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The Bank of Montreal (BMO) has launched a non-insured lifetime income product that, after a 10-year deferral period, promises lifetime payouts of 6% per year. If the contract is funded with after-tax money, the income is tax-free for the first 15 years and taxable thereafter.      

The product is called BMO Lifetime Cash Flow, and it is backed by the Toronto-based bank, which has an AA rating from DBRS Limited, an A+ rating from Standard & Poor’s and an Aa1 rating from Moody’s.  The minimum investment is $5,000, and the money is invested in mutual funds that grow more conservative over time. The all-in 2.75% annual fee is based on the account value. 

A BMO spokesperson told RIJ that, while the first 15 years of income consists of returned principal, the subsequent lifetime payouts (6% of principal) do not come out of the account value, which by then presumably contains 25 years of gains. “Payments after year 25 do not draw down on any portfolio gains or deposit value,” said Amanda Robinson. At the owner’s death, the remaining account value goes to beneficiaries.

Here are two illustrations of the just-announced Lifetime Cash Flow product (using Canadian dollars):

Jim, a 55-year-old single man, has no private pension and intends to retire in 10 years. He has $250,000 in taxable accounts and $300,000 in guaranteed investments in his Registered Retirement Savings Plan (RRSP), a tax-deferred account.

He needs $3,000 a month in retirement, half of which will come from his Canada Pension Plan (a payroll-based Social Security-like program) and his Old Age Security (a government pension based on years of residency in Canada).

To provide the other $1,500, he invests $100,000 of his after-tax savings in the BMO Lifetime Cash Flow program ($500 per month for life) and rolls his RRSP money into a Registered Retirement Income Fund (RRIF), from which he begins taking minimum required distributions ($1,000 per month).

At his death, Jim’s beneficiaries will receive the balance in his account, if any,  net of fees and withdrawals.

In the second scenario:

Ray plans to retire in 10 years, at age 70, with a defined benefit pension of $2,100 a month and $1,000 from the Canada Pension Plan and Old Age Security. His wife Abby, five years younger, never worked and so doesn’t qualify for the CPP. But she’ll get $400 a month as her Old Age Security. They have $400,000 in taxable accounts.

Their pensions will provide $3,500 a month–$700 a month shy of what they will need. To fill the gap, they invest $140,000 in Abby’s name in the BMO Lifetime Cash Flow program. They invest their remaining $260,000 elsewhere for income and growth. If Ray dies before her, Abby’s income from his pension will be reduced and his income under CPP and OAS will cease. 

A BMO spokesperson said the payouts are not adjusted for inflation, and the payouts apparently remain fixed at 6% of the initial investment even if the account value grows during the deferral period and after payments begin.  

Since 2009, BMO has offered LifeStage Retirement Income Portfolios, which are notes that pay an inflation-adjusted 6% of the initial investment for 15 years, starting immediately, or after a five-year wait, or after a 10-year wait. That product offered inflation-adjusted, but not lifetime, income. The new product offers lifetime, but not inflation-adjusted, income. 

The minimum deposit for the LifeStage Retirement Income Portfolios is $5,000. Each note costs about $100. Assets are invested in BMO’s Lifestage target-date funds. Investors can buy the notes with registered or non-registered (pre-tax or after-tax) savings, but after-tax money is recommended.

At the end of the deferral period—during which the assets are largely illiquid and the investments grow tax-deferred—the notes provide a tax-free, inflation-adjusted income of about 6% of principal per year for 15 years. The all-in annual fee is 2.75% per year.

When all principal has been paid out—i.e., the maturity date—the owner of the notes (or the beneficiary) receives the original deposit back, net of fees and payouts.  

In a typical scenario, a 55-year-old might put $100,000 in one of the notes. At age 65, he or she would receive an inflation-adjusted income starting at $6,000 per year for 15 years, tax-free, followed by reimbursement of any money left in the account. 

If the market value of the underlying investments drops too much, BMO retains the right to convert the account to a term-certain annuity. “On each business day, we will compare the Deposit Value of a version and series of LifeStage Retirement Income Notes to the annuity value of a LifeStage Retirement Income Note of the same version and series. If on any business day that Deposit Value is equal to or less than the annuity value, a “capital preservation event” will have occurred.

“This indicates that the value of the LifeStage Retirement Income Portfolio is not enough, if invested at the relevant government bond rates (or other higher rate as may be chosen by us), to pay the scheduled capital distributions during the remainder of the term and the Deposit Balance at maturity,” the information statement reads.

The BMO notes appear to resemble Barclays Bank’s Inflation-Indexed Level-Pay Notes, which were introduced last summer in the U.S., and which provide 10 years or 20 years of income backed by the bank. Like the Barclays product, the BMO notes aren’t intended to provide liquidity, although owners can try to sell them on the secondary market or back to BMO. As the product information statement says:

“A LifeStage Retirement Income Note is not designed to be repaid in full on demand at any time. Other than the regularly scheduled capital distributions that we make to you, you will not be able to withdraw the amount invested in a LifeStage Retirement Income Note until it matures. However, you may be able to sell your LifeStage Retirement Income Notes prior to maturity to BMO Nesbitt Burns Inc.,” a capital markets unit of BMO.   

Most Canadians receive the Old Age Security (maximum C$524 per month) that’s proportional to the number of years (up to 40) that a person has lived in Canada since age 18. Most also receive the Canada Pension Plan, an earnings-based benefit of up to C$934 a month. The poor are also eligible for a means-tested Guaranteed Income Supplement, and there’s an “Allowance” for spouses or partners of GIS recipients.

The BMO notes are expected to compete in Canada alongside variable annuities with living benefits, Sun Life Elite Plus, and the Desjardins Helios, the Financial Post reported.

© 2011 RIJ Publishing LLC. All rights reserved.

In a provocative new research paper, three writers, including one from the Federal Reserve Bank of Atlanta, suggest that broker-sold mutual funds tend to generate returns that are about one percentage point lower before fees than returns generated by less expensive direct-marketed mutual funds.  

Jonathan Reuter of Boston College, Diane Del Guercio of the University of Oregon and Paula Tkac of the Atlanta Fed argue that “mutual funds in broker-sold channels charge higher total fees because they need to compensate brokers for servicing investors, and earn lower before-fee returns, because they invest less in portfolio management.”

In short, they claim there’s a “tradeoff between investments in brokers and investments in portfolio management.” The study, published by the National Bureau of Economic Research and entitled “Broker Incentives and Mutual Fund Market Segmentation,” is based on mutual fund distribution data from 1996 through 2002.

The result, they say, is that direct-sold funds not only tend to be cheaper but also better-performing than broker-sold funds, leading to a significant difference in after-fee returns for investors. “This is an unintended consequence for people seeking advice,” Reuter said.

On an after-fee, risk-adjusted basis, broker-sold funds “underperform by about 2.5 percentage points,” Reuter told RIJ, citing a newer, unpublished working paper. “You’re underperforming by more than the fees. That’s the distressing thing.”

The paper also claims that some fund companies may appear to invest more in portfolio management than they actually do. “Consistent with the concern that management fees overstate investments in portfolio management, we find that the median management fee is 80 basis points, while the median subadvisory fee is only 40 basis points,” the authors said.

From a fund marketing standpoint, this makes sense, Reuter explained. Direct-sold companies cater to the informed, performance-driven, do-it-yourself investor, so they hire the best money managers. Broker-sold companies, in contrast, invest in the intermediary services that less self-reliant investors need or demand.

“Vanguard and Fidelity invest in better managers, they’re more likely to hire managers that went to more selective schools, and they get higher risk-adjusted returns,” Reuter said in an interview.

The study also found that very few mutual funds are sold both direct and through intermediaries—for the logical reason that people might not buy through a broker if they could get the exact same fund for less by buying direct.  “Only 3.3% of [fund] families serve both market segments,” the paper said. Because of this, brokers have no incentive to recommend index funds, since those funds can easily be purchased direct for less.

Direct-sold companies seem to be as good at active management as they are at indexing. “In the direct channel, the active funds and the index funds have about the same risk-adjusted performance after fees. When you compare across channels, in the broker channel, both the index and the active performance is really bad. That surprised the heck out of me,” Reuter said.

“Because actively managed funds in the direct channel have the strongest incentive to invest in portfolio management, a more powerful test of the puzzle of active management is whether index funds in the direct channel outperform actively managed funds, also in the direct channel,” the paper said.

“Within the distribution channel with the strongest incentive to invest in portfolio management, we find no evidence that index funds out- perform actively managed funds during our sample period. In contrast, when we focus on the sample of actively managed and index funds outside the direct channel, we find that index funds outperform actively managed funds by as much as 8.9 basis points” per month, the researchers wrote.

Even though their costs are high, brokers might be performing a social good by guiding certain investors into mutual funds and away from keeping their money in unproductive cash accounts, Reuter said. “Maybe it’s cheaper from a societal perspective,” he said.

© 2011 RIJ Publishing LLC. All rights reserved.

As I rang in 2011, I found myself in awe of how quickly time had passed and how much things have changed. The 1968 movie “2001: A Space Odyssey” caught our fantasy as a journey into the distant future, yet here we are a decade beyond 2001 (and more than 40 years after the movie came out).

And who ever thought Dick Tracy’s two-way audio-visual watch could exist outside a comic strip, or that 3- D color TV’s would hang on walls like paintings? Transporters and holodecks can’t be far behind.

The investment profession has also been on an odyssey: a quest for truth, spurred by the recent financial crisis. The truth was easier to grasp before investing became so complicated and challenging, with quantitative easing, bank failures, the mortgage crisis, etc. The recent lessons we’ve learned about excesses and fraud, especially those of 2008, have not yet been entirely digested, yet they should certainly not be forgotten.

So in this end-of-year commentary I review some of those lessons with an eye to the truth so we can benefit from them in the future. But before I bring us back to that painful 2008 and what has happened since, let’s review the year 2010. I then discuss 2008’s lessons, and conclude with my traditional review of the longer-term history of U.S. markets over the past 85 years, the longer odyssey.

U.S. stock market performance in 2010  

We dodged a bullet in 2010. At mid-year it was looking like 2010 was going to be a big fat letdown, but the last half of the year brought a nice recovery. In the meantime, gold, a current hot topic, continued its upward progression throughout the year. Gold was less volatile than U.S. stocks.

Smaller companies returned in excess of 25%, with small-cap growth leading the way with a 33% return, while larger companies lagged with returns in the low teens. Large-cap value in particular returned 14%. It was primarily this concentration in large-value companies that caused the S&P (15%) to lag the total market (18%) in 2010.  

• The total market (5000 stocks) returned 18%.
• The S&P500 lagged with a 15% return.
• Smaller companies were in favor, returning more than 20%, while large companies returned “only”13%.
• Materials and Consumer Discretionary companies performed best, earning 35% and 30% respectively.
• Health Care and Consumer Staples lagged with 6% and 9% returns. 

Foreign stock market performance in 2010

Now let’s turn our attention outside the US, where the total foreign market earned 17.5%, in line with the total US market’s 18%, but the Europe Australia and Far East (EAFE) index substantially lagged the total foreign market, earning only 8%.

Small-to-mid (“Smid”) cap value was in favor outside the US. However, unlike the S&P, stock selection within styles was poor. This is due to the country allocations of the EAFE. In other words, the EAFE suffered a double whammy: both style and country allocations were out of favor in 2010. The EAFE’s large value orientation was out of favor, as was its overweight in Europe-ex-UK, and its absence from Latin America.

• The total market (20,000 stocks) earned 17.5%, more than doubling the EAFE (900 stocks) index’s 8.2% return. 
• Small-to-mid (Smid) value was in favor, earning 30%, while large companies returned 12%. 
• Latin America and Emerging Markets led with 40% and 28% returns, respectively.
• Europe-ex-UK lagged with a 5% return.    

Unlearned Lessons from 2008

2008 brought us two painful lessons: the Madoff crime (see Madoff Prescription) exposed our vulnerabilities to trusted bandits, and we suffered the free-fall in value of almost every asset type as the mortgage crisis snowballed into deleveraging around the world. Madoff should have led us to heightened due diligence, but it has not. The market crash has investors concerned about “Black Swans” and searching for new portfolio constructs.

• The Madoff Mess showed us that most due diligence is a big fat fake-out, including due diligence on traditional long-only managers.
• Portfolio structure could be improved upon. In particular, core-satellite investing would be much better with a centric core, that is neither value nor growth, rather than a blend core that combines value and growth.
• The average 2010 Target Date Fund (TDF) lost 25% in 2008, demonstrating that fiduciaries should take back control by setting investment objectives. So far, fiduciaries have abdicated this responsibility to fund companies, with the predictable outcome that TDFs are built for profit rather than the best interests of the participants.      

The history of the US stock and bond markets, 1925-2010

• T-bills paid far less than inflation in 2010, earning 0.12% in a 1.21% inflationary environment. We paid the government to use their mattress. 
• Bonds were more “efficient”, delivering more returns per unit of risk, than stocks in the first 42 years, but they have been about as efficient in the most recent 43 years. The Sharpe ratio for bonds is .60 versus .38 for stocks in the first 42 years, but the Sharpe ratio for both is about the same in the more recent 43 years.
• The past decade has been the worst for stocks across the past eight consecutive 10-year periods.
• Average inflation in the past 43 years has been about three times that of the previous 42 years.  
• Long-term high grade bonds fared very well in 2010.   
• Of the last 85 years, on an inflation-adjusted basis, the market delivered positive returns in 58 calendar years and negative returns in 27, with an average annually compounded real return of 6.8%.

In The Decline of the Traditional Pension, George “Sandy” Mackenzie of AARP compares and contrasts four non-insured, do-it-yourself systematic withdrawal plans. Most RIJ readers will be familiar to some extent with these four techniques, which Mackenzie describes as:

1. Constant real withdrawals until assets are exhausted.
2. Withdrawals set to equal a predetermined share of the account value.
3. Withdrawals determined by remaining life expectancy.
4. A version of Method 2 that allows for increases or reductions in the withdrawal rates when markets go up or down, respectively. 

Spoiler alert: Mackenzie, like the Vanguard CFPs whose work was cited recently in RIJ (See “A Turbit Drawdown Strategy,” December 29), likes the fourth method, because it offers the best balance of flexibility and protection against longevity risk.

To evaluate the four methods, Mackenzie proposes a hypothetical 65-year-old retiree with $500,000, half in large cap equities (assumed 9% average real return, 20.1% standard deviation) and half in long-term bonds (assumed 2.8% average real return, 10.3% standard deviation). His initial withdrawal rate is 5%, his marginal and average tax rate is 20% and he pays one percent per year in fees.

Mackenzie applies each of the four withdrawal methods to the hypothetical and uses Monte Carlo simulations to assess their abilities to provide steady lifetime income. The trade-offs quickly become apparent: Method 1 provides the most stable income but the highest risk (25%) of running out of money. Method 2 is indefinitely sustainable but carries a high variability of income.

Method 3 is sustainable but income may drop off dramatically in later years if the investor outlives his life expectancy. That leaves Method 4, which is a less rigid form of Method 2—and is probably the kind of method that common sense would dictate (at least in the absence of the sort of unexpected financial shocks that often interrupt retirement).     

“None of the four do-it-yourself phased-withdrawal strategies can consistently generate both a steady or guaranteed minimum income and a predictable final balance, which could be greater than zero if the retiree wanted to leave a bequest,” Mackenzie writes.

“If income is to be kept steady or a minimum level is guaranteed, the final balance will vary hugely,” he observes. “Rule 4 is, however, more successful than the others in avoiding the extremes of a high final balance and plummeting standard of living in later years.”

As an alternative to the four methods, Mackenzie considers the possibility that the retiree might build a ladder of zero-coupon inflation-indexed risk-free bonds that lasts 25 years and produces an annual income of about $22,700—but at the cost of a low return.

None of these methods fully solves the longevity risk problem for Mackenzie, whose book clearly favors at least partial annuitization of assets before, at, or during retirement.

“Longevity risk poses an intractable problem for a phased withdrawal strategy,” he writes. “Apart from annuities, there is no instrument that retirees or financial planners can use to hedge it, and there is no phased withdrawal strategy that can substitute for annuitization in the provision of longevity insurance.”

 Without an annuity, a retiree or advisor may have to assume, as a practical matter, either that the retiree will live to the average life expectancy or to 95. The first of those assumptions can lead to a shortage of money at the very end of life, and the second can result in unnecessary hoarding.    

©  2011 RIJ Publishing LLC. All rights reserved.

The Great Recession threw millions of people out of jobs and thousands of people out of their financially inverted homes. In the process, it also played havoc with the lives of Baby Boomers who were saving for retirement or getting ready to retire. 

But how much, exactly, did it impact Boomers? Did it force them to retire earlier or later than expected? How many were affected? These and other questions are the topics of several new papers from the Center for Retirement Research at Boston College.

Here’s a roundup of the findings of several recent studies from researchers at the CRR or affiliated with it:

Did the crisis force older men to retire early?

Did the financial crisis, which nearly doubled the overall unemployment rate in the U.S., force older men out of the work force and into involuntary retirement? Yes, but not by a lot, according to Barry P. Bosworth and Gary Burtless of the Brookings Institution.  

“We estimate that the 4.6 percentage-point increase in prime-age unemployment between 2007 and 2009 reduced the [labor force] participation rate of 60-74 year-old men by between 0.8 and 1.7 percentage points,” they said in their report, “Recessions, Wealth Destruction, and the Timing of Retirement.”

“A weak job market and plummeting asset returns almost certainly have effects in the expected direction,” they wrote, referring to the reduction in employment among older men. “Those effects, however, are small in relation to variations we have seen in labor force participation, retirement rates, and pension claiming behavior over the past three decades.”

While the business downturn cost some older men their jobs, the drop in investment and housing values compelled other older men to work longer, Bosworth and Burtless noted, and the two trends effectively offset each other. The crisis affected the employment of older women less than it affected men, the research also showed. 

Life after a “force-out” can be messy

But those findings don’t mean that the financial crisis didn’t play havoc with the careers of many American men in their 50s. Even among those who found new work after a layoff or force-out, life became “messy,” according to Steven A. Sass and Anthony Webb of the Center for Retirement Research.

“Involuntary and pressured job loss between ages 50 and 56 is often followed by ‘messy’ employment patterns, so that focusing solely on the first post-displacement job fails to capture the long-term consequences of involuntary job loss,” they write.

“Displaced workers… are more likely to job-hop, to suffer further involuntary job losses, and to experience subsequent unemployment than those who were still working for their age-50 employer at age 56,” they add. The disruptions, of course, often strike during what should have been the prime retirement-saving years, and “increase the risk that [the workers] will be unable to maintain their pre-retirement standard of living in retirement.”

People who lose jobs between ages 50 and 56 are much less likely to be working full-time or at all at age 60, the authors note, adding that the outlook for older workers has trended worse over the years.  In the early 1980s, almost three out of four men ages 58 to 62 were still working for the same company that employed them at age 50. Today, that’s true for less than half of men.  

If the retirement age goes up, will 62-year-olds claim disability?

Some policymakers worry that if Congress raises the full retirement age, or FRA, to take financial pressure off the Social Security program, the policy could backfire because people might simply file for disability insurance (SSDI) instead, and no overall savings will result.   

After sifting through the data, Norma Coe and Kelly Haverstick of the Center for Retirement Research found that while the number of applications for SSDI might go up after an increase in the FRA, those applications won’t necessarily be granted.

“The characteristics of the SSDI application pool could change dramatically due to the increase in the FRA. Indeed, we do find significant differences in the applicants based on birth year.

“However, these changes in the applicant pool only lead to a decreased acceptance rate on the SSDI program once one applies. The SSDI recipient pool does not seem to change; we find no increase in SSDI benefit receipt based on birth year between age 55 and the FRA, once controlling for health and the determinants of SSDI insurance coverage.

Women and Social Security: Are the incentives misplaced?

The changing role of women in the workforce over the past few decades has not been matched by a change in the Social Security program’s treatment of women. More women than ever are working, but the program’s spousal and widow’s benefits mean that a woman could receive lower benefits after working and contributing to the program than she might receive if she had never worked or contributed.

In their paper, “The Treatment of Married Women by the Social Security Retirement System,” Andrew G. Biggs, Gayle L. Reznik, and Nada O. Eissa suggest that these incentives be reversed, given the need to increase overall participation in the labor force as America ages and the ratio of workers to retirees falls. 

They note two commonly proposed reforms to incentivize women to work outside the home. The first proposal would cap spousal benefits for high earning households, so that women could earn higher Social Security benefits by working and paying payroll taxes. A second reform proposal would increase widow’s benefits to 75% of the total benefits received by the couple when both were alive. This would produce a widow’s benefit that, in some cases at least, would in part depend on the earnings of the wife.

Times have changed, the researchers point out. “In 1960, the median first marriage for women occurred at age 20, leaving relatively little time for paid work prior to getting married. By 2003, the median value had risen to over age 25 and for educated women with the highest potential earnings marriages were delayed further.

“Thus, women today have more significant earnings prior to marriage and, due to higher rates of divorce, have a greater likelihood of needing to rely upon their own earnings to support themselves both in the present and, through saving and contributing to Social Security, in retirement.

A weak link, if any, between foreclosure and retirement security

Although the collapse of the real estate bubble caused a drop in housing values and a foreclosure epidemic, particularly in overbuilt areas in the South and West, older Americans do not seem to have suffered greatly as a result, according to “What Is the Impact of Foreclosures on Retirement Security,” a paper by Irena Dushi of the Social Security Administration, Leora Friedberg of the University of Virginia, and CRR’s Anthony Webb.

“Almost all of the housing wealth gains observed for cohorts aged 51-56 between 1992 and 2004 were erased by 2010, while their mortgages have grown throughout,” but “households nearing retirement have lower rates of housing distress than younger households, by measured by arrears and foreclosure rates,” they found.

The incidence of mortgage arrears and foreclosure among older households is relatively low, in comparison to the national average. Our projections suggest that the risk of arrears will increase to 3.4% among older households in 2010, and 4.4% by 2012.

Housing distress, when it does occur, is significantly related to layoffs and health shocks, as well as high loan-to-value ratios observed in 2006. Moreover, the incidence of housing distress is greater among ethnic minorities, even after controlling for income and education, possibly reflecting unfavorable mortgage terms.

© 2011 RIJ Publishing LLC. All rights reserved.