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Low Growth, High Inflation? It Could Happen.

Economics really is a dismal failure. It started out as a neat mental set of images that helped people understand the world. You were never really expected to find evidence for these mental pictures let alone start to run countries on the basis of it. In many respects, things were fine for economics while the facts were, by and large, hidden. The collection of data on a wholesale basis was for a very long time blissfully difficult to do. Testing economic theory against what actually happened remained a minority activity.

A case in point is the so-called Phillips Curve, which, plainly put, says that, as unemployment increases, so inflation decreases. The idea is logical – a reduction in demand because of increasing unemployment causes producers to reduce prices to bring the system back into equilibrium, and the fillip to the economy helps kick-start the cycle all over again. It’s a nice sensible picture. The trouble is, it doesn’t work.

Take, for instance, the Phillips Curve for the US. It looks more like someone has taken a shotgun to a barn door. You could get a computer program to draw a straight line or polynomial curve through it, but it would be a fanciful argument that led you to positing any kind of deterministic relationship. Data collection has debunked a rather nice idea.

But this is too harsh. Interestingly, the relationship varies from nation to nation and on what length of time of data you include. For instance, Japan shows a startling coincidence between theory and practice over the long term. The question arises as to why it is not universally applicable at all times and in all circumstances and to all nations.

The key seems to be, ‘the larger your deficit with the rest of the world, the more chaotic your Phillips Curve.’  In other words, the more you have an external deficit (as much as to say a dependency on other people’s money), the more your currency will flip around. In turn, this means your domestic inflation rate becomes more chaotic and less related to your correcting unemployment rate as the Phillips Curve would dictate.

Japan has a very strong external balance and a strong Phillips relationship. The UK and US have large external deficits and terrible Phillips Curves. Europe once had a large positive balance with the rest of the world and a Phillips Curve that was respectable. Lately, the region has slumped into deficit, explaining why, even with unemployment of 9% across the European region, inflation remains at 3% when it “should” be less than 1%.

The consequence of deficit reduction, the new mantra of the West, will be low growth and high unemployment. Believers in the Phillips Curve are expecting inflation to fall rapidly and even deflation to set in. But since we are now systematically in deficit and at the sway of the currency markets, this is not a foregone conclusion. In fact, the opposite may happen as our currencies decline. At the very least, inflation will stay much higher than policymakers are expecting or markets are currently anticipating given the level of unemployment.

For instance, over the next 10 years, US inflation is (according to the markets) expected to average just 2%. In the UK, the figure is 2.6%.  These numbers are ridiculously low if we have lost control of our own domestic inflation rate.  The combined effects of chronic external dependencies (both in terms of deficit funding and trade), the fragility of our currencies and the ability of emerging nations to buy the basic stuff of life from underneath us because they have money in the form of reserves could send inflation materially higher or keep it at the levels we are experiencing today. In anything other than the magical realism of some financial commentators, investors should be compensated for this with higher nominal yields and higher implied inflation rates from the markets. Neither of these things is happening at this time. The lack of compensation is just not something that can go on forever.

From our point of view, there are things we can do about this. Buying inflation-linked bonds in the US and UK are the obvious outlets, but, should ‘real’ yields rise, just buying inflation-linked bonds won’t be enough to create a positive return. Any rise in yields will cause index-linked bond prices to decline because even an index-linked bond possesses a duration – the rise and fall of prices as yields fall and rise.

Instead, we want access to the inflation aspect without the duration effect. To do this, we have been buying inflation-linked bonds and selling government bond futures against them. This way, as inflation expectations rise, the combined pair of a long and short makes money in an environment that is normally hostile to bonds. Conversely, if inflation expectations fall, the pair will experience a loss.

So far, this strategy appears to be working – in the US at least, where inflation expectations are rising. We suspect we will be doing more of this trade in the future, but there’s plenty time yet.

Stewart Cowley is head of fixed income at Old Mutual Asset Managers.

Fitch calls U.S. life industry “stable,” but notes concerns

In a new bulletin, “2012 Outlook: U.S. Life Insurance,” Fitch Ratings calls industry “stable,” but says it expects the “positive trends in industry earnings performance and investment results reported in 2011 to be pressured in 2012 due to the low interest rate environment, increased hedging costs, and ongoing market volatility.”

Among other things, the bulletin said:

  • Fitch expects that the industry’s large in-force book of variable annuity business will continue to be a drag on profitability over the near term. It could also cause a material hit to industry earnings and capital in an unexpected but still plausible severe stress scenario.
  • Near-term impacts due to low interest rates include reduced interest margins and increased statutory reserving associated with asset adequacy testing which could reduce statutory capital level by up to 5% in the fourth quarter of 2011. Insurers with defined benefit pension plans for their employees will face increased pension funding expenses in 2012.
  • Fitch remains concerned about the risk profile of the variable annuity (VA) business. Through the sale of VA products with secondary guarantees, insurers effectively have a short embedded-equity put exposure, the value of which is sensitive to interest rates and volatility.
  • Leading up to the 2008–2009 financial crisis, a key concern was the effectiveness of the industry’s variable annuity hedging programs. While the hedging programs that were in place were generally effective in mitigating losses from VA embedded guarantees, the industry was clearly under-hedged, relative to certain risks, and did experience a degree of hedge ineffectiveness.
  • Fitch believes that the industry has strengthened and expanded the scope of the VA hedging programs following the financial crisis. However, the industry’s hedging programs continue to be challenged by policyholder behavior risk, hedging costs, sensitivity to tail risk, and the long dated nature of the liability.
  • Policyholder behavior risk relates to pricing assumptions on lapsation, living benefit utilization, and mortality. Emerging experience is indicating that the industry’s assumptions may have been too aggressive, as a number of insurers have increased reserves in 2011 to reflect emerging experience. Fitch expects this trend to continue.

Andrew Davidson, CFA, one of the Fitch analysts who wrote the report, shared his views with RIJ about the charges against earnings and other adjustments that some life insurance companies reported at the end of the third quarter of 2011, as a result of changing market conditions and emerging trends in policyholder behavior.    

 “The products’ benefit features often have delayed benefit options, and the policyholders are just beginning to make decisions about them. The companies priced certain assumptions about utilization of benefits, and they’re in the process of getting more data points about it, and of adjusting their assumptions to match their experience,” he said.

“That’s what’s going on right now. If they made accurate assumptions, they don’t need to make reserve changes. It’s a company-by-company issue. A Prudential or a MetLife has more diversification of business outside of variable annuities than some other companies. 

 “Some companies will target hedging to reduce volatility in income, others to protect statutory capital, others to protect economic value of their book of business, so it’s difficult to make comparisons between companies. If the charge is not outsized in comparison to the book of business, ratings would not likely be affected. The companies can also make adjustments to their books of business.

“When you add to reserves it comes out of capital, so from a financial perspective you’ve got less capital. So the higher reserve and the lower capital are more representative of the true economics. The hedges offset some of the need for reserves; if hedging is not effective you have to reserve more.”

© 2011 RIJ Publishing, LLC. All rights reserved.

TD Bank predicts 2% growth, 8.8% unemployment in 2012

Despite signs of progress over the last few months—the economy grew at an annualized rate of 2% in July and September—the U.S. recovery remains vulnerable, according to a report released by TD Economics, an affiliate of TD Bank.

Although TD Economics projects 3.2% growth in the closing months of 2011—“economy’s best quarterly performance since mid-2010”—it expects growth of only about 1.9% during 2012 and 2.3% in 2013. The unemployment rate is expected to remain elevated at 8.8% by the end of next year, and 8.4% by 2013. 

The main headwinds, according to the report, are “financial market volatility, Europe’s dual banking and fiscal crises, and a highly polarized U.S. Congress,” as well as “overzealous fiscal restraint in Washington.”

A “disconnect” exists between positive economic performance and persistent economic pessimism among businesses and households, which seems to discount modest improvements in commercial bank lending, employment, credit quality, and credit delinquency rates since the financial crisis.  

TD Economics forecasts the eurozone economy to contract 1.2% in 2012. “Though the U.S. banking system has relatively small exposure to the debt of the most troubled periphery nations, a failure on the part of European policymakers to contain the crisis could lead to financial contagion migrating West,” the report said. “The eurozone’s governing structure was not built to take on the kind of extraordinary decisions at the kind of extraordinary pace the situation requires.”  

The failure of the Congressional “supercommittee” to reach consensus on deficit reduction may lead to steep spending cuts by 2013, and “partisan jockeying” on the payroll tax cut and emergency unemployment benefits could reduce economic growth by 0.7% next year, the report added. 234 – tasked with drawing up plans to bring the country’s deficit trajectory under control – failed to reach a consensus. As a result, steep spending cuts are slated to come into place by 2013. Partisan jockeying has left Congress at an impasse over whether to extend this year’s payroll tax cut and emergency unemployment benefits into 2012. Failure to do so could result in as much as a 0.7 percentage point drag on economic growth next year.

© 2011 RIJ Publishing LLC. All rights reserved.

 

Expect slow growth over next decade: Vanguard

Annual returns from a 50/50 equity/bond portfolio are likely to average between 4.5% and 6.5% in nominal terms and 3.5% to 4.5% in real terms over the next decade or so, according to forecasts in a November research brief from Vanguard.

Such returns would be below the historical average since 1926, (8.2% nominal, 5.1% real), but higher than in the past ten years in either the US or Japan. The estimate was based on Vanguard’s proprietary Capital Markets Model, as of September 30, 2011.

The fact that 10-year Treasury rates are only about 2% indicates the market’s belief that the U.S. economy will grow slowly over the next decade, Vanguard pointed out. Even if growth picks up and interest rates rise, bond prices will fall, hurting the returns of bondholders.

“But the future need not be dark, either,” Vanguard’s economics say. “Indeed, the present levels of interest rates and stock market valuations are arguably closer to the levels of the 1950s and 1960s, environments that over time produced respectable balanced portfolio returns.

“… We believe that realistically recalibrating one’s return expectations for a balanced portfolio is more prudent than making a drastic shift in allocation in an attempt either to defend against elevated market volatility or to pursue higher returns under the allure of higher yields, higher economic growth, or alternative investments,” they wrote.

“Investors who are unwilling or unable to lower their targeted rates of return or spending requirements may need to increase their savings rates—an approach that Vanguard research has shown can be quite effective in raising the odds of investment success.

“An alternative approach, for investors who feel locked to their return or spending targets, would be to adopt a somewhat more aggressive strategic asset allocation by increasing their holdings of equities. Of course, a direct result of this approach would be for the investor to bear higher portfolio volatility and greater downside risk.

To forecast U.S. bond market returns, Vanguard used the Standard & Poor’s High Grade Corporate Index from 1926 to 1968, the Citigroup High Grade Index from 1969 to 1972, the Lehman Brothers U.S. Long Credit AA Index from 1973 to 1975, and the Barclays Capital U.S. Aggregate Bond Index thereafter.

For U.S. stock market returns, Vanguard used the S&P 90 from 1926 to March 3, 1957; the S&P 500 Index from March 4, 1957, to 1974; the Dow Jones Wilshire 5000 Index from 1975 to April 22, 2005; and the MSCI US Broad Market Index thereafter. For international stock market returns, Vanguard used the MSCI EAFE Index from 1970 through 1988, and a blend of 75% MSCI EAFE Index and 25% MSCI Emerging Markets Index thereafter.

© 2011 RIJ Publishing LLC. All rights reserved.

Barclays Wealth and Securian announce new executives

Securian Financial Group names new president

Christopher M. Hilger has been appointed the 16th president of the 131-year-old Securian Financial Group, Inc., the company reported this week. Formerly executive vice president, Hilger succeeds Randy F. Wallake, who is retiring. The change is effective on January 1, 2012, according to chairman and CEO Robert L. Senkler.

Hilger, 47, will report to Senkler with accountability for all of Securian’s insurance businesses and its Information Services technology division. Hilger also serves as CEO of Allied Solutions, LLC a Securian subsidiary headquartered in Indianapolis, Ind., that distributes insurance products and services to financial institutions.

A 25-year veteran of the insurance industry, Hilger joined Securian in 2004 when the company purchased Allied Solutions, a distributor in the financial institution market. In 2007, he was named senior vice president of Securian’s Financial Institution Group and in 2010 was promoted to executive vice president with the added accountability for the company’s Group Insurance business.

Wallake, 63, also an insurance industry veteran, joined Securian in 1987 as vice president of pension sales and subsequently assumed responsibility for the company’s retirement business. In 2001, he was promoted to executive vice president, adding responsibility for the company’s individual insurance business and, two years later, its broker-dealer and trust operations. As president and vice chairman, he directed all of the company’s insurance businesses.  

 

Barclays Wealth appoints Joseph Danowsky as Americas Head of Solutions

Barclays Wealth, the leading global wealth manager by assets under management,  has hired Joseph Danowsky as a Managing Director and Head of Solutions for the Americas.

In this new role, Mr. Danowsky is responsible for delivering solutions on stock-related holdings to high net worth individuals as well as corporations, venture capital, and private equity funds. He reports to Paul Morton, Head of Capital Markets, Operating Platforms and Business Strategy for Barclays Wealth in the Americas.

Based in New York, Mr. Danowsky’s responsibilities at Barclays Wealth include: helping individuals manage restricted/concentrated stock positions through Rule 144 sales, 10b5-1 sales plans, and hedging and monetization strategies; providing companies with executive services such as stock option administration and corporate stock buy-backs; and assisting venture capital and private equity funds with restricted stock sales, share distributions, and hedging and monetization transactions.

Danowsky is also responsible for expanding the firm’s suite of client solutions to include specialized products such as managed option overlay programs and exchange funds. In his role, he will work closely with investment professionals across Barclays Wealth to deliver the full breadth of the firm’s investment services.

Danowsky joins Barclays Wealth from J.P. Morgan Securities, where he worked in a similar role for the past three years. Previously, he worked at Bear Stearns for more than two decades. Starting in 2001, Danowsky helped develop the firm’s Advisory Services/Wealth Management group, where he held the position of Senior Managing Director. Prior to that, Danowsky worked in the firm’s legal department managing a team that focused on derivatives transactions, insider and restricted stock issues, complex trading strategies, and prime broker arrangements.

Mr. Danowsky holds a J.D. from Harvard Law School and a B.A. in economics from the University of Pennsylvania, where he graduated summa cum laude and Phi Beta Kappa.

 

MassMutual introduces Pension Funding Scorecard

MassMutual has launched a new Pension Funding Scorecard to help defined benefit plan sponsors and retirement plan advisors evaluate portfolio performance and deal more effectively with the impact of market volatility on the funded status of their pension plans.

The Scorecard provides a quarter-by-quarter performance comparison for a liability-driven investing (LDI) portfolio vs. a traditional 60% equity/40% fixed income portfolio against the MassMutual Pension Liability Index (MMPLI). The MMPLI is based on aggregating data from defined benefit plans on MassMutual’s Retirement Services platform.

The tool also provides historical returns to help retirement plan advisors, plan administrators and chief financial officers make informed decisions about pension funding approaches.

LDI has achieved increasing attention for its ability to help mitigate the volatility and unpredictability of pension plan funding status. According to its proponents, LDI can enable better cash flow management and better alignment of asset and liability returns over time, while streamlining plan administration. In addition, LDI can often help reduce concerns associated with downturns in the equity markets, an issue that has spurred heightened interest in LDI among CFOs and pension committees.

Morningstar announces agenda for institutional conference

The annual Morningstar Ibbotson Conference will take place Feb. 23-24 at the Westin Diplomat Resort & Spa in Hollywood, Fla. The conference, Morningstar’s main event for institutions, will feature speakers from academic institutions and the financial services industry who will discuss new research and techniques in asset allocation, investment research, and portfolio construction.

Thomas Sargent, winner of the 2011 Nobel Prize in Economic Sciences and professor of economics and business at New York University, will deliver the keynote address and discuss the role of government policy and regulation in the midst of today’s economic crisis.

General session speakers include:

  • Liz Ann Sonders, chief investment strategist for Charles Schwab & Co., Inc., who will address the state of the markets and the forces that shape the economic landscape;
  • Charles Nelson, president of Great-West Retirement Services, who will discuss the opportunities and challenges in the retirement industry as defined contribution plans become the primary source for retirement security;
  • Meir Statman, Ph.D., Glenn Klimek professor of finance at Santa Clara University, who will address investor desires and behavioral finance;
  • William A. Strauss, senior economist and economic advisor for the Federal Reserve Bank of Chicago, who will provide his economic outlook for 2012; and
  • Roger Ibbotson, Ph.D., founder of Ibbotson Associates, professor of finance at Yale School of Management, and partner at Zebra Capital Management, who will examine the quarter-century controversy over the importance of asset allocation.

Topics of breakout sessions will include dynamic asset allocation, new techniques for mutual fund selection, target-date fund glide path stability, credit and liquidity risks of stable value products, asset-class- versus risk-factor-based asset allocation; and incorporating non-normal return assumptions into fund of funds optimization. In addition, John Rekenthaler, vice president of research for Morningstar will present an overview of the methodology behind the new Morningstar Analyst Rating for funds.

In addition to the conference, Morningstar will host an institutional software symposium focused on asset allocation for Morningstar Direct and Morningstar EnCorr clients on Wednesday, Feb. 22. Clients will receive training from product experts, trade ideas with peers, and explore Morningstar methodologies.

Envestnet acquires FundQuest

Envestnet, Inc., a provider of wealth management software and services to financial advisors, has acquired FundQuest Inc., BNP Paribas’ U.S. provider of fee-based managed services and solutions. The Boston-based firm managed about $15 billion as of June 30, 2011.

FundQuest, Inc. has provided managed account programs, overlay portfolio management, mutual funds, institutional asset management and investment consulting to RIAs, independent advisors, broker-dealers, banks and trust organizations since 1993.

Timothy Clift, formerly chief investment officer and chairman of the investment committee at FundQuest, Inc., will join Envestnet|PMC as chief investment strategist, responsible for the development of investment strategies for client portfolios as well as the development of manager and fund strategist selection methods.  

Clift joined FundQuest in 1994 and was responsible for its investment management programs for separately managed accounts, mutual funds, alternative investments, exchange-traded funds and annuities.  

Before joining FundQuest, Clift worked for Donaldson, Lufkin & Jenrette, where he was responsible for asset management, research and sales.  

“Simpson-Bowles” reforms would reduce middle-class Social Security receipts: Urban Institute

A new report from the Urban Institute claims that if the Social Security reforms recommended by the National Commission on Fiscal Responsibility and Reform a year ago were adopted, the Social Security benefits received by adults would decline relative to benefits currently scheduled.

In 2070, when all of the proposed provisions would be fully phased in, average benefits would be 14% lower for those in the middle of the earnings distribution, the Urban Institute report said.

While the proposal largely preserves scheduled benefits for those in the bottom earnings quintile, they would experience a projected 3% benefit reduction primarily because of the proposed COLA changes—despite the inclusion of several benefit enhancements for recipients with low lifetime earnings.

For those in top earnings quintile, projected benefits would fall by about a quarter. As a result, their projected first-year replacement rates from Social Security will decline markedly for future generations, along with their return from the payroll taxes they pay over their lifetimes. These declining returns could erode political support for OASDI.

The proposal generally leaves beneficiaries in the bottom four lifetime earnings quintiles with higher benefits than they would receive under a payable baseline (under which Social Security is not changed at all in the near term and beneficiaries faced across-the-board benefit reductions once the Trust Funds are exhausted).

Compared to a feasible baseline (under which action is similarly deferred until Trust Fund exhaustion, but at that point restores balance though an even division between benefit reductions and payroll tax increases), relatively fewer beneficiaries have higher benefits, but the lower two quintiles still do comparably well.

 The National Commission on Fiscal Responsibility and Reform (NCFRR), led by Erskine Bowles and Alan Simpson, released a set of recommendations in December 2010 to help place the Social Security program on a sounder long-run financial footing. These recommendations included the following provisions that reduce the long-run fiscal imbalance through increased payroll tax contributions or reduced benefits:

• Increase the earnings subject to the Social Security payroll tax;

• Modify the benefit formula to slow the growth of future benefits;

• When calculating the cost-of-living adjustment (COLA), replace the current version of the consumer price index (CPI), the CPI for urban wage earners and clerical workers, or CPI-W, with the chained consumer price index (C-CPI-U, also known as the superlative CPI);

• Index the Early Eligibility Age (EEA) and the Full Retirement Age (FRA) to life expectancy to maintain a roughly constant ratio of retirement years to work years; and

• Cover newly hired state and local workers under Old-Age, Survivors, and Disability Insurance (OASDI).

Additional provisions aim to shore up benefit adequacy and, in some cases, mitigate effects of the prior provisions. These adjustments include the following:

• A minimum benefit for full-career low-wage workers;

• A benefit enhancement for the long-lived and longtime disabled;

• A hardship exemption from increases in the EEA and FRA for individuals with low lifetime earnings and relatively long careers; and

• An option for beneficiaries subject to increases in EEA and FRA (because the hardship exemption does not apply to them) to start receiving up to one-half of the benefit for which they would be eligible at age 62.

This report presents distributional estimates of the effects of the commission’s proposal on future Social Security beneficiaries. All projections rely on the Urban Institute’s Dynamic Simulation of Income Model (DYNASIM), a model of the retirement resources of the U.S. population based on the 1990–1993 panels of the Survey of Income and Program Participation (SIPP).

Our distributional analysis reveals that the projected effects of NCFRR’s proposal are particularly deep relative to current law scheduled for those reaching retirement age several decades from now, when reductions are phased in. In addition, projected benefit reductions are closely related to lifetime earnings, with those at the bottom of the lifetime earnings distribution largely shielded and those at the top experiencing significant reductions.

© 2011 RIJ Publishing LLC. All rights reserved.

Sun Sets on Sun Life’s U.S. Annuity Business

A month after announcing a new “Vision” variable annuity with low costs and a tepid lifetime income guarantee, and two weeks after promoting COO Dean Connor to CEO, Sun Life Financial announced Monday that it was getting out of the annuity business in the U.S.

 “As a result of [a] strategic review,” the company said in a release, it “will close its domestic U.S. variable annuity and individual life products to new sales effective December 30, 2011.

“The decision to discontinue sales in these two lines of business is based on unfavorable product economics which, due to ongoing shifts in capital markets and regulatory requirements, no longer enhance shareholder value.”

In the third quarter of 2011, Sun Life accepted $681 million in new variable annuity premium, mainly for its Master Choice II and Masters Flex II contracts. Its 2011 year-to-date sales were $2.33 billion. It had 1.77% of the U.S. variable annuity market and was in 13th place in sales for the current year. With $19.2 billion in variable annuity assets under management in the U.S., it ranked 16th overall with a 1.35% market share, as of September 30, 2011.  

In a statement, Connor said, “To achieve growth in the U.S., we will focus on increasing sales in our employee benefits business, which is already a top ten player, and will expand our presence in the growing voluntary benefits segment.

“We are confident that with the focused investment announced earlier this year we can build leading positions in these two sustainable, less capital-intensive businesses. We will also continue to support growth in MFS, our highly successful investment manager that has a large U.S. presence and over US$250 billion of assets under management globally.” 

Along with other insurers operating in the U.S., Sun Life Financial was hurt in the third quarter of this year by stock market declines and low interest rate policies, which reduce the value of the assets backing its variable annuity guarantees and raise the cost of hedging those guarantees, respectively. The company reported a $572 million loss in the third quarter, according to National Underwriter.

Sun Life, as a Canadian company, was subject to Canadian accounting rules, which brought additional pressure on it. The same was true for John Hancock, a unit of Canada’s Manulife. John Hancock reduced distribution of its variable annuities in the U.S. after the third quarter.

Connor said Sun Life would focus its future growth into four “pillars”:    

  • Continuing to build on its leadership position in Canada in insurance, wealth management and employee benefits;
  • Becoming a leader in group insurance and voluntary benefits in the U.S.;
  • Supporting continued growth in MFS Investment Management, and broadening Sun Life’s other asset management businesses around the world; and
  • Strengthening Sun Life’s competitive position in Asia.

Starting in August 2009, Sun Life began a big push to raise its profile in the U.S. It hired The Martin Agency of Richmond, Va., to strengthen its brand.  Martin’s other clients included Genworth Financial, NASCAR, BF Goodrich, The JFK Presidential Library, WalMart, Geico and UPS. For Geico, it created the Cockney Gekko, the resentful Cavemen, and the Real People ads that paired ordinary policyholders with Little Richard, Joan Rivers, Peter Frampton, Charo and other celebrities.

Playing off its name, Sun Life also announced a partnership with Cirque du Soleil, the organization whose musical trapeze extravaganzas have become staple entertainment in Las Vegas and DisneyWorld. Sun Life is the Official Insurance Partner of Cirque du Soleil U.S. Big Top Touring Shows, U.S. Arena Touring Shows, and the Presenting Partner of a major new Cirque du Soleil U.S. show to be announced next month. Sun Life also bought the naming rights to the Miami Dolphins football stadium in Miami.

Stephen L. Deschenes, who has been a senior vice president and general manager of Sun Life’s annuity business since June 2009, could not be reached for comment. Before joining Sun Life, he served as senior vice president and chief marketing officer for the Retirement Income Group at MassMutual Financial Group.

Before joining MassMutual, Deschenes served as executive vice president for Fidelity Investments. A founder of the online financial advice site mPower (now part of Morningstar), Deschenes graduated magna cum laude from Harvard University.   

© 2011 RIJ Publishing LLC. All rights reserved.

Passive Equity Strategies Are Still Valid

The great debate goes on… and on and on.  “Active management wins!” “No—passive management wins!” The market behavior of the past two decades could support either argument. Or perhaps we need to redefine our terms. 3D Asset Management of East Hartford, Conn., for instance, has created a hybrid strategy that poses an interesting twist on the definitions of both passive and active. (More about 3D in a moment.)

Once upon a time, active equity investing meant trading stocks and passive investing meant buying and holding stocks. Starting in the 1990’s, when S&P 500 Index funds returned 17% or more a year, active and passive management came to mean trading or holding an entire asset class or index. An investment of $100,000 in the S&P 500 Index on January 1, 1990 would have grown to nearly $500,000 by December 31, 1999. Financial publications touted S&P 500 index funds as the only investment anyone could ever need.

Unfortunately, this type of passive strategy failed during the following decade, producing a 1% annual compounded loss. An investment of $100,000 in the S&P 500 Index on January 1, 2000 would have been worth just $90,000 at the end of the decade. Retirees who were drawing income from that type of account were devastated. By early 2010, passive strategies were being called “old school” methods that were obsolete in the “New Normal.”  

Did this poor performance invalidate passive equity investing? Not at all. We have been so focused on the rise and fall of the S&P 500 that we have forgotten the true definition of passive investing. A true passive strategy, history shows, was never meant to be limited to the S&P 500 or to any other single asset class.

The roots of today’s investing strategies can be traced to Harry Markowitz’ work. Prior to his   development of Modern Portfolio Theory in the 1950s, successful investment strategies were attributed to the ability to select and hold a handful of the “right” individual stocks. Markowitz’ “Theory of Portfolio Choice” showed that diversification could reduce risk without sacrificing yield and that investors could construct optimal portfolios that maximized return for given levels of risk. This work led to a Nobel Prize in economics for Markowitz, William Sharpe and Merton Miller in 1990.  

Twenty years later, at the University of Chicago, Eugene Fama and Kenneth French redefined passive investing. In the mid-1970s, Fama’s “Market Efficiency” white paper argued that, because equity markets were priced efficiently and because of the drag of active management fees, picking a few companies out of an asset class would offer no better returns than buying the whole asset class.

Fama/ French modeling recommends taking positions in all equity asset classes worldwide and weighting them according to each investor’s appetite for risk. Instead of holding just a few investments, passive portfolios of this type might hold shares in 8,000 to 10,000 companies. (The two men had the benefit of the Center for Research in Security Prices (CRSP) at the University of Chicago’s Graduate School of Business (now the Booth School). Created in 1960, CRSP remains one of the world’s largest database of historical investment returns.

Such portfolios could control costs and volatility while outperforming actively managed portfolios with similar risk exposure, Fama and French demonstrated. Sure enough, during the so-called “lost decade” of 2000 to 2009, diversified portfolios that followed their model delivered compound annual returns of 6% to 8% (with 8% coming from all-equity passive portfolios) Of the stock pickers and asset class “rotators” who called passive management a lost cause, few outperformed the Fama/French strategy. 

Does that mean that active management is dead? No, it simply needs to be redefined. 3D Asset Management follows the Fama/French mathematical weightings and uses exchange traded funds instead of index funds because they cost even less. But Wayne Connors, the 3D Asset Management principal who sets the firm’s allocations, also uses “active overlay”—a hybrid of active and passive strategies that involves actively managing the weights of asset classes in a diversified portfolio.  

Based on studies of investment behavior, 3D has observed that the movement of institutional money in and out of equities has short-term (over a period of 18 to 24 months) impact on the returns of certain asset classes and consequently adds to the volatility of a traditional passive portfolio. The firm subsequently demonstrated that yield can be increased and volatility reduced by tracking this behavior and adjusting the “weighting” of the indexes periodically—while remaining fully invested in all of them and adhering to the Fama/French model.    

For advisors who design income strategies for retired clients—whether you use a systematic withdrawal plan or a time-segmentation (bucket) strategy—this hybrid strategy is worth considering.  As the originator of the time-segmented Income for Life Model (IFLM) strategy now marketed by Wealth2K, I recommend this hybrid approach to my retired clients for the long-term segments of the model.

The volatility of the last few years has led the public to believe that all investment theory is obsolete and that only two options remain: to manage money very actively or to buy indexed annuities with income riders and shift all market risk to an insurer. Too many advisors have allowed themselves to get swept along by this same wave of emotion, when it’s our job to stay on the intellectual side of advice. If Markowitz, Fama and French are right, there is no rationale to “shift” long-term market risk. The lost opportunity-cost is too great.  Even in the worst of times, passive diversified portfolio design serves our clients well.

Phil Lubinski, CFP, is owner of the Strategic Distribution Institute, LLC.

Don’t Go Overboard with TIPS

The Fed’s aggressive monetary easing has many investors considering Treasury inflation-protected securities (TIPS) as a cornerstone of their retirement strategy. While TIPS’ unique ability to protect against CPI-based inflation is undeniable, many investors neglect to consider the risks they pose, particularly for those who have not yet reached retirement.

The U.S. began issuing TIPS in 1997. Backed by the full faith and credit of the U.S. government and assurances that inflation cannot eat away at their value, TIPS seemed to be a truly risk-free asset for U.S.-based investors.

In 2003, Zvi Bodie and Michael J. Clowes published the book, Worry-Free Investing: A Safe Approach to Achieving Your Lifetime Financial Goals, in which they argued that typical retirement-oriented investors should rely primarily on TIPS for their retirement savings. Other financial assets should be included in the retirement portfolio only once one has enough savings (after accounting for any income expected from Social Security and other defined-benefit pensions) to cover their planned retirement expenditures without these riskier assets.

In an interview in the February 2010 issue of Journal of Financial Planning, Bodie confirmed his continued endorsement of this strategy. He also indicated that his personal retirement portfolio is 100% in TIPS.

Let’s take a critical look at the safety of TIPS. To be clear, I do accept the arguments made by Bodie and others that it is fallacious to believe that stocks are less risky than bonds, even when held over long periods of time. And I don’t believe, as some do, that investing in TIPS is foolishly conservative in light of the historical risk premium provided by stocks. TIPS can play an important role in most retirement portfolios. But Bodie and Clowes’ strategy is not the no-brainer they make it out to be. Like other assets, TIPS have risks and do not eliminate the need for broad diversification.

1. TIPS have greater default risk than nominal government bonds.

The conventional wisdom is that U.S. government debt carries negligible default risk. Because the dollar is the world’s reserve currency, the government can easily issue bonds denominated in dollars. The U.S. can avoid default by “printing money” as the Federal Reserve buys U.S. Treasury bonds from the open markets, paying for their purchases by crediting the sellers with newly created bank reserves. Yes, we learned this summer that Congressional gridlock with regard to raising the debt ceiling could lead to a technical default, and, yes, there is an active credit default market for U.S. government debt – but, for now, let’s set these issues aside.

The default risk for TIPS, however, is actually greater than the default risk for traditional Treasury bonds. This is because, all things considered, issuing TIPS has more in common with issuing foreign-currency bonds than issuing domestic-currency bonds. TIPS owners will not necessarily get a free pass should inflation pick up in the coming years. Printing money to pay interest and principal on government debts will trigger inflation, which in turn raises the nominal value of payments the government must make on TIPS. Just as a country that borrows in a foreign currency cannot print money to pay its debt – printing money will only trigger depreciation of their exchange rate and make their debt obligations harder to meet – the U.S. government will not be able to print money to escape its obligations to TIPS investors.

History is full cases in which countries have defaulted on their foreign currency- denominated debt. To avoid an embarrassing outright default, the federal government could redefine the inflation measure downward in order to reduce its debt obligations, in which case TIPS owners may not receive adjustments appropriate for the actual rising costs of living. This would be a significant source of worry for individuals who primarily rely on TIPS to finance their retirement.

2. Fluctuating yields create reinvestment risk.

Figure 1 shows the yields from the 89 Treasury auctions on newly issued TIPS notes and bonds since January 1997. Until mid-2002, each auction for TIPS of the various maturities provided an initial yield above 3%. Lucky investors in 1998 and 1999 could have purchased 30-year TIPS yielding close to 4%, and yields on 10- and 20-year TIPS exceeded 4% in 1999 and 2000. Since mid-2002, though, yields around 2% have become the norm. Only the auction in October 2008 for the 5-year TIPS notes, held in the aftermath of the Lehman shock and an accompanying deflation scare, provided a real yield above 3%. Yields subsequently fell, and an auction for a five–year note held in October 2010 made headlines as the real yield dipped below zero (to -0.55%) for the first time. Purchasers of those issues locked in yields that will not keep pace with inflation.

Whatever the yield may be, whether you buy TIPS directly from the U.S. Treasury or from the secondary market, you will lock in the currently offered real yield as the real rate of return should you hold the security to its maturity date. Nevertheless, a retirement saver who may be planning a savings strategy over 20 to 40 years, and then planning for a subsequent withdrawal phase that may last another 30 or 40 years, will have no idea what the future real yields on TIPS are going to be. No TIPS have maturity dates sufficiently long to cover the full planning horizon for a young person, and assuming one plans to make multiple contributions to his or her retirement savings portfolio over time, that investor will face significant reinvestment risk that the future real yields on TIPS will be lower. More generally, one cannot know how much to save today for an all-TIPS strategy without also knowing what future real yields will be when future savings are invested or rolled over. The possibility of lower future real yields will require a higher savings rate today as a precaution.

3. TIPS may never offer 4% real yields again.

Figure 1 shows the downward trend in TIPS yields. TIPS yields may be decomposed into three components: a nominal yield consisting of an underlying real interest rate and expected inflation, an illiquidity premium, and an inflation-protection premium. According to Jennifer Roush, William Dudley, and Michelle Steinberg Ezer of the New York Federal Reserve Bank, since the introduction of TIPS, all three of these components have boosted TIPS yields relative to conventional bonds in ways that cannot be expected to continue in the future. In particular, when TIPS were first introduced, they offered a substantial premium to compensate for their illiquid new market. One set of estimates Roush et al discuss suggests that as much as 200 basis points of the yield for early 10-year TIPS derived from this premium.

The illiquidity premium subsequently declined as markets became more established, reducing TIPS yields since the initial years. This premium may never return. The inflation-protection premium is the yield investors are willing to sacrifice for the unique protection against inflation provided by TIPS – an insurance premium that investors pay. Roush et al cite several studies which estimated that inflation-protection premiums have been low since the introduction of TIPS, as investors may not have been too worried about inflation in these years. This would cause TIPS to sell for lower prices, and thus offer higher yields, than otherwise possible.

4. There is also real interest rate risk during retirement

As well, retirees may not always hold their TIPS to maturity if they wish to sell some of the principal during retirement. This subjects them to interest rate risk, which is the risk that an increase in interest rates will leave retirees selling their TIPS at lower prices. In The Simplest, Safest Withdrawal Strategy, Advisor Perspectives’ Robert Huebscher identified this as a potential risk for retirees using only TIPS. He made a strong case for using TIPS in retirement, though I’d emphasize his caveat that an all-TIPS strategy makes sense “if a retiree has sufficient funds to support a 4% withdrawal rate over 30 years.”  Next, I will discuss what savings may be required to pull this off when relying on TIPS both before and after retirement.

5. Low real yields make retirement planning costly

Much of the analysis of TIPS in the Bodie and Clowes book is based on TIPS providing a constant 3% yield in the future. The book’s publication in 2003 came right during the dying days of 3% yields for TIPS. Figure 2 shows some potential outcomes for a retirement saver with a constant real salary who saves over 30 years and makes plans for 30 years of retirement. With a planned 50% income replacement rate (with Social Security being added on top), a savings rate of 15% is needed when real yields are a constant 4%. The required savings rate increases to 20% with a 3% yield, to over 25% with a 2% yield, to over 35% with a 1% yield, and to 50% with a yield that matches inflation. Due to precautions for reinvestment risk, someone starting out with this strategy today should consider savings rates in the neighborhood of 35%, and that isn’t even particularly conservative nor would it help anyone living longer than the planned 30 years. The savings rates needed for an 85% replacement rate are accordingly higher.

This is important, as the higher the necessary savings rate, the less attractive or practical a TIPS strategy will appear and the more potential regret one will feel at having sacrificed so much should stocks provide decent returns after all. (I showed in an article on safe savings rates that a 16.6% savings rate was the highest savings rate anyone, even in the worst- case scenario, might have needed since 1871 for this type of 60-year lifecycle for a 60/40 portfolio of stocks and Bills.) Faced with the reality of such a high savings rate, an investor may be much more willing to take his or her chances with riskier assets in the hopes of earning a risk premium over time. A stock market boom could even push TIPS prices down, leaving one exposed to too much regret and the risk that investors will abandon the strategy at the worst possible time. At some point, the savings rate needed to implement the TIPS strategy will be too high to be feasible for even the most cautious retirement savers.

6. TIPS lack historical data

Finally, there is simply not enough historical data on TIPS to properly model their role as a retirement savings vehicle. For example, the period since the introduction of TIPS has been one of moderate inflation, and TIPS have yet to be tested by high inflation. It is reasonable to expect that high inflation will increase the demand for TIPS. At the same time, if inflation increases, it is conceivable that the supply of newly issued TIPS from the U.S. government could decline or even stop. Increased demand and a lower supply would both work to raise prices, which would push the real yields for TIPS lower. We have already witnessed negative TIPS yields, and in the future it is completely plausible that TIPS will consistently provide negative real yields, requiring further increases in savings rates. We just don’t know what to expect.

The Bottom Line

TIPS have many attractive features for a retirement savings portfolio. In particular, they protect against bouts of unexpected inflation. An all-TIPS strategy, however, will require a high saving rate that is only justified if TIPS are truly risk-free, which is not the case. I have a hard time accepting that TIPS will be invulnerable to the types of black swan events that could decimate an otherwise well-balanced portfolio, and that, after all, is the strategy’s main selling point.

Wade Pfau, Ph.D., CFA, is an associate professor of economics at the National Graduate Institute for Policy Studies (GRIPS) in Tokyo, Japan. He maintains a blog about retirement planning research at wpfau.blogspot.com

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© Copyright 2011, Advisor Perspectives, Inc. All rights reserved.

The Bucket

Vanguard participants earn an average of 3.76% a year over five years

For the three million or so plan participants in defined contribution plans whose records were kept by Vanguard, the average annual total return over the five-year period ending on December 31, 2010 was 3.76%, net of all investment expenses fees and independent of each participant’s unique contribution or withdrawal pattern. 

The average cumulative return for that period, which included the 2008-2009 crash in equity market prices and corporate bond prices, was 20.27%. From the end of 2007 to the end of 2010, the average Vanguard participant broke even, with virtually no total return gain or loss.

The results were reported in a November 2011 research brief, “Participants during the financial crisis: Total Returns, 2005-2010,” written by Stephen P. Utkus and Shantanu Bapat of the Vanguard Center for Retirement Research.

There was some dispersion around the averages. The youngest participants (<25) had the highest five-year annualized returns (4.18%) of any age group; those with the highest account balances (>$250,000) had the highest returns of any account size group by a small margin (3.97%). Those with household incomes between $30,000 and $50,000 had the highest returns of the income segments (3.84%) and men gain slightly more than women (3.84% versus 3.60%).     

But those with the highest average annualized five-year returns (4.65%) were the over-65-year-olds who had all their money in a single target date fund. They also had the lowest average equity exposure, at 40%.

Not surprisingly, participants who used single target date funds (3.90%) and people who used Vanguard’s managed account service (3.66%) experienced tightly clustered returns—there was little variation in a random sample of 1,000 participants.

For the self-directed participants in the sample, the performance was scattershot, with annual five-year returns ranging from highs of almost 15% for a handful of people to lows as deep as minus 7.5% for a few. Some of the deviation was attributed to holdings of company stock.

“Some participants’ more extreme portfolio construction strategies resulted in exceptionally positive results over the period and some resulted in very poor results,” the authors commented.

“For many others, investment results were scattered, seemingly unpredictably, across the risk-return space. For plan fiduciaries, an important question to weigh is whether such dispersion of outcomes reasonably reflects individual participants’ desires for portfolio customization—or their lack of skill at portfolio construction.”

 

MetLife issues earnings forecast for 2012

MetLife, Inc., company expects 2012 operating earnings to be between $5.1 billion and $5.6 billion ($4.80 to $5.20 per share), up 7% over 2011 adjusted results, the largest U.S. life insurer and leading variable annuity issuer said in a release this week. The adjustments reflect several one-time items in 2011 and the estimated impact of an industry-wide change in accounting methodology.

MetLife’s stock price peaked at about $63 in October 2007, fell below $14 in early 2009 and closed at about $32 this week. Its one-year return is a loss of more than 18%, according to Bloomberg.

Shares of other publicly held insurers, such as Lincoln National Corp., Hartford Financial Services Group, and Genworth Financial Inc., have suffered as much or more. 

A recent report in Bloomberg said:

The current low interest rates have hurt investment income at companies including MetLife, the largest U.S. life insurer. Treasuries have fluctuated over the past three months as European leaders tried to convince investors that nations in the region will be able to pay their debts. The U.S. 10-year yield rose to 2.42% on Oct. 28, after reaching a record low 1.67% on Sept. 23.

The average yield on MetLife’s more than $350 billion in fixed-income holdings sank to 4.8% in the three months ended Sept. 30 from 5.8 percent a year earlier, according to data on the insurer’s website. In addition to its bond portfolio, the life insurer is using funds to finance hard assets such as locomotives, power plants and real estate.

In addition to operating earnings growth in 2012, MetLife projects it will increase premiums, fees & other revenues by 5% over 2011 to between $47.3 billion and $48.6 billion, the company said in a release.

MetLife estimates its full year 2011 operating earnings will grow 32% to between $5.2 billion and $5.3 billion ($4.83 to $4.93 per share) compared with $3.9 billion ($4.43 per share) in 2010.

For 2011, MetLife expects to grow its premiums, fees and other revenues 32%, to be between $46.3 billion and $46.8 billion, compared with $35.2 billion in 2010.

Book value per share at year-end 2011 is expected to be between $56.15 and $57.25, up 28% from $44.18 at year-end 2010.

MetLife expects fourth quarter 2011 operating earnings of between $1.2 billion and $1.3 billion ($1.16 to $1.26 per share), up 7% from $1.2 billion ($1.19 per share) in the fourth quarter of 2010.

Per share calculations for full year and fourth quarter 2011 are based on 1,068.2 million and 1,066.5 million shares outstanding, respectively. Per share calculations for 2012 are based on 1,070.3 million average shares outstanding.

 

Plan sponsors give Vanguard top marks: Boston Research Group

Retirement plan sponsors ranked Vanguard tops in 2011 for overall satisfaction, value for cost, and investment performance, according to Boston Research Group’s 2011 Plan Sponsor Satisfaction and Loyalty Study. This marked the third consecutive year that Vanguard has achieved the #1 ranking for overall satisfaction; it has been in the top five in that category since 1999.

Boston Research Group (BRG) is a strategic market research and consulting firm that serves a number of industries, including the financial services industry. BRG conducts an independent annual survey of how plan sponsors perceive full-service retirement plan providers, which provide investment management and administrative services such as plan recordkeeping; accounting, legal, compliance, and trustee services; participant education; websites; customer service phone centers; and loan administration.

This year’s findings resulted from BRG’s nationwide survey between April and July 2011 of 1,454 401(k) plan sponsors with $5 million or more in plan assets. BRG establishes quotas for plan sponsor responses for each recordkeeper to achieve statistically reliable samples. Vanguard has been among the top-tier providers, as ranked by client satisfaction and cost, in every BRG survey since 1999.

The BRG findings follow a Cogent Research “Retirement Planscape 2011” survey this summer that rated Vanguard among the best in several categories, including brand impression, loyalty, and plan sponsor support. Conducted in March and April 2011, the survey cited Vanguard as the top defined contribution (DC) investment manager for favorable brand impression among those familiar with the brand.

In assessing attributes that help drive perception of a DC investment manager’s brand, plan sponsors placed Vanguard first in the categories of “competitive fees/fee structure” and “good value for the money.” In addition, Vanguard was second for “noteworthy organizational stability” and “industry-leading product innovation.” The survey studied the impact of brand and loyalty among a representative cross section of 1,994 401(k) plan sponsors.

 

Pre-retirees and retirees happy, optimistic

Americans’ trademark optimism is intact, at least in regard to retirement, despite the economic turbulence that is reportedly forcing many people to work longer and make do with less. In fact, many retirees found only one downside: They wish they could have done it sooner. That’s according to a new survey from The Hartford and MIT AgeLab.

The October 2011 Age of Opportunity study, which measured the opinions and concerns of Americans both in and approaching retirement, found that most retirees are pleased with their life, and both pre-retirees and retirees have a positive attitude about retirement overall:

  • Retirees are more likely to say “I am happier now that I am retired” (77%) than those who have yet to retire are to say “I will be happier after I retire” (64%).
  • Other than wishing they could retire earlier (35% of pre-retirees), or could have retired earlier (42% of retirees), many recent and soon-to-be retirees see few negatives about retiring.
  • Twenty-six percent of those nearing retirement said they feel “hopeful” about retirement, while 27% of those who have recently retired say they feel “peaceful.”
  • Among those who did find something less than positive about the next phase of their lives, dealing with medical or health issues was cited most often (2% for both pre-retirees and retirees).
  • Among retirees, the more affluent are twice as likely as others to cite giving up a fulfilling career as a negative to retirement.

The study, conducted by GfK Roper for The Hartford and the MIT AgeLab, surveyed people who are within 10 years of retiring versus those who have retired within the last 10 years, and attempted to answer the question, “Does the reality of retirement match expectations?”

Most pre-retirees and retirees cite health or medical issues as the thing they worry most about impacting their retirement. Health is definitely top of mind. Other health-related findings include:

  • If they could change one aspect of retirement, retirees say they would have saved more money or been better prepared financially (32%), but they also wish they’d paid more attention to the importance of health issues (13%).
  • When asked how long they would like to live, most said “as long as I am healthy” (80% of pre-retirees, 75% of retirees). In contrast, just 3% of pre-retirees and 4% of retirees said they would prefer to live as long as their money lasts.
  • Retirement-age Americans see themselves living a very long time. Many expect to make it into their 90s (29% of pre-retirees, 35% of retirees).
  • Although many retirees (48%) and most pre-retirees (63%) say their spouse is the person most likely to care for them if they become chronically ill, few (11% of pre-retirees and 10% of retirees) say their top concern is caring for a spouse or family member impacting their retirement.

When it comes to planning, both pre-retirees and retirees said a milestone birthday (19% of pre-retirees, 14% of retirees) or the realization that they are within 10 years of retiring (15% of pre-retirees, 11% of retirees) were the two most common triggers for serious financial planning.

It also seems that early planning plays off: More affluent retirees – those with $250,000 or more of investable assets – are twice as likely to say they began serious financial planning when they got their first job.

Both retirees and pre-retirees say they would give up some “extras” to help make ends meet in retirement, including moving to a more modest home (14% of retirees and 21% of pre-retirees), driving a less-expensive car (15% and 18%, respectively), or shopping less (17% for both). They were less willing to give up dining out, entertainment and recreational pursuits. Those who are more affluent are even more likely to “trade down” a home or car to preserve other aspects of their lifestyle.

Americans’ independent-mindedness also showed through as the survey found that retirees say they followed their own path, and pre-retirees hope to do the same. When asked what song they’d use to describe the retirement they have, or the one they hope to have, both groups most often chose (I Did It) “My Way.”

From Oct. 3-16, 2011, GfK Roper conducted a total of 1,964 telephone interviews with adults 45 years and older using RDD (random digit dialing). To qualify, respondents must have retired in the past 2-10 years (“retiree”) or plan to retire in the next 2-10 years (“pre-retiree”). These groups were further divided based on their household’s total investable assets, with quotas for under $250,000 and $250,000 or higher.

 

Securian finds opportunities for advisors among small business owners  

Securian Research has created a research paper to help financial advisors understand and cultivate small business owners as potential clients.

“For many financial advisors small business owners (SBOs) are highly desirable when building an advisory business because of the many financial services they need and use. But SBOs are legendarily difficult to get in front of because they are so busy and not particularly interested in hearing about a service they’re not convinced they need,” Securian said in a release.  

The paper, Small but mighty: Growing opportunities for financial advisors and small business owners, summarizes Securian’s analysis of the financial concerns of small business owners.

The online, statistically valid survey of 435 SBOs across the US shows their top financial concerns include cost control, profitability, building wealth, financial security for their families and rising health care costs.

Ironically, the percentages of SBOs who want outside assistance with these concerns is much larger than the percentage who actually seek and use it.   

There are circumstances under which SBOs consider seeking a financial advisor’s services. All fall in the typical advisor’s “sweet spot,” including business succession planning, personal finance, asset management and employee benefits.   

How does an advisor get on a small business owner’s radar? Recommendations from family members, business acquaintances, and other financial professionals provide the best entrée to an SBO. Clearly, networking with bankers, accountants and attorneys is important.

Securian will use the research to develop a “Small But Mighty” campaign that gives advisors a step-by-step approach to building their small business clientele.

Small business owners surveyed met these requirements:

  • Private company ownership, sole or shared
  • At least 50 percent responsibility company financial decisions
  • At least 50 percent responsibility for household financial decisions
  • For-profit company not in marketing, market research or financial planning
  • Three to 250 employees
  • Minimum of one year as owner.

 

Nationwide Financial aids in planning for retirement health care expenses

Health care is consistently among the main concerns of retirees and pre-retirees as they consider their post-employment finances. This, along with ongoing uncertainty over the future of Medicare, means that paying for heath care should now be taken into even greater consideration when planning for retirement.

To better assist advisors in helping clients plan for health care-related retirement expenses, Nationwide Financial today launched the Personal Health Care Assessment to help advisors estimate their clients’ health care expenses in retirement.

Today, Medicare provides health coverage to 46 million older or disabled Americans, but there are several common misconceptions about what is covered. In fact, Medicare currently covers only about 51% of the expenses associated with health care services.

Developed by leading physicians and experienced actuaries, The Personal Health Care Assessment program uses proprietary health risk analysis and up-to-date actuarial cost data such as personal health and lifestyle information, health care costs, actuarial data and medical coverage. The data is analyzed by these experts to identify a meaningful, personalized cost estimate that will help clients plan for future medical expenses.

The assessment starts with a questionnaire on the client’s health history, lifestyle and family history of medical conditions. After this, they will receive a report that offers suggestions for decreasing health risks. The report will tell clients about their health profile, health risks, estimated life expectancy based on those risks, and hypothetical out-of-pocket health care costs during their retirement.

The program also utilizes tools that allow for “what-if” scenarios. For example, how will a change in their year of retirement affect a client’s out-of-pocket heath care costs?

© 2011 RIJ Publishing LLC. All rights reserved.

Do Motley Fool stock recommendations beat the market?

Following the collective stock recommendations made by Motley Fool website readers and posted on the website in a certain way could have yielded substantial returns, according to a paper published this year by the National Bureau of Economic Research.

“A strategy of shorting stocks with a disproportionate number of negative picks on the site and buying stocks with a disproportionate number of positive picks produces a return of over 9 percent per annum over the sample period,” the paper said. 

“These results are mostly driven by the fact that negative picks on the site strongly predict future stock price declines, while positive picks on the site produce returns that are statistically indistinguishable from the market.”

Written by Judith A. Chevalier of Yale and Richard J. Zeckhauser and Christopher Avery of Harvard, the paper assesses the predictive power of approximately 2.5 million stock predictions submitted by individual users to the ‘CAPS’ website run by the Motley Fool company.

According to a summary of the paper published by NBER:

The data used in the analysis spans the period between November 2006 and December 2008, a period with significant swings in stock market performance. In the past, using different data sets, researchers have found that individuals perform poorly as stock market investors, except when they concentrate their portfolios on stocks for which they have an informational advantage.

And, while internet trading and message boards have facilitated trading, there is no evidence that those boards predict performance of the stocks. But the CAPS data differ from internet trading or online prediction markets in three ways: First, participants make precise predictions about future price, rather than simple buy/sell/hold recommendations. Second, the website provides a rating of participants by scoring their reputation.

And finally, CAPS synthesizes the history of past picks to produce a rating of each stock – on a 5-star scale.  The authors analyze the informational content of the CAPS picks by tracking the performance of portfolios formed on the basis of positive and negative picks (that is, predictions of increases and decreases in the prices of individual stocks, respectively).

A preliminary look at the relationship between individual picks in the CAPS system and subsequent stock market returns shows some interesting facts. For example, on average CAPS participants — like most stock market analysts — have been relatively bullish, producing a ratio of about five positive picks per negative pick.

Second, the relationship between returns for positive versus negative picks varies very little by market cap. Third, averaging across the whole time period, 5-star stocks outperformed 1-star stocks by 9 percentage points (although removing the height of the financial crisis increases the difference in returns between 5-star and 1-star to 14.6 percentage points). 

Most interestingly, these picks prove to be surprisingly informative about future stock prices. Although the return from investing in the positive-pick portfolio would have been negative over the course of the study period, the Motley Fool participants’ positive picks systematically outperformed the negative picks.

The authors posit that it may not be surprising that social investing websites are more successful at predicting abnormally negative future stock performance than they are at predicting abnormally positive future stock performance, because acting on negative information about the prospects for a stock can be more costly and difficult than acting on positive information about the prospects for a stock.

But the differences in returns between stocks ranked highly and stocks ranked poorly might be attributable to inherent differences in their characteristics, such as differences in risk, in market cap, or in past performance. Controlling for those factors, the authors find that differences in return are mostly due to stock picking.

© 2011 RIJ Publishing LLC. All rights reserved.

Portugal to apply pension funds to deficit

The Portuguese government has agreed to transfer €6bn ($8.05 bn) from the pension funds of four of country’s largest banks to the state as part of a plan to cut the deficit to 5.9% of GDP. The government will use the assets to meet its budget-deficit target and pay part of the state’s debts currently held by banks, according to a government official.  

Maria João Louro, business leader for retirement, risk and finance at Mercer, said the government believes the “exceptional measure” is the only means of avoiding tax hikes while meeting its public deficit target.

The measure aims to transfer the pension funds’ liabilities – specifically, liabilities related with pensions in payment – to the Social Security regime.

Ana Marta Vasa, partner at Towers Watson in Lisbon, told IPE.com that the banks had an interest in transferring liabilities because they wanted to reduce the volatility on their balance sheets stemming from defined benefit plans. 

João Louro added: “One of the main consequences for the four banks involved in this process will be the significant reduction of their pension funds’ assets by 50%. But the obligation to guarantee future pension increases, as well as post-retirement benefits and medical post-retirement expenses, will still be incurred by the banks’ pension funds.”

However, because this particular transfer only relates to pensions in payment without future increases, the current funding level of the first-pillar system is unlikely to be affected, according to João Louro.

“To control the current and future resources of the first pillar, it will be necessary to implement an effective governance policy and a continuous monitoring process on cash flows (due to the fact we are on pay-as-you-go system),” she said.

In a related matter, a year ago it was announced that Portugal’s ministry of finance and public administration, after more than a month of negotiations, would take responsibility for €2.8bn worth of pension liabilities for three schemes maintained by Telecom.

The asset transfer is set to help the government address its budget shortfall, which last year was almost 10%.

The treasury will now take responsibility for members of the three schemes – Plano de Pensões de Pessoal da Portugal Telecom/CGA, the Plano de Pensões Regulamentares da Companhia Portuguesa Rádio Marconi and the Plano de Pensões Marconi – and transfer them to the Regime Geral de Segurança Social, the state social security system.

Portugal Telecom’s most recent quarterly statement for the end of September indicated that the company had €2.3bn in assets in its pension plan, €471m in unfunded liabilities for pension obligations and a further €337m stemming from healthcare obligations.

The transfer to the social security system will therefore also cover workers for health-related matters, such as paternity or maternity leave, as well as unemployment, while the unfunded liabilities will be covered by the company.

The treasury, which is currently evaluating the best method for transferring the assets, said the move would reaffirm government commitment to a universal social welfare system for all workers.

While the Portuguese government currently only holds a 2% share in the company following its privatization, it possesses enhanced voting rights due to the 500 A shares it holds and can veto major decisions.

In the past, it was able to veto a takeover by Spain’s Telefónica of Brazilian mobile phone network Viva, in which Portugal Telecom and Telefónica have holdings. Telefónica is currently a majority shareholder in Portugal Telecom, along with Norges Bank, BlackRock and UBS, which hold 5.19%, 2.35% and 2% stakes, respectively.

© 2011 IPE.com. All rights reserved.

New Celent report forecasts DC trends

After a trillion-dollar decline in valuation in 2008, defined contribution asset levels set new highs in 2010, and DC plans’ share of US retirement assets is growing, according to a new report, from Celent, a Boston-based financial research and consulting firm.

The proprietary report, Developments in the Defined Contribution Market: New Funds and New Investment Vehicles in the US Market, covers 401(k), 403(b), 457 and Keogh plans, and anticipates these trends:

Continued emergence of new investment vehicles other than mutual funds in the DC market. These will include separate accounts, collective investment trusts, variable annuities, and company stock.  

Continued growth in the DC market. The DC market’s five-year CAGR of 6.4% from 2005 to 2010 is likely to continue going forward. Reasons for this include continued use of auto-enrollment and auto-escalation, as well as continued stickiness of flows.

Continued dominance of large record-keepers. The top ten record-keeper will continue to win large plan sponsors and maintain their strong market share of the record keeping business. Fidelity, in particular, will remain the largest record-keeper by a large margin.

Growth of CITs as an alternative to mutual funds. Collective investment trusts have cost, performance and regulatory benefits over mutual funds. From 2006 to 2010, CITs have gone from approximately $400 billion to $900 billion in the DC market (CITs are also used in the government’s Thrift Savings Plan). With many DC plans converting to a CIT vehicle, Celent expects them to grow to approximately $2 trillion within the DC market by 2015.

Pressure for regulatory oversight of collective investment trusts. By law collective funds are on the turf of bank regulators. But increasingly, the SEC has argued that it can look at advisors who sell collective investment trusts.

Growth of custom target date funds in DC market. From 2005 to 2010, the target date fund market has a CAGR of over 30%. Target date funds have been beneficiaries of the 2006 Pension Protection Act, and their status as a Qualified Default Investment Alternative.

Going forward, Celent expects growth to continue due to growing adoption of auto-enrollment and auto-escalation; increased plan sponsor demand for innovation, which will lead to growth in custom designs; reduced costs due to passive management for smaller plan sponsors; and increased participation of asset managers, who will be able to enter the market based on their strength in customizing portfolios.

As a result of the increased scrutiny of TDFs’ glide paths after larger-than-expected losses in 2008, many funds revamped their offering to include a more conservative glide path. These conservative paths are likely to limit payouts to plan participants.

Close to 18% of plan sponsors who are not currently using custom-designs indicated that they might consider switching from off-the-shelf to custom-designed funds in the next couple of years.

© 2011 RIJ Publishing LLC. All rights reserved.

The Fees Ate My Savings

To what extent do mutual fund fees undermine Americans’ attempts to save for retirement?

Cost-conscious investors have long observed that while mutual fund management fees may represent only a tiny fraction of an individual investor’s account balance, they often constitute a sizable portion of the individual’s returns—especially when those returns are low.

It’s also been widely observed that expenses can reduce cumulative returns over an average investor’s lifetime by tens of thousands of dollars—and that the reductions can frustrate even the best-laid plans to amass enough savings for retirement.    

With increasing scrutiny of 401(k) plan fees, which tend to be  smaller at larger plans and vice versa, and with the Department of Labor deadline for full fee transparency only about five months away, the fee question has rarely been as widely discussed as it is now.

As it happens, Stewart Neufeld, Ph.D., an assistant professor at the Institute of Gerontology at Wayne State University in New York, addresses that question in the current issue of the Journal of Financial Planning. He recommends that plan investment fees be cut to the price of an ETF fund, or no more than 10 bps a year.

In his provocatively titled paper, “The Tyranny of Compounding Fees: Are Mutual Funds Bleeding Retirement Accounts Dry?” he reports his analysis of the way the returns of the S&P 500 have been divided between the financial services industry and the investing public over various 10, 20, 30, 40 and 50-year historical periods.

“The bottom line is, mutual fund cost structures contribute substantially to inadequate accumulations in retirement accounts,” Neufeld writes. He then tries to remedy what he believes has been a general failure “to model the likely gap between market returns and that of the typical mutual fund over time frames relevant to individuals saving and investing for retirement.”

Neufeld considers three hypothetical equity funds whose fees reduce their annual returns relative to the market average (as represented by S&P 500 returns) by either 50 bps, 100 bps or, in a worst-case scenario, 250 bps a year. Then he looks at the performance of the S&P 500 during different periods and calculates the amount of average gains that would go to the client and the amount that would go to the fund company.

He finds that:

“if mutual funds underperform the S&P 500 by 250 bps annually, then after 10 years the financial services industry gets about 46% of the market gains on average, leaving the investor with 54%. Mutual fund investors fare considerably better when the level of mutual fund underperformance is only 50 bps annually—investors receive on average 82 percent of market gains over a 10-year time frame.

“As the investment period lengthens, the proportion of market gains that go to the industry becomes larger. For example, if mutual fund performance lags that of the S&P 500 by 250 bps annually over a 50-year investment period, the financial services industry captures about 74% of the market gains on average. If the performance lag is only 50 bps annually, then the proportion of market gains accruing to the industry after 50 years is about 23%.”

Neufeld goes on to assert that America’s 21st century retirement savings crisis might go away—or might have been prevented—by lower 401(k) fees:

“The current value of equity mutual fund assets in IRAs and defined-contribution plans is about $2.8 trillion (Investment Company Institute 2011). Assuming historical market returns, this amount would increase to $71 trillion (inflation adjusted) over 50 years. A performance lag relative to the S&P 500 of 250 bps annually would leave investors with about $20 trillion in their retirement accounts, a difference of market versus achieved returns of $51 trillion.

“To put this into perspective, this potential loss to investors is several times larger than the entire U.S. national debt, as it currently stands. An additional $51 trillion in retirement accounts over the next several decades would contribute significantly to solving the problem of inadequate retirement savings.”

© 2011 RIJ Publishing LLC. All rights reserved.

Lynne Ford leaves ING

Lynne Ford has left ING, effective November 30, an ING spokesperson confirmed today. Ford had been CEO of Individual Retirement, joining ING in December 2009 after spending much of her career at Wachovia. She currently serves as chairman of the board of the Insured Retirement Institute, according to the IRI website.

Ford’s departure was “the result of some consolidation within our broader retirement business. We have a large retirement plan business, and we more closely integrated Individual Retirement within the retirement plan business,” an ING spokesperson told RIJ. “So [Ford] decided to pursue opportunities outside ING.” Ford recently began reporting to the CEO of Retirement, Maliz Beames, based in Windsor, Conn.

ING Groep NV, based in the Netherlands, is in the process of divesting its U.S. businesses in the wake of its bailout by the Dutch government in 2008, the result of the company’s exposure to U.S. mortgage assets.

At Wachovia, which merged with Wells Fargo in late 2008, Ford served in a number of executive capacities within its investment and distribution organizations. In her recent role, Ford was responsible for the annuity and IRA products distributed across the company. This included the sales, marketing and product management for IRAs and annuities, as well as channel management, annuity operations and servicing.

She was also responsible for the company’s overall Retail Retirement strategy and branding as the company aimed to capitalize on the retirement market opportunity. In 2008, the business had annualized IRA sales of more than $30 billion and was the largest distributor of annuities in the U.S. with over $15 billion in total sales.

Prior to that role, Ford also served as senior vice president and director of sales initiatives for Evergreen Investments from 1997-2003, and a variety of sales capacities including national sales manager within Evergreen Investments from 1993-1997.

Ford earned a bachelor’s degree from Davidson College and a master’s degree from the University of North Carolina, Charlotte. 

ING is under European Union orders to sell its entire insurance and investment management businesses before the end of 2013 as a condition for approval of state aid received amid the financial crisis. The firm, the Netherlands biggest financial- services company, aims to divest the remaining parts of the unit in two initial public offerings, Bloomberg reported last July.

ING received 10 billion euros of state aid in 2008 and transferred the risk on 21.6 billion euros of U.S. mortgage assets to the Dutch government in 2009. The company has repaid 7 billion euros and plans to repay the rest by May.

In mid-2011, the firm agreed to sell its U.S. online bank to Capital One Financial Corp. for $9 billion to fulfill another EU requirement. In July, ING Groep NV agreed to sell most of its Latin American insurance operations to Grupo de Inversiones Suramericana, the parent company of Colombia’s largest bank, for about 2.7 billion euros ($3.9 billion).

© 2011 RIJ Publishing LLC. All rights reserved.

Five Challenges for Life Insurers in 2012: E&Y

Finding ways to manage both capital and risk in an uncertain political and economic climate will be the U.S. life insurance and annuity industry’s challenge in 2012, according to Ernst & Young’s new Global Insurance Center US Outlook.

“Pressures such as low interest rates, volatile equities markets, and a political and regulatory environment in flux will continue to impact the industry, making it difficult for insurers to boost earnings,” said Doug French, Financial Services and Insurance and Actuarial Advisory Services Leader at Ernst & Young LLP (US), in a release.

Ernst & Young has identified five challenges for US life insurers and annuity issuers in 2012:

1.      The low-interest-rate environment: Low interest rates should persist until at least 2013, increasing the risk of spread compression for existing products. At the same time, efforts to increase sales of fixed annuities and universal life insurance are hampered by low rates. While interest rates are likely to remain low through 2013, they could climb rapidly after the Federal Reserve’s Treasuries buying spree come to an end, French says. In such an event, disintermediation risk could be a concern, as policyholders jettison existing products in favor of investing in new ones with higher rates. Understanding the interaction of the asset and liability cash flows under a variety of scenarios will help prepare insurers to weather these stormy financial times.

2.      Accounting and regulatory convergence: Regulatory ambiguity will likely persist through 2012. Although the Dodd-Frank legislation has passed its first anniversary, many key rules have yet to be formalized, several of which will impact insurers. The Federal Insurance Office (FIO), created under Dodd-Frank may contend with the National Association of Insurance Commissioners (NAIC) around the Solvency II issue of “equivalency” for US insurance regulation. In addition to global regulatory developments on a macroeconomic scale, insurers may also want to consider specific regulatory changes at the microeconomic level and use them to their advantage.

3.      Predictive modeling: Analytic and predictive modeling techniques continue to improve, creating opportunities for increased sales, improved efficiency and expanded capabilities. Life insurers are looking to use predictive modeling to improve the speed and accuracy of underwriting, which is traditionally time-consuming and expensive. Beyond underwriting, life insurers are increasingly using analytics and predictive modeling to create opportunities for increased sales and improved efficiency, and even mitigate strategic risks. Given the extensive modeling of multiple scenarios required by the developing principles-based regulations, insurers will find that they can improve their risk management processes by gaining insight into the range of outcomes that can occur in the current volatile environment.

4.     Life insurance taxation: Insurers may be challenged by future Congressional efforts to reform the federal tax code. Implications exist for both corporate-level taxes and policyholder tax issues. Budget deficits and revenue generation are serious concerns, yet they will remain in flux because of the economic and political changes underway. The health of the economy will be a central political issue in the 2012 general election. That hot button could set in motion changes in the tax code, which may have significant repercussions for the life insurance industry.

5.      Internet potential: Insurance companies have historically operated via a very traditional sales model involving agents and face-to-face sales to consumers. At present, the extent of life insurer presence on the Internet largely consists of financial calculators of insurance needs; lead-generating activity like educational materials and product information; and proprietary web applications that support the sales force through online insurance application forms and illustrations. While insurance in its current form does not lend itself well to web sales, life insurers can leverage the technology to develop stronger ties to customers and build a better brand – especially with younger, web-savvy generations of insurance buyers.