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In his new book, Retirementology: Rethinking the American Dream in a New Economy (FT Press, 2010), Greg Salsbury looks soberly at the varieties of financial intoxication that have led so many Baby Boomers to be ill-prepared for retirement.

Yet Salsbury, a vice president at Jackson National Life with a Ph.D. in organizational communication, approaches this serious topic in a mordantly funny way, amusing himself (and his readers) with a nonsense nomenclature of behavioral finance neologisms like“ohnosis,” “finertia” and “financia nervosa.”

Retirementology, a sequel to Salsbury’s But What If I Live? The American Retirement Crisis (National Underwriter, 2006), is based on focus groups with affluent Boomers and Salsbury’s own strong views. It catalogs the dumb things that smart people do with money they should otherwise be saving. It also points out the path to fiscal redemption. 

Recently, Salsbury chatted with RIJ about the book.

RIJ: How scientific or thorough a survey of the American public was the research behind your new book?

Salsbury: It was qualitative research, not empirical. We tried to get a wide swatch of ages, and tried to get typical clients of advisors. We were not particularly interested in the abject poor. They will be at the mercy of the prevailing social welfare systems. We were interested in people who had some savings, who were working toward retirement, who saw themselves as involved in investing.

In the book, you lament Americans’ lack of financial foresight. But how can we be in bad shape if Americans currently have $16 trillion in retirement savings currently invested?

There’s a very small percentage who have adequately saved and they control a disproportionate amount of the savings. A massive percentage of those funds are in a very small percentage of hands, if you will. Two-thirds of all investable assets are with the Baby Boomers, and it’s growing more that way.

But the Boomers represent a financial puzzle for a number of reasons.  Here’s a sobering statistic. Every day 10,000 Boomers, a group the size of the population of Sedona, Arizona, becomes eligible for Medicare and Social Security, the unfunded liabilities of which were $107 trillion before the financial crisis. Those are people who have most of the money to start with but who will be disproportionately draining the system as well.

Just because you have money doesn’t mean you aren’t making the mistakes that I talk about in the book. It might be someone who is buying too much car or buying a 56-foot sailboat. Folks who had multi-thousand-dollar credit card balances thought nothing of adding tens or hundreds of thousands of dollars onto their mortgages. The mistakes happen at all economic levels. There are a lot of boomers who have overspent. They were counting on their house or their vacation home to pay for their retirement.  

The 401(k) activity is disappointing. The number of active participants peaked in 2005, and enrollment hasn’t returned to that level since. People stopped saving. In 2006 alone, people spent $41 billion on their pets. That’s more than the GDP of many countries. Americans went on a spending binge. In the middle of 2005, 40% of all new mortgages were for non-residences. There was an orgy of spending, along with an abandonment of prudent savings.

With the new health care bill becoming law, that will burden the upper end on taxes even further. California is the poster child for the impact of taxes. For four years, more people have left that state than arrived. The wealthy are fleeing the state. The percentage of seven-figure wage earners has been cut in half since 2005. It’s one of the most tax punitive states in the country. And now they’re escalating taxes even further on the upper two percent. There are not enough of those people to generate enough revenue in the first place, and now you chase them out of the state. That’s what they’ve done.

Why are they having such trouble fiscally? One in five budget dollars goes to public pensions. It’s difficult to attack the policies without sounding like you’re attacking the professions. But look at the dollar amounts. The average policeman collects a $97,000 pension. In Vallejo, California, it’s up to $207,900 a year.  To fund the average captain’s pension, it takes $3 million. 

So what’s to be done?

Any retirement plan is doomed by over-expectations. It’s not reasonable to expect three vacation homes or to seven luxury cruises. People will have to look at their spending. They will have to reassess their priorities. They will have to re-examine the amount of assistance that they can or will give to children. They will have to reexamine their use of 529 plans. They will have to ask, ‘Do I fund my retirement properly or give my kid $50,000 and blow myself up?’ People have to make prudent decisions. A lot of people convinced themselves that they were geniuses during the boom. They had one or two homes that were appreciating. They didn’t think they needed a financial advisor.

You recommend the use of ‘holistic money managers.’ What do you mean by that?

Historically, advisors left people on their own for all of their money matters except for their investment portfolio. But those things can’t be as neatly divorced today as they were historically. What you’re doing with your vacation homes and your rental properties may have a material impact on your retirement portfolio. People’s homes morphed from their largest asset to their largest liability.  

How do you handle your own money?

 Personally, I have had more conversations with my wife about spending. I re-examined my household spending. I didn’t get as carried away as some during the boom, but I’ve tried to be even more cautious since then.  For instance, the other day, when I was still having my first morning cup of coffee, a woman walked up the back steps of my deck. She shook my hand and said, ‘Hi, I’m Lacey.’ I said, ‘I’m Greg Salsbury.’ She said, ‘Don’t you know who I am? I’m here for the dogs.’ My wife, unbeknownst to me, had signed up for a dog-walking service. I cut that frivolity out.

You didn’t refinance your house, not even for home improvements?

I refinanced, but I didn’t take money out. It was all about getting lower interest rates. I’ve always maintained a balanced approach on that. I’ve been pretty involved in behavioral finance, so I haven’t been terribly swayed by the momentum of the moment in the market. My 401(k) savings is in a pretty standard allocation. As a 52-year-old male, I have 40 to 45 % of my 401(k) in equities. I have other accounts of similar size that are 100% equities.

What would be your single piece of investment advice to readers?  How should they have handled the crash of 2008-2009? 

They should have been well diversified to begin with. Getting out in the middle of the crisis would have been an improper response. Those who pulled out at the trough in 2009 and who are still sitting on the sidelines aren’t doing so well. But those who stayed the course recovered nicely.

© 2010 RIJ Publishing. All rights reserved.

Jackson National Life Distributors LLC

Thomas M. Marra, 51, has been named president and CEO of Symetra Financial Corp., succeeding Randall H Talbot, who held those positions for 12 years. Marra had spent 29 years at The Hartford Financial Services Group, where he was president and chief operating officer from 2007 to 2009.

Symetra Financial is the parent of Symetra Life Insurance Company, a life and annuity company that raised about $365 million in a January IPO and was listed on the New York Stock Exchange. Symetra originally expected to sell shares for $18 to $20 but ended up selling them for $12 a share. 

The company earned $46 million for the first quarter on $453 million in revenue, up from $5.1 million in net income on $379 million in sales in the first quarter of 2009.

Berkshire Hathaway, Warren Buffett’s company, owns 26.3% of Symetra Financial, according to press reports. White Mountain Insurance Group, of which Berkshire Hathaway subsidiary General Re owns 16%, also owns 26.3%. 

The board of Symetra decided to bring in Marra because he was available, and because board members decided Marra could “take the company to new heights,” said Symetra Chairman Lon Smith in a teleconference, according to a report in National Underwriter.   

Marra has chaired the National Association of Variable Annuities (now Insured Retirement Institute) and the American Council of Life Insurers. He is a Fellow of the Society of Actuaries, a member of the American Academy of Actuaries, and he serves on the board of St. Bonaventure University.

A 30-year veteran of the financial services business, Marra joined The Hartford Financial Services Group, Inc., in 1980 as an actuarial student. He became executive vice president of Hartford Life, Inc., in 1996, COO in 2000 and president in 2002.

Until 2004, Symetra was the life insurance division of Safeco Corp. But Safeco, focusing on property and casualty business, sold the unit for $1.35 billion to investors led by White Mountains and Berkshire Hathaway.

Marra said he has some concerns about the risks associated with Symetra’s large block of fixed annuity business but believes Symetra’s directors and managers understand the pros and cons of that market, National Underwriter reported. “Right now, having a position in fixed annuities is probably our lead strategy,” he said.

© 2010 RIJ Publishing. All rights reserved.

Lincoln Financial Group has launched MyConfidentFuture.com, “a website designed to help people make informed, educated financial decisions.”

“MyConfidentFuture.com provides up-to-date information and timely insights to help empower people to face their futures with confidence,” said Heather Dzielak, Chief Marketing Officer, Lincoln Financial Group.

The website is organized around topics that are relevant in today’s environment and delivers information people can use to successfully navigate their lives through all its transitions including how to:

• Manage risk with insurance
• Retire with lifetime income
• Save for retirement
• Prepare for the unexpected
• Manage the uncertainty of taxes

Lincoln Financial thought leaders and subject matter experts provide valuable educational tools and resources including:

• Videos on the impact of current issues and trends in the industry
• Calculators that provide a snapshot of an individual’s financial situation including a Roth Conversion calculator
• Research and insights to help people understand issues that impact financial planning challenges and solutions
• Surveys and worksheets to get people involved in the income-planning process

© 2010 RIJ Publishing. All rights reserved.

On June 2, the New York Insurance Department published a draft letter, “Guaranteed Withdrawal Benefits and Excess Withdrawals,” on its website that would give owners of annuities with guaranteed minimum withdrawal benefits a 30-day period in which to reconsider intentional or unintentional excess withdrawals.

The draft letter, which will be on the agency’s website until June 16, is intended to elicit comments from writers of annuities with that living benefit.

The agency is concerned that an unwitting excess withdrawal could, depending on the exact terms of the contract, cause a permanent and possibly disproportionate reduction in a contract owner’s guaranteed income base, thus affecting the owner’s financial security in retirement.

In proposing new requirements for such contracts, the draft letter states:

At the time an excess withdrawal is requested, insurers should provide a clear explanation of how the excess withdrawal will affect the contract owner’s guaranteed withdrawal amount.

Providing an explanation at the time the excess withdrawal is requested will enable the contract owner to assess the potential permanent impact on the guaranteed withdrawal amount and make an informed decision whether or not to take the excess withdrawal.

Insurers may want to consider as a best practice informing contract owners at the time of a request that an excess withdrawal may be cancelled within 30 days by returning the withdrawal to the company for crediting as of the date of receipt to the same investment options from which the withdrawal was taken.

To discourage owners of GMWB contracts from taking withdrawals during market downturns, when their account values are depressed, most GMWB contracts reduce the guaranteed income base to the same degree that the withdrawal reduces the account value. For example, if the income base were $100,000 and the account value were $80,000, a $20,000 withdrawal would reduce the income base to just $75,000 and reduce the annual payout (at a 5% payout rate) to $3,750 from $5,000.

While recognizing the insurers’ need to limit their exposure to such adverse behavior, New York insurance regulators wrote, “proportional reductions may result in guaranteed withdrawal reductions that are unfairly disproportionate to the excess withdrawal or amount received for a full surrender.”

New York proposes disclosure of the mechanism of the excess withdrawal aspects of the contract before the contract is issued and at the time of the request for a withdrawal that would cause a reduction in guaranteed income.

© 2010 RIJ Publishing. All rights reserved.

Providers of stable value funds for employer-sponsored retirement plans are concerned that some of the tougher restrictions on derivatives trading in the Democrats’ proposed financial regulations could disrupt their business and hurt the plan participants who hold about $650 billion in the funds.

The campaign to protect stable value funds from collateral damage under the new proposals (S. 3217 and H.R. 4173) is being led by the Defined Contribution Institutional Investors Association (DCIIA), a recently formed trade group of plan providers. According to a recent release from the DCIIA, “Financial Regulation and Consequences on America’s Retirement Savings”:

We believe that the definition of a “swap” contained in the bills could have the unintended consequence of materially and adversely impacting stable value funds.

Existing language in the bill could be interpreted to define “swaps” to include synthetic guaranteed investment contracts, sometimes referred to as “synthetic GICs,” and other types of stable value investment contracts.

DCIIA believes the impact of including stable value investment contracts in the provisions of the bill regulating ‘swaps’ may reduce millions of 401(k) plan participants’ access to or, at minimum increase the cost of, stable value funds.

We also believe it is possible that this legislation may lead to the complete elimination of stable value funds in DC plans, impacting the millions of Americans at or near retirement who rely the return and stability of stable value.”

The conflict apparently stems from the fact that stable value funds have, since the early 1990s, used swaps in the wrap contracts that keep their values stable. According to the Pension Investment Handbook (1998): 

“A synthetic GIC is an investment for tax-qualified, defined contribution pension plans consisting of two parts: an asset owned directly by the plan trust and a wrap contract providing book value protection for participant withdrawals prior to maturity.

“The synthetic is an alternative to a traditional GIC in a stable value fund that unbundles the GIC’s investment and insurance components. The plan investing in a traditional GIC owns a group annuity contract, and the insurance company owns and retains custody of the assets backing the contract. With a synthetic, the plan has custody of the asset and negotiates for the wrap contract providing the book value insurance protection separately.

“Synthetic GICs were first introduced in the late 1980s by banks and investment managers anxious to capture a share of the rapidly growing stable value market. By replicating the traditional GIC’s book value payment feature for participants, synthetic GICs were granted similar book value accounting treatment by many accounting firms.

“Synthetics offered the investor the opportunity to diversify away from what had become a very large single-industry concentration in their GIC funds. This need for diversification became a driving force in the stable value market following the financial difficulties of Executive Life and Mutual Benefit in 1991 and 1992 respectively. From a very low volume of sales in 1990, synthetic GICs rose to 35% of stable value sales in 1996.”

Other language in the proposed legislation would cause the swap dealers who are parties to stable value fund management to become fiduciaries and would redefine 401(k) plans as “major swap participants,” thus subjecting them to a host of new regulations and requirements.

In its release, DCIIA recommends that S. 3217 and H.R. 4173 “be reconciled to preserve the benefits of the current system for stable value funds.” It calls for:

• An exemption for stable value investment contracts issued by bank and other regulated financial institutions, to all or part of the swaps requirements of the bills.

• A provision that swaps dealers not be considered fiduciaries to those plans, when the swaps dealers don’t provide advice and when the plan is represented by an established fiduciary that is not related to the swaps dealer.

• An exemption of defined contribution plans that use swaps primarily to reduce portfolio risk from the definition of “major swap participant.”

© 2010 RIJ Publishing. All rights reserved.

If Americans begin to live longer than expected—that is, if miracle drugs overwhelm the effects of the obesity epidemic—then annuity manufacturers and the Social Security Administration would risk facing much higher payouts than expected.

Offsetting that risk by increasing reserves would force insurers to raise prices for life annuities. That would hurt demand annuities. Another solution that academics propose involves the use of so-called longevity bonds. 

A new brief from the Center for Retirement Research at Boston College, The Case for Longevity Bonds, highlights the benefits of these long-duration, coupon-only bonds, which governments alone would have the capacity to issue. (The brief is based on a longer paper, Sharing Longevity Risk: Why Governments Should Issue Longevity Bonds, from the Pensions Institute, Cass Business School, City University, London.)  

Governments would initially sell the bonds, earning a modest premium, to insurance companies. The bonds would pay coupons that would be higher when the more people outlived expectations and lower when fewer people did. No repayment of principal would be involved. As the brief explains:

• The bond coupons payable each year depend on the proportion of a given cohort that is alive in that year-for example, the percent of men born in 1945, and who were age 65 in 2010, that survives to 2011, 2012, and so on.

• Coupon payments are not made for ages for which longevity risk is low-for example, the first coupon might not be paid until the cohort reaches age 75 (such a bond would be called a deferred longevity bond.

• The coupon payments continue until the maturity date of the bond, which might be, for example, 40 years after the issue date, when the cohort of males reaches age 105.

• The bond pays coupons only and has no principal repayment.

It’s not a simple solution. The bonds would not make a perfect hedge for every insurer, since each insurer’s annuitant base would be different from the people on whose lives the bond’s coupons were calculated. Sub-populations with widely different longevities-African-American men from the southeast U.S. versus Hawaiian women of Asian descent, for instance-might need different longevity bonds.

The paper envisions a longevity bond market where, after a transition period, the government-sponsored bonds would cover only the risk from age 90 forward, thus relieving capital markets of the tail longevity risk that could eventually make life annuities prohibitively expensive.  

© 2010 RIJ Publishing. All rights reserved.

“The one investor who always loses money is the man who wants a piece of paper that represents both a sure thing and a gamble.”

Martin Mayer, the financial journalist (and my first cousin, once removed) used those words years ago to describe the participating preferred or income bond, which supposedly offered bond-like safety and stock-like potential.

As he wrote in Wall Street: Men and Money (Harper & Row, 1955), the first of his books about The Street, the banks, the Fed and other institutions, such securities were custom-built for the “sucker trade.” He didn’t think much of them.

When I study the complex income products that insurers and fund companies are cooking up for soon-to-retire Baby Boomers, Mr. Mayer’s description of income bonds often comes to mind. 

Many of us—and I include myself in the retirement income industry—are trying to build, sell or analyze products that purport to offer bond-like protection and stock-like potential.

The more I see of these products, the more they give me pause. I wonder not just about their ultimate value to the consumer, but also about their safety for the manufacturers. Even the principles that underlie them—which in their extreme forms seem to resemble the principles by which alchemists once tried to convert lead to gold—strike me as incongruously speculative, considering that they are purported to be risk-reduction tools.      

The products in question include almost anything that uses derivatives to keep risk temporarily at bay, in the way that music keeps risk temporarily at bay in a game of musical chairs.

Index annuities and variable annuities with lifetime income guarantees belong to this category. So do structured products that pay an absolute return unless the market vastly over- or underperforms, in which case the investor gets bupkes.

These products work great in the lab, and they keep financial engineers busy. But no one can promise or predict how they will perform. Every customer liquidates his product at a different point in financial history and ends up with different results.    

A product that is both a sure thing and a gamble obviously has broad appeal. Everyone loves one-stop shopping. We now have drugs that control both triglycerides and cholesterol. We have “crossover” automobiles that blend comfort, practicality and excitement. 

So it makes perfect sense that the financial services industry, forced to compete for the fragile resources of a feckless, flattered but financially unsophisticated (on average) cohort of Boomers, would concoct products that eliminate the need for tough choices.

Yet, at some point, the cost of the glue (i.e., derivatives) needed to overcome the tensions inside these products, plus the cost of feeding everyone at the table (manufacturers, distributors, corporate shareholders, employees, asset managers and, last of all, consumers) has to extinguish the value of the products in all but the most benign future scenarios.

In their complex versatility, many of today’s retirement products challenge the most basic and natural of laws: Keep It Simple Stupid (KISS). The more simplicity, the less room for stupidity. While bond funds and equity funds are not invulnerable to the uncertainty of the future, their risks seem relatively easy to gauge.

The issue goes beyond the virtue of simplicity over complexity and transparency over opacity. It involves the futility of creating win-win products for a market that thrives by generating losers and winners.

Still, it is the abiding nature of financial manufacturers to build products, and they must in turn dress up those products and move them. And for dressing, hope and optimism have always served well.

As my cousin also wrote in his first book, “It is notorious on Wall Street that a man selling stock in a gold mine may actually find some gold once the stock has been sold. It isn’t an everyday occurrence, but it isn’t impossible, either.”

© 2010 RIJ Publishing. All rights reserved.

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.