Archives: Articles

IssueM Articles

Cloudy with a Chance of Lawsuits

Posted on June 22, 2017 by -

It’s been repeated often enough that many take it for fact: That the DOL fiduciary rule’s Best Interest Contract Exemption (BICE) will trigger a deluge of multi-million-dollar class-action suits against financial institutions who sign it.

But is the rule, which became effective two weeks ago, really going to unleash a wave of huge lawsuits?

“I don’t think anyone really knows the answer to this question,” a brokerage executive told RIJ recently. “I think it’s safe to assume that plaintiff’s attorneys are going to try and find holes in the process and procedures that [we] establish.” He assumes that there will be lawsuits, and that those lawsuits will test the compliance procedures that brokerages are putting in place to make sure their advisors and brokers don’t violate the letter of the BICE.

“We’re being forced to set up procedures that we think will meet the requirements of the fiduciary rule,” the executive added. “We won’t really know if our assumptions of what those procedures should be are sufficient until we see how the lawsuits play out. Take [procedures] for IRA rollovers as an example. It seems unlikely that all of [the brokerages] will do it the same way. Who can say at this point which one of us has it right?”

Uncertainty among lawyers

When we asked ERISA attorney Fred Reish of the law firm Drinker Biddle & Reath whether the BICE will open a floodgate of lawsuits against financial services firms, as opponents of the exemption have predicted, he couldn’t make a firm prediction either.

“It’s hard to say,” Reish told RIJ. “There are two vehicles for litigation for private rights. One is class-action lawsuits and the other is regular [individual] lawsuits or arbitrations. I don’t think the latter is much more of a threat than exists now. [The BIC establishes] a higher standard of care, so there could be more violations.

“Class actions are another animal,” he said. “They are expensive and time consuming. I don’t know if our system provides any really attractive solution for the average person who has been wrongfully deprived of a small amount of money by a large business. It’s unfortunate.”

Marcia Wagner and Barry Salkin of the Wagner Group, a Boston-based benefits firm, agreed with Reish. Individuals who sign a contract can already sue in state court over a contract violation, they told RIJ. Groups can also organize to file class action suits in state courts against companies they believe harmed them.

The BIC and the fiduciary rule apparently don’t change any of that. They don’t change the ability of financial services firms to require that individual claims against them be handled through arbitration.

The rule doesn’t grant any new right to file breach-of-contract suits in federal court, but such a suit could end up being heard in federal court if the case involved parties from more than one state. In that event, state law would ordinarily still apply.

The ‘private right of action’

Opponents of the fiduciary rule have already sued the DOL in federal court in Dallas, charging that the agency, for several reasons, overstepped its authority in creating the BICE. One of those reasons, according to the suit filed by the U.S. Chamber of Commerce, the Indexed Annuity Council and the American Council of Life Insurers, was that the DOL had created a new “federal private right of action” against brokerages.

The suit claimed that only Congress, not the regulatory bureaucracy, can give private citizens the right to take someone to court to enforce a federal law. In the industry’s eyes, the agency deliberately stretched the rules and packaged its tough new fiduciary standard in the form of a contract to create a path of enforcement by investors and their attorneys. The implication was that the DOL knew that it lacked adequate resources to police thousands of IRA advisors and had no power to punish them for violations of the BIC.

The IRS can levy an excise tax and force “disgorgement” of ill-gotten gains, but that’s the only federal punishment available.

Brokerages would much rather be charged with a regulatory violation—and be quietly slapped with a warning or a fine—than be the target of private breach-of-contract suits. The suits could be publicly embarrassing and cost many millions of dollars in compensatory and punitive damages. The recent wave of suits against 401(k) and 403(b) plan sponsors and service providers for violations of fiduciary duty has demonstrated that.

“The industry concern isn’t necessarily that someone shouldn’t be able to sue them for an egregious abuse,” Barry Salkin told RIJ. “Industry people are concerned that if you put the enforcement mechanism in private hands rather than with a government agency, private parties won’t enforce it in the same way as a government agency would.

“No agency will be looking for ‘gotchas’ when a company slips up,” he said. “But a private party will be looking for small technical violations” of the type that will be almost inevitable when dealing with a regulation as detailed and complex as the fiduciary rule. “There’s a fear that it will lead to frivolous suits or at least strike suits intended to force large settlements.”   

The Texas federal judge ruled in favor of the DOL. Regarding the DOL’s right to force financial institutions to sign a contract with investors, the judge wrote, “BICE’s written contract requirement is reasonable because state law breach of contract claims for IRAs existed before the rulemaking, as an annuity is a contract enforceable under traditional principles of contract law.”

For its part, the Obama DOL, in the text of its final rule, acknowledged the path it had chosen and concluded that the “potential for liability [is] critical to ensuring adherence to the exemption’s stringent standards and protections.” In the previous administration’s eyes, its cause was just.

“The contractual requirement creates a mechanism for investors to enforce their rights and ensures that they will have a remedy for misconduct. In this way, the exemption creates a powerful incentive for financial institutions and advisers alike to oversee and adhere to basic fiduciary standards, without requiring the imposition of unduly rigid and prescriptive rules and conditions,” the final rule said.

As for the danger of frivolous lawsuits that might cost advisors a lot of money, the Obama DOL believed that the court system knows how to handle that problem. The final rule said, “While the warranty exposes financial institutions and advisers to litigation risk, these risks are circumscribed by the availability of binding arbitration for individual claims and the legal restrictions that courts generally use to police class actions.”

Although the federal courts have upheld the legitimacy of the BICE, that could change. Given the ambiguities of the situation—the vagueness of “best interest,” the overlapping of DOL and SEC jurisdictions in the realm of brokerage IRAs, and even the possibility of finding a friendlier judge—more lawsuits are likely to test the rule.

Alternately, the Trump DOL could decide before January 1, 2018 (the ultimate deadline for compliance with the rule) that the fiduciary rule’s overall burden on the financial advice industry, including potential litigation costs, outweighs its anticipated benefits to the public. That would be a step toward possible repeal.    

© 2017 RIJ Publishing LLC. All rights reserved. 

The Tell-Tale Brokerage Statement

Posted on June 22, 2017 by -

An acquaintance recently sent me a copy of his monthly brokerage IRA statement. One of the biggest financial services firms in the U.S. had issued it. In fact, it was a firm that has signed a Department of Labor “Best Interest Contract” (BIC) so that its advisors could sell indexed and variable annuities on commission without committing a “prohibited transaction.”

But the details of the monthly statement made me wonder if the big brokerages might underestimate their vulnerability to lawsuits for BIC violations.   

For instance, the brokerage statement showed that about 40% of the client’s IRA savings was invested in about 20 actively managed funds. Nine of those funds had expense ratios over 200 basis points, and six had expense ratios between 150 and 200 basis points. Without those funds, the client would still be well diversified in much cheaper passive funds. 

The acquaintance sent me the statement in part because he and his wife couldn’t tell how much they were paying in fees for their investments. I looked through the statement and, without looking up each fund’s expense ratio and multiplying it by the client’s position in the fund, I couldn’t tell either. The client also sent me the statement because his advisor had recommended a variable annuity with a lifetime withdrawal benefit.

I gave the person a list of questions to take back to his advisor. The advisor couldn’t tell him how much he was paying in fees on the IRA holdings or how much the variable annuity would cost. When asked about the commission on the annuity, the advisor said he wouldn’t have to worry about that because the employer paid the commission.

If a lot of the brokerage’s statements looked like this one—I’m assuming it was typical, but maybe it wasn’t—then this client’s best interests were not being served. And, assuming that failure to disclose fees or to use expensive funds in an IRA was intentional—to maximize the interest of the company—then this national firm seemed to offer plaintiff’s attorneys rich material for lawsuits for breach of the Best Interest Contract. 

So, while financial industry compliance lawyers might be burning their legal desk lamps all night trying to make their firms invulnerable to specific violations of the letter of the fiduciary rule, they might be overlooking clear violations of the spirit of the rule—violations that the firms commit simply by having a certain business model.

For instance, the advisor in this story is an employee in a publicly held firm. The primary responsibility of the management of a stock company is to maximize shareholder value. The primary responsibility of an employee-advisor is to his or her manager. How can that advisor always act in the client’s best interest?

It also turned out that this advisor was unfamiliar with certain important retirement income products, like qualified longevity annuity contracts. Without knowing all of the income options available, and without training in the use of these options, how could the advisor act in the client’s best interest?

Although financial intermediaries call themselves “advisors” when working with clients, they are known within the industry by other names, such as “producers” (who are most valued by their companies for recruiting high net worth clients and enhancing assets under management) or “distributors” (whom product manufacturers rely to bring more money into their companies). It won’t be easy to change the culture or the business model that this vocabulary signifies.

The Obama DOL was idealistic but naïve in its apparent belief that all financial intermediaries could meet the same high standard of conduct, regardless of the business models of their firms. It was always blindly unrealistic to expect employees of public companies, whose job is to produce or distribute or meet departmental goals, to be as loyal to clients as self-employed hourly-fee planners. But these conflicts of interest are not superficial or exceptional or easy to change.   

If big financial services firms don’t correct (or can’t justify) the kinds of habits embedded in the IRA brokerage statement I saw, then there might be a lot of BIC lawsuits. On the other hand, if those kinds of habits can persist, then the fiduciary rule may be too weak to help retirement investors much. 

© 2017 RIJ Publishing LLC. All rights reserved.

Wealthfront angles for upmarket clients

Posted on June 22, 2017 by -

Even as wirehouses and wealth management firms consider using digital automation to serve smaller-balance clients, Wealthfront, one of the first robo-advice firms, has added services exclusively for clients who bring $500,000 or more in taxable assets.

Wealthfront describes the service, called “Advanced Indexing,” as an improvement on “smart beta.” It is part of Wealthfront’s PassivePlus suite, which includes daily tax-loss harvesting and stock-level tax-loss harvesting known as Direct Indexing. The services cost a combined 0.25% annual expense ratio. 

In a release, Wealthfront gave credit for Advanced Indexing to its chief investment officer, Burton Malkiel, Ph.D. (author of the evergreen investment bible, “A Random Walk Down Wall Street”) and its vice president of research director, Jakub Jurek. Wealthfront also said it licenses PassivePlus from CSSC Investment Advisory Services, Inc. of Troy, Michigan.

Former trader Daniel Carroll founded in 2008 as KaChing, a website where professional investors managed virtual portfolios on KaChing and thousands of amateurs logged on to watch and mimic the trades in their own portfolios.

In 2009, KaChing began offering subscribers the ability to set up brokerage accounts that automatically mirrored the trades of professional money managers. The company changed its name to Wealthfront in 2010, after venture capitalist Andy Rachleff joined as CEO. Malkiel joined as CIO in November 2012. Wealthfront says it has $6 billion under management.

Advanced Indexing adds a level of sophistication to Wealthfront’s regular managed account offering. Where the basic service aims for a 50-50 equity-fixed income split using ETFs, Advanced Indexing divides the equity half into 30% individual stocks and 20% broad market equity ETFs, according to a white paper on Wealthfront’s website.

The weights of the individual securities are determined through a smart-beta or factor strategy, which uses five factors that affect future returns: value, momentum, dividend yield, market beta and volatility. The use of individual securities instead of ETFs lowers management expenses and raises the return on the equity portion of the account by about one%, Wealthfront claims.

There are two portfolio levels of Advanced Indexing. The first level involves holding 500 individual domestic stocks and has a minimum after-tax investment of $500,000. A higher level involves holding 1,000 individual domestic stocks and has a minimum after-tax investment of $1 million. The combined portfolio is subject to Wealthfront’s 0.25% advisory fee.

Advanced Indexing is bundled with Direct Indexing, a stock level tax-loss harvesting service that Wealthfront launched in 2013. It is available on accounts with balances of $100,000 or more. By using individual U.S. equity securities instead of total stock market ETFs, it lowers the portfolio’s expense ratio and enables more tax loss harvesting, which offsets its higher trading costs.

CSSC says on its website that “as of May 4, 2010, [we] patented decision-assistance technologies and methodologies that enable us to deal with the mass of information needed to comparatively evaluate such an expanded universe of choices. With it, we should be able to select any number of performance parameters, and separately weight each one, in order to score and rank the entire universe of available choices in a manner specific to each client’s individual needs. 

“Through use of this unique, new decision-assistance technology, we would enable consumers to determine for themselves which financial products and investment choices are truly best for them (fully objective, transparent and uninfluenced by the marketing hype, advertising claims, behind the scenes deals and relationships, and without any of the sales pressures, all too common within the traditional financial services marketplace).”

© 2017 RIJ Publishing LLC. All rights reserved.

Research supports investing Social Security funds in equities

Posted on June 22, 2017 by -

Given all the reasons not to talk about Social Security—politicians would rather discuss cutting taxes, repealing Obamacare or investigating the president—it’s not surprising that so little is heard lately about patching the program’s demographically-driven funding hole.

But when the Old Age and Survivors Insurance program regains the spotlight, as it will eventually, policymakers will probably consider investing some of Social Security’s excess tax receipts in U.S. equities, as a recent report from the Center for Retirement Research at Boston College recommends.

“Investing a portion (a maximum of 40%) of Social Security trust fund assets in equities would reduce the need for greater payroll tax contributions or benefit reductions,” said the May Issue Brief. “If equity investment had begun in 1984 or 1997, trust fund assets would be higher than they are currently, despite two major stock market slumps and a financial crisis.”

Investing trust fund assets in equities instead of special-issue U.S. Treasury bonds would not be anymore disruptive to the stock market than the equity investing that U.S. state governments already do, wrote Gary Burtless of the Brookings Institution, Alicia Munnell, the director of the CRR, and CRR researchers Anqi Chen and Wenliang Hou.

In addition, “equity investments could be structured to avoid government interference with capital markets or corporate decision making; and accounting for returns on a risk-adjusted basis would avoid the appearance of a free lunch,” they wrote.

The idea of invigorating Social Security’s investment returns with equities isn’t new. It came up two decades ago when then-President Clinton asked the 1994-1996 Social Security Advisory Council to consider options to achieve long-term solvency. It came up again when the George W. Bush administration was considering letting taxpayers direct part of their Social Security contributions into private defined contribution accounts.

The CRR paper doesn’t suggest that Social Security should include individual accounts, or that the program turn into a hybrid of defined benefit and defined contribution.  They suggest that the equity investment start small and build up incrementally over many years until reaching a maximum of 40%. 

Despite their confidence in the higher returns of equities over risk-free government bonds, the authors expect equity returns to be lower in the future than in the past. The average price/earnings ratio of U.S. stocks, which was 25.8 as of last December, suggests future real returns of 3.9%.

The current cyclically adjusted P/E (CAPE) ratio is 28.7 (as of February 2017), suggesting a future long-term return of 3.5% percent. Assuming, as an alternative, that the growth rate of stock prices will equal the growth rate of GDP, the forecast is for 4.3% average real equity returns. The median projection for future returns, the authors write, is 3.9% real and 6.6% nominal.

© 2017 RIJ Publishing LLC. All rights reserved.

Most advisors still many megabytes shy of a digital practice, says Fidelity (owner of eMoney)

Posted on June 22, 2017 by -

Imagine a new luxury sedan without lane departure warnings. Imagine an upscale hotel without free Wi-Fi in the lobby. Imagine a Wall Street trader without a Bloomberg. Imagine yourself without a smartphone. Imagine a restaurant that still serves cappuccino in those tall transparent ‘Irish coffee’ glasses. 

Now imagine a 21st century financial advisor who:

  • Doesn’t engage with clients on social media
  • Doesn’t use Google analytics to track website traffic
  • Doesn’t offer e-signature and e-delivery
  • Doesn’t use video conferencing
  • Doesn’t use automated email alerts and text messages

Sad, right? Often the case? Yes. Only 40% of advisors do those things, according to the Fidelity 2016 eAdvisor Study sponsored by Fidelity Clearing & Custody Solutions (FCCS), a unit of Fidelity Investments. But it beats the same survey’s 2014 results, when only 30% of advisors were tech-savvy enough to be called “eAdvisors” by Fidelity.

Fidelity, incidentally, owns eMoney Advisor, the advisor technology firm. So like Broadridge, FIS, Advicent and other digital technology firms that are all campaigning these days for the adoption of their products by brokerages and advisors (and predicting the imminent failure of those who don’t), the retirement industry giant has a horse in this race.       

Fidelity’s new survey says that “eAdvisors” (whom it defines as using twice as many different technologies as their peers) enjoy: 

  • 42% higher assets under management (AUM) than tech-indifferent advisors, up from 40% higher AUM in 2014
  • 35% more AUM per client than tech-indifferent advisors, up from a 14% gap between eAdvisors and their tech-indifferent peers in 2014
  • More $1M+ clients than tech-indifferent advisors
  • 24% higher compensation than tech-indifferent advisors
  • Higher satisfaction with their firm and career than tech-indifferent advisors

In addition, 54% of eAdvisors have client segmentation strategies, versus 40% of “tech indifferent” advisors. eAdvisors are also more likely to serve Gen X/Gen Y clients and to have plans to add digital advice technology within the next two years.

Based on the 2016 eAdvisor study findings, Fidelity identified four best practices that eAdvisors tend to employ:

  • Embrace a strong online presence to generate leads and engage with prospects and clients
  • Use technology to both simplify and enhance the client experience
  • Take advantage of technology solutions to create a holistic view of clients’ lives
  • Communicate and collaborate via technology to maintain and deepen client relationships

The survey also found that:

  • 64% of eAdvisors have a clear call-to-action on their websites than other advisors (35%), and more likely to utilize compelling visual images and content to engage visitors.
  • 94% of eAdvisors engage with clients/prospects on social media (Facebook, LinkedIn or Twitter) compared with 74% of tech-indifferent advisors.
  • 54% of eAdvisors use Google Analytics to track website traffic, versus only 28% of tech-indifferent advisors.
  • Two-thirds of eAdvisors offer clients e-signature options and nearly all provide e-delivery of statements and reports directly via email, as well as online access to such documents (95% and 94%, respectively).
  • 77% of eAdvisors provide interactive or visual reports, versus 38% of tech-indifferent advisors.
  • 87% of eAdvisors use data aggregation tools to provide the total picture of clients’ assets and liabilities. This is an 18% increase in use from eAdvisors in Fidelity’s 2014 study and nearly double the number of non-eAdvisors using such tools (46%).
  • 53% of eAdvisors use automated email alerts for client updates and 35% send text messages regarding updates or administrative tasks (versus 19% and 18% of tech-indifferent advisors, respectively).
  • More than half (52%) of eAdvisors communicate with clients via videoconferencing or online conferencing.
  • 65% of eAdvisors use collaboration technology in five or more ways with their clients, versus only 25% of tech-indifferent advisors.

Fidelity has developed a brief quiz for advisors interested in learning how they stack up on the “eAdvisor” scale, according to a recent release. The quiz asks advisors about their use of technology and, based on their feedback, identifies opportunities for integrating technology more deeply into their practices.

© 2017 RIJ Publishing LLC. All rights reserved.

Honorable Mention: Cimini goes to Voya, ‘smart beta’ coming to TDFs, and more

Posted on June 22, 2017 by -

Cimini to lead Voya’s retirement product business

Voya Financial has hired Jeff Cimini to lead its Retirement Product organization, the company announced this week. He will oversee product management, development, strategy, pricing, competitive intelligence, Voya Institutional Trust Company, and Voya’s advisory services for plan sponsors and participants.   

Cimini will be based in Voya’s Windsor, Connecticut office.  He will be a member of the Retirement leadership team and report to CEO of Retirement Charlie Nelson, effective July 3.

Most recently, Cimini was head of strategy for TIAA’s Institutional Financial Services division, and also served as head of sales and client services for TIAA’s select institutional clients.  Previously, he was head of Personal Retirement for Bank of America Merrill Lynch. He also spent more than 20 years with Fidelity Investments.  

Cimini’s experience includes stable value portfolio management, fund analysis, investment consulting and sales, consultant relations, defined contribution investment only (DCIO) sales and investment consulting services. He managed sales and distribution for the Fidelity Investments Life Insurance Company division and served as president of its three life insurance entities.

Cimini holds a bachelor’s degree in finance from the University of Massachusetts at Amherst and a Masters in finance from Boston College.

Strategic beta: An edge for active TDF makers?

How do active managers slow down investors’ flight to passive funds? Some of them will adopt “strategic beta” techniques, according to survey results published in the second quarter 2017 issue of The Cerulli Edge–U.S. Retirement Edition 

“Use of strategic beta strategies is the most likely feature of next-generation U.S. target-date products” was the sentiment of 38% of asset managers polled by Cerulli Associates, the Boston-based consulting firm.

“Strategic beta” used to be called “smart beta.” The term generally refers to a form of indexing where fund managers systematically overweight an index portfolio toward securities with attributes that are associated with higher returns, such as momentum or volatility.   

The goal is to achieve higher risk-adjusted returns than conventional market-cap-weighted index funds, at a cost somewhere between the cost of active funds and index funds. Whether it allows investors to defy the inherent correlation between risk-and-return by delivering higher returns without more risk hasn’t been proven, according to Morningstar.     

But it’s the kind of differentiator that actively managed TDF manufacturers can use in their fight against pure indexing. They could use strategic beta, for instance, to try to mitigate TDF investors exposure to “sequencing risk” as they approach retirement, beyond just changing a fund’s asset allocation.

(Sequencing risk is the risk to near-retirees or recent retirees that an ill-timed stock slump might force them to liquidate depressed assets for current income, thereby locking in losses.)

“Strategic beta strategies allow active managers to compete with pure passive on cost while retaining some of the value-add tenets associated with active management,” said Dan Cook, analyst at Cerulli, in a release. 

“For the larger target-date providers, strategic beta series can also serve as another option in their target-date product suite, giving plan sponsors the choice between passive, active, and strategic beta.”

But adding strategic beta to TDFs will likely “add another layer of complexity to the due diligence process” for defined contribution retirement plan sponsors and fiduciaries,” Cerulli noted. Asset managers who promote this potential enhancement must be prepared to explain and document its benefits.

Federal class action suit against Voya is dismissed

A 401(k) class action lawsuit that involved plan sponsor Nestle, recordkeeper Voya Financial and managed account provider Financial Engines has been dismissed by a federal district court judge in New York, NAPA net reported this week.

The suit, filed by participant Lisa Patrico and others in September 2016, claimed that Voya had breached its fiduciary duty to participants when it allegedly devised an arrangement with Financial Engines to collect excessive fees for investment advice services.

The judge disagreed. “The Complaint fails to allege facts showing that Defendants were ERISA fiduciaries with respect to their fees,” wrote Judge Lorna G. Schofield of the U.S. District Court for the Southern District of New York.

© 2017 RIJ Publishing LLC. All rights reserved.

What Keeps Equities Aloft: Grantham

Posted on June 21, 2017 by -

We value investors have bored momentum investors for decades by trotting out the axiom that the four most dangerous words are, “This time is different.” For 2017 I would like, however, to add to this warning: Conversely, it can be very dangerous indeed to assume that things are never different.

Of all these many differences, the most important for understanding the stock market is, in my opinion, the much higher level of corporate profits. With higher margins, of course the market is going to sell at higher prices. So how permanent are these higher margins? I used to call profit margins the most dependably mean-reverting series in finance. And they were through 1997.

So why did they stop mean reverting around the old trend? Or alternatively, why did they appear to jump to a much higher trend level of profits? It is unreasonable to expect to return to the old price trends—however measured—as long as profits stay at these higher levels.

So, what will it take to get corporate margins down in the US? Not to a temporary low, but to a level where they fluctuate, more or less permanently, around the earlier, lower average? Here are some of the influences on margins (in thinking about them, consider not only the possibilities for change back to the old conditions, but also the likely speed of such change):

  • Increased globalization has no doubt increased the value of brands, and the US has much more than its fair share of both the old established brands of the Coca-Cola and J&J variety and the new ones like Apple, Amazon, and Facebook. Even much more modest domestic brands—wakeboard distributors would be a suitable example—have allowed for returns on required capital to handsomely improve by moving the capital-intensive production to China and retaining only the brand management in the US. Impeding global trade today would decrease the advantages that have accrued to US corporations, but we can readily agree that any setback would be slow and reluctant, capitalism being what it is, compared to the steady gains of the last 20 years (particularly noticeable after China joined the WTO).
  • Steadily increasing corporate power over the last 40 years has been, I think it’s fair to say, the defining feature of the US government and politics in general. This has probably been a slight but growing negative for GDP growth and job creation, but has been good for corporate profit margins. And not evenly so, but skewed toward the larger and more politically savvy corporations. So that as new regulations proliferated, they tended to protect the large, established companies and hinder new entrants. Corporate power, however, really hinges on other things, especially the ease with which money can influence policy. In this, management was blessed by the Supreme Court, whose majority in the Citizens United decision put the seal of approval on corporate power over ordinary people. Maybe corporate power will weaken one day if it stimulates a broad pushback from the general public as Schumpeter predicted. But will it be quick enough to drag corporate margins back toward normal in the next 10 or 15 years? I suggest you don’t hold your breath.
  • It is hard to know if the lack of action from the Justice Department is related to the increased political power of corporations, but its increased inertia is clearly evident. There seems to be no reason to expect this to change in a hurry.
  • Previously, margins in what appeared to be very healthy economies were competed down to a remarkably stable return—economists used to be amazed by this stability—driven by waves of capital spending just as industry peak profits appeared. But now there is plenty of excess capacity and a reduced emphasis on growth relative to profitability. Consequently, there has been a slight decline in capital spending as a percentage of GDP. No speedy joy to be expected here.
  • The general pattern described so far is entirely compatible with increased monopoly power for US corporations. Put this way, if they had materially more monopoly power, we would expect to see exactly what we do see: higher profit margins; increased reluctance to expand capacity; slight reductions in GDP growth and productivity; pressure on wages, unions, and labor negotiations; and fewer new entrants into the corporate world and a declining number of increasingly large corporations. And because these factors affect the US more than other developed countries, US margins should be higher than theirs. It is a global system and we out-brand them.
  • The single largest input to higher margins, though, is likely to be the existence of much lower real interest rates since 1997 combined with higher leverage. Pre-1997 real rates averaged 200 bps higher than now and leverage was 25% lower. At the old average rate and leverage, profit margins on the S&P 500 would drop back 80% of the way to their previous much lower pre-1997 average, leaving them a mere 6% higher. (Turning up the rate dial just another 0.5% with a further modest reduction in leverage would push them to complete the round trip back to the old normal.)

This neat outcome tempted me to say, “Well that’s it then, these new higher margins are simply and exclusively the outcome of lower rates and higher leverage,” leaving only the remaining 20% of increased margins to be explained by our almost embarrassingly large number of other very plausible reasons for higher margins such as monopoly and increased corporate power.

But then I realized that there is a conundrum: In a world of reasonable competitiveness, higher margins from long-term lower rates should have been competed away. (Corporate risk had not materially changed, for interest coverage was unchanged and rate volatility was fine.) But they were not, and I believe it was precisely these other factors—increased monopoly, political, and brand power—that had created this new stickiness in profits that allowed these new higher margin levels to be sustained for so long.

So, to summarize, stock prices are held up by abnormal profit margins, which in turn are produced mainly by lower real rates, the benefits of which are not competed away because of increased monopoly power.

© 2017 GMO LLC.

This Couple Needs Your Advice

Posted on June 15, 2017 by -

A friend, now 64 years old and near retirement, recently asked me for suggestions about income planning. Despite relatively ample savings and real wealth, he and his wife aren’t sure if they can afford to stop working for the next 20 years or more. 

Though not members of America’s “one percent,” this self-employed professional couple is comfortable. They hold some $1.2 million in brokerage accounts at one of the big regional firms. They own two homes, valued at $1.23 million and $435,000.

The couple likes and trusts their current broker/advisor. Their well-diversified accounts have been growing. But the broker can’t answer detailed questions about the amount of fees they pay. For future income, she offered just one suggestion, that they invest $400,000 in one of her own firm’s variable annuities, which offers a living benefit and deferral bonus. 

How would you advise this couple? As a broker, advisor or planner, how you would solve their “case” based on the rough numbers provided in the boxes below? We’d like to hear about solutions that would help them:

  • Build a safe bridge from now to retirement, minimizing sequence of return risk.
  • Fill the gap between their desired retirement income and income from existing guaranteed sources.
  • Cover their sons’ graduate school expenses if necessary.
  • Travel abroad each year in early retirement.
  • Maintain their homes, both built in 1989.
  • Generate $50,000 to $70,000 per year from savings.
  • Protect this healthy, active couple from longevity risk.
  • Assure a legacy of $500,000 or more per child.

Here are a few essential facts about the couple, whom will call “Andrew” and “Laura.” They earned a combined $303,000 last year from their business ($200,000 AGI), which they will shut down when they retire. They also earned $27,600 from renting their second home. Andrew is 64 years old and plans to work until age 70 (while reserving the right to retire earlier).

Laura is 63 years old and would like to start working part-time immediately, which will reduce the couple’s income. Starting at age 65, she’ll begin receiving $585 per month from a pension that has an optional lump-sum value of $85,000. They have long-term care insurance.

Andrew and Laura will have a significant shortfall in guaranteed retirement income.  They expect to receive a combined $60,000 each year in Social Security benefits if they both claim at full retirement age, but $81,000 if they both claim at age 70. They will also receive about $7,000 from Laura’s pension. They would like a total of $140,000 in real pretax retirement income. So they have an “income gap” of $50,000 to $70,000.      

Here’s some of the data Andrew and Laura provided:

Case History asset allocation

Case history qualified accounts

Case history balance sheet

What would you tell Andrew and Laura to do? Take systematic withdrawals? Practice the 4% rule? Use time-segmentation or buckets? Set up a bond ladder? Buy immediate and/or deferred annuities? Luckily, their level of savings gives them (and you) a lot of options.   

Submit your income planning ideas by July 1, 2017. Be as specific (given the limits of the data) or as general as you wish. Explain how you would be compensated and provide a ballpark figure of annual advisory and investment costs. Tell us what type of broker, advisor or planner you are, what licenses/degrees/designations you have and how you usually get paid. We’ll publish your suggestions in a future issue.

© 2017 RIJ Publishing LLC. All rights reserved.

Don’t cut Medicaid, say Ivy League doctors

Posted on June 15, 2017 by -

Health care experts at MIT and Harvard protested the government’s threatened cuts to Medicaid, pointing out in an op-ed in the New York Times this week that “roughly one in three people now turning 65 will require nursing home care” and that Medicaid will eventually cover “over three-quarters of long-stay nursing home residents.” Though that will be a minority of U.S. retirees, it still means millions of people, including members of the middle class.

David Grabowski of Harvard Medical School, Jonathan Gruber of MIT and Vincent Mor of Brown University wrote in protest of the American Health Care Act, which has passed the House and is now with the Senate. The AHCA would cut Medicaid by over $800 billion. The budget released by President Trump last month would cut another $600 billion over 10 years, they said.   

According to research by Grabowski, Gruber and Mor:

¶ Medicaid accounts for one-sixth of all health care spending in the United States. Nearly two-thirds of its budget pays for older and disabled adults, primarily through long-term care services in nursing homes. Medicaid pays nearly half of nursing home costs for those suffering from the effects of Alzheimer’s or stroke.

¶ In some states, overall spending on older and disabled adults amounts to as much as three-quarters of Medicaid spending. They will be harmed if the program shrinks by 25% (as under the A.H.C.A.) or almost 50% (as under the Trump budget). If those cuts are made, many nursing homes would turn away Medicaid recipients as well as those who might need Medicaid eventually. Many older and disabled Medicaid beneficiaries will have nowhere else to go, they said. 

¶ Lower Medicaid reimbursement rates would likely cause reductions in nursing home staffing, particularly of nurses. A 10% lower reimbursement rate leads to an almost 10% decline in the ability of nursing home residents to perform common functions of daily living. It raises their odds of persistent pain by 5%, and the odds of a bedsore by two percent.

¶ Lower-quality nursing home care would lead to more hospitalizations and higher costs for Medicare. Each year, one-quarter of nursing home residents are moved to hospitals, where the daily costs are more than four times as high. A 10% reduction in nursing home reimbursements causes a five percent rise in the chance that a resident will need to be hospitalized.

© 2017 RIJ Publishing LLC. All rights reserved.

Three Lessons Learned

Posted on June 15, 2017 by -

A Philadelphia electronics tycoon who made his fortune manufacturing resistors and capacitors for the computer industry once told me in an interview that he’d learned his most important business lesson when he was still a young boy in 1930s Belarus. 

He said: “My father told me, Someday a man will put a lot of money on a table.  He’ll tell you, ‘It’s yours. Take it. Don’t worry, no one will ever know what happened here.’ But don’t take it. Even if you’re sure that no one will ever know, leave the money on the table.”

I still don’t know exactly what that story meant, aside from being a general admonition about the wisdom of honesty, but I’ve never forgotten it.

As someone famously wrote, a person can learn everything he or she really needs to know before graduating from kindergarten. In my case, it took a while longer. By my late 20s, however, life had taught me a few homely but memorable lessons about leadership, entrepreneurship, and cross-cultural relations.

Hard lesson from softball

Every August, my scout troop camped for a week in eastern Pennsylvania. We canoed, hiked and played softball. During my last summer in the troop, I was captain of one of the two softball teams. We would slug it out every afternoon through the week.

No one told us how to choose up sides, so before the first game I quickly and quietly recruited the best, most athletic players. No one objected, not even the other captain. And every afternoon, for six consecutive afternoons, my team dominated the other side. We routinely “batted around” on offense and shut out our opponents on defense.

I felt an unfamiliar sense of pride: I may have been a so-so ballplayer, but I was clearly a gifted manager. The pride, however, preceded a sudden fall.

Before the seventh and last game, the assistant scoutmaster approached me. He said it was time to break up my team and create at least one fair contest before camp ended. I felt ashamed—especially when I sensed his disappointment that I didn’t reach that conclusion on my own. The lesson: Good leaders look out for the larger group.

Everyone in the ‘swim pool’

In June of tenth grade, a friend and I wanted to celebrate the conclusion of a game we had organized in emulation of the plot of a movie called The 10th Victim, which neither of us had seen. (Our version was like “tag,” but more extended and elaborate. It gave boys an excuse to introduce themselves to girls, and vice-versa.)

But how should we organize the celebration? Biking near a golf-and-swim club a few days later, I stopped to ask the pool manager if he would rent me the pool for an evening. He said yes. The price was $50. That was a low hurdle even then, and I thought, forget The 10th Victim; I’ll ask everybody at school to contribute a buck to a “swim pool.” Brilliant. It seemed like a smoking-hot idea right up until 7:20 Monday morning, when I faced my homeroom classmates and thought, “This will never work.”

I was wrong. Before the bell rang, my pockets were stuffed with grimy, crumpled portraits of George Washington. By the end of last period, I had a roll of over $120. I paid the swim club manager his $50 and bought a trunk-load of hamburgers, soda and chips.

The following Saturday night, dozens of kids were splashing around in the Olympic-sized pool. I worked all through the party, bagged trash afterwards and cleared $10 for myself. I don’t remember meeting any of the girls. But I learned about an invisible energy in the universe called entrepreneurship.

When in Romania   

Years later I was ordering kabobs at a food kiosk in a government-run seaside resort in Romania. That sad country was still ruled by the bloody Ceausescu regime. I was traveling with (and covering, as a reporter) a college jazz band on a goodwill tour sponsored by the US Department of State.

A dozen of us had just returned from the Black Sea beaches, and we were famished. But there was a long queue at the kabob stand, and none of us had the energy or patience to stand in it. Somehow I was appointed to take kabob orders for everybody and to wait in line while they relaxed.

Eventually I reached the kiosk window and ordered 18 lamb kabobs. Big mistake. The cook and then the crowd lined up behind me exploded in protest when they realized what I was doing. Our efficient American strategy, which made perfect sense to us, didn’t play well here.  

Maybe they got angry because they were, after all, Communists. Or maybe any line of hungry people would have rebelled when they saw how long my 18-kabob order would make them wait. On the other hand, they’d have waited just as long if our whole group had lined up, or so I wanted to frame it.

But it was the egalitarian principle that mattered to the Romanians—one customer, one or two kabobs—and, as strangers in a strange land, we should have thought more carefully before bucking the system in our oblivious American way. The lesson: When in Rome, or Romania, heed the local customs.

The best perk

The electronics manufacturer mentioned at the beginning of this story was the late Felix Zandman, founder of Vishay Intertechnology, a company he named after his parents’ village. They died in Nazi camps; the teenage Zandman spent much of World War II crouched in a root cellar. He described his cinematic life in the book, “Never the Last Journey.”

When I met Zandman, he was still in his mid-60s. Over his career, he had invented photo-elastic coatings, which enabled the stress-analysis of aluminum aircraft wings without dangerous test flights. He had developed resistors that allowed jet fighters to warm up and take off faster and warp-resistant barrels that gave tanks greater firing range. 

At the end of our conversation, I asked a callow question. I knew from his biography that he owned homes in the U.S. and Europe and decorated them with expensive art. More than one sovereign government had honored him. He was able to pay an author $100,000 just to write his life story.

I wanted to know: Of all these perks, what did he like best about being rich? Looking through a window at the four-door Lincoln parked outside his office, he said with satisfaction, “Having a car and driver.”

© 2017 RIJ Publishing LLC. All rights reserved.

In fiduciary suit, Northrop Grumman settles with participants for $16.75 million

Posted on June 15, 2017 by -

Northrop Grumman has reached a $16.75 million settlement with its employees and retirees, represented by Schlichter, Bogard & Denton law firm, who had alleged that Northrop fiduciaries violated their fiduciary duties to participants in two 401(k) retirement plans, by “improperly causing those plans to pay Northrop for administrative services.”

The parties filed a motion for approval of the settlement Tuesday before Judge Andre Birotte Jr. of the U.S. District Court for the Central District of California. 

Schlichter first filed the Northrop case in 2006. The trial began in Los Angeles on March 14, 2017, and the settlement was reached after three days. The settlement covers conduct between Sept. 28, 2000 and May 11, 2009.

The settlement does not cover claims raised in Marshall v. Northrop Grumman Corp., a second case against Northrop filed by Schlichter, Bogard & Denton on September 9, 2016. It has similar allegations for conduct from 2010 to the present Marshall v. Northrop remains pending in the same court.

Schlichter, Bogard & Denton pioneered excessive fee 401(k) litigation on behalf of employees and retirees. Since 2006, the firm has filed over 20 such complaints and secured 13 settlements on behalf of employees. In 2009, the firm won the only full trial of a 401(k) excessive fee case against ABB. In 2015, the firm achieved a unanimous victory on behalf of employees, in the only 401(k) excessive fee case taken by the U.S. Supreme Court. In 2016, the firm brought excessive fee suits against 12 major universities with defined contribution retirement plans.

© 2017 RIJ Publishing LLC. All rights reserved.

A target date fund for RMDs, from Fidelity

Posted on June 15, 2017 by -

Fidelity’s new Simplicity RMD mutual funds are designed to make it easier for people over age 70 to rebalance their tax-deferred holdings after taking Required Minimum Distributions. In 2017, the first Baby Boomers will reach age 70½, the age when annual RMDs become mandatory.

The fund series “combines an age-appropriate and professionally-managed investment strategy with an optional automated calculation and distribution method to satisfy annual RMD requirements on the investor’s behalf,” said a Fidelity release this week.

Each Fidelity Simplicity RMD Fund consists of a blend of equity, fixed-income and short-term Fidelity mutual funds. The blend automatically becomes more conservative as an investor ages. Each fund name includes a date, and investors choose the fund that aligns with the year they turn 70.

The Fidelity Simplicity RMD Funds with longer time horizons will invest in a greater percentage of equities, while the funds with shorter time horizons will emphasize fixed-income and short-term assets.

There are five Simplicity RMD Funds. Those with longer time horizons hold higher percentages of equities:

  • Fidelity Simplicity RMD Income
  • Fidelity Simplicity RMD 2005
  • Fidelity Simplicity RMD 2010
  • Fidelity Simplicity RMD 2015
  • Fidelity Simplicity RMD 2020

For example, a traditional IRA owner who turned 70½ in 2015 would select the Simplicity RMD 2015 Fund. The table below shows the ranges of investor birth dates for which each fund was created and each fund’s total expenses. 

Fidelity Chart

Once people invest in a Simplicity RMD Funds, they can set up distributions through Fidelity’s automatic withdrawals service. Fidelity automatically calculates and distributes the investor’s RMD each year, monitoring withdrawal activity.

To support the Fidelity Simplicity RMD Funds, Fidelity offers these resources:

  • ‘Viewpoints’ articles about taking RMDs by the IRS deadline, and how to include RMDs as part of an overall retirement income strategy
  • Answers to frequently-asked questions about RMDs
  • An RMD calculator to help determine annual minimum distribution amounts
  • Access to Fidelity’s online Retirement Distribution Center, which estimates each account’s RMD and allows customers to set up, track and manage IRA withdrawals 
  • Fidelity’s Learning Center, providing a variety of resources, including: “To delay or not to delay? Options for taking your first Minimum Required Distribution (MRD)”

© 2017 RIJ Publishing LLC. All rights reserved.

Political turmoil sidelines UK pension reform

Posted on June 15, 2017 by -

A review of the UK’s defined benefit (DB) pension system has been cast into doubt by last week’s election result, when the Tories lost their majority in the House of Commons, IPE.com reported.

The Conservative Party pensions minister had begun to review DB plan regulation, and the Department for Work and Pensions (DWP) published a “green paper” on the topic last February.  

Now all bets on pension review are off. With negotiations about the UK’s exit from the European Union—i.e., “Brexit”—due to occur in less than two weeks, former Labor pensions spokesman Gregg McClymont said major pension reforms were unlikely soon. “A delay was always likely given Brexit. This has just taken it to a new level,” he said.

Theresa May had also reduced the post of pension minister to an undersecretary role in her administration, he added, which means that pensions have a weaker voice.

The DWP green paper would not be scrapped outright, however, said Sir Steve Webb, a pensions minister from 2010 to 2015. Now director of policy at Royal London, Webb said: “The government can’t do anything particularly bold – a big shakeup of pension tax relief for example. It would have to be targeted and incremental.”

With 318 seats—13 fewer than before the election and eight short of a majority–the Conservative Party is still remains the largest party in the UK parliament. To create a majority, it may form a coalition with Northern Ireland’s DUP, which has 10 seats. Labor picked up 29 seats in the election.

“Age has become an issue – it’s a party political divide in a way it has not been before,” McClymont said. “Younger voters have [always] supported Labor but the extent of the correlation is unheard of. It’s driven by economic reality.

“If you’re under 40 your income has been eroding and your ability to grow wealth assets is almost non-existent. You could argue that the parties’ promises need to catch up with that. We might get into a bidding war between who can promise the most to younger generations.”

As a result, over time auto-enrolment could become a bigger political issue, he added, as more people entered the pension savings arena and saving levels rose. Kevin LeGrand, president of the Pensions Management Institute, echoed that view:

“At this early stage it looks like the younger generation have been influential in changing the political landscape. If that proves to be correct, the recent focus of policies on pensioners’ interests on the basis of the strength of the grey vote may be reversed. This could result in a different policy approach between the generations.”

© 2017 IPE.com.

Honorable Mention

Posted on June 15, 2017 by -

TIAA completes purchase of Everbank

TIAA has completed its acquisition of EverBank Financial Corp and its wholly owned subsidiary EverBank. The transaction was originally announced August 8, 2016.

“The acquisition significantly expands TIAA’s existing retail banking and lending products and complements the company’s full suite of retirement, investment and advisory services,” and will allow TIAA to continue to serve its more than 15,000 institutional clients, a TIAA release said.

This acquisition also gives TIAA an employee base and business operations in Jacksonville, Florida, the bank’s headquarters, and other key markets.  TIAA also plans to continue to expand its digital capabilities for banking customers.

EverBank reported $27.8 billion in total assets and $19.3 billion in total deposits as of March 31, 2017.

The new, combined bank’s legal entity name is TIAA, FSB, but for the immediate future, the bank will continue to use the TIAA Direct and EverBank brands. 

The following management changes, announced last August, are effective today.

Kathie Andrade will continue in her role as CEO of TIAA’s Retail Financial Services business. She will also serve as chairman of the board of TIAA, FSB.

Blake Wilson, Everbank’s president and chief operating officer, will now serve as president and CEO of TIAA, FSB. He will remain a member of the board of directors of the new bank.

Robert Clements retired as EverBank Financial Corp’s chairman of the board and chief executive officer upon the completion of the acquisition.

Transamerica enriches variable annuity payout options

Transamerica has made enhancements to the Transamerica Income Edge living benefit rider, along with launching two new lower cost investment options.

Introduced in 2016, Transamerica Income Edge is a living benefit available with most Transamerica variable annuities aimed at enabling Baby Boomers and Generation X individuals to effectively plan their retirement.

Changes to the optional living benefit include a fee reduction, along with shortening the waiting period from five years down to three years for a customer to be eligible to start receiving a higher living benefit withdrawal percentage.

If investors wait three years after investing to begin taking withdrawals, they would be eligible for an automatic one percent increase on their withdrawal percentage, which escalates based on a tiered age scale.

After three full years, investors with a single life benefit who begin withdrawing between the ages of 59-64 can receive 5% income for life; those who begin withdrawing while in the 65-79 age range can receive 6% income for life; and if waiting until age 80 or older, the investor could receive 7% income for life.

Transamerica has also launched two new index portfolios approved for rider eligibility through Transamerica Income Edge.

TA U.S. Equity Index seeks investment results corresponding generally to the performance of the S&P 500 Index. TA International Equity Index provides access to large and mid-cap equities in developed markets outside the U.S. and Canada.  

Pensions still suffer from soft corporate bond rates: Milliman

Milliman, Inc., the global consulting and actuarial firm, today released the results of its latest Pension Funding Index (PFI), which analyzes the 100 largest U.S. corporate pension plans.

In May, the deficit for these plans rose by $22 billion from $257 billion to $279 billion, due to a decrease in the benchmark corporate bond interest rates used to value pension liabilities. As of May 31 the funded ratio had fallen to 83.8%, the 1.10% decline partially offset by investment returns.

“Corporate pensions have experienced a 23 basis point drop in discount rates since the start of the year, depleting funded status gains accumulated during the first quarter,” said Zorast Wadia, co-author of the Milliman 100 PFI. “While liabilities continue to pile up as discounts rates decline, investment returns have been above expectations for first five months of 2017, preventing further deterioration to pension funded status.”

  • Under an optimistic forecast, with interest rates reaching 4.11% by the end of 2017 (4.71% by the end of 2018) and 11% overall annual asset gains, the funded ratio would climb to 91% by the end of 2017 and 104% by the end of 2018. 
  • Under a pessimistic forecast, with a 3.41% discount rate at the end of 2017 (2.81% by the end of 2018) and 3.0% annual asset returns, the funded ratio would decline to 80% by the end of 2017 and 73% by the end of 2018.

To view the complete Pension Funding Index, go to http://us.milliman.com/PFI.  

ICI offers fresh data about Roth IRAs and traditional IRAs

The Obama Department of Labor’s fiduciary rule, by asserting DOL authority over Individual Retirement Accounts, has put a spotlight on IRAs. New reports from the Investment Company Institute (ICI) offer fresh data about owners of traditional, “rollover,” and Roth IRAs.

The reports, “The IRA Investor Profile: Traditional IRA Investors’ Activity, 2007–2015” and “The IRA Investor Profile: Roth IRA Investors’ Activity, 2007–2015,” are based on ICI’s IRA Investor Database, which houses account-level data for millions of IRA investors from year-end 2007 through year-end 2015.

The reports show:

Roth IRA investors tend to be younger than traditional IRA investors. At year-end 2015, 31% of Roth IRA investors were younger than 40, compared with 16% of traditional IRA investors. Only 25% of Roth IRA investors were 60 or older, compared with 40% of traditional IRA investors.

That’s because traditional IRAs are typically opened by rollovers, while Roth IRAs are more often started with contributions. Most (85%) of new traditional IRAs in 2015 were opened only with rollovers and more than half of traditional IRA investors with an account balance at year-end 2015 had rollovers in their account. About 71% of new Roth IRAs were opened only through contributions in tax year 2015.

People who open IRAs with contributions (not rollovers) tend to keep contributing. More than seven in 10 traditional IRA investors who contributed for tax year 2014 also contributed for tax 2015. Eight in 10 Roth IRA investors with contributions for 2014 also contributed for 2015.

Roth IRA owners are more likely to invest in equity mutual funds than are traditional IRA owners. At year-end 2015, 66% of Roth IRA assets, versus 54% of traditional IRA assets, were invested in equities and equity mutual funds, exchange-traded funds (ETFs), and closed-end funds. Some of these differences reflect the fact that Roth IRA investors tend to be younger, and younger investors typically allocate more toward equities. 

Allocation to target date funds and non-target date balanced funds were the same between Roth IRAs and traditional IRAs (18%), but Roth IRAs had less allocated to bonds and bond funds (7%) than traditional IRAs (16%). Roth IRAs also had a lower allocation to money market funds (6%) than traditional IRAs (9%).

Because annual withdrawals from traditional IRAs are mandatory starting at age 70½ but Roth IRA owners aren’t required to take withdrawals, their withdrawal activity is much lower. In 2015, only 4% of Roth IRA investors made withdrawals, compared with 24% of traditional IRA investors.  

The IRA Investor Database includes data on of IRA contributions, rollover, and withdrawal activity, and the types of assets that about 17 million investors hold in these accounts. It supplements existing household surveys and IRS tax data about IRA investors. 

© 2017 RIJ Publishing LLC. All rights reserved.

 

Morningstar Enters the Indexed Age

Posted on June 8, 2017 by -

Responding to demand from broker-dealers who intend to sell indexed annuities under the Department of Labor’s Best Interest Contract Exemption, Morningstar Inc. has added new data and new functionality to its Annuity Intelligence unit. Morningstar began rolling out the new services in April.

The Chicago-based firm, best known for mutual fund research, is adding information on 284 fixed deferred and fixed indexed contracts from 29 fixed and indexed annuity providers to its existing variable annuity database, once known as VARDS. Advisors can use the data to compare products or screen them for suitability for each client.

The new annuity universes are available now as an option in the Morningstar Annuity Intelligence Tool. The tool spares advisors the chore of combing through dense annuity prospectuses or sketchy marketing materials to glean key product data.

“We describe the products and explain how the benefits operate. We don’t just copy and past language from the prospectus,” according to Kevin Loffredi, senior manager, Annuity Solutions. “We get rid of jargon. People wanted to see that kind of information on the fixed indexed as well as the variable side. I’ve wanted to get fixed and indexed contracts into the tool for five or six years. Our clients said they want one source for all their annuity contract information.”

In recent years, sales of indexed annuities have grown much faster than sales of variable annuities. Indexed annuities thrive as an alternative to certificates of deposit in a low interest rate environment. As liabilities, they are less risky to issuers than variable annuities. That allows them to offer highly competitive lifetime income benefit riders.

The new service was hastened by the Department of Labor fiduciary rule. The rule, which goes into partial effect this week but may eventually be revised or repealed by the Trump administration, required brokerages to sign a Best Interest Contract Exemption [BICE], pledging that the client’s interests, not the advisor’s, drove the sale, if they want to sell either indexed or variable annuities to IRA owners and receive insurer-paid commissions on the sales.

“After the DOL came out with the fiduciary rule, which said that indexed annuities would be subject to the BICE, broker-dealers were knocking on our door, asking, ‘How can you help us prove that we’ve acted in the best interest of the client?’ Loffredi said. “We knew we needed to get indexed annuities into our research tool and our new Best Interest Proposal Tool. We decided to include multi-year guarantee annuities and market-value adjusted annuities as well.”

For brokerages, each step of a variable or indexed annuity sale under the BICE has to be documented. The brokerage firm, if called to account for an advisor’s sales recommendations, needs to be able to show that the selection of a particular contract was based on a client’s specific needs and desires, as opposed to the amount of compensation the sale would bring the advisor or the firm. 

In addition to data on contracts and a digital record of client-advisor interactions, the Annuity Intelligence Tool provides data to a separate software application, Morningstar Best Interest Proposal Tool. To a degree, it takes annuity product selection out of a firm’s or an advisor’s hands and turns it over to an algorithm to ensure objectivity.

For the brokerages, the Annuity Intelligence Tool provides a decision tree that allows a firm to filter the entire universe of annuity products by carrier, by range of benefit structures, by fee levels and surrender charge periods, and by variable investment options or index crediting strategies. Contracts that meet the firm’s criteria go on its product shelf for advisors to sell. Morningstar decision tree

The Morningstar Best Interest Proposal Tool provides a decision tree for advisors, allowing them to screen the available variable and indexed annuities for the contract with, for instance, a lifetime income benefit rider that best fulfills a client’s retirement income needs and matches his or her time horizon and premium size. 

Morningstar isn’t the only player in this market. Cannex, the Canadian-American firm that many intermediaries rely on for fresh annuity price quotes, introduced a wizard last fall that also helps advisors choose the right annuity and document the process for compliance with the terms of the Best Interest Contract Exemption.

But Cannex and Morningstar both said that their services can peacefully coexist.

“There is very little overlap,” Gary Baker, president of Cannex, told RIJ.  “CANNEX provides actual quotes and illustrations on the embedded guarantees in various types of annuities based on the profile of the client and their intended use of the contract. Morningstar’s service, including fixed annuities, provides a ‘qualitative’ comparison of products whereas we provide a ‘quantitative’ comparison. We have common clients that will use both services.” 

Cannex provides price quotes and contract specifics on single-premium immediate income annuities, deferred income annuities, and qualified longevity annuity contracts (QLACs), while Morningstar’s Annuity Intelligence Tool doesn’t. Captive agents of mutual life insurers, not brokerage advisors, historically sell most fixed income annuities.

“We look at firms like Cannex and eMoney as our partners in meeting the needs of advisors,” Loffredi said. “We’re not a financial planning firm, and we’re increasingly building out our integrations with companies like MoneyGuidePro and SalesForce. We have APIs and integrations where they, or us, can link in seamlessly. We’re not trying to disrupt the marketplace that’s out there now. We’re not looking to replace anyone. We can’t do it on our own.”

© 2017 RIJ Publishing LLC. All rights reserved.

Variable Annuities Suffer Steep Net Outflows

Posted on June 8, 2017 by -

Variable annuity sales dipped to their lowest level in a decade in the first quarter of 2017, and annual sales are on track to fall below $100 billion. The industry suffered net outflows of 17.9% in the first quarter.

At $22.95 billion, new sales of variable annuities were down 4.22% from Q4 2016 and down 10.43% from the same quarter last year, according to Morningstar’s quarterly VA Sales and Asset Report.

In the shrinking market, Jackson National, TIAA and Lincoln Financial were the only top-10 sellers to see a sales increase from the previous quarter. The rest of the top 10—who accounted for 80% of VA sales in the quarter—had double-digit sales declines from the previous quarter. Nearly every issuer had negative growth for the quarter.

But a 6.07% burst of first-quarter growth in the S&P 500 boosted total VA assets under management to $1.86 trillion, up 2.73% from the previous quarter and 4.49% from the first quarter of 2016.   

The evolving VA market has been buffeted by both positive and negative crosswinds. The rising stock market has been a tailwind; the interest rate environment has been a headwind for VAs while favoring fixed indexed annuities. Some firms have left the business. MetLife, once a big seller, has pulled back and spun-off its retail annuity business to fledgling Brighthouse Financial.

Voya Financial will soon be out of the book of VA business built by its predecessor, ING US. AXA has shifted its focus in part to a structured variable annuity that has no living benefits and therefore has low capital requirements. Jackson National’s popular Elite Access B, an accumulation-only product, also has relatively low reserve requirements.

Most recently, the VA business has been hurt by the weight of its own product fees and by the DOL fiduciary rule, which makes it harder for advisors to accept third-party commissions when selling VAs to IRA owners. 

With new sales of $4.46 billion in the quarter and a 19.43% market share, Jackson was by far the overall leader. Not counting TIAA, which sells group variable annuities, Jackson, had a big sales lead over the next biggest seller of individual variable annuities, AXA, which sold $2.5 billion in the quarter. Three firms, Jackson, TIAA and AXA, accounted for 58% of variable annuity sales in the quarter.

Among other firms with more than $100 million in sales, only five firms had increased sales compared to last year’s first quarter and the previous quarter: Jackson, AXA, Fidelity, Northwestern Mutual, and Great-West.

“Much of [Jackson’s sales surge] can be attributed to the fact that their living benefits, which are not the richest in the industry, require no managed volatility subaccounts or limits on equity exposure,” wrote Morningstar senior project manager Kevin Loffredi, in the quarterly report.

Jackson’s sales lead was most conspicuous in the Independent broker-dealer channel, where two-thirds of its sales in the quarter took place. The Lansing, MI-based insurer, a unit of the UK’s Prudential plc, was also the top seller in the wirehouse and bank/credit union channels.

The top-selling product in the first-quarter was Jackson’s Perspective II 7-year contract, which offers living benefit riders. Jackson’s Elite Access B, an accumulation-focused contract that offers exposure to alternatives, was the eighth best seller. AXA’s Structured Capital Strategies indexed variable annuity rose to third place in quarterly sales from 53rd place a year ago.

The captive agent channel, where TIAA dominates, led all channels in sales share with 39%, down slightly from 39.9%. The Independent channel share was 35.5%, up 1.8%. Each of the four other channels each had less than 10% share and were relatively unchanged.

TIAA, which started selling group variable annuities in 1952, has a 24% share of the total variable annuity assets under management, with $460.6 billion as of March 31, 2017. The next four largest AUM holders—MetLife, Jackson National. Prudential and Lincoln—have a combined 32% of the assets. The next five life insurers manage about 22.5% of the assets.

MetLife did not report sales of the MetLife branded contracts, Loffredi said. Morningstar is still receiving their assets and are combining their numbers with those of Brighthouse Financial.

© 2017 RIJ Publishing LLC. All rights reserved.

‘Don’t Expect Action By the SEC’

Posted on June 8, 2017 by -

The Security and Exchange Commission called this week for public comments on “standards of conduct” that apply to financial advisors when serving retail investors. But the SEC announcement only “unleashes more uncertainty into an already confused regulatory environment,” said an email bulletin this week from a prominent pension law firm.

The firm, Drinker Biddle, warned that “boards of directors, service providers and intermediaries should not expect action in the near future by the SEC with respect to a uniform standard of conduct, as this is not the first time the SEC has called for comments on this issue.”

So no one should hold his or her breath waiting for the SEC to push the Department of Labor, and its disruptive fiduciary rule, out of the brokerage space. The retirement industry and its legal teams are receiving about as much useful new information from the SEC about the fiduciary rule as Dorothy Gale got from the Scarecrow when she and Toto stopped to ask for directions to Oz.  

A turf conflict between agencies

The SEC’s intervention has long been sought by the investment industry, which is accustomed to and familiar with the SEC’s rules and their gentle enforcement by the industry’s internal watchdog, the Financial Industry Regulatory Authority. It is not accustomed, and resents, additional regulation by the DOL.

The DOL’s 2016 fiduciary rule for the first time asserted its authority over advisor behavior not just in the pension arena but also in the retail IRA arena. The rule affected commissioned sales of mutual funds and annuities to individual IRA owners, and was seen by many in the investment industry as an invasion of SEC-regulated and state-regulated territory by Labor.

Some members of the investment industry are concerned that, without an assertion of authority by the SEC, the DOL standards of conduct might eventually apply to all financial advice. It’s impractical, some have said, for advisors to have one code of ethics for clients’ IRAs and another for their taxable accounts.

The fiduciary rule doesn’t affect all advisors. It won’t have much impact on the conduct of Registered Investment Advisors, who have always had to act as trusted advisors. And it doesn’t affect fee-only planners for the same reason.

But the rule will have, and already has had, far-reaching effect on commission-paid advisors at brokerage firms, and on the product manufacturers who rely on those advisors to distribute their annuities and mutual funds.

Ambiguously, the rule goes into partial effect tomorrow, but now the DOL and the SEC have raised hopes—or fears, depending on your perspective—that the rule might be altered by promising to reopen it for review before January 1, 2018, when the rule is scheduled to take full effect. NAPA Net reported today that the DOL Secretary has sent a Request for Information on the fiduciary rule to the White House Office of Management and Budget as a first step toward reviewing the rule.

What we know now

Drinker Biddle issued an alert on June 6. According to attorneys Diana E. McCarthy and Joshua M. Lindauer:

  • The Fiduciary Rule will become effective on June 9, 2017.
  • On June 9, providers of investment advice to retirement clients will become fiduciaries and the “impartial conduct standards” will become a requirement of the prohibited transaction exemptions.
  • Between June 9 and January 1, 2018, the DOL “will not pursue claims against fiduciaries who are working diligently and in good faith to comply with the Fiduciary Rule and its exemptions.”
  • On June 1, 2017, the SEC issued a request for public comment on the standards of conduct applicable to investment advisers and broker-dealers when they provide investment advice to retail investors.
  • Absent further action by the DOL, intermediaries and advisers utilizing the BICE or PTE must be in full compliance with all of the exemptions’ conditions on January 1, 2018.
  • Between June 9 and January 1, 2018, financial institutions and advisers must comply with the “impartial conduct standards” when relying on the BICE and PTE. They must give act in accordance with ERISA’s standards of “prudence and loyalty” to clients, charge “no more than reasonable compensation,” and “make no misleading statements about investment transactions, compensation, and conflicts of interest.”

(Some advisors have wondered they can be sued for alleged violations of their fiduciary duty after the rule goes into effect. RIJ has been told that the danger of a new wave of class-action suits against brokerages—akin to the wave of suits against 401(k) sponsors and providers in recent years—has been exaggerated by opponents of the rule.)   

Given the Trump administration’s and the Republican Congress’ manifest distaste for federal regulation, they are likely to attack the Obama fiduciary rule. Meanwhile, financial firms are like football fans, waiting nervously while the “zebras” gather around a video booth and watch a replay to either confirm or overturn a ruling on the field—and make a decision that could well determine the outcome of the game.

© 2017 RIJ Publishing LLC. All rights reserved.