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Ten Rules-of-Thumb for Choosing Indices in Annuities

Once an adviser and client decide to buy a specific index-linked annuity contract, they need to allocate the client’s premium to one or more of the indices on whose performance their returns will depend. 

The client, on his or her own, will have no idea how to make that decision. When it comes to the newer hybrid, factor-driven, sector-driven or volatility-controlled indices, most advisers may be out of their depth as well.

That’s understandable. Index-linked annuities are the screwballs of the financial product world. Once they leave the pitcher’s hand, so to speak, their flight toward the catcher’s mitt is largely unpredictable. They may flutter, wobble or sink en route to the strike zone—or outside it.

All investments are wagers on an unknown future, of course. But it’s especially hard to forecast the yield of even the plain-vanilla indices in annuities because their performance is refracted by the lens of a crediting formula—i.e., the caps, spreads, and participation rates—which in turn are determined by the variable cost of the options on the index.

But allocations must be made. The folks who build these products shared some advice with RIJ about choosing indices inside FIAs and RILAs. We’ve summarized their wisdom below. 

Diversify, diversity. Rather than try to guess which index will perform best over a one-year crediting period or the multi-year term of the contract, the experts recommend dividing your money up evenly among all of them. The conventional wisdom is that if you choose five different indices, one of them is bound to perform well enough so that the overall contract produces an average annual gain of 5%.

That said, it’s important to avoid choosing indices that are highly overlapping or correlated and don’t help diversify the contract. Considering that many indices are indices of indices, and that they shift their sub-allocations in response to quarterly, monthly or even daily market signals, you’ll never know the effect, if any, of your addition to an already extensive diversification process.

Price index versus total return index. When choosing an index, determine whether the index tracks only the change in the market price of the underlying assets or if it tracks the total return, which will include dividends. Often, the issuer will use the price-only index because the options on it are cheaper, which allows the issuer to buy more upside with its options budget. 

“Uncapped” rates: Too good to be true? The open secret of the FIA business is that advisers and clients look at the crediting rates first, rather than the index, and will opt for crediting rates that are “uncapped.” In other words, the client will get 100% of the return of the index. But what if 100% of that index is doomed, by dint of its own internal governors and mufflers, never to exceed 75% of the S&P 500 Index? I’m told that you should go for the uncapped strategy so that you won’t miss out on a rare Golden Goose (the opposite of a Black Swan).

“Anyone can build a good back test, and there is data mining going on. But if you do it the right way, certain factors or markets will outperform going forward. It’s a bet that—based on sound merits and economic research and an analysis of long-term expected returns—warrants greater return. That possibility exists,” said Tom Haines, senior vice president, Capital Markets and Index Solutions at Annexus, in an interview. 

Be alert to the trade-off between volatility targets and caps. The higher the volatility target of a volatility-controlled balanced index, the higher the equity component will be and the lower the performance cap will be, and vice-versa. But how does one choose between an index with a 10% target and a 5% cap, and one with a 5% target and a 10% cap?

“A volatility managed index is inherently cheaper to write an option on,” said Adam Schenck, head of the Portfolio Management Group at Milliman, the actuarial consulting firm, in an interview. “That allows the issuer to increase the upside for the customer. So if you have a cap of 3% on an S&P 500 Index without volatility controls, you might have a cap of 10% on the same index with volatility controls.”

Beware OD-ing on vol-control. Sometimes the volatility control mechanism in an index will be too effective. Instead of smoothing out volatility en route to a safe 5% return, it drugs the poor index into a stupor. In that case, the index may be slow to wake up to the fact that markets have recovered. To mix metaphors, you want an anti-lock braking system rather than brakes that might lock up.

“Some indexes may not be good at detecting when markets will be calm, and they lock you out of the returns,” Schenck told RIJ. “There’s too much risk management in place. The volatility forecast misses too high, and the index thinks that markets are more volatile than they really are, and it under allocates to equities.”

What “ER” stands for. This doesn’t stand for Emergency Room. It stands for Excess Return. You may see two indices that appear identical, but one will have the capital letter ER at the end of its name and the other won’t. An in-depth explanation is beyond the scope of this article, but ER indicates that the return is based on changes in the prices of index futures rather than changes in the price of the index. “The excess return (ER) indexes use an excess return methodology by tracking the price of futures, which mitigates the impact of short-term interest rates,” an Allianz spokesperson told us.

Academically gifted? Some observers have a special predilection for indices created by well-known academics and based on their original research. Two examples would be Robert Shiller, the Nobel Prize-winning economist, or Roger Ibbotson, the Yale professor and entrepreneur who created Ibbotson Associates and sold it to Morningstar before starting Zebra Capital Management.

Stagger your purchases. Two people can buy the same annuity and choose the same indices in the same proportions yet experience very different returns. That can happen because one person bought the contract three months before the other, for instance, and so timed the market differently. Some advisers practice time-diversification by breaking up a client’s premium into multiple contracts, purchased at three- or six-month intervals.

Be careful when using bonds for risk-mitigation. “If the index uses bonds for risk control, make sure the re-allocation to bonds is tactical, so that you’re participating in bonds differently,” said Haines. “But you need access to all of the risk mitigation strategies—to global indexes, tactical bond indexes, short strategies. Combine them all. Don’t think that all you need for risk control are an S&P 500 Index and a bond fund.” 

Managing expectations. Index-linked annuities should be viewed as alternatives to bonds, we were told by several people. Regardless of the caps or participation rates, investors should expect the products to provide them with the kinds of returns—and level of safety—that they used to expect from bonds. By chance, they’ll deliver double-digit returns in one specific contract year. But, by design, they’ll attempt to use options on equity indices or hybrid indices to achieve an average annual return of 1.5% to 2% above the yield on highly rated corporate bonds, while eliminating or buffering the risk of loss. 

Why not DIY? You might wonder, “Why couldn’t my clients just buy the options that an annuity issuer would buy, and get the same potential reward? Why do they have to hand over $100,000 to an insurer so that it can spend $2,500 of their $100,000 on options?”

One answer we got was that private investor can’t access the options markets, or get exposure to sophisticated indices, to the extent that the annuity issuer can. The second answer was brief: the annuity offers tax deferral. The short-term capital gains from trading options could easily be eaten up by taxes.

© 2021 RIJ Publishing LLC. All rights reserved.

Diversification and Insurance: Which Should Come First?

To see the complete text of this article, click here. To visit the ‘Retirement Investing’ page at EDHEC-Risk Institute, click here. The authors are Nicole Beevers, Hannes Du Plessis, Lionel Martellini, and Vincent Milhau.  

MODERN PORTFOLIO THEORY suggests that the complex problem of investor welfare maximization subject to various constraints is best handled by jointly using three forms of risk management. First, diversification aims to harvest risk premia across and within asset classes with the lowest possible amount of risk and leads to the construction of well diversified performance-seeking portfolios (PSPs). Second, hedging aims to immunize a portfolio against certain risk factors and leads to hedging portfolios, including liability-hedging portfolios in asset-liability management, and goal-hedging portfolios in goal-based investing. It completes diversification in that it takes care of systematic risk factors, the exposures to which cannot be neutralized by diversifying a portfolio, while idiosyncratic risk is eliminated by diversification. Finally, insurance is captured via a dynamic allocation between a PSP and a hedging portfolio designed to secure an essential goal that can be the protection of a minimum amount of wealth or, more generally, the protection of a minimum amount of wealth relative to a benchmark.

Fund separation theorems from dynamic portfolio theory (see, eg, the seminal paper by Merton [1973] and Martellini and Milhau [2012] for the incorporation of minimum funding requirements) show that the investment strategy that maximizes an investor’s welfare uses all three techniques.

This discussion raises the following question: if diversification and insurance (ie, dynamic hedging) are not mutually exclusive techniques, is there an optimal order for them to be performed? Put differently, is it better to diversify a portfolio of insured payoffs or to insure a diversified portfolio? Since insurance has an opportunity cost, which takes the form of a limited participation in the upside of the PSP in favorable scenarios, compensating for the downside protection in unfavorable scenarios, and since diversification has no cost, intuition suggests that it should be more efficient to costlessly diversify away unrewarded risk before insuring the resulting portfolio at a cost. This lower opportunity cost is reflected in the lower price of the put option that protects against downside risk if the volatility of the underlying asset has been reduced first by diversification.

Several theoretical optimality results show that under certain assumptions, diversification should indeed come before insurance. El Karoui, Jeanblanc and Lacoste (2005) show that an investor who maximizes expected utility from future wealth with constant risk aversion and imposes a minimum wealth constraint should implement an extended form of option-based portfolio insurance (OBPI), where the underlying asset of the option is the portfolio that would be optimal in the absence of the constraint.

The latter portfolio is diversified because the expected utility criterion favors returns but penalizes risk, but it involves the expected returns and covariances of constituents and the risk aversion parameter (Merton [1973]). When the objective is to maximize the probability of reaching a target wealth level while respecting a floor, Föllmer and Leukert (1999) and Deguest et al (2015) establish that it is optimal to hold a knockout option that pays either the floor or the target, whose underlying asset is the ‘growth-optimal portfolio,’ that is the portfolio that maximizes the expected logarithmic return.

These theorems are obtained in a stylized framework where continuous trading, leverage and short sales are allowed, all risk and return parameters are perfectly known and the criterion is expected utility or the success probability. In practice, it can be argued that since crashes and recoveries in risky assets are not perfectly synchronized, it might be worthwhile to have an asset-by-asset control of the amount of risk-free asset to be invested in – and this would be done by applying insurance first.

In this context, this paper considers whether the question of which should come first, diversification or insurance, subsists in a context closer to real-world investment conditions than the theoretical environment in which the theoretical results are derived. We consider various diversification methods often used in practice, which avoid the estimation of expected returns and risk aversion. These are equal weighting, variance minimisation, risk parity (Maillard, Roncalli and Teiletche [2010]) and maximum diversification (Choueifaty and Coignard [2008]).

As far as insurance strategies are concerned, we test both constant proportion portfolio insurance (CPPI) and option-based portfolio insurance (OBPI), and we report several standard performance and risk metrics to compare the properties of the ‘diversification first’ and ‘insurance first’ approaches. A non-trivial methodological issue that arises in our study is how to construct a diversified portfolio of insured payoffs, given that the usual diversification methods require a covariance matrix estimate. We propose two estimators, both of which are consistent with the returns on the original securities, and one of which takes into account the composition of the insured portfolio.

Our results show that it matters whether insurance or diversification comes first. The big picture is that diversification before insurance tends to perform better than insurance before diversification in the long run, thereby confirming the aforementioned intuition about reducing the opportunity cost, but there are exceptions to this finding, since an equally weighted portfolio of CPPI-like payoffs outperforms a CPPI portfolio based on an equally weighted portfolio. Ultimately it seems that no one approach unambiguously prevails over the other, with respect to whether diversification or insurance should come first.

Nicole Beevers and Hannes Du Plessis are Quantitative Strategists, Rand Merchant Bank, a division of FirstRand Bank Ltd; Lionel Martellini is Professor of Finance, EDHEC Business School and Director, EDHEC-Risk Institute; Vincent Milhau is Research Director, EDHEC-Risk Institute.

Honorable Mention

Annuity sales will rebound in 2021: Secure Retirement Institute 

The Secure Retirement Institute (SRI) is forecasting all individual annuity product lines except traditional variable annuities and fixed-rate deferred annuities to rebound in 2021. Overall individual annuity sales could see a slight increase in 2021, as the US and the insurance industry slowly transition from the global pandemic.

Longer term, SRI expects the total annuity market to benefit from improving economic conditions, shifts in demographic, as well as technology implementations. By 2025, SRI is forecasting the annuity market to grow as much as 30%.

There are several factors that will likely drive the annuity market:

  • While economic conditions are forecasted to improve, historic low interest rates will continue to be a headwind.
  • Products with protection features will continue to be in high demand.
  • Demand for guaranteed income is expected to grow.

“The most significant factors that drive annuity sales are the economic and regulatory environment,” noted Todd Giesing, assistant vice president of SRI Annuity Research. “How, and how quickly, manufacturers and distributors respond to external factors will dictate the ultimate impact of these changes. The rate of change and adoption of solutions to the challenges created by the 2020 global pandemic were accelerated, as companies looked for ways to adapt and show resilience amidst massive disruption.”

A look at the individual products:

Traditional Variable Annuities (VA): SRI is projecting traditional VA sales to decline slightly in 2021. By 2022, traditional VA sales will flatten out as economic conditions improve. Slow growth will come back to the traditional VA market in 2023 through 2025. Improving interest rates will help carriers with pricing efficiencies in products with guaranteed living benefits, and smooth equity markets will aid in the slow growth of investment-focused traditional variable annuities.  

Registered Index-Linked Annuities (RILA): The RILA market has experienced remarkable growth over the past few years and this trend is expected to continue through 2025. New manufacturers continue to enter the market and SRI expects some to introduce guaranteed lifetime benefits riders to broaden the appeal of these products to investors. By 2025, RILA sales are expected to be double what they are today.

Fixed Indexed Annuities (FIA): The indexed annuity market faced an extremely challenging environment in 2020, and as a result saw sales decrease by nearly $20 billion in 2020. Looking ahead, as interest rates improve, indexed annuities should slowly return to growth mode in 2021, but will face challenges as RILA’s continued success will likely take a portion of flows away from FIA sales, particularly in the independent BD and bank channel. SRI does expect FIA sales to enjoy slow and steady growth through 2025, and to reach or exceed 2019 record sales levels.

Fixed-Rate Deferred Annuities (FRD): Record market volatility and highly competitive crediting rates drove 2020 FRD sales to their highest annual level since 2009, as consumers sought investment protection and guaranteed growth. Despite improving interest rates and market stability — which would normally drive investors toward other products with greater growth potential — FRD sales will be bolstered by the nearly $150 billion invested in short-term fixed-rate deferred products over the past three years that will be coming out of their surrender periods. Given the current market conditions, we expect many investors will likely reinvest in fixed-rate deferred annuity products due to the rising rates, driving sales to close to $50 billion over the next few years.

Income Annuities: Despite improving economic conditions, low interest rates will continue to challenge the value proposition of income annuities through 2025. In addition, more flexible income solutions, such as guaranteed living benefits, will continue to capture a majority of the flows for investors seeking income guarantees in their retirement portfolio. While the growing aging population will benefit these products, the challenges of limited liquidity and the inability for insurers to provide robust pricing to attract individuals to income annuities will limit income annuity sales growth.

‘Income-oriented’ models are a growth category: Cerulli

The latest issue of The Cerulli Edge—U.S. Monthly Product Trends includes an analysis of mutual fund and exchange-traded fund (ETF) product trends as of April 2021, explores asset managers’ desire to expand their product offerings, and discusses why outcome-oriented solutions may serve as an entry point for registered investment advisors (RIAs) into model portfolios. 

Highlights from this research:

  • In April, mutual fund assets rose 3.7% to more than $19.6 trillion. Net flows were positive in April ($50.0 billion), although at a lesser scale than experienced in March ($61.0 billion) and February ($57.1 billion). ETF assets surged past $6 trillion during April, climbing 5.0% during the month to end at $6.2 trillion. In addition to April’s equity market performance, net flows continue to propel the vehicle’s assets, having added $75.3 billion during the month.     
  • Over the last decade, financial advisors have become far more confident in implementing ETFs in client portfolios. This greater comfort, along with greater model use and fee compression, has spurred many large asset managers, including former mutual-fund-only stalwarts, to expand their product offerings to include ETFs. Cerulli anticipates vehicle diversification will continue in coming years, as asset managers hoping to gain size and scope will need to give their clients the ability to access their investment capital in the vehicle that best suits their needs.
  • Model providers may be better served providing targeted goals-oriented solutions that RIA practices can use to address specific needs than trying to contend with the sea of options competing for a limited market of true RIA outsourcers. Cerulli believes that income-oriented completion models are a meaningful growth opportunity for asset managers and model providers. The independent RIA channel may offer an ideal arena for establishing a foothold with its lower barriers to entry, especially for those with proven investment expertise that are launching new strategies.
Equitable and Venerable close transaction

Equitable Holdings, Inc. announced this week that it has successfully closed its transaction to reinsure legacy variable annuity policies sold between 2006 and 2008 with Venerable Holdings, Inc. and that AllianceBernstein will serve as the preferred investment manager for the transferred general account assets.

As part of the transaction, the Company also announced that its in-force variable annuity reinsurance entity, Corporate Solutions Life Re, has been acquired by Venerable. With the close of this transaction, Venerable’s pro forma assets under management and reinsurance increase to approximately $70 billion.

On a pro forma basis, Venerable has more than doubled its general account assets from $9 billion to $19 billion, in addition to over $51 billion in separate account reinsured. The transaction includes reinsurance of a legacy variable annuity block from Equitable Financial Life Insurance Company with the combined deal representing $36.5 billion of underlying account value and general account assets. Venerable has also reinsured its existing business into CS Life Re, enabling operating efficiencies and optimizing liquidity for its collective book of business.

In accordance with the terms of the agreement, Equitable Holdings has acquired a 9.09% equity stake in Venerable’s parent holding company, VA Capital Company LLC. In connection with such investment, the Company will have the right to designate a member of the Board of Managers of VA Capital Company LLC.

Equitable Holdings, Inc., is a financial services holding company comprised of Equitable and AllianceBernstein. It has about 12,000 employees and financial professionals, $822 billion in assets under management (as of 3/31/2021) and more than 5 million client relationships globally.

© 2021 RIJ Publishing LLC. All rights reserved.

Seeking ‘An Index that Moves’

Bryan Anderson owns Annuity Straight Talk in northwest Montana. He’s a licensed insurance agent who sells fixed annuities to people all over the US. Lately he’s been podcasting and training other advisers in how to communicate the indexed annuity value proposition to their clients. He manages the indexes in fixed indexed annuities (FIAs) much the same way that he might manage direct investments in index funds or exchange-traded funds (ETFs). 

His clients are just looking for safe, modest returns. “The people who buy FIAs are people who haven’t been able to time the market well. They’re not happy. They don’t have the emotional fortitude to deal with a 20% downward bump in the equity market, and they’re perfectly happy with an average return of 4.5%. I want to get them there.” Anderson told RIJ in a recent interview.

“I didn’t like the blended or hybrid indexes at first because I thought they were too complex. I had every skepticism that anybody could come up with. But over the past few years I’ve changed my mind. My clients tend to look at the participation rates. They like the idea of getting all of the returns.”

Clients are naturally drawn to a crediting method that will give them 100% of the index gain, even if they know that it’s 100% of performance that is more or less restrained by a volatility control mechanism. Such a mechanism might automatically reallocate the index holdings to safe assets when market volatility exceeds a 5%, 6% or 7% target, depending on the contract. 

Volatility control at the index level can also prevent an unexpected change in pricing, he said.  “The life insurers explained to us that they can better project pricing with a volatility-controlled contract. They don’t get stuck in the position of  suddenly having to reduce a 6% cap down to 3.5%,” he said. 

Like many advisers, Anderson welcomes lots of choices in an annuity, even if it adds complexity to the contract. “I like to see 15 different indexes. I know that at least one of them is going to grow. It’s just a matter of figuring out which one it will be,” he said. “Most of all I like to see an index that moves.” That is, he doesn’t want to use an index so volatility-controlled that it becomes inert. If it doesn’t respond to trends, he can’t get a feel for how it might behave in the future. 

How do clients generally divide their money among multiple indexes? “If there are six indexes, some people won’t want to over-think the decision. So they split their money among all six. Others will chase one or two,” he said. “We might be optimistic about one index in particular and put 60% of the money in that and then put 10% into four different ones. The worst situation is to not be in an index and then realize that you’d have gotten a much bigger gain there.” He also likes the flexibility of newer contracts. “In the old contracts you might be stuck with three index options. There was no way to go elsewhere until the contract was free of the surrender penalty.”

Some clients invest all of their money in a contract at once. Others split up their money across contracts. It depends in part on how much money they want to invest. “Some people go all in at one time. I’ve had people who bought a single contract for $500,000. Another who bought eight contracts that totaled $800,000,” he said.

To diversify across time, “I like to sell half at a time, to offset the crediting dates,” Anderson said. In one case, where we used the Bloomberg US Dynamic Balance Index, I put half of the money in a one-year contract and half in a two-year contract. That index had a second-year return of 15%.” He tries to deliver an average annual return of 5% to his clients, and keeps looking for it. “I know that there’s a 5% gain somewhere in there,” he said. 

Sometimes Anderson chooses the index, and sometimes his clients do. “A client might say to me, ‘You know best,’ or ‘We did OK last year, just keep it the same.’ But some people really get into it. One of my clients spends an hour a day after work looking at the charts. Then he tells me, ‘I want 20% of the money here and 40% there.’ He’s an intelligent guy who enjoys it. I like to see him having fun. It takes pressure off me; I’d say that about 25% of my clients are like that,” he said.

Anderson sees real value for the client, and not just the appearance of value, in the higher crediting rates that come with volatility control. For him, even those indexes have the potential to deliver the best of both worlds—higher returns than bonds with less risk. 

“Yes, there’s value there,” he said. But he knows better than to tell clients to expect the upper limits on returns. “It’s a matter of adjusting your sales tactics. If I know that a product could do 10%, then I know I have an opportunity to do 5%. I want a product that has the upside potential, but I won’t pitch them on it. I sell them on a 3.5% gain and tell them to look at the rest as gravy.”

© 2021 RIJ Publishing LLC. All rights reserved.

‘Sometimes the Market Swings Your Way’

Don Dady and Ron Shurts started Annexus in 2005. Lack of discipline in the distribution of index annuities, which led to lawsuits and prosecutions over high-pressure sales practices, was threatening to kill that business.

“Independent distribution was broken. The IMOs [insurance marketing organizations] had no control over the insurance agents. Insurers had no control over the agents. Nobody was supervising them. We saw that we could increase the value proposition of wholesale distribution if we handpicked a select group of distributors and gave them something different to offer,” Dady told RIJ recently.

“We built a virtual insurance company. Annexus performs all the functions of a life insurer except administration and investments. We’ll come up with annuity concepts, we’ll price them out, and take them to the insurer, work on the marketing story. We vet different indices and help choose the portfolio of indices that we think will work in a particular product. We ‘do it all’ without the baggage and overhead of a life company.”

Dady welcomes hybrid indexes into the indexed annuity business. “In my opinion, a lot of advisers aren’t comfortable with hybrid indexes because they’re not sure how they work. So they’re just going to sell the S&P 500 Index. It will be a safe approach. The options will be cheaper [because of the ample supply] but the volatility of the index and the participation rates will be lower.”

Before volatility controls were applied to the indexes in indexed annuities, they were used to dampen the volatility of the investments of variable annuities with lifetime income guarantees. “The control method was ‘just get out’ [of equities and into bonds or cash],” he said. “Now you have hybrid smart beta indices,  which are designed to drive growth using the same algorithms that asset managers use. ‘Value’ and ‘momentum’ are techniques that we can incorporate into the index, with dynamic allocation among the asset classes. There has been a learning curve for advisers and insurers. The insurers get it. The advisers still have work to do.”

Like Lau, Dady likes the value proposition of registered index-linked annuities, or RILA. “What’s driving the sales of RILAs is the distribution,” he said. “There are a lot more securities-licensed producers than insurance producers, and registration creates more credibility. The buffer enhances your option budget in a low-rate environment. The beauty of the products is that they insulate you from some but not all of the market volatility. If somebody is willing to be insulated from only the first 10% loss, that fuels our option budget.”

More so than Lau, Dady believes that owners of index annuities can expect to enjoy an occasional year of outperformance. “We shouldn’t set the consumer up to expect phenomenal returns from such a low-risk product. On average, there will be no double-digit returns,” he told RIJ. “But once in a while there will be. We have definitely seen some phenomenal returns with vol-controlled indexes. Sometimes the market swings in your favor.”

Annexus is currently partnering with The Index Standard, a fintech startup whose founder, Laurence Black, has developed an index evaluation tool for Dady’s distribution partners. “With The Index Standard, somebody for first time is pulling the curtains back and explaining the mechanics of the indexes.

“Some of the indices have been reverse engineered to look good in the past, but not necessarily to perform in the future. All of the 10-year look-backs look good. We vet the indexes to see how well-positioned they are on a forecasting basis. Black is asking questions like, ‘What drove the past performance of the index?’ and ‘Does the index have survivor bias? and ‘What percent of the index returns came from capital gains on bonds?’ We know that the likelihood that interest rates will fall by 300 basis points in the future is very low.

“With The Index Standard, we’ll be able to caution advisers about those things. We also want to make sure the contracts allow the adviser to create buckets, where they can diversify across non-correlated indexes. We remind advisers that the product is not designed to outperform equities. In the end, the FIA is a fixed income product. Using an equity index is a way to create a fixed income ‘alt.’

“We do not believe that the carriers have done that work for the adviser, We see indices that have been put in products that have not been vetted. Advisers need better tools to evaluate them. Three or four years from now, the industry will have better processes. They’ll build a framework to help advisers select indices.

“The low interest rates are definitely a challenge. But it’s all relative. We’re competing against fixed income. Now that the larger world is waking up to the risks of retirement, that’s really opening up our world. We have a major initiative with Nationwide for September in the in-plan space. We reinvented the annuity to make it look like a security. It’s a target date fund that generates a 6% income, designed to kick off income starting at age 65.”

© 2021 RIJ Publishing LLC. All rights reserved.

Too Much ‘Hocus Pocus’

David Lau has been marketing fee-based annuities to Registered Investment Advisor (RIA) firms and their Investment Advisor Representatives for years. He helped start Jefferson National Life, which pioneered the sale of low-cost variable annuities to RIAs; the firm was later sold to Nationwide.

A serial entrepreneur, he then launched DPL Financial Partners, a web platform where advisers without insurance licenses can learn about, purchase, and bill on a variety of no-commission insurance products. He likes indexed annuities as bond alternatives. But the FIAs and RILAs offered on the DPL platform do not contain volatility-controlled indexes.

“I generally don’t like the custom indexes that are in the market. I think there’s a lot of hocus-pocus going on,” he told RIJ. “They’re built to illustrate well and show well when you present to a clients. These products have been built to be sold, not built to be used.

“I don’t have a problem with volatility controls. That’s part of risk mitigation. If volatility control prevents the investor from moving to cash in a downturn, then it makes sense.” But he finds that some index designers deliberately set low volatility targets (restricting the range of returns) because the options on the index will cost less and their option budget will buy more potential upside.

“When you see popular indexes with target volatilities of only 4% or 5%, you know that they’re doing it to get more money to buy options and to get higher caps. If it sounds too good to be true, it probably is.” Lau told RIJ

“For instance, an issuer might offer the S&P 500 Index with a 4% cap in an FIA. If you put volatility controls on that index, suddenly you can afford to offer a 10% cap. That illustrates well to the client. It makes them feels like they could get 10% every year. The product will look good but it has very little chance of actually performing in that well.”

A RILA, or registered index-linked annuity, which also uses options on indexes to generate yield, can advertise even higher caps and participation rates than FIAs. But those higher rates are not illusory, he pointed out because the investor has increased his options budget by selling off part of the downside protection that an FIA offers. Instead a floor of zero returns, the RILA might have a downside “buffer” of 10%, which means that the investor is responsible for all losses beyond 10%. For instance, if the index goes down 14%, the client loses only 4%.

That makes sense to him and to his customers. “Clients love RILAs. They provide excellent risk protection and a strong return. Who doesn’t like the notion that you might get as much as 15% in a year and also have 10% protection on the downside?” he said.

Anyone who believes that an annuity issuer can take a tiny fraction of a contract owner’s annuity assets and turn it into a big gain doesn’t understand the math, Lau explained. That’s doubly true because many of the indexes used in annuities track the index price without including the yield.

“The carrier has an options budget. You can see what it is by what they’re paying in the fixed account. They might have 3% of the client’s money to buy options on the index. I don’t think you can generate multiples of that return by buying options on an index. It’s not going to happen. The index also has a lot of expenses that the fixed account doesn’t have. Roger Ibbotson once looked at 90 years of index returns and concluded index annuities should outperform bonds by only about 10%.” 

That said, Lau thinks the no-commission index annuities have great value for advisers and clients near retirement. Low interest rates and high correlations of asset performance are the reasons. “In the RIA world, these products are underused,” he said. “We’ve seen a lot more correlation of assets in the last ten years. As a result, diversification alone isn’t enough.

“You also have to look at the purpose of the product. It replaces fixed income. You’re looking for predictable return because that’s what you’re replacing. As an adviser, I might allocate 50% of a client’s assets to the fixed account, which might pay 2.5% to 3.1%. For the other 50% I’ll look for some upside from an index, perhaps the Russell 2000 or MSCI.

“At DPL, we’re trying to create insurance products, or bring products to market, that are built to be used by an advisor in a portfolio and not to be sold by a salesman,” he added. “So we go with the basic indexes like the Russell 2000 and S&P 500. We will be offering a custom index ourselves later this year. It’s going to include dividends. It will be built to provide consistent, real performance.”

© 2021 RIJ Publishing LLC. All rights reserved.

The Point of Indexing (in Annuities)

When Jack Bogle introduced indexing to the investing public in the 1970s, competitors mocked him. Investors won’t settle for “average” returns, they said. But they were wrong. By 2020, index funds (including exchange-traded funds or ETFs) were worth over $11 trillion worldwide.

Indexing has even saved the annuity industry. Using the equivalent of about 2.5% of a client’s premium to buy options on an equity index, life insurers can offer fixed and variable indexed annuities that can outperform bonds at times (like now) when bond yields are down and equity returns are up.  

Today, a single indexed annuity contract might include as many as 15 different index choices. About 48% of all fixed indexed annuity (FIA) sales are still allocated to the S&P 500 Index, according to Wink. But almost 40% now gets applied to “hybrid” indexes that blend the performance of stocks and bonds or dynamically allocate between asset classes in response to market volatility.

Every June, RIJ focuses on indexed annuities. Last year, we took a deep dive into the use of options in variable index-linked annuities. This year we want to find out what the proliferation of indexes—especially hybrid and volatility-controlled indexes—means for advisers and clients.

For instance, if an FIA contract offers multiple indexes, how does the adviser help the client decide which ones to use, and in what proportions? How do volatility-controlled indexes work, and by what financial alchemy can they offer such generous performance limits? For answers, we went to the people who work with these indexes every day.

For answers, we turned to agent Bryan Anderson of Annuity Straight Talk in Whitefish, Montana, to Don Dady, co-founder at Annexus, an annuity product designer and distributor in Scottsdale, AZ, and to David Lau, founder of the DPL Financial Partners annuity platform and a pioneer in marketing fee-based annuities to Registered Investment Advisors. These experts gave us three nuanced perspectives.

Our three specialists agreed on one thing: That indexed annuities offer people who are nearing retirement a source of higher yields (on average) than bonds provide in today’s low interest rate environment, while also insulating their principal from volatility during early retirement.

With respect to the hybrid or volatility-controlled indexes in indexed products, however, they hold different views. Lau regards them with skepticism; he believes they can be manipulated to give investors unrealistic expectations of potential gains.

Anderson welcomes the flexibility that a large selection of indexes gives him. He finds real value—not the illusion of a free lunch—in the higher caps and participation rates that volatility-controlled indexes are able to offer. Dady is working with Laurence Black of The Index Standard to create a tool that, he believes, can forecast the performance of the indexes well enough to enable advisers to make an optimum selection among them. 

For their comments, see the stories on today’s home page.

© 2021 RIJ Publishing LLC. All rights reserved.

A close look at ‘collective defined contribution’ plans

The economies of “pooling” are non-trivial. Whether it’s car-pooling with co-workers, buying life annuities, or joining an old-fashioned community “swim club,” the efficiencies that come from sharing an expense, a chore or a risk can deliver significant individual savings.

But pooling brings frictions and complexities as well. That’s why many people choose to install their own backyard swimming pools, avoid illiquid annuities, and commute solo to work every day.  

Which brings us to the concept of “collective defined contribution” or CDC plans. A timely new white paper from the Center for Retirement Initiatives at Georgetown University makes a case for these retirement plans, which try to blend elements of defined benefit pensions and of defined contribution plans in a best-of-both-worlds hybrid.

“A CDC plan is similar to a DB plan, but does not provide a guaranty from the employer,” write Charles E. F. Millard, David Pitt-Watson, and CRI executive director Angela M. Antonelli in “Securing a Reliable Income in Retirement.” They contribute to the ongoing debate over how best to help DC plan participants turn their tax-deferred savings into reliable income.

Like a DB plan, a CDC plan is overseen by a professional investment management team with the goal of paying participants an annual retirement income equal to a percentage of their final or average pay. The white paper describes the potential benefits and avoidable pitfalls of using CDC, and highlights lessons learned from CDC experiments in the Netherlands and the United Kingdom.

Ultimately, the authors favor CDC. “Recent studies suggest that a CDC plan will generate a retirement income at least 30% higher than a typical DC plan,” they write. “Recent reforms in the United States offer a potential new opportunity for the greater adoption of pooling, the introduction of CDC plans, and other future plan design considerations for policymakers.”

© 2021 RIJ Publishing LLC. All rights reserved.

Honorable Mention

Strength helps insurers withstand volatility: AM Best

An AM Best analysis of the U.S. life/annuity (L/A) industry under the rating agency’s Best’s Credit Rating Methodology highlights how volatility has a significant impact on a L/A company’s balance sheet strength and operating performance, the first two building blocks in AM Best’s ratings process.

The new Best’s Special Report, “Life/Annuity Benchmarking: Higher-Rated Companies Better Able to Withstand Volatility,” also shows how adequate and stable levels of capitalization are relevant to the strength of a company’s balance sheet. A high ratio of capital and surplus (C&S) to liabilities implies that the rating unit has a lot more capital cushion to absorb during periods of stress. Higher-assessed companies also are able to grow surplus more quickly than rating units with a weaker assessment.

AM Best uses a variety of benchmarking techniques to view companies from different perspectives, allowing for comparisons of absolute results and volatility levels across the industry. The primary quantitative tool used to evaluate balance sheet strength is Best’s Capital Adequacy Ratio (BCAR).

As the report shows, the balance sheet strength assessments of a little more than half the rating units are equal to their BCAR assessments. Meanwhile, the balance sheet strength assessments of 43% of entities are lower than their BCAR assessment, reflecting significant drag from components of the balance sheet strength other than the BCAR score, or from a relatively weaker parent organization.

Along with balance sheet strength, AM Best analyzes operating performance, business profile and enterprise risk management (ERM). Operating performance is a leading indicator of future balance sheet strength and long-term financial stability, as AM Best assesses the ability of an insurer to generate consistent earnings. Companies with an operating performance assessment of marginal or weak reported negative returns over the last 20 years and higher volatility. Anemic returns and greater volatility can act as a drag on ratings. Companies assessed lower on the operating performance scale have reported an operating loss in a much higher number of years than more favorably assessed companies, including an average of nine out of 20 years for companies with an operating performance assessment of weak.

L/A insurers have multiple product lines and business segments, and each business line has a different risk profile and capital requirements, and hence a different target rate of return. Volatility occurs at all levels, but AM Best is primarily concerned with the downside risk volatility seen at weaker rating units, given the negative impact such volatility can have on C&S and overall financial strength.

T Rowe price announces fund fee reductions and new TDF series

T. Rowe Price Group, Inc., a major target-date fund (TDF) provider, has announced expense reductions across its suite of target date mutual funds and trusts. The publicly-traded retirement plan provider also filed to register a new series of TDFs, the Retirement Blend Fund series, with the Securities and Exchange Commission (SEC).

The resulting asset-weighted average fee reduction, based on assets under management as of March 31, 2021, is 6.3 basis points across mutual funds and 4.8 basis points across trusts. Specific fee changes vary across products. 

Fee reductions on all T. Rowe Price’s target date portfolios will take effect on July 1, 2021. The new Retirement Blend Fund series is expected to be available publicly on or about July 28, 2021 and will offer Investor Class and I Class shares across all vintages, from 2005-2065.

A new marketing campaign, centered on the theme “Retirement. Meet Your Match,” will show the benefits of the firm’s TDFs.

The expense reduction announcement follows the firm’s establishment last April of a new unitary fee structure for all target date mutual funds. An all-inclusive management fee rate was set at the top level. As part of that restructuring, fees were reduced across the Retirement I Funds – I Class, Target Funds, and Retirement Income 2020 Fund.

The unitary fee structure for the target date mutual funds will remain in place and will reflect the updated fees beginning July 1, 2021. This top-down fee structure allows T. Rowe Price to lower target date mutual fund fees without changing underlying funds or allocations. The investment approach and benchmarks for the Retirement and Target series doesn’t change.

The Retirement Blend strategy has been in place at T. Rowe Price since 2018. It was previously only available in the collective investment trust (CIT) format. It will combine active and passive investment styles, using active management where a fully passive management approach may not be appropriate. It also provides the diversification and low costs of passive investments.

The Retirement Blend Funds will use the enhanced Retirement glide path with the same diversification and tactical asset allocation as the Retirement suite. T. Rowe Price recently announced that its target date portfolios are gradually moving to their enhanced glide paths; this transition began in April 2020 and is expected to take approximately two years to complete for all funds and trusts. Neither the Retirement Blend Funds launch nor the fee changes affect this transition process.

All of T. Rowe Price’s target date portfolios will continue to be managed by Wyatt Lee, CFA, head of Target Date Strategies, and portfolio managers Kimberly DeDominicis and Andrew Jacobs van Merlen, CFA.

Settlement reached in suit over high fees at Columbia’s 403(b) plan

Attorneys representing participants in Columbia University’s 403(b) defined contribution retirement savings plan filed a “preliminary settlement approval motion” this week, bringing their suit against the plan closer to completion. Columbia is represented by Schlichter Bogard & Denton LLP of St. Louis, a pioneer in participant-led class action suits.

The suit, filed in August 2016, alleged that the 403(b) plan charged excessive fees for administrative and investment services and violated the Employee Retirement Income Security Act of 1974 (ERISA). The motion filed this week approved the establishment of a $13 million settlement fund for the plaintiffs, as well as non-monetary relief involving changes in the 403(b) plan.

The complaint, Cates, et al. v. Trustees of Columbia University, et al., was filed in the U.S. District Court in the Southern District of New York and was scheduled to be one of the first cases to go to trial in that federal court since the onset of the COVID-19 pandemic.

Columbia has denied it committed any fiduciary breach in its operation of the plan. After the lawsuit was filed, the Columbia fiduciaries consolidated the plans’ administrative services and capped costs to a flat, per-participant fee, returning excess revenue to the plan participants.

Columbia has agreed, with consent of an independent consultant, to request competitive bids for administrative services again in the next 3-4 years.

Columbia has also agreed to maintain the lowest share class of plan investments in annuities and mutual funds, to continue to use an independent consultant to make recommendations, to prohibit the recordkeeper from using confidential information obtained from plan participants to sell other investment and wealth management services, and to inform all participants of their ability to move assets out of frozen investment options. Schlichter Bogard & Denton will monitor compliance with these terms for a three-year period.

Ubiquity adds ESG options to plan offerings

Small business retirement plan provider Ubiquity Retirement + Savings this week announced the introduction of environmental, social and governance (ESG) fund options to its 401(k) offerings, allowing plan sponsors to add socially responsible investments to the plan’s investment options.

Ubiquity’s ESG investment lineup includes low-cost mutual funds and exchange-traded funds (ETFs) from Vanguard, and is currently available for participants in the firm’s Custom(k) and Reserve(k) plans. Investments in U.S. ESG funds surpassed a record $51 billion in 2020, more than double the total from the previous year and a nearly tenfold increase from 2018, according to Morningstar.

Ubiquity Retirement + Savings “sits at the crossroads of HCM, SaaS and robo-recordkeeping,” according to a release. The firm was a pioneer in transparent, flat-fee retirement plans, helping participants at more than 9,000 businesses save over $2.5 billion over the past 20 years.

Personalized TDFs from Cuna Mutual

Cuna Mutual Group today announced the launch of YourTarget Portfolios, a new model portfolio program offering plan sponsors and advisors the ability to build custom-designed plans through the company’s Total Retirement Solutions platform.

YourTarget Portfolios is an open architecture program that allows plans of all sizes to structure portfolios that are more personalized than traditional target-date funds. The program offers multi-manager, age and risk-based portfolios from an open architecture investment universe across both active and passive strategies to optimize plan design and more precisely serve the individual circumstances of plan participants.

YourTarget Portfolios also offers innovative fiduciary protection and support through Envestnet Retirement Solutions (ERS), which features the option to delegate the role of custom portfolio design to a provided ERISA 3(38) fiduciary investment manager to develop, monitor and update portfolios on an ongoing basis. Program users can still choose to work with another 3(38) investment manager or manage their own portfolios as a 3(38) investment manager, as well.

© 2021 RIJ Publishing LLC. All rights reserved.

 

The Irony of Inflation Forecasting (Research Roundup)

Visions of beggars pushing wheelbarrows of banknotes sprang to America’s collective financial conscience on May 12 when the Bureau of Labor Statistics issued its monthly Consumer Price Index report. It showed a 4.2% rise in the index between April 2020 and April 2021.

Rising prices of petroleum products, used cars and trucks, lodging away from home, and airline tickets drove the increase. Because we’re so accustomed to low inflation (except in housing, equities and health care), that unusual increase launched a thousand headlines.

Will the Fed act, Wall Street wondered? Will it try to cool off the economy with an interest rate hike? That’s not likely (the Fed has been propping up bond prices and trying to stimulate employment), but the S&P 500 dropped 4% on May 12. It has since recovered, though not quite to its all-time high of 4,232, posted on May 3.

How does the Fed formulate inflation policy? How do CEOs form their inflation expectations? In a new study from the National Bureau of Economic Research, academic researchers try to answer those questions. Given the timeliness of the topic, we give this paper top billing in this month’s edition of RIJ’s Research Roundup.

Below, you’ll also find synopses of new research about:

  • The reasons why rational retirees keep saving
  • The hybridized stock-picking capabilities of “centaurs”
  • The four financial biases that affluent people avoid
  • The impact on male mortality rates of working longer

The Inflation Expectations of US Firms: Evidence from a New Survey,” by Bernardo Candia and Yuriy Gorodnichenko, University of California-Berkeley, and Olivier Coibion, University of Texas-Austin. NBER Working Paper 28836, May 2021.

Economics, like life, is rife with irony. Although Federal Reserve policymakers say they take their cues about inflationary trends from the CEOs of US companies, CEOs don’t pay much attention to inflation, aren’t informed about it, and most can’t name the Fed’s target inflation rate.

And, contrary to economic theory, the inflation expectations of CEOs are not “anchored” in any past inflation rate. CEOs aren’t much more informed about inflation than households, which aren’t informed at all.

“The inflation expectations of US firms’ managers display little anchoring: high and dispersed inflation expectations, high levels of uncertainty in their inflation forecasts, large revisions in both short-run and long-run expectations, and a strong correlation between the changes in short-run and long-run inflation expectations,” write authors Bernardo Candia, Olivier Coibion, and Yuriy Gorodnichenko.

The findings were based on the authors’ Survey of Firms’ Inflation Expectations (“SoFIE”) since 2018. Each quarter, a representative panel of CEOs respondents is asked for their inflation expectations in the US over the next 12 months and monetary policy. They are also asked for their “ long-run inflation expectations, perceived recent levels of inflation, uncertainty about future inflation risk, as well as knowledge of the Federal Reserve’s inflation target.” 

Only 20% of CEOs correctly identified the Fed’s inflation target (2%) and nearly two-thirds were “unwilling to even guess what the target is.” Of those who did, less than 50% thought it was between 1.5% and 2.5%. “Managers disagree just as much about what inflation has been over the last twelve months as they do about what it will be in the future, even though the former is publicly and freely available,” the study showed. 

Data from the survey shows “just how uninformed US firms are with respect to both inflation and monetary policy,” according to the paper. The irony of the findings is stated below.

“Firms’ inflation expectations are central to understanding the link between the nominal and real sides of the economy and therefore play a fundamental role in determining the nature of optimal monetary policy. Indeed, policymakers themselves have long emphasized the importance of firms’ inflation expectations in how they think about optimal policy, as illustrated in the initial quote,” the authors write.

Why Do Couples and Singles Save During Retirement?” by Mariacristina De Nardi, University of Minnesota and Federal Reserve Bank of Minneapolis, Eric French, Cambridge University, John Bailey Jones, Federal Reserve Bank of Richmond, and Rory McGee, University of Western Ontario. NBER Working Paper No. 28828, May 2021.

Florida’s retirees are famous for lining up at oceanside diners for the “Early Bird Special” discounts. But what compels retirees in general to economize? A team of economists at the Federal Reserve and elsewhere provide answers in their new paper: “Why Do Couples and Singles Save During Retirement?”

“While the savings of singles tend to fall with age, those of retired couples tend to increase or stay constant until one of the spouses dies.” the researchers write. “While medical expenses are an important driver of the savings of middle-income singles, bequest motives matter for couples and high-income singles, and generate transfers to non-spousal heirs whenever a household member dies.”

The study implies that the high-PI elderly get as much or more “utility” (i.e., reward) from giving money to heirs to enjoy than spending it on their own pleasures. Those who have high PI are by definition already protected from running out of money before they die. Pursuit of personal pleasures presumably ebbs as people enter their “no-go” 80s. 

The paper’s results have policy implications. “Couples and high-PI singles can easily self-insure against medical spending risk because they save to leave bequests,” the authors write. “Low-PI singles are well insured through Medicaid and do not need to save for medical expenses.

“In contrast, middle-PI singles set aside significant amounts of wealth for precautionary purposes because they are not rich enough to want to leave bequests, but are too rich to qualify for Medicaid. It is thus the middle-PI singles who would respond most to changes in public health insurance.”

From Man vs. Machine to Man + Machine: The Art and AI of Stock Analyses,” by Sean Cao and Baozhong Yang of Georgia State University, Wei Jiang, Columbia University, and Junbo L. Wang, Louisiana State University. NBER Working Paper No. 28800, May 2021.

If IBM’s Big Blue could outplay grandmaster Gary Kasparov at chess, could an artificial stock analyst using machine learning techniques (“artificial intelligence”) outperform Wall Street analysts at evaluating public companies and predicting future returns?

Yes and no, say four professors at US graduate business schools who built their own AI equity analyst and then compared its alpha-predicting abilities to those of humans after feeding it masses of corporate financial information, qualitative disclosure and macroeconomic indicators.” 

The most accurate stock analyst, they found, is what Kasparov himself called a centaur: a human analyst assisted by an AI co-pilot.

The AI analyst tends to outperform people when the “firm is complex, and when information is high-dimensional, transparent and voluminous. Human analysts remain competitive when critical information requires institutional knowledge (such as the nature of intangible assets).

“The edge of the AI over human analysts declines over time when analysts gain access to alternative data and to in-house AI resources. “Combining AI’s computational power and the human art of understanding soft information produces the highest potential in generating accurate forecasts. Our paper portraits a future of ‘machine plus human’ (instead of human displacement) in high-skill professions.”

The best analyst is the “‘centaur’ analyst, i.e., an analyst who makes forecasts that combine their own knowledge and the outputs/recommendations from AI models.” When the researchers supplemented the AI analyst’s information with forecasts by human Wall Street analysts, the resulting “man + machine” or “centaur” model outperformed 57.3% of the forecasts made by analysts, and outperformed the AI-only model in all years.

“Thus, AI analyst does not displace human analysts yet; and in fact an investor or analyst who combines AI’s computational power and the human art of understanding soft information can attain the best performance.”

The Financial Impact of Behavioral Biases: Understanding the extent and importance of behavioral biases,” by Sarwari Das, Behavioral Researcher, Sagneet Kaur, associate director of Behavioral Research, Steve Wendel, head of Behavioral Science, at Morningstar Behavioral Finance, May 25, 2021.

The more biased a person’s financial behavior—for example, the more a person believes in their own uneducated judgments, or the less a person understands how compound interest works—the less money they tend to have, according to a study released this week by Morningstar, Inc. Morningstar’s researchers found:   

  • The majority of Americans show biases of present bias, loss aversion, overconfidence, and base rate neglect. Each of these biases reflects a kind of intellectual myopia where people give too much importance to very recent events, very negative events, and personal views, and where they give too little importance to the effects of long-term compound interest.
  • On average, younger people showed higher levels of overconfidence compared with older individuals.
  • Higher bias levels directly correlate with lower checking and 401(k) balances, lower self-reported credit scores, failure to plan ahead and failure to save and invest.
  • Some common perceptions about financial biases may be misguided—neither gender is more biased than the other.

The Morningstar analysts surveyed a nationally representative sample of 1,211 Americans, sourced from NORC’s (University of Chicago) AmeriSpeak panel. Participants completed a “bias assessment” survey, which included questions for six biases and a measure of a person’s financial health. The biases included were:

Present Bias: The tendency to overvalue smaller rewards in the present at the expense of long-term goals.
Base Rate Neglect: The tendency to estimate the likelihood of an event on the basis of new, readily available information while neglecting the actual underlying probability of that event.
Overconfidence: The tendency to overweigh one’s own abilities or information when making an investment decision.
Loss Aversion: The tendency to fear losses relative to gains and relative to a reference point.
Exponential Growth Bias: The tendency to underestimate the impact of compound interest.
Gambler’s Fallacy: The tendency to believe that a random event is less (or more) likely to happen following a series of similar events—thus over (or under) predicting reversals in series like market trends.

Do Men Who Work Longer Live Longer? Evidence from the Netherlands,” by Alice Zulkarnain, the CPB Netherlands Bureau for Economic Policy Analysis and Center for Retirement Research at Boston College, and Matthew S. Rutledge, an associate professor of the practice of economics at Boston College and a CRR research fellow, May 2021.

For tenured professors and others who live by their brains and more or less dictate their own schedules, working past age 60 or even 65 isn’t a heavy lift. Not so for electricians and plumbers, whose knees and hips are worn out by that age. So governments find it difficult to set one-size-fits-all retirement ages.

Yet, with the ratio of retirees-to-workers rising, governments have financial reasons to encourage everyone to work longer, pay taxes longer, save longer, and spend fewer years in retirement. But if working longer caused people to live longer—and collect public or government pensions longer—the policy could backfire. 

Analysts at the Center for Retirement Research (CRR) at Boston College reviewed a real-world experiment in the Netherlands to see the impact of delayed-retirement tax incentives on worker behavior and mortality.

A few years ago, the Dutch government established a tax incentive aimed at encouraging men to work past age 60. The Netherlands’ Dootwerkbonus, introduced in 2009 and repealed in 2013, reduced taxes on labor income for each year a person worked after age 62. This bonus, in the form of a tax credit automatically applied at filing, was substantial: up to 5% of taxable income (subject to a cap) for people age 62, increasing to 10% at age 64 before phasing out at older ages. Those born from 1946 to 1949 stood to benefit the most. A group of workers born in 1943-1945 served as a control.

Men who worked longer due to the policy change saw their mortality rate in their 60s fall from about 8% to 6%. That suggests a two-month extension to their life expectancies between the ages 62-65. Extrapolating into the future, the increase in life expectancy could end up being more significant.

“If the reduction in men’s mortality is only temporary, their remaining life expectancy after age 60 would rise from 21.5 years to 21.7 years, or about two extra months. If, however, the effect on mortality is longer lasting, remaining life expectancy could increase by about two full years,” the authors wrote.

© 2021 RIJ Publishing LLC. All rights reserved.

Why Retirement Bills are a Bipartisan Slam-Dunk in Congress

Congressional Republicans and Democrats have agreed on very little for, oh, almost 30 years. But they’ve recently agreed on changes to the laws governing tax-deferred retirement plans—changes driven more by advocates for the retirement industry rather than by the public.

The latest piece of bipartisan legislation, the Retirement Security & Savings Act (S. 1770), was introduced by Sen. Rob Portman (R-OH) and Sen. Ben Cardin (D-MD) on May 21. It followed by about two weeks the unanimous approval by the House Ways & Means Committee of “Secure 2.0,” a bill introduced by Rep. Richard Neal (D-MA) and Rep. Kevin Brady (R-TX) and formally known as the Securing a Strong Retirement Act of 2021 (H.R. 2954).

These bills overlap in several areas. Their principal effects would be to help remove obstructions to the flow of payroll deferrals into the investment options in retirement plans. They would do this by raising some of the limits on payroll contributions and “catch-up” contributions, and giving more tax credits to employers who start plans.

That doesn’t help middle-income people much. Savings rates depend mainly on the capacity to save, and saving in tax-deferred plans is most attractive to high-income participants. Raising the contribution limits in order to encourage saving by the under-saved seems as useful as raising the height of a basketball net to encourage the participation of shorter players.

But it should help the retirement industry, which wanted a lift. Low margins have driven consolidation among recordkeepers. Low asset fees have made DCIO (defined contribution investment-only) fund companies increasingly dependent on rising AUM. Low interest rates have hurt annuity issuers. The steady outflow of 401(k) money to rollover IRAs threatens everyone except perhaps Vanguard and Fidelity, which have both markets covered.

Politics is famously the “art of the possible.” It is presumably easier—a slam dunk, apparently—for the two parties to respond in concert to a concerted industry-led, top-down initiative than to non-existent grassroots demands from plan participants. Rank-and-file participants don’t participate much in the plan design process. If they did, they might file fewer ERISA class action suits against plans.

Congress, in effect, proposes increasing the “tax expenditure” for incentivizing retirement savings. The tax expenditure for defined contribution plans between 2019 and 2023 has been estimated at $776 billion by the Tax Policy Center of the Urban Institute, or about half of the total tax expenditure for retirement savings over that period. The tax expenditure is a subsidy for the retirement industry (it reduces the upfront cost of their product and increases their assets under management by protecting balances from tax erosion) and for savers in the higher tax brackets.

Aside from making the Saver’s Credit (maximum: $1,000 per person) refundable to the individual’s retirement plan account (instead of as tax credit), these bills won’t do much to help the real retirement crisis in the US—the fact that a third of people in their 60s or older have less than $100,000 saved in defined contribution plan accounts.

Most Americans depend on Social Security for retirement security, yet only two members of the Ways & Means Committee spoke up to say that Congress’ priority should be to assure  Americans that they will receive full promised benefits even if the fictional Social Security “trust fund” reaches zero by 2034. (If the trust fund is a fiction, as George W. Bush told us in 2005, then its “crisis” is equally fictional.)

The Portman-Cardin bill, according to Sen. Portman’s website, includes more than 50 provisions and “addresses four major opportunities in the existing retirement system:

(1) allowing people who have saved too little to set more aside for their retirement;

(2) helping small businesses offer 401(k)s and other retirement plans;

(3) expanding access to retirement savings plans, including for low-income Americans without coverage; and

(4) providing more certainty and flexibility during Americans’ retirement years. The measure includes more than 50 provisions to accomplish these objectives.

The Portman Cardin bill
  • Establishes a new incentive for employers to offer a more generous automatic enrollment plan and receive a safe harbor from costly retirement plan rules. It provides a tax credit for employers that offer these safe harbor plans starting at six percent of pay in addition to the existing safe harbor at three percent. This gives employers the certainty to offer more generous retirement benefits to their employees.
  • Increases the “catch-up” contribution limits from $6,000 to $10,000 for baby boomers (individuals over age 60) with 401(k) plans.
  • Helps employees who are struggling to save for retirement and pay off student loan debt. It allows employers to make a matching contribution to the employee’s retirement account based on his or her student loan payment.
  • Allows employers to make an additional contribution on behalf of employees in a small business SIMPLE retirement plan.
  • Increases the allowable catch-up contribution to Individual Retirement Accounts (IRAs) by the inflation rate.
Help Small Businesses Offer 401(k)s & Other Retirement Plans
  • Increases the tax credit for the smallest businesses starting a new retirement plan to a larger percentage of their costs.
  • Simplifies rules for small businesses, including allowing all businesses to self-correct all inadvertent plan violations under the IRS’ Employee Plans Compliance Resolution System (EPCRS) without paying IRS fees or needing formal submissions to the IRS.
  • Simplifies “top-heavy” rules for small business plans to reduce the cost of enrolling new employees.
  • Establishes a new three-year, $500 per-year tax credit for small businesses that automatically re-enroll plan participants into the employer plan at least once every three years.
Expand Access to Retirement Savings Plans, including for Low-Income Americans Without Coverage
  • Expands the existing Saver’s Credit income thresholds to give more Americans access to increased credit amounts.
  • Creates a new “government match” for low-income savers by making the Saver’s Credit directly refundable into a retirement account.
  • Expands the eligibility of 401(k)s to include part-time workers that complete between 500 and 1,000 hours of service for two consecutive years.
  • Make it easier for employees to find lost retirement accounts by creating a national, online database of lost accounts.
  • Make it easier for military spouses who change jobs frequently to save for retirement.
Provide More Certainty & Flexibility During Americans’ Retirement Years
  • Raising the age for required minimum distributions from age 72 to age 75 by 2032, allowing all individuals choosing to work later in life to keep saving for retirement.
  • Creates an exception from required minimum distributions for individuals with $100,000 or less in aggregate retirement savings, allowing them to choose to keep saving for retirement at any age.
  • Reduces the current penalty for skipping required minimum distributions to 25% of the underpayment from 50% (in most cases), and as low as 10% for those who correct the error.  
  • Encourages expanded use of Qualifying Longevity Annuity Contracts (QLACs), for retirement plans that provide annual payments to individuals who outlive their life expectancy. QLACs prevent older Americans from outlasting their savings.
  • Protect retirees who received retirement plan overpayments through no fault of their own.

© 2021 RIJ Publishing LLC. All rights reserved.

Delaying Required IRA Distributions Again Would Largely Help Only The Wealthy

The House Ways & Means Committee is once again tinkering with the law that requires retirees to take minimum distributions from their individual retirement accounts (IRAs) and 401(k)s. Each time, Congress eases the required minimum distribution (RMD) rules at great cost to the federal government. Yet the beneficiaries would overwhelmingly be wealthy retirees and their future heirs.

The committee bill, approved today,  would make two big changes to RMDs. It would allow retirees to wait until age 75 before taking required minimum annual distributions and paying tax on them. Currently, they must begin taking distributions at age 72. And it would make it easier for older adults to avoid taking required distributions by investing their retirement funds in annuities.

The new RMD rules are included in the Securing a Strong Retirement (SECURE) Act of 2021. To be sure,  the measure would make some beneficial changes, including provisions that encourage more employers to auto-enroll workers in retirement plans, an important tool to encourage participation. But it also includes some clunkers, and the RMD rules are high on the list.

Fiddling

Congress can’t help fiddling with the RMD rules.

In December, 2019, Congress allowed workers to delay taking RMDs from age 70.5 to age 72. Last year, Congress waived minimum distributions entirely in response, it said, to the pandemic. Lawmakers felt it would not be fair to require retirees to take distributions after the stock market plunged in March, 2020. Except, whoops, the S&P index rose 16 percent for the year.

Now SECURE would gradually extend the delay to 75. It would rise to 73 in 2022, then 74 in 2029, and finally 75 in 2032. But don’t be surprised if a future Congress accelerates the timetable.  

Remember, the purpose of tax-free retirement plans is to help older adults save for their, um, retirement. It was not supposed to be another tool for bequests to family members. RMD rules are intended to make sure that these assets are taxed during a person’s expected life. Without the rules, rich retirees could simply stash assets in tax-advantage accounts until they die, then pass them on to heirs.

Not cheap

Delaying RMDs again would have major consequences, some unintended.  And it would not be cheap. At a time when lawmakers say they are worried about growing deficits, delaying RMDs would reduce federal revenue by almost $7 billion over 10 years. But the real cost would begin once the age phases up to 74 in 2029. At that point, revenue would fall by about $1.4 billion annually.

But its biggest problem is that delaying RMDs would be so regressive.

In 2018, the roughly 17 percent of taxpayers with adjusted gross incomes of $100,000-plus took more than half of the $253 billion in IRA distributions. Those making $50,000 or less took only about 20 percent.

In 2019, the median retirement account balance was only about $65,000, according to the latest Federal Reserve’s Survey of Consumer Finances.  Another survey found that nearly one-third of people in their 60s or older had less than $100,000 in defined contribution plan assets.

No help to many

Many low-income retirees with such limited retirement assets already take more than the required minimum annually to pay routine bills. Delaying required distributions would not benefit them in any way.

Keep in mind, as well, the life expectancy for low income people is far lower than for the wealthy. The RMD delay also is of no benefit for those who die before age 73.

It is the same story with enhanced annuities. Retirees with relatively little wealth receive few benefits from these investment. Someone investing that median $65,000 at age 65 would get an average payout of only about $250 a month.  

Unintended losers

Charities may be unintended losers from these changes.

They benefit from another complicated provision called qualified charitable distributions (QCDs). By contributing required distributions to charity, seniors can avoid tax on mandatory withdrawals. And QCDs have become a popular way for wealthy seniors to donate to charity.

It appears that these gifts fell sharply in 2020, largely in response to the temporary waiver of RMDs. And it would be no surprise if they continue to fall if wealthy seniors can delay distributions until age 75.

Some heirs are required to close, and pay tax on, their inherited IRAs within 10 years, although spouses and minor children and exempt from that requirement. Even for those subject the 10-year rule, the long deferral can be extremely valuable. 

The Biden Administration is proposing a major shift in the tax treatment of assets held outside of retirement accounts by taxing at death unrealized capital gains in excess of $1 million. By doing so, it would prevent wealthy people from passing on a large share of their wealth tax free.

The RMD change in the SECURE Act, by contrast, would make it easier for wealthy seniors to pass on retirement plan assets with any tax liability delayed for years.      

Note: Click here for the original version of this article at Tax Vox.

US Equity Flows Cool Down in April: Morningstar

Following a record $156 billion intake in March, inflows of long-term mutual funds and ETFs totaled a more moderate $124 billion during April, according to Morningstar Direct’s monthly fund flow report.

“Investors continued to favor passively managed strategies, pouring in $94 billion. About $30 billion went to actively managed funds. ETFs—most of which are passively managed—gathered $75 billion, while open-end mutual funds pulled in about $49 billion,” wrote Morningstar analysts Adam Sabban and Supreet Grewal.

After taking in a record $54 billion in March, US equity funds shed over $500 million in April. Large-blend funds saw the biggest month-over-month change, with roughly flat net flows in April after collecting $25 billion in March. Large-growth funds bled $7 billion, though they’ve regularly experienced outflows in recent years as investors appeared to rebalance away from one of the market’s best-performing equity categories.

Value funds, by contrast, have seen a resurgence in investor interest in 2021. Following a month of record inflows in March, value funds collected smaller but still significant totals in April. Large-value funds raked in about $4 billion, down from $20 billion in March but still enough for their fourth consecutive month of inflows. Small value funds took in about $900 million, well short of March’s record $5.4 billion. Most inflows in these two Morningstar Categories again found their way to passively managed funds, such as Vanguard Value Index VIVAX.

The market’s pivot to value-oriented niche categories continued in April. Equity categories (such as financials, natural resources, real estate, and energy) collected some of the highest totals within the sector-equity category group, which brought in $10.6 billion during the month. Natural resources funds gathered a record $2.7 billion in April, resulting in a month-over-month organic growth rate of 6.0%, the third-highest in the past decade. Passive funds that track the materials sector grabbed the greatest amount of assets in the category. Materials Select Sector SPDR ETF XLB, which tracks materials companies in the S&P 500, brought in the most with $761 million of inflows.

International-equity funds took in $31 billion in April, matching their total from March. Funds in the newly established world large-stock blend category took in more than $11 billion, a record in Morningstar data going back to 1993. Much of that total, however, went to two American Funds vehicles, American Funds Global Insight AGVDX and American Funds Capital World Growth and Income CWGIX, which together received more than $10 billion in new assets as a result of changes to American Funds’ target-date fund allocations. Diversified emerging-markets funds took in $7 billion in April, but that was about half of their record $14 billion inflow in March.

Taxable-bond funds picked up $65 billion in April, bringing their trailing-12-month total to $816 billion. Actively managed taxable-bond funds took in $30 billion, nearly half of the category group’s inflows for the month.

Contrary to their equity counterparts, actively managed taxable-bond funds have attracted a much greater share of investor interest. Over the trailing 12 months, they gathered $466 billion versus passive funds’ $350 billion. Bank-loan and inflation-protected bond funds added to their torrid first quarter, picking up $5.8 billion and $5.5 billion in April, respectively. The two categories experienced the highest organic growth rates within the category group for the year to date as investors sought fixed income funds that can better handle rising interest rates.

Morningstar debuted two new US category groups in April: Nontraditional equity and miscellaneous. These are spin-offs from the alternative category group, and they are intended to segregate more specific portions of the expansive alternative investments universe. Nontraditional equity contains long-short equity and derivative-income funds, strategies that go beyond traditional long-only investing but tend to maintain exposure to traditional market risks. The miscellaneous category group contains niche trading strategies, including leveraged and inverse (short) funds.

The alternative category group retains funds intended to serve as diversifiers with low correlations to broader markets, such as equity market- neutral and relative value arbitrage funds. Given their smaller sizes, absolute flows into these new category groups were modest relative to the others, but they posted some of the highest organic growth rates through the first four months of 2021. Investors may be seeking hedged or indirect exposure to markets given that equity indexes, such as the Morningstar US Large Cap Index, are at or near all-time highs and bond yields remain relatively low.

April’s list of funds with the most inflows includes a few oddities. Four American Funds offerings landed in the top 10, including American Funds Global Insight AGVDX, which gathered the second-most assets of all funds with $6.6 billion in inflows despite just an $8.0 billion asset base. Changes to American Funds’ target-date and model-portfolio allocations drove these changes. A pair of Jackson National funds used in variable annuity platforms also cracked the top 10, but these flows are likely due to fund restructurings rather than new investor dollars. 

© 2021 Morningstar Inc.

24 billion trades recorded on last January 27: Cerulli

As more self-directed investors enter financial markets in earnest, the demand for formal financial advice—and a willingness to pay for it—has increased, according to the latest Cerulli Edge—U.S. Retail Investor Edition. 

The infamous short-squeeze craze of 2021, fueled by a legion of Millennial and Gen-Z investors on Reddit, led to an average of 15 billion trades per day executed in January 2021, higher than the 10.9 billion trade average in 2020 (itself a 12-year high).

January 27, 2021 set a one-day record with 24 billion trades. Robinhood alone accounted for more than 25% of retail trades during this time, according to Bloomberg News.

The ease with which investors can trade on Robinhood has earned it a following among young investors eager to start investing. Yet the multitude of ways to engage in financial markets, from stocks and exchange-traded funds (ETFs) to options and short-squeezes, plus the gyrations of the markets in the past year, have led these investors to consider asking for formal help at an increased rate.

“Recent data collected indicates that self-directed investors are increasingly interested in formal financial assistance and willing to pay for that advice,” according to Scott Smith, director at Cerulli.

The “meme stock” craze of 1Q 2021 has some lessons for advisors, Cerulli said. “While these niche stocks accounted for less than 0.1% of market activity at the time, it highlights the need for advisors to keep tabs on how their clients consume and act on financial information, particularly on forums like Reddit,” said Smith.

Though the “democratization of finance” can be seen as a net positive for getting average investors engaged in the stock market with few barriers to entry, this freedom does not come without risk. As quickly as the “meme stocks” spiked, they fell just as fast. They have been volatile ever since, which can lead to large losses for investors who bought at inopportune moments.

While this should not necessarily lead advisors to dissuade their clients from making high-risk investments, it does become important for advisors to frame these market swings in the context of financial history and clients’ long-term goals in order to combat herding biases, according to Cerulli.

“Keeping abreast of the influences and influencers shaping discussions in public forums can help advisors frame these conversations on the clients’ terms while ensuring that the best laid financial plans are not squandered by temporary craze,” Smith said.

© 2021 RIJ Publishing LLC. All rights reserved.

Honorable Mention

Under proposed bill, non-profits could join PEPs

Senators Charles Grassley (R-Iowa), Maggie Hassan (D-N.H.), and James Lankford (R-Okla.) introduced a new bill this week, the “Improving Access to Retirement Savings Act.” The bill was immediately applauded by the Insured Retirement Institute, which advocates for the retirement industry.

The bill would encourage non-profit organizations to offer employee retirement benefits by providing those groups with the same access to pooled employer plans (PEPs) that the SECURE Act (Setting Every Community Up for Retirement Enhancement) offered to small businesses.

The measure also clarifies when a tax credit can be used by small businesses to help facilitate offering retirement plans to their employees if they join a multiple employer plan (MEP) or PEP. “This clarification will encourage more small businesses to offer a retirement plan and facilitate greater use of MEPs or PEPs as the means to provide that plan,” an IRI release said.

“The Improving Access to Retirement Savings Act complements the Securing a Stronger Retirement Act (HR 2954), which recently passed unanimously in the House Ways and Means Committee,” the release said.

NY ruling on Reg-187 could help life sales: AM Best 

AM Best, the ratings agency, believes life insurance companies’ regulatory burdens and costs could be eased by a recent court ruling overturning regulations geared toward increased consumer awareness in New York life insurance and annuity sales.

The state’s Supreme Court Appellate Division recently struck down the rules known as Regulation 187 as being “unconstitutionally vague.”

In a new Best’s Commentary, “Regulation 187 Overturned by Division of New York Supreme Court,” AM Best notes that the ruling also could lead to more life insurance sales, though New York regulators could still appeal the decision.

Regulation 187 had been in effect since August 2019 for annuities and February 2020 for life insurance. The regulation applied to sales transactions, as well as transactions involving in-force policies, to insure that such transactions or recommendations are in the best interest of the consumer and meet their financial objectives.

Regulation 187 identified suitability information needed at the time of transactions; defined the duties of producers—and of insurers where no producer is involved; and included insurer responsibilities and supervision requirements to assure compliance.

Fichtner named chief economist at Bipartisan Policy Center

The Bipartisan Policy Center announced this week that Jason Fichtner, Ph.D., will join BPC as vice president and chief economist.

Fichtner served in several positions at the Social Security Administration during the George W. Bush administration, including as deputy commissioner of Social Security, chief economist, and associate commissioner for retirement policy. He also worked as an economist with the IRS, Joint Economic Committee, and Mercatus Center, and has been a fellow with BPC for the past three years.

Fichtner is also a senior fellow with the Alliance for Lifetime Income and Retirement Income Institute and a research fellow with the University of Wisconsin-Madison Center for Financial Security. He also serves on the board of directors of the National Academy of Social Insurance as treasurer, the editorial advisory board of the Retirement Management Journal, and as a reviewer for the Journal of Pension Economics and Finance.

Fichtner is finishing the academic semester at the Johns Hopkins University School of Advanced International Studies, where he is a senior lecturer and an associate director of the Master of International Economics and Finance program. Throughout his academic career, he was also an adjunct professor at the Georgetown University McCourt School of Public Policy and the Virginia Tech Center for Public Administration and Policy.

His work has been featured in The Washington PostThe Wall Street JournalThe New York TimesInvestor’s Business DailyThe Los Angeles TimesThe Atlantic, and USA Today, as well as on broadcasts by PBS, NBC, and NPR. 

Thiel joins LifeYield’s board

Former Merrill Lynch executive John Thiel has been appointed to the fiduciary board of LifeYield, the provider of unified managed household (UMH) platforms.

As head of Wealth Management at Merrill Lynch, Thiel led the company’s shift into goals-based wealth management centered upon client outcomes. He currently sits on the boards of Franklin Templeton, FINRA Investor Education Foundation, the V Foundation, Decker Communications, and his alma mater, Florida State University.

As a senior advisor and partner at My Next Season, Thiel supports executives transitioning into retirement or new careers.

© 2021 RIJ Publishing LLC. All rights reserved.

Not Yet Legal in the US: CRITs

The 401(k) will continue to be the primary employer-provided private sector retirement savings program for the foreseeable future. Unfortunately, 401(k) plans are not designed to provide retirees with the steady lifetime retirement income they need.

Many participants would like to see income options in their 401(k) plans. Though employer plans can fulfill this role, to date most employers have expressed a reluctance to do so. Individuals are thus required to assume this challenge on their own.

Retirement income can be generated through pre-planned structured withdrawals from an investment portfolio, but this approach requires some investment expertise. It may not provide sustainable lifetime income nor does it offer longevity risk pooling, which can increase retirement income substantially.

Though an individual retiree can pool longevity risk by purchasing a guaranteed lifetime income annuity from an insurance company, these annuities are not popular. Many people consider them expensive relative to their benefits, especially in a low interest rate environment. Certain variable insurance products provide guaranteed minimum levels of income for life, but their fees can be high and they don’t pool longevity risk.

Welcome to CRITs

Collective Retirement Income Trusts (CRITs), though not currently allowed in the US under ERISA qualified plans or Individual Retirement Accounts (IRAs), offer an alternative for creating reliable income. CRITs, should they become permitted by law, would be established, administered and managed by financial institutions and open to anyone with retirement savings.

CRITs would work as follows: At or after retirement, investors would irrevocably transfer a portion of the assets in their employer plans or IRAs into a CRIT. The CRIT would pay the retiree a monthly income for as long as the CRIT has collective assets. The amount of the payments would be actuarially determined and subject to adjustments (increases or decreases) based on the actual mortality and investment experience under the CRIT.

These adjustments make certain that the CRIT does not run short of money but at the same time pays out actuarial gains to all retirees on a fair basis. Individuals could choose payments for life or for “life with a period certain.” (A 15-year period certain would likely result in a return of principal or more.) They could choose a single life contract or, to provide for another person, a joint-and-survivor contract.  

The CRIT would invest in a collective professionally managed balanced portfolio similar to a defined benefit pension fund. The retiree’s initial monthly benefit would be based on several factors: The amount of savings he or she transferred to the CRIT, an assumed investment rate of return based on the CRIT portfolio composition, the age of the retiree (and co-annuitant, if applicable), the assumed average life expectancy for the covered group (preferably gender-based), and the income option selected.

To allow the CRIT to pool longevity risk, CRIT participants may not withdraw money in a lump sum. Longevity risk pooling increases the benefits for all retirees. It anticipates the savings that will come as some participants die and forfeit their remaining savings to the fund. Retirees would not invest all their retirement savings in a CRIT. They would likely want to keep some funds for liquidity needs.

Unlike payments from traditional defined benefit plans and insured fixed income annuity contracts, the CRIT payments can fluctuate. The changes would reflect differences of the fund’s investment performance from the assumed rate of return and of the group’s actual mortality rate from its assumed mortality rate.

Additional changes to benefits might occur if it seems appropriate to adjust the future investment return or life expectancy assumption. A change in benefits might reflect changes in the investment environment or in the covered group’s life expectancy.

Available abroad, but not in US

To prevent large swings in benefit amounts (either up or down), benefit adjustments may be spread over several years. Note that the use of more conservative investment and life expectancy assumptions would reduce the size of the initial benefit but raise the likelihood of future benefit increases. A CRIT provider might also offer different sets of underlying investment portfolios. Highly risk-averse investors might select a conservative option. Those with more risk appetite could choose an aggressive option. 

In addition to longevity risk pooling, the CRIT can enhance retirement income in other ways. Professional investment managers may be able to achieve higher returns and lower expenses than individuals through access to investments not available to individuals. The CRIT might cost less to manufacture, administer, or distribute than an insurance product, and it would avoid the costs of the hedges that annuity issuers typically buy to protect themselves against adverse investment expense changes and mortality risk changes. In Canada, where such programs are newly being offered, studies show 25% higher payout rates from CRITs relative to insured fixed income annuities.   

CRITs are not currently available in the US. For CRITs to be allowed, a change in US pension law would be required. If they were allowed, the Treasury and Labor Departments would likely regulate them. Regulators would monitor overall CRIT operating expenses, asset holdings, investment return and life expectancy assumptions, and the methods used for adjusting benefit levels. Annual independent audits of the CRITs may also be appropriate.

While CRITs might compete with individual fixed income annuities, life insurers could be among the larger providers of CRITs. Life insurers would profit from administering them and would have no financial risk to reserve capital against, since retirees absorb all benefit level risk. While CRITs don’t guarantee investors against a drop in income, they are more likely than other risk-based income methods to produce steady income based on professional management in a collective diversified fund.

CRITs offer potential value to people who seek predictable lifetime income, who feel more comfortable letting professional institutions manage their retirement funds, who do not have access to unbiased outside expertise, and who do not participate in employer plans that offer retirement income options. Retirees in the Netherlands, Great Britain, Canada, and elsewhere are already benefiting from CRIT-type programs and plans, but Congress would have to amend US law before they could be offered to the public here.

Mark Shemtob, FSA MAAA MSPA FCA EA CFP,  can be reached at [email protected]

If the DOL Investigates You…

New Secretary of Labor Marty Walsh is known as a champion of the interests of working people, a group that retirement plan participants presumably belong to. His agency said in April that it might revisit the current “exemptions from prohibited transactions” for play advisers (Read FAQ 5, here).

But the former Boston mayor and former president of Laborers’ Union Local 223 seems more concerned about jobs these days than re-opening old debates over the meaning of “best interest” and “fiduciary” with respect to advising ERISA plan sponsors and participants.

So Registered Investment Advisors and broker-dealers have no special reason to fear a storm-surge of DOL investigations into the probity of their investment or rollover recommendations. The DOL will still launch investigations, however, and they’ll be as Kafka-esque as ever.

To help prepare advisers for what a DOL investigation might entail, the ERISA experts at the law firm of Faegre Drinker held a webinar two weeks ago. They offered answers to some of the most common concerns and apprehensions that advisory firms have about DOL investigations.

The bad news seems to be that cooperating with a DOL investigation can be distracting and time-consuming. The good news is that investigators prefer to arrive at amicable solutions that allow both sides to raise a flag and declare victory at the end.

What happens first, and how should I act?

“In most cases, you’ll receive a letter informing you that your organization is under investigation under ERISA, with regard to your advice to pension plans or 401(k)s,” said Faegre Drinker partner Josh Waldbesser, himself a former DOL investigator. “You’ll typically get a long list of document requests and a request for ‘voluntary cooperation.’ A letter might say, ‘Give us all communications to subject X.’”

His advice: Call your ERISA lawyer and stay calm. Many aspects of the investigation will be negotiable. That includes the scope of the investigation, the range of documents you need to produce, the amount of time you’ll be given to produce them, the people who will be interviewed and, when the time comes, the terms of the outcome.

“You can negotiate everything and you should,” said partner Phil Gutwein, noting that the DOL isn’t your friend, either. “Approach this as you would litigation. Think of the DOL as a plaintiff’s attorney. They have similar incentives to find a problem and to get certain results. You need to figure out something you can give them to end it. Position your response to get the result you want. Being strategic pays off in the end.”

What will the DOL investigators be looking for?

Their job, obviously, is to look for violations of the Employee Retirement Income Security Act of 1974, as ERISA is officially known. If your firm advises a retirement plan, the DOL will be looking for any evidence of prohibited transactions, such as the sale of your firm’s proprietary products. They’ll look at the plan’s Form 5500 for red-flag investments and for opaque fee arrangements. They’ll want to know if your firm is properly bonded.

“Their biggest focus will be on prohibited transactions and conflicts of interest,” Waldbesser said. “You can have an economic conflict, related to a proprietary product for example, that can easily be rectified. You may have a source of undisclosed compensation. Those are the things you want to have at front-of-mind.” 

“ESOPs [Employee Stock Ownership Plans] have been an enforcement priority for years,” said Brad Campbell, also a Faegre Drinker partner. “There are incentives within the DOL to investigate sales to participants and rollovers. We’ve seen a focus on fiduciary service providers, compensation for RIAs, proprietary goods or services, and managed accounts.” Gutwein added, “Sometimes the DOL finds something amiss at a plan sponsor, and then starts looking at the plan fiduciaries for sins of commission or omission.” 

“I often hear the question, ‘Does the DOL have a quota for finding violations? Or did we just get unlucky?’” Campbell said.

How can we not shoot ourselves in the foot?

Ask the agents why they’re investigating you. That will help you tailor your response and speed the resolution. “Don’t withhold anything and don’t volunteer anything—unless you want to volunteer low-hanging fruit,” Campbell said. Finding a violation, getting a correction, and closing the case is in everybody’s interest.

“They don’t want to read truckloads of documents any more than you want to produce them,” Waldbesser said. “Don’t wait until you can send them all of your documents. Send them the easy-to-reach documents right away, and the harder-to-reach documents later, when you can lay hands on them.”

If your firm is both an RIA and a broker-dealer, find out which one the DOL is interested in. Some practices are prohibited at one and not the other. “Ask the agents if they’re investigating the RIA or the B/D,” said Campbell. “If you can narrow it to the RIA, all the better. From the very beginning, negotiate the scope of the investigation and keep it as narrow as possible.”

Be cooperative, but “don’t invite them to go through our files,” said Faegre Drinker senior counsel Bruce Ashton. “Don’t be tempted to do a data dump. You must provide anything they ask for. Sometimes you can withhold things under attorney/client privilege. Some internal memos you may not want to provide.”

The worst thing you can do is not to cooperate with the investigation by ignoring requests.

How long is the investigation likely to take?

The initial phase, for fact-finding, is also the longest phase. “You can expect it to take months and it may drag out for years,” Waldbesser said. “You might receive a request for a document and then not hear from the DOL for a long time.”

Agents may be called away to other duties. Regional offices of the DOL may need to decide which region should lead the investigation. Don’t be surprised, or worried, if you don’t hear from them. “It’s not bad if there’s a long pause,” Campbell said. “Let sleeping investors lie. There’s no need to reach out to them.”

You may be asked to sign a tolling agreement to stop the statute-of-limitations clock from running down. If the DOL is going to file a lawsuit, there’s a rule that its fact-finding phase has to end at least six months prior to the filing. Delays may also occur because of jurisdictional overlap. If your company has offices in two different DOL districts, you might get calls from both districts, or have to wait until the two districts sort out who should investigate you.

What sort of resolution can I expect?

The vast majority of investigations do not wind up as law suits,” said Waldbesser, a former Chicago-based DOL investigator.

“There’s no ‘quota’ system per se, but the investigators are measured on performance. There are different ways the DOL measures that,” Campbell said. “They used to look at the rate of opening new cases, rather than opening ‘good’ or ‘likely’ cases. Then they looked at the number of cases closed with results.” If they find something simple, like inadequate bonding, and they can get a solution with action right away, they’re likely to take it. “Their fiscal year ends September 30, so there’s a lot of desire to wrap things up by then.”

“The DOL has a lot of authority, but if you don’t cooperate they’ll sue and they don’t want to have to do that,” Gutwein said. “That provides each side with an incentive to compromise. The DOL only has so many resources, so there’s a desire to resolve a case without more effort than necessary.”

© 2021 RIJ Publishing LLC. All rights reserved.