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Where’s the Scandal?

Posted on September 21, 2010 by Edward Jay Epstein -

The idea that Goldman Sachs, Citibank and other big banks duped Fed officials into buying their distressed pools of debt at 100 cents on the dollar has become a relentless part of the public post-mortem on the financial crisis of 2008.

To be sure, the New York Federal Reserve Bank, using a vehicle called Maiden Lane III, paid billions of dollars to 16 banks for collateralized debt obligations (CDOs) insured by AIG through credit default swaps, and canceled AIG’s contractual responsibility for that insurance. By doing so, the 16 banks got the plunging CDOs off their books and AIG got rid of an albatross around its neck.

But did the Fed really make a deal with the devil?

Opinion makers thought so. Describing the deal in the Times, Nobel laureate Paul Krugman wrote that “Taxpayers not only ended up honoring foolish promises made by other people, they ended up doing so at 100 cents on the dollar,” adding, “By making what was in effect a multibillion-dollar gift to Wall Street, policy makers undermined their own credibility—and put the broader economy at risk.”

Eliot Spitzer, the former governor of New York, was even more severe, terming the payments to the banks a “real disgrace.” And during the public hearings held by the Congressionally-appointed Financial Crisis Inquiry Commission in July 2010, commission member Brooksley Born expressed bitter indignation that Goldman Sachs was “100% recompensed on that deal” and that “the only people who were out money were the American public.”

Such charges neglected three pertinent facts. First, the Fed did not pay “100 cents on the dollar.” According to the Fed’s website, it paid $29.1 billion for CDOs with a face value of $62.1 billion, or about 48 cents on the dollar.

Second, U.S. taxpayers did not lose money on the CDOs. The Fed bought these securities very close to their price nadir in November 2008, and they rose in value with the bond rally in 2009 and 2010. In fact, as of September 8, 2010, the Fed has earned a $7.9 billion profit on them—at least on paper.

Third, the CDOs have continued repaying large amounts of principal and interest. To finance their acquisition, the Fed made a $24.3 billion loan to Maiden Lane III. So far the CDOs have paid back over $9.3 billion. At the current rate, the remaining loan will be repaid in less than four years. Meanwhile, the Fed earns interest of one percent above the London Interbank Offered Rate (LIBOR) on the loan.

The outrage over this deal has not focused on the supposed damage to the Fed, or even to American taxpayers. The outrage has been about the lack of damage the deal caused the 16 banks that had bought insurance on their CDOs. These 16 banks wound up getting back roughly their entire insured investment.

But not entirely at taxpayer’s expense. When the market value of the CDOs began plunging in July 2007, and their ratings were downgraded, AIG, which had issued their credit default swaps, had a contractual obligation to send them “collateral payments” equivalent to the drop in the CDO’s market value.

By November 2008, though AIG teetered on bankruptcy from making these payments, the 16 banks’ actual exposure on the CDOs was only their depressed market value. When the Fed bought back the CDOs at their market value, the banks got back what remained of their insured investment.

As Macaulay observed, the Puritans objected to the sport of bearbaiting not because it hurt the bear but because it gave pleasure to spectators. In the Fed bailout, the critics complained that the banks, especially Goldman Sachs, did not suffer enough pain.

Critics pointed out, correctly, that the U.S. government had the power to force the banks that received TARP funds to accept less than market value for the CDOs—or take a “haircut,” in the parlance of Wall Street. Such a haircut would have allowed the Fed to earn even more than it eventually did on the appreciation of the CDOs. AIG, which was the Fed’s junior partner in the profits of Maiden Lane III and is now 79.8% owned by the U.S., would have benefited as well.

But such an accommodation, if it took place, would have required the agreement of all 16 banks, raising a problem. Twelve of the 16 banks were foreign-owned and held approximately two-thirds of the AIG-insured CDOs. These banks had little incentive to accept anything below the market price for their CDOs because their AIG insurance coverage was still in force.

Indeed, the French bank Société Générale SA, which was the single largest holder of AIG-insured CDOs, informed the Fed that its regulators in France would not permit it to sell the CDOs below their market value and that it could not legally accept a haircut as long as AIG was solvent. This position, which other European banks took, ruled out a voluntary haircut.

The Fed could still have exercised the nuclear option: letting AIG go bankrupt. But such a move would have released the evils of a Pandora’s box—not because AIG, with a trillion dollars in assets, was too big to fail, but because it was too interwoven into the fabric of the global financial system.

AIG’s subsidiaries, operating in 130 countries, insured a large part of the commerce flowing between China, North America and Europe. Their seizure by state and government regulatory authorities could have paralyzed world trade and caused a panic among the insured. In the U.S. alone, AIG insured 30 million people. The billions of dollars worth of state and local funds in its guaranteed investment programs would have been frozen.

An AIG bankruptcy could cause an even greater financial crisis abroad. European banks depended on AIG’s French subsidiary, Banque AIG, for the “regulatory capital” they needed to meet government-mandated capital-to-debt ratios. AIG performed this feat through complex derivative swaps. A bankruptcy, or even change of ownership in Banque AIG, would require major European banks to call in hundreds of billions of dollars in loans.

Rather than risk financial Armageddon, the U.S. government decided to save AIG. The Fed now could hardly threaten to put AIG into bankruptcy to pressure the banks to take a haircut. So Goldman Sachs, Société Générale, Citibank, JP Morgan Chase and the other counter parties won their huge bet on CDOs. They bet not merely on the securities, or even on AIG’s solvency, but that, even if AIG’s obligations exceeded its means, the U.S. government would not allow AIG to fail. That assessment was correct.

But the Fed, which financed the purchase of the CDOs from the banks, also did not lose. The market price that the Fed paid for the CDOs at the depths of the crisis—48 cents on the dollar— turned out to be much less than their actual value. So the Fed now stands to make a multi-billion dollar profit.

AIG of course lost heavily, with the U.S. Treasury getting almost 80% of the company. But that is the consequence of a bad bet: that CDOs would not be downgraded and plunge in value. Whether or not the U.S. recoups its investment in AIG is still an open question. But, by saving AIG, the Fed prevented the collapse of the international financial system. So where is the scandal?

Quote of the Week

Posted on September 16, 2010 by Editor Test -

The Pros and Cons of 401(k) Annuities

Posted on September 16, 2010 by Editor Test -

The prominence of the witnesses testified to the significance of the DoL/Treasury Department hearings this week on so-called “401k annuities” and other tools that can help plan participants turn their savings into income–either while they save, when they reach retirement, or in retirement.

Delegates from the retirement industry’s A-list made statements, including (in addition to those mentioned in today’s cover story) JP Morgan, TIAA-CREF, Lincoln Financial Group, Great-West Life, Dow Chemical, Honeywell, Hueler Companies, Vanguard, Nataxis Global Asset Management, Financial Engines, and consultants Towers Watson, Milliman, and Hewitt.

Many of these companies have introduced in-plan income products already. TIAA-CREF pioneered the group variable annuity in the 1950s. Vanguard and Hueler announced an agreement last week to give Vanguard IRA owners access to Hueler’s online SPIA supermarket, which provides institutionally priced income annuities to participants in 1,200 plan.

Prudential Retirement and Great-West offer stand-alone guaranteed lifetime income riders to participants with target-date funds. Financial Engines expects to offer an in-plan option in late 2010 or early 2011. Asset managers Vanguard, Fidelity, Putnam and Russell all sell payout mutual funds, which deliver predictable but non-guaranteed income streams.

Trade, labor, and consumer advocacy groups also contributed their thoughts. The AFL-CIO, the Investment Company Institute, the Profit-Sharing and 401(k) Council of America, the American Council of Life Insurers, the American Society of Pension Professionals and Actuaries and the Spark Institute all gave testimony. Other groups and firms can contribute statements via e-mail over the next month.

Some witnesses praised in-plan annuities, while others, like Steve Utkus of Vanguard, tried to bury them. To be sure, there are plenty of good reasons for putting income options in plans, either as savings vehicles (deferred annuities) or exit options (immediate annuities, payout funds).

Big plan sponsors have economies of scale and bargaining power that lower the costs of products, administration, and education. Plan sponsors are also in a unique position to set up a program that applies the employer match to the purchase of future income—a path that MetLife and Mutual of Omaha are pursuing. Like contributions to a defined benefit plan, that kind of program would leverage the time value of money and mitigate the interest rate risk and timing risk associated with the lump sum purchase of an annuity at retirement.

Counter-arguments

But there are plenty of many counter-arguments for putting annuities in DC plans. For plan sponsors, there are potentially huge expenses associated with evaluating the costs and benefits of different income product vendors and in educating employees. Above, all liability for picking the wrong provider or for giving employers bad (in retrospect) advice scares them. “Fiduciaries are paranoid and rightly so,” says Sheldon Smith, an ERISA attorney and president of ASPPA.

As for participants, most of them won’t retire from their current employer/plan sponsor. From the participant perspective, the average person spends only 4.2 years in any particular job and might participate in several 401(k) plans. There are also portability issues. Participants may want to change employers or get out of income products. Employers may want to change annuity providers.

Adapting recordkeeping systems to multiple income options, or options that might change suddenly, could also pose problems, especially for small employers. Ninety-percent of plans have fewer than 100 participants. Only the largest 10% of plans, which account for 85% of all participants, may be able to cope with the legal, educational, and recordkeeping challenges of in-plan options.

Other problems: most 401(k) accounts, even at retirement, are too small to annuitize at all, let alone big enough to allow for the ideal solution: partial annuitization. Annuity purchases can also trigger the need for spousal approval, potentially increasing paperwork for sponsors. Gender-neutral pricing rules in 401(k) plans also mean that retail annuities, which have gender-specific pricing, can offer men much higher payout rates than in-plan annuities.

Alternate vision

The zeal for putting guaranteed income options in DC plans is limited mainly to insurers. Asset managers like Vanguard and Fidelity, which are the custodians of millions of rollover IRAs, believe that most people will consolidate their tax-deferred savings in an IRAs and then buy an annuity—or simply take systematic withdrawals. Investment advisors think along the same lines, and millions of Americans are likely to take this path.

Even if you build in-plan annuities, will they come? There’s a lot of disagreement over whether Americans want in-plan annuity options. Even in DB plans, 90% of retirees who have the option choose lump sum payouts over lifetime income streams. Shlomo Benartzi of UCLA, and an Allianz Life consultant, cited evidence of high annuitization rates in some companies, and MetLife said participants like a partial annuitization option. But the evidence is inconsistent. Most people don’t want to give up control over their assets or even part of their assets, especially not at time they stop working, when their retirement plans are still unsettled.

There’s also the crowding-out problem. Thanks to Social Security, most middle-class plan participants will get at least half of their retirement income coming from an annuity, and have no compelling reason to annuitize their DC savings. On the contrary, they may need their DC assets to stay liquid for emergencies, bequests, weddings or simply long-deferred pleasures.

To overcome this resistance or inertia, some witnesses said, the government might have to approve a qualified default annuity option, analogous to auto-enrollment and the qualified default investment options in 401(k) plans. One witness, Josh Shapiro of the National Coordinating Committee for Multiemployer Plans, asserted that nothing short of mandatory annuitization of DC assets at retirement will really change the game. The DoL and Treasury, as well as sponsors and plan providers, have already ruled that out.

In Search of Safe Harbors

Posted on September 15, 2010 by Editor Test -

Of the many gnarly reasons why so few 401(k) participants have access to ‘in-plan’ lifetime income solutions, the biggest obstacle may be the plan sponsor’s fear of lawsuits from participants if the sponsor’s chosen annuity provider ever went broke.

“The fiduciary issue is so daunting that it ends the conversation,” said David Wray, the director of the Profit Sharing and 401(k) Council of America, a trade group for plan sponsors. “Sponsors ask, ‘We’re guaranteeing payments for 30 or 35 years?’ It stops the conversation. It’s a wall.”

It’s a wall that executives at many insurers and other financial services firms would love to see breached or demolished. That’s why so many of them told a Department of Labor panel Tuesday that the DoL should identify a process or path—a ‘safe harbor’—by which they could choose an annuity provider without liability.

“The government has to stand behind us when we stand behind a decision,” Wray said. “There has to be confidence that someone will make sure the annuity payments keep coming, and it’s not the employer.” Lest the panel miss his point, he added, “If one of these programs goes down, the political fallout will be significant.”

“Fiduciaries are paranoid and rightly so,” says Sheldon Smith, an ERISA attorney and president of ASPPA.

A safe harbor already exists, but plan sponsors and others say it leaves many questions unanswered. Is the fiduciary duty the same for all types of income products, guaranteed and non-guaranteed? How often would the company have to check the strength of the provider? Can companies change their minds and switch providers without exposure to liability?

Insurers say that their strength ratings are available for anyone to see. But, in the wake of the financial crisis, sponsors aren’t so sure they can rely on the ratings agencies or the oversight of state insurance commissioners.

Aside from a clearer fiduciary standard, insurers, asset managers and others asked the Departments of Labor and Treasury for the following:

Provide safe harbor for advice about retirement income. Plan sponsors want to see the rules on investment advice broadened, so that sponsors can educate participants about retirement income options without future liability for poor participant choices, and so that sponsors can use plan assets to pay for the education.

Encourage partial annuitization. One of the big obstacles, real or perceived, to the use of income annuities is that participants can’t annuitize part of their plan assets or don’t know that they can choose to annuitize only a portion of their assets. Witnesses asked the government to work to encourage partial annuitization.

Provide guidance on expressing savings as retirement income in participant statements and websites. Many witnesses argued that showing plan participants how much retirement income their plan assets will buy, instead of just showing them their current account balance, would motivate people to save more and help them appreciate that their account’s purpose is to provide retirement income, not wealth accumulation. They requested DoL guidelines for providing such illustrations in a compliant way. Since so many variables go into making projections about retirement income, that won’t be easy, however.

Eight Ways to Simplify Retirement Accounts

Posted on September 15, 2010 by Editor Test -

The sections of the tax code that cover tax-deferred and tax-exempt savings programs are a mess—well intentioned perhaps, but a mess. Stop somebody on the street and ask him to explain the tax treatment of Roth IRA withdrawals. You might as well ask directions to Maracaibo.

People in high places have been thinking about cleaning up this mess. A thick new whitepaper called “The Report on Tax Reform Options: Simplification, Compliance, and Corporate Taxation,” includes at least eight ways to rationalize the rules governing the hodge-podge of programs that we know as IRAs, FSAs, HSAs, 401(k)s, 403(b)s, 529s, SIMPLE-IRAs, SARSEPs, etc.

The report contains both good and bad news. The good news is that lots of interesting alternatives to the status quo exist—like making contribution limits the same for on IRAs and 401(k)s, or letting half the people skip their Required Minimum Distributions.

The bad news is that any change the tax law will inevitably gore somebody’s ox. What one person sees as the elimination of a wasteful and ineffective tax incentive will strike other people as a confiscatory tax hike. And no matter what happens, unintended consequences are likely follow.

But something apparently needs to be done. According to the report, the government “spends” $118 billion a year on tax-deferred retirement, health care and education accounts, but the wrong people are using them. Of the $118 billion in uncollected taxes, 84% stays with people who make $100,000 or more a year. That’s not the kind of social engineering this administration is aiming for.

Here are the eight suggestions:

Consolidate Retirement Accounts and Harmonize Statutory Requirements. There’s currently a hodge-podge of related but distinct tax-deferred or tax-exempt savings programs in the tax code, from 401(k)s and 403(b)s to 529s, from IRAs to FSAs and HSAs, and from SIMPLE plans to SARSEPs. They have different rules regarding eligibility, contribution limits, and withdrawals.
Integrate IRA and 401(k)-type Contribution Limits and Disallow Nondeductible Contributions. The advisory board suggested raising the limits on deductible contributions to IRAs (currently $5,000 a year) to the same level as the limit on 401(k) plans. This would eliminate a lot of paperwork for people who currently make IRA contributions that exceed the $5,000 limit. On the other hand, it might reduce tax receipts and would disproportionately favor high-earners.
Restrict use of IRA assets for non-retirement purposes. One of the redundancies of the current system is that people can use the money in their IRAs for certain medical or educational expenses instead of retirement. The advisory board recommends imposing strict limits on the use of funds in retirement saving accounts for non-retirement purposes. Taxpayers would instead be encouraged to use 529 Plans for college savings and HSAs or FSAs for medical bills.
Clarify and Improve Saving Incentives. The report proposes an expansion of the existing Saver’s Credit to a match from the government as an incentive to low-income workers to save. The existing credit offers a tax deduction, which doesn’t help low-income workers. The report also proposes an “automatic IRA” rule, which would require employers in business for at least two years and with more than ten employees to default their employees into an IRA and start deducting contributions from their payroll. Employees could drop out of the program if they wished.
Reduce Retirement Account Leakage. Under current rules, it’s relatively easy for people to squander their tax-deferred savings by spending them when they change jobs or by borrowing against them and not re-paying the loans before they change jobs. The report suggested restricting access to 401(k) and IRA money, but acknowledged that restrictions would create paperwork for employers and hardship for some employees.
Relax non-discrimination rules for small plans. Many owners of small companies are discouraged from offering their workforce a 401(k) plan because the rules limit their ability to discriminate in favor of their most-valued employees by contributing more for them than for rank-and-file workers. One solution would be to replace existing non-discrimination rules and apply the rules associated with SIMPLE 401(k) plans.
Eliminate RMDs for small accounts. Eliminating the distribution requirement for those with tax-deferred savings under $50,000 relieve would eliminate the burden of calculating RMDs for half of retirement account owners over age 70½, while exempting only 6% of retirement assets from taxation each year. Today, retirees over age 70½ must multiply their tax-deferred assets by an age-specific factor to determine the amount of savings they must remove from their tax-deferred account(s) and pay taxes on. For people with several tax-favored accounts, the calculation and the decision regarding which account to tap for the distribution can be complicated. One caveat: People with small accounts are the ones most likely to be in circumstances that force them to take distributions each year, whether required or not.
End the ‘Curse of the MAGI.’ Today, retirees must fill out an 18-line worksheet to calculate the percentage of their benefits is subject to income tax. Much of the complexity comes from having to determine whether zero, 50% or 85% of benefits should be included in modified adjusted taxable income (MAGI). The panel suggested a return to pre-1993 system of taxing Social Security benefits and other income separately.

Conservatives might bridle at the suggestion that people in higher tax brackets shouldn’t reap most of the benefits of tax deferral or exemption, or that a tax break is a “cost” and that a failure to collect taxes is equivalent to an expense for the American people. As we’ve seen in the debate over extending the Bush tax cuts, they regard the closure of a tax break as a tax hike.

But there’s a Democrat in the White House, and his administration holds the liberal viewpoint that tax breaks should either pay for themselves by helping to achieve a public policy goal—in this case, by encouraging people who make under $100,000 to save more—or be eliminated. It would probably be politically impossible to eliminate popular tax breaks; a judicious pruning or tweaking might be the only option.

Making a Case for the 401(k) Annuity

Posted on September 14, 2010 by Kerry Pechter -

There’s upwards of $4 trillion in defined contribution plans, and lots of insurers like MetLife, Prudential, and AVIVA and asset managers like Putnam, Russell, and Fidelity Investments sell products that can help participants turn those assets into lifetime income.

To date, relatively few plans offer those products as in-plan ioptions. Plan sponsors don’t want lawsuits from long-departed employees if their chosen annuity issuer fails in 10 or 20 years. And plan participants haven’t exactly been clamoring for annuities.

But the biggest, most innovative 401(k) providers are gearing up for in-plan options. And, with Social Security facing lean years, the Obama administration seems willing to clear away existing regulatory hurdles and help people convert their 401(k)s to lifetime income.

Those vectors intersected in Washington earlier this week, during two days of hearings on in-plan options, hosted by the Departments of Labor and Treasury. The hearings themselves were a sequel to the Request for Information about in-plan options that the DoL and Treasury issued last spring, which elicited a huge response from the financial services industry—and from paranoids who think they see a federal plot to follow Argentina’s example and confiscate private retirement assets.

The hearings were rewardingly comprehensive, but they had a central theme. Many financial services companies want the DoL to create a “safe harbor” for in-plan income products. They want the DoL to bless a due diligence process that, if followed, will enable plan sponsors to choose annuity vendors without fear of participant lawsuits if the vendor—a life insurance company, in most cases—fails. A safe harbor may already exist, but it’s too full of legal loopholes to make most sponsors feel immune to litigation.

It’s too soon to say what will happen. It appears—though no one said it explicitly—that the DoL would like to see middle-class plan participants have access to a variety of low-cost, transparent payout options that they can easily compare. Income product providers presumably want to compete for exclusive or semi-exclusive plan sponsor relationships, and to focus (unavoidably) on participants with big balances. The interests of populism and private enterprise overlap here, but they don’t dovetail.

Depending on a lot of factors—future interest rates, the path of economic recovery, the outcome of the 2012 presidential election—this week’s hearing could mark a turning point in how Americans fund their retirement. One speaker called this a “key juncture” for the DoL. Or its reams of documents could be headed for the shredder.

Vanguard Launches New Index ETFs

Posted on September 14, 2010 by Editor Test -

Vanguard has introduced eight new index mutual funds and nine new exchange-traded funds (ETFs) based on S&P domestic stock benchmarks, including an S&P 500 Index ETF with an expense ratio of only six basis points, an industry low for that type of ETF.

With the expansion, Vanguard offers 55 ETFs, including eight new equity funds as well as ETFs targeting the growth and value segments of the S&P 500 Index and the growth, value, and blend segments of the S&P MidCap 400 and SmallCap 600 Indexes.

Vanguard’s $23 billion in ETF net cash flow through August led the industry. Cash flow into Vanguard’s equity ETFs has been particularly strong, accounting for 74% of Vanguard’s total ETF cash flow and 51% of the industry’s equity ETF positive cash flow, according to Bloomberg. Vanguard’s ETF assets under management have jumped 60% since August 2009, rising from $71 billion to $113 billion.

In the coming months, Vanguard plans to introduce 11 additional index funds with ETF Shares. On the equity side, Vanguard will add a suite of seven funds with ETF Shares to offer exposure to value, growth, and blend segments of the U.S. stock market based on the large-cap Russell 1000 Index series and the small-cap Russell 2000 Index series. A broad market fund and ETF seeking to track the Russell 3000 Index will also be offered.

On the bond side, Vanguard will offer three new municipal bond index funds with traditional and exchange-traded shares, tracking benchmarks in the S&P National AMT-Free Municipal Bond Index series. The expense ratio for Vanguard’s new municipal ETFs is estimated to be 0.12%.

Vanguard has also filed for a new real estate fund, which will be benchmarked to the S&P Global ex-U.S. Property Index. Vanguard Global ex-U.S. Real Estate Index Fund will offer Investor Shares, Institutional Shares, Signal Shares, and ETF Shares.

These planned products will bring Vanguard’s ETF stable to 66 offerings, including suites of domestic stock ETFs based on benchmarks from MSCI, S&P, and Russell.

The Six Emotional Stages of Retirement

Posted on September 14, 2010 by Editor Test -

Americans’ attitudes, ambitions and preparation for retirement have changed dramatically as a result of the recession. Five years after introducing the stages of retirement With its recent study, New Retirement Mindscape II, Ameriprise Financial revisited its 2005 New Retirement Mindscape study to take the emotional pulse of people approaching and in retirement.

The findings register the impact of the financial crisis, he difficult economic environment has had on people. In 2005, the U.S. economy was riding a prosperous high. “Five years later our society is in a very different place, and as a result, consumers are approaching retirement with a different mindset,” said Craig Brimhall, vice president of retirement wealth strategies at Ameriprise Financial.

“The years leading up to retirement used to be filled with a sense of excited anticipation, but now we are seeing people hesitate and really question if they are making the right decision. And in the first year of retirement, a stage once synonymous with feelings of liberation, consumers are facing new doubts, concerns and the reality that retirement may not be what they expected,” he said.

Based on telephone interviews with 2,000 U.S. adults ages 40 to 75 last May, The New Retirement Mindscape II^SM study identified six distinct attitudinal and behavioral stages that occur before and during retirement:

1) Imagination, 6-15 years before retirement

2) Hesitation, 3-5 years before retirement

3) Anticipation, 2 years before retirement

4) Realization, first year of retirement

5) Reorientation, 2-15 years after retirement

6) Reconciliation, 16+ years after retirement

Stage 1: Imagination (six to 15 years prior to retirement) – People in this earliest stage preceding retirement are less “hopeful” (71% vs. 81%) and “optimistic” (72% vs. 77%) than they were in 2005. But 84% feel “happy” and 70% feel “enthusiastic” about retirement, perhaps because they still have time to recover from the recession.

Stage 2: Hesitation (three to five years prior to retirement) –Significantly fewer in the Hesitation stage expect to feel “happy” in retirement than did so in 2005 (82% vs. 92%). Probably because of job setbacks and conflicting financial priorities, fewer in this group have set aside less money in employer-sponsored plans or taxable accounts than in 2005 (74% vs. 91%). They are less likely than those in the Anticipation stage to expect to greatly enjoy retirement (64% vs. 75%) or to save in non-retirement accounts (67% vs. 83%).

Stage 3: Anticipation (two years prior to retirement) – Excitement begins to build in the final two years before retirement day. People in the Anticipation stage are likely to feel “on track” for retirement (77%), possibly because they are also the most likely to be saving and investing (83%) and working with a financial advisor (54%).

Stage 4: Realization (retirement day to one year following) –The optimism and excitement that accompanied this stage five years ago have been muted by the recession. With sharp declines in the value of portfolios, as well as “forced retirements” due to layoffs and career setbacks, many people are struggling. Compared to 2005, far fewer enjoy retirement “a great deal” (56% vs. 78%), say they live their dream (45% vs. 68%) or feel that retirement has worked out as they planned (57% vs. 77%).

Stage 5: Reorientation (two to 15 years after retirement) – Most people enter the Reorientation stage feeling more “happy” (80%) and “on track” for retirement (69%) than in previous stages. They continue to enjoy having “control over their time,” even more than in 2005. More set aside money for retirement (83% vs. 72%) and are working with a financial advisor (43% vs. 34%).

Stage 6: Reconciliation (16 or more years after retirement) – Most people in the Reconciliation stage feel “happy” (80%), but they report more depression than in 2005 (20% vs. 5%). Troubled by the loss of income and social connections, only 56% say they enjoy retirement “a great deal” (56%), compared with 75% five years ago.

9 in 10 VAs Sold With Living Benefits

Posted on September 14, 2010 by Editor Test -

Guaranteed Living Benefit (GLB) riders were elected in variable annuities (VA) generating $20.3 billion of new deferred VA premium in the second quarter, an 18% increase over the first quarter, according to LIMRA’s second quarter study, which represents 95% of the variable annuity GLB industry.

“Guaranteed living benefits remain extremely popular in this uncertain market as consumers seek financial security for their retirement,” said Dan Beatrice, senior analyst, LIMRA Retirement Research. “We believe the GLBs will continue to be an important driver of variable annuity sales in the foreseeable future.”

For the third consecutive quarter, GLBs were elected 87% of the time when any GLB is available for purchase. The guaranteed lifetime withdrawal benefit (GLWB) election rate remained at 64%. Guaranteed minimum income benefit (GMIB) riders were elected 17% of the time; while, guaranteed minimum accumulation benefit (GMAB) and guaranteed minimum withdrawal (GMWB) each had a three percent election rate in the second quarter of 2010.

LIMRA estimates that GLBs were available in contracts generating $23.2 billion of new deferred VA premium during the second quarter. VA assets with GLB decreased three percent from $440 billion in the first quarter of 2010 to $427 billion at the end of the second quarter of 2010; and total VA assets dropped five percent from $1.433 trillion to $1.358 trillion during the same period.

The rate at which any GLB was elected increased one percent in the career distribution (75%) and bank channels (92%); while independent (90%) and wirehouse (90%) channels remained steady.

LIMRA’s Variable Annuity Guaranteed Living Benefit Election Tracking Survey collects VA GLB sales, election rates and assets on a quarterly basis. The 27 survey participants represent 95% of second quarter 2010 industry sales in which a GLB was elected.

Banks Selling More VAs, Mutual Funds

Posted on September 14, 2010 by Editor Test -

U.S. banks saw solid increases in variable annuity and mutual fund revenue for the first half of 2010 but a drop in fixed annuity revenue, National Underwriter reported.

Bank variable annuity revenue was 16% higher during the first half than it was during the first half of 2009, and bank mutual fund revenue was 31% higher, according to Kehrer-LIMRA, a unit of LIMRA, Windsor, Conn. Bank fixed annuity revenue was 27% lower.

The Kehrer-LIMRA report includes 56 banks and credit unions that account for about 40% of the investment revenue at smaller financial institutions.

Investment sales revenue per bank rep fell 37% between 2008 and 2009. During the first half of 2010, bank rep productivity has been 32% higher than it was during the comparable period in 2009.

Similarly, new investment sales revenue per dedicated bank financial rep fell 10% between 2008 and 2009, but that productivity indicator has been 7% higher in the first half of the current year than in the first half of 2009.

Bank investment income per $1 million in total bank revenue fell 12% in 2008, but median investment program revenue increased 5%. That means investment program revenue increased at a majority of the banks, Kehrer-LIMRA says.

For all of 2009, fixed annuity revenue was down 25%, variable annuity revenue was down 21%, and life insurance revenue was up 15%.

Expect Three New Regs by Year-End

Posted on September 14, 2010 by Editor Test -

The Department of Labor has reported that it has three new sets of guidance at the Office of Management and Budget, which suggests that all three will be issued before the end of the year, says Fred Reish, an ERISA expert and managing director, Reish & Reicher, a Los Angeles law firm. “This fall promises to be interesting,” he noted.

• New TDF disclosures. This regulation that would impose new disclosure requirements on target date funds in order to qualify as QDIAs and to obtain the fiduciary safe harbor for defaulted participants. When effective, this will require that additional, meaningful information be given to the participants preceding default. (As a practical matter, participants who elect those investments will be given the same information).

• Fee disclosure regulation for participants. This rule was issued in proposed form by the Bush Administration, but was never finalized. The new Administration has picked up that regulation and developed a final regulation. While DOL speakers are giving little specific information, it appears that the regulation will be similar to the proposal. The burden for complying with the regulation will primarily fall upon recordkeepers and bundled providers.

• An expanded definition of fiduciary. There is little in the way of information about the contents of the regulation. However, it seems clear that it will expand the definition of fiduciary advice and that more financial advisers and investment advisers/consultants will be considered to be fiduciaries. Depending on how far that definition is expanded, it could have a major impact on broker-dealers.

Quote of the Week

Posted on September 14, 2010 by Editor Test -

“The automatic annuitization of retirement balances could help workers achieve a steady stream of income that is guaranteed for life.” From The Report on Tax Reform Options, issued by The President’s Economic Recovery Advisory Board in August 2010.

Jefferson National Offers DFA Funds

Posted on September 8, 2010 by Editor Test -

Jefferson National, issuer a flat $20/month insurance fee variable annuity, now offers access to funds from Dimensional Fund Advisors. Dimensional’s funds are available tax-deferred to financial advisors who use Jefferson National’s Monument Advisor, the number one RIA-sold VA for three consecutive years according to Morningstar VARDS Data.

Through the new offering, advisors can access six funds:

VA Global Bond Portfolio
VA US Targeted Value Portfolio
VA US Large Value Portfolio
VA International Small Portfolio
VA Short-Term Fixed Portfolio
VA International Value Portfolio

Jefferson National’s Monument Advisor offers more than 250 investment options, or five times the number offered by most VAs, the company said, including the most subaccounts with the Five Star and Four Star Morningstar Rating for a second consecutive year.

According to Cerulli Associates, the fee-based advisory market is one of the fastest-growing segments in the financial industry, with assets topping more than $7.2 trillion as of 2008,and more than 65% of brokers surveyed said they would be interested in going independent.

SIFMA Urges Uniform Standard for Advisors, Brokers

Posted on September 8, 2010 by Editor Test -

The Securities Industry and Financial Markets Association (SIFMA) has submitted comments to the Securities and Exchange Commission (SEC) in advance of its study on the obligations of investment advisers and broker dealers.

In comments to the SEC, SIFMA highlighted the following key principles the Commission should focus on during their six month study:

• The interests of individual investors should be put first. When providing personalized investment advice to individual investors, broker-dealers and investment advisers should deal fairly with clients.

• Broker-dealers and investment advisers should appropriately manage conflict of interest by providing individual investors with full disclosure that is simple and clear and allows them to make informed investment decisions.

• Individual investors should continue to have access to a wide range of investment products and services, a choice among financial service provider relationships and options for paying for financial services and products.

• Any standard of conduct adopted by the SEC should reduce confusion about existing legal and regulatory regimes by being the exclusive uniform standard that applies to broker-dealers and investment advisers when providing personalized investment advice about securities to individual investors.

In addition, SIFMA requested that the SEC ensure that broker-dealers be able to provide individual investors with best execution and liquidity as principal and offer proprietary and affiliated products that certain investors desire. As noted in the letter, broker-dealers offer a variety of products on a principal basis, including fixed-income products such as municipal bonds, initial public offerings and other underwritten offerings.

The comment letter can be found at the following link: http://www.sifma.org/assets/0/232/234/124802/bcb2b9b1-5a0f-4f20-bda3-690160807abb.pdf.

Fitch Deems Life Insurers “Stable”

Posted on September 8, 2010 by Editor Test -

Fitch Ratings has upgraded the outlook for the U.S. life insurance sector to stable from negative. The negative outlook was initially assigned in September 2008. A stable outlook for the sector indicates that Fitch believes a vast majority of insurer ratings will be affirmed as they are reviewed over the next 12-18 months.

A special report published today, ‘U.S. Life Insurance Sector: Outlook Revised to Stable’ is available at www.fitchratings.com.

Over the next 12-18 months, Fitch’s primary rating concerns for life insurers include:

Uncertainty over the economic outlook and the potential for a double-dip recession.
Higher-than-expected losses on commercial real estate (CRE) related assets.
Emerging interest rate risk due to historically low interest rates, which are having an impact on industry investment yields, and uncertainty regarding the direction of future interest rates.

The Stable Rating Outlook for the U.S. life insurance sector reflects the industry’s improved balance sheet and operating fundamentals. Fitch notes that sustained improvements in investment valuations and financial market liquidity has resulted in a significant reduction in investment losses, and allowed the industry to raise capital and fund near-term maturities.

Fitch expects that favorable trends in industry earnings performance and investment results in 2010 will continue over the near term, but will continue to lag pre-crisis results due to the lower interest rate environment and steps taken by the industry to lower risk in the investment portfolio by reducing investment allocations away from higher risk, higher return asset classes.

Results in 2010 have benefited from improved interest margins, higher equity market valuations (relative to prior year), and the aforementioned decline in investment losses. Fitch expects the industry’s large in-force variable annuity business to be a drag on profitability over the near term, and could cause a material hit to industry earnings and capital in an unexpected, but still possible, severe stress scenario.

Fitch views the passage of the Dodd-Frank bill earlier this year as credit neutral for life insurers but recognizes that uncertainties remain over the interpretation of several aspects of the bill. Primary concerns include the potential designation as a systemically important non-bank financial institution and its implications, and the uncertain impact on industry sales practices, particularly for registered products.

The outlook revision also considers the positive steps taken by a number of life companies to de-risk their product offerings, reduce reliance on institutional funding sources, and strengthen hedging and other risk mitigation programs.

Since the September 2008 shift of Fitch’s U.S. life insurance industry rating outlook to negative, Fitch has downgraded 35 out of 55 rated U.S. life insurance groups one or more times. Over the same time period, Fitch has upgraded two U.S. life insurance groups. The large majority of the rating downgrades during this period were limited to one to two notches. While ratings of U.S. life insurers have been broadly affected by the financial crisis, the limited magnitude of the rating downgrades reflected the industry’s relatively stable liability structure and strong capital position going into the credit downturn.

Fitch’s sector outlook assumes a continued, albeit weak, economic recovery with modest GDP growth and continued high unemployment levels. Fitch’s outlook does not incorporate exogenous shocks to the economy, and will factor in such events should they occur. Fitch’s expectation for CRE-related investment losses are closely tied to Fitch’s economic assumptions. Fitch continues to believe that the industry’s CRE-related loss exposure is manageable and has been reasonably factored into existing ratings under Fitch’s stress testing methodology.

From the perspective of interest rate risk, over the near term, minimum rate guarantees incorporated in the policyholder accounts of the U.S. life insurance industry will limit the ability of life insurers to maintain interest margins due to low investment yields. Longer term, Fitch is concerned that strategies that life insurers may be using to reach for additional yield will make them vulnerable to disintermediation and asset-liability mismatches in a rapidly rising interest rate environment. Such strategies could include extending portfolio durations and asset-liability mismatches, accepting higher levels of lower rated securities, and amassing sector concentrations.

By Another Name, Annuities Would Smell Sweeter

Posted on September 8, 2010 by Editor Test -

Even though most people like the annuity concept, more than half (53%) of Americans aged 44-75 expressed distaste for the word “annuity”, according to a survey from Allianz Life Insurance Company of North America.

Some 80% of 3,200 people surveyed preferred a product with four percent return and a principal guarantee over a product with an 8% return subject to market risk—thus answering the classic behavioral finance question, Would you prefer a 100% change of $50 or a 50% chance of $100. But they balk at the word, “annuity.”

“No other financial product offers guaranteed income for life. Government, financial planners and the industry need to re-educate the American public about what these products do and how they can help secure a stable retirement,” Allianz Life said in a release.

The study, titled Reclaiming the Future: Challenging Retirement Income Perceptions, found that respondents had decades-old prejudices regarding annuities. Fifty-three percent first formed their opinion of annuities 10-20 or more years ago. Only 27% knew of innovations made with annuities during the past five to 10 years. Only 23% know that variable annuities allow contract holders to participate in market gains.

When people understand annuities, they’re very satisfied with them. According to the study, 76% of annuity owners are “very happy” with their purchase. More than half of owners like the product because it’s a safe, long-term investment vehicle (57%), a great way to supplement their retirement income (56%), and an effective tool to get tax-deferred growth potential (56%). Consumers ranked annuities second-highest (50%) in satisfaction among all financial instruments, beating mutual funds (38%), stocks (36%), U.S. savings bonds (35%) and CDs 25%).

Vanguard and Hueler Partner to Provide Low-Cost Income Annuities

Posted on September 8, 2010 by Editor Test -

Vanguard and the Hueler Companies, two companies identified with low-cost retirement savings and income solutions, have teamed up to offer a web-based service that lets individual investors seek competitive quotes on income annuities from several major insurers for purchase in their rollover IRAs.

The deal links Vanguard, a leading provider of jumbo 401(k) plans and a major destination for rollover money from other providers’ platforms, with Hueler, a relatively small Minneapolis firm whose CEO, Kelli Hueler, has virtually crusaded for making income annuities available to retirees at “institutional” prices five percent or more less than retail.

Currently, on Hueler’s Income Solutions web-based platform, near-retirees in participating 401(k) plans can ask for competitive bids from participating companies, including Hartford Life, ING Life, Integrity Life, John Hancock Life, MetLife, Mutual of Omaha, Pacific Life, Principal Life, Prudential Insurance, and Western National Life.

The timing of the announcement is significant. It comes a week ahead of Department of Labor hearings on in-plan income options. The hearings themselves mark the new phase of competition for rollover dollars that is heating up among asset management firms and insurance companies.

Both Kelli Hueler, CEO of the Hueler Companies, and Steve Utkus of Vanguard Retirement Research Center, are scheduled to testify at the September 14-15 hearings.

Today, the two companies issued the following release:

Vanguard Annuity Access™, coupled with Hueler Companies’ Income Solutions® platform, is designed for individuals seeking a guaranteed stream of income in retirement to augment their investment holdings, workplace retirement plan, and Social Security benefits,” the companies said in a release.

“The service can be particularly attractive to retirement plan participants rolling their assets over to a Vanguard IRA (individual retirement account) as they retire. Prospective purchasers can obtain customized quotes on a real-time basis and evaluate competitively priced, directly comparable contracts from multiple companies.

Hueler Companies has been a leading provider of web-based annuity purchase systems since 2004. The firm now provides participants in more than 1,000 defined contribution plans access to income annuities as a tax-deferred rollover option for their retirement assets.

“Traditionally, annuities have been viewed as complex products that were sold and not bought. Vanguard Annuity Access brings the tools and transparency to the annuity-buying process, enabling self-directed individuals interested in a ‘paycheck for life’ option to make an informed decision,” said Tim Buckley, managing director of Vanguard’s Retail Investor Group.

Mr. Buckley added that the new annuity service complements Vanguard’s market-based options for retirees, which include systematic withdrawals from a diversified portfolio of low-cost Vanguard mutual funds, Vanguard Managed Payout Funds, and retirement income plans developed by a Certified Financial Planner™ (CFP) professional.

“The new Vanguard Annuity Access service is a powerful collaboration that brings together Hueler’s proven low-cost annuity platform with Vanguard’s trusted name,” said Kelli Hueler, CEO of Hueler Companies. “Now prospective annuity purchasers—both retirement-ready plan participants completing a rollover and transitioning individual investors—will benefit from an easy-to-use online resource supported by Vanguard’s licensed, non-commissioned annuity specialists.”

Income Annuities for DC Plan Participants Entering Retirement
Defined contribution plan sponsors are paying increased attention to retirement income strategies, with the goal of providing their participants with the education and tools they need to translate their lump-sum benefits into sustainable income. Since many sponsors are concerned that “in-plan” options such as income annuities will lead to added fiduciary responsibility and increased plan complexity, Vanguard Annuity Access will be offered to participants as an IRA rollover option.

“More than 80% of retiring participants in Vanguard-administered DC plans leave their employer’s plan within three years, typically for an IRA rollover account. As a result, our plan-sponsor clients are interested in an “outside-the-plan” guaranteed income program,” said Barbara Fallon-Walsh, head of Vanguard Institutional Retirement Plan Services. “Many plan sponsors offer the Vanguard Financial Plan service for their participants aged 55 and older, which provides them with free access to a CFP who can help them with retirement income planning. Vanguard Annuity Access represents an additional service they can offer participants entering retirement.”

Vanguard provides recordkeeping and investment services to 3.5 million participants and 1,700 plan sponsors in more than 2,500 defined contribution plans.

Plain Talk about the Risks of Income Annuities
John Ameriks, head of Vanguard Investment Counseling & Research co-author of Vanguard retirement income research (including Generating Guaranteed Income: Understanding Income Annuities) encourages retirees to weigh the pros of guaranteed income versus the cons, which include loss of investment liquidity, the potential reduction in bequeathable wealth, and the risk of default of the underlying insurer.

Costs are another important consideration. The investment management, distribution, administrative and other costs associated with fixed annuity products are reflected in annuity quotes. As a result, the “apples-to-apples” comparability of quotes at the time they are obtained is critical in evaluating whether contracts are competitive among their peers.

Vanguard Annuity Access is designed to provide competitive payments to investors, resulting from the meaningful competition among insurance companies on the Income Solutions platform and from the institutional, or group-rate, pricing of the annuities offered. The quotes should also be competitive because of the low transaction fee of 2% of the annuity purchase amount.

“For retirees who place a high value on having an additional lifetime income guarantee beyond Social Security and a pension—and are willing to accept the costs and risks of annuitization—low-cost income annuities can be an important part of a broader investment plan,” said Mr. Ameriks.

Fixed Deferred Annuities Also Available
The Vanguard Annuity Access service will also offer access to fixed deferred annuities with fixed interest durations ranging from three to seven years. These savings vehicles are designed for tax-sensitive investors wishing to supplement other forms of retirement savings, such as 401(k) plans and IRAs. A fixed deferred annuity lets clients earn a fixed interest rate on their savings for a set number of years. Both the interest rate and principal are guaranteed by the insurance company that issues the annuity.

The Big Red Stag’s Mistake

Posted on September 8, 2010 by Editor Test -

Like many students of the variable annuity game, I have been watching The Hartford Financial Services Group’s recent public relations disaster closely. My first thought: what a terrible waste of brand strength. Even though The Hartford has struggled rather publicly through the financial crisis—it needed a $2.5 billion infusion from Allianz SE and $3.4 billion from Uncle Sam—its brand has held up pretty well.

But this latest incident could knock a few points off the Big Red Stag’s antlers.

It could also snowball into more than just a public relations disaster. At a time when the Treasury Department is about to auction The Hartford stock warrants to recoup TARP money, and when the Securities and Exchange Commission is pondering the suitability/fiduciary standard for broker-dealer reps, a news story that raises questions about the financial stability of any insurer or the integrity of any reps could have wider implications. On Tuesday, in fact, the Connecticut insurance commissioner, Tom Sullivan, said he would look into the matter.

That may be why one industry observer told me that the issue is “very touchy” and that other variable annuity issuers “are watching it closely.”

If I read Darla Mercado’s recent stories in Investment News correctly, someone at Hartford Life Distributors mailed letters to owners of certain Hartford variable annuities—presumably including ones with underpriced living benefits that were sold during the pre-Crisis VA ‘arms race’—suggesting that they talk to their advisors about possibly exchanging those contracts for contracts with the insurer’s less risky-to-the-issuer Personal Retirement Manager income rider. (See RIJ’s article on the product.) The letter is signed by a vice president of product management at Hartford Life Distributors.

Late last month, at least some contract owners apparently received those letters before their advisors received similar letters from The Hartford giving them a heads-up about the communication with clients. That mix-up alone would be a violation of protocol, and a good way to jeopardize Hartford’s hard-won third-party distributor relationships. It’s an unwritten law that the client belongs to the advisor, not the carrier.

The company has explained that the client letters went to people whose contracts were out of the surrender period—if it were otherwise, this would be an uglier matter—and that such letters were not unusual. “The letters to advisors simply didn’t go out on time,” according to the insurer. I’ve seen both letters. They are brief and dry. To say that the letters “entice” owners to exchange contracts, as the Investment News article did, seems to me like an exaggeration.

I was told by one observer that such letters, especially to clients, are “not typically” sent out by VA issuers, however. That person also noted that both letters contain headlines that mention an “Exchange Program.” The use of the word “program” apparently triggers a requirement of SEC or at least FINRA approval. The implications of that, if any, aren’t clear.

Worse case scenario: The letter to clients could foster speculation that The Hartford is worried about the risks associated with contracts still on its books, which leads to questions about its financial stability. The letter also allows speculation that the original contract may have been less than suitable for the client, which raises questions of advisor integrity or competence.

Those are not questions that anyone in the insurance or brokerage industries wants anyone to be asking. The annuities industry, which two years ago had to deal with the NBC Dateline fiasco involving indexed annuities, doesn’t need another image-flaying scandal. Neither does The Hartford.

A few weeks ago, in Cogent Research’s Advisor Brandscape 2010 research study, the reputation of The Hartford’s variable annuity business was still very high among advisors. The company’s VA sales had fallen to 18^th place at the end of the first quarter of this year—perhaps by design, as CEO Liam McGee suggested in statements last spring—but it still ranked as high as third in brand imagery, trailing only industry leaders MetLife and Prudential.

Advisors don’t necessarily see the Hartford as an innovator, the study showed, but 34% of advisors considered the company a “leader in the VA industry.” Regional broker/dealer reps in particular held it in high regard. Bank advisors ranked it second among VA issuers in terms of “good value for the money” and third overall in “offers the best retirement income products.”

But the trend has been negative. From 2009 to 2010, the company slipped from fourth place to seventh place in brand equity score. And while it still ranked first in advisor market penetration, with 44% of advisors listing it among their VA providers, it lost ground in the percentage of advisors who considered it their primary VA provider.

Starting in late 2009, the variable annuity market has split starkly into those companies who are truly committed to the product and those who, post-Crisis, had serious doubts about the wisdom of selling long-term equity puts. Prudential, MetLife, and Jackson National are committed. The Hartford, John Hancock and ING have had second thoughts. Tellingly, the leaders have stuck with generous income riders while doubters switched to simpler products with lower fees and more modest promises. The public, and advisors, prefer the generous products.

It’s somewhat ironic that The Hartford wanted to get investors out of the type of product that’s justifiably more popular—because of its richer terms—than the one that it’s trying to lure investors into. In hindsight, the company might have capitalized on the good will established by those rich promises rather than trying, it now appears, to renege on them. Failure to accept a sunk loss is a mistake that behavioral finance experts warn amateurs to avoid.

It is my understanding that, accounting issues aside, even the most generous-looking lifetime income guarantees don’t represent a loss for the issuer unless or until the contract owner(s) are still alive when the account value (as a result of allowable withdrawals and/or poor market performance) goes to zero. Of course, there may be a method to this madness that escapes me or that The Hartford isn’t sharing.

There’s no need to scold The Hartford here, because Bob MacDonald, the former CEO of ITT Life, a one-time Hartford subsidiary, did a thorough job of it on his blog this week. MacDonald, a legendary and controversial figure who built an equity-indexed annuity empire at Allianz Life of North America in the first half of this decade, writes:

“It is obvious that despite all that has happened to the success and good name of Hartford over the past few years, the management of the company is still highly capable of consistently making decisions that are not in the best interests of the company. Clearly the CEO, who has no insurance experience, has demonstrated his inability to change the environment of self-destruction at Hartford.

“Knowing the past actions of Hartford management and its current arrogant attitude toward customers and the distribution system, one could rightfully question ever buying or selling a product of the Hartford. It seems – as I have suggested previously – the only way to save Hartford from itself is for the company to be acquired by another insurance organization that can clean house and return Hartford to the great company it once was.”

That type of righteousness will probably be tough for the folks at Hartford to hear, knowing that it comes from the mischievious author of books with titles like Beat the System and Cheat to Win.

The Hartford’s letter-gate problem might merely reflect one company’s or one executive’s idiosyncratic error—or, to be polite, the appearance of error. And, in ordinary times, the whole mess might vanish overnight. But these aren’t ordinary times. Investors are nervous, markets are volatile, a potentially game-changing election is coming up, and the reputation of the financial services industry is under examination. A cap-gun could set off a panic.

Meet Meir Statman

Posted on September 7, 2010 by Editor Test -

Economists once assumed, perhaps for the sake of sheer convenience, that the typical investor was a paragon of rationality, always able to apply his or her highest, most objective reasoning abilities to financial decisions.

Now we know that an assortment of psychological, biological, and cultural factors, mediated by ineffable hormones and neurotransmitters, shape the way we measure risk and reward and how we spend our money.

These mental and physical factors are the subject of the new book, What Investors Really Want (McGraw Hill, 2010), by Meir Statman, the Glenn Klimek professor of finance at Santa Clara University near San Jose, California. As the following excerpts show, the book draws on a wide range of evidence and reveals the complexities of behavioral finance in language that’s accessible to almost anyone.

Take, for instance, Statman’s description of an experiment where researchers tested children’s ability to delay gratification–a process linked to financial behavior. The children were promised an extra marshmallow if they were able to wait patiently for a teacher to return to their playroom after a short absence:

“Imagine yourself as a four-year-old at a nursery school. A teacher escorts you into a room and together you play with some toys. Then the teacher says that you would play again with these toys some more later but asks you to sit for now at a table on which there is a bell.

“The teacher shows you two marshmallows and says that he or she must leave for a while. If you wait until the teacher comes back, you can have the two marshmallows. You can ring the bell at any time you want to call the teacher back, but if you ring the bell you’ll get only one marshmallow, not two. Would you be able to resist the urge to ring the bell before 15 minutes is up?

“Children who resist the temptation to ring the bell have better self-control than children who ring the bell, and differences in self-control have profound consequences in life, including financial life. Children who exercised sufficient self-control to resist the temptation of the marshmallow grew up to be more academically and socially competent, verbally fluent, smart, attentive, able to plan, and able to deal with frustration and stress. They also scored higher on the SAT.”

Aside from psychological processes, there are also physiological processes for some of our financial decisions, Statman writes. He cites research showing that people who eat turkey and other foods high in tryptophan, an amino acid that is a chemical precursor of serotonin, a neurotransmitter that affects mood and activity levels, are less likely to act on impulse than people who eat high-carbohydrate foods.

“People who had the traditional Thanksgiving dinner exhibited lower impulsiveness, reflected in a lower willingness to buy a Dell Home Inspiron personal computer on Black Friday, than people who had pizza, quesadilla, lasagna, pasta, burrito, salmon, or noodles,” he writes.

Along with the link between impulsivity and neurotransmitters, a physiologic link has been found between a certain region of the brain and the reaction to prices in certain people, Statman’s research shows. He describes an experiment where people were given an MRI while seeing a product, then its price, and then being asked whether they would like to buy it or not:

“Seeing the price caused greater activation in the insula among people who decided not to buy the product than among people whose choice to buy. The insula is a brain region associated with painful sensations such as social exclusion and disgusting odors.”

Some of our behavior is more easily traced to cultural influences, rather than physiological or psychological ones. For instance, “More than 32% of Japanese parents plan to leave a greater amount to the child who takes care of them in old age, while only 2.5% of American parents plan to do so,” Statman writes. “More than 7% of Japanese parents plan to give more to the oldest son or daughter and almost 7% plan to give more to the child who continues a parent’s business, while such plans are almost absent among American parents.”

Whether culturally-instilled or psychological, Statman’s book shows that the fear of poverty affects virtually all of us on a deep level, and freedom from that fear appears to be a blessing that’s as satisfying than wealth. That’s one of Statman’s principal arguments in favor of owning income annuities or choosing to annuitize a defined benefit pension.

“Freedom from the fear of poverty improves our mental health as riches do,” he writes. “Retirees who have at least some of their income in the form of pensions or annuities have greater freedom from the fear of poverty than retirees who draw income from their savings, concerned that they might outlive their money.

“Retirees with pensions or annuities were more satisfied with their life in retirement than retirees with similar incomes from sources other than pensions or annuities. Retirees with pensions or annuities also had fewer symptoms of depression than retirees without such pensions or annuities.”

Even the sense that we are poor compared to other people can drive us to make somewhat risky, and even desperate decisions, the research shows. As Statman puts it, “We are driven to gamble when we are reminded that we are poor.”

He describes an experiment where people waiting at a bus station were paid “$5 in single dollar bills to complete a questionnaire. One version of the questionnaire, given to half the people, was designed to make them feel adequate, with incomes in the middle of the income range. It asked whether their annual incomes were less than $10,000, between $10,000 and $20,000, and then, in increments, to the top category of more than $60,000.

“The other version of the questionnaire, given to the other half, was designed to make them feel poor. It asked whether their annual incomes were less than $100,000, between $100,000 and $250,000, and then in increments to the top category of more than $1 million.

“Next, the experimenters showed each person five $1 lottery tickets and asked how many they wished to buy. People who were made to feel poor bought more lottery tickets than people who were made to feel that their incomes were adequate.”

“What Investors Really Want”

Posted on September 7, 2010 by Kerry Pechter -

When managing his own savings, the behavioral economist Meir Statman practices what he teaches. If his emerging markets equities fund loses value, for instance, he doesn’t panic and go to cash. Nor does he “rebalance” by shifting assets from bond to stocks.

More likely, he would move the depreciated stock fund into a similar stock fund to capture the tax-deductible loss (without engaging in a wash sale). He wouldn’t touch his bond money, which he regards as protection against future poverty.

“I’m very risk-averse with downside money,” he told RIJ recently. “I think that the idea of looking at the portfolio as a whole, and having the same risk tolerance for all of your money, is wrong. I wouldn’t recommend any change based on a prediction of what stocks will do, or on the belief that stocks were cheap.”

The Glenn Klimek professor of finance at Santa Clara University’s Leavey School of Business in Silicon Valley, Statman has just published What Investors Really Want (McGraw Hill, 2010). His book combines personal anecdotes and academic research in an amiable narrative that emanates tolerance for our all-too-human financial foibles.

Most investors want at least a glimmer of hope for future riches and they want to avoid falling into poverty, Statman believes. In the jargon of the Street, they want upside potential and downside protection. Evidence of this is easy to find, he says.

It can be seen in the universal popularity of lottery tickets. It can also be seen in the way investors buy hybrid investments, like balanced funds, equity-indexed annuities and variable annuities with lifetime income guarantees. It can also be seen in the chronically low sales of fixed income annuities, which offer no opportunity for growth.

At the same time, people struggle with self-control as they seek to balance the desire to spend now with the desire to save for the future. “We deal with this by creating rules,” he said. “One rule is to spend in income but never dip into capital. Another rule is to spend only four percent of wealth in retirement. Payout mutual funds serve a psychological purpose, he said, by make dips into capital “invisible” to the owner.

“People are aware of their problem with self-control and look for ways to deal with it,” said Statman, who was born in Germany in 1947 to Polish parents who had fled the Nazis in 1939. After five years on a collective farm in Siberia, followed by the limbo of a Displaced Persons camp, they emigrated to Israel, where Statman grew up. He came to the U.S. for graduate study in the early 70s.

“The desire not to be poor and to become rich still exist when people are retired,” Statman told RIJ, “and that is the bane of immediate annuities, which are presented as ‘We are going to take all your money and give you a few thousand dollars a month.’

“But that deprives me of any chance of becoming rich. Advisors and annuity designers should be saying, ‘Let’s put a portion of your money into an annuity to supplement Social Security. You’ll be protected from the downside and still have money to put into growth stocks.’ That really is the ideal scenario.”

Most people aren’t as rational about money as economists once assumed or as hopelessly innumerate as some behavioralists paint them, he says. “Ninety-eight percent of us are normal. Sometimes we are stupid and sometimes we are smart. The question is, how can we raise the ratio of smart behavior to stupid?”

While the financial services industry has a pretty good grip on the public’s desire for upside potential and downside protection, it lags behind other industries in understanding that people often think of mutual funds or wealth management services the same way they think of automobiles or watches—as expression of themselves.

“Money is just a way station to what you do with that money. Both standard and behavioral finance seem to regard investing as neutral or unique. Investment products and services are like other products and services.

“You might describe Vanguard, for instance, as a company that sells good merchandise at a good price. But investing at Vanguard also makes me proud that I’m smart enough not to waste my money. Vanguard is an expression of me just the way my Toyota is an expression of me. I could buy a Lamborghini, but I’d feel like a phony.”

People invest in active funds instead of index funds for a good reason, Statman said. “Only 20% of stock investors invest in index funds. Knowing what we know about performance, you might say that people who invest in actively managed funds are stupid. But you wouldn’t call people who buy Rolex watches stupid just because Rolexes don’t tell time any better than Timex watches.

“If you ask people in the watch business, they won’t deny that they’re appealing to a sense of status or beauty. But money managers wouldn’t admit that that’s what they do,” he said.

“People invest in active funds because active funds give them the hope of being rich. Some say you shouldn’t pay for hope. But people pay for hope all the time. Look at lottery tickets. An advisor might tell you not to buy lottery tickets. But I’d say, go ahead and buy one once a week. You’ll lose your money, but for $52 you’ll have hope for an entire year,” he said.

But to take advantage of the craving for hope—i.e., greed—is foul play, Statman claims. If active fund managers were more candid, he says, they’d drop the pretense that they merely seek alpha through securities analysis. They make bets in order to outperform their peers. They advertise their good quarters, but bury the results of their bad bets, fostering an impression that active funds are consistent outperformers.

To counteract such stealth, Advisors should act as financial physicians for their clients, Statman said. An advisor should help people make smart, practicable choices, he said, creating a plan that accommodates their hope for upside and fear of ruin without over-indulging them.

“A good advisor will let people spend five percent of your money on frivolity, but make sure they don’t spend their serious money on lottery tickets,” he said. “I am passionate about the need for advisors to be their as financial physicians, because people do stupid things when they’re on their own.”

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