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Rule 151A After the American Equity Decision: Not Only Isn’t It Dead; It Wasn’t Even Needed

Posted on August 4, 2009 by John L. Olsen -

Last week, the U.S. Court of Appeals for the 2^nd District decided American Equity Investment Life Insurance Co. et al. v. SEC. (No. 09-1021). For some observers, this was a “victory” for those who insist that fixed index annuities are not, and should not be considered, “securities,” subject to regulation by the SEC (which Rule 151A asserted).

It was not a victory. Rule 151A was not overturned. The Court remanded it to the SEC for “reconsideration,” solely because it found that the SEC had not given proper consideration to the rule’s effect on “efficiency, competition, and capital formation” in the annuity industry, as required by Sect. 2(b) of the Securities Act of 1933. The SEC is free to re-submit Rule 151A, provided it supplies a “Sect. 2(b) analysis” that satisfies the Court.

Most observers understand this. Curiously, however, few who have written about this case seem to have noticed that the SEC didn’t really need Rule 151A at all! If its goal was to declare that fixed index annuities are “securities,” subject to its authority, it’s had the authority to do so for more than two decades—in Rule 151.

Rule 151, which has been on the books for 23 years, and is clarified in SEC Release 33-6645 (May 29, 1986), offers a “safe harbor.” Contracts which meet its tests will be deemed to qualify for the Sect. 3(a)(8) exclusion of the Securities Act of 1933 and, thus, will not be “securities” (subject to SEC authority). Release 33-6645 includes the following:

After reviewing the comments, the Commission has determined that it would be appropriate to extend the rule to permit insurers to make limited use of index features in determining the excess interest rate, so long as the excess rate is not modified more frequently then once per year. The insurer, therefore, would be permitted to specify an index to which it will refer, no more often than annually, to determine the excess rate that it will guarantee under the contract for the next 12-month or longer period. Once determined, the rate of excess interest credited to a particular purchase payment or to the value accumulated under the contract must remain in effect for at least the one-year time period established by the rule.

In the author’s judgment, NO index annuity can pass that test, as ALL index annuities credit interest retrospectively. They can’t credit interest prospectively because the index performance on which interest will be based has not happened yet. But that won’t satisfy the test cited above, which clearly states that, to qualify for the Rule 151 “safe harbor,” an annuity must calculate “excess interest” (over and above the interest rate contractually guaranteed), declare that interest, and guarantee to credit that rate for at least “the next 12-month or longer period.” The operative word here is “next.”

Why, then, did the SEC feel the need to declare, in Rule 151A (over two decades later), that any annuity in which the “excess” interest credited will, “more likely than not,” exceed the guaranteed rate, will fail to meet the Rule 151 tests and will, therefore, be a “security”?

Why didn’t the SEC simply assert the “must calculate interest in advance” test and declare that all fixed index annuities fail it?

I don’t know for certain. I haven’t met anyone (yet) who does. But I can speculate. Is it possible that the SEC realized that a strict interpretation of the “calculate interest in advance” test would not only leave index annuities outside its safe harbor, but some non-indexed contracts as well?

The SEC developed that test because (as it said in Release 33-6645) it believed that retroactive interest declarations shift “investment risk” to the purchaser, and that vehicles that do that are more like “securities” than “insurance.” Might it have realized, belatedly, that checking accounts that pay interest based on fluctuating money market rates (and that do not guarantee the current rate for an entire year) work the same way, and that declaring those instruments to be “securities” would be going altogether too far?

Whatever its reasons, the SEC hasn’t asserted the 151 test (to this author’s knowledge). But now that 151A has been remanded to it for a reconsideration that will probably require considerable time, effort, and expense to do properly, might it now decide to do so?

I wouldn’t be at all surprised.

So, where’s that leave those who don’t want to have to satisfy SEC rules (whatever they’ll be)—and FINRA rules (whatever they’ll be)—in offering fixed index annuities to their clients?

It leaves us with a lot of work to do.

The task for those who oppose SEC regulation of index annuities is, in my opinion, not a firm resistance to a “reconsidered” Rule 151A, but an overturning of the 23-year-old Rule 151 (at least, to the extent of the interest rate crediting provision cited above). Congress might produce that result if HR 2733 or S 1389, or something similar, becomes law. But I won’t hold my breath waiting for that to happen.

John L. Olsen, CLU, ChFC, AEP, is a principal of Olsen Financial Group, St. Louis, and co-author with Michael E. Kitces of The Annuity Advisor (2^nd Ed., National Underwriter Co., 2009).

How to Walk Through Fire

Posted on August 4, 2009 by Kerry Pechter -

Since last fall’s market crash, you hear a lot about advisors who are struggling to repair their clients’ portfolios, their clients’ confidence in them, or their clients’ optimism about retiring on schedule. But not every advisor or client is singing the Wall Street blues.

Three advisors who, perhaps coincidentally, all live and work in the Western half of the U.S., say that most of their older clients feel cool and calm despite the firestorm around them. That’s because they’ve already established a retirement floor income that’s invulnerable to market volatility.

In Denver, for instance, Phil Lubinski’s clients who are within five years of retirement aren’t canceling any travel plans. That’s because Lubinski, who uses a version of the classic “bucket method” of investment management, has pre-funded their initial retirement years.

“I read all these articles about people who say, ‘I can’t afford to retire when I wanted to,’” Lubinski said recently. “I estimate that people need at least $175,000 of income over the first five years of retirement. Five years before retirement, I’ll carve off $146,000 and let it grow for five years at three percent. Then the next five years is covered.

“Some people will say, ‘Do I really want to give up five years of market returns on almost $150,000?’ I say, ‘What’s more important: the rate of return or the certainty of being able to retire on schedule? If you keep the money invested, you run the risk of not being able to retire.’ I advised one client to put $400,000 in a stable value fund before retirement. He said, ‘Are you nuts?’”

“It just seems obvious to me,” Lubinski added. “So few people or advisors have a strategy that looks ahead farther than 12 months. They’re not thinking long-term.”

When creating a retirement income plan, Lubinski sets up six “buckets” and divides the client’s investable assets among them. Generally, the first bucket is filled with cash equivalents and funds the first five years of retirement. The next bucket, typically in bonds, funds the next five. Each succeeding bucket starts with a smaller base and a higher risk profile. The sixth bucket funds living expenses from ages 90 to 95, if needed, or a bequest.

If the assets in each bucket grow at their historical rates, they will be converted to low-risk assets at “maturity.” If they don’t grow, the client adapts by spending less or perhaps borrowing from the last bucket. “It’s always possible that that year’s income won’t be as high as we thought it would be. On the other hand, if you hit your [appreciation] target early or if you can hit by going in at a lower risk level, that’s what we’ll do,” Lubinski said.

The misunderstood asset

Dean Barber, who runs an advisory firm in Lenexa, Kansas, specializes in clients who are about to retire or have already retired, including about 600 families with $700 million under management. “We deal with the ‘Millionaire Next Door’,” he said—folks who tend to err on the side of risk-aversion and frugality.

Perhaps because of his clients’ age and risk profile, Barber focuses on playing defense. “Our philosophy is to protect first and grow second,” he told RIJ. “In late 2007 and early 2008, we got extremely defensive. So our conservative portfolios were down only one percent, and our most aggressive was down 22%. We deployed a little more capital back into stocks in February of this year, and now we’re about 20% long in equities in our most conservative portfolio.”

Exploiting Social Security is the center of Barber’s retirement income philosophy. Unlike many retirees who might take Social Security benefits at 62 and protect other wealth, Barber’s clients take Social Security at age 70 and set aside no-risk assets as bridge income until then.

“Let’s say you want to replace Social Security for a few years. You take a piece of money and spend it down. You spend the IRA money. You use a money market account or a short-term bond fund, and you create a high probably of success. Sequence of returns risk disappears,” Barber told RIJ recently.

“Social Security is a misunderstood asset class,” he said. “You’d need almost $250,000 more in savings to equal what Social Security can do for you, with its increases over time. The amount of dollars left on the table by not incorporating Social Security as the main driver is shocking. But our industry gets paid to manage assets, so why would they tell you spend your money first?”

That reduces the pressure to assume market risk, so Barber can focus on addressing other risks in retirement. “There are so many more risks than market risks,” he said. “You have to ask yourself the question, what could possibly go wrong? There are taxes—that’s just around the corner. There’s inflation. There’s the premature death of a family member. Bad investments are just one potential problem.”

‘Situational awareness’

Larry Frank, a Rocklin, California, advisor, has a somewhat younger clientele who are just encountering income issues. As first reported in an earlier issue of RIJ, he combines a traditional 3% to 5% SWiP method for generating retirement income with a two-bucket system that segregates client assets into ready money and reserves.

As his clients have aged, Frank has gone through a personal evolution. “The first time I went through this kind of market, between 2000 to 2003, I was on the learning curve,” he said. “I believed the mantra that if you invest for the long term, you’ll come out fine. At the time, my clients were still accumulators.”

Frank dealt with the 2008-2009 market crisis mainly by responding early. Two years ago, spotting troubling economic signals, he stopped buying the market dips and backed away from equities, particularly for clients close to retirement.

“Starting in the middle of 2007, I began pulling back, to a moderate allocation of 60% to 80% stocks,” he said. “Because my over-55 group is more at risk of losing employment or having a health issue, I pulled them back to a balanced 50/50 allocation moderate allocation, and in April 2008 I pulled them back another notch, to 75% short-term bonds and 25% stocks. But the accumulators we didn’t change unless they insisted. They went down with the market and now they’re coming back with the market.”

“Other advisors claim that this is market timing,” he said. “But I’m not trying to predict anything. It’s all based on mathematical triggers.” For instance, if a decline in market values raises a client’s effective withdrawal rate high enough to substantially increase the client’s age-adjusted risk of running out of money, he’ll tweak the payout rate and, in some cases, halt the flow of money from the long-term bucket to the short-term bucket.

At the same time, he’ll study economic indicators and Federal Reserve policy to determine whether the fluctuations are likely to be market noise or a fundamental market shift. “You have to do it with the grey matter,” said Frank, who described his system in the Journal of Financial Planning last April. “In the military”—Frank flew helicopters and C-141 transports—“we called it developing ‘situational awareness.’”

Target-Date Funds ‘At a Crossroads,’ Cerulli Says

Posted on July 29, 2009 by Editor Test -

Has the target-date fund opportunity peaked for asset managers? According to a Cerulli Special Report, “Target-Date Funds: Still Viable?” there’s still opportunity. However, success hinges on shelf space, product design, regulation, and performance.

“We view the industry as being at a crossroads. More than 70% of asset managers feel that they have just begun to tap this opportunity, while a small but growing percentage think it has reached its peak. The top three fund managers currently control nearly 80% of target date fund assets,” says Cindy Zarker, lead analyst of the report.

The report explains that asset managers face a number of challenges in the short term and longer term. Some challenges, such as performance concerns, may soon begin to abate, reflecting a short-term reaction to the market and economic crisis, while others may plague asset managers indefinitely such as fee pressure, limited access to shelf space, and the challenge of balancing greater customization with scalability.

“We feel that asset managers will be well served to carefully assess the true opportunity against potential risks. Firms should ask themselves if they can gain critical mass without access to a recordkeeping platform. If they examine these tough questions, some may find that this is not the market for them, and fund consolidation becomes the logical option,” continues Zarker.

Nearly 70% of target-date fund portfolios have less than $100 million AUM, and most asset managers consider $100 million to $150 million to be the minimum level of assets for a mutual fund to be profitable.

“Target fund consolidation is needed—not because the product concept is flawed—but because target funds can be a distraction from higher potential initiatives. Hanging onto small, unprofitable funds can be a drag on an entire asset management organization consuming valuable resources from the legal department to marketing,” concludes Zarker.

Despite considerable challenges, asset managers believe that open architecture will ultimately take in this market, leading to sub-advisory opportunities. This shift, along with product innovation, will allow for meaningful asset gathering.

The Hartford Continues to Shed Jobs

Posted on July 29, 2009 by Editor Test -

The Hartford has cut nearly 270 jobs in its investment products division nationwide, reflecting a slowdown in variable annuity sales and the company’s decision to shrink the problematic business. The job cuts included a variety of functions, including wholesaling.

“Fewer than 20” of the layoffs were in Connecticut, said David Potter, a spokesman for Simsbury, CT-based Hartford Life, which is part of The Hartford Financial Services Group. The investment products division sells annuities, mutual funds and retirement plans.

“The reductions reflect the need to realign our expenses with the reduced volume of business that we have experienced in our investment products business, particularly variable annuities,” Potter said.

The Hartford had already cut 475 jobs in Connecticut since late 2008, according to the Hartford Courant. More layoffs at the company are expected. As of late June, The Hartford had roughly 12,000 Connecticut employees.

The company has been laying off employees as part of efforts to reduce annual expenses by $250 million a year by the end of this year. The Hartford, which has suffered heavy investment losses and problems in its variable annuity business, accepted $3.4 billion in federal bailout funds last month.

Nationwide Adds Annuity Option to Morgan Stanley UMAs

Posted on July 29, 2009 by Editor Test -

Morgan Stanley Smith Barney announced that it has launched Select Retirement, which adds an optional Nationwide Life Insurance fixed income annuity option to the Select unified management account program as a way to convert UMA assets to lifetime income.

“We expect that the ability to combine a UMA with access to guaranteed lifetime income will be viewed by our industry as an important step forward,” said James J. Tracy, Director of Consulting Group for Morgan Stanley Smith Barney.

Select Retirement creates an opportunity to offer clients income guarantees that were not previously available for UMAs that include separately managed accounts (SMAs).

“By teaming with Morgan Stanley Smith Barney, we’re able to draw upon the collective financial strength and experience of both firms to build an investment and income strategy that Financial Advisors can provide to help clients preparing for or in retirement,” said John Carter, president of Nationwide Financial Distributors, Inc.

Before and after activating Select Retirement, eligible investors can use Select UMA to help build assets. Select UMA provides a selection of diversified asset allocation strategies and the ability to construct portfolios with a mix of separately managed accounts, mutual funds and/or exchange-traded funds (ETFs).

“With Select UMA, investors receive the convenience and efficiencies of a single account that integrates asset allocation, product selection, account administration and performance reporting,” said Marc Brookman, Director of Product Development for Morgan Stanley Smith Barney. Investors also can benefit from the personal guidance of their Financial Advisor and the expertise of Morgan Stanley Smith Barney’s centralized asset allocation and manager research teams, he said.

“The ability to combine Select Retirement with Select UMA provides Financial Advisors with a powerful program for clients who seek to balance asset growth potential while at the same time eliminating the worst-case scenario of outliving their income,” said James J. Tracy. “This may prove to be an especially helpful strategy for near-retirees and retirees who are hesitant to return to the equities markets at this time.”

What Financial Advisors Worry About

Posted on July 29, 2009 by Editor Test -

What Financial Advisors Worry About
Rank
1	Client losses
2	Client anger
3	May have to postpone your own retirement
4	Have to sell less profitable products to make up income shortfall
5	Future of practice is in jeopardy
6	Decreased likelihood of selling your practice
Source: Brinker Barometer Results Highlights Second Quarter 2009, Brinker Capital

Black Swans: Are they Really Infrequent?

Posted on July 29, 2009 by Editor Test -

Black Swans: Are they Really Infrequent?
2007-9	Subprime / Credit / Global Financial Crisis
2001-2	Dot-com Bust, Sept 11 Attacks, Argentine Default
1998	LTCM and Russian Default
1997-8	Asian Financial Crisis
1994-5	Mexican Peso Crisis
1992-3	European Monetary System Crisis
1989-91	U.S. S&L and Latin American Debt Crises
1987	Black Monday
1982	Mexico Debt Default (leading to international debt crisis)
Source: “Defined Contributions: What’s Next,” PIMCO Institute

Goldman Sachs Eyes DC Market

Posted on July 29, 2009 by Editor Test -

Goldman Sachs Asset Management wants to get more of its mutual funds into 401(k) plans, said Scott E. Kilgallen, managing director and head of platform distribution at the New York firm. By year-end, the company plans to have 28 professionals in its defined contribution unit, up from four at the end of 2007.

“We’ve been in the retirement business for 20 years managing defined benefit assets, but are now really ramping up our DC effort,” said Mr. Kilgallen. GSAM executives plan to offer more esoteric investment strategies, such as hedge-fund replication and other absolute-return strategies.

The firm is still a small player in the DC business, with only $10.68 billion under management in DC plans. Goldman Sachs Asset Management, established in 1988, has $343.23 billion in worldwide institutional assets under management. It ranks 16th among the largest institutional managers.

Drew Carrington, UBS Global Asset Management’s head of defined contribution and retirement solutions, Chicago, said Goldman’s best bet will be large plans, which typically work directly with a fund provider without a third party. “The sale at big DC plans is now more like a DB sale than the record keeper-led sales from several years ago. They’re really focusing on making the right investment decisions.”

Mr. Carrington, whose firm competes with Goldman, added that for Goldman, as with a lot of traditional defined benefit plan providers, “innovation will be very important. They need to provide solutions that plan sponsors can’t usually get out of traditional record keepers. And if they can communicate those solutions, using DC language, and help participants achieve their objectives, they can succeed.”

Social Security Tax Base Shrinks as Upper Incomes Grow

Posted on July 29, 2009 by Editor Test -

Executives and other highly compensated employees represent only six percent of U.S. wage-earners but receive more than one-third of all pay in the U.S., the Wall Street Journal found in an analysis of Social Security Administration data. Billions of dollars more in compensation goes unrecorded by the government.

Highly paid employees received nearly $2.1 trillion of the $6.4 trillion in total U.S. pay in 2007, the latest figures show. The compensation numbers don’t include incentive stock options, unexercised stock options, unvested restricted stock units and certain benefits.

The pay of employees who earn more than the Social Security wage base of $106,800 rose 78%, or nearly $1 trillion, over the past decade, compared to a 61% increase for other workers, according to the analysis.

As executive pay has increased, the percentage of wages subject to payroll taxes has shrunk, to 83% from 90% in 1982. Compensation that isn’t subject to the portion of payroll tax that funds old age benefits now represents foregone revenue of $115 billion a year.

Lawmakers over the years have tried to raise or eliminate the taxable wage ceiling, as was done for the Medicare portion in 1993. Lifting the earnings ceiling could result in higher Social Security benefits payments to higher-income individuals, but the additional tax revenue would have decades to grow, thus offsetting the added costs.

Social Security Administration actuaries estimate that removing the earnings ceiling could eliminate the trust fund’s deficit altogether for the next 75 years, or nearly eliminate it if credit toward benefits was provided for the additional taxable earnings.

What Obama Didn’t Say About Health Care

Posted on July 29, 2009 by Editor Test -

Because the rising cost of health care can wipe out much of a person’s retirement savings, I’ve been watching the debate over national health care policy closely. In fact, I’ve been paying attention to it for a couple of decades. The debate hasn’t changed much during that time.

In the early 1980s, people began to worry in earnest about health care cost inflation. Corporations responded with workplace fitness programs. HMOs, then still new, promised a thrifty alternative to fee-for-service. The government tried to discourage adjacent hospitals from duplicating equipment. Researchers at Dartmouth pointed to large inexplicable geographical discrepancies in health care spending. The editor of the New England Journal of Medicine, Arnold Relman, railed against his fellow doctors for milking the insurance system.

Twenty-five years later, we’re in the same hole, only deeper. Workplace fitness programs proliferated, but didn’t reach the hourly workers most at risk for lung and heart diseases. The HMO concept, with its capitation and denial of care, proved unpopular. Hospitals became corporate profit-centers. Those geographical discrepancies in spending went unaddressed. Just recently, Arnold Relman was still chiding his fellow doctors for milking the system.

Mr. Obama has called for change. At a recent press conference, he pointed to the Cleveland Clinic and the Mayo Clinic as models of efficient health care delivery. He referred to countries that deliver better health care for less, as measured by the share of GDP they devote to medicine. His ideas make sense. But he did not mention that many if not all doctors in those clinics and those countries earn a salary.

To my knowledge, America’s science majors, for the most part, don’t sweat through school and shoulder mounds of debt so that they can work for a salary. They’re entrepreneurial. As Lyndon Johnson discovered at the founding of Medicare, doctors won’t accept price controls. They may choose to donate care to the needy when it suits them, but they won’t let the government turn their profession into a public utility. It won’t happen, not in our lifetimes.

Yet the status quo cannot continue. Doctors and hospitals have compromised their positions of trust. They have been abused by the health insurance system and they feel justified in abusing it back. I’ve known doctors to brag about billing at high rates for work performed cheaply by a lab or a low-paid assistant. I’ve seen them buy diagnostic equipment and over-prescribe its use. I’ve seen hospitals overbill by 100% in anticipation of being reimbursed at 50%. As a result, we all spend too much for health care.

To live outside the law you must be honest, Robert Zimmerman said. If doctors want to maintain their “trusted advisor” status, they need to refrain from gaming the system. When too many people game the system, there is soon no system left to game. It’s a shame that as a nation we’ve reached this point, where we spend much more on health care than other advanced countries but cover fewer people. But here we are. And if we don’t solve this financial cancer, if you will, it will consume our retirement savings.

Yesterday, I asked Jane Jacobs, a spokesman for the Mayo Clinic, exactly how that world-famous institution in Rochester, Minnesota, saves money. Putting doctors on salary isn’t the whole story, she said. The clinic lowers costs by pooling patient information in a way that minimizes redundant tests and procedures. It also finds ethical ways to manage the care of the very old so that vast sums are not spent during the final months of life. That issue—rationing care to the very old—could be more difficult than the question of physician compensation. The ethical aspects of the health care debate—and of the financial regulatory debate—may prove more intractable than the economic ones.

Will SEC Rustle Insurers’ Cash Cow?

Posted on July 29, 2009 by Editor Test -

Not much was permanently resolved last week by a federal appellate court’s decision in the matter of American Equity Investment Life et al. v. the Securities and Exchange Commission, in which the fixed indexed annuity (FIA) industry is challenging the SEC’s right to regulate its product.

Yet the ruling, which sent the case back—“remanded” it, in legalese—to the SEC for revision, was significant.

On the one hand, the D.C. Court of Appeals affirmed the SEC’s primary contention that FIAs are too risky not to be regulated as securities. But the court rejected as “flawed” the SEC’s contention that Rule 151A will stimulate rather than reduce competition in the FIA space.

The decision could push back the anticipated January 2011 start date for Rule 151A indefinitely—and give insurance companies and the National Association of Insurance Commissioners (NAIC) more time to pursue legislation that would put FIAs beyond the SEC’s reach.

For now, the status quo prevails. Insurance agents without security licenses can sell FIAs, which are structured products consisting of bonds and S&P Index options. Insurance-licensed registered reps can sell them too, but must submit their sales to their broker-dealers for approval.

There’s upwards of $1 billion in commissions at stake. The insurance industry maintains that FIAs are legally its cash cow. It accuses broker dealers and the SEC—privately, not publicly—of using regulatory reform as a pretext to rustle that cow.

Hence the court’s focus on economic factors. “In June of 2008 I wrote, ‘the proposal could result in a loss of $852 million to insurance industry distribution channels,” said Jack Marrion, a behavioral finance consultant and author of Index Annuities: Power and Protection.

“‘Most of this loss would be incurred by small entities, and it would result in a major increase in costs for insurance agents.’ It was on this basis that 151A was sent back for SEC to assess the economic damage 151A might cause,” he added.

The July 21 ruling “is a setback for the SEC,” said Sheryl Moore, president and CEO of AnnuitySpecs.com, which compiles index annuity product profiles and other data. “They are going to have extreme difficulty attempting to prove that Rule 151A improves ‘competition, efficiency, and capital formation.’ Regarding competition specifically, the number of carriers and products in this market has steadily declined since FINRA issued the Notice to Members 05-50 in August of 2005.

“This is not a victory for the indexed annuity industry, but it has given us time,” she added. “Now, it is more important than ever for the indexed annuity distribution to get face time with their legislators; call and write in support of HR 2733 and S 1389. These bills will ensure that indexed annuities continue to be regulated as fixed insurance products.”

Meeting the court’s demand for a demonstration that Rule 151A doesn’t restrain trade will be “a formidable and time-consuming task, and there is no assurance that the court will find that the SEC’s follow-up meets the statutory standard,” agreed securities and insurance law expert Joan Boros, of the Washington law firm, Jorden Burt, said in a prepared statement.

“The task, among other things, may require the SEC to subject its review to still another round of public comment. In view of the current pressures on the SEC regarding proposed financial regulatory reform, it is quite uncertain whether (and when) the SEC will choose to assume these tasks,” she wrote.

Marrion expressed the same doubts. “The SEC could revisit this area and conduct a thorough analysis on the economic effects and try this again, but I don’t think they will,” he said.

“First, the SEC plate is a little fuller than it was last summer with other regulatory needs—since the lack of SEC oversight has been blamed for billions of dollars in securities losses it is harder to justify attacking an instrument that protects against loss. Second, there are active bills in Congress that, if passed, would mandate index annuities are not securities, so SEC could wind up simply wasting their time in an area they may not control.

“Third, the issue that was the real reason 151A was passed—that index annuity sellers are unregulated cowboys—is being handled. FINRA has effectively back-doored putting supervision on index annuities by making broker dealers responsible for supervising rep sales of all products, whether securities or not.

“In addition, NAIC is quickly moving forward on new suitability regulations that could cause the agent and supervising marketing company to lose their insurance license for an unsuitable annuity sale. The unregulated sales issue is being addressed,” he added.

As the FIA industry tries to persuade Congress to protect its product from the securities industry, it’s unclear what weight the appellate court’s ruling that index annuities are risky assets will carry, if any. In their ruling, the three-judge panel of the D.C. Court of Appeals offered the following reasoning.

“In petitioners’ view, investment risk exists only where the purchaser of a security faces the possibility of a loss of principal. Petitioners’ view is certainly a defensible one. However, that is not sufficient to establish that the SEC’s rule is arbitrary or capricious.

“As the SEC points out, comparing two slightly different annuity products—one with a 5% interest rate guaranteed ahead of time; one with an interest rate that could be between one and 10% determined at the end of the year—the second product is riskier than the first product because its potential return could be lower than the rate of return from the first product, even though it guarantees a minimum return rate of at least one percent.

“Indeed,” the ruling continued, “the key characteristic of FIAs is that they offer a wide range of potential yearly return interest rates based on the performance of a securities index. This potential for a greater rate of return is what makes FIAs potentially more enticing than those exempt annuities that guarantee an interest rate ahead of time but at a lower rate. As we have noted above, this key distinction between these two products shows that FIAs are more like securities from a risk perspective than other annuity contracts.”

A Summer Crop of Variable Annuities

Posted on July 29, 2009 by Kerry Pechter -

Judging by the latest wave of variable annuity contracts, insurers have chosen to “de-risk” their products in one of two ways: by simplifying them and slashing prices or by maintaining rich benefits and simply charging more for them.

In July, several firms have released new products, including John Hancock and MetLife, who appear to have taken the simpler route, and Allianz Life and Genworth Financial, which appear to carry on the tradition of high costs and complexity.

The products are appearing just in time for the summer rally in equities. The DJIA closed just under 9,100 points on Tuesday afternoon, up from a low of about 6,700 last March. Annuity manufacturers say the new products are not trying to time the market.

Simplify, simplify

With its AnnuityNote contract, John Hancock Life has taken a “less is more” approach. AnnuityNote requires contract owners to make no complicated choices. There’s only one investment option, one income option, and one comprehensive fee.

Investors in the contract must put all their money in a diversified, passively-managed 70% stock/30% bond balanced fund from MFC Global Investment Management. Five years after contract purchase, they can take a lifetime income of five percent per year of their initial payment or their account balance, whichever is greater.

The all-in price, including the cost of investment management and the lifetime income guarantee, is 1.74% per year. All contracts are sold on an A share basis, with a three percent commission. There’s no surrender period and no withdrawal charge.

Tom Mullen, chief marketing officer for annuities at the ManuLife unit, said the product was aimed at the same niche as managed-payout mutual funds, but with a guarantee. “We approached the redesign with the idea that if you could built a mutual fund with a true guarantee, that product would get broad acceptance. While it wouldn’t necessarily fit the mold of the annuity aficionados, it would help us tap into the 80% of the advisors who don’t ordinarily use annuities,” he said.

John Hancock sold $9.6 billion worth of variable annuities in 2008 and $2.1 billion in the first quarter of 2009. Mullen said the company’s damage from living benefit guarantees has been “commensurate with our market share” but that the company had no exposure to mortgage-backed securities. The firm’s S&P strength rating is AA+.

The complex approach

Allianz Life’s new Vision variable annuity prospectus, on the other hand, defies any easy interpretation, even for someone used to reading prospectuses of this type. And the combined annual fees—including a 1.40% M&E fee and fund fees as high as 1.95%—can easily exceed four percent.

The contract offers two main riders, an Investment Protector that costs 80 basis points a year (to a maximum of 2.50%) and that protects the value of the initial investment during a 10-year waiting period. But the owner has to keep track of three values: the actual contract value, the rider anniversary value (the highest value on any contract anniversary), and the target value, which is currently 95% of the target value but could be as low as 80% in the future. It’s confusing.

The other rider is the Income Protector, a guaranteed lifetime withdrawal benefit that costs 1.05% (maximum, 2.50%) for a single life and 1.20% (maximum, 2.75%) for two. The guaranteed payout rates are only 4.5% for owners age 65 to 79, and 5.5% for those aged 80 and over. The payments are based on what seemed like a very complex schedule of enhancements to the contract value, ranging from one percent to 2.5% every quarter during the accumulation period—currently as long as 20 years.

As for investments, there’s a fairly complex table to determine how much of the contract value can be allocated to a four different groups of investment options. But the principle is simple. Generally, the required allocation grows more conservative as the income start date draws closer. The allocation gets more conservative at a much faster rate when the contract value is lower than the target value.

“In March, we suspended the sales of the previous Vision rider because of the turmoil in the market,” said Jasmine Jirele, Allianz Life’s vice president of Product Innovation. “With the new rider, we wanted to make the statement that the VA arms race is over, so we took the pulled benefits back. We wanted to make sure what we was offering was sustainable. The pricing and the products reflect what we’ve learned, and in the industry as a whole we’re seeing early signs of rational pricing.”

GLWB ‘Lite’

On July 20, MetLife introduced its Simple Solutions variable annuity with a guaranteed lifetime withdrawal benefit, which features one income option, only four investment options, and a three-page application. Its five-year surrender period starts with a seven percent withdrawal charge.

The prices are modest, at least compared to VA contracts of the past. The M&E fee is 0.75% and the administration fee is 0.25%. The lifetime income rider costs 1.00% for a single life, and 1.20% for joint coverage (maximum, 1.60% and 1.80%, respectively). The investment options—balanced funds with 35%, 50%, and 65% target equity allocations and a money market fund—cost 59 basis points to 112 bps.

“The goal in creating Simple Solutions was to give individuals and the banks which serve them an easy-to-understand, lower-cost variable annuity with solid basic benefits,” said MetLife managing director Kevin Crowe in a release. “Bank representatives may traditionally sell fixed annuities, but this variable product offers additional benefits their clients may need, all packaged in an easy-to-explain product with a simple application.”

During the accumulation phase, the guaranteed income base is stepped up to the account balance, if higher, on the contract anniversary. The payout rates are 4% until age 65, 5% through age 75, and 6% thereafter. The owner can also annuitize the contract on a fixed or variable basis.

Another ‘Income Protector’

Also on July 20, Genworth rolled out its RetireReady One variable annuity. What’s new about this contract, according to a Genworth spokesperson, is its guaranteed lifetime withdrawal benefit rider, called, like Allianz Life’s rider, the Income Protector.

For a 1.10% rider fee (maximum 2.50%), this Income Protector offers a payout schedule similar to its namesake: the lifetime income rate for a single life begins at 3% at age 50 and moves up a half-percent every five years before reaching 7.0% at age 80. The withdrawal percentage for a joint account is a half-percent lower in each age band.

Investment options are constrained to a set of three balanced portfolios, with equity allocations of 40%, 60%, or 70%, or to a group of designated BlackRock funds and a GE Investments Total Return Fund.

During the accumulation period, the Income Protector offers a surprisingly big roll-up—6% per year, compounded daily—for those who are willing to wait for 10 years after the contract date. Until then, limited withdrawals are allowed. If exceeded, the roll-up process stops.

Martin Weiss on the CalPERS Suit

Posted on July 22, 2009 by Editor Test -

Martin Weiss, Ph.D, who founded Weiss Ratings and later sold it to Street.com, has been called a “gadfly” in financial circles. As the current president of Weiss Research Inc. and publisher of Safe Money, he is now out of the ratings industry. But he remains a critic of grade-inflation, group-think, and the misuse of incentives within it.

RIJ asked Weiss, whose new book, The Ultimate Depression Survival Guide (Wiley, 2009) reached sixth place on the New York Times Hardcover Business Best Sellers list on June 5, to share his thoughts on the California’s state pension fund’s suit against Standard & Poor’s, Moody’s, and Fitch Ratings. Here’s the result of our Q&A:

RIJ: What was your reaction to the news of the lawsuit against the big three Nationally Recognized Statistical Rating Organizations, or NRSROs?

WEISS: I think CalPERS is very much justified in taking this action. I believe there’s abundant evidence already revealed, and in Congressional investigations and testimonies, that will give them a good paper trail for discovery. Their richest vein in that discovery, in my opinion, will be the depositions of individual analysts-both those who are currently employed and those who have left Moody’s and S&P.

RIJ: And what do you think those depositions will show?

WEISS: I’ve spoken to quite a few analysts, and those have disclosed egregious manipulations and conflicts of interest that go beyond what is generally known. There’s the typical thing, where an analyst felt that bonds should be downgraded and was overruled by principals.

That’s number one. Number two is compensation made over and above published fees, with the understanding that it would result in a better grade. There are payoffs tacitly or implicitly tied to a higher grade. There’s a higher bar to proving that, but I don’t think they will have to prove that to prevail.

The defense will be, ‘We did our best to cover all the available fact. There’s always a judgment we have to make based on our experience.’ So it will be important to depose ex-analysts or analysts, to ask, if the analysts have all those years of experience, why are the principals overruling the them?

RIJ: The suit says the rating agencies helped design the structured investment vehicles, or SIVs. Why shouldn’t the ratings agencies help their clients produce the safest possible product?

WEISS: Consider Consumer Reports, which is the standard to which the rating agencies should be held. Suppose you wanted to build the ultimate cell phone, a phone that would beat the iPhone. Then, suppose Consumer Reports says, ‘We know exactly how to get the ultimate rating from us.’

The cell phone manufacturer asks how, and Consumer Reports says ‘We’ll design it to the specs that meet our standard, and you’ll get the perfect package.’ Any consumer, even without legal training, would say that’s hanky panky. No matter how you spin it, it doesn’t pass the smell test.

RIJ: During the Enron scandal, didn’t the rating agencies successfully defend themselves from these types of accusations?

WEISS: In this case there’s more evidence than there was in Enron, and I don’t believe ratings agencies helped design Enron’s derivatives. This business of designing products and rating them has ‘hit the fan.’

RIJ: I can understand the incentive for a rating agency to improve the rating of its own client’s SIV. But why would the other agencies give that SIV the same high rating?

WEISS: It’s ‘scratch my back I’ll scratch your back.’ There has always been very little variation in the ratings between the three top NRSROs. All three use the same conflicted business model. They’re the ‘three musketeers.’ If you had more entrants into the field who aren’t conflicted, and if they had some inroads into market share, you might see more variation and more accurate ratings. But the barriers to entry in that business are too high.

RIJ: The system seems to have worked until now.

WEISS: The general assumption has been that Moody’s, S&P, and Fitch are very smart and know what they are doing. I don’t think anyone realized the depth of the conflicts and the severity of the consequences, in terms of the size of the losses that could accrue. In normal times they get away with it. People don’t notice it because growth reduces the risk and it doesn’t show up. Those fault lines and weaknesses only appear when there are major earthquakes.

PIMCO Expects Erosion in Value of U.S. Dollar

Posted on July 22, 2009 by Editor Test -

Over the next few years, investors should focus on the front end of the yield curve, invest in income-producing securities, look outside the U.S. for credit opportunities and hedge against a weak U.S. dollar, according to Bill Gross, CIO of PIMCO, and his colleagues.

“The key assumption of our Secular Outlook is that following the severe shocks to the global economy in the second half of 2008, the world embarked upon a journey of change not likely to be reversed over the next few years,” PIMCO officials wrote in the firm’s third-quarter market outlook report, released in mid-July. They said the journey would be marked by “starts, stops and volatility.”

As such, the firm plans to overweight “duration” and take exposure out to the five- to 10-year part of the yield curve. “However, consistent with our Secular Outlook, we plan to also retain an emphasis on the short end of curves in the U.S., Europe and the U.K. as central banks are likely to tighten more slowly than markets expect,” the report said.

In addition, the firm plans to retain an overweight position in agency mortgages but at lower levels than earlier in the year; PIMCO also will trim its holdings of corporate bonds in the financial sector while retaining a focus on industries such as pipelines, utilities, telecoms and energy companies—sectors that exhibit, in PIMCO’s words, “defensive characteristics and assets that provide strong collateral.”

PIMCO managers also expect to maintain their municipal bond positions focused on longer maturities, “which currently offer the most attractive relative value after recent gains,” the report said.

Finally, the firm is focusing on the currencies of emerging markets like Brazil and Mexico. “In light of an expected long-run erosion in the value of the U.S. dollar, PIMCO will look to take positions in select emerging market currencies that we believe have the most compelling appreciation potential.” the report said.

Interest Rates To Stay Very Low: Bernanke

Posted on July 22, 2009 by Editor Test -

The Federal Reserve plans to keep short-term interest rates at “exceptionally low levels for an extended period,” despite signs that the economy is improving, Fed Chairman Ben Bernanke said at a hearing before the House Financial Services Committee on July 21.

The Fed was prepared, however, to withdraw the “extraordinary policy measures” the agency has taken in response to the financial crisis and the recession to avoid a future increase in the inflation rate, he said.

“The [Federal Open Market Committee] has been devoting considerable attention to issues relating to its exit strategy, and we are confident that we have the necessary tools to implement that strategy when appropriate,” Bernanke said.

Bernanke, delivering the Fed’s semiannual economic report to Congress, said the Fed expects economic output to “increase slightly” for the remainder of 2009 after declining in the first half. “The recovery is expected to be gradual in 2010, with some acceleration in activity in 2011,” he said.

Consumer spending has been relatively stable and the decline in housing activity appears to have moderated, which Bernanke said was evidence of improvement. “Businesses have continued to cut capital spending and liquidate inventories, but the likely slowdown in the pace of inventory liquidation in coming quarters represents another factor that may support a turnaround in activity,” he added.

“Despite these positive signs, the rate of job loss remains high and the unemployment rate has continued its steep rise,” he continued. “Job insecurity, together with declines in home values and tight credit, is likely to limit gains in consumer spending. The possibility that the recent stabilization in household spending will prove transient is an important downside risk to the outlook.”

NAVA Becomes “Insured Retirement Institute”

Posted on July 22, 2009 by Editor Test -

The trade association formerly known as NAVA concluded its secretive, six-month rebranding process this week with the announcement that it will henceforth be called the Insured Retirement Institute, or IRI.

Judging by its prepared statement, the IRI will try to broaden its membership to include financial advisors. In the past, the membership has reflected the organization’s roots. It began as the National Association of Variable Annuities in 1991, and its members were mainly insurance companies that issued variable annuities and the technology vendors who served them.

The rebranding effort began last October, when Cathy Weatherford replaced Mark Mackey as NAVA’s CEO and president. Weatherford, who had been CEO of the National Association of Insurance Commissioners, then replaced the entire staff except for Deborah Tucker, who has led the organization’s Straight-Through-Processing initiative.

Besides reaching out to financial advisors, who are a crucial link in the variable annuity distribution process, the organization has said it intends to be a stronger lobbying force for its members’ interests. Weatherford and her chief operating officer, former Ohio insurance commissioner Lee Covington, are registered Washington lobbyists. The organization recently relocated its headquarters to Washington, D.C., from Reston, Va.

IRI has also created a new web site, www.IRIonline.org, that “offers IRI members, financial advisors and consumers a central, trusted resource for the latest news and innovative tools for insured retirement planning.”

“This is a critical moment in our industry that requires a new, reinvigorated approach,” said Weatherford. “IRI will be a trusted resource for consumers looking for guaranteed income in an economy and times where there is little certainty. We will provide consumers with the knowledge and confidence in retirement planning that can no longer be taken for granted.”

Crisis Investigators Appointed

Posted on July 22, 2009 by Editor Test -

Congress has established a 10-member Financial Crisis Inquiry Commission to help investigate the causes of the U.S. and global financial crisis. But don’t hold your breath waiting for the answer. The commission’s report isn’t due until December 15, 2010.

Former California state treasurer Phil Angelides was appointed by Speaker of the House Nancy Pelosi (D-Calif) and Senate Majority Leader Harry Reid (D-Nev) to chair the inquiry. Brooksley Born, who warned about the impending crisis while serving as head of the Commodities Futures Trading Commission, was also named to the commission.

The other four commission members named by Pelosi and Reid are: former Senator Bob Graham of Florida, Heather Murren, a retired managing director at Merrill Lynch, Byron Georgiou, a Las Vegas-based businessman and attorney, and John Thompson, chairman of Symantec Corp.

Republicans appointed four members: Former House Ways and Means Committee Chairman Bill Thomas, who will serve as vice chairman of the commission, Peter Wallison of the American Enterprise Institute, ex-Congressional Budget Office Director Doug Holtz-Eakin and former National Economic Council Director Keith Hennessey.

Massive Drop in 300 Large Company Pension Funds: Towers Perrin

Posted on July 22, 2009 by Editor Test -

The funded status of the typical U.S. pension plan fell four percent in June, according to the Towers Perrin Pension Index. In fiscal 2008, the funds of the companies in the TP 300 fell in aggregate value from a $47 billion surplus to a $339 billion shortfall.

Moderate portfolio returns and a decline in bond yield combined to push the index lower. The results were reported in Towers Perrin’s firm’s latest Capital Market Update (CMU).

The index, which reflects the asset/liability performance of a hypothetical benchmark pension plan, remains up by 1.4% for the year to date. However, the June results represent a decline of 23% over the past 12 months.

The benchmark investment portfolio used in the Towers Perrin Pension Index experienced a 0.3% return for June and has returned 3.9% for the year to date. The liabilities used in measuring the index (based on projected benefit obligations) rose 4.6% in June and have increased by 1.8% for the year to date.

Towers Perrin’s monthly update includes an estimate of the aggregated pension financial results for 300 large U.S. companies in the TP 300. The companies’ aggregate funded position changed from a $47 billion surplus as of the end of their 2007 fiscal years, to an unfunded amount of $339 billion at the end of their 2008 fiscal years-a decline of $386 billion for fiscal year 2008.

The firm’s projection to June 30, 2009 indicates a current unfunded amount of $344 billion for these companies, a slight deterioration in funded status since the close of the 2008 fiscal years.

Insecurity Grows Among Retirees

Posted on July 22, 2009 by Editor Test -

The number of retirees who say they are worried about financial security has more than doubled in the past year, and many are tightening budgets or seeking professional financial advice. Forty-nine percent of retirees said they felt less secure than when they first entered retirement, compared with 20% who said so last year.

The findings come from a survey of retirees aged 56 to 77 with $100,000 or more in investable household assets, conducted by LIMRA, the Society of Actuaries (SOA) and the International Foundation for Retirement Education (InFRE). The organizations released the findings July 14 in a report titled What a Difference a Year Makes, highlighting changes in retirees’ attitudes from 2008 to 2009.

Of the retirees surveyed, 43% said their tolerance for investment risk has gone down since last year, and many were concerned about the possibility of inflation.

The retirees whose investment risk tolerance declined in the past year gave the following main reasons:

Concern about the economy, 79%
Concern about future inflation, 45%
Not enough time to recover from the economic downturn, 39%
Change in house value, 28%

“Retirees are definitely feeling the effects of the 2008 financial crisis, and have begun changing their behavior,” said Sally A. Bryck, LIMRA associate research director, who led the project. “While seven in 10 respondents said they can still cover their basic expenses and afford a few extras, the number who said they spend money on whatever they want dropped sharply from 38% in 2008 to 22% in 2009.

“We also see an increase in the number of retirees who have personal financial advisors,” Bryck added. “Today 61% say they have a personal financial advisor compared to 56% in 2008. Seeking professional help shows how severely things have changed and how unsure retirees are about doing things themselves.”

The survey also found a significant decline in the number of retirees who feel very confident they have saved enough money to live comfortably throughout their retirement. Today, only one in four of the retirees are extremely confident they have saved enough, a 12 percentage-point drop year over year.

One way to decrease concern over outliving money, risks of inflation, and other financial hazards is to use some financial assets to generate guaranteed lifetime income.

SOA member Anna Rappaport, FSA, MAAA, noted that, “Unfortunately, many retirees are not thinking long term. Even among retirees for whom Social Security does not cover their basic expenses, a guaranteed lifetime income, such as that provided by an annuity, is not a core focus of the retirement plans of the retirees surveyed. Among retirees whose core expenses are not covered by Social Security, 31% indicated interest in converting a part of their savings into guaranteed lifetime income.”

“To make sure they do not outlive their assets, retirees need to take an actuarial perspective in managing retirement risks and focus on long-term goals and challenges,” she added.

Hold Brokers and Advisors to One Standard, SEC Chief Says

Posted on July 21, 2009 by Editor Test -

In testimony before a House subcommittee July 14, SEC
chairman Mary L. Schapiro emerged as a regulatory hawk,
displaying much more passion for government oversight of the
securities business than she did in her previous job as head of the
Financial Industry Regulatory Authority, or FINRA.

Among her themes:

Registered reps must accept fiduciary responsibility if they give financial advice.
Target date funds should make their risks more apparent.
Hedge funds have “flown under the radar too long.”
The SEC should keep a closer eye on the credit rating agencies.

And, Schapiro pointed out, the SEC won’t be able to enforce those policies without more staff attorneys, more technology, and more funding.

Regarding registered reps, she wants them to put clients first. “We are also closely examining the broker-dealer and investment adviser regulatory regimes and assessing how they can best be harmonized and improved for the benefit of investors,” Schapiro told the House Financial Services Committee’s Subcommittee on Capital Markets, Insurance and Government-Sponsored Enterprises.

“Many investors do not recognize the differences in standards of conduct or the regulatory protections applicable to broker-dealers and investment advisers. When investors receive similar services from similar financial service providers, the service providers should be subject to the same standard of conduct and regulatory requirements, regardless of the label attached to the providers.

“All financial service providers that provide personalized investment advice about securities should owe a fiduciary duty to their customers or clients and be subject to equivalent regulation. I support the standard contained in the bill Treasury recently put forth, which would require broker-dealers and investment advisers to act solely in the interests of their customers or clients when providing investment advice.

On the issue of regulating hedge funds, she apparently rejects the idea that rich investors don’t need the government to watch their backs. “Hedge funds and other unregulated private pools of capital have flown under the radar for far too long,” she testified. “I support the recommendation in the Administration’s white paper that advisers to hedge funds and other private pools of capital should be required to register with the SEC under the Investment Advisers Act.”

Target-date funds, a marketing concept whose flaws were revealed by last fall’s equity market crash, also drew Schapiro’s belated attention. “Target date funds… have produced some troubling investment results,” she told legislators. “The average loss in 2008 among 31 funds with a 2010 retirement date was almost 25%. In addition, varying strategies among these funds produced widely varying results, as returns of 2010 target date funds ranged from minus 3.6% to minus 41%.”

Pro forma, Schapiro recommended more disclosure, despite the fact that few investors read disclosures. “I can assure you that our staff is closely reviewing target date funds’ disclosure about their asset allocations. …We will consider whether additional disclosure measures are needed to better align target date funds’ asset allocations with investor expectations.”

On the topic of the ratings agencies (see this week’s cover story), she said the SEC is committed to “strengthening the integrity of the ratings process, and more effectively addressing the potential for conflicts of interest inherent in the ratings process for structured finance products.”

The Commission, she said, wants to require Nationally Recognized Statistical Rating Organizations (NRSROs) to disclose ratings history information for 100% of all issuer-paid credit ratings and to prohibit an NRSRO from issuing a rating for a structured finance product paid for by the product’s issuer, sponsor, or underwriter unless the information about the product provided to the NRSRO is made available to other NRSROs.

Finally, Schapiro described the years leading up to the financial crisis as a period of weakness at the SEC. “Beginning in Fiscal 2005, the SEC faced three consecutive years of flat or declining budgets, the end result being a 10% reduction in its workforce and a cut of more than 50% in its new technology investments,” she said.

“This occurred at the same time that the securities markets we regulate were growing significantly in size and complexity,” she said. “Since 2005, when these cutbacks began, average daily trading volume has nearly doubled; the investment advisor industry has grown by over 30% in number and over 40% in assets under management; and broker-dealer operations have expanded significantly in size, complexity, and geographic diversity.”

“The SEC currently has only about 450 examiners to oversee 11,300 investment advisers and 8,000 mutual funds. If advisers to hedge funds, private equity funds and venture capital funds were required to register with the SEC, as contemplated by the Administration’s white paper, our staff roughly estimates that approximately 2,000 additional investment advisers would register… Significant additional resources would be necessary for the Commission to take on additional responsibility in this area,” she claimed.

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