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A Decade to Remember. Or Not.

Posted on January 5, 2010 by Ron Surz -

In April of 2008, I started writing about the miserable stock markets we’ve experienced in this first decade of the 21st century, suggesting that things might even get worse. They did.

Then they got better in 2009, but not good enough to bring the decade into positive territory. We have just experienced the worst U.S stock market decade in the past eight decades, starting in the 1930s.

In this end-of-year commentary, I examine the past year and the past decade, placing them into perspective relative to the long run history of our stock markets. I discuss both domestic and foreign stock markets. Toward the end, I focus on my specialty, target date funds.

The worst calendar-decade ever
The U.S. stock market, as measured by the S&P 500, earned 26.5% in 2009, rebounding from a 37% loss in 2008. This recovery was not enough to restore previous losses, however, so we’ve ended the decade with an average annualized loss on the S&P of 1% per year, well below the 84-year long term average return of 9.8% per year.

By contrast, bond performance for the year (4%) and the decade (7.4%) was in line with historical averages (6.1%), as was inflation (2.8%). Completing the picture, we’re paying the government to use their mattress, with Treasury bills yielding 0.15% for 2009.

Of the eight calendar decades for which we have complete stock market data, the 2000s were the worst performing, although they were not the worst 10-year period ever. The following chart shows the returns of the past eight calendar decades, as well as the best and worst 10-year periods ever.

There have been worse times than the 2000s: the S&P lost 5% per year in the 10 years ending August 31, 1939, and we just experienced the worst real 10-year loss in the period ending February 28, 2009. That decade brought real cumulative losses of 49%, or 6.5% per year. Investors would have been better off in bonds or Treasury bills than in stocks.

In 2009, all boats were lifted
What sectors, styles, and countries have performed best and worst? The bottom line: everything worked in 2009, and only growth stocks failed for the decade. The real questions of course are all about the future; an understanding of the past should help.

Style Returns in 2009 As the exhibit on the right shows, every investment style had substantial gains in 2009. Smaller companies gained more than 40%, exceeding the 24% return to larger companies. Similarly, growth outperformed value, earning 37% versus 29%.

The “stuff in the middle” that we call “Core” surprised by underperforming both value and growth, a somewhat unusual occurrence. Our style definitions are mutually exclusive and exhaustive, making them excellent for style analyses, both returns-based and holdings-based. Note that we use Surz Style Pure indexes throughout this commentary, as described at the end.

On the sector front, every sector had gains in aggregate, but it was certainly possible to lose money in several sectors. In the exhibit below, we show the range of portfolio opportunities available in each economic sector by using a simulation approach that creates portfolios at random, selecting from stocks in each sector. We call this approach “Portfolio Opportunity Distributions” (PODs).

As you can see in the next exhibit, Information Technology was the best performing sector for the year, earning 65.74% (middle of the “Info Tech” floating bar), while Finance was the worst sector with an 11.44% return. But note the ranges of the floating bars. Financials had a lot of opportunities, i.e. a large spread in portfolio returns, while consumer discretionary was quite narrow.

Note also how the S&P 500 performed in each sector (red dot), near median in most, but underperforming in energy, where smaller companies fared best. The S&P 500 underperformed the broad market of roughly 5500 stocks in 2009, earning 26.5% versus the total market’s 31% return. Note also the sector weighting differences in the bottom of the graph. You can use this exhibit to dissect your own performance.

Sector Opportunities in 2009: S&P500 ranked against Total Market

Opportunities abroad
Moving outside the US, it was possible to double your money. Foreign markets fared much better than the US in 2009, earning 45% versus our 31%. Latin American stocks returned a sensational 108% in the year, and every country except Japan outperformed the US, so some will say that diversification “worked” in 2009, vindicating portfolio theory.

In the aftermath of the 2008 catastrophe many lamented that diversification didn’t work when you needed it most because everything tanked at the same time. Nothing works all the time, and diversification doesn’t promise better performance, just greater stability of returns. It is indeed a world market, and owning more than just U.S. companies was valuable in 2009.

The decade of the 2000s
Annual reporting season will start soon, and this is one of those unfortunate times when consultants and investment managers will try to console their clients by explaining how their pain is less, hopefully, than most others. Based on our analysis, the average US stock fund eked out a modest 0.1% per year gain during the past decade. It was a decrepit decade.

The good news, however, is that much of the pain was limited to just the growth sectors of the market. This will be particularly awkward and delicate for growth stock managers, and is likely to bring forth the difficult question about the superiority of value investing. As for value and blend (or core) managers, they should have delivered positive returns for the decade, with smaller value stocks delivering double-digit returns.

In other words, style effects are extremely pronounced and important for evaluating long-term performance. The old saw that value and growth perform about the same over the long run does not apply to the past decade. Similarly, there was a wide spread of country results during the decade, with Japan losing 2.8% per year while Australia & New Zealand delivered 20% returns.

So here’s my prediction of what evaluators like Morningstar will proclaim: Growth stock managers were more skillful than value managers during the decade because the majority of growth stock managers outperformed their benchmarks, while the majority of value managers lagged their benchmarks.

This is poppycock caused by a peer group flaw known as classification bias. Peer groups are terrible backdrops for evaluating performance. That’s why we provide you a better way in the next two exhibits, which are being published here weeks before the “real” results are available.

The universes in these exhibits are created using PODs. They represent all of the possible portfolios that managers could have held when selecting stocks from the indicated markets.

Traditional peer groups are very poor barometers of success or failure because of their myriad biases. Everyone knows that it’s easy to find a peer group provider that makes you look good, but for some reason the industry tolerates, even condones, this deceptive practice.

Now is the time to stop the subterfuge, because we can. PODs are bias free and are therefore a much more reliable performance evaluation backdrop, plus they’re available now, many weeks before the “real” biased peer groups. You can use the chart below to get an early and accurate ranking of your own portfolio. Just plot your dot.

TDFs: A good idea gone awry?
Many retirees, as well as those who are saving for retirement, have invested in target date funds. Target date funds start out aggressively when the target date is distant and then become more conservative as the target date draws near.

The target date fund (TDF) industry is growing rapidly. Currently encompassing $310 Billion, this industry is forecast to grow above $2.5 Trillion in the next 10 years [see Casey, Quirk 2009], primarily because it has become the preferred qualified default investment alternative (QDIA) under the Pension Protection Act of 2006.

TDFs are a reasonably good idea, but suffer from pathetic execution, at least so far. This is due in large part to the fact that most TDFs are currently designed to serve beneficiaries beyond the target date, to death, instead of to their presumed target-the retirement date.

Such funds have come to be known as “THROUGH” funds (as opposed to “TO” funds which are designed to end at the target date). A secondary issue with TO funds is the amount of equities that should be held at the target date; we believe zero is the correct answer because savings are most dear as retirement draws near.

2008 was disastrous for TDFs, with the typical 2010 fund losing 25%, because it held 45% in equities. 2010 funds are intended for those retiring between 2005 and 2015. We should have learned a lesson from 2008, but little has changed other than it is likely that the Securities and Exchange Commission and Department of Labor will require fuller disclosure, especially about the meaning of the date in target date fund names. Perhaps THROUGH funds will have to be called target death funds.

An important question for fiduciaries is what are the risk and reward trade-offs of THROUGH versus TO TDF paths. To answer this, we have measured ending wealth and risk for all 40-year glide paths going back to 1926. Importantly, the risk measure is dollar-weighted downside deviation, which we call “risk of ruin.” The rationale for this measure of risk is provided in my 2009 Advisor Perspectives article. The graph below summarizes the results.

As you can see, the reward-to-risk is about the same for the complete 40-year glide path, but TO funds dominate over the critical last 10 years of the path. So now you know the risk and reward considerations in your choice between TO and THROUGH – although both provide roughly the same reward-to-risk profiles over the full 40 years, “TO” funds are much safer over the final 10-year period as the target date approaches.

Defined contribution plan fiduciaries have come to believe that any target date fund will suffice because all target date funds are qualified default investment alternatives (QDIAs). But there are huge differences among target date funds, especially near the target date, so this generic belief is false. Fiduciaries have the responsibility to select and monitor good target date funds. In particular, convenience and familiarity are foolish reasons for entrusting employee savings to the plan’s recordkeeper.

Ron Surz is president of PPCA, Inc. and its subsidiary, Target Date Solutions.

This commentary incorporates Surz Style Pure® Indexes, StokTrib holdings-based style analysis and attribution, and Portfolio Opportunity Distributions. Surz Style Pure indexes are available for free on Evestment Alliance, MPI, Zephyr, Factset, Informa, SunGard, Pertrac, Morningstar, and other platforms. Designed especially for returns-based style analysis, they meet William F. Sharpe’s recommendation to use a style palette that is mutually exclusive (no stock is in more than one style) and exhaustive (the collection of indexes comprise the entire market).

REFERENCES

Basu, Anup and Michael Drew, “Portfolio Size Effects in Retirement Accounts: What Does it Imply for Lifecycle Asset Allocation.” Journal of Portfolio Management, April 2009

Casey, Quirk & Associates, “Target Date Retirement Funds: The New Defined-Contribution Battleground”. November 2009 Research Paper.

Siegel, Laurence B. 2003. Benchmarks and Investment Management. Research Foundation of CFA Institute, Charlottesville, Va.

Statman, Meir. “What Do Investors Want?” Journal of Portfolio Management, 30th Anniversary Edition 2004, pp. 153-161

Surz, Ronald J., “Should Investors Hold More Equities Near Retirement, or Less?” Advisor Perspectives, August 2009.

————–,“The New Trust but Verify.” PPCA White Paper, November 2009.

The Medical-Industrial Complex

Posted on December 23, 2009 by Editor Test -

In 1980, Arnold S. Relman, M.D., then the editor of the New England Journal of Medicine, described the devolution of his profession into a profit-driven business. In a famous editorial, he called the health care industry a “medical-industrial complex.” He didn’t mean it as a compliment.

His 2007 book, “Second Opinion: Rescuing America’s Health Care” (Public Affairs), called for the end of for-profit medicine in the U.S. This week I telephoned Dr. Relman at his home in suburban Boston—he’s a professor emeritus of Harvard Medical School—and asked for his opinion of the health care bill that the Democratic leadership of the Senate has promised to pass by Christmas.

“It’s a mixed bag,” he said. “My wife, Marcia Angell, who writes about health care and appears a lot on TV, differs with me on this issue. We both believe that in the long run we need a single-payer system, and a revised and reformed delivery system to get rid of fee-for-service and private insurance and the commercial aspect of health care.

“She agrees with Howard Dean that the current effort is so inadequate that it would be better to see it disappear and start over. I disagree. I believe that what comes out will be very inadequate and will not attack the cost problem, and that it has many deficiencies.

“But I believe that it’s better than nothing and it would be a serious mistake if Congress failed to do anything. If we get nothing out early next year, it will be years and years before we attack the problem again.

“If we do get a bill out, it will not control costs. There is not a prayer that it will affect the continuing inflation of costs. What will happen is what’s happening here in Massachusetts. They passed a law over three years ago which almost wiped out un-insurance. Only two percent have no health insurance. But the state is going broke because of rising costs.

“It’s bad in Massachusetts. They can’t afford to cover all the uninsured with the present system, and that’s what will happen in the United States as a whole if this legislation is passed. We may get more people insured but we won’t be able to afford it.

“But that’s better than nothing, because we’ll have to do something. Business—that is the 80% of the economy that has nothing to do with health care—will see that they’ve been screwed by the industry and the public will see that we need a tax-based insurance system.

“The private insurance system is a parasite. There’s overwhelming evidence that they don’t contribute anything for the money they take out of the system. We’ll need them to go into some other business. We’ll have to pay them off or buy them out. That will become clear over the next couple of years after this is passed.

“My profession is slowly waking up to the fact that it can’t keep the current system. They will have to trade fee-for-service for salaried positions, so that we have lots of Mayo Clinics all over the country. Ten years ago, the overwhelming majority of doctors reflexively opposed any kind of government system. Now they’re beginning to have second thoughts.

“It’s better to have something passed. More people will get covered. Costs will go up more rapidly than before. And maybe we’ll begin to make changes we should have made years ago. My wife says, ‘You’re dreaming. If it gets passed, people will say, Look at how bad the government messed things up.’

“Marcia and I have both testified in Washington. Single-payer was off the table from the beginning. [Sen. Max] Baucus made it clear he wouldn’t hold single-payer hearings. He invited Marcia to come down and meet with him personally, and talk about single-payer. He listened sympathetically and said, ‘If we were starting from scratch, I’d be for single-payer. But there’s too much water over the dam, and we have to make deals with the AMA, the insurance industry and the drug industry.’

“My wife takes a dim view of that. But I’m saying that half a loaf is better than none. It remains to be seen what, if anything, will come out of it. Even if the Senate does pass a bill, we don’t know what will happen in the conference with the House. In the afterword of the new edition of my book, I say I can’t predict what will happen, but if anything comes out it still won’t solve our problem.

“Money is driving everything. As I wrote in 1980, medicine has become a commodity in trade. It’s extremely profitable the way that it’s organized, and as long as we allow investors and profits to drive the system we’re hopeless. Costs will continue to rise and rise because government is going to put more money into the industry. The good side is that more people will be covered, more people will have insurance, and that’s good enough to start with.

“But we have to start working as soon as it passes. We have to get started on real reform. Ultimately we will turn things around. I’m not sure the only solution is single-payer tax-supported insurance. We need no insurance at all—just universal access, a budget that we have to live by, and not-for-profit multi-specialty medical groups with plenty of primary care and salaried doctors. We can afford it if we get rid of the waste, fraud, profits and overhead. The problem is not the money. It’s the system.”

Lawmakers Dilute Fiduciary Standard for Discount Brokers

Posted on December 23, 2009 by Editor Test -

A one-sentence provision in the huge financial services reform bill passed by the House last week would require brokers to provide advice as fiduciaries but hold them only to suitability standards when they execute that advice by making trades, Investment News reported.

The legislation, which the Senate has yet to consider, would require the Securities and Exchange Commission to establish a fiduciary duty for brokers who provide investment advice. But the bill adds language that says registered reps have no “continuing duty of care or loyalty to the customer” after providing the advice.

The provision was apparently for the benefit of discount brokerage firms, such as Charles Schwab & Co. Inc., the report said.

“That could be read to eviscerate fiduciary duty,” Marilyn Mohrman-Gillis, managing director of public policy for the Certified Financial Planner Board of Standards Inc., said of the provision.

“It’s OK to hat-switch” under the provision, said Neil Simon, vice president of government relations for the Investment Adviser Association. Under the clause, “The duty applies only at the time the advice is given. It does not extend throughout the relationship.” Allowing brokers to “switch hats” between the two standards of care would confuse clients, he adds.

New Executive Hires at AVIVA USA, ING

Posted on December 23, 2009 by Editor Test -

Aviva USA, Des Moines, Iowa, has named Jeff Frazee as senior vice president and chief information officer of its life and annuity business. Frazee will be responsible for information technology functions supporting the business. He had been senior vice president and chief information officer of West Bend Mutual Insurance Co, West Bend, Wisc.

ING Financial Solutions has hired Lynne Ford as the CEO of its annuity and rollover business. Ford had been executive vice president and managing director of the retail retirement group at Wells Fargo & Company, San Francisco.

Ford had spent most of her career at Wachovia Bank, which merged with Wells Fargo in late 2008. She will report to Rob Leary, CEO of ING Insurance U.S., part of ING Groep, the Netherlands.

Cerulli Calls DB(k) a “Diamond in the Rough”

Posted on December 23, 2009 by Editor Test -

On January 1, 2010, employers will be able to install “DB(k)” benefits. These new retirement savings vehicles blend the guarantee of a pension with the growth potential and ease of use of a 401(k), according to the fourth quarter issue of The Cerulli Edge–Retirement Division.

“The major advantages of these plans relate to compliance concerns,” the report said. “These plans are exempt from typical top-heavy or non-discrimination 401(k) testing rules so they can be skewed toward highly paid workers. They also have simplified filing requirements when run in tandem with a 401(k) plan. Cerulli views the DB(k) plan as a buried gem in 2010.

“DB plans in general are receiving short-term funding relief from stricter rules imposed by the PPA, but funding pain is quite acute with experiences from the current recession likely hastening the private pension’s decline. But, Cerulli believes a diamond in the rough exists in the PPA that seeks to revive pension benefits in combination with 401(k) plans—the DB(k) plan for 2010.”

In other findings, Cerulli reported:

Disappointment. The timing of poor economic conditions and a change in executive leadership has derailed the great intentions of PPA for enhancing growth in DC plans.

Damp reception. A one-time Roth IRA conversion opportunity in 2010 is being met with skepticism by providers fearing movement of sticky IRA assets, anxiety by advisors confounded by predicting tax changes, and confusion by investors about the true benefits of a Roth IRA.

Hybrid vigor. The PPA’s 2010 clarification of the tax treatment of long-term care payments from annuity products effectively enables the development of so-called annuity/long-term care insurance combination products, requiring insurance companies to examine how they might construct and distribute these hybrids.

New York Life SPIA Sales Up 35% in 2009

Posted on December 23, 2009 by Editor Test -

New York Life reported record annuity and mutual fund sales in the third quarter of 2009. The company said it is on pace to sell $1.6 billion worth of fixed immediate annuity sales in 2009, a 35% increase over 2008.

The company, the largest mutual life insurer in the U.S., led all issuers in fixed immediate annuity sales, was first in fixed annuity sales in the bank channel and was fifth in total annuity sales, up from 11th from a year earlier.

Chris Blunt, executive vice president and head of Retirement Income Security for New York Life, said that gross sales of New York Life’s proprietary MainStay Funds grew 25% through September 30 versus the same period last year and had the highest net new flows in its history.

Factors Explaining Future Federal Spending on Medicare, Medicaid, and Social Security

Posted on December 23, 2009 by Editor Test -

Factors Explaining Future Federal Spending on Medicare, Medicaid, and Social Security

Source: Congressional Budget Office, November 2009

Test Your Financial Sophistication

Posted on December 23, 2009 by Editor Test -

How financially sophisticated are you? To find out, answer these 18 True or False questions. When you’re finished, compare your answers with the Answer Key at the end of this article. Allot yourself five points for each correct answer.

A perfect score would be 90. The average college-educated person over age 55 scored 61.25, or 68%. If you’re wondering whether you can get continuing education credit for taking the test, the answer is, “Not as far as we know.”

This test was designed by Annamaria Lusardi of Dartmouth College, Olivia S. Mitchell of The Wharton School and Vilsa Curto of Harvard University for people over age 55 with varying levels of education. A paper based on their findings, “Financial Literacy and Financial Sophistication in the Older Population: Evidence from the 2008 HRS,” was published by the Michigan Retirement Research Center at the University of Michigan in September 2009.

1. You should put all your money into the safest investment you can find and accept whatever returns it pays.

2. I understand the stock market reasonably well.

3. An employee of a company with publicly traded stock should have a lot of his or her retirement savings in the company’s stock.

4. It is best to avoid owning stocks of foreign companies.

5. Even older retired people should hold some stocks.

6. You should invest most of your money in either mutual funds or a large number of different stocks instead of just a few stocks.

7.To make money in the stock market, you have to buy and sell stocks often.

8. For a family with a working husband and a wife staying home to take care of their young children, life insurance that will replace three years of income is not enough life insurance.

9. If you invest for the long run, the annual fees of mutual funds are unimportant.

10. If the interest rate falls, bond prices will fall.

11. When an investor spreads money between 20 stocks, rather than 2, the risk of losing a lot of money increases.

12. It is hard to find mutual funds that have annual fees of less than one percent of assets.

13. The more you diversify among stocks, the more of your money you can invest in stocks.

14. If you are smart, it is easy to pick individual company stocks that will have better than average returns.

15. Financially, investing in the stock market is no better than buying lottery tickets.

16. Using money in a bank savings account to pay off credit card debt is usually a good idea.

17. If you start out with $1,000 and earn an average return of 10% per year for 30 years, after compounding, the initial $1,000 will have grown to more than $6,000.

18. It’s possible to invest in the stock market in a way that makes it hard for people to take unfair advantage of you.

Answers.
1. F; 2. T; 3. F; 4. F; 5. T; 6. T; 7. F; 8. T; 9. F; 10. F; 11. F; 12. F; 13. T; 14. F; 15. F; 16. T; 17. T; 18. T.

The Passion of Anna

Posted on December 23, 2009 by Editor Test -

Soon after Annamaria Lusardi began her research into financial literacy in the United States—or rather, into the average American’s lack of financial literacy—she experienced a professorial epiphany of sorts.

The Dartmouth economist realized that financial literacy is not a trivial topic, as some of her peers once scoffed. On the contrary, she sensed that anyone who can’t grasp concepts like compound interest is bound to fail in a 21st century society.

“A lot of my colleagues told me that I should work on something more serious,” Lusardi told RIJ in a recent interview. “But people who aren’t well-equipped to make financial decisions are the ones who’ll face more risk in the future.”

Then came the financial crisis of 2008, and Lusardi’s view became mainstream. The near-collapse of the world banking system awakened many people, including several members of the incoming Obama administration, to the fact that what Americans don’t know about money can indeed hurt them—and hurt the country.

Now Lusardi and her frequent co-investigator since 2000, Olivia Mitchell, the director of the Pension Research Council at the Wharton School, are in demand. They’ve been called down to Washington to advise the Treasury Department’s Office of Financial Education.

And last October, they and the RAND Corporation received a $3 million Social Security Administration grant to open a Financial Literacy Center at Wharton and Dartmouth, and to design and pilot new programs to raise America’s financial IQ.

A few days ago, shortly after Lusardi, a native of Milan, Italy, returned from a financial literacy conference in Brazil, she answered a few questions from RIJ. Here’s an edited transcript of that interview.

RIJ: Professor Lusardi, how would you describe the financial knowledge of the average American?

LUSARDI: The result of all the work I have done with Olivia Mitchell, in every age group and every survey we have discovered how little most Americans know about economics and finance.

RIJ: What makes Americans so generally deficient in financial literacy?

LUSARDI: Americans are not alone. We have done surveys in other countries and we find a lack of financial literacy everywhere. It’s not that people are getting worse. It’s that the world has changed. In the past, in our parents’ generation, they didn’t face a lot of difficult financial decisions. The biggest decision they probably made regarded their mortgage.

That situation has changed. Even at a young age, people are faced with financial decisions about credit cards. Workers are now in charge of making decisions about their pensions. They are facing complex financial markets. The world has changed and we need to face those changes.

When we talk about financial literacy, the important word is not financial but literacy. In the past it would be impossible to live in a modern society without being able to read and write. Today’s it’s impossible to live in a modern economic society without being able to read and write financially. Everybody’s making decisions and we cannot get away without equipping people to make those decisions.

RIJ: Do you think it may be too later for the Boomers to learn more about finance?

LUSARDI: It’s not too late. People are making important decisions at every age. What worries me is that making the wrong decision late in life can have dire consequences, because you don’t have time to catch up. If you make a wrong decision about when to draw Social Security, or whether to annuitize your wealth, you might not be able to afford a comfortable retirement.

RIJ: But will financial education help? Even well educated people made dumb mistakes with their money during the real estate boom?

LUSARDI: The idea is not that if we educate people they will not make any more mistakes. It’s like driving licenses. We require them but we can’t eliminate accidents. But we must give them the basics. When I think of financial literacy, I think of things like interest compounding. If you understand that, you will know that it’s important to start saving early and not to borrow at high interest rates.

RIJ: Where would financial education do the most good?

LUSARDI: In 1996, the Jump$tart Coalition for Personal Financial Literacy started doing a study of high school students every two years. They found that only a small group of students is financially literate, and that group is disproportionately composed of white males from college-educated parents. This means that if we don’t introduce financial literacy in school then people will have to learn it from their families. That’s fine if you come from a college-educated family. But not everyone can learn at home. So we need to provide education in school.

We also need to pay attention to specific groups. Financial literacy is lacking among women. That is a big group. Women are in charge of making a lot of financial decisions and they increasingly have to fend for themselves. Women are in the workforce, but their earnings are lower than men’s, they take time off to have kids, they rely on less stable wages, and there is a high divorce rate. So accumulation for a pension is difficult.

RIJ: Rather than try to educate everyone, why not just establish good rules-of-thumb, like ‘Everyone should try to postpone Social Security benefits until they reach age 70?’ Or establish new practices like auto-enrollment in retirement plans.

LUSARDI: There have been statements that automatic enrollment in retirement plans is a solution to financial illiteracy. But if you are in debt you shouldn’t be automatically enrolling in a 401(k) plan. You have to decrease your debt first. Or if you buy an expensive mortgage because you don’t have any liquidity for a down payment, I haven’t helped you by automatically enrolling you in a retirement plan.

‘Everyone should take Social Security at age 70’ is too crude a rule for my taste. And it’s not true that everybody should wait until age 70. On the other hand, it’s not obvious to me why we present the information in such a way that the default appears to be to take it at age 62.

We shouldn’t be telling people that they can start at age 62. We should push them to start much later. I cannot overstate how important it is for people, if they are healthy, to try to take Social Security as late as possible.

RIJ: The retirement crisis seems to have made more people aware of financial literacy.

LUSARDI: If it wasn’t for the financial crisis, I don’t think we would be talking about financial literacy. It’s a teachable moment. I have been working on this since 2000, and I receive few invitations to talk about it. Publishing papers was really difficult. There was a lot of skepticism that lack of financial knowledge could be so powerful.

But the crisis has shown in such a strong way that people are making mistakes. A lot of people didn’t understand what they were doing. From an economist’s point of view, financial literacy is a public good. If people make mistakes, and if we have to rescue them when they do, then it’s really important to do prevention.

There has always been skepticism about financial literacy, but I think the financial crisis has proven us right. People can make very bad mistakes, and those mistakes have consequences for them and for society. So academics are now turning to this issue and are trying to find evidence-based research. We are very humble, we don’t claim that we will be successful in solving the problem of financial literacy, but we want to give it a try.

Can’t Do The Math

Posted on December 23, 2009 by Kerry Pechter -

The global financial crisis and the analyses of its causes and effects have helped expose the embarrassing fact that Americans don’t know nearly as much about economics, finance or investments as they should.

Leaving aside the revelation that bankers, regulators and even Treasury Secretaries blundered, the crisis highlighted a growing body of evidence that most people can’t answer simple questions about compound interest or investment diversification.

For some researchers, that evidence helps explain why so many Americans fall victim to balloon mortgages and high-interest credit. Even more seriously, it implies that many Boomers aren’t financially competent to plan for their own retirement.

“We find strikingly low levels of debt literacy across the U.S. population,” said a December 2008 paper by Anna Lusardi of Dartmouth and Harvard’s Peter Tufano. “It is particularly severe among women, the elderly, minorities, and those who are divorced and separated.”

And financial ignorance isn’t bliss; it’s expensive. Lusardi estimates that about a third of the $11.2 billion spent in 2008 on late fees and other avoidable credit card charges alone was rung up by “the less knowledgeable,” who pay “46% higher fees than do the more knowledgeable.”

Often mocked by economists as too trivial for serious attention, financial literacy is now getting some respect. Indeed, the federal government this fall funded a $3 million Financial Literacy Center at Dartmouth and the Wharton School, with Lusardi as director. Still, financial literacy experts wonder if Boomers will succeed in building up their math skills before they make fatal errors with their savings.

Three questions
Lusardi, author of “Overcoming the Savings Slump: How to Increase the Effectiveness of Financial Education and Saving Programs” (University of Chicago Press, 2009), has spent much of the last eight years working with Olivia Mitchell, director of the Wharton’s Pension Research Council, to design survey questions to measure financial literacy in the U.S.

Here are some of the questions she’s asked, and that most people get wrong:

1. Suppose you owe $1,000 on your credit card and the interest rate you are charged is 20% per year compounded annually. If you didn’t pay anything off, at this interest rate, how many years would it take for the amount you owe to double?

2. You owe $3,000 on your credit card. You pay a minimum payment of $30 each month. At an Annual Percentage Rate of 12% (or 1% per month), how many years would it take to eliminate your credit card debt if you made no additional new charges?

3. You purchase an appliance, which costs $1,000. To pay for this appliance, you are given the following two options: a) Pay 12 monthly installments of $100 each; b) Borrow at a 20% annual interest rate and pay back $1,200 a year from now. Which is the more advantageous offer?

For the first question, fewer than 36% of those surveyed knew that it would take more than two but less than five years. In the second question, about 35% knew that you could never get out of debt that way. Only about seven percent identified “b” as the correct answer to the third question.

Dire consequences
Those best equipped for success in America—young, white, married, college-educated men—tend to be the most financially literate. Others—those over age 50, the 70% without a college degree, women, African Americans, Hispanics, the divorced and separated—tend to be less so. Among high school students, Lusardi found widespread financial illiteracy, except among white males whose parents are college-educated.

Besides paying higher credit card fees, people who lack financial literacy are less likely to use mutual funds with lower fees, more likely to avoid stocks (especially foreign stocks), less likely to refinance their mortgage when advantageous and less likely to plan for retirement.

It’s not so much that Americans are falling behind in financial literacy, says Lusardi; it’s that the world has become more financially demanding of everyone. In particular, millions of Boomers are not equipped to handle the responsibilities that come from having a defined contribution retirement plan instead of a traditional pension—including the responsibility to know how to take distributions in retirement.

“What worries me is that making the wrong decision late in life can have dire consequences, because you don’t have time to catch up,” Lusardi told RIJ. “If you make a wrong decision about when to draw Social Security, or whether to annuitize your wealth, you might not be able to afford a comfortable retirement.”

The fallout from subprime mortgage crisis showed that all of us suffer when the financially illiterate make mistakes. Taxpayers often have to bail out or rescue people—CEOs and commoners alike—who get themselves into personal or system-threatening financial jams.

What to do about it
Historically, financial literacy has had a low priority among economists. Economic theory rested on the assumption that participants in the marketplace acted rationally and in their own best interest. Even if disadvantaged people lacked financial literacy, some experts felt, that was probably among the least of their problems.

But Lusardi, Mitchell, and a few others give financial literacy much higher priority in the hierarchy of human needs. If you teach people the rudiments of investing, they say, you can equip them to solve their bigger problems—or at least prevent them from sliding into debt, bankruptcy and dependency.

This belief relies on two assumptions, however. First, it assumes that the financially challenged are willing and able to learn. Second, it assumes that people make foolish choices with their money out of ignorance and not because circumstances force them to.

One of the more paternalistic responses to financial illiteracy in the retirement savings arena has been to auto-enroll employees in employer-sponsored plans, to provide default investments such as target-date funds and to automatically hike employees’ contribution rates.

For financial literacy champions, however, these are band-aid solutions that boost assets-under-management without addressing the real problem. For instance, these measures doesn’t show people how to balance their need to save for retirement with their need to save for a down payment on a home or educate their children.

“My view is that many ‘nudge-type’ structures can and probably should be implemented, but they will not be sufficient,” Wharton’s Olivia Mitchell told RIJ in an e-mail. “They don’t teach people to become financial adults, to learn to make their own decisions when the easy answers don’t suffice.

“For instance, we can prohibit frequent trading to combat overconfidence but people will find a way around such restrictions. Or we could rule out certain types of financial transactions—for example, adjustable rate mortgages—but this doesn’t give people the tools to decipher and decide on some as-yet-undiscovered financial instrument.

“We can also enhance disclosure—of credit card interest, etc.—but this won’t stop kids from running up credit when they get card applications in the mail,” she added. “And when things get suddenly complex—when the market tanks and there is 10% joblessness—people need to have thought about how to protect against these eventualities while they still have time to plan ahead.”

Another Departure from MassMutual Retirement Income

Posted on December 16, 2009 by Editor Test -

Gary F. Baker, vice president in the retirement income business division of Massachusetts Mutual Life Insurance Co., has left the company, marking the last of a string of departures from the retirement income group, Investment News reported.

In June, Stephen L. Deschenes, the former senior vice president and chief marketing officer for the group, left MassMutual to join Sun Life Financial Inc.’s U.S. division as senior vice president and general manager of the company’s annuity unit. In August, Tom Johnson, a former senior vice president for retirement income and strategic business development at MassMutual, left the company as part of a restructuring that laid off 500 employees. Johnson has since joined New York Life.

MassMutual launched its retirement income group in 2005, when the firm acquired Jerome S. Golden’s business, called Golden Retirement Resources. The insurer brought on Mr. Baker, an 18-year veteran of GE Capital Assurance Co. (now Genworth Financial Inc.), along with Mr. Deschenes and Mr. Johnson, to run the group.

Over the past couple of years, though, MassMutual has been hit by the market meltdown and ratings downgrades. In response, the company has shifted course to focus on traditional insurance products, according to people familiar with the situation. As a result, the insurer has virtually all but shut down its retirement income group.

An Announcement From Chairman Scrooge

Posted on December 16, 2009 by Editor Test -

The number of companies offering traditional holiday bonuses in 2009 are at record lows, according to a new survey from Hewitt Associates. While the current economy has accelerated the decrease, Hewitt’s research shows a steady trend away from these bonuses toward the adoption of more formal pay-for-performance programs.

Less than a quarter (24%) of 300 companies surveyed are offering holiday bonuses this year, down from 42% in 2008. Of those giving bonuses, nearly half (49%) will give cash, spending a median of $250 per employee, and 39% will give gift cards with a median value of $35 per employee. One in five companies will give a turkey, ham or other food.

Replacing holiday bonuses are variable pay programs, which have increasingly emerged as the primary pay for performance vehicle for employers and make up a greater portion of an employee’s overall compensation package.

According to Hewitt research, average employer spending on variable pay as a percent of payroll has steadily increased over the past decade, from 9.7 percent in 2000 to 11.2 percent in 2010. Meanwhile, average pay raises have been steadily decreasing. In 2000, average salary increases were 4.3 percent compared to just 1.8 percent, in 2009.

“Holiday bonuses have been falling out of favor in recent years as companies face increased pressure to reduce costs and are more focused on growth and performance,” said Ken Abosch, head of Hewitt’s North American Broad-Based Compensation Consulting practice.

“Instead of giving arbitrary, across-the-board bonuses, employers want to find ways to appropriately reward their highest performing employees. And they are doing this by reserving more of their compensation budgets for bonuses that are based on performance and must be re-earned each year.”

Apparently no one has told CEOs how much even a small company-wide holiday bonus can improve morale and cohesiveness, or how demoralizing and divisive it is for managers to reserve the bulk of the raises for a few often subjectively-chosen “star” performers.

Goldman Sachs Announces Compensation Changes

Posted on December 16, 2009 by Editor Test -

The board of directors of Goldman Sachs Group, Inc., last Thursday approved changes to its compensation practices for 2009. According to a release on the company’s website:

The 30 members of the firm’s management committee, including global divisional and regional leaders, will receive 100% of their discretionary compensation in “Shares at Risk,” which are restricted for five years. Discretionary compensation represents “the vast majority” of senior management’s compensation and is directly tied to the firm’s overall performance.
Shares at Risk cannot be sold for five years, in addition to other restrictions. The five-year holding period includes an enhanced recapture provision that will permit the firm to recapture the shares if the employee engaged in materially improper risk analysis or failed sufficiently to raise concerns about risks.
The enhanced recapture rights build off an existing clawback mechanism which includes any conduct that is detrimental to the firm, including conduct resulting in a material restatement of the financial statements or material financial harm to the firm or one of its business units.
Shareholders will have an advisory vote on the firm’s compensation principles and the compensation of its named executive officers at the firm’s Annual Meeting of Shareholders in 2010.

In a statement, chairman and CEO Lloyd C. Blankfein said, “The measures that we are announcing today reflect the compensation principles that we articulated at our shareholders’ meeting in May. We believe our compensation policies are the strongest in our industry and ensure that compensation accurately reflects the firm’s performance and incentivizes behavior that is in the public’s and our shareholders’ best interests.

“In addition, by subjecting our compensation principles and executive compensation to a shareholder advisory vote, we are further strengthening our dialogue with shareholders on the important issue of compensation.”

JPMorgan Dials Down Its Return Expectations

Posted on December 16, 2009 by Editor Test -

JPMorgan Asset Management lowered its expected long-term (10-15 years) returns for equities and fixed income while boosting the real estate outlook, Stu Schweitzer, global markets strategist, said in a client conference call last week, according to Pensions and Investments Online.

Expected returns for both domestic and international large-cap stocks were lowered by 1.5 percentage points, to 7.5% a year for the S&P 500 and to 7.75% for MSCI EAFE. Emerging markets equity was trimmed only 75 basis points to 9.5%.

In bonds, the expected returns for the Barclays Capital U.S. Aggregate fixed-income benchmark was reduced one percentage point to 4.5%, while the expected return for U.S. high-yield bonds—which have experienced a 50% return this year—was reduced 3.5 percentage points to 7.5%.

In contrast, real estate—currently near 1993 valuations—is expected to produce equity-like returns. REITs are expected to return 7.75%; U.S. direct real estate, 8%; and U.S. value-added real estate, 9.25%.

Meanwhile, the median expected return for private equity is 8.5%. Directional hedge funds are expected to return 7%; non-directional, 5.5%; and fund of funds, 6.5%. Hedge funds are attractive if investors can get into top-quartile funds with low volatility, Mr. Schweitzer said.

Mr. Schweitzer warned that global monetary policy—except for the European Central Bank—will focus more on economic growth than on controlling inflation. He added that yields curves likely will steepen more than expected, reducing bond returns.

Big Money Gravitates to Wirehouse Stars

Posted on December 16, 2009 by Editor Test -

The four remaining wirehouses-Merrill Lynch/Bank of America, Morgan Stanley Smith Barney, Wells Fargo/Wachovia and UBS-control nearly half of all advisor-managed assets, Cerulli Associates reported.

About 80% of their assets, or $3 trillion, is managed by advisor teams that manage over $200 million each and typically have four advisors, one of whom is an asset management specialist, and two administrative staff.

The size of the teams allows them to offer a broader set of services to investors, and their network of external specialists make them suitable for investors with over $1 million in net worth.

These top advisors are unlikely to go independent, Cerulli believes. They tend to be more loyal to the channel due to their ties to their employers’ proprietary offerings and aren’t likely to trade their salaries and bonuses to set up their own shop.

Cerulli predicts the wirehouses will remain an important channel for asset managers, despite the industry trend toward independence. Large wirehouse teams are extremely productive and can be a profitable channel for an asset manager that understands this subset.

In other findings from the December issue of The Cerulli Edge-U.S. Asset Management Edition:

Post crisis, asset managers should provide product options that creatively manage beta, as opposed to only pursuing alpha. This will require a significant change in mindset, however.

In addition to probable 12b-1 regulation changes, trends in the distribution landscape and downward pressure on fees will affect mutual fund industry profitability. Trends include the institutionalization of the sales process, the spread of ETFs and industry consolidation.

The House Passes Financial Regulation Without Republicans

Posted on December 16, 2009 by Editor Test -

The House of Representatives, by a vote of 223 to 202, approved a Democratic plan last Friday to tighten federal regulation of Wall Street and banks, the New York Times reported. No Republican legislators voted for the bill.

The bill, which is still subject to changes by the White House and the Senate, would:

Consolidate several existing federal agencies into a single Consumer Financial Protection Agency that would set and enforce rules on credit cards, mortgages and loans. Retailers and auto dealers would be exempt from the agency’s oversight.
Preserve the federal government’s ability to pre-empt tougher state consumer protection laws under certain circumstances.
Allow consumers to sue credit rating agenc ies for flawed evaluations of financial products.
Allow shareholders to vote on compensation and “golden parachute” severance packages and require that independent directors sit on compensation committees.
Allow regulators to ban inappropriate or imprudently risky compensation practices for banks and other financial institutions.
Establish a council of federal regulators to monitor the market.
Impose stricter standards and regulations on firms that are large enough or interconnected enough to put the entire economy at risk. The government would set up a $150 billion fund, financed by assessments on large financial firms, to dissolve any large and complex financial companies that it deemed too risky.
Merge the Office of the Comptroller, which supervises federally chartered banks, with the Office of Thrift Supervision, which supervises savings and loans.
Impose tighter restrictions on the largely unregulated derivatives market and require many derivatives to be traded through clearinghouses where they could be monitored by the Securities and Exchange Commission and the Commodity Futures Trading Commission.
Require hedge funds and private equity companies with more than $150 million in assets to be registered with the SEC and to disclose financial information. Venture capital companies and Small Business Investment Companies would be exempt.
Redirect $4 billion from the bank bailout fund to provide low-interest loans to unemployed homeowners struggling to keep their residences and to purchase and repair abandoned and foreclosed homes.
Under an amendment introduced last Thursday, investment advisors who are associated with broker-dealers would not be regulated by the Financial Industry Regulatory Authority (FINRA), National Underwriter reported.

Share of Estate Tax Paid, By Income Slice, 2009

Posted on December 16, 2009 by Editor Test -

‘Here There Be Dragons’

Posted on December 15, 2009 by Jeff Goldsmith -

Last week, the Congressional Budget Office weighed in on the biggest economic imponderable in the health care debate: how private health insurance premiums will behave under health reform.

Building on its December 2008 CBO health insurance market analysis, CBO forecast largely benign effects from health reform’s private market reforms and subsidies on the vast majority of the presently insured (e.g. voting public).

According to CBO, only 17% of Americans in the so-called non-group market—largely individuals—would see premium increases in 2016 (the CBO reference year), because they would be required to purchase fatter benefits with less economic risk.

CBO believes that the other 83% of the presently insured will see little or no change.

I think the fiscal risks of a partially federalized private health benefit are significantly greater than CBO has suggested.

Estimated premium subsidies in proposed legislation—$574 billion over ten years in HR 3962—are pegged to estimated private health insurance premiums.

If, as a result of legislative intervention, premiums actually rise by, say, double the forecasted rates, Congress will be under fierce political pressure to match the increases, or throw millions of people who depend on subsidies back into the ranks of the uninsured.

Where that additional money would come from in 2016, with trillion-dollar deficits, Social Security transitioning to negative cash flow, and baby boomers flooding onto Medicare, becomes a large question.

What we’re really talking about is trying to predict the fluid dynamics of a $900 billion lake of money—the private insurance premium pool. Lake volume is determined by how private insurers price their products, which, in turn, is determined by how their actuaries forecast both variables that will be politically controlled and variables that are beyond political control.

Terra incognita

Under health reform, the federal government will aggressively restructure insurance underwriting practices. Insurers will be required to:

Issue policies to anyone who applies.
Cover an (politically determined) “essential benefit.”
Not cap the benefit for those with catastrophic medical expenses.
Not charge more than two or three times the least expensive rate to the oldest or sickest in the pool.
Add people in their 20s to their parents’ policies, and a host of other factors.

There is no actuarial roadmap through this completely restructured insurance marketplace. It’s terra incognita, properly labeled “Here There Be Dragons!”

Health reform will also create a new Boulder Dam to hold back the lake—a system of health insurance exchanges that become the gateway to the private market, not only for those presently uninsured, but also for a large number of the currently insured population. The exchange’s rules will be the de facto regulatory hurdle health plans will have to surmount to reach the rest of us.

Some humility is appropriate here for all forecasters: the behavior of that lake of money is a classic complex phenomenon.

Benign assumptions

For all the comforting semblance of objectivity, the CBO’s analysis is just a guess—an educated guess—about how the lake will behave if you completely restructure its boundaries. You can model the heck out of it, but all you really do is reframe your uncertainties.

CBO makes some truly debatable assumptions that lead to their benign forecast:

That there is little provider cost shifting in the present market, and will be less in the future because of all the newly covered folks.
That there will be limited risk selection risk from those who take up coverage; that more healthy people will take up coverage in the most volatile non-group segment because of premium subsidies.
That there will be only modest increases in health care use due to the legislatively mandated reduction in cost sharing by subscribers.
That there will be little or no inflationary impact on health care prices of increased demand for health care from the uninsured.

It is actually hard to construct a rosier scenario than the one CBO created.

What’s really happening

Let’s contrast CBO’s rosy scenario with what’s happening right now in the market segments with the greatest risk-individual and small-group coverage.

Presently, the private insurance cost trend is between 8% and 9% across the health system, and rising. Large groups are seeing rate quotes for 2010 below that number. Individual and small-group clients are seeing mid-to high teen rate increases for 2010.

What accounts for the widening spread between inflation and health costs, and between cost and rate quotes, in the non-group market segment that health reform will restructure?

Actual health care demand—hospital admissions, physician visits, prescriptions filled—remains pretty soggy (flat or low single digits), so whatever is pushing up rates isn’t driven by primary demand.

Why rates run ahead of costs or inflation

Cost shifting is certainly a rising contributor to both spreads—cost above inflation and rates above cost.

CBO seems to think that just because providers charge insurers higher rates than Medicare and Medicaid doesn’t mean that they are shifting costs. If it weren’t for cost shifting, most providers who have margins wouldn’t have them. Private insurance is where all their profits come from.

When Medicare flattened costs under the Balanced Budget Act (BBA) in 1997, the result was a lagged surge in private insurer costs, which peaked in 2003. Coincidence? I don’t think so.

I and my consulting colleagues have spent this fall telling providers that it’s time to learn to make money at Medicare rates, because health reform could eventually force insurers to restructure their contracts or cap their rates.

Another contributor to the spread between the 8-9% cost trend and mid- to high-teen rate increases is the effort by insurers to float their overhead (which is being whittled away at, rather than energetically cut) on a smaller base of profitable risk business.

These plans may have lost as many as nine million risk lives in the past two awful years, and if it were not for hefty Medicare Advantage enrollment gains, a lot of the bigger plans would be in a heap of trouble.

Since Medicare Advantage margins will be sharply cut by health reform, we may be seeing some anticipatory rate increases to small-group and individual subscribers.

Lake Mead of money

All in all, the fiscal risks from an open-ended new entitlement to premium subsidies are likely to be significantly larger than CBO estimates.

Instead of neat economic models with ten variables, we need something closer to chaos theory to explain how the nearly trillion-dollar Lake Mead of money will behave when we completely re-engineer its flow pattern. Perhaps the Corps of Engineers can lend CBO some staff.

Jeff Goldsmith is president of Health Futures, Inc., and author of The Long Baby Boom: An Optimistic Vision for a Graying Generation (Johns Hopkins University Press, 2008).

Thoughts on the Future of Retirement Income Products

Posted on December 15, 2009 by Joseph A. Tomlinson, CFP -

In the past few years, we have seen the emergence of many new retirement income products. With the exception of guaranteed minimum withdrawal riders on variable annuities, however, we have seen very little in the way of sales of any of the products. In this article, I’ll discuss pros and cons of the various products from my perspective as a financial planner, assess the prospects for these products, and recommend what I believe would be an optimal solution for many people.

The Immediate Annuity

This product has been the “product of the future” for more than a decade, but the future never seems to arrive. Sales limp along at an annual rate of $10 billion or so, compared to $250 billion for deferred annuities. One rationale for the low sales is consumer aversion to large, irreversible financial commitments, particularly where shorter-than-expected longevity would result in a retrospectively bad investment. Sales may also be low because financial salespeople are loath to sell a financial product that kills the prospect of any future rollover commissions. Given the lack of sales push or customer pull, insurance companies don’t devote a lot of resources to developing or promoting such products.

However, despite all the negatives, the immediate annuity is a simple product that can match up well with retirement income needs, particularly if payments increase with inflation. Prospects for this product may improve if 401(k) plans are enhanced to make it easy to convert savings into retirement income. It could become attractive for fee-based planners, but few fee-based planners serve the low- and middle-income clients who could best use the mortality-pooling benefits of an immediate annuity to stretch scarce retirement savings. Also, most financial planners have focused on accumulation and not retirement income products.

The following changes might allow immediate annuities (and other retirement products I’ll discuss later) to play a more prominent role in retirement planning:

Requiring that retirement savings plans offer an immediate annuity option.
Providing tax subsidies for financial planning to spur the development of a fee-based financial planning industry serving participants in retirement plans.
Providing planners with the training and software they will need to incorporate immediate annuities and other guaranteed products in retirement plans.

Longevity Insurance

This product also goes by the longer name of Advance-Life Delayed Annuity (ALDA). It’s an income annuity where the first payment is delayed for a number of years. For example, a 65-year-old man could purchase longevity insurance that pays an income for life that begins at age 85. If the individual dies before reaching age 85, no payout occurs. The individual would need to plan on making retirement savings last to age 85 and then rely on the longevity insurance for income thereafter. The individual would be freed from the planning challenge of trying to make retirement assets last for an unknown future lifetime.

Because of the income deferral, this product costs less than an immediate annuity. An immediate annuity paying an inflation-adjusted $20,000 per year might cost about $290,000, while longevity insurance paying the same benefit would cost only about $40,000.

This product first came on the market a couple of years ago and I’m aware of two companies that offer it. Anecdotal evidence suggests that sales have been miniscule. As with the immediate annuity, the retirement marketplace doesn’t seem to be set up to pay much attention to this type of product. Also, the financial crisis and the problems faced by a formerly AAA company like AIG have made individuals nervous about buying a product that delays income for 20 or more years.

The product also has a fundamental design problem. Going back to our example, let’s say the individual buys the product and then needs to make other savings last until age 85. If individuals make overly aggressive assumptions about investment growth, they may run out of assets before age 85 and then face a period without income. If they are too conservative, they may reach age 85 with more assets than they need, and may regret not spending more money when they could have enjoyed it.

The fix for this problem would be to combine longevity insurance with a product that guarantees withdrawals until age 85 regardless of investment performance. This would be an acronymic marriage of a limited-term GMWB or RCLA (discussed next) with the ALDA. I believe that longevity insurance has potential as a component in building retirement guarantees, but I don’t foresee strong prospects for it as a stand-alone product.

The Guaranteed Minimum Withdrawal Benefit (GMWB)

This product is offered as a variable annuity rider and has gone through a number of transformations over the decade or so of its existence. The latest version, called the Guaranteed Lifetime Withdrawal Benefit (GLWB), guarantees the annuity purchaser certain minimum withdrawals from the annuity for life (5% of the initial purchase amount is typical), regardless of investment performance. The purchaser pays .50% to 1.00% per year for this rider.

I like this concept for its guarantees, but I have these concerns:

Complexity. This is an “actuaries-gone-wild” product where instead of offering a simple income guarantee based on an initial purchase amount, the product’s guarantees vary with a ratcheting provision based on underlying fund performance. As a financial planner, I would rather show the client something simpler-“Pay X, and y ou’re guaranteed Y-end of story.”

Lack of Inflation Protection. At 2.5% inflation, a 5% fixed guarantee is worth only about 3% in 20 years, and 3% isn’t much of a withdrawal guarantee. I would like to see a product whose guaranteed payouts increase based on actual inflation. Products offered today provide some upside based on underlying fund performance, but the correlation with actual inflation is tenuous.

Cost. A typical variable annuity costs about 2.25% per year. If we add .50% to 1.00% for the rider, we’re near 3.00%. Recent estimates for the premium of future stock returns over bond returns range from 3% to 6%. If that’s the case, a client who uses a variable annuity with a GLWB rider might end up paying out between 50% and 100% of the equity premium in fees.

Rider Utilization. At least one study has shown that, to make best use of the GWLB rider, the customer should take withdrawals at the maximum allowed level immediately after purchase and continue them for life—that is, turn the product into an immediate annuity with an equity-linked refund feature. My impression is that most customers will use the product for accumulation and never call on the income features at all—thereby turning the product into a very expensive mutual fund investment.

In some ways, the GLWB is ideal for guaranteeing retirement income. But its effectiveness in meeting customer needs is seriously compromised. Given the attractive commissions offered on variable annuities, I expect sales to remain strong. But I think there is a better way forward for the customer, and that takes the form of the next product.

Ruin Contingent Life Annuity (RCLA)

This product is the brainchild of Professor Moshe Milevsky of York University in Toronto. He has noted that it is basically an unbundled version of the GLWB. The product was described in detail in Retirement Income Journal so I’ll provide a simplified example here.

Begin with a block of assets that will be used to provide inflation-adjusted withdrawals at some set percentage of the initial amount. The customer purchases a guarantee that if the funds are depleted-due to longevity, poor investment returns, or an adverse sequence of investment returns-the guarantee will kick in and inflation-adjusted payment will continue for life. Because payouts are a function of multiple contingencies-longevity and investment related-the product will cost less than a longevity insurance policy that pays out based on longevity only.

Before illustrating how the RCLA works, I’ll show results for other product solutions. We’ll start with a 65-year-old man with $325,000 of savings and the desire to withdraw an inflation-adjusted $20,000 per year for life. One solution would be simply to invest the money, take systematic withdrawals, and hope the money lasts a lifetime. Assuming 2% inflation, 4% bond returns, 8% stock returns, and a 50/50 stock bond mix, the portfolio would last until age 91. The risks with this approach are: (1) living beyond age 91, (2) experiencing returns lower than assumed, or (3) experiencing a bad sequence of returns, i.e. low returns in the early years of retirement.

A very different solution would be to guarantee a lifetime income by purchasing an immediate annuity. At current rates, an inflation-adjusted annuity generating an initial income of $20,000 might cost about $290,000. That would meet the need for guaranteed lifetime income, but would lock up all but $35,000 of the available funds and leave disappointed heirs if the retiree were to die early.

What about longevity insurance? An ALDA purchased at age 65 and providing $20,000 per year (in today’s dollars) beginning at age 85 would cost about $40,000. That would leave $285,000 to provide income for 20 years. Based on the inflation and investment assumptions used in the systematic withdrawal example above, we would expect the $285,000 to last 22 years-not much margin to guard against bad investment experience. Based on some Monte Carlo analysis, there’s a 44% chance the assets would not last the needed 20 years.

Now let’s look at the RCLA. An RCLA able to produce the required income might cost roughly $20,000, leaving $305,000 as the portfolio on which guaranteed withdrawals would be taken. In effect, we have created the same lifetime guarantee as the immediate annuity, but with $305,000 of initial liquidity for heirs vs. $35,000 if we purchased an immediate annuity. Among legacy-minded retirees, this may lessen the resistance to the initial purchase. (Of course, the $35,000 would be expected to grow over time and the $305,000 to decline, making the immediate annuity potentially the better investment if the retiree lives a long life.) I have not provided an example based on a variable annuity with a GLWB because I am not aware of any that provide a simple inflation guarantee. But with their high expense charges, GLWBs would not produce results as attractive as with the RCLA.

Compared with the RCLA, a disadvantage of annuities and longevity insurance is that the pricing reflects the insurance companies’ cost of holding reserves for such products in fixed income investments. Even though these represent long-term commitments, insurers are not allowed to support them with a mix of stock and bond investments. GLWB and RCLA pricing allows for equity investing and equity option pricing, which means a lower price for consumers.

Conclusion

Both immediate annuities and the RCLA can help clients build secure retirement plans. But neither of them, as I suggested earlier, is likely to get off the drawing board and into retiree portfolios without major changes, such as mandating that retirement savings plans offer the product, subsidizing the growth of the fee-based planner industry, and providing software and training that supports the use of this product. Existing product delivery systems won’t suffice.

Bridge to Somewhere

Posted on December 15, 2009 by Kerry Pechter -

Brent Burns and Steve Huxley of Asset Dedication, LLC, like to compare their retirement income-generating unified managed account methodology to the Apollo moonshot, an event that most Boomers should have no trouble recalling.

The spacecraft’s wobbly moonward path required a lot of course corrections along the way, say the Mill Valley, Calif., entrepreneurs. Similarly, a retirement portfolio won’t adhere to its intended 30-year trajectory without frequent adjustments by an advisor.

That’s one way to describe what they do. But you could also visualize their program as a five-year extension ladder built out of bonds. Each year, if they wish, retired investors and their advisors can keep extending the ladder—presumably until their portfolios are more or less safe from ruin.

“It’s liability-driven investing for individuals,” said Huxley and Burns in a recent interview with RIJ. “We call it Dedicated Portfolio Theory. It relies on the same institutional concepts that foundations and endowments have used for years.”

In recent years, entrepreneurs, insurance companies, and even trade groups have introduced a flock of outcome-based, liability-matching planning methodologies for retirement income generation, offering them as potential alternatives to systematic withdrawals from balanced portfolios. Some employ annuities and some don’t.

Huxley and Burns were pioneers in that movement. With their book, Asset Dedication (McGraw-Hill, 2004), they identified the weaknesses of traditional asset allocation during retirement early on. Even earlier, in 2002, they formed a company with the same name, but didn’t signed up their first client until 2007. Now, having allied with BondDesk Group LLC in November, they’re ramping up their marketing.

Building a “bond bridge”
To a layman’s ears, Asset Dedication’s UMA sounds like a bucket system that’s built around a proprietary bond laddering technique, coupled with an illustration system and integrated with back office support. It includes a one-year cash bucket, a five-year to 10-year bond bucket, and a long-term equity bucket.

The product’s strongest points, its creators say, are that it can deliver predictable inflation-adjusted income year after year and can be customized for each client. Systematic distributions from a bond fund would be a lot more risky, and laddered zero-coupon bonds or a period-certain immediate annuities would be more expensive, they claim.

“Technically, it’s a bond ladder but we call it a bond bridge,” Huxley told RIJ. “It smoothes out income in retirement. Our algorithm reduces the opportunity costs of buying bonds, so you get the most income for the least amount of money. It frees up resources that you can use to extend the bond-bridge or dump into stocks.”

Rolling Time Horizons On the other hand, there’s nothing magical about this methodology. While aimed at creating a rolling buffer zone between a retiree’s market-sensitive assets and his or her monthly cash flow, it doesn’t necessarily exempt advisors or clients from potentially difficult timing decisions during retirement, Huxley and Burns conceded.

“You may have to take a pay cut,” they acknowledged, if it became necessary to buy (“roll over”) an additional year’s income at a time when the portfolio’s equity investments are depressed. The alternative strategy would be to maintain current spending levels and accept an incrementally higher risk of portfolio “ruin.”

The minimum initial investment in the UMA is $250,000 for a household account and $100,000 for management of the bond assets alone. The fee is 35 basis points a year for the first $5 million invested, 25 basis points for the next $5 million and 15 basis points for money over $10 million. Huxley and Burns say the system is designed for low turnover and high tax-efficiency.

Comparisons to funds and annuities
How would Asset Dedication’s five-year bond bridge compare to a five-year period certain immediate annuity? In one of the firm’s published examples, a hypothetical client receives an inflation-adjusted income averaging about $98,000 a year over the first five years of retirement, for an initial cost of $468,000. By comparison, an annuity that produced $98,000 a year for five years, assuming a two percent annual growth rate and no fees, would cost $471,157, according to an annuity calculator at bankrate.com.

Earlier this year, PIMCO introduced a TIPS-based payout fund that provides predictable inflation-adjusted income for 10-year or 20-year intervals. Huxley and Burns were asked to compare it to their product.

“Pimco’s funds are designed as a mutual fund for thousands of clients,” Burns said. “Our strategy generates income specific to each client based on their financial plan. We match the cash flows needed—usually to within one percent—and do this dynamically through the use of rolling horizons. We can use TIPS, Treasuries, AA or better corporate, or munis.

“The best and cheapest solution shifts over time as the spreads between the different fixed income securities change,” he said. “There are times when it is much more expensive to generate the same income profile using TIPS. Right now they are relatively cheap, but two years ago, they were expensive and we have certainly seen them shift that way over the last few weeks.”

But couldn’t an advisor build his or her own bond ladder? “It is not as easy as it sounds,” said Huxley, who teaches at the University of San Francisco School of Business and Management. “Determining the precise number of bonds to buy so as to match cash flows over a period of years can be extremely difficult and time consuming, particularly if cash flows are not steady.”

If investors want to avoid the stress or risk of funding five years of retirement income all at once when they retire, the Asset Dedication system allows them the option of buying a series of five-year bonds, starting five years before retirement.

Target market
Independent fee-based advisors, as opposed to registered reps, are Asset Dedication’s target market. “We dovetail with people who are true financial planners, who are the financial quarterbacks for their clients who provide comprehensive advice, not just investment advice,” Burns said.

“We’re just a piece of what they do. They drive the strategy and we drive the implementation. We can’t build our portfolios unless there’s already an investment plan in place,” he added. Asset Dedication has made several presentations to NAPFA (National Association of Personal Financial Advisors), an organization of fee-only advisors.

Advisors should feel at home with Asset Dedication’s choice of strategic partners. Its affiliation with BondDesk Group, begun last month, gives Huxley and Burns access to a large inventory of bonds. (Also based in Mill Valley, Calif., BondDesk is described by BusinessWeek as an odd-lot fixed-income electronic trading platform for broker dealers in North America.)

The low-fee custodians of the UMAs—Schwab, Fidelity and TD Ameritrade—are obviously familiar to advisors. For the equity bucket of their system, Asset Dedication relies on investments managed by Dimensional Fund Advisors (DFA), which sells low-cost funds only to select advisors.

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