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With BluePrint Income, AARP Ups its Ante on Annuity Sales

Posted on May 14, 2020 by -

AARP members get a lot of discounts for their $16-a-year membership fees. They get discounts on steak dinners at McCormick & Schmick’s, cash-back on Chase credit-card purchases, 20% off the price of Harry & David’s curated fruit boxes, cheap ZipCar rates and so on.

With the purchasing power of 38 million age 50+ members behind it, AARP also offers deals on insurance—on MedicareAdvantage plans from United HealthCare, long-term care coverage from New York Life, auto insurance from The Hartford, and dental plans from Delta. There’s even coverage for your dog or cat from PetPlan.

Annuities are also on AARP’s menu of services for older Americans. Until recently, New York Life was AARP’s sole vendor of income annuities. This month, AARP switched gears to partner with Blueprint Income, a New York-based fintech firm, to create a multi-provider, multi-product online annuity sales platform.

“We thought that having a choice of annuities would be a benefit to our members,” said John Larew, president and CEO of AARP Services, Inc. (AARP Services, Inc., a for-profit company, is legally at arms-length from AARP, the non-profit organization that advocates for older Americans. AARP Services generated almost $840 million in royalty revenue for AARP in 2015, the most recent data available.)

AARP members who visit the platform will find quotes (generated by CANNEX) from seven highly-rated life insurance companies on the kinds of annuities that Americans buy the least of—single premium immediate and deferred income annuities (SPIAs and DIAs), Personal Pensions (DIAs that are funded with monthly contributions over decades) and CD-like multi-year guaranteed rate fixed deferred annuities (MYGAs).

The historically tiny sales of those products, and the nation’s return to an ultra-low interest rate environment, pose headwinds for Blueprint Income. Nonetheless, its young founders believe that simple, transparent annuities that pool longevity risk just need the right distribution technology and the kind of break that the partnership with AARP Services may provide.

AARP Services evidently felt the same. “When its contract with New York Life was expiring, AARP Services expressed some interest in working with us,” said Matt Carey, Blueprint Income’s CEO and co-founder (with fellow Penn alumnus Adam Colombo and fellow Wharton School alumnus Nimish Shukla). “They wanted something more like a platform, that was more ‘tech forward,’ and that had multiple life insurers.”

Quotes from seven insurers

If you visit the AARP/Blueprint site, the first thing you see is an image of a white coffee cup on a table in front of a tablet computer that displays sample annuity quotes. As you scroll down, you choose one of the three tracks: “Fixed Annuity” (MYGAs), “Income Annuity” (SPIAs, DIAs and Qualified Longevity Annuity Contracts or QLACs) and “Personal Pension,” which is a multi-premium deferred income annuity.

The site is mainly a quote-and-sales engine, plus lots of education and phone support, rather than a planning engine per se. If a visitor picks the Income Annuity path, he or she finds prompts for inputs about birth date, gender, state of residence and whether the annuity is for one or two people. The next page requests income start date, premium amount, and whether the premium payment is from a tax-deferred or taxable account. Then you click to see the exact quotes.

The annuity issuers include New York Life, Guardian Life, Mutual of Omaha, Western & Southern Financial Group, Pacific Life, Lincoln Financial, and Principal Financial Group. All are rated A+ or better by A.M. Best. All except two are mutual companies; Lincoln and Principal are publicly traded.

AARP members don’t necessarily get higher payout rates or better yields when they order an annuity on the platform. But they do get a complimentary annual “retirement income check-up” from a salaried, insurance-licensed Blueprint Income adviser—plus AARP’s implicit seal of approval.

What you don’t see on the site is a planning calculator per se. There’s no wizard that requires health status (for life expectancy estimates), total savings, home equity (for reverse mortgage or downsizing potential), estimated expenses in retirement, or guaranteed income sources—any or all of which would help determine what percentage of a person’s overall portfolio needs to be allocated to an income annuity.

“[A planning calculator] is not something that we have made available on the site, but we do assist clients with this kind of analysis on a case-by-case basis,” Carey told RIJ. “We’ve found that our clients are less exploratory [than many visitors to annuity sites]. Most come to the site with a specific premium they want to invest or income they want to receive in mind already.”

Technology rules

Other firms have sold income annuities over the Internet to consumers. Through the Fidelity Insurance Network, Fidelity investors can compare customized quotes from six different issuers. At Income Solutions, five annuity issuers compete for new business from individual visitors or advisers. Hersh Stern has been selling income annuities online at immediateannuities.com since 1996.

Nationwide recently tried partnering with a fintech firm on a pilot program selling multi-premium personal pensions online in Arizona, but discontinued that venture over a year ago. Other entrepreneurs, like David Lau of DPL Financial Partners and David Stone of ARIA/RetireOne, as well as SIMON and Halo, have created platforms where Registered Investment Advisors can buy no-commission annuities.

Carey started Blueprint Income (originally called Abaris) in 2014 while he was still a graduate student at Wharton. A stint at the Treasury Department, where he worked with Mark Iwry, a deputy Treasury secretary in the Obama Administration (and creator of the QLAC) got him fired up about the potential for applying fintech to annuities.

“When we adopted the b-to-c (business-to-consumer) model, people told us that it wouldn’t work,” said Carey. “But we now have a viable b/c model. The market is saying it wants an easier annuity buying process. People are looking to buy and not be sold. We grew 200% in past year on the revenue and premium sides. This year we’re well into the hundreds of millions of dollars in premium.”

You might think that consumer ignorance or resistance to annuities might be the biggest obstacle to the success of the b-to-c sales model, but historically there have been obstacles on the insurance company side—with slow processing, demands for paper documents, and long delays between impulse to buy and actual purchase.

So, Blueprint Income appears to have worked as much on streamlining the back-end of the process as on the design of its hip, Millennial-friendly client interface. “Our focus on the software development side has been on the functionality of our quoting software, digital application, and post-purchase policy management,” Carey told RIJ. “For example, the interface we built with Pacific Life that encompasses quoting, digital application, and order entry is a good example of this.”

Carey said that back-end technology is Blueprint Income’s edge. “We grew last year despite the interest rate environment because people are looking to buy and looking to buy in the way we offer,” he added. “It’s a way to do the entire process digitally, with no paper forms or six-week waits. We’re issuing policies in a single day. We’re the only company in the space that’s a software company first and not an insurance distribution company first.”

The 80/20 rule

Larew and Carey are both bullish on direct-to-consumer sales of annuities, despite the low interest rates, which have reduced yields on the most basic income annuities to about 5% for 65-year-olds, and despite the fact that most people aren’t ready to shop for annuities on their own.

“We did the research, and we could see that the reality of direct-to-consumer marketing of annuities has never lived up to its on-paper potential. It’s a complex sale, even for an educated consumer. You’re asking someone to write a large check, and there are psychological barriers to that. We’re not blind to the challenges but we’re very aware of the potential benefits,” Larew told RIJ.

Carey points out that low rates don’t negate the mortality-pooling benefits that come from life-contingent income annuities. “In terms of how interest rates affect annuity sales, the low-rate environment applies to all fixed investments,” he said.

“Unless we’re poised for a future where the risk premium is higher than in the past, people will have fewer options to get yield. One way to get reliable extra yield is from mortality pooling. People tend to think that interest rates will go back up, but we could be in a prolonged low rate environment. It means that they will have to find other sources of yield.”

Most laypersons don’t understand mortality pooling. But AARP is betting that a critical mass of willing annuity buyers exists. On the annuities platform, we’ll be “dealing with members of a segment of the consumer market who are comfortable making their own financial decisions,” said Larew. “In theory, that segment will grow as the advantages of this type of distribution channel becomes clear, as interest in the product grows, and as more people become accustomed to buying financial products direct via digital platforms.”

Carey adds: “We’ve observed that about 80% of the public don’t know about annuities, so you focus on the 20% who do, and you use that as the basis for your growth. Over time, with the Alliance for Lifetime Income publicizing the importance of guaranteed retirement income, and the SECURE Act making it easier to put annuities in 401(k) plans, there’s been a strong nudge. This is all creating a tailwind for us. Twenty percent is a large enough customer base to build a business on.”

© 2020 RIJ Publishing LLC. All rights reserved.

A Marvel of Financial Engineering

Posted on May 14, 2020 by -

Issuers of fixed indexed annuities (FIAs) generate returns for contract owners based mainly on the movement of equity indexes. By purchasing options on the indexes with part of the income they glean from investing client money in bonds, they can capture some—but not all—of the index growth.

Low interest rates and high market volatility are headwinds for FIA issuers. Low rates can squeeze the issuer’s budget for buying option. Volatility can drive up the cost of options. But, internally, FIAs contain many levers and dials that an issuer can manipulate to burnish a product’s curb appeal.

Two powerhouses of the FIA world, AIG Life & Retirement and Scottsdale-based Annexus, a designer and distributor of FIAs, use almost every possible tool to enhance X5 Advantage, a new FIA with a non-optional lifetime income benefit. AIG’s American General Life subsidiary is the issuer.

The X5 Advantage orchestrates a symphony of deferral bonuses, a long surrender period, embedded fees, leverage, risk-sharing negative floors, assumed lapse rates, volatility-managed indexes, caps, participation rates, spreads and finely-tuned age-based payout rates to serve a surprising number of purposes.

With only a small bit of skin, indirectly, in the equity markets, X5 Advantage aims to satisfy the revenue needs of the life insurer, the distributor, the agent/adviser, and—eventually—to mitigate a client’s market risk, sequence risk, mortality risk, longevity risk and nursing home risk.

Impossible? Not if you hold it long enough. Like a tough cut of beef that becomes fit for a king if you cook it for a long time at a low temperature, this product aims to turn the little that the market offers right now into a feast for everyone involved. It’s a marvel of financial engineering.

Bonuses are the key

X5 Advantage has two stages: An accumulation stage that starts at purchase, and an income stage that starts no less than 10 years later, at the end of the surrender period. During the accumulation stage, the client gets interest credits based on the performance of options on volatility-managed equity indexes from PIMCO, Morgan Stanley or S&P.

The payout rate doesn’t reach 5% of the benefit base until age 70 for a single person (4.5% for a couple), but there are bonuses. During the accumulation stage, the benefit base (equal to the premium at the time of purchase) rises by 200% of each year’s earnings. During the payout stage, the benefit base rises by 150% of the annual earnings.

Here’s how AIG illustrates the product in its brochure. John, a 60-year-old who plans to retire at age 70, funds his X5 Advantage with a $100,000 premium and chooses a 10-year strategy with two five-year terms. Ten years later, his account value is $165,772. But, thanks to the annual bonus, his benefit base has grown to $247,937.

At age 70, and not before, John begins drawing an annual income of 5% of the benefit base, or almost $12,400. The benefit base, and the income stream on which it is based, both keep growing after income begins, by the aforementioned 150% of annual credited interest. These are better terms than a deferred income annuity (DIA) with 10-year deferral period could promise. Anecdotally, that’s partly because FIAs have higher lapse rates than DIAs, which are virtually illiquid.

If John becomes ill and needs nursing home care, he can receive double the usual income amount for up to five years. There are two death benefit options. If John died at age 70, for instance, his beneficiaries could get either his account value ($165,772) in a lump sum or his benefit base ($247,937) in five annual payments of $49,587 each.

Participation rates, spreads and risk-sharing

Those are the bonuses. What about the caps and participation rates on the interest crediting methods? The issuers carefully manage the portion of the index gains the FIA owner can lock in at the conclusion of each one-year, five-year, or ten-year crediting term.

And what about the indexes? In this case, the three custom indexes all contain volatility controls that can dampen the index gains from the inside and take out the market spikes.

Contract owners can get exposure to the Morgan Stanley Expanded Horizons Index, the PIMCO Global Elite Markets Index and an S&P 500 Daily Risk Control 7% USD Excess Return Index. The box below lists the current crediting rates, according to AIG’s product rate sheet.

From the X5Advantage Rate Sheet

As an example of volatility control, let’s compare the S&P 500 Daily Risk Control 7% USD Excess Return with the traditional S&P 500 Index. The risk-controlled version has a net one-year return of 3.87% while the traditional version has a one-year return of 2.31%. The “Excess return” part of the index name reflects the fact that the investment is leveraged; the contract owner gets the portion of the return (3.87% in this case) that was in excess of the cost of borrowing money to do the leveraging.

Looking again at the box above, you can see more of the dials and levers that allow the issuer to fine-tune the risk/return proposition. For instance, two of the crediting strategies have 1% “spreads.” That means the contract owner would get the participation rate (100%, 60% or 40%, depending on the strategy) of the index return minus 1%.

Both the five-year and 10-year strategies have a minus-5% floor on possible losses in any one-year or two-year term within a crediting period, respectively. (But a negative return for the entire crediting period is guaranteed not to occur.) This risk-shift to the client allows the issuer to advertise slightly higher caps by shifting some of the investment risk to the client.

The one-year strategies have participation rates that are less than 100%. If the index gained seven percent, for instance, the client gets either 45% or 60% of 6% (2.7% or 3.6%) depending on which index he or she chose. The one-year option also has a 1% spread, which is subtracted from the credited interest. It also has participation rates, which are alternatives to caps.

To protect the issuer, the rates are subject to change by the issuer at the end of each crediting period. To protect the client, there are guaranteed minimums. The five-year crediting strategies have a minimum participation rate of 50%, a maximum spread of 3%, and a minimum index term floor of -10%. The one-year point-to-point crediting strategies have a minimum participation rate of 25% and a maximum spread of 3%. The ten-year crediting strategies have a minimum participation rate of 50% and a maximum spread of 3%.

As good as it gets

The past dozen years have been tough for annuity issuers. With low bond yields reducing the return on their fixed income assets, but a booming equity market, they’ve had to create products, such as variable and index annuities, that tap into the bounty of the long bull market. It creates a lot of complex engineering to interface an insurer’s general account with the equity markets without violating any state or federal regulations.

For indexed annuities to do a lot with a little, they also need time. But as long as the contract owner holds onto the contract and follows its rules, several of his or her major retirement risks will be addressed. For near-retirees who can’t afford a fee-based adviser, products like the X5 Advantage may be as good as it gets under current market conditions.

© 2020 RIJ Publishing LLC. All rights reserved.

Why the World Has a Dollar Shortage, Despite Massive Fed Action

Posted on May 14, 2020 by -

How can the Fed launch an “unlimited” monetary stimulus with congress approving a $2 trillion package and the dollar index remain strong? The answer lies in the rising global dollar shortage, and should be a lesson for monetary alchemists around the world.

The $2 trillion stimulus package agreed by Congress is around 10% of GDP and, if we include the Fed borrowing facilities for working capital, it means $6 trillion in liquidity for consumers and firms over the next nine months.

The stimulus package approved by Congress is made up of the next key items:

Permanent fiscal transfers to households and firms of almost $5 trillion.

  • Individuals will receive a $1,200 cash payment ($300 billion in total).
  • The loans for small businesses, which become grants if jobs are maintained ($367 billion).
  • Increase in unemployment insurance payments which now cover 100% of lost wages for four months ($200 billion).
  • $100 billion for the healthcare system, as well as $150 billion for state and local governments. The remainder of the package comes from temporary liquidity support to households and firms, including tax delays and waivers.
  • Finally, the use of the Treasury’s Exchange Stabilization Fund for $500 billion of loans for non-financial firms.

To this, we must add the massive quantitative easing program announced by the Fed.

First, we must understand that the word “unlimited” is only a communication tool. It is not unlimited. It is limited by the confidence and demand of US dollars.

I have had the pleasure of working with several members of the Federal Reserve, and the truth is that they know it is not unlimited. But they know that communication matters.

The Federal Reserve has identified the Achilles heel of the world economy: the enormous global shortage of dollars. The global dollar shortage is estimated to be $13 trillion now, if we deduct dollar-based liabilities from money supply including reserves.

How did we reach such a dollar shortage? In the past 20 years, dollar-denominated debt in emerging and developed economies, led by China, has exploded. The reason is simple, domestic and international investors do not accept local currency risk in large quantities knowing that, in an event like what we are currently experiencing, many countries will decide to make huge devaluations and destroy their bondholders.

According to the Bank of International Settlements, the outstanding amount of dollar-denominated bonds issued by emerging and European countries in addition to China has doubled from $30 to $60 trillion between 2008 and 2019. Those countries now face more than $2 trillion of dollar-denominated maturities in the next two years and, in addition, the fall in exports, GDP and the price of commodities has generated a massive hole in dollar revenues for most economies.

If we take the US dollar reserves of the most indebted countries and deduct the outstanding liabilities with the estimated foreign exchange revenues in this crisis… The global dollar shortage may rise from 13 trillions of dollars in March 2020 to $ 20 trillion in December … And that is if we do not estimate a lasting global recession.

China maintains $3 trillion of reserves and is one of the best-prepared countries, but still, those total reserves cover around 60% of existing commitments. If export revenues collapse, dollar scarcity increases. In 2019, Chinese issuers increased their dollar- denominated debt by $200 billion as exports slowed.

Gold reserves are not enough. If we look at the main economies’ gold reserves, they account for less than 2% of money supply. Russia has the largest gold reserves versus money supply. China’s gold reserves: 0.007% of its money supply (M2), Russia’s gold reserves: about 9% of its money supply.

As such, there is no “gold-backed” currency in the world. The best protected—in gold—the Ruble, suffers the same volatility in commodity slump and recession times as others due to the same issue of US dollar scarcity, although not even close to the volatility of those Latin American countries that face both falling US dollar reserves and a collapse in demand from their own citizens of their domestic currency (as in Argentina).

The Federal Reserve knows that it has the largest bazooka at its disposal because the rest of the world needs at least $20 trillion by the end of the year. So it can increase the balance sheet and support a large deficit increase of $10 trillion and the US dollar shortage would remain.

The US dollar does not weaken excessively because the rest of the countries are facing a huge loss of reserves while at the same time increasing their monetary base in local currency much faster than the Federal Reserve, but without being a global reserve currency.

Second, the accumulation of gold reserves of the central banks of the past years has been more than offset in a few months by the increase in the monetary base of the world-leading countries. In other words, the gold reserves of many countries have increased but at a much slower rate than their monetary base.

The Federal Reserve knows something else: In the current circumstances and with a global crisis on the horizon, global demand for bonds from emerging countries in local currency will likely collapse, far below their financing needs. Dependence on the US dollar will then increase. Why? When hundreds of countries try to copy the Federal Reserve printing and cutting rates without having the legal, investment and financial security of the United States, they fall into the trap that I comment in my book, “Escape from the Central Bank Trap: How to Escape From the $20 Trillion Monetary Expansion Unharmed” (Business Expert Press, 2017). A country cannot expect to have a global reserve currency and maintain capital controls and investment security gaps at the same time.

The ECB will likely understand this shortly when the huge trade surplus that supports the euro collapses in the face of a crisis. Japan learned that lesson by turning the yen into a currency backed by huge dollar savings and increased its legal and investment security to the standards of the US or UK, despite its own monetary madness.

The race to zero of central banks in their monetary madness is not to see who wins, but who loses first. And those that fail are always the ones who play at being the Fed and the US without the US’s economic freedom, legal certainty, and investor security.

The Federal Reserve can be criticized, and rightly so, for its monetary madness, but at least it is the only central bank that truly analyzes the global demand for US dollars. In reality, the Fed QE is not unlimited, it is limited by the real demand for US currency, something that other central banks ignore or prefer to forget. Can the US dollar lose its global reserve position? Sure it can, but never to a country that decides to commit the same monetary follies as the Fed without their analysis of real demand for the currency they manage.

This should be a lesson for all countries. If you fall into the trap of playing reserve currency and endless printing without understanding demand, your US dollar dependence will intensify.

© 2020 Mises Institute. Reprinted by permission.

https://mises.org/wire/why-world-has-dollar-shortage-despite-massive-fed-action

Public pensions are not a drag: Study

Posted on May 7, 2020 by -

Public pension funds generating $179.4 billion more in state and local government revenues than taxpayers put in 2018, according to a biennial study by the National Conference on Public Employee Retirement Systems.

Public pensions’ financial impact rose 30.6% from $137.3 billion in 2016, according to a new study, “Unintended Consequences: How Scaling Back Public Pensions Puts Government Revenues at Risk.” The 2020 edition of the study builds on NCPERS’ 2018 analysis of how investment and spending connected to pension funds affects state and local economies and revenues.

The analysis draws on historical data from public sources including the U.S. Census Bureau, Bureau of Economic Analysis, and Bureau of Labor Statistics. While pension fund assets are invested globally, the economic impact of these investments can be traced down to individual states based on the NCPERS study methodology.

“If public pensions didn’t exist, policy makers would need to increase taxes on their constituents to sustain the current level of public services,” said Michael Kahn, NCPERS’s research director and the study’s architect. He noted that in 40 states, pensions were net contributors to revenue in 2018, an increase from 38 states in 2016.

The original Unintended Consequences study in 2018 examined how state economies and tax revenues are affected when pension funds invest their assets and retirees spend their pension checks, and how taxpayer contributions compare to revenues, said Hank H. Kim, executive director and counsel of NCPERS.

“Pensions are often cast as a pawn in political dramas over short-term spending,” Kim said in the release. “This study underscores that breaking faith with public pensions is actually a costly strategy for state and local government. In the long-term, diminishing public pensions will backfire.”

NCPERS’s analysis of the data also showed:

The economy grows by $1,372 for each $1,000 of pension fund assets. The size of pension fund assets—$4.3 trillion in 2018—means that the impact of this growth is greatly magnified, the study found. Investment of public pension fund assets and spending of pension checks by retirees in their local communities contributed $1.7 trillion to the U.S. economy.

Economic growth attributable to public pensions generated approximately $341.4 billion in state and local revenues. Adjusting this figure for taxpayer contribution $162 billion yields pensions’ net positive impact of $179.4 billion.

Founded in 1941, the National Conference on Public Employee Retirement Systems (NCPERS) is the largest trade association for public sector pension funds, representing more than 500 funds throughout the United States and Canada with more than $4 trillion in pension assets.

© 2020 RIJ Publishing LLC. All rights reserved.

New index options on Allianz Life indexed variable annuity offer high three-year caps

Posted on May 7, 2020 by -

Allianz Life has issued longer-term index options on its Index Advantage variable indexed annuity, with a 20% downside buffer and cumulative caps on appreciation of as much as 80% over three years.

Investors can choose to link their accounts to the performance of either the large-cap S&P 500 Index or the small-cap Russell 2000 Index. The three-year crediting rate limits are 75% and 80%, respectively, according to a May 4 product rate sheet. The current rates expire June 1, 2020.

On the upside, clients have a one-time opportunity between contract anniversaries to lock in a gain in the value of the contract for the rest of the term. The contract can lose value if the three-year term ends with a cumulative loss of more than 20%.

The product has a 1.25% annual contract fee, a $50 annual maintenance free on contracts worth less than $100,000, and (if applicable) a maximum anniversary value death benefit fee of 20 basis points.

The one-year index option of the Index Advantage has different indexes, crediting rate limits, and buffers or floors, as shown in the chart below.

Source: Allianz Life.

 

© 2020 RIJ Publishing LLC. All rights reserved.

 

The Short and the Long of the Fed Buying Corporate Bonds

Posted on May 7, 2020 by -

By enhancing liquidity and improving functionality in the corporate bond markets, new U.S. Federal Reserve (Fed) programs have been good news in the short term. Yet a number of unknowns remain regarding the rollout of these programs, and we foresee potentially challenging impacts for more highly levered companies over the longer term.

The Fed’s Rapid and Aggressive Actions

The Fed has rapidly deployed its tools to improve liquidity and stabilize markets that were rocked by the economic impact of COVID-19.

The Fed’s efforts, announced on March 23, included new programs that allowed the purchase of corporate bonds, aiming to enhance the flow of credit to corporations.

The central bank established two credit facilities. Through the first, the Primary Market Corporate Credit Facility (PMCCF), the Fed can buy new-issue investment-grade bonds with maturities of up to four years. Through the second, the Secondary Market Corporate Credit Facility (SMCCF), the Fed can buy secondary-market investment-grade corporate bonds with maturities of up to five years as well as exchange-traded funds (ETFs) that invest in investment-grade corporate bonds.

On April 9, the Fed dramatically increased the size and scope of these facilities. It raised their combined size to $750 billion, and expanded both programs to include recently downgraded corporate issuers that had previously been rated investment grade (a BBB-/Baa3 rating or higher) as of March 22—so-called “fallen angels.” The Fed also said it could buy high-yield ETFs through its SMCCF.

In addition to these programs, the Fed has rolled out many other initiatives to improve market functionality and liquidity, including emergency rate cuts and quantitative easing (QE) programs.

With serious concerns about liquidity and stability in all areas of the fixed-income market, the Fed has taken a more aggressive stance than it did during the Global Financial Crisis, combining QE with other initiatives all at once rather than sequentially.

The Short Term

While the Fed has announced programs geared at purchasing corporate bonds, to date it has not actually made these purchases. Still, its programs have already had a positive effect on corporate credit spreads.

Through April 8, for example, the Fed’s corporate bond programs (the PMCCF and SMCCF) caused investment- grade spreads to tighten by 120 basis points (bps) and high-yield spreads to tighten by 229 bps from their widest levels on March 23 (the day the Fed launched these programs). This is notable because spreads reflect the difference in yield between a Treasury and a corporate bond, where widening is typically perceived as default risk rising.

In addition to leading to spread tightening, the Fed’s announcement led to a surge in new investment-grade bond issuance, led by high-quality credits, in March.

Corporate spreads continued to tighten after the Fed’s April 9 announcement, increasing the size and scope of these facilities and including fallen angels and high-yield ETFs (in the case of the SMCCF).

Even though ETFs only represent approximately 3.5% of the high-yield market, this announcement boosted investor sentiment, driving investors to high-yield bonds. As a result, the high-yield new-issue market reopened after essentially being closed in March.

The Long Term

There are still many unknowns surrounding the Fed’s foray into corporate debt. It remains unclear when the Fed will begin buying corporate bonds, and when it does, at what pace the purchases will take place. Our current expectation is sometime in May. More details will likely be announced in the coming weeks.

These facilities are likely to remain active through September, but the ultimate length of the programs will depend on the path of the recovery, which is a big wild card. We see the recovery likely being staggered, but it is not easily predicted given that a virus-driven, global economic downturn is unprecedented.

We do expect, however, that corporate leverage will rise across the board as companies see their earnings

decrease and sell more debt to raise funds. We expect this to result in more downgrades.

This process has already begun. This year more than $120 billion of investment-grade bonds have been downgraded to high-yield status, and we see the potential for much more as the year progresses. Approximately $300 billion of BBB-rated debt in the investment-grade sector is on watch for downgrades or has a negative outlook set by rating agencies.

We estimate that as much as $200 billion of debt (about 3.7% of the investment-grade market) could be downgraded over the next 12 to 18 months, placing it into the fallen-angel category.

We expect these fallen angels to be heavily concentrated in the energy and manufacturing sectors. But other sectors—including leisure, transportation, and consumer products—also have sizable debt that is on watch for downgrades by rating agencies. Those sectors may be hit as well.

We anticipate seeing downgrades across the full rating spectrum: A-rated credits downgraded to BBB, BBB credits downgraded to BB, BB credits downgraded to B, and so on.

Increased leverage will likely lead to more defaults and bankruptcies, especially for companies that entered this downturn with already-high leverage levels. We expect these bankruptcies to be concentrated among companies with lower-B and CCC ratings as well as companies in cyclical sectors, particularly energy. Oil prices at today’s historically low levels are uneconomical for a high-yield company.

Overall, we don’t expect the Fed’s programs to provide much support for lower-quality credits given the expected fundamental deterioration.

Implications

In sum, the Fed’s aggressive actions have benefited the markets in the short term. Longer term, however, we think there will be downgrades, defaults, and bankruptcies, particularly among companies that came into the downturn with high leverage.

In this environment, we are being more defensive, seeking value in high-quality investment-grade credit. There will be plenty of time to increase risk as we come out of the downturn—but for now, there are simply too many unknowns.

Ruta Ziverte is head of fixed income for William Blair. This article first appeared here. 

What it means when ETFs deviate from NAVs: Cerulli

Posted on May 7, 2020 by -

Deviations in the market price of fixed-income exchange-traded funds (ETFs) from their net asset values (NAV)—one of the concerns most widely cited by financial advisers—occurred several times in March, according to the latest issue of the Cerulli Edge–U.S. Asset and Wealth Management Edition.

“COVID-19 is putting fixed-income ETFs to the test,” the report said. “The deviations underscore the importance of educating advisors about the distinctions associated with both the ETF and mutual fund vehicles with the goal being advisors’ use of both in concert.”

In late February, as the markets began to react to coronavirus, some of the largest fixed-income ETFs traded with increased bid-ask spreads and, at times, significantly below their NAVs. This deviation may force ETF investors to sell their shares below the reported value of holdings at a time of crisis, making the vehicle appear to be a poorer option than a comparable mutual fund that transacted at the NAV.

While this may suggest that investors in the mutual fund vehicle were better served, Cerulli associate director Daniil Shapiro warned that, “This deviation in NAV should be interpreted with nuance and should impact how both ETFs and mutual funds are positioned to advisors.”

Why did ETFs fall below the NAV in February? At the highest level, ETF trading is supported by market makers and authorized participants who need to ensure that their activities are profitable and will add a margin of safety, resulting in lower ETF prices and investors effectively paying some price for access to liquidity.

Alternately, since NAVs for many fixed-income positions are “marked-to-model,” the share price may need time to catch up to the true value of the underlying holdings—a friction that market makers will try to price in.

“For advisors, the takeaway should be that no vehicle is perfect. Each has unique advantages,” wrote Shapiro in the new report. “If discounts exist in an ETF vehicle offering similar exposure, advisors purchasing a mutual fund as a long-term holding may be overpaying and would be better served in an ETF.

“Investors who do not need intra-day liquidity but may need to sell at a specific date may well be best served by the mutual fund. They may avoid paying some liquidity charge should they have to sell during a tumultuous period.”

© 2020 RIJ Publishing LLC. All rights reserved.

We Could Use Some Inflation

Posted on May 7, 2020 by -

My bank’s small business loan officer called me yesterday. In normal times, the bank calls only when a fraudster in Texas or the Ukraine abuses my debit card number. But this time, she just wanted to chat. So I asked her about the Paycheck Protection Program (PPP).

Our small community bank has made about 9,000 PPP loans so far, she said. Then she asked if I’d like to borrow up to 10 weeks of income, forgivable if spent on payroll. It didn’t matter that I was self-employed and would just pay myself. She emailed me a loan application.

A lot of Benjamins are in motion. On Monday, the U.S. Treasury announced that it would borrow $2.999 trillion in the current quarter and another $677 billion in the fall. Even in wartime, the Treasury has never borrowed more than $1.8 trillion in a year.

There are several ways to think about this money. It’s not like the old, indestructible, intrinsically valuable money, like the 1921 ‘Walking Liberty’ silver dollars I collected. Like gold itself, this commodity money feels reassuring in the hand. It’s also the easiest to remove from circulation.

The country’s money is also a creature of credit. It appears when governments spend and banks lend. It disappears when taxes are collected and loans are repaid. It can be fickle too: A market correction can erase half of a country’s savings overnight—and put a billion dollars in one short-seller’s pocket.

The kind of money that the federal government will create this quarter may be the hardest to get your mind around. When private spending slows, the Fed and Treasury fill the hole by borrowing against future tax receipts. As long as the future is infinitely long and the U.S. infinitely rich, our pockets are infinitely deep.

Where does $3 trillion come from?

When I heard that Treasury would borrow almost $3 trillion this quarter, I admit that the floor trembled a little under my feet. So I emailed a laconic macroeconomist I know and asked him, Who will buy all those bonds? “Everyone,” he replied. Would all that borrowing-and-spending cause inflation, I asked. “No,” he wrote.

Hoping for more information, I called Vanguard and talked to Gemma Wright-Casparius, who manages Vanguard’s active Treasury and inflation-linked (TIPS) bond funds. “It’s a big circular handoff,” she explained.

Asset managers like Vanguard, pension funds, life insurance companies, foreign central banks and individuals buy Treasuries to fund government expenditures. The expenditures become deposits (liabilities) in U.S. banks, which need to add cash reserves for them. The Fed furnishes those reserves by buying Treasuries from the banks. “The capital is going from one pocket to another,” she told me.

In theory, the Fed could buy IOUs directly from the Treasury, and leave the private sector out of the loop. But then money wouldn’t circulate through the financial system and the private economy would stop. That still leaves the question of inflation: Won’t an infusion of $4 trillion or $5 trillion this year into a $22 trillion economy drive up prices?

Not if it replaces money that’s gone. Wright-Casparius said that the 2020 stimulus, despite its size, won’t be immediately inflationary because it’s filling a vacuum—the financial crevasse that suddenly opened up in the U.S. economy when 20-odd million people stopped earning money and paying bills in April.

“In the long run, when economies are fully reopened, you could get a synchronized resurgence of global growth,” she added. “Depending on how long policy makers leave the stimulus in the system, it might be inflationary. “But the Treasury is only borrowing money for a limited period of time. By 2022, projections indicate they’re planning to unwind the stimulus.” (It’s not clear exactly how the training wheels will be removed.)

Then I reached out to Barry Eichengreen, a macroeconomist at the University of California at Berkeley and author of How Global Currencies Work (Princeton, 2017) and other books about money. I asked him where the Treasury could get so much money so fast.

“If you are asking, ‘Where will the Treasury get the money to run a $5 trillion deficit this year?’ the answer goes as follows: It will sell bonds.” To make sure an over-supply of Treasuries doesn’t drive down their prices and raise interest rates, “the Fed has a program in place to prevent ‘disorderly conditions’ in Treasury bond markets,” he said. That is, the Fed will step in as a buyer.

“So the question then becomes: Is this money-printing inflationary? Does the Treasury effectively ‘get the money’ by running inflation (what economists would refer to as ‘imposing an inflation tax’)?  There is much debate about this at the moment among macroeconomists,” he continued.

“I would caution against mindlessly succumbing to the instinctual reaction that ‘money-printing is always and everywhere inflationary,’” he wrote. “Some macroeconomists warned that the Fed’s extraordinary actions starting in 2008-9 would cause an explosion of inflation, and they were wrong. The Fed has consistently been unable to get inflation up to its modest 2% target despite the unprecedented peacetime expansion of its balance sheet from 2008 to 2019.”

Why doesn’t the extra money cause inflation? “After a crisis, households ‘deleverage’ (they save rather than spend),” he said. “Firms are cautious about committing to ambitious fixed investment plans in the presence of uncertainty about the nature of the post-crisis environment. So the money the Fed creates (the cash it ‘prints’) mainly sits idle in individual and corporate savings accounts (and in retirement savings accounts). Whether and for how long this will continue is the question that is being debated.”

Tax increases versus inflation

Googling for more information about Treasury sales and inflation, I found articles by Chris Brightman, the partner of Rob Arnott at Research Affiliates, Olivier Blanchard of the Peterson Institute for International Economics, and Tim Duy, a University of Oregon economist who writes the FedWatch blog.

Brightman was the most inflation-wary of anyone I heard from. “Some combination of tax increases and spending cuts following the coming recovery will become necessary to prevent a spike of inflation,” he wrote recently. “Will Congress understand precisely when to execute this fiscal U-turn? Will our politicians display the required foresight and courage? I worry. A future bout of high and volatile inflation may prove to be a toxic side effect of today’s experimental economic medicine.”

But Olivier Blanchard forecasts only a 3% risk of inflation. “One may still worry that, when social distancing is relaxed, pent-up demand will lead to a burst in spending, and some inflation. If it happens, it is unlikely to be large and long enough to destabilize inflation expectations, and it is likely to disappear quickly,” he writes.

Tim Duy agrees that deflation is the bigger threat. “It was common early in the crisis to view the viral outbreak as a supply shock because, from the U.S. perspective, it appeared to be largely impacting the flow of goods from China. This original view suggested an inflationary impact from the virus,” he wrote at Bloomberg Opinion last week.

“The demand-side impact, however, now clearly dominates the economic outlook. Shutting large portions of the economy resulted in a collapse in spending and surging unemployment,” Duy observed. “Yes, in comparison to the dismal second-quarter numbers, the third quarter will likely bounce as some activity returns. This bounce, however, will not be sufficient to lessen the gaping hole in demand left by the virus.”

As for myself, I haven’t decided whether or not to apply for that PPP loan from my bank. I hesitate to borrow—no matter how “forgivable” they say the debt will be. But if this crisis lasts long enough, I might wish I had.

© 2020 RIJ Publishing LLC. All rights reserved.

Advisers feel confidence and caution, survey shows

Posted on April 30, 2020 by -

Financial advisers generally feel confident in their abilities to weather the current crisis, but they feel some pressure on their own revenues and profitability and are uncertain about the future, according to a new report from the syndicated research firm Practical Perspectives. 

The report is based on a survey of 525 independent advisers, full-service advisers and Registered Investment Advisors (RIAs). It was conducted during the first week of April 2020 by Practical Perspectives CEO Howard Schneider, who has been tracking adviser sentiment for many years.

The most common portfolio adjustments by advisers were to raise cash allocations, shift money from more aggressive stocks to less volatile, dividend-paying stocks, and decrease equity allocation overall, the survey showed.

Full service advisers (60%) were the ones most likely, by as much as 10 percentage points, to raise cash allocations. Independent advisers (44%) were most likely to shift toward dividend-paying stocks and RIAs (39%) were most likely to reduce equity exposure generally.

Regarding the future, “Nearly three in four advisors, or 74%, believe markets will be higher compared to end of March 2020,” Schneider’s report on the survey said. “However, a plurality of advisors expect the improved return will not recapture the full extent of the decline and performance will still be negative year-to-date six months from now.

“Only one in 10 advisors are optimistic that markets will recover and be positive for the year six months from now,” the report added. “An additional one in six advisors expect a recovery in markets to be flat for the year by end of September. A similar share of advisors are more pessimistic and expect markets to be lower over the next six months.”

While most advisors said that social-distancing and quarantining haven’t hampered their ability to serve clients, “they do acknowledge the negative impact upon key practice metrics, notably revenues and profitability,” the report said. “How a projected decline in the financial strength of advisor practices plays out over time may accelerate consolidation and the exodus of small practitioners from the industry.”

For a copy of the report, click here.

© 2020 RIJ Publishing LLC. All rights reserved.

Companies with Resistance to COVID-19

Posted on April 30, 2020 by -

Just as healthier people seem to resist the COVID-19 virus better, the share prices of financially healthier companies fell relatively less during the market crash last month, according to an analysis  by academics at the Haas School of Business at the University of California at Berkeley and in Hong Kong.

In their paper, “Corporate Immunity to the COVID-19 Pandemic,” Ross Levine of Berkeley, Wenzhi Ding and Chen Lin of Hong Kong University, and Wensi Xie of the Chinese University of Hong Kong pointed out that, even as the S&P 500 Index fell by 34% in the first quarter of 2020, the damage varied significantly from firm to firm, even among those in the same industry.

Examining data from more than 6,000 companies in 56 economies, the analysts found certain characteristics common to the hardier companies:

  • Stronger pre-2020 finances (more cash, less debt, and larger profits)
  • Less exposure to COVID-19 through global supply chains and customer locations
  • More CSR (Corporate Social Responsibility) activities
  • Less entrenched executives (indicated by absence of takeover defenses)
  • Less large block ownership (>5% of shares) by hedge funds
  • More large block ownership by non-financial firms (a sign of long-term investments from strategic partners)

Ross Levine

“The traits of firms were common knowledge,” Levine told RIJ. “How the market would price them once a pandemic hit was not known. Fundamentally, there are debates about the sign and importance of CSR, executive entrenchment, board structure, executive compensation, and ownership on a corporation’s resilience to adverse shocks. The response to the pandemic helps determine which theories about corporate resilience actually hold in practice.”

Cash and leverage levels, not surprisingly, mattered a lot. “Comparing two otherwise similar firms, the low-cash firm—the firm with one standard deviation lower pre-2020 ratio of cash-to-assets—would experience an almost 6% (of the sample mean weekly stock return) extra drop in its stock returns in response to the same COVID-19 shock,” the paper said.

“Using a similar comparison, a high-leverage firm (one standard deviation greater pre-2020 leverage than an otherwise similar firm) would experience an extra 10% (of the sample mean value of weekly stock returns) drop in stock returns according to our estimates,” the authors added.

Companies where hedge funds owned big stakes were also more vulnerable. “Hedge funds sell their shares rapidly in response to negative information about COVID-19 cases, intensifying downward pressure on prices, while owners with long-run, strategic commitments to firms (including large corporations), tend to dampen the adverse impact of the pandemic on stock prices,” the paper said.

“Hedge funds might be more focused on pursuing short-run stock performance and engaging in high-frequency trading than other blockholders,” it continued. “As a result, they might be more likely to sell shares quickly in response to news about COVID-19, generating downward pressure on the prices of companies in which they are large shareholders.”

Good corporate citizens and companies with a home-market focus also fared relatively well in the crash. “CSR investments strengthen the informal ties between a firm and its workers, suppliers, customers, and other stakeholders, enabling the firm to more effectively and efficiently work with those stakeholders, and enhance the firm’s likelihood of survival and future success,” the academics wrote.

They added that “the stock price of the more internationally exposed firm would fall by 3.25 percentage points more than the less exposed firm over two months” and that “stock prices in economies with a larger proportion of the population aged over 65 have experienced much sharper declines.”

Investors also appeared to recognize that a country’s “legal traditions” can be correlated with stock prices.

“Firms in economies with French, German, and socialist legal traditions experienced milder stock price declines than those with a common law tradition,” the paper said. “To the extent that legal origin captures state vs. individual/court power, these results suggest that markets viewed states with more power as better able to address the public health crisis, mitigating stock price declines.”

RIJ asked Levine how inclusion in index funds, and the systematic risk that they confer on stocks in the index, might have affected the price volatility of individual stocks. He replied that causality tends to run in the opposite direction. “In general, when index funds simply buy and hold a particular weighted portfolio of stocks, and those weights do not change frequently, stock prices are determined by those who do trade,” he said.

Information spreads like a virus

In their research paper, “Feverish Stock Price Reactions” to COVID-19, Stefano Ramelli and Alexander F. Wagner compare the spread of the investment panic to the spread of the virus, dividing the panic into three stages: Incubation (January 2-17, 2020); Outbreak (January 20-February 21); and Fever (February 24-March 20).

The authors use data from corporate earnings calls, Google keyword searches, and stock price movements, to reconstruct the spread of investor anxiety about specific corporate characteristics—a company’s degree of globalization, leverage, sensitivity to quarantines and social distancing—as the virus progressed.

During the “outbreak” phase, investors and analysts were mainly worried about a firm’s degree of exposure to international supply chains. As the crisis progressed to the fever stage, they became more concerned about a firm’s degree of leverage and lack of liquidity.

Like Levine, et al., the authors of this paper observe that highly leveraged companies with low cash reserves were the most vulnerable—and therefore benefited most from the Federal Reserve’s actions.

“The Fed announcement to purchase newly issued bonds and loans on the primary market can be expected to support firms running low on cash because it means that they can effectively raise funds immediately from the Fed. The announcement to purchase outstanding corporate bonds and exchange-traded funds (ETFs) on the secondary market can be expected to support firms with high leverage,” they wrote.

© 2020 RIJ Publishing LLC. All rights reserved.

Honorable Mention

Posted on April 30, 2020 by -

Money market funds win, alternatives lose in Q1 2020: Cerulli

Investor fear and uncertainty fueled a flight to equity index funds and money market funds and away from other equity mutual funds and exchange-traded funds (ETFs) in the first quarter of 2020, according to a new issue of The Cerulli Edge–U.S. Monthly Product Trends.

Highlights from the report include:

  • In total, investors pulled about $320 billion from mutual funds and ETFs during March, although passive U.S. equity ($40.9 billion) was exempt from the general trend. The demand for passive U.S. equity likely stems from investors reallocating to low-cost equity index-tracking products to take advantage of bargains.
  • Asset managers suffered double-digit asset declines, with mutual funds falling 13.6% and ETFs declining 12.4% in March. Net flows out of the vehicles totaled $335.2 billion, or 2.2% of February month-end assets.
  • The decline in ETF assets was softened by the fact that investors held steady on a net basis, adding $9.3 billion in positive flows into the vehicle during March. Fixed-income ETFs struggled in March, suffering $20.7 billion in net negative flows. Alternative ETFs gathered significant flows YTD, especially relative to the small size of the category ($46 billion).
  • Money market funds received net flows of $684.7 billion, raising assets 19% to $4.3 trillion. Taxable money market funds added $823.5 billion, while tax-free and prime bled $3.0 billion and $135.9 billion, respectively. The discrepancy in flows highlights investor demand for safety of government-backed securities.
  • Despite a few bright spots for alternatives, Cerulli said the performance of key liquid alternatives categories in 1Q 2020 as well their long-term performance relative to stock and bond funds make them “a tough pitch.” One bright spot has been managed futures funds, which, after a long period of poor returns, were flat in 1Q 2020. Managed futures showed the lowest five-year correlation to equity markets.
Average tax-deferred retirement balance down 19% in Q1 2020: Fidelity

The major market downturn in March caused average 401(k), IRA and 403(b) balances to drop substantially across Fidelity Investments’ more than 30 million IRA, 401(k) and 403(b) accounts in the first quarter of 2020, according to an analysis by the Boston-based retirement giant.

The average 401(k) balance was $91,400, down 19% from the record high of $112,300 in Q4 2019. The average IRA balance was $98,900, a 14% decrease from last quarter. The average 403(b)/tax-exempt account balance was $75,700, down 19% from last quarter. (Note: Median account values, not provided, are typically substantially lower than average account values.)

Despite those setbacks, contributions to retirement accounts persisted, according to Fidelity. The average 401(k) contribution rate was 8.9% in the first quarter, consistent with Q4 2019; 15% of 401(k) participants increased their contribution rate in the quarter. The analysis also showed:

  • The average employer contribution was 4.7%, up from 4.6% in the previous quarter and equal to 4.7% in Q1 2019.
  • The average contribution to an IRA in Q1 2020 grew to $3,330, up 10% from the average in Q1 2019.
  • Contributions to 403(b)/tax exempt account increased to 6.9%, up from 5.6% in Q4 2019 and 5.4% a year ago.
  • The number of newly opened IRAs reached a record 407,000 in Q1 2020, up 36% over Q1 2019.
  • The number of Millennials contributing to IRAs increased 41% over last year, while the amount contributed by Millennials increased 64%.
  • Among female Millennials, the number of IRAs increased 20% from Q1 2019.
  • The number of Roth IRAs among Millennials increased 41% over the last year, with the amount of Roth IRA contributions growing 64%.
  • Only 7.3% of individuals changed their 401(k) allocation, up from 5.2% in Q4 2019.
  • Of savers who made a change, 60% made only one change in the quarter.
  • Among Baby Boomers, 9.9% changed their 401(k) allocation, with most moving their savings into a conservative investment option.
  • Among those with 403(b)/tax-exempt accounts, 5.2% changed their allocation, up from 4.1% last quarter.
  • Only 3% of participants in Fidelity’s 401(k) and 403(b)/tax-exempt platform dropped their allocation to 0% equities.
  • Hardship withdrawals increased slightly, but new 401(k) loans dropped. Before the CARES Act passed in late March, only 1.4% of individuals took a hardship withdrawal from their 401(k) in Q1 2020, less than half a percentage point more than the 0.9% in Q1 2019.
  • Only 2.3% of 401(k) participants initiated a loan in Q1, down from the 2.6% in Q4 2019 and even with 2.3% in Q1 2019. Individuals did not draw significant funds from their retirement accounts in the first quarter.

Average daily customer calls from Fidelity’s retail and workplace investors increased 20% in Q1 2020 versus Q1 2019, and Fidelity’s new COVID-19 resource centers received nearly one million views through the end of the quarter.

Lincoln Financial waives retirement plan withdrawal, loan fees

Lincoln Financial Group is taking steps to support customers experiencing COVID-19-related financial challenges, including relief for retirement savers, flexibility for policyholders, and support for the community and business.

In support of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), Lincoln Financial is waiving eligible withdrawal and loan initiation fees. Lincoln’s team of retirement consultants are providing one-on-one support by phone or online.

Additionally, Lincoln is sharing educational materials and hosting webinars to help plan participants decide whether a loan or withdrawal is the right option for them and understand how it might affect their long-term goals.

Kevin Kennedy named CMO at Pacific Life Retirement Solutions

Kevin Kennedy has been named senior vice president, sales and chief marketing officer of Pacific Life’s Retirement Solutions Division, which had more than $14 billion in 2019 sales of fixed and variable annuities, structured settlements, and retirement plan annuities.

Kennedy will oversee the division’s sales and marketing organization with oversight for sales execution and analytics, strategic partner and asset manager relationships, structured settlements, and expansion into the registered investment advisor (RIA) market.

Before joining Pacific Life, he was managing director and head of individual retirement at AXA Equitable Holdings, where he was in charge of product design and pricing, business strategy, and distribution of the individual retirement product line.

© 2020 RIJ Publishing LLC. All rights reserved.

 

Fed chairman promises to do ‘whatever it takes’

Posted on April 30, 2020 by -

Noting that the Federal Reserve can lend money but not spend it, Fed chairman Jerome Powell promised that he would act “forcefully, proactively and aggressively” for long as it takes to prevent the COVID-19 pandemic from inflicting long-term damage on the U.S. economy.

Responding to questions from reporters via video streaming Wednesday afternoon, Powell acknowledged that lasting damage could occur if too many Americans remained out of work too long or if too many small companies failed.

“A wave of unnecessary insolvencies could do long-term damage to the productive capacity of the economy. That’s a risk,” he said. “There’s also the global dimension. Problems overseas could weigh on our performance.”

The Fed will continue to buy Treasury securities, U.S. agency-backed securities and mortgage-backed securities, Powell said, adding that its Primary Market Corporate Credit Facility and Secondary Market Corporate Credit Facility, which will be equipped to buy up to $750 billion in corporate bonds “will be operating soon.”

At the same time, the Fed is working on the establishment of the Main Street New Loan and Expanded Loan Facilities, which would facilitate bank or credit union loans up to a total of $600 billion to small and medium-sized businesses with up to 10,000 employees and $2.5 billion in 2019 revenues.

Under the programs, Congress also appropriated of tens of billions of dollars to absorb losses under the loan programs, because the Fed is not allowed to take on credit risk. Asked about the future, Powell emphasized that interest rates would stay low until the economy recovers, but he said the recovery timeline is uncertain.

“We’ll definitely see a sharp slowdown in the second quarter. In the next phase, let’s say in the third quarter, there will likely be less social distancing and the economy will begin to recover,” Powell said.

“We might see a large increase in output, but it’s unlikely to bring us quickly back to pre-crisis levels. The sooner we have the virus under control, the sooner people will begin to feel confident about the economy. It will take some time to get back to normal or maximum employment,” he added.

As for the Fed’s lending capacity, Powell said, “If demand for lending facilities is greater than estimated then we’ll expand them. It’s not like the Paycheck Protection Program where a certain amount is allocated and then it ends. We won’t stop lending until we exhaust the Treasury’s equity and we’re a long way from doing that.”

The Fed’s offer to buy corporate securities calmed the credit markets, he added. “So far we’ve only made short-term money market loans, and not other corporate loans. But our actions have already built confidence in the market, and many companies have been able to refinance themselves privately since we announced the facility. The announcement alone has had an effect.”

Here’s yesterday’s formal announcement by the Federal Open Market Committee:

The Federal Reserve is committed to using its full range of tools to support the U.S. economy in this challenging time, thereby promoting its maximum employment and price stability goals.

The coronavirus outbreak is causing tremendous human and economic hardship across the United States and around the world. The virus and the measures taken to protect public health are inducing sharp declines in economic activity and a surge in job losses. Weaker demand and significantly lower oil prices are holding down consumer price inflation. The disruptions to economic activity here and abroad have significantly affected financial conditions and have impaired the flow of credit to U.S. households and businesses.

The ongoing public health crisis will weigh heavily on economic activity, employment, and inflation in the near term, and poses considerable risks to the economic outlook over the medium term. In light of these developments, the Committee decided to maintain the target range for the federal funds rate at 0 to 1/4 percent. The Committee expects to maintain this target range until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.

The Committee will continue to monitor the implications of incoming information for the economic outlook, including information related to public health, as well as global developments and muted inflation pressures, and will use its tools and act as appropriate to support the economy. In determining the timing and size of future adjustments to the stance of monetary policy, the Committee will assess realized and expected economic conditions relative to its maximum employment objective and its symmetric 2 percent inflation objective. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.

To support the flow of credit to households and businesses, the Federal Reserve will continue to purchase Treasury securities and agency residential and commercial mortgage-backed securities in the amounts needed to support smooth market functioning, thereby fostering effective transmission of monetary policy to broader financial conditions. In addition, the Open Market Desk will continue to offer large-scale overnight and term repurchase agreement operations. The Committee will closely monitor market conditions and is prepared to adjust its plans as appropriate.

Voting for the monetary policy action were Jerome H. Powell, Chair; John C. Williams, Vice Chair; Michelle W. Bowman; Lael Brainard; Richard H. Clarida; Patrick Harker; Robert S. Kaplan; Neel Kashkari; Loretta J. Mester; and Randal K. Quarles.

© 2020 RIJ Publishing LLC. All rights reserved.

Look Homeward, Seeker of Liquidity

Posted on April 29, 2020 by -

Reverse mortgage lines of credit (ReLOCs) can be cash lifelines for older people left jobless by the COVID-19 pandemic—providing liquidity and relieving the pressure they might feel to sell stocks at distressed prices.

Throughout the pandemic, ReLOCs are also more likely than conventional home equity lines of credit (HELOCs) to remain available. One major bank, JP Morgan Chase, recently said it would temporarily stop offering HELOCs for fear that home values might drop in a roiled economy.

A program of the U.S. Department of Housing and Urban Development (HUD), ReLOCs are not so vulnerable to passing economic storms. “In theory, the government could shut down any of its loan programs, but that would typically require an Act of Congress,” said Don Graves, who educates advisers about reverse mortgages, in an interview with RIJ this week.

Don Graves

“HELOCs can be frozen, cancelled or reduced at the banks discretion when certain economic conditions are present. But a ReLOC can’t be arbitrarily cancelled, frozen or reduced,” Graves said. He’s a principal at HECM Advisors Group and has a Retirement Income Certified Professional designation from The American College.

Under the HUD reverse mortgage program, Americans ages 62 and older with even a small amount equity in their home (depending on their age) can borrow against it in several ways. They can convert home equity to a monthly payment, borrow a lump sum, or open a line of credit and use it as needed. If they still have a conventional mortgage, they can refinance with a reverse mortgage and eliminate their monthly mortgage payment.

Reverse mortgages can even be used finance a new home, but that was not the original intent of the program, which was designed to help older people access home equity without selling their homes, thus allowing them to “age in place.”

Borrowers have the option of paying down a ReLOC, but they don’t have to. The lender will recoup any outstanding loan balance, with interest, when the house is sold (usually at the death of the borrowers). If the proceeds from the sale of the home exceed the loan balance, the excess goes to the borrower’s beneficiaries.

“Most of the calls I get are about eliminating a monthly payment,” Graves told RIJ. “That’s been my mantra [when I speak to groups of advisers]. If you’re over 62, why have a mandatory payment when you could have a voluntary payment?” He offered an example.

“Let’s say the client has a $400,000 home and a $160,000 conventional mortgage with a monthly payment of $1,000. After paying off the existing mortgage with a $160,000 ReLOC, the client still owes $160,000, but he or she doesn’t have to make payments,” he said.

“The loan balance will go down if he continues to make monthly payments, but he’s paying down a line of credit,” he added. “So he can still get the money back out. You took a nonproductive payment and restructured with a new loan that can’t be frozen, cancelled or reduced.” Graves noted that the unused balance of the line of credit  rises each year by the amount of the interest rate on the loan plus half a percent.

RIJ ran a multi-week series of articles on reverse mortgages in the spring of 2016. Click here to read the first installment in that series.

Closing costs are a common objection to opening a ReLOC. They might be $8,000 to $11,000 on a $200,000 reverse mortgage. Closing costs can be added to the loan.

A ReLOC can pay for itself during a financial crisis, Graves tells skeptics, by providing liquidity and preventing the forced sale of depressed assets. “Wade Pfau, Ph.D., has told advisers to use the ReLOC as a volatility buffer. His research shows that the benefit of avoiding the impact of just one bad year in the market makes the costs of creating the ReLOC negligible by comparison,” he said. Pfau recently published a book on reverse mortgages.

Advisers should feel a professional obligation to understand ReLOCs, Graves said. “Advisers who have retiring or retired clients and who hold themselves out to be ‘holistic,’ should reasonably be expected to say, ‘Let’s look at all of your assets, including your housing wealth.’ Most of my 21 years in this business has been spent convincing advisers how this fits into their clients’ plans. I give them a framework for using the reverse mortgage,” he told RIJ. 

Low interest rates may reduce the yields of bonds and payout rates of annuities, but they favor ReLOCs by allowing homeowners to borrow more than they could if mortgage lending rates were higher. “We’re seeing a movement that won’t go away,” Graves told RIJ. “Advisers haven’t paid attention because the hoof-beats of the bull market drowned out more conservative strategies.”

© 2020 RIJ Publishing LLC. All rights reserved.

Honorable Mention

Posted on April 23, 2020 by -

Survey: How retirement plan sponsors and providers are coping

A new survey of 21 retirement plan recordkeepers, asset managers and service providers by the Spark Institute and the Defined Contribution Institutional Association Retirement Research Center shows how plan providers are dealing with the COVID-19 pandemic and the CARES Act.

  • Recordkeepers are tracking coronavirus-related distributions (CRDs). Two-thirds are accepting self-attestations from participants that they meet the eligibility requirement. Over 80% of those surveyed have already updated their systems and procedures to accommodate the CARES Act. Another 9% should be updated within a week. The volume of distribution requests and questions is up significantly. Still, more than two-thirds of the industry is meeting their Service Level Agreements (SLAs) to clients.
  • None of the surveyed companies plans to lay off or reduce staff, but many have imposed hiring freezes on certain business units. To address shelter-in-place rules and social distancing guidelines, 98% of the industry is now working from home. This is up from 20% in January. The transition to working from home caused minimal disruption since the industry has had work from home procedures in place for more than a decade.
  • To address the increase in employees working from home, recordkeepers have responded with an increased focus on cyber-security, supplying employees with necessary technology, and online team calls.
  • About half of plan sponsors are considering reducing employer contributions until the crisis is over. To help avoid this, recordkeepers and plan sponsors are also discussing alternative tactics to address plan expense and cash flow concerns. For example, forfeiture accounts and ERISA budget accounts can be leveraged by plan sponsors to help pay some plan expenses.
  • Many plan sponsors previously considering a Request For Proposal process have decided to put that process on hold. With so many of their employees now working from home, some plan sponsors are concerned with managing paperwork and required document signatures, payroll and staffing issues, and a lack of necessary technology infrastructure.
  • Unlike in the 2009 financial crisis, most participants are not shifting their investments, but instead are looking for loans or hardship withdrawals. For those participants that are moving assets the shift is toward fixed income products.
RetireOne and Halo partner to distribute annuities and structured notes to fee-based advisers online

RetireOne, the insurance product trading platform for fee-based advisers, and Halo, a structured notes purchasing platform, have announced a partnership where RetireOne’s clients will be able to use Halo’s platform to buy structured notes and annuities.

“Clients of our RIA partners can now layer in the kinds of principal protections that have traditionally been expensive, and available only to qualified or institutional investors through brokers,” said RetireOne CEO David Stone, in a release. “Our RIA partners can choose curated structured notes, or they can design, price, and bid out custom-built solutions,”

Low interest rates are pressuring RIAs to look beyond traditional fixed income for risk-off solutions, the release said. Structured notes, a global investment product category with over $3 trillion of assets, remains relatively small in the U.S., at just over $60 billion.

HALO co-founder and CEO Biju Kulathakal said, “Halo’s technology helps analyze, customize, execute, manage and liquidate structured notes in an efficient and transparent way. This brings clients much needed access and competition to the structured note market.”

A structured note is a hybrid security that helps an investor target a level of expected returns and protection levels over a set period of time. Issued by major financial institutions, these instruments can generate returns in up, down and flat markets.

Serving over 900 RIAs and fee-based advisors since 2011, Aria Retirement Solutions’ RetireOne is an independent platform for fee-based insurance solutions. With offerings from multiple “A” rated companies, this fiduciary marketplace serves RIAs at no additional cost to them or their clients.

Social Security funding levels are stable, but don’t yet reflect COVID-19 impact

The combined asset reserves of the Social Security Trust Funds (Old-Age and Survivors Insurance and Disability Insurance) are projected to be depleted in 2035, the same as projected last year, with 79% of benefits payable at that time, according to the annual report of the Social Security Board of Trustees.

The OASI Trust Fund is projected to become depleted in 2034, the same as last year’s estimate, with 76% of benefits payable at that time. The DI Trust Fund is estimated to become depleted in 2065, extended 13 years from last year’s estimate of 2052, with 92% of benefits still payable.

These estimates do not reflect the still-unknown effects of the COVID-19 pandemic on the payroll tax receipts of the programs, the trustees said.

According to the Trustees’ 2020 Annual Report to Congress:

The asset reserves of the combined OASI and DI Trust Funds increased by $2.5 billion in 2019 to a total of $2.897 trillion.

The total annual cost of the program is projected to exceed total annual income, for the first time since 1982, in 2021 and remain higher throughout the 75-year projection period. As a result, asset reserves are expected to decline during 2021. Social Security’s cost has exceeded its non-interest income since 2010.

According to the Trustees’ report:

Total income, including interest, to the combined OASI and DI Trust Funds amounted to $1.062 trillion in 2019. ($944.5 billion from net payroll tax contributions, $36.5 billion from taxation of benefits, and $81 billion in interest)

Total expenditures from the combined OASI and DI Trust Funds amounted to $1.059 trillion in 2019.

Social Security paid benefits of $1.048 trillion in calendar year 2019. There were about 64 million beneficiaries at the end of the calendar year.

The projected actuarial deficit over the 75-year long-range period is 3.21% of taxable payroll – higher than the 2.78% projected in last year’s report.

During 2019, an estimated 178 million people had earnings covered by Social Security and paid payroll taxes.

The cost of $6.4 billion to administer the Social Security program in 2019 was a very low 0.6% of total expenditures.

The combined Trust Fund asset reserves earned interest at an effective annual rate of 2.8% in 2019.

The Board of Trustees usually comprises six members. Four serve by virtue of their positions with the federal government: Steven T. Mnuchin, Secretary of the Treasury and Managing Trustee; Andrew Saul, Commissioner of Social Security; Alex M. Azar II, Secretary of Health and Human Services; and Eugene Scalia, Secretary of Labor. The two public trustee positions are currently vacant.

View the 2020 Trustees Report at www.socialsecurity.gov/OACT/TR/2020/.

View an infographic about the program’s long-term financial outlook at www.socialsecurity.gov/policy/social-security-long-term-financial-outlook.html.

© 2020 RIJ Publishing LLC. All rights reserved.

 

How $240 billion in new COVID-19 money will be spent

Posted on April 23, 2020 by -

On April 21, Congress amended the Paycheck Protection Program and Health Care Enhancement Act to nearly double—to some $670 billion—the amount of federal spending to guarantee loans to small businesses and for supplies, salaries and research to fight the nationwide COVID-19 pandemic.

The amendment, passed Tuesday and published in the Congressional Record the same day, stipulates new spending of $240.25 billion, disbursed in the following way:

$30 billion to guarantee loans made by insured depository institutions and credit unions with consolidated assets of not less than $10 billion and less than $50 billion

$30 billion to guarantee loans made by community financial institutions, insured depository institutions, and credit unions with consolidated assets of less than $10 billion

$75 billion for the Public Health and Social Services Emergency Fund to reimburse eligible health care providers for health care-related expenses or lost revenues attributable to coronavirus

$25 billion to research, develop, validate, manufacture, purchase, administer, and expand capacity for COVID–19 tests to effectively monitor and suppress COVID–19

$11 billion to states, localities, territories, tribes, tribal organizations, urban Indian health organizations, or health service providers to tribes for necessary expenses to develop, purchase, administer, process, and analyze COVID–19 tests

$2 billion shall be allocated to states, localities, and territories according to the formula that applied to the Public Health Emergency Preparedness cooperative agreement in fiscal year 2019

$4.25 billion shall be allocated to States, localities, and territories based on relative number of cases of COVID–19

$750 million shall be allocated in coordination with the Director of the Indian Health Service

$1 billion to the Centers for Disease Control and Prevention—CDC-Wide Activities and Program Support for surveillance, epidemiology, laboratory capacity expansion, contact tracing, public health data surveillance and analytics infrastructure modernization, disseminating information about testing, and workforce support necessary to expand and improve COVID–19 testing

$306 million to the National Institutes of Health—National Cancer Institute, to develop, validate, improve, and implement serological testing and associated technologies

$500 million to the National Institutes of Health—National Institute of Biomedical Imaging and Bioengineering, to accelerate research, development, and implementation of point of care and other rapid testing related to coronavirus

$1 billion to develop, validate, improve, and implement testing and associated technologies; to accelerate research, development, and implementation of point of care and other rapid testing

$1 billion to the Biomedical Advanced Research and Development Authority for necessary expenses of advanced research, development, manufacturing, production, and purchase of diagnostic, serologic, or other COVID–19 tests or related supplies

$22 million to support activities associated with diagnostic, serological, antigen, and other tests, and related administrative activities

$600 million for grants to federally qualified health centers

$225 million for COVID–19 testing and related expenses, through grants or other mechanisms, to rural health clinics, for building or construction of temporary structures, leasing of properties, and retrofitting facilities to support COVID–19 testing

$12 million to the Office of the Secretary, Office of Inspector General, for oversight of activities supported with coronavirus funds

$2.1 billion for Small Business Administration salaries and expenses

$50 billion for the Disaster Loans Program

$10 billion for Emergency Economic Injury Disaster Loan Grants

© 2020 RIJ Publishing LLC. All rights reserved.

‘This is Not Modern Monetary Theory’

Posted on April 22, 2020 by -

Modern Money Theory (MMT) has been thrust into the spotlight again, as numerous governments around the world respond to the pandemic. Unfortunately, those invoking MMT misrepresent its main tenets. For example, we are being told MMT calls for helicopter drops of cash or having the Federal Reserve finance government spending through rebooted quantitative easing.

This is not MMT, which provides an analysis of fiscal and monetary policy applicable to national governments with sovereign, nonconvertible currencies. It concludes that the sovereign currency issuer (1) does not face a “budget constraint” (as conventionally defined), (2) cannot “run out of money,” (3) meets its obligations by paying in its own currency, and (4) can set the interest rate on any obligations it issues.

Yeva Nersisyan

Current procedures adopted by the Treasury, the central bank, and private banks allow government to spend up to the budget approved by Congress and signed by the president. No change of procedures, no money printing, no helicopter drops are required. Modern governments use central banks to make and receive all payments through private banks.

When the Treasury spends, the Fed credits a bank’s reserves, and the bank credits the deposits of the recipient. Taxes reverse that, with reserves and the taxpayer’s deposit debited. This is all accomplished through keystrokes—something government cannot run out of. Both the Treasury and the Fed can sell bonds (in the new issue and open markets, respectively) to offer banks higher returns than they get on reserves.

As MMT explains, since reserves must be exchanged when purchasing government bonds, the reserves must be supplied first before bonds can be purchased. It demonstrates how the Fed provides the needed reserves even as it upholds the prohibition against “lending” to the Treasury by never buying the bonds directly. None of this is optional for the Fed. It cannot refuse to clear government checks, nor can it refuse the reserves banks need to clear payments. It is the government’s bank, after all, and is focused on the stability of the payments system.

Randall Wray

Government can make all payments as they come due. Bond vigilantes cannot force default, although their portfolio preferences could affect interest rates and exchange rates. But the central bank’s interest rate target is the most important determinant of interest rates on the entire structure of bond rates. Bond vigilantes cannot hold the nation hostage—the central bank can always overrule them. In truth, the only bond vigilante we face is the Fed. And in recent years it has demonstrated a commitment to keeping rates low. In any event, the Fed is a creature of Congress, and Congress can seize control of interest rates if it wishes to do so.

Finally, the Treasury can “afford” to make all payments on debt as they come due, no matter how high the Fed pushes rates. Affordability is not the issue. The issue will be over the desirability of making big interest payments to bondholders. If that is seen as undesirable, Congress can tax away whatever it deems excessive.

What we emphasize is that sovereign governments face resource constraints, not financial constraints. We have always argued that too much spending—whether by government or by the private sector—can cause inflation. Below full employment, government spending creates “free lunches” as it utilizes resources that would otherwise be left idle. Unemployment is evidence that the country is living below its means. Full employment means that the nation is living up to its means. A country lives beyond its means only when it goes beyond full employment, when more government spending competes for resources already in use—which could cause inflation.

MMT rejects the analogy between a sovereign government’s budget and a household’s. The difference between households and the sovereign holds true in times of crisis and also in normal times, regardless of the level of interest rates and existing levels of outstanding government bonds (i.e., national debt). The sovereign can never run out of finance—period.

MMT does not advocate policy to ramp up deficits. A budget deficit is an outcome, not a goal or policy tool to be used in recession. There is no such thing as “deficit spending” to be used in a downturn or crisis. Government uses the same procedures no matter the budgetary outcome—which will not be known until the end of the fiscal year, as it depends on the economy’s performance. The spending will have occurred before we even know the end-of-the-year budget balance.

An important lesson to learn from the COVID-19 crisis is that the government’s ability to run deficits is not limited to times of crisis. Indeed, it was a policy error to keep the economy below full employment before this crisis hit in the belief that government spending was limited by financial constraints. Ironically, the real limits faced by government before the pandemic were far less constraining than the limits faced after the virus had brought a huge part of our productive capacity to a halt.

We hope this pandemic will teach us that in normal times we must build up our supplies, our infrastructure, and our institutions to be able to deal with crises. We should not wait for the next national crisis to live up to our means.

Yeva Nersisyan is an associate professor of economics at Franklin and Marshall College. Senior Scholar L. Randall Wray is a professor of economics at Bard College. This essay was first published by the Levy Economics Institute of Bard College. 

Portfolio Rebound: How Long Should It Take?

Posted on April 22, 2020 by -

Markets operate in two different modes: random (or “normal,” in the Gaussian world) and fractal (non-normal, extreme). My work on the luck factor (i.e., a person’s sequence of returns) over 20 years has indicated that markets are random about 94% of the time and fractal for the remaining 6% (about 3% up and 3% down) of the time.

When the markets are in random mode, well-known strategies such as asset allocation, diversification, rebalancing, dollar-cost averaging, buy-and-hold, work perfectly well. But these strategies don’t help much when markets are fractally going down. You might say, why worry if it happens only 3% of the time? The answer is simple: a big drop can wipe out 10 years of retirement income.

After a fractal event, we all hope that a recovery comes quickly. Fortunately, central banks have jumped in to help. But these rescues did not come cheap. The global total debt, which was $87 trillion (U.S.) dollars in year 2000, is now an estimated $253 trillion (before accounting for the financial impact of the COVID-19 event), according to The Guardian, January 8, 2020.

Our question is this: How many months or years should it take a portfolio to recover its original value after a big drawdown (assuming that central banks keep bailing out the economy—and shifting the burden to future generations)?

In our analysis, we make projections using actual market history, which we call “aftcasting” (as opposed to “forecasting”). Within a single chart, aftcasting can display the outcomes of all historical asset values of all portfolios since 1900. That is, it offers a bird’s-eye view of all outcomes for a given client-scenario. It provides the long-term portfolio success and failure statistics with exact historical accuracy by including actual historical equity performance, inflation rates, and interest rates, as well as the actual historical sequencing/correlation of these data sets.

Keith and Jane

Let’s consider a hypothetical accumulation portfolio. Keith, 30, has a portfolio worth $100,000. The asset mix is 70% equities and 30% fixed income. For equities, we use S&P500 index as a proxy. We use the historical interest on 6-month CDs plus 0.5% as the net yield for the fixed income portion of his portfolio. This approximates a bond ladder with an average maturity of about five to seven years at current yields, assuming no defaults and no capital gains/losses.

Keith plans to add $4,000 each year to his portfolio. Thus his accumulation ratio is 4%, which expresses the annual addition as a percentage of the portfolio value ($4,000 / $100,000).

Then a fractal event happens. Keith’s portfolio loses 25% of its value, dropping to $75,000. Keith asks, “When will my portfolio be back at $100,000, the pre-crash value?”

Figure 1 displays the aftcast. In an aftcast, there are no assumed rates of return. Each of the gray lines represents future market performance, starting in each specific year since 1900. The blue line represents the median portfolio; half of the gray lines are above it and half below. The green line indicates the “lucky” outcome; it represents the top decile (top 10%) of all outcomes. A lucky outcome typically happens when a recovery is “V-shaped.” The red line indicates the “unlucky” outcome; it represents the bottom decile. An unlucky outcome usually signifies a multi-year bear market (like those beginning in 1929 or 2000) with several after-shocks.

Note that it took about 2.6 years for the median line to reach the original portfolio value of $100,000 (the horizontal dashed line). If this were a V-shaped recovery,  however, Keith’s portfolio would recover in about 16 months. If this were a multi-year bear market, he would not see the $100,000 mark again for 6.6 years, thanks mainly to his periodic contributions.

Our next example involves someone in the retirement stage. Jane, 65, has just retired. Her portfolio, worth $500,000, consists of 40% equities and 60% fixed income investments.

Jane needs her savings to generate an income of $15,000 each year. Her initial withdrawal rate is 3% ($15,000 / $500,000), which she can sustain indefinitely. She plans to withdraw $15,000 per year (indexed to the Consumer Price Index) or the amount of her Minimum Required Distribution from tax-deferred accounts, whichever is larger.

A fractal event happens, and Jane’s portfolio value drops 25% to $375,000. Jane asks, “When will my portfolio get back to its $500,000 pre-crash value?” Figure 2 displays the aftcast. (To simplify the illustration, the loss-percentages suffered by Jane and Keith are kept equal at 25%, even though, due to their different asset allocations, their portfolio balances would respond differently to market conditions.)

If this loss were followed by a V-shaped recovery, Jane would see her portfolio value reach the original $500,000 after about 4.5 years. The median portfolio never reaches that $500,000 mark, however.

Our question was not whether or not Jane will have lifelong income; she likely will unless she lives far beyond age 90. We asked, “When will Jane’s portfolio reach $500,000? again.” It probably won’t.

Median recovery times of different asset allocations

To complete this study, I ran a multitude of scenarios. The results are summarized in Figure 3. Let’s use an example to illustrate them further.

Jeff has a balanced portfolio of $1 million. He does not add any money to it, nor does he need any income from it. (His “accumulation rate” for these purposes is zero.) After an unfortunate market event, his portfolio is down 22%. When can Jeff expect to see his portfolio back at the $1 million mark?

In Figure 3, we draw a vertical line (the dashed line on the chart) starting at the 22% initial portfolio loss on the horizontal axis. Continue this line until it reaches 0% accumulation curve. From this point, draw a horizontal line towards the left axis. It’s about 4.4 years. Historically, this is how long it took the median portfolio to reach its pre-loss value.

You might wonder what would happen if, instead of following the median path, this loss were followed by a V-shaped recovery (lucky outcome) or a multi-year downturn (unlucky). For precise answers, you’d need to run an aftcast for each specific scenario. But there’s a rule of thumb.

To estimate the lucky outcome, divide the median by 3. To estimate the unlucky outcome, multiply the median by 2.5. In our example, the median was 4.4 years. If Jeff is lucky, his portfolio will bounce back to $1 million in 1.5 years, calculated as 4.4 / 3. If he is unlucky, the rebound may take as long as 11 years, calculated as 4.4 x 2.5. This assumes that Jeff stays invested throughout the volatility period and does not bail out.

You might ask about the impact of asset allocation. When fractal events happen, asset mix doesn’t greatly affect the recovery time. If the portfolio is heavy in equities, it loses more but recovers faster. The difference in asset mix impacts the dollar dimension much more than the time dimension. The important factor here is the client’s ability to stay-the-course during adverse market events. (In this article, I used 40/60 asset mix for all decumulation portfolios and 70/30 for all accumulation portfolios.)

Let’s drill-down on the problem of staying power, aka “behavioral risk.” Consider two investors, both in the early stages of investing. Both are 30 years old and have $100,000 in their portfolios. They each add $4,000 annually to their portfolio.

Chase and Grace

Chase is more aggressive; he believes that stocks are “for the long run.” He proudly holds a portfolio of 100% stocks. The only problem is, Chase never tested his own risk tolerance.

Grace, by contrast, is a conservative investor. She knows her risk tolerance and holds an asset mix of 40% stocks/60% fixed income. A fractal market event happens, and the equity index drops 40%. The fixed income portion stays the same. Now, Chase’s portfolio is worth only $60,000. Having never experienced a loss like this, he gets scared and changes his asset mix to 40/60. Grace’s portfolio is now worth $84k and she holds on to her investments.

Their experiences over the next 20 years are depicted in Figure 4. The lines show their median portfolio values based on market history since 1900. Because Grace had staying power, she accumulated more assets than Chase, who bailed out and reset his asset mix. That mistake cost him a lot of money and accumulation time.

Even if Grace had gotten scared and made her asset mix more conservative, she would still be ahead of Chase, because her initial losses were lower.

The best time to make an asset mix more conservative is not after a loss but before one. The best opportunities to discover your own risk tolerance are actual life experiences. No risk tolerance questionnaire will give you an accurate answer. The lesson: Stay conservative until you discover your own risk tolerance.

In this example, we looked at only a single occurrence of bailing-out behavior. In my 24 years in the investment business, I can say with confidence that if this type of misbehavior happens once, it will likely happen again. Such self-sabotage will reoccur until the lesson is learned.

Practical action steps

To summarize the lessons of this study:

  • Know thy risk tolerance. The most effective way of increasing your investment success is to look at yourself first and decide on your risk tolerance. Err on the side of less risk.
  • During the early accumulation stage, keep the portfolio at a conservative 40% equity/60% fixed income. Maintain this mix until your annual accumulation dollar amount is less than 4% of the portfolio value. Regardless of how many risk tolerance questionnaires you fill out, you won’t know how you will respond to black swan events until they actually happen. Can you hang on to your investments when large, multi-year losses happen? You won’t know that until it happens for the first time. Stay conservative until then.
  • During the mature accumulation stage, if your risk tolerance permits, you can maintain a 60/40 mix, which will provide sufficient growth with reasonable risk.
  • Ten years before retirement, move your asset mix back to 40/60. You might need a full 10 years of recovery time after a nasty black swan event. Therefore, between ages 60 and 65, reduce the risk.
  • Once you retire and switch from accumulation to decumulation, the math of loss flips on its head—dramatically so. Even if your initial withdrawal rate is a modest 3%, you may never again see the pre-loss asset value of the portfolio.
  • If the withdrawal rate in retirement (3% to 4%) is too low to cover essential expenses, consider guaranteed income products such as life annuities or segregated funds (variable annuities) with guaranteed lifetime withdrawal benefits. Why? When you’re using a safe withdrawal rate, a portfolio loss as small as 15% can reduce income noticeably.
  • If withdrawals from the portfolio are intended purely for discretionary and non-essential expenses, but preservation of capital is important, then use a variable annuity with a lifetime withdrawal benefit to protect assets, as well as to reduce behavioral risk.
  • If withdrawals from the portfolio are for discretionary and non-essential expenses only, and preservation of capital is not important, a traditional investment portfolio will work.

This study is based on the market history of the last century. It assumes that the current central bank borrowing binge can continue indefinitely. During the last century, fixed income was the “safer” side of a portfolio. Going forward, it might turn into the riskier side. We shall see. Meanwhile, enjoy this recovery.

Jim Otar is a retired financial planner and retired professional engineer. He is the founder of www.retirementoptimizer.com. His past articles won the CFP Board Article Awards in 2001 and 2002. He is the author of Unveiling the Retirement Myth, a 525-page textbook. He can be reached at [email protected]