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Chris Blunt, executive vice president of Retirement Income Security at New York Life, says his company cushions itself from a potential interest rate hike in three principal ways: by buying hedges on its portfolio, careful asset/liability management and relying on its $15 billion in surplus.

“A steady rise in rates would be positive actually. It would be wonderful to see a 50 bps rise per year” because the rise in investment income coupon allows New York Life to credit higher rates, and, “as buy and hold investors, we are less affected by any interim decline in market price.  The ‘spike in rates’ scenario is the one that would hurt most insurance companies. If rates go up 500 bps in a year, then investment income bond coupons can’t catch up with the sharp decline in market prices.”

Because the assets and liabilities of New York Life’s existing books of immediate annuities and life insurance contracts are more easily matched, a change in interest rates doesn’t affect them, he said. And because an insurer has a lot of long-dated obligations, fluctuations in short-term rates don’t matter much. But New York Life also sells a lot of fixed annuities, which are more difficult to asset/liability match, and are less competitive with certificates of deposit when the yield curve flattens. His company also sells income annuities, which are less competitive when yields on long-term bonds are low.

“We model our liabilities on a spike scenario. We ask, ‘What happens to liabilities and assets under different circumstances, what are the potential mismatches and will the mismatch be beyond our reserves?’  So we modeled out the scenarios to see what happens if interest rates go up and by how much, and we purchased over $100 million in interest rate caps, which buys us a significant amount of coverage. 

“These are interest rate options that only pay off if short-term interest rates go up a significant amount. That would help prepare us for a ‘black swan’ type of event,” he added. The derivatives are purchased from about a half dozen counterparties to diversify the risk. “We would like to think that others have taken similar steps, but we’re a mutual so we know we can afford to sacrifice short-term profits to assure the long-term permanence of the institution.”

© 2010 RIJ Publishing. All rights reserved.

Ken Volpert, a principal who runs the $500 billion taxable bond group at Vanguard, is unruffled about interest rates. A sharp rise in intermediate and long-term rates isn’t likely, he says. The economy is weak and the bond market has already priced in a potential rate hike by the Fed.

“The rates are already there,” Volpert told RIJ, noting that futures contracts reflect a Fed Funds rate of 2%, compared to today’s target Fed Funds rate of zero to 0.25%. “Normally the spread between two-year and 10-year Treasuries is 100 basis points; today it’s 280 basis points,” he said.

“The increase is already priced in. Intermediate and long-term bonds are already paying the rates that the market thinks they will be after a rate hike. The question is, what will actually happen versus market expectations? We don’t think they’ll raise rates as fast as the market is pricing in right now.”

An inflation scare could theoretically trigger a sharp rise in long-term rates, he said, but he sees little chance of inflation as long as the U.S. economy remains sluggish. “There is so much slack in the economy. Global deflationary forces are very powerful,” Volpert said.

As the Fed reduces its balance sheet by selling the debt it bought from troubled banks, it will absorb cash from the economy and slow it down, he believes. If the banks started lending the $1.2 trillion they have on reserve at the Fed, it would be inflationary; but they aren’t—because loan demand is low and because the Fed, for the first time, is paying interest on those reserves.   

At the moment, Volpert is over-weighting corporate bonds and asset-backed securities. Vanguard, characteristically, is advising its retail bond fund investors to stay diversified and not concentrate their money in short-term bonds, because short-term rates are likely to move much more than long-term rates.   

”We’re not looking at a crisis,” he said. “We’re very much on hold. You want to be in intermediate bonds. We think rates will rise less than the markets believe.” For more of Vanguard’s views, see Deficits, the Fed, and rising interest rates: Implications and considerations for bond investors, from the Vanguard Center for Retirement Research.

© 2010 RIJ Publishing. All rights reserved.

Michael Pento, chief economist of Delta Global Advisors, looks out from the bow of the U.S.S. Economy and sees an iceberg the size of Mount Everest dead ahead. Big-time inflation is coming, he believes. It won’t happen because of rapid economic growth, but because the Fed will be forced to “monetize the debt”—that is, print money to redeem its bonds from creditors.  

“There’s no doubt that the 30-year bull market in Treasuries is over,” Pento told RIJ. “The question is how much and how quickly will rates rise. Since 1969, the average return on 10-year Treasury bonds was 7.31%, more than twice as high as we are today. Why is it like that? You’re seeing a global flight to the dollar and to the bond market, as a result of the credit and sovereign debt crises. But does do prices deserve to be that low? Is it sustainable?

“You have a huge buildup in latent inflation in the monetary base and Fed balance sheet. Every time rates have been so low, it creates inflation. If bond traders are not completely brain dead, they will have to price in the risk of inflation and the Fed will have to move off its zero percent stance. They’re ignoring the inflation that’s in front of their eyes. Look at the Producer Price Index. It’s up 6% in the past year, while the Consumer Price Index is up only 2.4%.

“We have $8.8 trillion in T-bonds that we had to auction off because of declining maturity durations. Instead of selling 30-year bonds, we’re selling short-term notes, so we have to turn over the debt more frequently. Once we get into a rising rate environment—not to 20% like the early 80s,but it will have to rise—interest rate expenses will skyrocket. So the risk of sovereign default or a failed Treasury auction is rising.”

So what should investors do? “You could short the long end of the Treasury curve,” Pento said. “Some ETFs do that. You could buy an alternative currency, one that’s not debased by fiat. Gold is still far below where it was in 1981, on an inflation-adjusted basis.”

 © 2010 RIJ Publishing. All rights reserved.

Daniel O. Kane is the chief actuary at Prudential Annuities, where one of his primary chores is to manage the risks of the Highest Daily 6, Prudential’s flagship variable annuity with a lifetime income guarantee. He called the current interest rate “sustainable.” His worst-case scenario: A Japan-like “lost decade.”

“We do a lot of hedging our benefits, primarily to offset the long-range interest rate risk. For us, at the company level, interest rates that are either too high or too low are risky.  The most risk is on the low end. The guarantees we’re making are more valuable to the customer when interest rates drop.”

“If interest rates go up, it produces another risk,” he said. Besides buying hedges, Prudential supports the income guarantees in its the Highest Daily 6 product by shifting account assets out of equities and into a fixed income account when equity prices fall. A sharp rise in rates would hurt that account. 

“In the short term, it reduces the value of that account. But there are countervailing effects. The bond value may drop initially but on a long-term basis you now have more income earned going forward. So from a long-term liability perspective, higher rates help.  If you’re discounting that liability they can also help.”

“We do hedge our interest rate risk.  Rho is interest rate risk, and we manage it primarily by buying interest rate swaps. There’s a reserve associated with it so we calculate a liability and record it in our financial statements.

“Regarding our obligation to make lifetime payments, we enter into swaps and buy equity and interest rate derivatives. Everything else being equal, the lower the interest rates the higher the hedge costs. We and others in the [variable annuity] industry have reduced the guarantees not only because equities didn’t perform well but also because interest rates have gone down.

“The worst case for us would be a Japan-like scenario where you have 15 years of the equity market being down 70%, and interest rates at one percent. That scenario isn’t good for any insurance company because all of the long-dated liabilities. The situation in the U.S. was extreme a year ago. Toward end of 2008 interest rates were low and the market was down, and that was an extreme environment. We are currently in a sustainable environment.”

 © 2010 RIJ Publishing. All rights reserved.

Kathleen C. Gaffney, CFA, is a fixed income portfolio manager at Loomis, Sayles & Co., a Boston-based unit of Natixis Global Asset Management. In a recent webcast, she briefed advisors on a report, Multisector Strategies in a Rising Rate Environment, by herself and Dan Fuss, Matt Eagan and Elaine Stokes of the Loomis, Sayles Multisector Team.

In the following excerpts from their report, they describe four rules for making money in bonds today: Maintain a yield advantage; Maximize specific risk; Minimize market risk; Go global:  

“Yield advantage is a powerful offset to the headwinds of rising interest rates. We strive to build portfolios with a significant yield advantage over what might be earned by a portfolio that is similar to, say, the Barclay’s Capital Government/Credit Index.” If rates go up 75 basis points and prices go down, for instance, you’ll still be making money on a BB bond paying 7%. But you’ll take a loss on a Treasury note, they write. 

“An experienced bond picker can often counter the headwinds of a rising interest rate environment… We are currently on the hunt for securities with positive corporate fundamentals, including: Companies with strong market demand and a global reach, including emerging markets; fast-growing companies that can deleverage and be eligible for upgrade; opportunities across the entire capital structure; new, innovative industries.”

Don’t necessarily go to short maturities in this environment, Loomis, Sayles says. “Many financial textbooks teach that reducing duration is among the best prescriptions for protecting a bond portfolio from rising interest rates. However, this advice leaves out a couple of important points. First, timing is important. The slope of the yield curve is exceptionally steep at the moment (the 10-year US Treasury yields approximately 280 basis points more than the two-year US Treasury).”

“Dramatically shortening a bond portfolio’s maturity therefore would carry a penalty in the form of a large yield give-up. Our interest rate outlook suggests it may be simply too early and too costly to significantly shorten duration at this point. While we have trimmed some longer bonds at the edges in recent months, we don’t believe another significant move is likely to take place until later in this cycle.”

“On a relative basis, TIPS may outperform nominal Treasury bonds significantly. However, unless inflation ramps up very quickly in the next couple of years, we do not believe TIPS offer enough absolute return potential to warrant an investment. Given their low coupon, low yield, and the absence of a clear near-term inflation trigger in the markets, we would likely not utilize TIPS in our portfolios at this time.”

Loomis, Sayles also recommends investing in non-U.S. dollar denominated bonds. “We are not necessarily universally negative on the US dollar. In fact, we think the greenback should fare well versus the other major reserve currencies, the yen and the euro, which are tied to countries with slower growth rates and weaker demographic trends. But we do see the U.S. dollar adjusting lower to currencies tied to the faster growing regions of the world in Asia and Latin America.”

“We favor the Australian dollar, the New Zealand dollar and the Canadian dollar, which are collectively referred to as ‘commodity currencies.’ These small, resource-rich countries can directly benefit from any growing demand for raw materials coming from emerging markets. We believe building positions in sovereign and corporate debt denominated in these currencies can assist the portfolios by acting as a natural hedge against inflation expectations in the U.S.”

 © 2010 RIJ Publishing. All rights reserved.

Introducing a lump sum payment as part of pension benefits could decrease the risks for Dutch pension funds, Hewitt Associates suggests.

A lump sum of up to 50% of the benefits would raise pension funds’ financial buffers and reduce the financial effects of increased longevity, Hewitt claimed in a response to the proposals of social affairs’ minister Piet Hein Donner to increase both buffers and contributions.  

“Pension funds don’t need to keep extra financial reserves for the money they have already paid through a lump sum payment. This will increase their leeway for indexation as well as raise their cover ratio by some percentage points,” argued Hewitt’s Arnold Jager.

“In order to prevent participants from spending straight away, they should only be allowed to use a lump sum payment for paying off a mortgage, or use the capital within a set period of between five or ten years through a frozen account,” he explained.

“Although this won’t be a lifelong benefit, pensioners will have more money available when their spending is usually the highest. An additional advantage is that the lump sum payment becomes part of the inheritance if the pensioner dies.” Lump sum payments will bring the Dutch pension system more in line with other capital-funded systems in the surrounding countries, according to Hewitt.

The United Kingdom, Germany, Belgium and Switzerland already offer their participants the option of a one-off payment as part of their pension rights at the retirement date.

In the Netherlands only pension rights that entitle members to yearly benefits of less than €400 ($600) can be bought off, because of the administrative burden of these small pensions to pension funds.

“Although a lump sum payment will probably have a limited effect on the buffers, it will certainly decrease the longevity risk,” commented Lans Bovenberg, Professor at Tilburg University and Netspar, the platform for pensions, retirement and ageing.

“However, the advantage will increase if the longevity risk is born by pension funds’ active participants, as the Goudswaard Committee has suggested,” Bovenberg added. “It will increase schemes’ stability by limiting risks and buffer requirements.”

But in the economist’s opinion, the lump sum should by capped at 20%. “If pensioners have spent most of their money early in retirement, they will become a financial burden for society when they require extra care later,” he explained.

© 2010 RIJ Publishing. All rights reserved.

A new, more volatile macroeconomic era may be emerging in the wake of government solutions taken to solve the financial crisis worldwide, according to St. Louis Federal Reserve President James Bullard.

On U.S. regulatory reform, Bullard said important problems will remain unresolved by the proposed legislation. He spoke recently at the Swedbank Economic Outlook Conference, “Economic Policy in the Aftermath of the Financial Crisis.”

“In the U.S. and globally, the recovery remains on track,” Bullard said in his presentation, “Policy Challenges for Central Banks in the Aftermath of the Crisis.” In the U.S., real GDP is expected to match its second quarter 2008 peak before year-end, he said.

While the current sovereign debt crisis in Europe has raised concerns of financial market contagion, “There are several reasons why this new threat to global recovery will probably fall short of becoming a worldwide recessionary shock,” Bullard explained. He expects global growth to return in 2010 and continue in 2011.

“Governments have made it very clear over the course of the last two years that they will not allow major financial institutions to fail outright at this juncture. Because these too-big-to-fail guarantees are in place, the contagion effects are much less likely to occur,” he added.

But these policy moves have eroded the credibility for stable rules-based policy built up over the last 25 years, he said.

“One key problem going forward will be how to re-establish credibility for macroeconomic policy. Credible policies are more effective, but may not be possible in the near term,” he said. “There are clear limits to what U.S. regulatory reform is likely to accomplish. Important problems will remain unresolved.”

For example, the reform package does not fully address the non-bank financial firms, also known as the shadow-banking sector, which played a huge role in the crisis. “It is a hallmark of the crisis in the U.S. that these firms turned out to be susceptible to run-like phenomena. Additional capital requirements do not solve this problem. I expect the problem of runs on non-bank financial firms to remain part of the macroeconomic landscape for the foreseeable future.”

“New regulations need to take a view of the entire financial landscape. Otherwise, many activities are forced into less regulated entities,” he said. “Pending legislation does not appear to be sufficiently broad in concept to address this concern.”

On interest rate policy, he said, “The policy to keep rates near zero for an extended period can influence real activity at the zero lower bound, according to modern monetary theories. The effects depend on the credibility of the promise… Markets may confuse the policy with the ‘interest rate peg’ policy, in which rates do not adjust in response to shocks. In particular, multiple equilibria or ‘bubbles’ are possible.”

The Fed’s near-zero interest rate policy had been supplemented with an effective quantitative easing policy. Removing this policy without triggering inflation will depend on perceptions about how and when it will be removed. “In theory, any credible commitment to remove the policy in finite time will work well,” he said. “In practice, markets may well lose faith sooner than that.”

© 2010 RIJ Publishing. All rights reserved.

Financial advisor practices are serving more retirement income clients these days, but planners, brokers and RIAs fret about managing investment risk for those investors.

So says The Continued Evolution of Retirement Income Delivery: An Analysis of Leading Practices in Advisor Support, a new 110-page report from GDC Research and Practical Perspectives, two independent consulting and research firms.

Sixty-three percent of advisors say they have experienced net growth in the past year in serving retirement income clients, the report said. Advisors also find these clients are receptive to consolidating relationships.

While 91% of advisors believe they can effectively serve new retirees, they are increasingly wary of how t o manage investment risk for retirement income clients. One in four advisors are now less confident in their ability to manage investment risk compared to one year ago. They attribute that to market doldrums, low interest rates, and expectations of slow economic growth. 

“In response to this uncertainty, advisors have taken a number of actions including rebalancing portfolio targets, shifting to more conservative allocations, and increasing use of guaranteed solutions such as variable annuities,” the authors said in a release.

“Advisors are gearing up to support the inevitable wave of boomer retirees, adding new products and services as well as expanding advice delivery” said Dennis Gallant, president of GDC Research and co-author of the report. “Yet only a limited number of advisors—less than one in 25—have shifted the primary focus of their practice to serve this growing market.”

“There continues to be little consensus in the best way to create retirement income streams or manage portfolios,” said Howard Schneider, president of Practical Perspectives, the report co-author. “While there is growing use of certain vehicles such as ETFs and variable annuities, we continue to find significant variation in the approaches, products and providers that advisors use to deliver retirement income to clients.”

The findings are based on over 100 on-line surveys conducted in March 2010 with financial advisors and representatives, as well as interviews with advisors and industry executives. Full service brokers, independent brokers, financial planners, Registered Investment Advisors (RIAs), and bank/insurance representatives participated.

To purchase the report, contact [email protected] or [email protected].

Other highlights of the report include:

• 86% of advisors say support for low-balance and affluent retirement income clients requires the same amount of time and effort.   

• Nearly eight in 10 advisors have changed the way they manage investment risk for retirement income clients in the past year.

• Shifts in government programs and benefits (38% of advisors are concerned), increased taxes (34%), and rising health care expenses (28%) are wild card factors that worry advisors.

• Favorite providers for advisors who are building retirement income portfolios include American Funds, Franklin Templeton and BlackRock/iShares, though those firms don’t have specific new solutions for this marketplace.

• Regarding annuities, 55% of advisors are concerned about “the ability of annuity providers to deliver on long-term benefits” and over 90% worry about “safety and credit rating.”

© 2010 RIJ Publishing. All rights reserved.

A Treasury Department official says the Obama administration will push for including a broad fiduciary standard provision in the final financial services bill, National Underwriter reported.

At a conference organized by the Financial Industry Regulatory Authority in Baltimore last week, Treasury Undersecretary Neal Wolin said the administration would fight attempts to weaken H.R. 4173, the Wall Street Consumer Reform and Consumer Protection Act, when talks to reconcile differing House and Senate versions of the legislation get under way June 15.

“We believe that retail brokers offering investment advice should be subject to the same fiduciary standard of care as investment advisors, and we will work to include that provision in the final bill. 

The Securities and Exchange Commission now requires investment advisors to put customers’ interests ahead of their own. Broker-dealers and life insurance distributors affiliated with broker-dealers must merely verify that the products they sell customers suit the needs of those customers.

So far, the House version of 4173 would provide two safe harbors for insurance agents and investment advisers. One says that receiving a commission doesn’t automatically violate the standard. The other says an agent or advisor that captive agents wouldn’t automatically violate the standard simply by selling one firm’s products.

The Senate version, supported by the life insurance industry, underwriters, agents and brokers, and the National Association of Insurance and Financial Advisors (NAIFA) calls only for the SEC to study the issue and report back to Congress.

The House bill fiduciary standard provision and the Obama administration version are ambiguous, said NAIFA president Thomas Currey. An SEC study of the standard-of-care issue “would result in a fact-based approach to address real problems rather than by adopting a ‘one-size fits all’ amorphous fiduciary standard—the need for which is unsupported by any factual findings,” he said. 

Rep. Barney Frank, D-Mass., chairman of the House Financial Services Committee, said Monday in a memo that he wants the House to act on a reconciled bill June 29. That schedule would give the Senate 3 days to act before Congress is set to leave for its Independence Day break July 2.

© 2010 RIJ Publishing. All rights reserved.

At an estimated $16.7 billion in the first quarter of 2010, U.S. sales of fixed annuities were down 15% from the prior quarter and down 52% from the record-setting year-ago quarter, according to the Beacon Research Fixed Annuity Premium Study.

New York Life reclaimed overall sales leadership from Western National, which dropped to fourth place. Allianz Life moved to second from third place on the strength of its top-selling MasterDex X indexed annuity. Aviva jumped two notches to come in third.

Book value annuit ies remained the dominant product type in first quarter 2010, but their 41% share was the lowest since third quarter 2007.  The indexed annuity share of sales hit a 12-quarter high of 40%.

“It is difficult to predict the near-term direction of fixed annuity sales. Fixed annuity rates are down, which typically dampens sales.  But the spread of corporate bond yields over Treasury rates has widened,” said Jeremy Alexander, CEO of Beacon Research.

“This generally provides fixed annuities with a rate advantage that boosts results,” he added. “Sales also may benefit from recent stock market volatility and the flight to safety.  Long term, we continue to expect growth for fixed annuities due to rising demand from Baby Boomers nearing and entering retirement.”

First quarter results include sales of some 425 products. By product type, first quarter estimated sales were:

Book value, $6.8 billion

Indexed, $6.7 billion

Fixed income (including income annuities), $1.8 billion

Market value-adjusted (MVA), $1.3 billion.

Sales for all product types were below prior and year-ago quarters. Year-ago results hit a record driven by book value sales, due to a flight to safety combined with a strong fixed annuity rate advantage. Sales data does not include sales through structured settlements or employer-sponsored retirement plans.

Relative to the previous quarter, MVA and book value annuities dropped 25% and 24%, respectively.  Income annuities were down 7%. Indexed annuity sales fell 2%.  Compared to first quarter 2009, book value annuity sales were 64% lower. MVAs were down 80%. Income and indexed annuities declined 6% and 5%, respectively.

First quarter results for the top five Study participants were:

By product type, New York Life also led in book value sales, replacing Western National, and remained the dominant issuer of fixed income products. Allianz was again number one in indexed annuities. Hartford replaced American National as MVA sales leader.

The Allianz MasterDex X, an indexed annuity, was again the quarter’s best-selling product. The New York Life Preferred Fixed Annuity took second place and was the only book value product in the top five. Two indexed products, American Equity’s Retirement Gold and Aviva USA’s BPA Select 12, placed third and fourth.  The New York Life Lifetime Income Annuity was fifth.

MasterDex X was again the top independent producer product. The New York Life Preferred Fixed Annuity was the new bestseller in banks. Among captive agents, the New York Life Lifetime Income Annuity took top honors. There were new leading products in the remaining channels, as follows:

Credited rates increased slightly from fourth quarter, but their rate advantage was narrower relative to the conservative alternatives.  Top multi-year credited rates were in the 4% range on interest guarantee periods (IGPs) of seven years or more.  Rates at or above the threshold 5% level were available only for the first year of some multi-year and renewal rate products.  Book value annuity sales moved to shorter IGPs, apparently because buyers expected rates to rise and did not want to lock in the quarter’s low credited rates for long periods. MVA sales shifted from the middle to both shorter and longer IGPs.

© 2010 RIJ Publishing. All rights reserved.