife manager told RIJ privately, “People lost their jobs over [GMIB Max].”

On the other hand, all of the other top-five variable annuity issuers from 2011—Prudential, Jackson National, TIAA-CREF and Lincoln Financial—appear on track to equal or surpass their 2011 VA sales in 2012.

Through nine months of 2012, Prudential had sold $16.2 billion, Jackson National $15.3 billion, TIAA-CREF $10.7 billion and Lincoln Financial $7.3 billion. A year ago, they had sold $15.8 billion, $13.7 billion, $10.1 billion and $7.2 billion, respectively.

The makeup and order of the 20 leading VA issuers has changed slightly this year. At this time in 2011, Sun Life was the 13^th largest issuer; it exited the business and doesn’t appear on LIMRA’s latest Top 20 list. John Hancock, which sold $1.46 billion in the first nine months of 2011, sold only $660 million in the first nine months of 2012.

While some are fading, others are rising. Guardian Life, which was 20^th a year ago with $793.8 million in sales through the first nine months of 2011, is now 17^th with $1.15 billion. Principal Financial, absent from the YTD 3Q 2011 list, was 20^th on the YTD 3Q 2012 list, with $622.8 million in sales.

Here come the DIAs

The fastest-growing product in the annuity industry this year has been the deferred income annuity (DIA). Sales have grown steadily in 2012, from $160 million in the first quarter to $210 million in the second quarter and $270 million in the third quarter of 2012, LIMRA said.

Sales of single premium immediate annuities (SPIAs), at $2.0 billion, were down 9% compared to one year ago, but were up slightly from the second quarter of 2012. In the first nine months of 2012, SPIA sales declined 8% compared with the prior year period.

Fixed indexed annuities (FIA) have continued to boom, relatively speaking, thanks largely to their guaranteed lifetime withdrawal riders (GLWB). LIMRA estimates that 88% of indexed annuities sold offer a GLWB option.

FIA sales were strong in the third quarter at $8.7 billion, primarily due to new companies like Security Benefit ($2.13 billion in total fixed annuity sales in first nine months of 2012) performing well in the market, LIMRA As of September 30, indexed annuity sales were up 6% year over year, at $25.4 billion. LIMRA expects another record sales year for FIAs in 2012.

Because of low yields, however, total fixed annuity sales remained bleak, falling 13% in the third quarter to levels not seen since early 2007. Fixed-rate deferred annuities (book value and market value adjusted) fell precipitously in the third quarter, down 26% from the third quarter of 2011.

Book value sales sank 28% in the third quarter to $5.0 billion. Market-value adjusted (MVA) sales were $1.0 billion, down 17%. For the year, book value and MVA declined 31% and 13% respectively. Fixed-rate deferred product sales are at the lowest level since the late 1990s.

US lags in resilience to financial adversity: Barclays

Posted on November 19, 2012 by Editor Test -

People in faster-growing regions of the world interpret failure differently from Americans, according to the latest report in the Barclays Wealth Insights series.

The report, entitled “If at First You Don’t Succeed… Mapping Global Attitudes to Adversity,” showed that only 71% of US high net worth individuals (HNWI) agreed with the statement, “Viewing failure positively is essential for an economy to grow.”

By comparison, 91% of the wealthy in the Middle East and 80% in Asia agreed. On average, 74% of global HNWIs agree with that statement.

The report also compared traits such as persistence and optimism in different cultures, as well as the way people in different parts of the world view setbacks. Only 37% of US respondents agreed that “Past failure in entrepreneurial endeavors increases the chance that a new business will succeed,” compared with 81% of HNWIs in the Middle East and 67% in Asia.

About half (49%) of US HNWIs believe that anyone can learn to become a successful entrepreneur by working hard, while 83% of respondents in the Middle East reported the same belief.

Global HNWIs also report different experiences with the recent global financial crisis: 44% of US respondents say it provided them with opportunities compared with 53% of Asian respondents. Asked “if an entrepreneur’s business is failing, the entrepreneur should persist instead of cutting losses,” 55% of Middle Easterners, 53% of Asians, 41% of Asians agreed.

How entrepreneurs think
Entrepreneurs and non-entrepreneurs think differently about risk, opportunity and failure, the study showed. Self-described entrepreneurs recover from setbacks easier than those who say they are non-entrepreneurs. Among the entrepreneurs, 34% say that failure encouraged them to try again and 29% report being able to bounce back quickly, compared with 19% and 17% of non-entrepreneurs.

Perhaps most significantly, respondents who identify themselves as entrepreneurs are more able to learn from failure than non-entrepreneurs – 56% vs. 41%. They are also more likely to say that failure helped to strengthen their character (39% vs. 21%).

The Barclays survey found that people who are persistent, optimistic or both, are less likely to say they have experienced failure in their personal investments than those who do not possess these traits.

US regional differences
Notable differences in attitudes toward failure emerged between regions in the US:

Only 29% of respondents in the West think past failure increases the chance of future success, the lowest percentage across regions.
The Northeast sees the most opportunity in tough times; 48% said the recent global financial crisis has provided them with opportunities.
The Midwest is the most optimistic region, with 49% of respondents agreeing that they have learned a great deal from business failures and 77% saying that viewing failure positively is essential for an economy to grow.

Ledbury Research conducted the survey of more than 2,000 high net worth individuals in partnership with the Barclays Behavioral Finance team in the first half of 2012. Those surveyed each had over $1.5 million (or the equivalent) in total net worth and 200 had more than $15 million. Respondents were drawn from 17 countries around the world. More than 750 of the respondents identified themselves as entrepreneurs.

Younger investors’ faith in equities remains low: T. Rowe Price

Posted on November 19, 2012 by Editor Test -

Long-term retirement investors have not regained their faith in equity investing, according to a new survey from T. Rowe Price, which polled 850 investors ages 50 and under and found that only 61% believed that stocks are important for achieving retirement savings goals.

Only about half of investors (51%) surveyed said that their risk tolerance remains the same as before the financial crisis, and 37% say they are now avoiding stocks because of current economic or market conditions.

Through September 2012, net new cash flow into stock mutual funds was negative in 30 of the last 48 months and in 15 of the last 16 months, according to the Investment Company Institute. Other findings of the T. Rowe Price survey included:

37% of investors say that they are currently not investing in stocks. Factors cited include the pace of the U.S. recovery, general market volatility, political uncertainty, rising health care costs, actual or potential unemployment, the pace of the global economic recovery, the pace of the U.S. housing market’s recovery, the Eurozone debt crisis, and potentially higher taxes next year on income, dividends, and capital gains.
76% of investors say they are only “somewhat or not at all” willing to take on more credit risk to obtain a potentially higher yield from bonds.
81% of investors say they are saving about the same or more than they were before 2008.

Advisor Software, Inc., partners with Redtail Technology

Posted on November 19, 2012 by Editor Test -

Advisor Software Inc., a provider of wealth management solutions for the financial advisor market, has agreed to provide its planning tools to financial professionals who use Redtail Technology Inc. client relationship management (CRM) systems. The partnership will integrate ASI’s direct-to-advisor product, goalgamiPro, with Redtail’s CRM suite.

Developed for advisors looking for an alternative to the comprehensive, book-length financial plan, goalgamiPro is a web-based platform that uses the notion of the household balance sheet to enable advisors to create a plan in eight minutes, and generate a series of client-focused one-page reports.

In addition to improving advisor efficiency by reducing planning time, the goalgamiPro quick planning solution has also been designed to:

Generate leads: goalgamiPro comes with a household balance sheet PowerPoint deck for lunch or dinner seminars. goalgamiPro is then used to prepare a report for a free 30-minute household balance sheet assessment.
Strengthen client relationships: goalgamiPro also comes with Collaboration Connect, a client goal planning website enabled by the advisor and integrated with goalgamiPro.

“As the technology for the financial services industry becomes increasingly CRM-centric, individual advisors are seeking planning tools that can easily be launched when time does not allow for completing a full financial planning analysis,” said Neal Ringquist, President and Chief Operating Officer of ASI. “The integration of goalgamiPro with Redtail’s very popular CRM platform gives advisors an optimal tool to make quick assessments of their clients’ goal plans.”

Tax changes offer advisors opportunity to contact investors

Posted on November 19, 2012 by Editor Test -

Most high net worth investors (63%) worry that their investment portfolios will be hurt by tax code changes in the wake of President Obama’s re-election, and 64% don’t believe they can offset pending tax increases, according to a new Nationwide Financial survey.

The Harris Interactive survey of 751 investors with $250,000 or more in annual household income or investable assets released found that 60% of survey respondents say they either won’t or are unsure if they will meet with a financial advisor to discuss how these changes may affect their portfolio.

More than half (56%) of survey respondents believe their individual federal taxes will increase. Nearly half (48%) expect tax rates to increase, particularly for the wealthy, and 30% believe tax rates will increase across the board. Nearly seven in ten think either that Bush-era tax cuts will be eliminated entirely (35%) or reduced for the wealthiest Americans (33%).

Despite these concerns, 61% either don’t plan to make adjustments to their portfolio or don’t know what adjustments to make. Of those who do plan to meet with a financial advisor, 26% will wait until 2013 or after tax code changes take affect.

As advisors well know, Bush-era tax cuts are set to expire at the end of 2012, raising the top four marginal brackets and eliminating the 10% bracket. The phase-out of itemized deductions for high income earners is set to return. Tax on dividend income is set to increase from 15% to ordinary income rates (up to 39.6%). Long-term capital gains rates are scheduled to rise to 20% from 15% for most taxpayers. Those with high overall income and investment earnings will face an additional 3.8% Medicare investment earnings surtax. The gift and estate tax exemption is scheduled to shrink from $5.12 million to $1 million.

Four in ten (41%) survey respondents want more education on the tax advantages of annuities and about a quarter want more education on the tax advantages of life insurance (21%) and 401(k) plans (25%). Six in ten (59%) don’t know about the changes to estate and gift tax limitations and say they do not understand very much or at all how a life insurance policy can help them take advantage of the current gift tax exemption limits (60%). Forty-three percent would like more education on that topic.

Harris Interactive conducted the tax study online between September 28 and October 5, 2012. The respondents were 751 adults ages 18+ having $250,000 or more in annual household income or investable assets. Since the survey was conducted before Nov. 6, respondents were asked to assume both potential election outcomes. The data represented here focuses on responses where respondents assumed the President would be re-elected.

Fund flows favor bonds again in October: Morningstar

Posted on November 19, 2012 by Editor Test -

A net $27.7 billion flowed into long-term mutual funds in October, the 10th consecutive month of inflows, according to the November 2012 edition of the Morningstar Direct U.S. Open-end Asset Flows Update.

Bonds once again dominated the flows, though stocks retained their majority. Since October 2007, the percentage of invested assets in long-term stock mutual funds (open-ended and ETF) has dropped to 37% from 48%, and the share in taxable bond funds has doubled, to 26%.

Investors added $29.6 billion to taxable-bond funds ($33.9 billion including exchange-traded funds) and withdrew $8.3 billion from U.S.-stock funds (a $19.6 billion outflow including ETFs) in October. Intermediate-term bond, which is heavy in corporate bonds, brought in $11.4 billion, the most of any category.

Year to date, investors have added $224 billion to the taxable-bond asset class (up 10.8% from the end of 2011) and have withdrawn $85 billion from U.S.-stock funds (negative 2.7%). Since the beginning of the year, intermediate-term bond funds have gained almost $94 billion.

Large-cap stock funds remain the largest category of U.S. funds. Between them, large-blend, large growth and large value have lost a net $60 billion or so in 2012, but they are still the first ($1.14 trillion), third ($827 billion) and fourth ($604 billion) largest fund styles, respectively. Intermediate-term bond funds netted $94 billion in 2012 and ranked second.

Vanguard remained the largest fund family. Its funds netted $81 billion so far this year and grew to $1.53 trillion for a market share of almost 17%. PIMCO led all bond firms with inflows of $8.1 billion in October and $50.5 billion year-to-date.

Other highlights from the Morningstar report included:

Higher-risk segments of the bond market. Multi-sector bond, bank loan, emerging- markets bond, nontraditional bond, world bond, and high-yield bond categories each saw inflows of greater than $1 billion in October. Year to date, these six categories have taken in more than $80 billion, or 13% of beginning-period assets.

Municipal bonds. Investors also found municipal bonds attractive as $917 million flowed into high-yield muni-bond funds in October, bringing the total for the category to nearly $11 billion for the year-to-date period, or 20% of beginning-period assets. National long, intermediate, and short municipals brought in a total of $3 billion for the month and about $28 billion year to date, or 10% of beginning-period assets.

Alternatives. This category of funds has had the greatest organic growth rate of any asset class in 2012, collecting $12.4 billion year-to-date inflows. Within alternatives, investors were looking to hedge their equity exposure. The bear-market category collected $628 million, or 11.6% of assets at the beginning of the month, while long-short funds saw inflows of $628 billion, or 2.6% of beginning-month assets.

U.S. stock funds. The large blend category took in $1.4 billion, but that inflow was offset by outflows in the asset class’s other categories. Large growth, with redemptions of $4.3 billion, saw the largest outflow of any category, while large value funds had outflows of $2.0 billion.

International stock funds. While diversified emerging-markets funds saw inflows, most other international-stock categories experienced outflows. Diversified emerging-markets collected $925 million, while China region and Latin America stock funds both lost slightly more than $100 million. World stock lost $913 million.

PIMCO. Flagship PIMCO Total Return brought in $2.4 billion, more than any other fund for the month. The Gold-rated fund has returned 9.49% year to date, placing it among the top 13% of funds in its category. PIMCO Income and PIMCO Unconstrained Bond each brought in more than $1 billion.

The Bogle Perspective

Posted on November 19, 2012 by Editor Test -

When Jack Bogle mounted the podium to speak at the National Association of Personal Financial Advisors East meeting in Baltimore two weeks ago, everybody there stood up from their lunches and applauded.

And well they should have. Because by inventing Vanguard index funds that cost only 10 to 20 basis points a year, Bogle eliminated the cost of an active fund manager and opened a niche for fee-based advisors.

Bogle, who was my employer in the late 1990s, is famous for popularizing if not inventing two slogans: “Stay the course” and “Costs matter.” Years ago, he pointed out the obvious but overlooked fact that while fees may represent a trivial fraction of an investor’s principal, they can consume a staggering proportion of his returns in the long run.

His lecture at the NAPFA conference was, as it usually is, passionate and populist. Using simple charts and graphs, Bogle demonstrated that the average investor, after adjusting his or her returns for fees, taxes, inflation, bad luck and errors, is lucky to net 2% a year from investing in stocks and bonds.

Maybe they admire him because he says—and his voice cracks into a disarming falsetto when he gets excited—what most of us can’t say, which is simply the truth. He started doing it decades ago, well before sheer longevity gave him license. Case in point: He ended his talk with a declaration that combatting climate change and controlling the proliferation of firearms are the country’s two greatest imperatives. “That has to be stopped,” he said about guns.

Whether investors agree or disagree with Bogle’s broader opinions, they have certainly endorsed his investment philosophy. As of the end of October, Vanguard was the largest mutual fund family, with over $1.5 trillion in assets (a five- or six-fold increase in 15 years) and a market share of about 17%.

* * *

Only a few of the presentations at the NAPFA East conference focused entirely on retirement income.

Jim Otar, the Toronto engineer-turned-advisor, whose 2009 book (“Unveiling the Retirement Myth”) and retirement calculator (the $100 Retirement Optimizer) have earned a modest cult following, gave a talk called Advanced Retirement Distribution Planning. Rick Miller, the well-known Boston-area economist-turned-advisor, gave back-to-back breakout sessions on Understanding Longevity.

Neither of these speakers strongly advocated life annuities per se, but both of them presented evidence that, in my opinion, argued implicitly in favor of them. Their numbers suggested that most healthy couples with long-lived parents who want to maximize their annual spending in retirement should probably use at least part of their money to buy a life annuity that starts sometime after age 70.

Here’s why. Otar’s “Zone Strategy” diagrams, which depict the segmentation of clients into those who are underfunded, barely funded, and abundantly funded for retirement, illustrated his contention that the greater the percent of their savings that retirees want to spend each year, the more strongly he would advise them to buy life annuities after age 70—or ignore a high risk of running out of money before they die.

To put that another way: Regardless of how much money you start with, a life annuity can increase your freedom to spend and consume. Those in poor health, or who can afford to live on their investment yield alone, or who value a big legacy over current consumption, are the only ones who wouldn’t benefit from the payoff that comes to annuity owners—assuming that they live a long time.

Rick Miller’s presentation showed just how long Boomer couples (particularly those who are healthy and wealthy) should expect to live, and it’s well into the life-annuity-makes-sense range. An advisor today can count on seeing up to three of every ten 65-year-old male clients and four of every ten 65-year-old female clients reach the age of 90, he said. One in eight retired men and one in five retired women will reach age 95.

Ergo, prudent advisors should assume that their healthy 65-year-old client couples will spend up to 35 years in retirement. (Cindy Levering of the Society of Actuaries assisted Miller on the presentation.)

At present, few fee-based advisors recommend life annuities—because the yields (before age 70) are low and because they’d reduce their own fee income if they did. (Annuitized assets don’t ordinarily count as AUM.) But if an advisor expects at least one member of a client couple to live beyond age 90, encouraging them to buy a joint-and-survivor life annuity might be the most fiduciary thing to do.

At the very least, a life annuity reduces overall portfolio risk and thereby allows clients to take more risk with their non-annuitized wealth. It could also spare them the anxiety and indignity of worrying about market volatility in their old age, or about running out of money before they die, or about spending the funds they had hoped to preserve for a legacy.

The Four Kinds of Financial Advisors

Posted on November 19, 2012 by Kerry Pechter -

As people in the money biz know, financial advisors come in many flavors: Brokers, RIAs, fee-only, fee-based, dually licensed, etc. They differ in the way they’re paid and in the master they ultimately serve, whether it be a bank, their clients, or themselves.

In a presentation at The Wharton School last spring, fee-only planners Paula Hogan and Rick Miller showed that it’s also useful to think of advisors or planners in terms of the professional “paradigm” that they use, consciously or not, when working with their clients.

Advisors, they posit, use one of four paradigms. There’s the Traditional, the Life Cycle, the Behavioral (which tosses psychology into the mix) and what they call the “Advisor Experience” paradigm, where the advisor dons the robe of life counselor.

While most advisors are still Traditionals (i.e., who focus on accumulation-stage investment advice), the combined impact of the financial crisis, Boomer retirement, the advent of behavioral economics and fee compression is forcing more advisors to evolve beyond the traditional approach.

Which kind of advisor are you? Are you strictly a “numbers guy”? Or do your clients share their dreams and self-doubts with you, and rely on you to help them realize their most personal ambitions?

Below you’ll find descriptions of Miller and Hogan’s four paradigms, taken directly from the essay they presented at the conference on “The Market for Retirement Financial Advice” sponsored by the Wharton School’s Pension Research Council and Boettner Center for Pensions and Retirement Research in Philadelphia in May 2012. Maybe you’ll recognize yourself in one or two of them.

Traditional Paradigm (The advisor as technician)

A planner steeped in the Traditional paradigm would focus on building a large portfolio using mainly the strategies of diversification and precautionary saving.
Financial risk would be tailored to the client’s perceived risk tolerance.
The Traditional advisor believes in the long-term safety of stocks, and typically recommends that clients “stay the course” in volatile markets.
If the client has too little savings, the advisor might propose ramping up risk to make up for a shortfall. If the client has a surplus, a traditional advisor would also encourage the client to ramp up risk.
To deal with longevity risk—the risk of outliving savings—the advisor would design a sustainable portfolio withdrawal program, most likely starting with a 4% per year withdrawal rate that rises with inflation each year thereafter.
The withdrawal strategy could include a buffer of several years of cash reserves, smoothed withdrawal rates and/or withdrawal rates that are adjusted in response to market valuations.
Long-term care insurance might be suggested as a complement to portfolio wealth.

Life Cycle Paradigm (The advisor as strategist)

An advisor working from the life cycle point of view would add hedging and insuring to standard portfolio strategies in order to smooth consumption over a lifetime.
He or she would insist on tailoring the risk of the financial portfolio to the risk in the client’s human capital in addition to the clients risk tolerance and personal goals. She would ask the client to specify the timing and cost and relative importance of various life goals.
The Life Cycle advisor would be aiming, especially for the most important goals, to match assets and liabilities through some combination of TIPS ladders and immediate inflation-protected annuities. More aspirational goals would be funded by riskier investments strategies.
The Life Cycle advisor will start showing which goals can’t be fully funded in the case of too little wealth. When there is ample wealth, the Life Cycle Advisor will show how big the client’s legacy will be, given his or her current standard of living. The Life Cycle advisor will also suggest working shorter, longer, or differently as a core strategy.

Behavioral Paradigm (The advisor as ‘framer’)

The advisor coming from the behavioral point of view would want to arrange for portfolio guarantees in order to address the client’s presumed loss aversion. She would also work hard to correctly frame decisions about how much portfolio risk to take and how to view portfolio performances.
The behavioral advisor would focus on annuitization strategies with downside protection guarantees paired with some upside potential, after sorting through the various biases of both the client and the advisor.
Unless the client has a friend or relative who needed custodial care in old age, the behavioral advisor will address the client’s presumed “denial and/or implausible expectations about aging” before developing the appropriate financial strategy.
The behavioral advisor will echo the Life Cycle ideas of changing the level of saving, risk taking, and work duration. To improve decision-making, he will also engage the client in a discussion designed to recheck the client’s values and her way of “framing” money issues. The advisor will ask questions like, “Are you sure there isn’t enough money for your well-being?”

Advisor Experience Paradigm (The advisor as life-coach)

In the trenches of the Advisor Experience paradigm, much time would be spent at the outset agreeing upon which of the four paradigms is in play and also discovering and resetting any preconceptions the client might have about risk and return expectations and benchmarking.
The Advisor Experience advisor will be ready with the strategies of changing the levels of saving, spending, working, and risk taking but will start with a values discussion. The client will be urged to ask him or herself: What do I care about and value? Where do I find meaning and purpose? What are my money values? How can I align meaning and purpose with money habits? How do I bring about the personal change that I desire?
Implementation of the plan will be a personally developed action plan of measured small-step progress.
The Advisor Experience advisor has multiple roles, including counselor, information resource, technical expert, cheerleader, accountability figure and healer.

Advisors, of course, are free to choose which paradigm they want to follow. But Hogan (left) and Miller make it clear that every client relationship involves behavioral and emotional elements, whether the advisors decide to deal with them or not. To ignore them entirely would be to risk leaving part of the job undone, or perhaps even doing it badly.

The authors don’t appear to favor one paradigm over another, but they imply that as advisors grow in sophistication and experience, they’re likely to graduate from the Traditional to the Life Cycle paradigm and then, depending on their own preference or level of interpersonal skill, to the Behavioral and Advisor Experience paradigms.

It’s no coincidence that this sort of self-examination is happening now in the advisor community. The financial crisis, the migration toward fee-based compensation, the arrival of the Boomer retirement phenomenon, along with need for individuals to take more responsibility for protecting themselves from health, sequence of returns, and longevity risks, are all pushing Traditional advisors toward the Life Cycle model, the two advisors told RIJ in a recent interview.

“The reason you’re seeing so much emphasis on this now is that people are living longer, and they’re more responsible for financing a longer life,” said Hogan, who is based in Milwaukee. “Their money has to last for a long time,” Hogan said.

Miller (right), whose firm, Sensible Financial, is based near Boston, agreed. “The Life Cycle model is just beginning to make in-roads in the profession. More advisors are recognizing its importance. The next wave is going to involve behavioral economics. Advisors are beginning to talk about that, but we’re not applying it in a systematic way.”

A retirement income-oriented advisor, almost by definition, has to adopt the Life Cycle paradigm, which emphasizes risk management, goal-setting, and asset-liability matching, as well as a greater awareness of the erosion of purchasing power by inflation over a long retirement.

“Where 10-year Treasuries have been thought of as the safe asset in Modern Portfolio Theory, the life-cycle perspective would suggest that the safe asset would be TIPS,” Miller added. “Secondly, if you think about your future retirement expenses as a liability, one way to fund that liability would be to use single premium annuity that’s indexed to inflation.”

The evolution from one paradigm to another implies an evolution in compensation models as well. Miller and Hogan don’t address that issue in their essay, but Miller commented on it during an interview. As advisors expand their services beyond product sales and even beyond asset management, they may need forms of compensation other than commissions or asset-based fees.

“It’s useful to think of financial advice as a professional service,” he told RIJ. “So you would expect to see the compensation systems that you see in other professions, such as hourly rates or retainers, and less compensation that’s linked to transactions, and potentially even less linked to assets.”

“Quote” of the Week

Posted on November 15, 2012 by Editor Test -

Unconfirmed: Apollo nearest to acquiring Aviva U.S.

Posted on November 15, 2012 by Editor Test -

Apollo Global Management LLC is said to be in the lead to buy Aviva Plc’s U.S. life insurance and annuities unit, positioning the buyout firm to beat Philip Falcone’s Harbinger Group Inc., according to a report on Bloomberg.net.

Apollo is bidding jointly with Guggenheim Partners LLC, Bloomberg said, quoting a source it did not identify. A sale would occur at a “substantial discount” to the unit’s book value, excluding debt, of 2.4 billion pounds or $3.8 billion, Aviva chief financial officer Pat Regan said last week.

Representatives at Aviva, Apollo, Guggenheim and Harbinger declined to comment on the deal, which is not completed and may still collapse. Aviva acquired most of its U.S. operations through the $2.9 billion purchase of Des Moines, Iowa-based AmerUs Group Co. in 2006.

Apollo, a private-equity firm run by Leon Black, last month boosted capital at its Athene Holding Ltd. annuity business by contributing assets valued at more than $800 million from a publicly traded fund it manages.

That infusion would enable Athene to acquire more annuity assets and eventually achieve enough scale to issue shares to the public, according to a presentation to investors.

Annuities are contracts issued by life insurers that offer tax deferral, guaranteed rates of return, death benefits and/or guaranteed income.

Apollo created Athene in 2009 and expanded in 2011 through the $628 million purchase of Royal Bank of Canada’s U.S. life insurance unit. Athene in July agreed to buy Presidential Life Corp. for about $415 million.

Aviva, the U.K.’s second-biggest insurer by market value, is selling or winding down almost a third of its 58 businesses, striving to get out of less profitable markets and boost capital reserves reduced by the European sovereign-debt crisis.

After IPO, ING U.S. will start two-year rebranding effort

Posted on November 15, 2012 by Editor Test -

Between 2001 and 2012, ING U.S., the holding company for ING Groep’s financial services companies in the U.S., put a huge effort into building the strength of its brand, exemplified by campaigns highlighting the color orange, the Retirement Number, and the image of the Dutch royal lion.

That effort was highly successful. According to industry surveys, brand awareness for ING in the U.S. has grown dramatically, increasing from 11% in 2001 to 79% in 2012, according to a recent SEC filing.

But now that ING U.S. is separating from ING Groep—the U.S. holding company filed a registration statement last week with the SEC for an initial public offering of common stock—ING U.S. faces the task of creating a completely new brand.

ING U.S.’s future brand name hasn’t been disclosed, but the trademarked tagline will be “America’s Retirement Company,” according to the SEC registration statement. Whether it will be able to supplant entrenched retirement leaders like Fidelity and Vanguard remains to be seen.

“We plan to invest substantial resources to develop and build awareness of our new brand, based on our vision to be America’s Retirement Company™. We believe that strong brand recognition is the first step in reestablishing ourselves with all of our stakeholders as a standalone company,” the company said in a release last week.

According to the registration statement, ING U.S. has already developed a rebranding strategy, but doesn’t expect to “formally shift the majority of our advertising and marketing to our new brand name until 8 to 15 months” after the IPO. The rebranding process is expected to take about two years.

ING Group entered the United States life insurance market in 1975 through the acquisition of Wisconsin National Life Insurance Company, followed in 1976 with its acquisition of Midwestern United Life Insurance Company and Security Life of Denver Insurance Company in 1979. ING Group significantly expanded its presence in the United States in the late 1990s and 2000s with the acquisitions of Equitable Life Insurance Company of Iowa (1997), Furman Selz, an investment advisory company (1997), ReliaStar Life Insurance Company (including Pilgrim Capital Corporation) (2000), Aetna Life Insurance and Annuity Company (including Aeltus Investment Management) (2000) and CitiStreet (2008).

Under the ING brand, these companies offer retail and institutional life insurance, retirement plans, mutual funds, managed accounts, alternative investments, institutional investment management, annuities, employee benefits and financial planning.

In its IPO registration statement, ING U.S. emphasized that it has taken steps to minimize the risks associated with its variable annuity closed block of business. ING was a leading seller of VAs with generous living benefits prior to the financial crisis, but de-risked as the crisis unfolded.

“In 2009, we decided to cease sales of retail variable annuity products with substantial guarantee features (the last policies were issued in early 2010 and we placed this portfolio in run-off). Subsequently, we refined our hedging program to dynamically protect regulatory reserves and rating agency capital of the variable annuities block for adverse equity market movements. In addition, since 2010, we have increased statutory reserves considerably, added significant interest rate risk protection and have more closely aligned our policyholder behavior assumptions with experience.”

The ING U.S. Retirement Solutions business acquired CitiStreet after the financial crisis to become, after Fidelity, the second largest provider of defined contribution retirement plans in the U.S., as measured by the number of plan sponsors and number of plan participants for which we provide recordkeeping services,” the registration statement said. “We are one of the few retirement services providers in the U.S. capable of using our industry presence and scale to efficiently support small, mid, large and mega-sized employers in the 401(k), 403(b) and 457 market segments.”

The spin-off of ING U.S. is just one of the steps that ING Groep N.V. has had to take to reimburse the Dutch government for bailing it out during the financial crisis. The Dutch insurer continues to cut costs internally. Last week, IPE.com reported that ING Groep will eliminate 1,350 jobs at its Dutch pensions insurer, Nationale Nederlanden. Jan Hommen, ING’s chairman, said the measures would save about €200m a year by the end of 2014.

Citing capacity limits, Jackson will refuse incoming 1035 transfers for a month

Posted on November 15, 2012 by Editor Test -

Jackson National Life Insurance Companyannounced last week that it was “approaching the upper range for calendar year 2012 for total premium from variable annuities (VAs) that offer optional guaranteed benefits.”

Jackson estimated it has approximately $1 billion in remaining capacity. As in prior years, Jackson will manage the volume of its VA business commensurate with the overall growth of its balance sheet.

To manage sales volumes, Jackson said it will no longer accept new 1035 exchange business or qualified transfers of assets for VAs that offer optional guaranteed benefits as of 4 p.m. Eastern Standard Time on Tuesday, November 13, 2012.

As of December 15, 2012, Jackson will resume accepting new 1035 exchange business and qualified transfers of assets, if premium from new sales is less than $1 billion between November 13 and then.

No limitation will be placed on new 1035 exchange business or qualified transfers of assets for Jackson’s Elite Access product, which offers alternative investment options that whose potential volatility makes them unsuitable for guaranteed living benefits.

“We are proactively communicating with our distribution partners about Jackson approaching the high end of the range for 2012 sales of our very popular VAs that offer optional guaranteed benefits,” said Clifford Jack, executive vice president and head of retail for Jackson. “Our wholesaling and service teams are well-positioned to implement the necessary actions to limit production with minimal disruptions to our partners and their clients.”

This week, Jackson National Life reported $19.6 billion of total sales and deposits during the first nine months of 2012, driven by $15.3 billion of variable annuity (VA) sales.

VA sales were up 11.3% over the $13.7 billion in VA sales recorded during the first nine months of 2011. Sales of Elite Access totaled $630.1 million during the period from launch on March 5, 2012, through September 30, 2012. Excluding Elite Access, Jackson’s overall VA sales growth during the first nine months of 2012 was 6.8% year over year.

In the first nine months of 2012, Jackson completed the $663.3 million acquisition of SRLC America Holding Corp (SRLC) and remitted a $400.0 million dividend to its parent company, while ending the period with more than $4.1 billion of regulatory adjusted capital, according to a company release.

Compared to the same period of the prior year, fixed annuity sales of $713.5 million were up 34.5%, and FIA sales of $1.2 billion were up 13.5% during the first nine months of 2012.

Curian Capital LLC, Jackson’s retail asset management subsidiary, increased assets under management to $10.4 billion as of September 30, 2012, up from $7.3 billion as of December 31, 2011.

Jackson National Life is rated A+ (superior) by A.M. Best, AA (very strong) by Standard & Poor’s, AA (very strong) by Fitch Ratings and A1 (good) by Moody’s Investors Service.

Nationwide adds TOPS managed volatility funds to VA line-up

Posted on November 15, 2012 by Editor Test -

Nationwide Financial has added four new managed volatility funds to its core VA line-up. Additionally, the company will add three fund options, including one managed volatility fund, for its guaranteed lifetime withdrawal benefit, The Nationwide Lifetime Income Rider(Nationwide L.inc).

New funds for Nationwide’s core VA line-up include:

American Funds Insurance Series^® Protected Asset Allocation Fund^SM
TOPS^TM Protected Balanced ETF Portfolio
TOPS^TM Protected Moderate Growth ETF Portfolio
TOPS^TM Protected Growth ETF Portfolio

The American Funds Insurance Series Protected Asset Allocation Fund will also be available as a Nationwide L.inc investment option. Within the VA, the Protected Asset Allocation Fund can offers an equity allocation range of 40% to 80%, depending on market conditions, with a target mix of 60% stocks and 40% bonds.

The Nationwide VA with Nationwide L.inc offers a 7% simple interest roll-up on the original income benefit base and a 5% payout if withdrawals begin at age 65.

Nationwide Financial will also add two non-managed volatility funds back to the Nationwide L.inc investment option line-up. Both offer 60/40 equity exposure:

NVIT Cardinal Moderate Fund
NVIT Investor Destination Moderate Fund

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.”

Life Cycle Paradigm (The advisor as strategist)

Behavioral Paradigm (The advisor as ‘framer’)

Advisor Experience Paradigm (The advisor as life-coach)

Data Connection