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With UK Gilt yields hovering around a 319-year low, Dutch bond yields at 500-year lows and US Treasuries offering negative returns across all maturity spectrums, it is unsurprising that trustees of pension schemes are questioning whether fixed income (or bond) assets are overvalued.

Furthermore, UK pension schemes looking to de-risk have an additional conundrum whether they should move their assets from equities yielding 3.7% (FTSE All-Share Dividend Yield as at 31 August) to Gilts yielding 2% (15-year Gilt yield as at 31 August). After adjusting for inflation, these Gilts are also yielding negative returns. This makes Gilts less of a risk-free asset and more of a return-free asset.

So how should a UK pension scheme allocate its assets in such an environment? Should they be de-risking or not? The rest of this article sets out some options for pension schemes to consider. The action for pension schemes will depend on their individual situation such as the funding level and strength of the sponsor.

Whilst in the short term both Gilt yields and equity markets can go lower, safe-haven bonds such as Gilts and US Treasuries are over-priced by most long-term measures. If a pension scheme’s funding level and risk budget permits, it could look to allocate its portfolio towards return-enhancing assets by increasing allocation to equity assets. The relative valuation of these assets means investing in assets that back dividend growth or have high spreads could deliver excess return for pension schemes able to handle the short-term risk. Once governments in the developed world have managed to muddle through the recession and there is some resolution to the euro-zone crisis, equities should deliver significant outperformance relative to bonds.

In the meantime, higher equity allocation could lead to higher volatility of funding level. It is also worth noting that a number of pension schemes over last two years have been considering high-yield bonds as an alternative to Gilts to obtain a higher return. This has created a huge demand in the market over this period. However, this is beginning to taper off, as shown by the volume of trading in European high-yield debt market in the last few quarters. 

Yields on high-yield debt have declined towards 7% within the BofA Merrill Lynch US High Yield Master II Constrained index, a level that historically has acted as a floor. In addition, 39% of high-yield debt within the index now trades above its call price. In May 2011, this figure reached 44% just prior to a pronounced decline in prices, possibly suggesting prices are likely to begin to fall soon.

For schemes that wish to de-risk and reduce the volatility of their funding level, they need to first evaluate whether they can afford to do so. For some pension schemes, paying the current market price to hold greater bond investments may be worthwhile to obtain greater certainty of outcomes relative to their liability. If the strategic rationale allows, then pension schemes should not get distracted by the current investment environment. However, the current investment markets also offer opportunities to improve the existing interest rate and inflation hedges without increasing allocation to fixed income assets. This may include slowing the move towards long-duration bonds by investing in shorter-duration bonds or taking advantage of low break-even inflation to switch nominal bond holdings into inflation-linked bond holdings.

Other options available for pension schemes concerned about rising interest rates and losing the absolute value of their bond investment could be to transfer some of their fixed income investment into an unconstrained or absolute return mandate. An unconstrained approach offers a superior ability to navigate interest rate and credit cycles and, as a result, may offer better protection in rising interest rate and spread-widening environments than a long-only fund.

Similar to unconstrained bonds is the greater use of alternative asset classes to obtain inflation and interest rate exposure whilst outperforming government bonds. These alternative assets include timber/forestry, infrastructure (with low private equity correlation) or even solar PV panels for those schemes looking for some added environmental benefits.

Determining the appropriate course for your pension scheme – be it de-risking or re-risking – rests on a number of factors including your funding level and risk appetite. But fundamental to any such process is a governance structure with the agility to react to rapidly changing market environments. This is where trustees who are faced with resource constraints may benefit from working with an investment professional such as a fiduciary manager that is able to identify and implement investment decisions quickly.

To hear the two candidates tell it, the U.S. presidential election offers a dramatic choice on the economy: Vote for me, each says, if you want a robust recovery; pick my opponent, and we’ll plunge back into recession.

But regardless of who wins, important economic factors will remain facts of life. Millions of American homeowners are “underwater,” owing more than their homes are worth and weakening the consumer demand that is key to the economy. Employers, even if they are flush with money, won’t hire more workers until they need them—when demand rises or appears ready to.

The debt crisis in Europe resists a quick solution, and deficits and overhanging debt in the U.S. are too big to be whittled down very fast. These deficits will compete for federal revenue that could stimulate the economy through more spending or cuts in taxes.

Given the size of these problems, what is the most likely economic landscape to emerge after the election if President Barack Obama, a Democrat, wins, or if Republican challenger Mitt Romney wins?

Three Wharton faculty members say that, either way, the future is likely to look much like the present, for several years at least. “The notion in the political debate is that if you just do something a little bit differently, things will get much better. But it doesn’t work like that,” says Wharton finance professor Franklin Allen.  

“It seems to me that one of the most depressing things about this campaign has been that it’s more or less tit-for-tat, gotcha issues that have emerged, rather than any serious talk about what [the candidates] are going to do [regarding] the looming problems with the economy,” says Wharton finance professor Richard J. Herring.  

Whoever he is, the next president will face an immediate economic crisis, including the “fiscal cliff,” tax increases and deep spending cuts that will kick in automatically unless Congress and the White House can agree on an alternative. The cliff is a result of a standoff in 2011 over raising the debt ceiling. “I think once the election’s over, that’s going to be the big issue,” says Allen.

What if the Democrats, who support tax increases on the wealthy, and the Republicans, who do not, cannot agree, and the automatic provisions kick in? “I think it’s quite likely that would lead to recession,” Allen states, predicting that tax hikes and cuts in government spending would reduce gross domestic product by about 3%.

While both candidates say their policies would speed job creation, the problems run too deep to be resolved quickly, Allen adds. “It’s become a much more serious problem than we have ever had in this country before,” he says, arguing that many of today’s unemployed will remain so unless they are retrained, a lengthy and expensive process that he says is currently inadequate.

Indeed, according to Allen, the current economic problems are unique in American history. The clearest analogy is Japan, which has been struggling for many years. What’s the solution? “I don’t think anybody really knows,” Allen says.

A divided government

Obama proposes a continuation of the policies of his first term, which included efforts to stimulate the economy through federal spending and modest tax reductions focused mainly on people with low and middle-class incomes. He would allow the Bush-era tax cuts to lapse for people earning more than $250,000 a year, but would keep them for people earning less. He would stay the course with his health care overhaul—the Patient Protection and Affordable Care Act, or Obamacare—and would keep most of the regulations imposed on the financial services industry after the financial crisis.

Romney’s most dramatic economic proposal is to reduce tax rates even below the Bush levels in effect today, while making up for the lost revenue by eliminating some unspecified deductions and tax loopholes. Romney wants to repeal parts of Obamacare and many of the financial regulations. He would loosen environmental regulations and, compared to Obama, place heavier emphasis on exploiting coal and oil.

While the candidates’ economic philosophies and positions are dramatically different, neither is likely to engineer a sweeping policy change, says Herring. The reason: divided government.

Polls predict a close election, with neither contender’s coattails long enough to ensure massive wins by his party’s congressional candidates. The odds thus seem to favor a continued division in government, with neither party getting a veto-proof majority in Congress or a filibuster-proof super-majority in the Senate.

“We have to recognize the fact that whoever wins isn’t going to get a huge, sweeping mandate to do whatever they want,” Herring says. Severe problems undermining the economy are therefore likely to remain unsolved, including the decay of roads, bridges and other infrastructure, debt problems, the eventual insolvency of Medicare and American students’ lagging educational achievements compared to other developed countries.

“The question is, what are they going to do on the margins?” Herring asks.

Federal tax policy is, as most agree, far too complex and confusing, Herring says. But neither candidate is likely to have the mandate it would take to change this, given the vested interests that would resist. While Romney, who has emphasized tax overhaul more than Obama, says he would strip out many deductions and loopholes, he has not said which ones, but has indicated he would not go after popular ones like the income tax deduction on mortgage interest.

‘The worst possible consequence’

The presidential campaign has also focused on two health care issues with significant impact on the economy: Obamacare, the 2010 law that overhauled medical insurance, and Medicare, the financially troubled health care entitlement program for the elderly.

Obama considers the Patient Protection and Affordable Care Act his greatest achievement and has promised to preserve it, while Romney wants to repeal much of it and replace it with a plan that he has not fully detailed. With a continuation of divided government, Obamacare will likely survive, Herring predicts. “Romney has not clearly articulated a workable alternative, though heaven knows we don’t really understand the thing we’ve got.”

From an economic perspective, a key problem with Obamacare as written, says Herring, is the requirement that businesses with 50 or more workers provide health insurance. That has dampened the creation and growth of small businesses, which are the primary source of new jobs, he argues. Unemployment stands at just over 8%.

In the long run, problems with Medicare will have more economic impact than issues surrounding Obamacare, says Mark V. Pauly, professor of health care management at Wharton. By providing insurance to the previously uninsured, Obamacare will “give you a clean conscience,” he jokes, “but Medicare will clean out your bank account. So, from an economic point of view, Medicare is much more consequential.”

Both issues, Pauly says, create uncertainties that weaken business confidence, which in turn helps stifle economic growth. Many business people favor the Republican promise to repeal Obamacare, but worry about what would come next, while Obamacare’s business mandates are a known quantity for now. “If Republicans win and I’m a business providing health insurance, I have a hard time knowing what to expect,” Pauly notes.

In a similar way, Republicans have a more aggressive plan for reducing the Medicare funding shortfall by subsidizing participants who would shop for health insurance on the free market. But polls show that many Americans worry they would then end up shouldering more of their own health care costs in retirement, so it is unclear Republicans would push for all the changes they have proposed even if they swept the election.

On the other hand, says Pauly, Democrats have yet to propose a clear plan for preserving the current Medicare system for the long term, making the outlook unclear for future beneficiaries. “That kind of uncertainty, in the short run, is about the worst consequence of all the debate about health care,” he says.

Divided government would also make it difficult, if not impossible, to resolve problems with the 2010 Dodd-Frank financial reform law, which has business-dampening features like heavy reporting requirements to multiple agencies, Herring says. One of that law’s key goals was to prevent the need for future bailouts of financial services companies deemed “too big to fail,” but there are serious questions about whether the Dodd-Frank safeguards would work, he adds.

The stock market, after plunging in 2008 amid the financial crisis, has recouped nearly all of its losses. But Herring notes that a key factor in this rebound was the Federal Reserve’s efforts to keep interest rates low. Stocks may not do as well after these efforts end, as they must at some point. “We’re clearly relying much too much on monetary policy,” he says. “The Fed has basically been turning cartwheels” to bolster the markets and economy.

The alternative—better fiscal policy to reduce the danger from factors like the federal government’s huge deficits and debt—seems unlikely given divided government, according to Herring. As things stand now—and are likely to stand after the election—major problems like the deficits, debt, growing health care costs and eventual insolvency of Medicare will be kicked down the road to be dealt with later, after they have become worse and the solutions more costly, he predicts. “If we actually wait until there’s no choice, it’s going to be very painful.” 

© 2012 RIJ Publishing LLC. All rights reserved.

The president of Prudential Annuities spoke with RIJ on Tuesday, three days after a New York Times story put a decidedly negative spin on his firm’s recent decision not to allow owners of its generous, but discontinued, variable annuity contracts with HD6 or HD7 lifetime income riders to make new contributions to their contracts.

Bob O’Donnell, who helped design and launch the HD or “Highest Daily” products five years ago, acknowledged that the Times apparently erred in saying that the products offer “guaranteed returns” (instead, they offer guaranteed increases in the “income base” on which annual payouts are calculated). But he disagreed with any assumption that that misconception was widespread.

“I have observed a big increase in the understanding of the variable annuity industry’s value proposition over the past five or six years,” O’Donnell said in a phone interview. “At one time the guarantees were perceived to be applied to the account balance, but I think that misunderstanding has been remedied.”

O’Donnell added, “With $120 billion in assets and 70% percent of those assets in the living benefit riders, we have no complaints around people alleging that they assumed one thing and got another. We’re not seeing that. If there was that misunderstanding, someone would have complained to us or the broker-dealer.”

As for the decision not to accept new contributions from closed contracts, even from existing owners of those contracts, O’Donnell said that Prudential wasn’t the first variable annuity issuer to take that step and said that it was motivated to protect Prudential shareholders, customers and intermediaries alike. 

“It’s only when you meet the needs of all three constituents, only when you have a value proposition that meets the needs of all of them, that you can have a sustainable business strategy. If we didn’t consider the shareholder, then they shouldn’t be investing in our business,” he said.

O’Donnell was also asked to comment on Federal Reserve chairman Ben Bernanke’s recent announcement that U.S. interest rates would be suppressed until 2015, and on the impact that such rate suppression might have on annuity issuers.

“I think that our industry can sustain low interest rates, period,” he said. “The challenge comes in when rates are moving so much. If you price a product assuming a 3% environment—let’s use 10-year Treasuries as a proxy—and rates drop to 2%, the cost of doing business is going to be higher at 2% than 3%. Your product is now selling in a 2% environment and putting pressure on the profits, relative to what you expected.

“But we can price a compelling value proposition at 2% or 1.5%. The industry can price a compelling longevity value proposition that generates an appropriate return for the shareholder. I’m less concerned about ratings staying at 1.75% than I am about rates going from 2% to 1%. It’s the volatility that creates the strain.

“Yes, low interest rates do mean that we have to put more capital against the business. But as long as we have a pretty stable outlook we can respond with a sustainable value proposition. But at Prudential we spend less time trying to predict what will happen than trying to prepare for what might happen. That’s what the regulators look at too.”

Regarding the issue of not accepting new contributions to closed contracts from existing contract owners, a MetLife executive confirmed that it took that step over the summer.

“We have suspended purchase payments for many of our GMIB riders, and we did so effective August 20,” said Bennett Kleinberg, a MetLife vice president and actuary. “There were some benefits that we restricted earlier in the year, but the great majority of the older products were accepting subsequent purchase payments. We are suspending them due to the challenging economic environment and particularly the lower interest rate environment.”

MetLife began contacting contract owners in mid-July, he said, and the last date for contributions was August 20.

AXA Equitable, which sold large amounts of rich VA riders in 2007, made a similar move last winter. “Not all Accumulator contracts have been closed to new contributions, just the contracts prior to version 9.0, which launched in June 2009. We sent out letters to shareholders in February 2012,” said Discretion Winter, an AXA Equitable spokesperson.

Jackson National is an exception to the trend. “Currently, Jackson does not restrict sub pays into existing contracts,” said Melissa Hernandez of Jackson National’s communications department.

Steve McDonnell of Soleares Research, told RIJ that Ameriprise had recently placed limits on contributions to certain versions of its SecureSource benefit series, and that John Hancock and Protective were limiting premium going into certain variable annuity contracts or riders.

© 2012 RIJ Publishing LLC. All rights reserved.

A variable annuity introduced this summer by Symetra Life offers a combination of conventional fund options as well as a selection of “Pension Reserve” funds that allow contract owners to buy units of retirement income between four and 16 years ahead of their income commencement date.

The 14 Pension Reserve Funds in the Symetra True Variable Annuity were engineered for the Bellevue, Wash.-based life insurer by Seattle-based Russell Investments, according to Dan Guilbert, executive vice president of Symetra Life’s Retirement Division.

The no-load product is aimed at registered investment advisors (RIAs), a segment of the advisor community that tends to have the wealthiest clients but historically has shown little interest in buying variable annuities. The mortality & expense fee is only 60 basis points a year and the expense ratio of each Pension Reserve fund is only 40 basis points.

For Symetra, a publicly traded company, the product poses little risk to the enterprise. Unlike a variable annuity with a guaranteed lifetime withdrawal benefit, this product relies on bonds held to maturity to fund an income floor rather than on a mix of fixed income and equity mutual funds. That means it needs no equity hedging, which becomes prohibitively expensive in a low interest rate environment. And because these are no-load contracts, Symetra doesn’t face the potential risk of failing to recover commissions because of a market downturn.

“We’re doing ALM—asset/liability matching,” Guilbert told RIJ. “The underlying investments are long-dated Treasuries. We haven’t seen this type of unbundling from anyone else. It’s pretty transparent and straightforward. You can put money in the pension funds at the beginning. And you can change your mind and sell out of them a month later.”

The product offers some of the peace of mind of a deferred income annuity, because it allows contract owners to lock in a future income stream that can increase but not decline. It also offers some of the flexibility of a variable annuity with a lifetime income benefit, because contract owners can access their account values at any time before income begins if they prefer.

“We also sell the Freedom Income Annuity, which is a typical deferred income annuity where you give $100,000 today and it will provide you with an income in five years. But between now and five years from now, you have no access to that money. With this product, you buy the True variable annuity, and allocate all or part of your money to one of the Pension Reserve Funds,” Guilbert said.

Aspects of the product resemble elements of past or existing products, such as The Hartford’s Personal Retirement Manager, AXA Equitable’s Retirement Cornerstone, or the proposed BlackRock-MetLife SponsorMatch product for 401(k) plan participants, in the sense that they all offer opportunities for upside potential and downside protection in separate investment sleeves while allowing opportunities for transfers between the two.  

The Symetra True contract offers the owner considerable but not unlimited flexibility in choosing an income start date. There are 14 Pension Reserve Funds, corresponding to four different target retirement years (2016, 2020, 2024 and 2028; see chart) and four eligible age ranges based on birth year (1942-47, 1948-52, 1953-57, and 1958-62). Someone born in 1951, for instance, could start income in any of four different years, depending on whether they wanted income to begin at age 65, 69, 73 or 78.

The current unit price of each dollar of future income depends on the length of time between the purchase date and the income date, on the age of the person at the time income begins, and on the prevailing interest rate on the purchase date. As with any pension, future benefit units are cheaper when interest rates are higher, and vice-versa.

Current prices of units in Symetra’s Pension Reserve Funds reflect today’s low interest rates, so they’re not dazzling. As the chart below shows, a 50-year-old who wants annual income starting in 2024 would pay almost $19 per dollar of it ($189,400 for $10,000 a year for life) today. A 65-year-old would pay only $115,300 today for the same income on the same date. For comparison, the purchase price of a hypothetical $10,000 annual income starting today would be about $150,000 for a 65-year-old man, according to immediateannuities.com.

Symetra True contract owners have the option of investing in conventional fund options and then moving the money to the Pension Reserve funds. They can also invest in more than one Pension Resesrve fund, and thereby build a ladder of income annuities. There is no joint-and-survivor payout option in the income-producing funds, but owners of those funds can use the assets at retirement to buy a Symetra immediate income annuity. If the SPIA is paying a higher rate, they can get the higher rate.

What’s the catch? Flexibility isn’t free. With New York Life’s deferred income annuity, for purposes of comparison, you can get a higher level of guaranteed future income because there’s no liquidity during the waiting period, unless the annuitant dies and triggers the death benefit. At the same time, the Symetra True’s Pension Reserve funds offer less potential upside than the latest version of New York Life’s DIA, which offers equity exposure during the deferral period. 

Instead, Symetra offers a bit more flexibility before the income start date. In terms of growth, it does allow the contract owner to benefit from rising interest rates, because the market price of income units will go down as rates rise. By the same token, if the owner decides to pull money out of the Pension Reserve funds after rates go up, he or she will take a haircut because the unit price of the Pension Reserve Fund will have moved in the opposite direction as rates. 

© 2012 RIJ Publishing LLC. All rights reserved.