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How Annuity Owners Behave in a Storm

Posted on March 19, 2020 by Editorial Staff -

Based on its own studies of annuity policyholder behavior since 2007, Connecticut-based actuarial firm Ruark Consulting published a report yesterday on the responses that annuity issuers can expect from policyholders amid the current volatility.

According to the report, “Market Turmoil: What Does It Mean for Annuity Policyholder Behavior,” variable annuity writers should expect:

Greater persistency overall, but elevated surrenders for at-the-money GLWB
Greater income utilization, especially for GLWB after the deferral incentive period and “hybrid” GMIB
Greater GMIB annuitization elections, especially on traditional “pro-rata” benefit forms

Fixed indexed annuity writers should expect:

Greater persistency for GLIB, and lower persistency without GLIB
Greater income utilization for GLIB

In addition, the impact of COVID-19 on mortality will likely depend on the level of containment among the general population at retirement ages, with potential differences between those with and without living benefit guarantees.

To access the report, click here.

Observation Posts

Posted on March 19, 2020 by Kerry Pechter -

As if we weren’t already deeply divided, Americans are now asked to stand six feet apart. Clear verbal communication, not communicable viruses, is now essential. Words can be contagious, for good or ill. If the following comments go viral, no harm will be done, and maybe some good.

This week, RIJ asked some of the influencers in its network to share their thoughts about our unprecedented medico-political-economic dilemma. Here’s what economists, insurance agents, financial advisers, and entrepreneurs told us:

‘Don’t wait for the good news’

Stocks will begin to recover long before the pandemic is on the wane. The strongest bull markets are not built on a foundation of good news, but on diminishing bad news. Wouldn’t it be nice if the world of academic finance had coined the expression “equity fear premium” instead of “equity risk premium”?! That premium is at its best when fear is at a peak. It will be hard to be perfectly right on the turning point, naturally, but don’t wait for the good news—just wait until the pattern of bad news lets up. —Rob Arnott, Research Associates

Time for ‘Series I Savings Bonds’

The current crisis has intensified risk and made Series I Savings Bonds even more desirable. As I have written many times before, these bonds are the best kept secret in America. There is an annual limit of $10,000 per person, and I advise all of my friends and relatives to buy the maximum every year. Here is a recent interview I gave on the subject: America’s Best Kept Investing Secret. —Zvi Bodie, Boston University

‘Who is selling and why?’

Revelatory moments break generalizations about generations. Boomer retirement plans become at least more clearly dichotomized: Probability-based plans vs. Safety-first plans. The former seemed wiser before. The latter seems wiser now. The uncertain wisdom of the choice of plan remains. Is this revelatory moment a reset of future business growth, such that prices cannot swing back the other way, and fast? Selling breaks the uncertainty by realizing the loss. Do you have a sense of who is selling and why? How many have their Household Balance Sheet assets matched or mismatched to the duration of their liabilities? —Francois Gadenne, co-founder, chair and executive director of The Curve Triangle & Rectangle Institute

‘Flight to safety’

There’ll be a flight to safety with annuities. The market that we’re witnessing now will drive annuity sales because people will realize they need more guarantees in their portfolios than they have currently. They’ll say, ‘We probably shouldn’t be this deep into risk.’ The demographic tidal wave of baby boomers reaching retirement age wants guarantees, and annuities are the only product on the planet that provide a lifetime income stream.—Stan ‘The Annuity Man’ Haithcock, in ThinkAdvisor

‘No one has pulled out of the [annuity] business’

Companies are reducing rates, pulling select annuities, pulling select riders, but no one has pulled out of the business yet. Although it seems like the sky is falling, this is the PERFECT market environment for sales. Consumers want guarantees, and annuities are all about the guarantees.—Sheryl Moore, CEO, WinkIntel

‘Production will be crippled for some time’

The Great Depression of the 1930s witnessed a huge shock to aggregate demand. What we are now experiencing is a huge shock to aggregate supply; albeit one that will have depressing multiplier effects on demand. A strong stimulative package is desperately needed, but it will not be able to restore GDP to its pre-Coronavirus level, because production will be crippled for some time. A well-designed package will help offset the decline in personal expenditure of laid-off workers and self-employed persons for those goods and services the economy is still capable of producing.—Sandy Mackenzie, former editor, Journal of Retirement

The trend toward longer retirements will end

Projections of retirement security will soon be changing to reflect a more realistic assessment of what returns will be available to old and young retirees alike. I hope that financial advisers and intermediaries start learning their lesson.

All of this builds on top of a public system that cannot possibly support its current level of guaranteed benefits for what will rise to close to one-third of the adult population if people continue to retire on average at age 64. The almost century-long trend toward ever more years spent in retirement will almost certainly end, if for no other reason than that someone must meet the demand for labor.

At the same time, the stock crash will increase public demand for the government, rather than a risky market, to provide retirement security—which in many ways could be supplied and afforded if we recognize the need for labor and emphasize a minimum base of support. The spur for more retirement security induced by the crash may require those with above-median income to work more, save more, and pay more taxes (though don’t expect to hear any of this from those running for office). —Eugene Steuerle, the Urban Institute.

A moratorium on foreclosures, evictions and debt collection

Forget the Trump re-election gambit of $1,000-2,000 checks for all. The problem is a collapse of supply, not demand. Putting more cash into the economy is not a solution when people cannot go to work. We should tackle the health crisis directly (free testing and Federal government single-payer medical care for all who might have been exposed; Federal government-paid sick leave and parental leave for all affected by the crisis) and then deal with those affected economically (more inclusive and higher paying unemployment benefits for ANYONE who has lost work or hours because of the crisis; Federal government cash payments targeted to those who need it most) and as well affected small business (loans or grants, but with conditionality).

Since the 2007 crash, the biggest corporations have enjoyed high profits, but instead of investing, they used all their profits for stock-buybacks and because of that they have no cushion for the proverbial “rainy day.” And now it is pouring. Any financial or nonfinancial corporation that seeks help must be effectively nationalized under the control of a government-appointed manager. All the corporation’s top management would submit letters of resignation that could be used at any time by the government’s manager to clean house. Stock buy-backs for recipients of government aid would be banned; CEO pay would be permanently reduced to appropriate General Schedule levels; and the government’s manager would decide whether it is in the nation’s interest to try to save the firm or to shut it down.

Finally we need a moratorium on foreclosures, evictions of renters, debt collections, student loan debt, utilities bills, late fees, hikes of rents or interest rates, and all taxes until the crisis passes. Significant jail time for anyone who violates the moratorium. —Randall Wray, Senior Scholar, Levy Economics Institute, Professor of Economics, Bard College

‘We need something good to come out of this’

After an 11-year bull market, the past 30 days will most certainly serve as a wakeup call for both advisors and investors. Even prior to these events, many of those in and near retirement were already taking steps to protect their retirement portfolio from the volatility of the markets. Without a doubt, that trend will now accelerate. Any product that can provide some level of protection and/or income guarantees will likely see increased demand.

The industry itself will change forever. By the time this crisis passes, flexible work schedules and working remotely will no longer be something done by portions of the workforce as a convenience to those workers. Such work schedules will become a way of life for virtually every firm. In addition, I predict that this crisis will finally drag the insurance and annuity industry into the 21st century.

By the time we settle into the new normal, our need to continue to function—when so many can’t come into the office—will finally bring an end to all of the passing of paper, processing of physical checks and the need for wet signatures (and don’t even get me started on faxes). One can only hope I’m right about that, because we need something good to come out of this.—Scott Stolz, annuity distribution

Volatile retirement income creates anxiety

The current conditions in the financial markets are revealing that Denmark, with its growing emphasis on variable income annuities (payments fluctuate with the markets), is facing a retirement crisis. These products imply riding a roller coaster of retirement income. The initial income is affected by sudden market swings; market volatility will cause your retirement income to vary too much from year to year, creating anxiety among retirees and is soon-to-be retirees.—Per Linnemann, former Chief Actuary, Denmark

‘A longer path to improvement’

While acknowledging the Life/Annuity industry’s strong capital and liquidity resources, the report identified these challenges:

A material acceleration in a global economic slowdown, increasing the expectation of dampened earnings throughout 2020 for spread and fee-driven businesses
A rapid further deterioration in the U.S. economy, paired with its direct impact on equities and interest rates
A greater expectation of a longer path to sufficient improvements from record low levels for the 10-year Treasury yield, as well as a flattened yield curve.—A.M. Best Company, March 17, 2020

Insurance has a unique advantage

Like all intermediated retail financial products, life insurance and annuities have a nontrivial distribution cost, but in the case of insurance products, it is somewhat alleviated by the embedded interest rate in the policies and tax deferral. However, when the embedded interest rate goes toward zero, the tax deferral aspect means nothing and the cost of distribution becomes more obvious and off-putting to potential purchasers. The same can be said of other intermediated financial products, such mutual funds, hedge funds and the like.

But life insurance and annuities do address some concerns through the pooling of risks and guarantees that cannot be matched by other intermediated financial products. While those customers who purchase insurance products solely for their financial attractiveness may be dissuaded under current circumstances, still there remains nothing else that can insure against living too short or too long.

As long as agents stress these features and find clients who are interested in managing these risks, they have an advantage over other marketers.—David Babbel, emeritus professor, Finance and Insurance, the Wharton School.

‘Keep working, delay Social Security’

You can’t ‘should have done’ anything. It’s simply not possible, so take a few deep breaths and try to relax. So, you didn’t reduce your exposure to equities when you had the chance. You didn’t move 20% of your retirement savings into a deferred annuity to ‘take some risk of the table’, as Tom Hegna says. Keep working if you can. Delay taking Social Security. Consider a Home Equity Conversion Mortgage (HECM, or reverse mortgage) line of credit if you need income now. Just don’t make any knee-jerk decisions you can’t take back, like panic selling. Things will improve. They always do. This time, just don’t go back to whatever you were doing and forget about your to-do list of financial and insurance decisions. You may not get another chance to get it right. —Bill Borton, W.R. Borton & Associates

‘A mad scramble’

We’ve had two cruises cancelled in the past six weeks. Just today we returned from Quito where our trip to the Galapagos was cancelled. The Ecuadorian government was going to close the Quito airport at midnight Monday. There was a mad scramble to get out.

The recent experience has caught everybody—not just the cruise industry—scrambling to figure out how best to deal with it. Nursing homes like that one in Seattle show how easily viruses can spread. Will people change their minds about putting loved ones in nursing homes? If so, what alternatives are there? What about retirement communities in general? Will they become breeding grounds for viruses? Don’t know the answer to either question.—Steven Slifer, Numbernomics.com

Shocks loom for U.S. life insurers, annuity issuers: A.M. Best

Posted on March 18, 2020 by Editorial Staff -

AM Best has downgraded its outlook on the U.S. life/annuity (L/A) industry to negative due to the “significant volatility and uncertainty in the financial markets created by the COVID-19 virus,” the respected ratings agency reported this week.

In its March 17 report, “Market Segment Outlook: U.S. Life/Annuity,” AM Best reversed its previous view that “the overall impact for most carriers was likely to be manageable.”

“Because the financial markets have responded negatively and quickly to the outbreak of COVID-19, the longer-term economic impact remains uncertain,” the report said. “As interest rates and the equity markets plummet, AM Best expects operating performance to move to the negative, driven by declining sales and intensifying spread compression.”

While acknowledging the L/A industry’s strong capital and liquidity resources, the report identified these challenges:

A material acceleration in a global economic slowdown, increasing the expectation of dampened earnings throughout 2020 for spread and fee-driven businesses
A rapid further deterioration in the U.S. economy, paired with its direct impact on equities and interest rates
A greater expectation of a longer path to sufficient improvements from record low levels for the 10-year Treasury yield, as well as a flattened yield curve

In the United States, the Federal Reserve (Fed) cut the federal funds rate by 50 basis points on March 3, 2020, followed quickly by a further reduction on March 15 to a target range of 0-25 basis points. At the same time, the Fed launched a $700 billion quantitative easing program. The 10-year Treasury note fell below 50 basis points to a record low at one point this March, and remains below 1%.

AM Best anticipates that COVID-19 also will significantly affect the L/A industry’s ability to move forward quickly with costly innovation efforts. Factors moderating these negatives include:

The industry’s strong capitalization and improved liquidity
Stress testing that has better prepared the industry for downturns from economic and pandemic-type events
Credit spread widening to offset some of the interest rate decline

“Carriers with less capital, questionable liquidity access and limited business profiles or outsized exposures to at-risk sectors such as energy, retail, and travel, will feel the negative economic impact faster and more deeply than most of the industry,” the report said.

“For companies active in variable products, separate account assets will be marked to market, resulting in declines in asset-based fees. L/A insurers taking on higher degrees of investment risk and those with less-than-optimal asset-liability matching strategies are likely to be more negatively impacted as well.”

Ironically, the U.S. life/health industry saw solid growth in pre-tax and net operating profits in 2019. Net income increased by 12.6% year-over-year to $45.6 billion. Capital and surplus for the industry increased by 6.2% from the end of 2018, reaching $415.6 billion at year-end 2019.

These preliminary financial results were detailed in the recent Best’s Special Report, titled, “First Look: 12-Month 2019 Life/Annuity Financial Results.” The data is derived from companies’ annual statutory statements that were received by March 10, 2019, representing an estimated 95% of total industry premiums and annuity considerations.

According to the report, the life/annuity industry’s total income for 2019 increased by 3.0% to $872.3 billion compared with the previous year. A $59.5 billion increase in premiums and annuity considerations was offset by a $38.0 billion decline in other income.

These significant swings were primarily the result of modified coinsurance agreements and the recapture of retrocessions from foreign affiliates at American General Life Insurance Company, Hannover Life Reassurance Company of America and United States Life Insurance in the City of New York.

Income growth slightly outpaced a 2.5% increase in total expenses, leading to a pre-tax operating gain of $55.1 billion, 11.8% higher than in the previous year. A $4.2 billion increase in taxes was offset by a $3.5 billion reduction in net realized capital losses, resulting in the $5.1 billion year-over-year increase in net income.

IPO Signals Strategic Shift at Jackson National

Posted on March 18, 2020 by Editorial Staff -

Seeking outside capital to fuel Jackson National Life’s aggressive retirement product diversification strategy, the U.S. life insurer’s British parent has decided to sell a minority position in Jackson via an initial public offering (IPO) in the U.S.

Prudential plc said in a March 11 release that it sees a “substantial opportunity for Jackson’s products” in the U.S., “the world’s largest retirement savings market and the continuing transition of millions of Americans into retirement.”

“In order to diversify at pace, Jackson will need access to additional investment, which we believe would best be provided by third parties,” Prudential plc’s release said. “We are today announcing that the Board has determined that the preferred route to achieve this is a minority Initial Public Offering (IPO) of Jackson.”

Prudential plc appears to have acted under shareholder pressure. The Financial Times reported February 24 that Dan Loeb, leader of Third Point, the $14 billion US hedge fund that has a stake in Prudential worth nearly $2bn, had urged the insurer’s board to separate Prudential’s US and Asian businesses and eliminate its UK head office. Prudential no longer has any operations in the UK, but it remains the largest insurer listed on the London market, with a value of £37bn.

Jackson National emerged as the U.S. variable annuity sales leader about seven years ago—especially since Prudential and MetLife throttled down their sales pace. More recently, Jackson, AIG and other life insurers have diversified their product offerings for greater stability.

“In 2019, Jackson diversified its annuity sales to focus on growing its fixed annuity market share, which propelled its overall growth in 2019,” said Todd Giesing, senior annuity research director at the Secure Retirement Institute, in a release this week. “Jackson’s fixed indexed annuity sales jumped a staggering 1,293% in 2019, while their fixed-rate deferred annuity sales climbed 169%.”

According to Prudential plc:

US adjusted operating profit increased by 20% to $3.07 billion, reflecting the impact of lower market-related amortisation of deferred acquisition costs. Higher equity markets also led to US separate account assets increasing by 19% to $195.1 billion. Our US business continued its long-term track record of delivering cash to the Group, remitting a dividend of $525 million during the year.

US APE (Annual premium equivalent) sales increased by 8%, driven by fixed income and fixed index annuities, in line with our diversification strategy. New business profit declined by 28%, reflecting lower interest rates and changes in product mix.

Prudential plc bought Michigan-based Jackson for $610 million in 1986. The business, which has four million U.S. customers, accounts for half of the group’s operating profit.

Jackson today announced its full-year financial results, generating $3 billion in IFRS pre-tax operating income in 2019, an increase of 22% over 2018 and the highest in company history. Jackson also reported $22.2 billion in total sales and deposits, noting significant growth in fixed and fixed index annuity sales.

The British insurer, which is not related to Newark, NJ-based Prudential Financial, acknowledged the potential impact of the pandemic and financial crisis on its industry.

“We continue to monitor closely the development of the coronavirus outbreak and are focused on the health and well-being of our customers and staff. The outbreak has slowed economic activity and dampened our sales momentum in Hong Kong and China,” the firm said in a release, adding, “lower levels of new sales activity in affected markets are to be expected with a consequential effect on new business profit. Our in-force business is proving robust.”

“The U.S. is the world’s largest retirement market, with trillions of dollars expected to move from savings into retirement income products over the next decade,” said Michael Falcon, CEO of Jackson Holdings LLC. “Jackson’s ambition is to play the fullest role possible in this through a strategy of diversifying its product range and distribution network. Over time, this is expected to lead to a more balanced mix of policyholder liabilities and enhance statutory capital and cash generation.”

Strong equity markets drove the company’s 2019 results, Falcon said. Variable annuity separate account assets, which generate asset-based fees, totaled a record $195.1 billion in 2019.

“As Jackson works to achieve commercial diversification, we are continuing our efforts to balance our business,” said Falcon. “By offering the right mix of products through the right distribution channels, we have strengthened our leadership position in the U.S. retirement market. Our deliberate approach has enabled us to deepen our presence in the advisory space and capture new opportunities as we move into the next phase of our growth.”

How to Avoid H.R. Mistakes Stemming from COVID-19

Posted on March 18, 2020 by No Author -

Turn 401(k)s into Bond Ladders

Posted on March 18, 2020 by Kerry Pechter -

Bond ladders or certificate-of-deposit ladders are tried-and-true techniques for establishing predictable yearly income in retirement. But they currently have drawbacks. CD rates are too low, and bond ladders require large investments. Neither can be built by 401(k) plan participants prior to retirement.

One easy alternative is to use defined maturity funds (DMFs). These diversified bond funds combine the best features of a bond ladder and a bond fund, either as insulation from interest rate risk or as a safe stairway of annual income in retirement. Invesco and BlackRock offer them as exchange-traded funds (ETFs). Fidelity offers them as municipal bond funds.

Franklin Templeton distributes its defined maturity bond funds through retirement plans. The firm brought its first DMF to market in 2015, but it got little traction. The passage of the SECURE Act in December could change that by helping to reframe the 401(k) as a generator of retirement income.

“Prior to the passage of the SECURE Act, plan sponsors were broadly reluctant to embrace the income challenge,” said Drew Carrington, senior vice president and head of Institutional Defined Contribution at Franklin Templeton, in a recent interview with RIJ. “That was primarily because of the annuity selection liability issue.”

Carrington was referring to plan sponsors’ concerns that they could be sued if a life insurer who sold annuities to their participants later defaulted. “Decisions about products like ours, that have no insurance component, have also been held up [by those concerns],” he said.

Drew Carrington

“We’re hoping that passage of the SECURE Act will drive renewed interest and spur action. We’ve seen a couple RFPs [requests for proposals] from plan sponsors. We hope that this may represent a turning point in the acceptance of retirement income options in 401(k) plans.”

Franklin Templeton’s institutional DMFs are liquid, actively managed diversified mutual funds containing a mix of investment-grade, non-callable bonds that all mature in the same year. There are no mortgage-backed securities or floating-rate bonds. They are structured so that plan participants who have retirement spending needs in 2021 might invest in a 2021 Fund, a 2022 Fund, etc. The current expense ratio is 32 basis points (0.32%) per year.

The DMFs are intended to fit the contribution and accumulation pattern of a 401(k) participant. “Every two weeks a person could purchase small slices of a fund. Other people might reach age 60 and decide to buy a five-year bond ladder all at once. Other people might say, ‘I’ll buy a new fund every year for five years,’” Carrington said. “You can go either way. The funds have liquidity and a daily price. The closer they get to maturity, the less volatile their value will be. If you sell the fund prior to maturity, there could be a market value decline. But barring a default the fund should mature at its par value,” he added.

DMF ladders can be extended indefinitely, but Franklin Templeton envisions ladders of five years. “Our theory was that that’s about as far out as most people have a sense of planning for. If you ask them what their income needs will be in a year, they can usually tell you. But if you ask them how much they’ll be spending in 12 years, they don’t know. So we created a five-year program, with one fixed maturing fund for each of the five years.”

There’s a stereotype of rank-and-file retirement plan participants as largely disengaged from their retirement savings. Franklin Templeton also wondered if most people are too focused on yield and internal rates of return to appreciate the predictability of a ladder. “Some initial feedback from plan sponsors was that participants wouldn’t understand this, so we held focus groups,” Carrington told RIJ. “To ensure a broader swath of the US population, we made a point of conducting them in states such as Texas and Illinois instead of focusing on financial hubs like New York. The groups consisted of people over age 50 and currently participating in a 401(k) plan. Otherwise, they were as demographically diverse as possible.

“The interesting finding was that people immediately grasped that this was like a CD. They weren’t hung up on the yield component. They understood that you’d dedicate a portion of your savings today to the payment of certain expenses in the future. People thought of it as bucketing.

“We often heard people say, ‘I could set aside dollars to pay for a certain expense, like property taxes. Then I wouldn’t have to worry about that expense and I could spend my other money as I wish. One person asked, ‘Can I do this in different amounts each year?’

“As a general rule, the defined contribution industry tends to underestimate participants’ financial literacy. However, from our focus groups, we found that people intuitively grasped this product. I am now more inclined to think that participants close to retirement have a better sense of what they need than the industry gives them credit for.”

Franklin Templeton envisions participants using a bucketing strategy, where one income bucket consists of a DMF ladder and a later income bucket of a deferred annuity, or QLAC, or qualified longevity annuity contract. Created by the U.S. Treasury in 2014, QLACs allow Americans to buy late-life deferred income annuities with up to 25% of their tax-deferred savings (to a maximum of $135,000 for 2020) without violating the requirement to start taking distributions from tax-deferred accounts after reaching age 72.

The asset management firm asked retirement experts from The American College to run Monte Carlo simulations of the hypothetical performance of a Franklin Templeton DMF ladder, a portfolio of growth funds, and a MetLife QLAC during retirement to see if it outperformed the traditional 4% “safe withdrawal rule” established by William Bengen in 1994.

“We asked Michael Finke and Wade Pfau to answer the question, ‘If we think about risks like volatility and longevity risk in retirement, would a combination of a bond ladder, a QLAC and a growth portfolio outperform the 4% rule on those two metrics, and their answer was ‘Yes,’” Carrington said.

“The research is compelling on that point. If your goal is wealth maximization on average and you care only about that, the answer is ‘No.’ Higher equity allocations create the potential for higher ending wealth. But they create a wider dispersion of outcomes in terms of income variability and longevity risk.”

Carrington sees the potential to partner with an annuity issuer on products that combine DMFs and QLACs. “We’re not officially co-marketing with an insurance company, but we are certainly open to joining into a conversation with others. That’s why we did the joint project with MetLife and The American College,” he told RIJ.

Carrington imagines the following scenario. “Most people will retire in their early 60s, draw down Social Security in their mid-60s and buy a QLAC that starts in their mid-80s. So we’re looking at a 10- to 15-year window for these bond funds,” he said.

“In that framing, if you make a back-of-the-envelope assumption that people can put up to 25% of their qualified savings into a QLAC, and put five percent into each year of your five-year bond ladder. That’s a total of 50%. The other half of the portfolio is left to address income needs and inflation risk in the years [between the end of the bond ladder and the beginning of the QLAC income].

“HR departments tell us, my participants aren’t asking for income products. But we say, there will be second order effects. Think about rearview cameras in cars. Nobody knew they wanted rearview cameras until they had them. Now they get in a car without one and say, ‘Where’s the rearview camera?’”

A response to last week’s cover story

Posted on March 12, 2020 by David Babbel -

Thank you for including a synopsis of the Shoven et al. study in Retirement Income Journal. In your summary comment on the Shoven article, you stated:

“The paper suggests that it doesn’t make much sense for people in the bottom half of the income distribution to defer Social Security benefits until age 70 or to buy life annuities.”

Much of what Shoven et al. observe is correct. But I don’t agree that negative real interest rates necessarily imply that there’s no reason to defer Social Security benefits until age 70 or to buy life annuities (particularly deferred life annuities).

Let me explain.

Under current practices, Social Security benefits beyond 62 years of age tend to increase by roughly 8% per year of delay up to age 70. This is due to the mortality assumptions and the assumed interest rate embedded in those increments. Because the 8% yearly increment (which remains inflation-adjusted throughout the remainder of life) is higher than can be justified on economic and actuarial grounds, it still may be a good choice to delay Social Security until later years, even 70.

In addition, the tontine nature of life annuities, and particularly deferred income annuities, means that their high “mortality credits” should continue to attract new buyers, despite very low or even negative embedded real rates of interest.

Arrow, Debreu and Hirshleifer provided the theoretical basis for that attraction in their Nobel Prize elaborations of “state-preference theory.” They showed that the value that one places on money depends upon the state of nature, including the individual circumstances, under which money is received.

In such states, one may use negative discount rates to assess annuities’ future value, thereby leading to potentially attractive returns. Thus, annuity payments that are “loaded up” with mortality credits can be particularly valuable, especially when someone can’t work or is dependent on assistance from a possibly insolvent government.

Even if the government is able to honor its promises without debasing its currency, the mortality credits will create impressive returns for those who survive beyond the average lifetime.

Dave Babbel Professor Emeritus, Finance and Insurance The Wharton School, University of Pennsylvania

Vanguard reboots a managed income fund

Posted on March 12, 2020 by Editorial Staff -

Vanguard has changed the name of its Vanguard Managed Payout Fund to Vanguard Managed Allocation Fund. The fund also added a new portfolio manager to its team, effective immediately, and eliminated monthly payouts in favor of an annual distribution. The last monthly payment will be made in May.

The fund’s structure, composition, and investment advisor won’t change. It remain a fund-of-funds, investing in equities, fixed income, commodities, and alternative assets through other Vanguard funds. Vanguard Quantitative Equity Group (QEG), the firm’s internal active fund advisory arm, will continue to manage it.

The fund currently invests 52% of its assets in stocks, 23% in bonds, and 25% in alternatives. The fund is expected to retain an expense ratio of 0.32%.

Vanguard introduced three managed payout portfolios in 2008, each with its own target payout rate in retirement. But the financial crisis hurt the launch and the product sputtered. In 2014, the portfolios were merged into a single Managed Payout Fund with an annual target distribution rate of 4%. The fund has attracted only $1.9 billion. Most shareholders reinvested their distributions instead of taking monthly income.

Vanguard advised investors who want a regular stream of cash distributions to establish an automatic withdrawal plan from their Vanguard accounts.

Vanguard Managed Allocation Fund will continue to invest in a diversified portfolio of Vanguard funds, including but not limited to:

Vanguard Total International Stock Index Fund
Vanguard Alternative Strategies Fund
Vanguard Total Bond Market II Index Fund
Vanguard Total Stock Market Index Fund
Vanguard Global Minimum Volatility Fund
Vanguard Commodity Strategy Fund
Vanguard Total International Bond Index Fund
Vanguard Ultra-Short-Term Bond Fund
Vanguard Value Index Fund
Vanguard Market Neutral Fund
Vanguard Emerging Markets Stock Index Fund

Vanguard is positioning the revised fund for several audiences: As a cash-flow management tool for endowments and foundations, as an in-plan retirement income solution, or as part of a retirement income strategy for individual investors and their advisors, or as a diversified asset for institutional investors.

Vanguard’s Quantitative Equity Group was created in 1991. It is comprised of 37 portfolio managers, strategists, and analysts, and manages assets worth more than $44.5 billion. It is led by John Ameriks.

Fei Xu and Anatoly Shtekhman, managers of Vanguard Alternative Strategies Fund and Vanguard Commodity Strategy Fund, will manage the Managed Allocation fund’s portfolio.

Shtekhman earned a B.S. in mathematics from the University of Scranton, an M.S. in finance from Boston College, and an M.B.A. from the Wharton School of the University of Pennsylvania. Xu received a B.S. from Beijing University, an M.S. in geophysics from UCLA, and an M.B.A. from the Fuqua School of Business, Duke University.

Stay Calm, But Nimble

Posted on March 12, 2020 by Wade Pfau, Steve Parrish and David Littell -

For retirement income planning in this chaos, the years before you retire should be the key consideration:

If you’re at or near retirement, “selling out” of the market is going to make the “sequence of return” issue a reality rather than a mere risk. Still, these market moves can be a wake-up call to put a strategy in place to make sure it doesn’t derail your retirement. (At left: Wade Pfau.)

If you’re years away from retirement, and have the stomach for it, there are some opportunities for loss harvesting and discounted stock buying. (Just remember that you could also be taking a bad thing and making it worse.)

We’ve been financial services witnesses to all the U.S. financial crises beginning with the near-hyperinflation of the early 1980s. These are the lessons we learned:

No two situations have been the same.
This one’s been a somewhat predictable disturbance to the supply chain; the 2008 crisis was more related to a liquidity crunch.
The “dot.com bubble” was consumer overconfidence followed a correction scenario. So, the exit out of this situation may be very different from the past.

What the financial crises of the past had in common was the tendency of too many people to sell low and buy high. A page from the financial playbook suggests not to do panic selling.

At the tactical level, there are opportunities in retirement planning:

Be prudent about how much conservatism you want to bake into your approach. Given today’s low interest rate environment, you’ll need to save even more in bonds if you shift away from stocks.
A simple rule to follow is to look at your portfolio balance on the date you retired, and whenever the current balance is less than that number, draw down from the buffer asset. Otherwise, you withdraw from your portfolio.
Investors with a whole life insurance policy can also potentially borrow from the cash savings component of their plan, since it is later repaid by deductions when the death benefit is paid out.
If you believe the market will correct, particularly if the current situation is hurting your income, now may be a great time to make conversions to Roth IRAs (and pay a lower tax).
If you have the time and stomach for it, harvesting losses now with a reinvest in a correlated asset may work for you. It may give you a tax deduction without changing your economic position.

On the flip side of this, particularly if your income is temporarily down, realizing income may make sense. For example, surrendering some of the IRA that you were going to surrender next year anyway could work. If you own a business, collecting on receivables or selling appreciated inventory (especially if that inventory is in demand) might generate some lower-taxed income.

A Reminder that Market Risk Is Real

Posted on March 12, 2020 by Kerry Pechter -

Panic is not a productive response to any situation, no matter how serious. Panic attacks are often abject cries for help that, by themselves, are purely counter-productive. Better to remind yourself that “intelligence is knowing what to do when you don’t know what to do.”

Then relax and wait for your brain to suggest the next move. It will.

But what about your panic-stricken clients? A lot depends on how old they are. One adviser I know faced a phone meeting this week with a fairly new client whose assets he hadn’t yet had a chance to reallocate. The client, a 62-year-old business owner, had had $700,000 in equities until 10 days ago.

“I’ll tell him three things,” the adviser said. “‘First, at your age, you should have been more diversified. Second, you can do nothing and ride it out. Or you can move 40% of that account to a fixed indexed annuity right now.'”

I don’t know yet how the client reacted. The client apparently also owns a fair amount of whole life insurance. This particular adviser often recommends life insurance for affluent retirees, both as a source of cash during moments like these and as a counterweight to a life-only single premium immediate annuity.

Of course, there’s an upside to downturns. “Stay the course” is the Boglehead response. But the bigger the drop, the bigger the opportunity for those with cash or near-cash. We love other products when they’re “on sale”: why not equities? If you were 50:50 in stocks and bonds before this correction, maybe you should rebalance toward stocks. Think of it this way: the market just regained a lot of equity risk premium.

Life insurers/annuity issuers can use this crisis to gently remind retirement savers and investors that risk is still real—and that insurance products and managed volatility products can help them sleep easier. (The Alliance for Lifetime Income should be busy this week with a follow-up to its “M.U.G.” promotion.) For life insurers who are buying back their own stocks, I assume this slide to be a windfall. For firms with big books of variable annuity business, the slump probably hurts fee revenue. Another interest rate cut certainly won’t help the sale of new fixed annuities.

The retirement conference schedule is being disrupted as we speak. The March 22 Adviser2X conference in New Orleans has been postponed until late July. I’m waiting for updates from Investment News, LIMRA, and the American Retirement Association about their retirement summits, all of them set for late April.

For basketball fans, March Madness is turning into March Sadness. As a college hoops fan, I’m following developments this week. The Ivy League cancelled its tournament. So far, the NCAA appears to have decided that the show will go on, but not before live audiences. Victory over the virus is more important.

An Actuary Assesses COVID-19

Posted on March 11, 2020 by Matthew Edwards -

As the world grapples with the growing COVID-19 (coronavirus) threat, a useful reference point is the Spanish Flu of 1918. Given what we now know about COVID-19, are we looking at something of similar severity to the Spanish Flu, or materially less severe, or perhaps worse?

Up until now, the Spanish Flu has been generally regarded as a “worst case” reference point in pandemic modeling: This is as bad as it could get.

The thinking would be that healthcare is so much more advanced now, and we are not recovering from four years of strategic war as was the case then. These positive factors should more than compensate for the (then unimaginable) extent of international air travel and globalization of trade. But perhaps that rationale no longer holds, and we could be heading for something similar.

Plausible mortality impacts

Matthew Edwards

An actuary’s immediate reaction to COVID-19 is, of course, to model it. But even now, with more than two months of data, there are considerable obstacles to any plausible modeling using the typical pandemic modeling methods (e.g. the ‘SIR’ approach of splitting people into the states of susceptible, infected, and recovering, with age/gender-specific transition rates) and this article does not attempt any such modeling.

Most pandemic models involve a “spread” assumption, R0, which represents how many individuals an infected person will transmit the virus to (in an otherwise perfectly susceptible population). An R0 parameter of one, for instance, equates to a stable state; a value greater than one (at the start of an outbreak) implies growth in infections, with the potential for exponential growth in the absence of interventions. Normal influenza spread implies a parameter of two to three whereas measles is one of the most contagious viruses with an R0 of 12 to 16.

At the moment, even this fundamental element is uncertain by a wide range. Various publications so far have it ranging from 1.4 to over six, while even the World Health Organization’s (WHO’s) suggested range allows almost 100% variation (from 1.4 to 2.5).

In addition, as a further complication, the effective rate of reproduction will differ between countries and also vary over time as people shift their routines to avoid infection (hopefully decreasing as people and governments become more aware of the problems).

Then we have the problem of mortality, the case fatality rate (CFR), which measures the mortality of infected cases. Overall estimates are around 2%, but here there is wide variation between the experience in Wuhan (above 5%) and outside that area (of the order of 0.7%). Reporting and data issues add further uncertainty; even determining the number of cases is challenging, especially given the asymptomatic cases whose number cannot accurately be measured.

These figures compare with the following reference points:

The overall CFR in any country is likely to be heavily influenced by the availability of appropriate healthcare resources. However, the age variability seen so far is likely to be similar across countries.

The Chinese experience showed mortality rates varying broadly and exponentially by age, from circa 0.2% for ages up to 40, increasing to 4% for the 60 to 69 age band, 8% for the next decade of age, and roughly doubling again to 15% for anyone 80 or older. (This concentration of deaths at higher ages is supported by observation of the ages of reported European fatalities.)

So what sort of impact is plausible? To paint a very broad picture, if we assume a CFR in the 0.5% to 1.0% range (in line with the ‘outside Hubei’ COVID-19 figures to date, and the 1957/68 pandemics), this could lead to, as a plausible order-of-magnitude conjecture, a doubling of mortality in a country such as the U.K. for a period of several months. That is, an overall doubling of population mortality, not a doubling of mortality for infected cases. This would be a bad outcome (and is not a ‘best estimate’ prediction), but it is plausible.

Moreover, the above broad-brush perspective deliberately overlooks various likely and material indirect impacts. The likely surge in patient volumes at healthcare facilities related to a sustained COVID-19 outbreak in any country could mean a corresponding squeeze on access to care (and hence, increased mortality) for patients already suffering from other serious conditions in secondary care. There will be an equivalent but less severe effect at the primary care level.

Quarantine and self-isolation will also have a detrimental effect on those suffering from chronic conditions at home. The healthcare workforce will itself be depleted by absences. Furthermore, supplies of medicine taken for granted will potentially be adversely affected by production supply chain issues.

There is one material mitigating point from an insurance perspective, if not from that of the individuals affected: the coronavirus will disproportionately affect the less healthy (in particular, people already with chronic conditions), and hence the mortality impact does not consist entirely of ‘new’ deaths but will include a material proportion of ‘accelerated’ deaths (hence leading to correspondingly reduced mortality in later years).

A more positive point for insurers is the opportunity for innovative product design in the face of a very clear set of consumer concerns. By way of example, Generali announced in February a new product aimed specifically at providing coronavirus cover for healthcare costs and loss of earnings; other major insurers have launched similar products.

Impacts for insurers

The variability of the mortality impact by age makes the impact highly variable by type of insurer. Clearly, annuity writers will experience an unusually high mortality year (even under the more benign scenarios). Protection writers will see a mortality impact likely to be of similar order of magnitude to their capital allowance for life cat risk (for example, the Standard Formula of Solvency II sets this at 1.5 per mille, and internal model firms will have generally similar calibrations); the major question for them is the extent of their reinsurance.

The main losers will be firms with large whole of life books but low levels of reinsurance: there is likely to be a large amount of sum at risk for policyholders in their 50s and 60s, with a material mortality impact from the COVID-19 outbreak.

However, there are a range of other impacts that insurers with well-developed risk management functions and capital models should already be prepared for (one silver lining of the COVID-19 problem is that it does focus minds on real-life examples of complex interacting risks stemming from just one driver).

Asset markets are clearly badly affected, with (by way of example) the FTSE-100 down 12.7% and the S&P 500 down 8.6% from January 1 to February 28 this year. Operational risk will be a concern, with firms needing to prepare for significant staff absences, and absences in their suppliers (third-party outsourcers will not be “immune” to the problem themselves).

Occurring as this outbreak has immediately after most firms’ year-end means that insurers will have a couple more months to wait and see before finalizing their revised assumptions for mid-year reporting. By this time, mortality assumptions are likely to need increasing, probably with a short-term adjustment, while annuity writers might find it reasonable to wait and see as far as base assumptions go, noting that they can be fairly aggressive this year with improvement assumptions.

For instance, in the U.K., this is likely to mean no insurer will want to move to the latest mortality projection model CMI_2019, which gives slightly higher life expectancies than the previous versions. (In theory, the proper approach would be to combine a short-term adjustment to base tables with incorporation of CMI_2019, allowing for greater life expectancy for survivors. In practice, the uncertainties that will persist until even end 2020 will likely mitigate against this approach.)

In an ideal world, actuaries would wait for near-certainty before changing any major assumptions. In the first half of 2020, such an approach is unfortunately not feasible.

S&P500 vs. High Quality Bonds (2007-2020)

Posted on March 11, 2020 by No Author -

Quote of the Week

Posted on March 5, 2020 by No Author -

Bonuses enhance yield in Allianz Life’s new indexed annuity

Posted on March 5, 2020 by Editorial Staff -

When stocks and bonds are trading at record or near-record prices and risk premiums shrink to almost nothing, investors, advisers and product developers have to get creative in their search for safe yield. All of today’s fruit is high-hanging.

In the absence of attractive bond yields, some life insurers offer annuity contracts with bonuses. Allianz Life of North America has led the indexed annuity market for some two decades with its bonus products. It rolled out the latest version this week.

Allianz Benefit Control is the product’s name. If the contract owner earns an annual credit from the appreciation of the underlying equity index-linked options, Allianz Life enhances the credit and, as directed by the owner, adds it to one of the two sleeves in the contract.

One sleeve is the contract’s account value. That’s what owners receive if they cash out today (net of surrender fees and market value adjustments). The second sleeve is the “protected income value” or PIV. The insurer multiplies the PIV by an age-adjusted payout percentage to calculate the annual income that owners can receive for the rest of their lives.

Owners who want the highest possible future income can raise their PIVs by 250% of annual earned interest, if any, and also raise their account values by 50% of their earned interest. In other words, if someone earns 4% for the year, the PIV goes up by 10% and the account value goes up by 2%. That’s option one.

Alternately, owners can raise their PIVs by 150% of earned interest and raise their account values by 100% of earned interest. If someone earns 4%, the PIV goes up by 6% and the account value goes up by 4%. That’s option two.

The product brochure offers an example. It hypothesizes a 58-year-old woman who makes a $100,000 contract payment. She plans to retire at age 65. Allianz Life immediately raises her PIV to $110,000 with a 10% purchase bonus.

In her first year of ownership, she earns 4%. If she has chosen option one, her PIV goes up by 10% and her account value goes up 2%. If she has chosen option two, her PIV goes up by 6% and her account value goes up 4%.

When she reaches age 65, her PIV has grown to a projected $186,000 or so. At that age, her age-adjusted payout percentage is 3.75%. She’s entitled to about $7,000 a year for life. That income can go up if she earns additional interest from the fixed indexed annuity, which keeps on going even after income begins. If for some reason she needs nursing home care, she could double her annual rate of withdrawal under the contract’s Alliance Income Multiplier benefit. Future annual withdrawals will be substantially lower, however.

The contract is complex, to be sure. Part of the complexity comes from the flexibility. The product can be used for accumulation or income. Liquidity is available but limited by the surrender fee, which starts at 9.3% in the first year and declines to 1.05% in the tenth year. The bonuses need to be weighed against the low payout percentages, which reach no higher than 4.75% for a single contract owner age 80 or more.

Part of the complexity also stems from the fact that the “planning process”—the kind of planning that a fee-based or fee-only adviser might provide to a client—is pre-baked into the product and lasts for the life of the client. The adviser or agent who sells an annuity contract is getting paid a commission by the issuer for distribution services, not necessarily for giving advice.

To use an analogy from the Internet world, buying an indexed annuity with lots of complex flexibility is like buying software as a service (SaaS). SaaS products often give their subscribers a lot of cloud-based functionality but rely largely on the subscriber to run it. There’s telephone or chat support after the sale, but the value of the product depends a lot on the subscriber’s own capability and perseverance.

Few fee-only advisers would sell a product like this, even if it were available on a no-commission basis. They earn asset-based, hourly, or by-the-project fees for offering guidance, not products. If they were looking for a scalable way to help mass affluent clients, such a product might fit into their practices.

But it probably wouldn’t suit their personalities. Fee-only advisers tend to regard annuities and other packaged products the way master woodworkers regard ready-made retail furniture. They’re certain they could produce something better and cheaper on their own workbenches.

But the larger point here is that low interest rates—which have lasted for years and could last for many more—send players in different niches of the retirement business in different directions toward different solutions for different types of customers. For life insurers who manufacture indexed annuities, bonus contracts like Allianz Benefit Control make the most sense.

Yes, I Finally Bought an Annuity

Posted on March 5, 2020 by Kerry Pechter -

Last week’s market bungee-jump told me that my wife and I were right to buy an income annuity in late 2018. We bought a deferred period-certain contract that will deliver monthly income for our first 10 years of retirement.

By luck, we bought it before the 2019 rate cuts. Added to Social Security, it will cover our basic expenses. Our other savings is in stock funds, balanced funds, my wife’s small TIAA annuity, or cash. Annuity experts may groan at our decision. We bought “an expensive bond ladder.” We got no “mortality credits.”

But my wife is six years younger than I am. The payout from a joint life annuity looked unattractive. And she rejected any solution that jeopardized our heirs. The term-contract also gave us the nominal monthly income we needed for the portion of savings that we were prepared to spend on it. (The deferral period helped close the gap.)

Yes, we “discounted” our chances of living too long; but future equity gains might allow us to buy more years of safe income. (We hope.) As a backup, we have home equity and three daughters. Deciding to buy the contract wasn’t easy. Maybe it wasn’t even rational. But we feel relieved. We don’t sweat these short-term market slides.

“Buffered” ETFs for sensitive stomachs

Posted on March 5, 2020 by Editorial Staff -

Jittery investors don’t necessarily have to use index-linked annuities or structured notes to get protected equity exposure based on the purchase of options. They can use exchange-traded funds, or ETFs.

Since August 2018, Innovator Capital Management LLC, with subadvisor Milliman, has been issuing one-year ETFs that deliver returns between an upside cap and a downside buffer, with a choice of exposure to five different indices.

So far, Innovator has issued 41 one-year buffered ETFs. The funds now have about $2 billion in assets under management, Innovator CEO Bruce Bond said in a release this week.

The latest offering, the March Series of Innovator S&P 500 Buffer ETFs, started trading on the Cboe (Chicago Board Options Exchange) on March 2, Innovator Capital announced this week.

Like structured annuities (aka registered index-linked annuities or RILAs), the Defined Outcome ETFs use options to generate a customized range of returns based on the movement of an equity index. Investors can earn up to a capped return, while downside “buffer” zones limit their exposure to loss.

The products’ buffers, like airbags in cars, are designed to give retail investors a sense of safety—enough to prevent them from bailing out of equities during rocky markets. The ETFs give investors “defined exposures on broad benchmark indexes, where the downside buffer level, upside growth potential, and outcome period are all known, prior to investing,” the release said.

Each fund in the series has an annual management fee of 0.79%. Exposures to the S&P 500, NASDAQ 100, Russell 2000, MSCI EAFE, or MSCI EM indices are available. Investors can get protection from the first 9% of losses, or the first 15% of losses, and any losses between 5% and 35% over the one-year investment period. The upside caps for each fund are fixed when it is issued.

Like all ETFs, funds in the Innovator series trade throughout the day on an exchange. They’re more liquid than structured notes, Innovator said. Investors can buy into a one-year fund after its launch date, and they can roll their investment over for another year at the end of each “outcome period.” The original buffers and caps are likely to have changed, however.

A tool at the Innovator website shows where the ETF stands at any given time and what the current crediting terms are. The ETFs reset annually and can be held indefinitely.

Crediting formulas for the March Series of Innovator S&P 500 Buffer ETFs, as of 3/2/20 were:

*The caps above are shown gross of the 0.79% management fee. “Cap” refers to the maximum potential return, before fees and expenses and any shareholder transaction fees and any extraordinary expenses, if held over the full Outcome Period.

According to Innovator, each ETF holds custom exchange-traded FLEX Options with varying strike prices (the price at which the option purchaser can buy or sell the security, at the expiration date), and the same expiration date (approximately one year).

The layering of the FLEX Options with varying strike prices provides the mechanism for producing a Fund’s range of outcomes (i.e., the cap or buffer). Each fund intends to rollover options components annually, on the last business day of the month associated with each Fund.

Milliman Financial Risk Management LLC (Milliman FRM), the subadviser of the ETFs, also helped design the Cboe S&P 500 Target Outcome Indexes. The Innovator Defined Outcome S&P 500 Buffer ETFs are benchmarked against them.

DCIIA Retirement Research Center’s Founding Members

Posted on March 5, 2020 by No Author -

At These Rates, Why Bother to Save?

Posted on March 5, 2020 by Kerry Pechter -

Responding to last week’s stock market plunge—when fear literally went viral—the Federal Reserve lowered its benchmark fed funds rate by 50 basis points. The central bank was signaling that investors should… what, exactly? Is the message:

Remain calm and stay invested, because liquidity will remain cheap and abundant, or
Don’t bother saving, because safe assets won’t yield enough to make delayed-gratification—the very essence of saving—attractive.

The answer may depend on how much you earn per year and what you think your retirement will be like. For people in households with incomes under $62,000 a year and below-average health, the answer is likely to be “2,” according to a new paper from Stanford University economist John Shoven and three of his top former students.

If people behave rationally, as classical economists assume, then they are bound to notice that the return on government bonds is now less than the inflation rate. They may therefore decide to spend freely in early retirement rather than save their money until later, when it will buy less and when they might not be able to enjoy it.

“We find that for many, perhaps most, people in the bottom half of the lifetime earnings distribution, it is optimal to spend out their retirement wealth well before death and to live on Social Security alone after that. Very low earners may find it optimal to not engage in retirement saving at all,” they wrote in “Can Low Retirement Savings Be Rationalized?” NBER Working Paper 26784, February 2020.

Shoven and his co-authors—Jason S. Scott, Sita N. Slavov of George Mason University and John G. Watson of Stanford—challenge at least two major assumptions about retirement planning. One is the life-cycle hypothesis, which says that people want their consumption to be fairly constant over their entire life-cycle. The second, which is related, is the idea that people will need to 65% to 85% of their pre-retirement income in retirement to avoid feeling a decline in living standard.

This might apply to affluent people, the paper says. But people for whom Social Security will replace a large percentage of their pre-retirement income, and who expect to rely on Medicaid if they live long enough to need long-term care, have more reason to behave like the grasshopper in Aesop’s fable than the ant.

John Shoven

“Today, the real rate of interest is negative,” Shoven told RIJ this week. “So if you set aside money today, you’ll be able to afford lower consumption in the future than today. There are significant consequences to this era that we’re living in. For many people, their return on savings is less than zero. Bank accounts pay a quarter of a percent. They’re basically offer a minus two percent yield.

“If you said today, ‘Boy, I want to consume $30,000 per year when I’m 80,’ you realize that with today’s low rates you’d have to save a lot more to have $30,000 when you’re 80,” Shoven told RIJ this week.

“You might say, with rates so low, I’ll change the tilt of consumption. You’ll take that trip to Europe at age 70. We’re saying that declining consumption during retirement can be attractive—given the market rewards for patience. You might feel differently than you did fifteen years ago when you could get 2.5% real return if you invested in safe assets. the safe real rate of return was 2.5%.”

Shoven was asked if conserving money against the fearful possibility of big medical bills in old age would be rational. “With respect to high medical expenses, particularly with the cost of long term care, it is so expensive that it’s difficult to provide for,” he told RIJ.

“Many people who need long-term care will be supported by Medicaid. They’ll get about the same level of care whether they go into care with $50,000 in savings or if they have zero.”

[For people in the bottom half of the income distribution], “any achievable goal will be so small compared to the size of the need, that they lose by hoarding. They say, ‘I could be frugal and save $50,000, or I could enjoy myself now.’” If you spend your last $50,000 on long-term care, “You’re basically helping Medicaid instead of yourself,” he added.

While there’s an old saying about saving for a rainy day, Shoven suspects that people feel little motivation to save for tomorrow if they believe they will be sick tomorrow and won’t feel like vacationing.

“A representative sample of individuals are asked to imagine there is an even chance that they are in good or poor health at age 80,” the paper said. “They are then asked to how they would allocate a $10,000 windfall between those two possibilities. Would they prefer to have all, most, some or none of the windfall in the healthy or unhealthy state? Of interest for our work is that the answers, while volatile, tended to allocate wealth between the unhealthy and healthy outcome at an approximately 1:2 ratio.” A healthy day is worth twice as much as a sick day.

It’s not likely, Shoven added, that low-income savers will respond to low yields by taking more risk. “The model says, ‘Declining consumption is optimal, given the way the market fails to reward delayed consumption,” he said. “In other words, whatever resources you have, you’ll spend more in your younger years.

“We don’t address the possibility that, in the face of extremely low interest rates, some people will say, ‘I’ll take more risk with my investments.’ We didn’t go into that. Typically, as people get older, they want to be in safe assets.”

If correct, this paper’s conclusions clash with more than one of the basic rules of thumb for retirement planning. The paper suggests that it doesn’t make much sense for people in the bottom half of the income distribution to defer Social Security benefits until age 70 or to buy life annuities.

“The considerations in this paper may help to explain the lack of demand for private annuities,” the authors wrote. “Spending liquid assets for annuities whose payout pattern does not correspond with optimal consumption isn’t particularly attractive. It is well known that private annuity markets suffer from adverse selection [the tendency for people with long life-expectancies to buy annuities]. Adding a sub-optimal pattern of payouts [with constant rather than declining consumption] further reduces the attractiveness of annuities, especially for those in the lower part of the income distribution.”

The paper’s reliance on the concept of homo economicus—the assumption that ordinary people think like economists—might raise the eyebrows of behavioral economists who believe that many people exhibit “irrationality” or “bounded rationality” when dealing with money.

“There could be a criticism of our approach in the sense that people might behave with rules of thumb rather than completely rationally,” Shoven conceded. “This is a rational approach. Like a lot of economists, we assume rationality on the part of the investor. The simple, rational model that economists use doesn’t argue for a constant standard of living as you age.”

Project LIMA Aims to Solve the Annuity Puzzle

Posted on February 27, 2020 by Kerry Pechter -

Let’s assume that most American retirees would be better off with pensions. And let’s assume that most people who want a pension would have to buy it with part of their 401(k) savings. How then would you retrofit the 401(k) system to make that possible?

One new proposal is Project LIMA, or Lifetime Income Managed Accounts. This specific idea comes from the math laboratories of Milliman, the actuarial consulting firm whose risk-management algorithms are embedded in a wide range of mutual funds and annuities.

If a 401(k) plan sponsor adopted LIMA, a participant who has elected to use a managed account (as opposed to a target date fund) could apply a percentage of each payday contribution to the gradual purchase of a qualified lifetime annuity contract, or QLAC. In retirement, the QLAC would deliver inflation-adjusted monthly income for life.

We’re hearing about LIMA now because the SECURE Act finally passed. The Act makes it less likely that a participant might sue an employer over any adverse consequences of buying an in-plan annuity. That includes QLACs inside managed accounts as well as target date funds with “guaranteed income riders.”

But legal liability hasn’t been the only reason that illiquid, life-contingent deferred income annuities haven’t taken up residence in 401(k)s (though they’ve long existed in 403b plans). The fund firms who provide investment options for 401(k) earn a percentage of assets under management, or AUM.

Until now, any money diverted into multi-premium annuities would disappear from AUM and from recordkeeping statements. One of the proposals within Project LIMA is that the annuity value stays in the managed account, shows up in recordkeeping statements, and is in turn part of AUM. Richter is hopeful that providing this substantiated valuation process for the annuity income stream will provide a basis for billing.

Michelle Richter

“Milliman’s contribution to the recipe, and it’s essential to the design, is the valuation and dynamic re-valuation of the annuity within the managed account,” said Michelle Richter, the Milliman consultant who is leading the Project LIMA effort.

“Providing this substantiation valuation process for the annuity income stream will provide a basis for billing,” she added. “We are starting from a ‘safety first’ perspective [i.e., aiming to generate enough guaranteed income through the annuity to cover basic retirement expenses] and ladder into guaranteed income across the rate environment. But there are a lot of ways that this could be implemented.”

Growing income gradually

In a hypothetical example offered by Milliman, a 40-year-old participant, Jane Doe, has a $50,000 DC plan balance. She plans to retire at age 67. She’s a conservative investor who has chosen a managed account over a target date fund, and an asset allocation of 50% stocks and 50% bonds.

Jane is offered the option of enrolling in a managed account with a QLAC. She fills out a questionnaire that will reveal her estimated basic expenses in retirement and how much more guaranteed income, above Social Security and pension, if any, she will require to cover those expenses. She then chooses either to start a) buying a QLAC that will meet her essential monthly retirement expenses, b) buying a QLAC with her employer’s matching contribution, or c) not buy a QLAC.

The LIMA algorithm determines that approximately 3% of her savings should be contributed to a QLAC each year. At the end of the first year, she’ll have $25,000 in stocks, $23,519 in bonds, and a QLAC with a book value of $1,481. Fast-forward 13 years: At age 53, Jane now has $123,632 in stocks, $69,894 in bonds, and a QLAC with a book value of $44,293.

During those 13 years, the adviser handling her managed account would have rebalanced her portfolio allocations back to her conservative risk level. The LIMA algorithms would also determine the amount of annuities Jane Doe needs to acquire over time to achieve her ‘Safety First’ income targets. As Richter envisions the process, Jane will have purchased pieces of QLAC from several different life insurance companies by then.

If Jane decides to leave her employer, she can roll over to a managed IRA provided, perhaps, by the same fund company that provided her 401(k) managed account. Somehow—and this part isn’t complete—her slivers of QLAC from different insurers would be resolved into a single payment. She would begin receiving income from the QLAC sometime between age 72 and age 85.

“Several insurers tell us they have capacity for and interest in QLACs, assuming that the distribution likes it. A lot of new recordkeeping work would have to be done to handle QLACs in-plan, as opposed to selling them as standalone products,” Richter said.

“To the extent that the QLACs are embedded in a managed account structure, it’s easier for the recordkeeper and the asset manager to handle, as opposed to managing separate assets,” she added. “Since SECURE passing, there has been more discussion about how annuities as retirement income solutions are expected to make their way into 401(k) plans, and we are excited about the potential of designs like Project LIMA.”

What’s old is new again

The efficiency (or “utility” in economics) of this concept was recognized long ago. Many have seen the wisdom of buying annuities incrementally instead of with lump sums and delaying payouts to age 80 or later, when each premium dollar buys the most income.

In 2004, Moshe Milevsky of York University proposed the Advanced Life Deferred Annuity, or ALDA. It was contingent on both life and exhaustion of a deductible. “A consumer can invest or allocate $1 per month… and receive between $20 and $40 per month in benefits, assuming the deductible in this insurance policy is set high enough,” he wrote.

Jason S. Scott, Ph.D., the current director of the Retiree Research Center at Financial Engines, wrote in 2007, “A new type of annuity, a longevity annuity, is optimal for retirees unwilling to fully annuitize. For a typical retiree, allocating 10%-15% of wealth to a longevity annuity creates spending benefits comparable to an immediate annuity allocation of 60% or more.” But in 2011, when Financial Engines launched its managed account income-generation tool, Income+, automatic annuitization of assets was not in the design.

In 2008, six months before the financial crisis, MetLife and Barclays Global Investors collaborated on an ambitious but never-launched 401(k) program called SponsorMatch. Participants would apply their employers’ matching contributions to purchases of future income. That same year, MassMutual and entrepreneur Jerry Golden experimented with a rollover IRA product, the Retirement Management Account, which turned qualified retirement savings into income.

CANNEX, the provider of annuity data and comparative analysis tools, has been working for years on the problem of valuing income annuities so that they fit better into advisers’ AUM business models. Some of its technology might find its way into LIMA.

“We’ve been waiting for something to change in the industry to facilitate quotes in this area. The SECURE Act helps considerably,” Tamiko Toland, head of Annuity Research at CANNEX USA, told RIJ.

Several big retirement plan providers, such as Prudential and Empower, have already approached the in-plan annuity challenge, but from a different angle. They’ve offered target date funds with lifetime income riders as a 401(k) investment option. Their products are called IncomeFlex and SecureFoundation, respectively.

Unlike QLACs, these riders offer participants liquidity and a guarantee that, if their own account hits zero before they die (and they have obeyed the contractual limits on annual withdrawals), the insurer will continue making their monthly annuity payments as long as they live. Such contracts offer life insurers an attractive combination of high fee income with low risk exposure.

But sales of that TDF-based product have been low, in part because most plan sponsors hesitate to put their participants’ nest eggs in one life insurer’s basket. (Connecticut-based United Technologies Corp. solved that problem by using three living benefit providers that compete through a bidding process.) Richter is hopeful that multiple insurers will want to participate in Project LIMA.

“We started to quietly investigate the premise of the LIMA project back in the fall, with some reasonable industry interest,” Richter told RIJ. “We’re talking with a number of organizations spanning the asset management, recordkeeping and insurance industries. More than one version of what we’re imagining would require all of those three communities’ joint collaboration.”

Investors pump money into bonds: Morningstar

Posted on February 27, 2020 by No Author -

Long-term mutual funds and exchange-traded funds gathered $82.8 billion in January—their best month since January 2018. But the mix of recipients has shifted in two years. In January 2018, 46% of inflows went to U.S. and international equity funds; in January 2020, however, those two categories combined suffered net outflows, according to the monthly fund flow report from Morningstar Research.

Instead, investors pumped money into fixed-income funds last month. The taxable-bond group took in a record $63.6 billion, topping the previous record of $50.5 billion set only one month prior. Those flows accounted for almost 77% of all long-term fund inflows in January.

The strong January marked 13 straight months of inflows into taxable-bond funds. Both actively and passively managed funds in the category benefited. Actively managed taxable-bond funds raked in $36.9 billion in January, their best showing since September 2009. Their passively managed counterparts added $26.7 billion.

Within the taxable-bond space, investors took interest in core strategies focused mostly on investment-grade securities. Intermediate core-bond funds gathered $17.3 billion for the month, just shy of the $17.4 billion record reached in January 2018. The intermediate core-plus category’s $12.7 billion of inflows was a record, beating the old mark of $10.9 billion set in December 2019.

Records fell for municipal-bond funds, too, as investors continued to hunt for sources of tax-free income. With $14.1 billion in January inflows, they blew past the previous mark of $11.2 billion set in February 2019. Prior to that, the last time muni flows hit $11 billion in a month was in September 2009 as the U.S. began to recover from the global financial crisis. Funds in the muni national intermediate category fared the best, pulling in $5.2 billion in January. That built upon a solid 2019, when the category led all muni cohorts in total flows.

Meanwhile, U.S. equity funds had their worst month since February 2018, suffering $22.5 billion of outflows. Some of this is likely due to portfolio rebalancing after a strong 2019 for U.S. equities overall. Actively managed funds felt the most pain. More than $30 billion flowed out of those products; conversely, passive options netted $7.9 billion.

International equity funds were a bright spot, taking in $18.7 billion—their best month of inflows since February 2018. On a net basis, all the money went to passively managed funds. They garnered $20 billion in January while their active colleagues saw $1.2 billion in net redemptions. Investors generally sought broad exposure to international equities. Vanguard Total International Stock Index was a top recipient of passive-product inflows, amassing $4.8 billion during the month.

Among equity categories, U.S. large-growth funds had their third-worst outflows—$9 billion—since the start of 2017. Investors’ money has been exiting that style-box segment for a while now. The category has had net redemptions every calendar year since 2004. Though its total net assets grew by nearly 137% to $1.9 trillion over that 16-year period, the outflows whittled large-growth funds’ share of the open-end/ETF universe from 16% in early 2004 to only 9% in January 2020.