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Spock-o-nomics at the RIIA Meeting

CHICAGO—Clad in dark jacket and turtleneck, Moshe Milevsky beguiled the Retirement Income Industry Association’s conference Tuesday with a presentation about investor behavior on Vulcan, the Class M planet where Mr. Spock was born.

The specific topic was “longevity risk aversion.” You may never have heard of it, and neither had most of the 135 or so attendees at RIIA’s spring meeting, which is to its industry what the Democratic National Convention is to politics—at least in its diversity of viewpoints.

Milevsky, the well-known goateed Toronto-based finance professor and writer, asked the gathering at Morningstar/Ibbotson headquarters to imagine a Planet Vulcan where the inhabitants had only one investment option, risk-free inflation-protected bonds with a real return of 2% to 2.5%.

Vulcans differed, however, in their fear of outliving their money and in their access to pensions. Milevsky’s advice to them was that the less they feared outliving their money and the larger their pension or annuity income, the more they could spend each year in retirement.

That may sound reasonable on its face. But it collides like a maverick asteroid with two pieces of conventional wisdom: that 4% is the proper asset drawdown rate in retirement and that stocks are the proper investment for people who are afraid they might survive long enough to exhaust their assets.

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“Don’t scare people by saying you have to invest in stocks if you expect to live to age 95,” said Milevsky, who is the author of, most recently, Your Money Milestones: A Guide to Making the 9 Most Important Financial Decisions of Your Life (FT Press, 2010).

‘Floor, Then Upside’
Not everyone in Morningstar’s corporate auditorium—which its striking view of the 50-ft sculpture by Picasso in Daley Plaza and Chicago’s pillared, classical-revival City Hall—may have accepted Milevsky’s assumption that people who are averse to longevity risk are equally averse to financial risk.

But that seemed to be fine with RIIA president Francois Gadenne, who confessed in his conference-concluding remarks Tuesday that he loves a good intellectual tussle. The same might be said for most of RIIA’s eclectic and distinguished membership, which includes insurance company executives, mutual fund executives, economists and other academics, software vendors and income-oriented advisors.

Its sixth spring conference is a turning point for RIIA. It marks the most public introduction so far of the books, training program, and professional designation—the Retirement Management Analyst—that RIIA leadership has been developing for more than a year.

The philosophy behind the designation is “build a floor, then create upside.” As a group, RIIA believes that pre-retirement or “accumulation” investing is fundamentally different from investing during retirement. In the latter, reducing risk becomes paramount.

This idea doesn’t simply mean adopting a more conservative asset allocation or other wealth preservation tactics in retirement. It means that retirees should lock down a safe, adequate income—from pensions, Social Security, annuities, laddered bonds, or structured notes, etc.—before putting money at risk.

[See accompanying feature story “Floor It!” on Michael J. Zwecher’s new book, Retirement Portfolios: Theory, Construction and Management (John Wiley & Sons, 2010), which is required reading for the RMA designation.]

This concept is somewhat heretical. It strikes at Jeremy J. Siegel’s bullish dogma that, on average, stocks pay off in the long run. RIIA contends that on average isn’t good enough in retirement, where an ill-timed fat-tail event can mean a diet of cat food for the elderly. Stocks, many RIIA members might concede, aren’t necessarily bad for retirees. But they aren’t good for money that retirees can’t afford to lose.

It’s no coincidence that, more so than most retirement industry groups, RIIA has academics and economists among its members. Their conservative viewpoint reflects their focus on public policy rather than the exciting, but ultimately zero-sum outcomes produced by the financial markets.

On the other hand, that philosophy doesn’t preclude profits, and the stocks-are-just-for-mad-money idea was implicit to some extent in most of the presentations at the conference, including the presentations by leading marketers of retirement products and planning tools. 

Income products and processes
On the product side, for instance, Tom Streiff of PIMCO talked about his firm’s TIPS funds, which pays out a predictable, inflation-protected income over either 10 or 20 years. Tom Johnson of New York Life followed with a discussion of the mortality credits embedded in immediate annuities.

On the planning side, Jack Sharry of LifeYield explained his company’s proprietary strategies for tax-efficient decumulation. Boston University economist Larry Kotlikoff presented his widely-used ESPlanner software, which focuses on maintaining a consistent standard of living in retirement through “consumption smoothing.”

Whether stocks pay off in the long run was the central issue in a panel discussion on the usefulness of time-segmented retirement planning methods. “Time-segmented” or “bucket” methods generally include the many strategies that dedicate certain assets in a retirement portfolio to fulfilling income needs during specific segments of time, usually ranging from one to five years.

The panelists—Gary Baker of Cannex Financial Exchanges, Sherrie Grabot of Guided Choice, Tom Idzorek of Ibbotson, Larry Kotlikoff and moderator Richard Fullmer of Russell Investments—were asked whether it makes sense to assign progressively riskier assets to the buckets, so that a bucket designated for liquidation in 20 years, say, could safely be stuffed with emerging market small-cap stocks on the presumption that they are likely to “mature” in value by then.

This narrow question was a bit of a straw man, and the discussion was not conclusive. But it seemed to settle on the fact that many people do find time-segmentation or buckets to be a useful framework for retirement income planning. And it was noted that bucketing doesn’t require investing in stocks, or the belief in stocks-for-the-long-run, to be useful.

In his presentation, Milevsky approached the risky assets issue from a different angle. He suggested that there’s an “internal contradiction” in telling people who are worried about outliving their assets to put more money in equities. “You can’t deal with extreme aversion to longevity risk only with stocks,” he said. 

His slide show, and the paper it was based on, “Spending Retirement on Planet Vulcan,” suggested—somewhat counter-intuitively—that adding annuities to a retirement portfolio is a better way to enhance the retirement drawdown rate and to make your money last than adding stocks.

“If you worry about living, which is different from expecting to live,” he told RIJ, “then you should increase your allocation to annuities rather than gambling on stocks, which is inconsistent with said risk aversion.”

© 2010 RIJ Publishing. All rights reserved.

401(k)s: They’re Not (Necessarily) Just for Employees Any More

Among the things that a retiring employee could traditionally expect from his or her employer – gold watch, cakes, cards, and golf- or gardening-related gifts – they could also be pretty sure they’d soon be booted from the company 401(k) plan.

Since these retirement savings plans were introduced in 1978, companies generally haven’t allowed non-employees to hitch a free ride, since the cost of keeping them in the plan outweighed the advantages of keeping their dollars in the plan.

More recently, however, the tide has begun to turn among employers, retirees, record keepers and regulators that could keep more retirees in their 401(k) plans well into, or even straight through, their retirement.

Anecdotal evidence certainly supports the notion that this will become a trend. At recent meetings PIMCO had with 18 large plan sponsors, a show of hands indicated that a decade ago, none of the plans would have considered keeping retirees. But today, all 18 say they want to keep retirees on the plan, and 16 said they are actively developing plans to retain them.

Though it’s hard to know exactly how strong the trend will be, the stage is certainly being set for an increasing number of retirees to stick with their 401(k) plans. And it’s nearly certain that at least some plans will start to do whatever they can to retain retirees’ assets in the years to come, and that many savers will likely be attracted to the benefits of staying in a plan.

The Employer’s View
Companies have traditionally wanted to get retirees out of the plan as fast as possible because they didn’t want to foot the bill for administrative tasks, answering questions and dealing with ad hoc withdrawals for people who were no longer with the company. Compounding this was the even larger problem that they simply didn’t have the administrative capability to write the regular checks that retirees often need to meet their day-to-day spending needs.

In recent years, however, record keepers have started developing technologies that can help 401(k) plan sponsors more economically meet retirees’ needs, including installment plan methodologies that can efficiently make regular monthly payments. It’s clear that all the economies and efficiencies aren’t built in yet, but as the processes improve and become more prevalent, it will likely continue to diminish employers’ aversion to keeping retirees.

As recordkeeping improves, other potential advantages of retaining retirees start to emerge, particularly the benefit of keeping assets – usually the largest balances in the plan – on the plan’s books. The more assets in the plan, the more administrative costs are spread out, and the more economical it may be for all participants. Many plans are also finding that not all retirees start drawing money from their plans in the early years, as they rely on other funds such as Social Security or money they’ve already paid taxes on. So not only do the big balances often stick around longer than the employer might expect, but the retirees do not necessarily require much service beyond simple administration.

The Retiree’s View
Just as plans have historically wanted retirees out, there is a whole industry made up of brokers, advisers, planners and certain mutual fund companies that are eager to acquire retirees by rolling over their 401(k) savings. PIMCO estimates that assets eligible for rollover out of defined contribution plans will be almost $400 billion this year alone, and it’s clear there will be lots of players competing to manage that money.

For a retiree, this means the options are growing, and each has trade-offs that warrant consideration. On one side of the equation are retirees who don’t have, or care to have a full-service financial advisor, whether for cost savings or other reasons. Typically the investment choices inside 401(k)s often have institutional pricing, which can carry lower expense ratios than share classes on other platforms. In an effort to retain retirees, some companies have also begun to build programs aimed at helping savers plan for retirement and offering guidance on how they can meet their goals.

On the other side of the coin, we feel it’s abundantly clear why some retirees would want to leave the plan in favor of a full-service adviser relationship. While employers are offering guidance and other services, they are unlikely to completely capture the retiree’s total financial condition and therefore are not likely to offer a comprehensive financial plan as a full-service adviser would.

Potential Policy Tailwinds
There also seems to be some political wind blowing in support of policy that makes it easier or more attractive for plan sponsors to retain retirees. Recently, the Treasury Department and the Department of Labor sent a request for information to a broad swath of the financial services industry, looking for feedback on the variety of methods of offering guaranteed lifetime income benefits inside 401(k) plans. Since this was simply a request, it’s hard to know if it will lead to regulatory or legislative outcomes. Nonetheless, by canvassing the industry on the subject, the government is showing a clear interest in finding new ways for retirees to get guaranteed lifetime income options, including within employers’ 401(k) plans.

A Changing Perception
Since their introduction more than three decades ago, 401(k) plans have been almost exclusively a tool for the accumulation phase of retirement savings, but there is growing momentum towards efforts to make them a credible choice for the decumulation phase as well. As employers make efforts to push the trend forward, advantages are emerging for both the retiree and the plan. With defined benefit plans and Social Security unlikely to be primary sources of retirement income in the future, policymakers are also taking measures to determine whether 401(k)s present a potential platform for distributing lifetime guarantee benefits to retirees.

It’s unlikely that plan sponsors will supplant the holistic advice offered by the financial advisory industry, but they do represent an emerging alternative for delivering retirement income.

© 2010 PIMCO, Inc. All rights reserved.

PIMCO
PIMCO’s recently introduced Real Income 2019 Fund and Real Income 2029 Fund are designed to provide monthly inflation-adjusted distributions made up of both interest and principal which are paid out until the funds reach their final maturity date. The funds replicate TIPS in the maturity gaps that exist, creating an efficient and systematic means of providing income in retirement. Although TIPS are guaranteed by the U.S. government, the funds’ distributions are not guaranteed. The funds pursue all the best qualities of TIPS, with a frequency of income payments designed to help meet the needs of most retirees.

To receive more information about Real Income 2019 and Real Income 2029 Funds, please provide the following information: Email
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This material contains the current opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626.©2010, PIMCO.

 

A company of Allianz Global Investors


Industry Views are special reports that are sponsored and independent from RIJ’s editorial content.

Financial Reform Bill Released by Senator Dodd

Senator Christopher Dodd (D-CT), chairman of the Senate Committee on Banking, Housing and Urban Affairs, released a draft of his financial reform bill on March 15.

A summary of the bill’s main provisions was published by the blog, OpenCongress.org, including the following highlights:

Consumer Protections with Authority and Independence: Creates a new independent watchdog, housed at the Federal Reserve, with the authority to ensure American consumers get the clear, accurate information they need to shop for mortgages, credit cards, and other financial products, and protect them from hidden fees, abusive terms, and deceptive practices.

Ends Too Big to Fail: Ends the possibility that taxpayers will be asked to write a check to bail out financial firms that threaten the economy by:

  • Creating a safe way to liquidate failed financial firms.
  • Imposing tough new capital and leverage requirements that make it undesirable to get too big.
  • Updating the Fed’s authority to allow system-wide support but no longer prop up individual firms.
  • Establishing rigorous standards and supervision to protect the economy and American consumers, investors and businesses.

Advanced Warning System: Creates a council to identify and address systemic risks posed by large, complex companies, products, and activities before they threaten the stability of the economy.

Transparency & Accountability for Exotic Instruments: Eliminates loopholes that allow risky and abusive practices to go on unnoticed and unregulated—including loopholes for over-the-counter derivatives, asset-backed securities, hedge funds, mortgage brokers and payday lenders.

Federal Bank Supervision: Streamlines bank supervision to create clarity and accountability. Protects the dual banking system that supports community banks.

Executive Compensation and Corporate Governance: Provides shareholders with a say on pay and corporate affairs with a non-binding vote on executive compensation.

Protects Investors: Provides new rules for transparency and accountability for credit rating agencies to protect investors and businesses.

© 2010 RIJ Publishing. All rights reserved.

Two Insurers, Two Multi-Media Web Strategies

Two major retirement product providers, The Principal and AXA Equitable, have established new multi-media web portals, one to appeal to crisis-battered Americans and the other reaching out to bloggers and reporters.

Principal Financial Group has launched “AmericaRebuilds.com,” an online planning center that’s designed “to engage, educate, inspire and motivate Americans to take action,” the company said in a release.   

The site features educational tools, videos and guidance from third-party financial experts and advisors;  videos and stories of Americans and their businesses at different stages of rebuilding; financial calculators; and assistance finding an advisor.

The Principal will partner with Time Warner divisions, Time Inc. and Turner broadcasting to drive traffic to the site. With appearances by financial expert Jean Chatzky, the campaign includes a category exclusive sponsorship of CNN’s “Building Up America” series across CNN, HLN and Airport Networks. 

The Principal’s “Rebuild” advertisements will run throughout national print, broadcast, cable, financial trade and local business journals, as well as NCAA basketball and football event sponsorships.

The effort also includes a mobile website that furnishes users with a retirement planning calculator; information about budgeting, saving and other goals; savings tips; an advisor locator; and a calendar with reminders to call advisors.  

AXA Equitable Life Insurance, meanwhile, has announced the launched “The Source,” a multi-media Web site linked to the company’s existing online press room. It’s intended to promote AXA Equitable as a resource and thought leader on financial protection and retirement planning.

“Innovation remains the fabric of our communications efforts,” said Barbara Goodstein, executive vice president and chief innovation officer. “The Source is the latest example of how the tools at our disposal—notably technology and creativity in this case—help to create a unique platform of learning.”

AXA Equitable hopes bloggers as well as traditional media will use The Source to keep up on financial security trends and the growing pressure on individuals to generate retirement income beyond Social Security and employer-sponsored plans.

Multi-media content now on the site includes highlights of a forum that featured former Federal Reserve Board Chairman Paul Volcker,  a look at trends in inflation, interest rates and taxes, and a video that reports on the unique financial needs of women.

© 2010 RIJ Publishing. All rights reserved.

New Research Analyzes Benefits of Roth Conversion

A new research brief from the Center for Retirement Research at Boston College demonstrates that converting assets from a traditional tax-deferred IRA to a tax-free Roth IRA is most likely to benefit people who:

  • Expect their income tax rates to rise after they retire.
  • Want to defer withdrawing money from their IRAs longer than the rules for traditional IRAs permit.
  • Wish to boost their total IRA balances more than the restrictions on their annual contributions will allow.

The brief, “Should You Convert a Traditional IRA Into a Roth IRA?,” by Richard W. Kopcke and Francis M. Vitagliano, indicates how large the potential market for Roth conversions in 2010, when could be.

“In 2008, the assets in IRA accounts totaled $3.6 trillion,” they write. “These balances exceed, by significant margins, the assets held in defined benefit pension plans and in other defined contribution plans. Traditional IRAs account for more than 95% of total IRA assets.

These conversions will appeal to those who are likely to find that the mandatory distribution rules for traditional IRAs force them to withdraw their balances too soon. Roth accounts give retirees who have adequate financial resources more latitude for making withdrawals in the most favorable manner.

The study also suggests that Roth IRAs enable retirees to leave a larger bequest to their spouses or other heirs. “This option should be particularly valuable to people who expect their IRA savings to provide retirement income for dependents,” the brief said.

Beginning this year, the Tax Increase Prevention and Reconciliation Act of 2005 allows all workers with traditional IRAs to transfer all or part of their balances into Roth IRAs without restriction.

People who have 401(k) plans with former employers can participate as well. The balances in 401(k) plans can be rolled over into traditional IRAs, without penalty or restriction, once people stop working for the sponsoring employer.

Those who hold old 401(k) accounts can convert these balances directly into Roth IRAs, as provided in the Pension Protection Act of 2006. People who convert their balances must include the amount of their transfer in their taxable income.

Those who make transfers in 2010 have the option of paying the tax entirely this year or including half the transfer in taxable income in 2011 and half in 2012. In the future, the tax must be paid entirely in the year of the transfer.

© 2010 RIJ Publishing. All rights reserved.

 

Credit Crunch Looms in 2012, Analysts Say

Starting in 2012, more than $700 billion in high-yield corporate debt will begin to come due, causing concern among bond analysts, The New York Times reported.

Junk bonds are set to mature at a rate of $155 billion in 2012, $212 billion in 2013 and $338 billion in 2014, up from only $21 billion in 2010. That will create what bond analysts call a “maturity wall.”

The concern is that the U.S. government—which must borrow or refinance an estimated $2 trillion in 2012—could absorb much of the available capital or push up interest rates, crowding out private borrowers and possibly causing defaults or bankruptcies. 

 “An avalanche is brewing in 2012 and beyond if companies don’t get out in front of this,” said Kevin Cassidy, a senior credit officer at Moody’s Investors Service, which warned March 15 that the U.S. and other Western nations were moving closer to losing their gilded Aaa credit ratings.

On the junk bond side, private equity firms and many nonfinancial companies borrowed huge amounts on easy terms before 2007, with debt maturities of five to seven years. Many firms whose debt matured in 2009 and 2010 have extended their loans to 2012 and later.

The situation in 2012 could resemble the meltdown in mortgage-backed securities. In the mid-2000s, junk bonds were packaged into collateralized loan obligations, then hedged and used as collateral for still more risky loans. “The question is, ‘Should these deals have ever been financed in the first place?’” asked Anders J. Maxwell, a corporate restructuring specialist at Peter J. Solomon Company in New York.

That could hurt private equity firms like Bain Capital and Kohlberg Kravis & Roberts, who led leveraged buyouts in the pre-crisis boom. Hospital owner HCA, taken private in 2006 for $33 billion, must pay or refinance $13.3 billion between 2012 and 2014. TXU, a giant Texas utility, has to refinance $20.9 billion in that period. 

Depending on the economy and the demand for high-yield debt, those high-risk borrowers could be crowded out of the debt market by better-rated borrowers, like the U.S. government and corporations with good credit.

The federal budget deficit in 2012 will total $974 billion, according to the Treasury Department, and $859 billion in old bonds will have to be refinanced. In both 2013 and 2014, the U.S. will need to raise $1.4 trillion.

Another $1.2 trillion in investment-grade debt will have to be refinanced between 2012 and 2014, including $526 billion in 2012. An estimated $59.7 billion in commercial mortgage-backed securities will also mature in 2012. 

© 2010 RIJ Publishing. All rights reserved.

Target-Date CTFs: The Next DC Gold Rush?

Because of their low fees, flexibility and fiduciary structure, collective trust funds (CTFs)—particularly those that serve as vehicles for target-date funds—are the talk of the defined contribution world, according to Cerulli Associates.

The Boston-based research firm’s ongoing surveys show that asset managers’ interest in CTFs is driven by client demand and competition from peers. The structure of CTFs apparently gives them a leg up on mutual funds in target-date products.

Any bank that acts as trustee of a CTF by definition must act as a fiduciary for the fund’s assets. If pending regulations force investment managers to assume fiduciary responsibility over target-date funds, CTFs, unlike mutual funds, will already be providing this service.

Unlike 40-Act mutual funds, CTFs can invest in alternative asset classes, such as direct real estate. This means CTFs could invest in non-correlated asset classes, thus making them a better single-fund solution for target-date investors.

Alternative investments have not been used much in CTFs so far-a sign that the market is young or that trustees are reluctant to take on additional fiduciary risk.

CTFs aren’t filed with the Securities and Exchange Commission, so it’s hard to assess them. Cerulli encourages firms to participate in industry surveys and databases to increase transparency in this industry.

Other findings in Cerulli’s latest research report include:

  • In a recent Cerulli survey, 29% of respondents expect CTF asset growth in 2010 to increase by 20% or more and 53% believe it will increase by 10%-20%.
  • Cerulli projects $108 billion in private DB contributions for 2010-much of which is likely to flow into long-duration fixed-income investments.
  • Variable annuity hedging strategies have expanded to the investment options that underlie the insurance guarantees. This could create opportunities for asset managers with domestic small-value or fixed income experience.

© 2010 RIJ Publishing. All rights reserved.

 

 

Milliman Offers Hedging Strategies to Distributors

Milliman, the global actuarial consulting firm that for years has been advising annuity manufacturers, has diversified its business strategy and is now working directly with financial products distributors. 

While the firm continues, among other things, to assist insurance companies in creating variable annuity living benefits riders, the consulting firm will now also help wirehouses and advisory platforms offer customized hedging strategies for individual accounts.

“This is the first time that were working with the financial platforms. Our activity is basically identical but the kind of group that we’re working with has changed,” said Kenneth P. Mungan, Milliman’s Financial Risk Management Practice Leader.

He did not say which wirehouses or advisory platforms Milliman has started working with, but he indicated that they included some of the largest.

The new strategy was apparently catalyzed by the financial crisis and its aftermath. Individual investors are looking for a way to protect equity-rich portfolios going forward. Since diversification in commodities or real estate didn’t work last time, advisors and their clients are expected to be receptive to hedging strategies.

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“Individuals can go through advisory process with an unprotected portfolio, with complete exposure to the market. Or, at the other end of the spectrum, you have variable annuities with living benefits,” he said. Milliman sees a market opening up for a middle strategy, using uncomplicated hedges that would mitigate the effects of severe market downturns, without creating a huge drag on returns. 

“We’re seeing the emergence of a client account on a platform with a protection strategy that would contain hedge aspects. So many people have withdrawn from the market. This would give them protection,” Mungan said.

Milliman would offer clients its economies of scale, its hedging experience, its technology base, called the Milliman Grid Computing Facility, and its ability to monitor risk 24-hours a day through trading floors in Chicago, London and Sydney.

The new strategy might appear to threaten annuity manufacturers, because wirehouse clients will be able to get their hedging programs straight from Milliman without having to buy it in the expensive context of a variable annuity with a living benefit rider.

But Mungan said that his group will create new business for insurance companies by enhancing demand for their unbundled living benefit riders, also called stand-alone living benefits or SALBs. Some of the clients who use Milliman-made hedges to protect their equity investments may want to add SALBs), which add protection against longevity risk by guaranteeing lifetime income. 

“Under this model, the cost of the hedge for the insurance company drops dramatically, so that the customer could end up with the optional [lifetime income] guarantee at a lower price point,” Mungan said.

Besides the failure of diversification in the crisis, demand for Milliman’s new service is driven by low bond returns, and the prospect of low total bond returns for many years ahead in a rising rate environment. The third driver is the fact that Baby Boomers haven’t saved enough for retirement, and therefore have to invest in equities to reach their goals.

“Most investors haven’t saved enough money to invest only in bonds,” he said. “They would be locking in failure if they do.”

A March 1 article on Milliman’s website, “Challenges for financial advisors,” by Milliman project manager Matt Zimmerman, explains the new hedging strategies in general terms. The article describes a hypothetical hedged portfolio of large cap stocks that employs a “5% stop-loss rule” to lock in gains during a rising equity market. During a falling market, the hedge assets are intended to grow and the gains are “harvested” when they reach a “pre-set threshold.”

Part of the protective effect would be behavioral, Zimmerman wrote. The presence of an equities hedge would make investors less likely to panic and sell their stocks during a sharp downturn, since they know that the hedge, like a bungee diver’s cord, would prevent them from hitting bottom.

© 2010 RIJ Publishing. All rights reserved.

Breaking Up Is Hard to Do…

Clearly, the time has come to consider partition. The country’s sectarian rivalry has grown too violent. Its regional cultures are too incompatible. The rage runs too deep.

I’m not talking about Iraq or Afghanistan. I’m talking about the United States.

Partition will be difficult, no doubt. Mapping the new borders will require an army of high-tech Masons and Dixons. But could it be any harder than collaborating on health care or retirement policy? I don’t think so.

I propose that we combine the 19 states that currently have two Democratic senators into a new country, composed of AR, CO, NM, CA, OR, WA, NY, PA, ND, MT, VA, MN, WI, IL, DE, MD, NJ, HI and RI.

Then we should turn the 16 states that have two Republican senators into a second country. Its members would include AZ, AK, NV, WY, ID, TX, KS, MS, AL, GA, SC, ME, OK, TN, UT and KY.

States with divided senate delegations could be cut in two, King Solomon-style. Each state could work out its internal partition on a county-by-county or perhaps township-by-township basis. That won’t take long. VT and CT, which each have one independent senator, could bore a tunnel under MA and form their own country.

We’ve tried to live in harmony. Folks, it’s not working.

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Half of our society believes that the rich exploit the poor and the other half believes the poor ride free. One half believes in public policy and the other wonders what that is. One half believes that Treasury bonds are safe. The other half believes they’re toilet tissue.

Partition, in a sense, is already here. The Republicans have seceded into a passive-aggressive snit, unified by the belief that next fall the voters will reward them just for saying no. The Democrats are too philosophically heterogeneous to unite behind anything big. They divide and conquer themselves.

Sure, partitions can be messy. When India was partitioned in 1948, a few million Hindu and Muslim lives were lost. And when Stalin, Churchill and Roosevelt redrew the map of Eastern Europe at the Yalta Conference, the Poles, Czechs and Hungarians weren’t happy. But you can’t please everyone.

The borders of the two new countries look gerrymandered, I admit. But they won’t be any more convoluted than most of the school districts in my county. Smuggling could be an issue. Since the South is sure to abolish taxes, we can expect an epidemic of it. Speaking of epidemics, the free health care in the North will attract a lot of illegals.

Some of you may say secession is a bad idea, that we tried this once before. But that’s the beauty of it. Many of the legislators who refuse to recognize the Obama government come from same states that rejected Lincoln in 1860. We’ve learned from our mistakes and we’ll do it right this time.

The devil will be in the details. We’ll need to divvy up our warheads, reroute the natural gas pipelines and create new currencies. At this point we can only speculate about where President Gingrich will locate his new Sunbelt capital. But if we all work together, in a true spirit of cooperation, we can make partition work. Yes, we can.

© 2010 RIJ Publishing. All rights reserved.

The Empire Strikes Back

The financial crisis exposed the weaknesses of 401(k) plans and sparked criticism that the employer-based defined contribution (DC) savings system is too expensive, too risky, and leaves too many Americans unprepared for retirement.

In response, the major 401(k) service providers—including several close competitors—have started a Washington-based trade organization to conduct research, promote their agenda and, specifically, to make DC plans more like defined benefit (DB) plans.

The Defined Contribution Institutional Investment Association, or DCIIA, unveiled itself earlier this month, in time to respond to a Labor Department request-for-information on income options in 401(k) plans. “We have consistently heard that now is the time to influence the public policy debate,” the group says in its statement of core beliefs.

Big insurers and investment firms like MetLife, New York Life, Goldman Sachs, PIMCO, AllianceBernstein and others have chipped in $15,000 each to belong to the DCIIA. Consulting firms like Hewitt, Mercer and Ibbotson have paid $3,500 a piece. Plan sponsors can join for only $1,000. The group has about 40 members so far. It will hold its first policy forum May 11 in Washington, D.C.

Stacy Schaus, the leader of the DC practice at PIMCO, the giant bond manager, and the DCIIA’s chair, told RIJ, “We’re looking at defined contribution asset management through a defined benefit lens. We’re asking, ‘How do we increase the likelihood that participants will meet their income goals?’ There are people who are saying that DC plans should be taken away altogether, so making these plans better is in our best interest.”

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“Our general consensus is that there are a lot of real positives in the defined contribution system, but that there are ways to build it and refine it,” added Lew Minsky, the DCIIA’s executive director. “We felt strongly that we can improve the investments in defined contribution plans by using institutional approaches. There’s no reason why large DC plans can’t look a lot like DB plans. For instance, the returns are better in DB plans and we want to close that gap.”

“DB-ization” of DC
In dedicating itself to the “DB-ization” of DC plans, the DCIIA intends to bring more of the investment practices and possibly the annuitization options of DB plans to 401(k) plans. DB plans, on average, are said to earn about one percent more per year than defined contribution plans—though it’s hard to imagine an apples-to-apples comparison.

That means greater use of collective trusts as a cheaper alternative to mutual funds, customized as opposed to off-the-rack target date funds, and “deemed IRAs” that keep employees’ assets in the plan even after the employees leave the company or retires.

A big part of the DCIIA’s mission is to lower the costs of 401(k) plans and make the fees more transparent. Collective trusts, or commingled funds, are one way to cut costs. Because they are not marketed to the public or filed with the Securities and Exchange Commission, collective trusts are about 25 basis points cheaper than mutual funds—but not necessarily more transparent. (See our news story in this issue, “Target-Date CTFs: The Next DC Gold Rush?”)

“About half of the defined contribution money is in mutual funds. But instead of mutual funds you could have custom funds or collective trusts or target date funds that are set up as collective trusts. Depending on the structure you hold the fund in, you can make it cheaper for the participant,” said Jody Strakosch, national director of Institutional Income Annuities at MetLife and a member of the DCIIA’s retirement income committee.

The group promotes the tools made possible by the Pension Protection Act of 2006, including default enrollment of participants, qualified default investment options, managed accounts, and default escalation of contributions. It is also expected to discuss strategies for protecting participants from the kind of volatility they experienced in 2008 and 2009.

“Certainly the defined contribution community as a whole is talking about whether there are methods to manage the volatility in DC plans,” said David Wray, president of the Profit-Sharing Council of America, an association of plan sponsors.

Custom TDFs and “Deemed” IRAs
Wider use of stable value funds might be one response to volatility. Another might be the expansion of customized target date funds to a broader audience. About one-third of DC plans with over $1 billion in assets now use bespoke TDFs, but smaller plans are said to face hurdles in using them.

“We know that more companies are managing their own target date strategies,” said Schaus. “Instead using off-the-shelf target date funds, more plan sponsors are opting for target date strategies that are plan-specific and whose holdings could be managed more actively.

“You could have someone determining how much money goes into the different asset classes or you can add asset classes to the menu. It would happen automatically behind the scenes so you don’t have to ask participants every step of the way,” she added.

DCIIA members also expected the latest behavioral finance tools in DC plans, like defaults, to expand coverage and increase account balances. “There’s a lot you can do with defaults and nudges that don’t take away the participant’s autonomy but lead to better outcomes. We want to create a system where the default is success and not failure,” said Minsky.

Deemed IRAs are another interest of the group. Also nicknamed “sidecar” IRAs, these are in-plan IRAs where former or retired employees can continue to benefit from the low costs of their plan while getting the flexibility of an IRA, including the ability to buy an institutionally-priced income annuity with part of their savings. Hueler Companies, which offers institutionally-priced income annuities to 401(k) plans through a web-based platform, is a DCIIA member.

Asset retention, always a priority for investment managers, is getting popular with plan sponsors, and deemed IRAs serve that strategy. More plan sponsors than in the past want to keep former employees’ money in the plan, Schaus said. It helps them maintain their economies of scale.

“There’s a conversation in the plan sponsor community about keeping money in the plan,” said David Wray. “As people reach retirement age, they’ll have higher balances. If they take their money out of the plan, it changes the demographics and reduces the sponsor’s ability to pay for the plan. Larger companies especially feel that people should stay in the plan, where the economies of scale are greater and the fees are lower.”

The DCIIA’s executive committee includes:

  • Stacy Schaus, PIMCO, Chair
  • Toni Brown, Mercer, Vice Chair and Secretary
  • Jim Sia, Wellington, 2nd Vice Chair and Treasurer
  • Kevin Vandolder, EnnisKnupp, At-large Executive Committee Member
  • Ross Bremen, NEPC, Public Policy & Legal Committee
  • Drew Carrington, UBS, Retirement Income Committee
  • Richard Davies, AllianceBernstein, Investment Policy & Design Committee
  • Mary Beth Glotzbach, Morningstar, Governance, Benchmarking & Communications Committee
  • Lori Lucas, Callan, Research & Surveys Committee
  • Laurie Nordquist, Wells Fargo, Trust & Recordkeeping Committee
  • Lew Minsky, DCIIA, Executive Director

© 2010 RIJ Publishing. All rights reserved.

Jackson Announces Record Sales, Profit in 2009

Jackson National Life Insurance (Jackson) achieved record sales and deposits of $15.2 billion and record International Financial Reporting Standards (IFRS) net income of $670 million in 2009, the company reported March 9.

Total sales and deposits were 8% higher than in 2008 and consisted entirely of retail products. Jackson’s 2009 IFRS net income increased from an IFRS net loss of $1.0 billion in 2008, primarily due to the positive impact of movements in non-operating derivative holdings.

A unit of Britain’s Prudential plc, Jackson sold $10.0 billion in variable annuities during 2009, compared to $6.5 billion during the prior year. Sales of fixed index annuities totaled $2.2 billion, up from $928 million in 2008.

To preserve capital, Jackson sold only about $1.6 billion in traditional individual deferred fixed annuities during 2009, compared to nearly $3.2 billion during the prior year. Annuity net flows (total premium minus surrenders, exchanges and annuitizations) of $7.9 billion in 2009 were 82 percent higher than 2008.

At December 31, 2009, Jackson had $4.0 billion of regulatory adjusted capital, more than eight times the regulatory requirements. Jackson has maintained the same financial strength ratings for more than seven years and, during 2009, all four of the major rating agencies affirmed Jackson’s financial strength ratings.

As of February 28, 2010, Jackson had the following ratings:

  • A+ (superior) A.M. Best financial strength rating, the second highest of 16 rating categories
  • AA (very strong) Standard & Poor’s insurer financial strength rating, the third highest of 21 rating categories
  • AA (very strong) Fitch Ratings insurer financial strength rating, the third highest of 24 rating categories
  • A1 (good) Moody’s Investors Service, Inc. insurance financial strength rating, the fifth highest of 23 rating categories


“The effectiveness of our hedging programs contributed materially to Jackson’s financial stability during 2009,” said Andy Hopping, Jackson executive vice president and chief financial officer. “Jackson’s variable annuity hedges sufficiently protected the company’s statutory capital, and the increase in value of our interest rate derivatives was a key driver of Jackson’s record 2009 IFRS net income.”

In 2009, Jackson sold $53 million in life insurance products, compared to $58 million in 2008. Jackson did not sell any institutional products during 2009, as the company directed available capital to support higher-margin annuity sales.

Jackson achieved top-four rankings in total annuity, variable annuity and fixed index annuity sales during full-year 2009. Jackson ranked:

  • Fourth in total annuity sales during 2009 with a market share of 5.9%, up from 11th and a market share of 4.0% in 2008.
  • Fourth in new variable annuity sales during 2009, with a market share of 8.1%, up from 12th and a market share of 4.3% in 2008.
  • Fourth in fixed index annuity sales, with a market share of 7.5%, up from 9th and a market share of 3.5% in 2008.
  • 13th in traditional deferred fixed annuity sales, with a market share of 2.2%, compared to sixth and a market share of 4.5% in 2008.

Curian Capital, Jackson’s separately managed accounts subsidiary, accumulated more than $1.2 billion in deposits during 2009, up from nearly $1.1 billion during the prior year.

Platform enhancements, new distribution agreements and recovering equity markets drove quarterly deposits to a record high of $464 million during the fourth quarter of 2009, up 203% from the fourth quarter of 2008 and 22% higher than the third quarter of 2009. As of December 31, 2009, Curian’s assets under management totaled $3.6 billion, compared to $2.6 billion at the end of 2008.

Jackson’s affiliate, National Planning Holdings, Inc., a network of four independent broker-dealers, generated IFRS revenue of $611 million and IFRS net income of $3 million during 2009, compared to IFRS revenue of $608 million and IFRS net income of $9 million during 2008. The network reported gross product sales of nearly $14.1 billion in 2009, compared to $14.6 billion during the prior year. At December 31, 2009, NPH had increased its number of registered representatives to 3,478 from 3,165 at December 31, 2008.

© 2010 RIJ Publishing. All rights reserved.

 

Pacific Life Creates “Retirement Solutions Division”

Retirement Solutions Division is the new official name of Pacific Life’s Annuities & Mutual Funds Division. The full transition is expected to be completed by the end of 2010.

“The new name reflects the division’s diversified business mix and consultative wholesaling strategy,” said Dewey Bushaw, executive vice president.  “The name change further defines the longer-term strategy of creating and bringing new and innovative retirement income products to the market and offering simplified lower-fee retirement product solutions that include variable and fixed annuities and mutual funds.”

The change also reflects a recent internal transfer of Pacific Life’s structured settlements and retirement annuities business to the division.

“We’ve evolved from just offering variable annuities,” Mr. Bushaw says.  “The Retirement Solutions Division is uniquely positioned to offer a spectrum of retirement products designed for both retail and institutional clients.  Our long-term focus will continue to emphasize the development and distribution of retirement and investment products that help protect retirement assets, provide growth opportunities, and create retirement security for investors.”

© 2010 RIJ Publishing. All rights reserved.

MetLife To Acquire ALICO for $15.5 Million

MetLife Inc. plans to complete its rumored acquisition of American Life Insurance Company (ALICO) from American International Group Inc. (AIG) for about $15.5 billion in cash and shares, the New York Times reported.

Founded in 1921, ALICO sells accident and health insurance, life insurance and fixed annuities to about 20 million clients in 55 countries. It has 12,500 employees and 60,000 agents, brokers, banks and other intermediaries in its distribution networks.

The acquisition would give New York-based MetLife a significant presence in Japan, Europe and South America, and number-one positions in the life markets in Russia and Chile, in terms of premiums written, MetLife said.

The boards of both MetLife and AIG have approved the transaction, and the companies hope to close by the end of the year. The deal should result in few layoffs, because ALICO has little overlap with MetLife’s operations, MetLife executives report.

In a conference call with analysts, MetLife CFO Bill Wheeler said AIG would own 8% of MetLife as a result of the deal. Its stake could potentially rise to 14% in 2011, if it converts the preferred shares it received from MetLife to common shares. AIG will not have a representative on MetLife’s board, a MetLife spokesperson said, and AIG must vote its shares in the same proportion as other MetLife common shareholders vote their shares.

The MetLife-ALICO deal is the second proposed sale of a key subsidiary of AIG that AIG has announced in little more than a week. AIG announced March 1 that had agreed to sell AIA Group Ltd., an international life unit, to Prudential plc, London, for about $35 billion.

If all goes as planned, AIG will generate a total of about $51 billion in deal volume, including $31.5 billion in cash and $19.2 billion in securities. AIG would pay the $31.5 billion to the Federal Reserve Bank of New York, cutting what it owes to the New York Fed to about $45 billion.

The special purpose vehicle formed by AIG and the New York Fed to hold AIG’s interests in ALICO would hold more than 78 million shares of MetLife common stock, about 6.9 million shares of MetLife preferred stock that could be converted into about 68 million shares of common stock, and 40 million equity units of MetLife with a liquidation preference of $3 billion, according to AIG and MetLife.

© 2010 RIJ Publishing. All rights reserved.

Stock Losses Won’t Hurt ‘Early Boomers’

The recent stock market crash and its impact on retirement accounts will not force many early Baby Boomers to delay their retirements, according to new research by the National Bureau of Economic Research.

That’s because most early Boomers aren’t heavily reliant on stocks for future income, and because recession-related unemployment may actually force many people now in their mid- to late-50s to retire early. On average, early Boomers are expected to delay their retirements by only 1.5 months.

The paper, “What the Stock Market Decline Means for the Financial Security and Retirement Choices of the Near-Retirement Population,” was written by NBER Research Associate Alan Gustman and co-authors Thomas Steinmeier and Nahid Tabatabai.

For their incomes during retirement, the early Baby Boomers will rely far more on Social Security and defined benefit plans than on the stock market.

Only about 15% of the wealth of workers aged 53 to 58, or $116,535, was in stocks (directly or in retirement plans) at the time of the cash. More than a quarter of their household wealth was concentrated in anticipated Social Security payments. Early Boomers have relatively little dependence on assets in defined contribution plans.

Households with at least one member age 53 to 58 had an average of $766,945 in total wealth in 2006, according to the Health and Retirement Study survey of 22,500 households. Social Security was their single largest asset (26% of total wealth on average), followed by pensions (23%) and home equity (22%).

The drop in housing prices is also unlikely to greatly affect their retirement plans. Only 1.7% of early Boomers had negative home equity in 2006. Most had either no mortgage or had positive equity. Nearly half of early Boomer households had no mortgage at all.

If housing prices were to fall 20%, only 6.4% of the households in this age group would be “underwater,” according to the study. Typically, it will be many years before these boomers sell their homes to capture the equity in them.

If the pattern evident after the 2001-2002 stock market crash holds true for the latest crisis, those who defer retirement to rebuild their savings will be far outnumbered by those forced to retire early because they can’t find good jobs.

© 2010 RIJ Publishing. All rights reserved.

Pension Funding Edged Higher in February

Rising equity prices lifted the typical U.S. corporate pension plan’s funding status by 1.6 percentage points in February, to 85.3%, according to BNY Mellon Asset Management.

Assets for the typical plan rose 1.8% and liabilities decreased 0.1 percent for the month, as reported by the BNY Mellon Pension Summary Report for February 2010.

“Plans also benefited from a slight increase in the Aa corporate bond rate, which moved from 5.92% to 5.96% and resulted in a slight decrease in liability values,” said Peter Austin, executive director of BNY Mellon Pension Services, the pension services arm of BNY Mellon Asset Management.

Plan liabilities are calculated using the yields of long-term investment grade corporate bonds. Higher yields on these bonds result in lower liabilities.

“February was a good month as interest rates held steady during the equity market rally,” said Austin. “We have experienced a nice recovery in funding levels over the last three months.”

But he warned of pension funded status volatility ahead, stemming from economic troubles in the European Union and the U.S. deficit, adding, “We continue to see significant interest in liability driven investing (LDI) from plans looking to limit their exposure to volatility.”

BNY Mellon has $22.3 trillion in assets under custody and administration, $1.1 trillion in assets under management, services $12.0 trillion in outstanding debt and processes global payments averaging $1.6 trillion per day.  

© 2010 RIJ Publishing. All rights reserved.

 

Top Ten Annuity Sellers 2009

Top Ten Annuity Sellers, 2009*
Company Sales ($bn)
MetLife 22.37
Prudential Annuities 17.35
TIAA-CREF 13.92
Jackson National Life 13.86
AIG 12.51
Lincoln Financial 12.12
New York Life 11.59
ING 10.13
RiverSource Life 9.27
Allianz Life 8.47
Total Top Ten 131.59
Industry Total 234.90
Top 10 Share 56%
*Includes fixed and variable.
Source: LIMRA.

If You’re Human, You Have Capital

Paul Krugman, the Nobel laureate, Princeton economist and controversial New York Times columnist, revealed in a recent magazine profile that he and his wife liquidated their stocks ten years ago and now invest only in bonds or cash.

“It just takes a lot of work to think about it,” Krugman told an interviewer, “and at no point—except maybe early 2009, if I’d been really feeling daring, stocks really did look cheap.”

“We bought a couple of things,” [his wife, Robin] Wells said. “We bought muni bonds and some Ford Motor bonds. The thing is, if you look at it on a historical basis, even back in the two-thousands, stocks are not cheap.”

They may be selling themselves short. Someone like Krugman, a tenured professor in his mid-50s with a secure, “bond-like” income, might be wiser to balance out his personal “balance sheet” by diversifying into stocks.

Indeed, investors and their financial advisors risk missing half the picture if they limit their planning decisions to the familiar but narrow mixture of stocks, bonds and other financial assets that are in conventional investment portfolios.

Holistic approach
Instead, they should approach their finances more holistically, says Peng Chen, president of Ibbotson Associates. They should be thinking in terms of individual or household “balance sheets.”

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How is a balance sheet different from a portfolio? As Chen explained in a presentation at the Morningstar/Ibbotson conference in Orlando last week, an individual balance sheet includes one’s human capital.

Human capital, as opposed to financial capital, consists of the present value of future earnings, the present value of future savings, and even the present value of Social Security and anticipated pensions.

“It’s the largest and most illiquid asset that people have,” Chen said. “It’s based on age and occupation. And, as you go through different life stages, it influences your investment decisions.”

Only when these assets are listed on an individual balance sheet, alongside liabilities like the present value of pre- and post-retirement expenses, is it possible to answer questions like: How much should I allocate to stocks and bonds? How much life insurance do I need? Should I buy a guaranteed retirement income?

One of the principal rewards of this approach is the realization that some human capital (like Prof. Krugman’s) is more predictable than others (like a real estate agent’s or a stockbroker’s).

That leads to the somewhat counter-intuitive insight that a person who chooses a low-volatility career in academics should go farther out on the limb of the efficient frontier than a real estate agent, who might have a natural appetite for risk.

Depending on his or her occupation, a person’s answers on a risk assessment questionnaire, if based solely on emotion or temperament, might lead an advisor to assign that individual an overly risky or overly conservative asset allocation.

Putting the present value of human capital and personal expenses at the center of the financial planning process, rather than at the periphery, leads to other insights as well, Chen pointed out.

Guaranteed products
By defining expected income and expenses, both before and during retirement, it helps people determine how much life insurance they should buy during their working years and how large an annuity they might need during retirement.

Chen also demonstrated that retirement requires a new way of thinking about the traditional efficient frontier of investments. In retirement, the efficient frontier chart must incorporate considerations like how much income the retirees will need, how much risk of an income shortfall they can tolerate, and whether they want to plan for a 20-year or a 30-year retirement.

For instance, a 20% equity, 80% bond portfolio might easily produce 20 years of adequate income, but not be as reliable over 30 years. Guaranteed products, such as immediate annuities or deferred variable annuities with lifetime income benefits, might be too conservative for a 20-year retirement, but essential for a 30-year retirement.

“Longevity risk is the biggest fat tail for individual investors to manage during retirement,” Chen said. “If you’re planning for 30 years, it would be foolish not to be looking at [annuities].”

Human capital has been the subject of research papers by Chen, Moshe Milevsky of York University and others in recent years. It is also the central theme of Milevsky’s book, Are You a Stock or a Bond: Create Your Own Pension Plan for a Secure Financial Future (FT Press, 2009).

© 2010 RIJ Publishing. All rights reserved.

The Joy of Illiquidity

Illiquidity was a prime suspect in the recent financial crisis. So it was curious to hear someone praise the virtue of illiquidity at the annual Morningstar/Ibbotson Conference in Orlando last week.

But when Roger Ibbotson talks, people listen.

The Yale School of Management professor, who founded the research firm of Ibbotson Associates in 1977 (and sold it to Morningstar Inc. in 2006), also has a nine-year-old hedge fund, Zebra Capital. One of its raison d’êtres: to exploit the “illiquidity discount.”

“We short all the exciting stocks,” the lanky, 66-year-old Ibbotson joked as he described Zebra’s preference for stocks with healthy earnings but very low trading volume and low prices.

Illiquidity, either in stocks or in bonds, should be viewed as an investment style distinct from capitalization, value/growth, maturity or credit risk, he said in plugging the Milford, Conn.-based Zebra Capital’s services.

Overlapping with the universe of alternative investments, these low-turnover assets include private real estate, distressed debt, hedged equity, natural resources, commodities, private capital and emerging market equities, Ibbotson said.

“Liquidity seems to have an impact on realized and expected returns across all types of securities and across all locations,” Ibbotson and Yale colleague Zhiwu Chen wrote in a June 2008 paper, “Liquidity as an Investment Style.”

Advertisement “Liquidity is valuable in any security, and the market seems to be willing to pay a high price for it,” they wrote. “Correspondingly, the market accepts a lower return for liquidity. Liquidity seems to be an investment style that is different from size or value. This result seems to hold up in almost any equity market subset and in any location.”

The flipside of the illiquidity discount is the liquidity premium. That is, investors are generally willing to pay more for a stock or bond that, for one reason or another, offers the kind of liquidity reflected in high-volume trading.

For any given size or style, the more illiquid the stock, the higher its historical (1972 to 2009) compound annual return, Zebra Capital’s research shows. Even among value stocks and small-cap stocks, the illiquidity discount appears to boost performance by an extra point or two. (See Data Connection on today’s homepage.)

Over those 37 years, for instance, the least liquid of the smallest small-cap stocks outperformed the most liquid, 17.87% to 5.92%. The least liquid of the largest large-cap stocks outperformed the most liquid, 12.29% to 9.46%.

Looking at value vs. growth stocks, the least liquid of the value stocks outperformed the most liquid, 20.63% to 12.33%, and the least liquid growth stocks outperformed the most liquid, 11.36% to 3.32%.

While high liquidity small-cap stocks underperformed high liquidity large cap stocks, 5.52% to 9.46%, high liquidity value stocks outperformed high liquidity growth stocks, 12.33% to 3.32%.

(Data showing whether or not these relationships held true during time periods smaller than 37 years was not immediately available.)

Much of Ibbotson’s talk was aimed at explaining portfolio behavior in the financial crisis. Contrary to conventional wisdom, he said, diversification in stocks and bonds worked during the crash—it just didn’t work as well as people expected it to. But a mix of stocks and bonds offered significant portfolio protections, as expected. “Stocks and bonds are great diversifiers,” he said.

Diversification within asset classes doesn’t work as well as most people assume, Ibbotson said. Many investors still misinterpret the famous 1986 Gary Brinson study on variations in pension fund returns to mean that differences in asset allocation account for 90% of portfolio returns.

In reality, systematic risk (also known as market risk, aggregate risk or un-diversifiable risk) accounts for as much as 70% of a portfolio’s returns, he said. Asset allocation, as commonly understood, accounts for only about 16% of returns.

“People don’t understand that diversification doesn’t take away the 70% caused by the market,” Ibbotson said. “That’s why they’re asking, ‘Why didn’t diversification work in 2008?’”

© 2010 RIJ Publishing. All rights reserved.

Black Swan or Black Turkey?

“Black swan,” the phrase that Nassim Taleb’ s bestseller of the same name affixed to the financial lexicon, is typically used to describe improbable catastrophes that defy any reasonable prediction.

Some people have suggested that the financial crisis of 2007-2009 was a black swan event. Others, like Laurence B. Siegel, the research director of the Research Foundation of the CFA Institute, think it was a bird of a different feather.

“We didn’t have a black swan. We had a black turkey,” said Siegel, who offered a post-mortem of the crisis—and suggestions for investment strategies going forward—at the Morningstar/Ibbotson conference in Orlando March 5.

Larry SiegelSiegel, who edited his organization’s new book,  “Insights into the Global Financial Crisis,” defined a black turkey as “an event that is entirely consistent with past data but that no one thought would happen.”

An explosive mixture of leverage and volatility was the proximate cause of the crisis, Siegel said, in a presentation that tried to summarize in 45 minutes the views of the book’s 20-some contributors. As interest rate spreads shrank, investors resorted to leverage and speculation to make money. Then spreads widened.

But the deeper cause was government meddling in the markets, he believes. Government responses to earlier crises have added layer after layer of moral hazard to the system by mitigating the cost of failure. Like the controversial policy of suppressing natural forest fires, it only fueled the fire next time.

So people took absurd risks, trusting that the Invisible Hand wouldn’t slap them silly. But the pendulum inevitably swung the other way. “It was totally predictable,” said Siegel, who has an MBA from the University of Chicago and favors Chicago School, free-market solutions. “Big declines always follow huge advances.”

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Far from being rare, he said, black turkeys occur regularly in high finance. He listed “a flock of turkeys” since 1911, including six stock crises in the U.S., a 40-year bear market in long Treasury bonds after 1941, gold and oil bubbles in the 1980s and a 20-year bear equity market in Japan. (See chart).

In the latest crisis, the government’s culpability extended beyond moral hazard, he said. Invoking the views of Peter Wallison, an American Enterprise Institute fellow and a contributor to the book, Siegel traced the crisis to efforts during the Carter and Clinton administrations to encourage lending to low- and middle-income homebuyers.

But the recipe for a truly disastrous housing bubble was not complete until the George W. Bush administration, when the Department of Housing and Urban Development required Fannie Mae and Freddie Mac to step up purchases of loans made to low income borrowers.

A Flock of Turkeys
Asset Class Time period Decline
U.S. stocks* 1911-1920 51%
U.S. stocks (DJIA, daily) 1929-1932 89%
Long U.S. T-bonds* 1941-1981 67%
U.S. stocks 1973-1974 49%
UK stocks* 1972-1974 74%
Gold 1980-1985 62%
Oil 1980-1986 71%
Japanese stocks 1990-2009 82%
U.S. stocks (S&P) 2000-2002 49%
U.S. stocks (NASDAQ) 2000-2002 78%
U.S. stocks (S&P) 2007-2009 57%
*Real total return. Source: Laurence B. Siegel.

As the crisis unfolded in the fall of 2008, the government should have restored liquidity to the financial system but, in his view, shouldn’t have bailed out companies like AIG. The financial system, which by that time accounted for 40% of the profits of the S&P 500 companies, needed to slim down.

Unemployment in the financial sector has provided “creative destruction,” he said, and as a result we’ve “seen a return toward equilibrium in financial services.”

Going forward, Siegel advised money managers to look for inflation hedges. That means Treasury Inflation-Protected Securities and floating rate note funds for those who want maximum protection, plus cash in case high interest rates follow inflation.

For investors less willing to sacrifice return for safety, he recommended real estate, commodities, non-dollar denominated assets, real asset-related private equity, and equity investments in companies with fixed nominal costs and variable revenues.

© 2010 RIJ Publishing. All rights reserved.