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Target Date Funds: What’s Under the Hood?

Posted on February 2, 2017 by Editorial Staff -

Target date funds (TDFs) have steadily gained usage since the Pension Protection Act of 2006 made them QDIAs—qualified default investment alternatives—in 401(k) plans with auto-enrollment features. In 2006, 28% of new 401(k) participants bought a TDF; by 2014, that figure was 59%, according to EBRI.

In a new policy brief from the Center for Retirement Research at Boston College, a quartet of academics examine the underlying funds, costs, performance and management of TDFs and find that:

TDFs often invest in specialized assets, as well as conventional stocks and bonds. The typical TDF invests in 17 funds on average. These holdings include emerging markets, real estate, and commodities. The prevalence of these specialized assets has increased over time.
TDF fees are only modestly higher than if an investor assembled a similar portfolio on his own. To avoid overlay fees, an investor might consider replicating the TDF portfolio on his own, but the analysis found little benefit from this “do-it-yourself” approach.
TDF investment returns, on average, fall short of their benchmark indices but perform about the same as all other mutual funds, the authors found. “When [the overlay or funds-of-funds wrap fee] fee—roughly 50 basis points on average—is added, the total alpha is roughly minus-70 basis points. This value approximates the average alpha for mutual funds in general.”
TDF managers’ decisions, in terms of marketing timing and fund additions, sometimes hurt performance. “Three types of fund family objectives can adversely affect TDF returns. First, TDF managers tended to favor start-up funds, which had substantially lower returns over the next three years than the alternatives within their fund family,” the authors found.

The four authors of the brief were Edward J. Elton and Martin J. Gruber, professors emeriti and scholars in residence at New York University’s (NYU) Stern School of Business; Andre de Souza, visiting assistant professor of finance at the Stern School; the late Christopher R. Blake, formerly Joseph Keating, S.J. Distinguished Professor at Fordham University.

President Trump to require ‘two-for-one’ regulations

Posted on February 2, 2017 by Wagner Law Group -

‘Focus on issues in your direct control,’ A.M. Best urges annuity issuers

Posted on February 2, 2017 by Editorial Staff -

Rising rates, increased potential for lower taxes and reduced regulatory hurdles: These post-presidential signs bode well for U.S. life/annuity insurers in 2017, according to a new A.M. Best special report. But insurers “still need to remain focused on the issues that… remain more directly in the industry’s control,” said an A.M. Best release this week.

The 2017 Review & Preview Best’s Special Report, “Many Headwinds, But Life/Annuity Insurers Remain Focused on What They Can Control,” notes that A.M. Best revised its outlook for 2017 on the L/A industry from stable to negative. “The industry… does not look vulnerable to any single shock, but is susceptible to a multitude of pressures that raise operational risk and is placing increasing time constraints on senior management,” the release said.

“The biggest unknown for the L/A industry is which of these regulatory changes”—principles-based reserving or the DOL fiduciary rule—“will remain intact under the new Republican administration, or whether some or all will be either materially delayed, overhauled or repealed altogether,” A.M. Best added.

The prospect of disruption from financial technology/insurance technology companies likely will drive highly strategic-focused merger and acquisition activity, A.M. Best said. The ratings firm advised insurers to focus on:

Modernization of the business model through improved systems and data analytics to improve underwriting and profitable top line growth
Managing through an uncertain and potentially volatile global economic and regulatory environment
Strategic decision-making for asset allocation and business profile

According to the remaining text of the statement:

“In 2016, economic headwinds, evidenced through low interest rates, continued to impact both sides of the balance sheet through increased credit and liquidity risks, lower investment portfolio returns and increased reserving.

“Robust equity markets and benign credit markets partially have offset some of this pressure, and many companies have taken advantage of lower financing costs to prepay near-term debt maturities, resulting in modest short-term increases to financial leverage.”

Honorable Mention

Posted on February 2, 2017 by Editorial Staff -

Hope trumps fear in new Ed Jones survey

A majority of Americans surveyed (57%) believe that the new presidential administration will impact their retirement savings income strategy and nearly half (48%) expect an uptick in market volatility in 1Q2017, according to a survey sponsored by the advisory firm Edward Jones.

Among Americans with investments, 42% believe that the new administration will positively impact their portfolio in the coming year, and about one-quarter (27%) of expect a negative effect on their assets.

Three-quarters of those surveyed believe their investment assets will be impacted over the long-term, with nearly half (46%) anticipating a positive effect. Baby Boomer investors, ages 53-71, are the most optimistic, with 52% expecting a positive long-term impact; 39% of Millennials and 48% of Gen-X investors were optimistic.

“Regardless of what the perceived impact of the new administration is, it’s important to focus on what you can control, and avoid making rash decisions based off emotion, especially where retirement planning is concerned,” said Scott Thoma, Principal and Retirement Strategist for Edward Jones, in a release.

The survey was conducted by ORC International’s Telephone CARAVAN Omnibus for Edward Jones. The survey was conducted among a nationally representative sample of 1015 respondents from January 19-22, 2017.

Hanlon Investment Management links to BlackRock’s iRetire methodology

Hanlon Investment Management said this week that it is offering BlackRock’s iRetire retirement investment framework to financial advisors and wealth managers on the Hanlon Wealth Advisor Platform.

The iRetire framework, introduced in 2015, lets advisors estimate how much income their clients’ current savings could provide annually in retirement and how changes in behavior (e.g., working longer, saving more, changing their investment strategy) could help close the income gap.

The iRetire platform draws on CoRI methodology, the engine behind BlackRock’s retirement income indexes, and the risk analytics of Aladdin, BlackRock’s risk and enterprise investment system. Advisors can also use iRetire insights to build various portfolio scenarios for clients to consider based on their retirement income goals.

The iRetire platform provides advisors with tools and resources to let investors see where they stand when it comes to the number that really matters—annual retirement income—and take action to help their clients close the retirement income gap.

Hanlon offers asset management, technology, and practice management solutions to thousands of advisors nationwide. Hanlon’s Wealth Advisor Platform helps advisors manage portfolio accounting, reporting and marketing, to investment management and retirement planning.

Private equity firm eyes DC market, offers ‘performance-based pricing’

In hopes of distributing its private equity investment options to defined contribution plan participants, Pantheon, a $35.2 billion global private equity firm, has introduced “performance-based pricing” as an option for its private equity strategies targeted at the DC market.

“Based on the strong returns the private equity asset class has delivered in recent years5, Pantheon believes that private equity strategies have the potential to address the performance delta between DB and DC plans and merit consideration as a viable investment option by plan sponsors,” Pantheon, which invests in infrastructure funds and real assets funds, said in a release.

The idea is to make often-illiquid private equity investments, which defined benefit pension fund managers have used to boost returns, accessible to DC plans. Historically, DB plans have outperformed DC plans for reasons that include a shift toward alternative assets and differing investment fee structures.

Pantheon’s performance pricing option would apply only to that portion of a portfolio invested in private equity investments (e.g., not including cash and liquid securities). Pantheon would take its performance-based fee only when the performance of the private assets in the portfolio beats performance of the S&P 500.

Pantheon does not receive all the performance fees that accrued immediately. When a performance fee is accrued, it is gradually paid to Pantheon over at least eight calendar quarters. This leaves a reservoir available to offset performance fee accruals in scenarios of underperformance.

Because Pantheon’s strategy intends to accommodate periodic trading, and the fee accrued would be reflected in the strategy NAV as of the relevant period, investors will not pay for performance they did not experience.

Pantheon said it is working with general partners, including KKR, to seek to manage the less predictable and irregular investor capital inflows that can be expected in a DC plan, and to facilitate efficient deployment.

“The need for expedited capital deployment presents some potential challenges. Our objective is to facilitate efficient GP capital deployment to reduce potential cash drag, and address the more irregular capital flows typically experienced by a DC plan,” said Kevin Albert, managing director at Pantheon.

Pantheon is majority-owned by Affiliated Managers Group Inc, a NYSE-listed global asset management company with equity investments in leading boutique investment management firms.

Many in the ‘gig economy’ plan to work indefinitely

Über drivers, musicians, contract software engineers, consultants and “gig” workers of all stripes, as well as self-employed professionals and garage-based entrepreneurs—all belong to the global army of people who don’t necessarily participate in formal retirement savings plans.

Many of them are still young; but they won’t always be. So how do they save for retirement? Do they save for retirement? Do they reinvest all of their spare revenue back into the business? Do they plan to sell their businesses to finance their retirement years? And, importantly, how can retirement asset managers better assess, nurture and capture this growing but atomized market?

The Transamerica Center for Retirement Studies and Aegon Center for Longevity and Retirement have co-sponsored a survey and report that gauge the attitudes toward retirement among people in 16 countries who are self-employed or who work part-time in the contract or “gig” economy.

The report, “Retirement Preparations in a New Age of Self-Employment,” may be a step toward serving these elusive potential customers. The underlying survey offers several insights, most of them common-sensical if not self-evident. It doesn’t explore the question of whether the self-employed are gravitating toward robo-advisors like Betterment in lieu of established financial service providers like Transamerica.

The survey showed that the self-employed rarely anticipate a specific retirement date. Many expect to retire after the age 65 or never (40% globally, 56% U.S.), perhaps not realizing that retirement isn’t always voluntary, even for the self-employed. More than two-thirds (69% globally and in the U.S.) envision a “flexible transition” to retirement.

Only 26% globally (25% U.S.) say they are either “very” or “extremely confident” that they will achieve a comfortable retirement, the survey found. Other findings of the report include:

26% globally (29% U.S.) expect to change the way they work (e.g., work part-time or on temporary contracts) for a while before they fully retire.
20% globally (17% U.S.) plan to change the way they work and continue to do paid work throughout retirement.
23% globally and in the U.S. say they will keep working as they currently do. Retirement age won’t change the way they work.
The self-employed will keep working because they want to keep active (63% globally, 67% U.S.) and/or because they enjoy their work (51% globally, 54% U.S.).
28% globally and in the U.S. will keep working because they’re worried that social security benefits will be lower than expected or that their savings might not last their lifetimes (27% globally, 22% U.S.), or because they haven’t saved enough (26% globally and in the U.S.).

About one-third of the self-employed (34% globally, 36% U.S.) say they save for retirement. Some save occasionally (22% globally, 19% U.S.) or that they have stopped saving (17% globally, 24% U.S.). Others say they intend to start saving in the future (20% globally, 14% U.S.).

While most of the self-employed (60% globally, 63% U.S.) have a retirement planning strategy, few have a written plan (13% globally, 20% U.S.). Relatively few (38% globally, 39% U.S.) have a backup income plan in case they’re forced to retire early.

As sources of retirement income, the self-employed cite social security (33% globally, 48% U.S.) and savings (38% globally, 32% U.S.). Few (14% globally, 15% U.S.) cite their business as a means for saving for retirement.

The survey covered self-employed workers in Australia, Brazil, Canada, China, France, Germany, Hungary, India, Japan, The Netherlands, Poland, Spain, Turkey, United Kingdom, and United States.

Más o Menos: Ticos Cheerfully Eke By

Posted on February 1, 2017 by Kerry Pechter -

Many in the U.S. are still leery of European-style social democracy, with its taxpayer-funded universal medical care and mandatory, centrally managed workplace savings programs. But modern Costa Rica embraced the social democratic model almost 70 years ago, after its civil war, and never turned back.

To say that the system here works flawlessly, however, or that it is financially sound, would be an exaggeration.

On the one hand, Costa Ricans, unlike North Americans, can take basic medical care for granted. “When Obamacare was introduced, I tried to explain the health care situation in the U.S. to my maid,” said Alberto Trejos, dean of the MBA program at INCAE, a San Jose business school created in the early 1960s with help from Harvard and U.S. foreign aid. “She didn’t understand it. She’s an immigrant from Nicaragua, and she still couldn’t imagine that someone wouldn’t be able to a doctor if they needed to.”

On the other hand, Costa Ricans who want the best, most prompt health care need to buy supplemental insurance—or simply pay doctors and hospitals in cash. And only a small percentage of Costa Ricans can afford to do that.

A congenial academic of about 50 who earned his economics Ph.D. at Penn and once taught at Northwestern University, Trejos (below) was Minister of Trade during the presidency of Abel Pacheco de la Espriella (2002-2006). Among other things, he helped negotiate the Central American Free Trade Agreement, or CAFTA.

With its 4.8 million people, Costa Rica’s economic issues are comparable to those of a big U.S. city, like Los Angeles or Chicago: Fiscal debt and deficits; aggressive public sector unions with pension issues; traffic jams and a creaky intra-city rail line; uneven access to health care; a neglected African-American region (the Caribbean coast); and drugs (Costa Rican authorities interdict many tons of Colombian cocaine each year, which arrives here by boat for transfer to Mexico-bound planes). Yet the tensions of a large U.S. city seem absent here, as the famously friendly “Ticos” enjoy what some here like to call “pura vida,” or pure life.

Trejos, who runs an econometric consultancy and a business consultancy here in addition to his academic work, discussed a few of these issues with RIJ, in no particular order, over glasses of iced lassi at a bistro in San Jose’s fashionable Escazu suburb.

‘Intel Inside’–or not

Costa Rica still exports a lot of coffee and bananas, but its economy today depends on agriculture for only 6% of GDP. It’s mainly a service economy, with tourism as an important engine. The creation of tax-advantaged free trade zones and the passage of the North American Free Trade Agreement have brought foreign investment over the past two decades.

U.S. electronics companies like Hewlett Packard and Intel, surgical supply firms like Boston Scientific and Hospira (a unit of Pfizer), and retailers, especially Walmart, employ thousands of Costa Ricans. In 2012, according to news reports, call centers employed as many as 16,000 Costa Ricans. Still, an estimated half of what Costa Ricans earn is off the books, in the “informal” economy, and therefore out of reach of the taxes that fund universal health care and pensions.

Intel’s 20-year presence in Costa Rica illustrates the good news/bad news contradictions of globalization, an issue that figured prominently in the recent U.S. election. In 1997, the giant chipmaker built a large microprocessor plant in Costa Rica. At the time, East Asia’s gravitational pull on U.S. manufacturers hadn’t yet gathered critical mass, and American companies were still looking to the south for low-cost labor and tax concessions.

Putting a big Intel facility in Costa Rica’s tax-free Export Promotion Zone was, as one Intel executive said at the time, “like putting a whale in a swimming pool.” Intel’s investment of $300 million over two years (and a total commitment of $600 million) was equal to 2.1% to Costa Rica’s GDP. (The Economist magazine estimated the value of Intel’s investment here at $2 billion.)

Intel was a boon to Costa Rica for 17 solid years. Intel built two facilities outside San Jose: one for high-tech chip assembly and testing (where raw silicon wafers are diced, infused with circuitry and tested) and another for research and design. A network of local suppliers flourished. A Bank of America call center arrived. Largely because of Intel, Costa Rica GDP jumped to 8% in 1998 and 1999. Intel alone accounted for about 20% of the country’s exports.

Then, in April 2014, Intel said it would move 1,500 manufacturing workers from Costa Rica to Malaysia, China and Vietnam, attracted by lower costs in Asia. Intel still employs about 1,200 research and design workers in Costa Rica. (Only days before Intel’s announcement, Costa Ricans had elected a center-left president, but Trejos rejects the idea that that played any role in the chipmaker’s decision.)

To focus on the Intel episode, Trejos suggested, is to sell Costa Rica short. “We have the highest fraction of our territory as environmentally protected land in the world,” he told me. “All of our electricity is generated from renewable resources. In terms of biodiversity we are bigger than Russia. We doubled the forest cover of the nation between 1987 and 2015, a time where most countries lost forest cover. We are the oldest democracy in the developing world, and one of the ten oldest in the whole world. We have been without armed forces, unilaterally disarming, for 68 years.”

Canadian-style finance

Dollars, colones and merchandise easily change hands in Costa Rica. If you walk down the busy Avenida Central in the San Pedro Montes de Oca suburb of San Jose, you pass several bank branches and ATM sites. If you run out of colones, you can pay almost anybody in U.S. dollars without being badly cheated on the exchange rate. All but the smallest shops and restaurants take major debit and credit cards. Tips are typically included in restaurant bills.

The government owns four of the biggest banks here: Bancredito, Banco Popular, Banco de Costa Rica and Banco National. These commercial banks, along with three private banks, make most of the collateralized loans on which the country’s business runs. “The financial market is bank-controlled and highly-regulated. It’s old-fashioned financial services, similar to Canada’s. There’s very little funky finance here,” Trejos said.

No major U.S. banks currently compete in this market. The private banks include BAC and Davivienda, both from Colombia, Scotiabank, a $900 billion Canadian bank that bought Citigroup’s banking operations here a year ago, and Cathay Bank, a $13 billion Los Angeles-based U.S. bank. BAC and Banc Lafise, two Nicaraguan banks, also operate here. Costa Rica has twice resisted pressure from U.S. banks to sell its banking system: once in 1948, when the banks were first nationalized, and again in 1967. Private banks were eventually permitted and now comprise about 30% of the banking industry.

‘A different view of life’

At a time when the U.S. Congress is preparing to repeal the Affordable Care Act (Obamacare) and replace it with something more market-driven, Costa Rica is proud of its national health service. Officially, Ticos pay about 15% of their salaries toward universal health care. In other words, a relatively few highly paid workers contribute a lot more than the poor for access to the same medical services, thus subsidizing the nation’s health care system for all.

In practice, Costa Rica’s widely admired medical system (one of the reasons North Americans choose to retire here) has two and perhaps three tiers. About 40% of Costa Ricans also have private health insurance, said Trejos, a physician’s son. Some doctors work full-time for the national health service while others, like Trejos’ family doctor, divide their time between public and private service. “It’s a different view of life,” Trejos said, referring to most doctors’ sense of obligation to serve the public.

Bottomless potholes

Costa Rica avoided the extremes of the Great Financial Crisis (though zombie condominium towers and resorts on the Pacific Coast testify to a period of speculative real estate investment), but the government struggles—more successfully than some countries, worse than in others—to cover the cost of basic services.

The most obvious and exasperating problem in Costa Rica is the lack of good transportation infrastructure. Not long ago, the rate of auto ownership jumped from 14% of households to 37% without “a single new road being built,” Trejos said. The country’s roads are improving but its “huecos,” or potholes, remain large, numerous and legendary.

A light rail line runs the breadth of the city, but many cars are outdated and decrepit—they are literally used cars, purchased second-hand by Costa Rica from Spain several years ago—and the rail service seems to do nothing to relieve rush-hour congestion. Lax zoning regulation has allowed housing to sprawl over the hills and into the arroyos that surround San Jose. This rugged topography, a thin mask of the volcanic activity underneath, resists easy road-building and complicates the delivery of essential services.

The biggest public controversy and frustration in Costa Rica today is the battle over public sector pensions. A powerful coalition of unions represent the public employees, and they have reportedly arranged to pay themselves, via the nation’s budget, a variety of bonuses and benefits that private-sector Costa Ricans don’t have.

“You might see a math professor, who had a final salary of $8,000 a month, retiring on $23,000 a month,” Trejos said by way of illustration. As of the end of January, the unions appeared to have the upper hand. A recent news story in The Tico Times said that union leaders had just called off a national strike, scheduled for February 6, but only after the legislature tabled a bill that would have eliminated their perks.

Uncontrolled spending on public sector pensions, and other sources of fiscal imbalances, such as tax evasion, now plague Costa Rica, whose financial management has oscillated between pro-business and populist administrations. In January, Fitch Ratings downgraded the country’s long-term bonds to BB from BB+.

Fitch also downgraded the long-term issuer default ratings of four state-owned and two private Costa Rican banks. These latest developments mark the return of difficulties that Costa Ricans thought they had resolved. “I’m less optimistic than I was five years ago,” Trejos said. “Ten years ago we didn’t think that public finances would be broken again. Problems that we had a few years ago, that we thought were solved, are creeping up again.”

Fed No Longer Controls Rates

Posted on February 1, 2017 by Brian Singer, CFA -

I’ve written previously about how central bank policies across the globe are manipulating asset prices. To recap, the Bank of Japan (BOJ) is buying short- and long-term sovereigns, credit, and equity. They are literally buying every single asset class. The European Central Bank (ECB) is buying all of these asset classes except equity. The Fed is buying short- and long-term sovereigns, but not credit or equity.

These central bank activities are boosting asset prices, but that can’t last forever. As a result, in the current environment, it’s very difficult for the market to have a strong conviction on long-term fundamental value because investors don’t know what asset prices really should be.

This creates more uncertainty and risk, so from a portfolio positioning perspective, this phenomenon, among other “Why” investment process considerations, has caused us to dampen some of our positions in markets and currencies around the world.

Over time, this environment will settle down. The Fed raised rates at the end of last year and has signaled that it anticipates three rate hikes in 2017. At the same time, it’s hard to say that the Fed is actually in control of interest rates. Ultimately, they have ceded a lot of control to the market, and market participants are dictating monetary policy. Why do I say that?

For the last four or five decades, the Fed has always focused on not surprising the market. As they approach each of their meetings, they’re looking, as everyone else is, at the probabilities that are priced into the short yield curve and LIBOR-OIS (Overnight Indexed Swap) spreads to determine whether or not the market is pricing assets based on the expectation that the Fed is going to raise rates. If this probability is below 50%, the Fed won’t act, but if the probability is above 75%, the Fed will raise rates.

However, we believe the probability of the Fed raising rates three times in 2017 is less than what the market has begun to price in post the Donald Trump election. So, we’re a little bit less concerned by the potential for the Fed to raise rates multiple times over the coming year.

Brian Singer, CFA, is a partner and head of the Dynamic Allocation Strategies Team and Portfolio Manager at William Blair Funds.

President Trump and the DOL Fiduciary Rule

Posted on February 1, 2017 by Kerry Pechter -

From my distant roost here in Costa Rica, I’ve been following news about the Trump administration’s first two weeks and wondering how his recent and future executive orders will change the fate of the DOL’s fiduciary (or conflict of interest) rule, originally scheduled to take effect in April.

If you believe, as I do, that the DOL rule was a trailing indicator of the larger technology-driven trend toward lower costs and disintermediation of human advisors—the Amazon-ification of financial services—then you may agree that no matter what the thinking-fast-and-not-slow President Trump does, he can’t stop the tide any more than Canute could.

You have only to look at massive net mutual fund flows to Vanguard at the expense of actively managed fund companies over the past few years (as reported each month by Morningstar) to see that many Americans prefer low-cost, transparent, web-mediated financial services, including advice.

But Trump (or his Labor Secretary) can take the teeth out of the DOL rule by removing investors’ right to file class action suits against providers who display a pattern of un-fiduciary conduct toward rollover IRA clients. Financial services companies won’t feel as much pressure to meet a true fiduciary standard, with respect to any account. Such a move might ease the downward pressure that the fiduciary rule was bound to—was designed to—exert on the costs (i.e., industry profits) associated with retirement accounts (and, by contagion, with all accounts).

To me, the fiduciary rule was always about putting price controls on the fees associated with rollover IRA accounts, and giving IRA owners the same protections from unreasonable fees that ERISA intended for 401(k) participants. It was always about the money. Calling the rule an “extension of the definition of the fiduciary standard to a much broader range of professionals” was mainly a way for some opponents of the rule to fog its purpose: Helping savers keep more of their money and ensuring that service providers keep less.

The DOL was right to extend ERISA protections—low, transparent fees—to rollover IRA accounts. Whether the savings was in 401(k)s, 403(b)s or rollover IRAs, it was still tax-deferred; that is, subsidized by the nation. As long as the DOL continued to allow providers to charge whatever the market would bear, the providers would ipso facto consume the subsidy. Unrestricted pricing in a publicly subsidized market isn’t kosher.

Maintaining the subsidy under these circumstances would have been unfair to the average taxpayer. But few people in the private financial services industry, particularly those in publicly held companies, seemed to understand that the fiduciary rule, in the long run, might help protect the tax expenditure for retirement savings. They simply saw a threat to their turf and naturally defended it.

(Despite the subsidy, many providers felt no obligation to serve middle-class customers unless they were sufficiently compensated. They reserved the right to decide what reasonable compensation should be. If middle-class customers lost services for lack of adequate incentives, it wouldn’t be their fault; it would be the fault of misguided do-gooders who defied market forces.)

In short, they wanted it both ways: A tax subsidy for their products and the right to charge what the market would bear. But, thanks, to technology, that can’t last. They will eventually lose market share, I believe, not because of a DOL rule but because of competition from digitally-driven direct marketers, both old school (Vanguard) and new school (Betterment).

Still, stopping the DOL rule matters. If the DOL rule is removed or neutered, then each financial services company will have more breathing-room to decide how it plans to use the savings that digital automation brings. The management of each firm, depending on its business model, will decide how much of those savings to share with the end customer and how much to keep as profit. A cooperative like Vanguard will continue to pass much of its savings onto its customers (while still making boatloads of money), as it has for decades. Other types of firms, however, are likely to behave differently.

Publicly traded firms, like the wirehouses, are likely to want to keep as much as the savings as they can for their primary constituency: their shareholders (including senior executives). One indicator: These firms appear to be opting to use digital technology internally to make advisors more efficient (and eventually, I think, employ fewer advisors). If they can serve more customers with fewer advisors while maintaining traditional fees, profits should soar.

Maintaining traditional fees should be easier if Phyllis Borzi (or someone like her) isn’t monitoring them or trying to define “reasonable fees.” The Trump administration, which looms as the closest thing to a dictatorship that the U.S. has yet seen, and is likely to usher in the most reactionary period in American history since the McCarthy Era, will probably, by action or inaction, relieve downward pricing pressures from those publicly traded companies while they decide how to proceed.

Skin in the Game

Posted on January 27, 2017 by Kerry Pechter -

To find out how Costa Rica’s social security system works, on Wednesday I walked from my Airbnb condo in the San Pedro section of San Jose, along a congested avenue and past a mall to the Equus Tower, where I rode to the 11^th floor and stepped through frosted glass doors into the offices of SUPEN, the country’s pension authority.

After a few minutes’ wait, during which I looked out at the Coronado mountain range, Alvaro Ramos Chaves, the head of SUPEN since he succeeded Edgar Robles in mid-2015, introduced himself. In his early 30s, with an economics Ph.D. from U.C.-Berkeley, Ramos pointed to a small tube in his ear and said that if he didn’t seem to understand my questions clearly, deafness, not poor English, would be the reason.

Clarity never became an issue. For ninety minutes or so, he described the basic architecture of the Costa Rican national pension system, the investment restrictions and other challenges that his office deals with, and the outlook for the country’s economy, where jobs—the financial aquifer for the pension system—depend on tourism, the back-office operations of bigger countries, and agriculture.

Compare and contrast

Costa Rica’s retirement system faces many of the same demographic and economic challenges that the U.S. system faces, but there are significant differences in the way the two programs work.

The national defined benefit system resembles Social Security. But its defined contribution system is mandatory, not voluntary, and the contributions are managed collectively, not individually. About 68% of workers participate; the goal is 80%. About 100,000 Costa Ricans who never contributed to any plan currently receive about $150 a month in retirement from the government.

About 14.41% comes out of payroll for retirement benefits. (The median income for Costa Rica’s 4.8 million people is about $12,000.) That contribution rate will soon rise by a percentage point. About 9% (of which employers pay almost 5%) goes to pay for a defined benefit pension and 4.25% goes to the defined contribution pension. There’s also a 5% tax for unemployment insurance.

Before 2000, Costa Ricans 7.5% for a defined benefit that replaced 60% to 70% of earnings after at least 20 years of participation, Ramos said. But then came a big demographic shift. Women joined the workforce and the birth rate, formerly four per woman, dropped to 1.9. Meanwhile, life expectancies rose, and the country now has the world’s highest longevity among men over age 80, Ramos said. Costa Rica added the mandatory DC plan to patch the actuarial gap.

Like North Americans, many Costa Ricans—“Ticos,” an affectionate diminutive, is their adopted nickname–face the likelihood of spending 20 years or more in retirement. Costa Rica’s national health system, financed by a 15% payroll tax, has helped push up longevity. Taken together, retirement taxes and health taxes add up to a hefty (and some say counterproductive) bite. But the highest marginal income tax rate for Costa Ricans is only 15%, and only those earning more than $1,500 a month (a mere 15% of the population) pay any income tax at all.

Bigger taxes loom on the horizon, however. Ramos cited a recent University of Costa Rica study showing that if the system retains its current retirement age and benefits, pensions could cost 35% of wages by 2060. There’s also, by the way, a sales tax that operates like a value-added tax (VAT), with the difference that the tax is not applied consistently at every stage of production and distribution.

Where the nest eggs grow

Contributions to the DB system are invested in Costa Rican government bonds. There’s an “implicit contingent fund,” similar to the Social Security trust fund in the U.S. Like our trust fund, Costa Rica’s has an expiration date. Remedial tweaks to the system, made in December 2015, have postponed that deadline by eight years, to 2038.

Contributions to the DC system go into funds that are managed by any of six state-licensed asset management firms, known as OPCs. Costa Rican firms run five and a Colombian firm runs the sixth. Most participants put their money into a single default funds, and few take advantage of a right to add voluntary contributions to other investment options. Other than GE Capital, which sold its business to the Colombian firm, no American company has ever managed a tranche of the Costa Rican DC money.

By statute, these firms can invest up to 50% of Costa Rica’s roughly $10 billion in assets (of a total of $14 billion in total national pension assets) outside of the country. But currently they invest only 10% abroad. “There’s a lot of room to grow,” Ramos told me. “The system is still immature. Another $4 billion could leave the country,” he said. Recently, under guidance from the World Bank, Costa Rica switched from a rules-based to a risk-based supervision system, which should give the OPCs more flexibility in their choice of investments.

OPCs earn a maximum of 50 basis points for their services. The fee fell recently from 70 basis points, and will go lower in the future, Ramos said. Personally, he doubts that neither a rigidly fixed fee nor the lowest possible fee will optimize investment outcomes. “You won’t have a sophisticated system if you charge too little,” he said. “In the Netherlands,” known for pension sophistication, “the fee is 66 basis points.”

Costa Rican men can take monthly retirement benefits at age 62 and women at age 60, from both the DB and DC plans. “We do allow lump sum distributions from the DC plan, but the rules have not been well thought-out,” Ramos told RIJ. “If your DC benefit is less than 10% of your DB benefit, you can take the DC benefit as a lump sum.”

Because the DC plan is relatively new, “very few people have a DC benefit right now that’s bigger than 10%,” he said, because the plan, known here as the IVM, is relatively new. “We expect the lump sum to become more common,” he added.

“What annoys people here is that there is no partial lump sum option. But I don’t like a partial option. As it stands today, if you retire and have never used your unemployment fund, then you have that as a lump sum,” he said.

Sleep-deprivation triggers

What keeps Ramos awake at night? In his view, the spread between equity returns and bond returns, driven partly by the vast monopolistic profits of tech companies like Amazon, Facebook, and Apple. Their stock prices will keep going up, he said, they’ll have huge cash flows and they’ll never have to issue borrow money from pension bonds. “There will be no bonds from companies like Apple. So it will be harder and harder for pensions to find investments. That’s a big concern for me.”

Advances in automation, such as the use of intelligent chatbots to replace call center operators, also worries him. “In the past 40 years, we’ve gone from an agricultural economy to a service economy. We’re the ‘back office’ of the world. ‘So far so good.’ But what happens to us [and El Salvador or the Philippines] if the back office is automated?”

Globalization, of course, giveth and taketh away. For years, an Intel chip assembly plant and design facility employed thousands of Costa Ricans and accounted for an enormous 5% of national GDP. In 2014, however, Intel relocated its chip assembly operation to Asia, and Costa Rica lost 1,500 high-paying jobs.

Fewer jobs means less tax revenue which means rough times for pension systems. “This is a worldwide phenomenon,” Ramos noted. Climate change also worries him. In the fall of 2016, Costa Rica’s Caribbean-facing coast experienced its first hurricane damage in 200 years. Hurricanes can discourage investment and tourism and are expensive to mop up after.

Changes in rainfall patterns could also hurt the country’s agriculture sector. Costa Rica grows coffee the cooler highlands and bananas in the warmer lowlands. Warmer ocean temperatures could hurt its commercial fishing industry—a major employer—as well as popular sport fishing for sailfish and tarpon off the Pacific coast. “This climate change is real,” Ramos said.

Because of the inter-generational conflict that national pensions often entail—the current generation pays for the previous generation’s benefits—pension policy is not just an economic or financial problem but also a political and personal problem. Ramos told me that he feels this tension first hand.

“My generation paid for the previous generation, and the next generation will pay even more. My baby daughter will begin contributing to our pension system in 2040. How much are we going to ask her and her peers to pay?” To prevent pension taxes from ballooning to 35%, his agency will have to come up with some innovations.

“I like the Swedish system,” he said. “They have notional account system for defined benefit plans, where benefits are connected to future productivity. Right now, in Costa Rica, the two are disconnected.

“The traditional DB plan guarantees you a certain level of purchasing power in the future, even if the future productivity isn’t high enough to support it. In Sweden, if the country is poorer when you retire, you get a lower benefit. The retirees have skin in the game.”

TIAA offers double-shot of income solutions for DC plans

Posted on January 26, 2017 by Editorial Staff -

TIAA is launching two new custom target date fund series, both of which are designed to add an ingredient to defined contribution plans that they usually lack: a mechanism for converting savings to a pension-like income stream in retirement. TIAA calls them “Custom Default Solutions.”

The two solutions are called Target Date Plus Models and Target Income Models. Plan sponsors and/or their third-party consultants select the investment options and design the glide paths formulas for their TDFs and combine them with one of two income solutions on TIAA’s recordkeeping platform, a TIAA release this week said.

Target Date Plus Models allows plan sponsors to combine their own investment choices with the equivalent of “TIAA Traditional,” the fixed deferred annuity that has long been used by millions of TIAA’s 403(b) university clients for a portion of their savings. Retirees typically take the income over no less than 10 years or as a life with period-certain annuity.

“Target Date Plus Models substitute standard bond funds with a guaranteed fixed annuity, such as TIAA Traditional, that provides certainty of income, within the familiar target-date structure,” the release said.

“These models typically follow the automated glide path many participants expect. However, plan sponsors and their consultants can use their own in-house expertise to manage the glide path and investment options to fit the specific demographics of their participants.”

“With Target Date Plus Models, we can leverage TIAA’s open architecture platform to combine best-in-class mutual funds with TIAA Traditional,” said plan sponsor advisors Pete Kaplan and Brian Petros, President and CEO of PKFinancial Group in Twinsburg, Ohio, in the release.

“In addition to guaranteed income in retirement, TIAA Traditional offers a proven historical crediting rate, reduced volatility compared to bond funds and a guaranteed minimum rate of return,” the release said.

The second solution, Target Income Models, employs a TDF product design that TIAA is licensing from Dimensional Fund Advisors. DFA bought it from Nobel Prize winner Robert Merton, who developed it with Zvi Bodie in the early 2000s and piloted it under the trade name SmartNest at Philips Electronics in the Netherlands.

Target Income Models aim to replace a specific portion of income in retirement using the same investment approach of many defined-benefit plans: a liability-driven investment (LDI) strategy. They “allow for customization that goes beyond age to incorporate savings habits, additional income sources,” the release said.

“Participants are seamlessly moved among multiple glide paths based on their personalized funding ratio, income replacement goal and market conditions. The models in this solution become more conservative over time, similar to target-date funds.”

Target Income Models balance growth assets with income-hedging assets, primarily through high-quality Treasury Inflation-Protected Securities (TIPS) to lessen the impact of interest rate and inflation risk on retirement income.

Target Date Plus Models and Target Income Models are eligible to be selected as Qualified Default Investment Alternatives (QDIA).

Jackson issues fee-based version of popular Elite Access VA

Posted on January 26, 2017 by Editorial Staff -

Jackson National Life has issued a fee-based version of its popular Elite Access variable annuity, under the name Elite Access Advisory. In a release this week, Jackson called it “a fast follower to the introduction of Perspective Advisory, Jackson’s first fee-based variable annuity, released in September 2016.”

Elite Access as a B-share VA was first issued in 2012, when advisors were hungry for access to so-called liquid alternative assets. Its sales through the first three quarters of 2016 were $1.94 billion.

That represented a year-over-year slippage in sales ranking to tenth from third—perhaps because of recent slippage of interest among advisors in alternative assets. Elite Access Total Jackson National’s VA sales through the third quarters of 2016 were an industry-leading $12.88 billion, according to Morningstar.

EA Advisory’s key features include:

Advisor compensation is fee-based, rather than commission-based.
Zero mortality, expense and administration charge. The contract charge is $10 per month.
A three-year withdrawal charge schedule, starting at 2% and dropping to one percent in the second year and zero thereafter.
More than 100 investment options.
The standard ability to withdraw the contract’s earnings or 10% of the contract’s remaining premium each year, whichever is greater, without penalty.

Greg Cicotte, executive vice president and chief distribution officer for Jackson, said in a release this week, “As advisors and their firms continue to determine how best to comply with the U.S. Department of Labor (DOL) fiduciary rules, we’ve seen increased market demand for products compatible with fee-based accounts.”

Dream-House Shopping in Costa Rica

Posted on January 23, 2017 by Kerry Pechter -

A 65-year-old guitarist, composer and world traveler told me recently that Costa Rica comes in three main geographical flavors for would-be expatriate retirees: the Pacific coast, the central highlands, and the Caribbean coast. He and his wife chose the third option.

Nine years ago, on their fifth or sixth birding expedition to Costa Rica, the couple rented a car and drove to the country’s remote southeastern corner, a place they’d never been. A random dirt road led them to the beach and an octagonal house that captivated them. Built for maximum feng shui, with greenery and light, its eight sides honored the bagua, Taoism’s eight principles of reality.

The house was for sale. Its mystical vibe seduced them into paying $150,000 in cash for it. Monkeys, sloths, macaws, butterflies and gekkos would be their neighbors as they aged. The house would yield rental income when they were away. “We wanted to do it outright,” said the musician, who wears his grey-blond hair in a ponytail. “It was definitely impulsive.”

He didn’t show me pictures of the house; until I looked online I didn’t know exactly how much a vacation home or full-time residence might cost in Costa Rica. Homes here are relatively cheap, I found, but hardly dirt-cheap. The price range is wide—from less than $100,000 for a small aerie in the forest to many millions of dollars for luxury on the scale of, say, Beverly Hills.

You can go urban or rural; mountain or beach; rustic or granite countertop. I’ll provide some examples of homes selling at low, medium and high price-points in each of the three major sections of the country. If you currently live in icy Boston, Chicago or Minneapolis—or if you voted for Hillary Clinton—the idea of moving to Costa Rica might be appealing right now.

The laid-back Caribbean coast

The Caribbean coast was a good fit for this couple. Backpackers, surfers, musicians and Europeans are drawn by its low cost, remoteness and Afro-Caribbean culture. Starting in 1867, black laborers were brought to Costa Rica from Caribbean islands to build a railroad from San Jose to Puerto Limon, still the biggest city on the east coast.

Jobs on the railroad and on United Fruit banana plantations eventually departed, but black workers and their descendants remained. Until about 1950, they were confined to the coast area by law. A history of race-driven underinvestment has shaped the Limon region, lending it the charms and drawbacks of severe neglect. Climate change alert: Three months ago, a hurricane hit Costa Rica’s east coast for the first time in 200 years.

$85,000. If you’re looking to emulate the Robinson Crusoe lifestyle, $85,000 will get you “an adorable jungle studio tucked in the canopy” near Cocles, a Caribbean beach community a mile or so southeast of Puerto Viejo. Painted raspberry, with white trim and a narrow veranda, it’s basically a tree house. But you can’t beat the price. (Right)

$149,000. Up the coast from Puerto Viejo, near Cahuita, I found a golden-yellow three-bedroom house literally built around the roots of a giant fig tree in the rainforest near the beach. The price for the house on 1500 square meters of rainforest: $149,000. The home is separated into two structures; one for the kitchen, dining and living areas, and one for two bedrooms. A thatch-covered pathway connects them.

The upscale central highlands

If you aren’t inclined to hug trees, but want a safe place that’s near a major city, good health care facilities and an international airport, where you can mingle with other English-speaking expatriates, a gated community on the mountain slopes near San Jose in the suburb of Santa Ana, might interest you. The altitude (about 3,000 feet above sea level) keeps the highlands cool at night. Nearby volcanoes rise to over 10,000 feet. Rainforests and beaches can be reached by car within a couple of hours.

Santa Ana has grown rapidly in recent years, shaped by expatriate habits and tastes. While retaining some small town charm, it has new upscale grocery stores, gourmet restaurants, banks, gas stations, medical and dental clinics, coffee houses, hotels, and private schools. The best public golf course in Costa Rica is located in nearby Lindora. (I haven’t been there, but it sounds like Orange County, Calif.)

$2,000 per month. The smart way to find out if you’d like living full-time in Costa Rica would be to live here for a year in a rental. For $2,000 a month, you can rent an opulent 2,700 sq ft, three-bedroom, two-bath one-story teak-and-tile house with a terra cotta roof in a gated community in the hills near Santa Ana.

$874,000. Let’s suppose that you want it all: A secluded horse farm on 7.9 highland acres, within easy access to U.S.-style shopping amenities, downtown San Jose, and the airport. (Left.) You can have it in Santa Ana for less than $1 million. There’s an existing two-bedroom house and one-bedroom guesthouse, but you could expand. It’s been landscaped for construction of one or more additional homes. There’s a fence around it and a steel entrance gate.

(Many houses in San Jose, if not enclosed in a gated community, appear to be tiny upscale prisons in reverse. Their iron fences, barred windows and barbed-, razor-, or electrified wire along the tops of garden walls, suggest a risk of home invasion that North Americans may find unsettling or even alarming.)

The desirable Pacific coast

The Pacific Coast is Costa Rica’s most popular tourist destination. This is where you’ll find the old coffee port of Puntarenas, the Nicoya Peninsula and several national parks. There’s a Cancun-ish concentration of resorts, clubs, white beaches, snorkeling, trophy fishing, and eco-tourism. For sale, there are isolated mountain retreats, oceanfront villas, and casita neighborhoods to fit a range of budgets.

$219,000. Quepos, a small town on the Pacific Coast not far from San Jose is one of the most popular destinations in Costa Rica. Located south of town there’s a 2,000 sq ft villa with a two-bedroom main house and a rentable one-bedroom efficiency apartment in a gated community. It’s only a short drive north of the Manuel Antonio National Park, where you can find wildlife and waterfalls.

$398,000. If you want luxurious isolation, you might like this somewhat remote tile-roofed compound on a hilltop near the Pacific Ocean (right). The two-bedroom main house and one-bedroom guesthouse perch on 4.7 landscaped acres. There’s no pool but anearby waterfall looks swimmable. The property is listed for only $398,000, probably because of its one-hour distance from the beach town of Quepos, or maybe because the guesthouse’s shower and toilet are outside, shielded only by an open-air tile enclosure. That’s life in the tropics.

Caveat emptor

Costa Rica isn’t for everybody, at least not as a permanent retirement home. According to one source, about 60% of the outsiders who move here eventually move back to where they came from. My musician friend noted that, since he bought his house in Puerto Viejo, his visits to Costa Rica are consumed by the chores associated with maintaining the property as a first-class rental. He and his wife have also noticed that their commitment to Costa Rica has crowded out their freedom to travel elsewhere.

Others move back for what seem to be predictable emotional reasons.“The draw is relatively cheap living in a stable country, with friendly, happy, helpful people,” one retired American physician who bought a house on the Pacific coast told RIJ. “There is also a significant American expat community.

“People return to the US for much the same reasons they would return from other countries. Disability. An expat who had a failed back surgery in the US moved back because CR is not very handicapped-accessible. Medical issues, a need for therapies not available in CR or that are cheaper with Medicare, the death of a spouse: there are lots of reasons to leave. Some move back for the closeness of family, or because things just didn’t seem to work out.”

The Illusions Driving Up US Asset Prices

Posted on January 23, 2017 by Robert Shiller -

Speculative markets have always been vulnerable to illusion. But seeing the folly in markets provides no clear advantage in forecasting outcomes, because changes in the force of the illusion are difficult to predict.

In the United States, two illusions have been important recently in financial markets. One is the carefully nurtured perception that President-elect Donald Trump is a business genius who can apply his deal-making skills to make America great again. The other is a naturally occurring illusion: the proximity of Dow 20,000. The Dow Jones Industrial Average has been above 19,000 since November, and countless news stories have focused on its flirtation with the 20,000 barrier – which might be crossed by the time this commentary is published. Whatever happens, Dow 20,000 will still have a psychological impact on markets.

Trump has never been clear and consistent about what he will do as president. Tax cuts are clearly on his agenda, and the stimulus could lead to higher asset prices. Lower corporate taxes are naturally supposed to lead to higher share prices, while cuts in personal income tax might lead to higher home prices (though possibly offset by other changes in the tax system).

But it is not just Trump’s proposed tax changes that plausibly affect market psychology. The US has never had a president like him. Not only is he an actor, like Ronald Reagan; he is also a motivational writer and speaker, a brand name in real estate, and a tough deal maker. If he ever reveals his financial information, or if his family is able to use his influence as president to improve its bottom line, he might even prove to be successful in business.

The closest we can come to Trump among former US presidents might be Calvin Coolidge, an extremely pro-business tax cutter. “The chief business of the American people is business,” Coolidge famously declared, while his treasury secretary, Andrew Mellon – one of America’s wealthiest men – advocated tax cuts for the rich, which would “trickle down” in benefits to the less fortunate.

The US economy during the Coolidge administration was very successful, but the boom ended badly in 1929, just after Coolidge stepped down, with the stock-market crash and the beginning of the Great Depression. During the 1930s, the 1920s were looked upon wistfully, but also as a time of fakery and cheating.

Of course, history is never destiny, and Coolidge is only one observation – hardly a solid basis for a forecast. Moreover, unlike Trump, both Coolidge and Mellon were levelheaded and temperate in their manner.

But add to the Trump effect all the attention paid to Dow 20,000, and we have the makings of a powerful illusion. On November 10, 2016, two days after Donald J. Trump was elected, the Dow Jones average hit a new record high – and has since set 16 more daily records, all trumpeted by news media.

That sounds like important news for Trump. In fact, the Dow had already hit nine record highs before the election, when Hillary Clinton was projected to win. In nominal terms, the Dow is up 70% from its peak in January 2000. On November 29, 2016, it was announced that the S&P/CoreLogic/Case-Shiller National Home Price Index (which I co-founded with my esteemed former colleague Karl E. Case, who died last July) reached a record high the previous September. The previous record was set more than ten years earlier, in July 2006.

But these numbers are illusory. The US has a national policy of overall inflation. The US Federal Reserve has set an inflation “objective” of 2% in terms of the personal consumption expenditure deflator. This means that all prices should tend to go up by about 2% per year, or 22% per decade.

The Dow is up only 19% in real (inflation-adjusted) terms since 2000. A 19% increase in 17 years is underwhelming, and the national home price index that Case and I created is still 16% below its 2006 peak in real terms. But hardly anyone focuses on these inflation-corrected numbers.

The Fed, like the world’s other central banks, is steadily debasing the currency, in order to create inflation. A Google Ngrams search of books shows that use of the term “inflation-targeting” began growing exponentially in the early 1990s, when the target was typically far below actual inflation. The idea that we actually want moderate positive inflation – “price stability,” not zero inflation – appears to have started to take shape in policy circles around the time of the 1990-1991 recession. Lawrence Summers argued that the public has an “irrational” resistance to the declining nominal wages that some would have to suffer in a zero-inflation regime.

Many people appear not to understand that inflation is a change in the units of measurement. Unfortunately, although the 2% inflation target is largely a feel-good policy, people tend to draw too much inspiration from it. Irving Fisher called this fixation on nominal price growth the “money illusion” in an eponymous 1928 book.

That doesn’t mean that we set new speculative-market records every day. Stock-price movements tend to approximate what economists call “random walks,” with prices reflecting small daily shocks that are about equally likely to be positive or negative. And random walks tend to go through long periods when they are well below their previous peak; the chance of setting a record soon is negligible, given how far prices would have to rise. But once they do reach a new record high, prices are far more likely to set additional records – probably not on consecutive days, but within a short interval.

In the US, the combination of Trump and a succession of new asset-price records – call it Trump-squared – has been sustaining the illusion underpinning current market optimism. For those who are not too stressed from having taken extreme positions in the markets, it will be interesting (if not profitable) to observe how the illusion morphs into a new perception – one that implies very different levels for speculative markets.

Rx for Retirement: A Low Dose of Equities

Posted on January 23, 2017 by Kerry Pechter -

When we talk about the risks of retirement, we often look at longevity risk, market risk, sequence risk and over-spending risk in isolation. But what if we integrated them into one multivariable risk? How would that affect our opinions about, for instance, the right equity allocation in retirement?

A research paper on that topic by Keith C. Brown of the University of Texas and W.V. Harlow of Empower Retirement has just won a Special Distinction Award from the Journal of Investment Management. The award will be presented at the Spring JOIM Conference in San Diego March 12-14. (For an earlier, public version of the article, click here.)

Brown and Harlow recommend lower equity allocations than the 60% that is assumed by the so-called 4% safe withdrawal strategy. Here’s what they say: “For retirement investors attempting to minimize downside risk while sustaining future withdrawals, appropriate equity allocations range between five and 25%.”

Even when you plug in different capital market assumptions, the recommendations hardly vary, they write. They also claim that investors with substantial bequest motives should “still be relatively conservative with their stock allocations, adding that bigger equity allocations create substantial risk to “the sustainability of retirement savings and incomes.”

To reach these conclusions, they used a model they call Retirement Present Value. A retirement plan’s RPV is equal to the “net present value of assets minus liabilities weighted by the probability of the investor’s survival throughout his or her post- retirement life.” A Monte Carlo simulation generates a range of positive and negative RPVs.

In other words, they look at spending rates, life expectancies, investment returns and expenses to find out which equity levels generate enough upside to produce positive portfolio values for the longest period, without adding a counter-productive level of volatility.

Their model, they admit, isn’t novel. “The calculation of RPV is straightforward and merely an adaptation of the familiar method of determining the discounted present value of a series of future cash flows,” they write. But their conclusions fly in the face of conventional wisdom, which calls for at least 50% equities in retirement.

For 65-year-olds to 85-year-olds seeking the minimum risk of running out of money, Brown and Harlow recommend only five to 10% equities in a portfolio that includes lots of cash. They observe that, while a typical TDF today might have a 48% stock allocation, and use cash or cash equivalents to buffer the volatility, such a portfolio should need no more than 25% equities, assuming that bonds replaced the cash allocation.

“The stock allocation increases in the absence of cash, [but] on a percentage basis the bond allocation increases by even more. Relatively speaking, bonds become the more attractive alternative to cash and the stock allocation still remains well below conventionally recommended levels,” Brown wrote to RIJ in an email. Even people who are more concerned about providing a large bequest than running out of money should hold only 35% to 45% equities.

“Taken as a whole, the findings in this study should give any investor a considerable amount to ponder before setting his or her asset allocation path in retirement,” Harlow and Brown write.

“If mitigating the risk of outliving one’s retirement resources is the cornerstone of the asset allocation decision, it is critical to limit equity exposure and recognize the impact that investment volatility and mortality risk can have on the sustainability of the retirement plan.”

With equity prices as well as bond prices close to record highs, such a strategy might suit the times we live in. If asset prices (despite our hopes) have nowhere to go but down, then the safe bet for those entering retirement may be to relinquish the pursuit, embrace “secular stagnation,” and to focus on preserving what they’ve got.

But current valuations don’t appear to be what drives Brown and Harlow’s results. Rather, they identify the primary cause of retirement shortfall as sequence risk—the risk that a market crash will force a retiree to sell depressed assets in order to produce income for living expenses. Other practitioners might believe that there are alternate ways to deal with sequence risk than by maintaining a low-equity portfolio.

Index and ETF providers dominate fund flows in 2016: Morningstar

Posted on January 23, 2017 by Editorial Staff -

Morningstar, Inc. reported estimated U.S. mutual fund and exchange-traded fund (ETF) asset flows for December 2016. Investors ended the year by favoring passively managed U.S. equity funds over actively managed funds by a record margin, placing an estimated $50.8 billion in passive funds in December.

On the active side, investors pulled $23 billion out of U.S. equity funds during the month. (Morningstar estimates net flow for mutual funds by computing the change in assets not explained by the performance of the fund and net flow for ETFs by computing the change in shares outstanding.)

Highlights from Morningstar’s report about U.S. asset flows in December:

Investors’ preferences have shifted. They now favor stock funds over bond funds, amid growing optimism about the U.S. economy and continued rising interest rates and inflation. The net inflow for U.S. stock funds hit its highest monthly total since April 2000, at $27.8 billion. Taxable bond funds saw overall net inflows of $14.6 billion in December.
December 2016 saw overall outflows from alternative strategies of $4.4 billion, with full-year outflows of $4.7 billion. This marked the worst showing for alternative funds since 2005. It’s a significant reversal from 2015 when they took in $13.3 billion.
Bank-loan funds were a leading category in December, with inflows of $6.0 billion on the active side and $1.4 billion for passive strategies, continuing a recent trend of growing interest in these funds.
Vanguard dominated the flows landscape in 2016. The firm took in $277.0 billion in total new money during the year, finishing at $3.4 trillion in long-term assets. American Funds saw $4.9 billion in active outflows during 2016, while Fidelity Investments offset some of its active fund outflows with $37.2 billion in passive inflows.
Among passive and exchange-traded funds, the SPDR S&P 500 ETF took in the most assets at $14.3 billion for December 2016, followed by three Vanguard funds with offerings for U.S. stocks, international stocks, and U.S. bonds.
PIMCO Income, which has a Morningstar Analyst Rating of Silver, took in $1.5 billion in December and $13.7 billion for 2016. It was the top active individual fund in terms of inflows. Bronze-rated Franklin Federal Tax Free Income defied the trend for outflows in December among active municipal-bond funds, seeing inflows of $1.4 billion.

For more information about Morningstar Asset Flows, please visit http://global.morningstar.com/assetflows.

Interest rate drought not over: A.M. Best

Posted on January 23, 2017 by Editorial Staff -

The low interest rate environment will likely remain a challenge for the life/annuity (L/A) insurance industry in 2017, as companies continue to invest new money and the proceeds of richer maturing assets into new bonds at current rates, according to A.M. Best.

A new Best’s Special Report, “Shifts in Bond Portfolio Strategies Help Life/Annuity Insurers Navigate Low Interest Rates,” notes that bond portfolio yields have continued to decline. The Federal Reserve’s 25 basis point rate hike in December 2016 was only the second hike in the last decade.

Reinvestment risk remains a key issue. Holdings have been reinvested at lower rates since 2012. While aggregated industry bond portfolio yields have consistently declined to 4.71% in 2015 from 4.88% in 2014 and 4.99% in 2013, strategic investment decisions have helped mitigate further declines in book yield.

If bond portfolio allocations had remained static as of year-end 2012, the industry’s bond portfolio yield would have declined to 4.54% in 2015 from 4.86% in 2013, a difference of 10 to 20 basis points in each of the last three years.

Private placement bonds have surged by 70%, to $847.0 billion in 2015 from $497.3 billion in 2005. Private placement bonds are in limited availability and require a lot of expertise to manage. Only about 60% of L/A insurers held them as part of their bond portfolio as of year-end 2015. Insurers with investment portfolios greater than $10 billion held all but 4% of private placement bonds.

Companies also have increased the duration of their overall bond portfolios. A.M. Best said. Average maturities have increased to nearly 11 years since 2013, after sitting at less than 10 years prior to 2010.

Unless rates rise, insurers will need to find higher yields in order to maintain operating profitability and manage spread compression. The trends of investing lower on the credit scale, lengthening portfolio durations and increasing allocations to alternative fixed income assets such as private placements are well underway.

A.M. Best’s said it believes that “by introducing products with lower risk characteristics into an older in-force block of business, L/A insurers may be able to maintain, perhaps at lower levels of profitability than in years past, a buffer against the continued low rate environment and declining yields.”

Fifth Third Bank acquires The Retirement Corporation of America

Posted on January 23, 2017 by Editorial Staff -

Fifth Third Bank announced this week that it will acquire The Retirement Corporation of America is a registered investment adviser (RIA) that provides retirement education and planning as well as “investment management solutions geared toward the needs of retirees,” according to a release.

Both firms are based in Cincinnati, Ohio. The transaction awaits regulatory approval and is expected to close in April.

Fifth Third delivers “financial empowerment programming” under its own brand and through sponsorships, a release said. The Retirement Corporation of America provides “education platforms, lifestyle focused events and investment programs designed to help maximize post-retirement income.”

The Retirement Corporation of America traces its roots back to 1984 when Dan Kiley and his father, Tom Kiley, founded the original advisory firm.

Fifth Third Bancorp is a diversified financial services company. As of Sept. 30, 2016, it had $143 billion in assets and operated 1,191 full-service banking centers, including 94 Bank Mart locations, most open seven days a week, inside select grocery stores and 2,497 ATMs in Ohio, Kentucky, Indiana, Michigan, Illinois, Florida, Tennessee, West Virginia, Georgia and North Carolina.

Established in 1858, Fifth Third operates four main businesses: Commercial Banking, Branch Banking, Consumer Lending, and Wealth & Asset Management. It also has an 18.3% interest in Vantiv Holding, LLC. As of Sept. 30, 2016, Fifth Third had $314 billion in assets under care, of which it managed $27 billion for individuals, corporations and not-for-profit organizations.

Skin in the (Costa Rican Retirement) Game

Posted on January 20, 2017 by Kerry Pechter -

To find out how Costa Rica’s social security system works, I walked from my Airbnb condo in the San Pedro section of San Jose, up a congested avenue and past a mall to the Equus Tower, where I rode to the 11th floor and stepped through frosted glass doors into the offices of SUPEN, the country’s pension authority.

After a few minutes’ wait, during which I gazed out at the nearby Coronado mountain range, Alvaro Ramos Chaves arrived and shook my hand. In his early 30s, with an economics Ph.D. from U.C.-Berkeley, he has been head of SUPEN since succeeding Edgar Robles in mid-2015. As we sat down at a conference table, Ramos pointed to a small tube in his ear and said that if he didn’t seem to understand my questions clearly, deafness, not poor English, would be the reason.

Compare and contrast

Costa Rica’s retirement system faces many of the same demographic and economic challenges that the U.S. system faces, but there are significant differences in the way the two programs work.

Costa Ricans used to paid 7.5% of salary for a defined benefit that replaced 60% to 70% of earnings after at least 20 years of participation, Ramos said. But then came a big demographic shift. Women joined the workforce and the birth rate, formerly four per woman, dropped to 1.9. Meanwhile, life expectancies rose, and the country now has the world’s highest longevity among men over age 80, Ramos said. But in 200o, Costa Rica added the mandatory DC plan to patch the actuarial gap.

Where the nest eggs grow

Contributions to the basic DB system, or IVM, are invested in Costa Rican government bonds. There’s an “implicit contingent fund,” similar to the Social Security trust fund in the U.S. Like our trust fund, Costa Rica’s has an expiration date. Remedial tweaks to the system, made in December 2015, have postponed that deadline by eight years, to 2038, Ramos said.

Contributions to the DC system go into funds that are managed by any of six state-licensed asset management firms, known as OPCs. Costa Rican firms run five and a Colombian firm runs the sixth. Most participants put their money into a single default fund. Only 3.7% of those over age 18 take advantage of their right to add voluntary contributions to other investment options. Other than GE Capital, which sold its business to the Colombian firm, no American company has ever managed a tranche of the Costa Rican DC money.

By statute, these firms can invest up to 40% of Costa Rica’s roughly $10 billion in assets (of a total of $14 billion in total national pension assets) outside of the country. But currently they invest only about 10% abroad. “There’s a lot of room to grow,” Ramos told me. “The system is still immature. Another $4 billion could leave the country,” he said. Recently, under guidance from the World Bank, Costa Rica switched from a rules-based to a risk-based supervision system, which should give the OPCs more flexibility in their choice of investments.

Because the DC plan is relatively new, “very few people have a DC benefit right now that’s bigger than 10%,” he said, because the plan is relatively new. “We expect the lump sum to become more common,” he added.

In addition to the lump sum provision, participants can receive interest alone from their savings and set aside the principal for a bequest. They can also draw down a combination of interest and “some capital” each year, or they can buy an individual annuity. “What annoys people here is that there is no partial lump sum option. But I don’t like a partial option. As it stands today, if you retire and have never used your unemployment fund, then you have that as a lump sum,” he said.

Sleep-deprivation triggers

Fewer jobs means less tax revenue which means rough times for pension systems. “This is a worldwide phenomenon,” Ramos noted. Climate change also worries him. It made its presence felt in the fall of 2016, when Costa Rica’s Caribbean-facing coast experienced its first hurricane damage in 200 years. Hurricanes can discourage investment and are expensive to clean up after.

Changes in rainfall could also hurt the country’s agriculture sector. Costa Rica has long grown coffee in the cool central highlands and bananas in the warmer lowlands. Warmer ocean temperatures could hurt its commercial fishing industry—a major employer—and perhaps degrade sport fishing for sailfish and tarpon off the Pacific coast. “This climate change is real,” Ramos said.

“I like the Swedish system,” he said. “They have a notional account system for defined benefit plans, where benefits are connected to future productivity. Right now, in Costa Rica, the two are disconnected.

“The traditional DB plan guarantees you a certain level of purchasing power in the future, even if productivity in the future isn’t high enough to support the benefits. In Sweden, if the country is poorer when you retire, you get a lower benefit. The retirees have skin in the game.”

Who Will Sell Transamerica’s New No-Commission VA?

Posted on January 20, 2017 by Kerry Pechter -

On January 17, Transamerica began distributing a new no-commission variable annuity contract designed for advisors who are expected to adapt to the Department of Labor’s fiduciary rule, effective this April, by moving to an asset-under-management (AUM) compensation program and not selling commission products.

But details of the prospectus of the contract, called Transamerica Variable Annuity I-Share, suggest that it is as complex and expensive as older VAs with multiple income riders—perhaps more so than the DOL would consider fiduciary. It’s hard to imagine exactly where, in the context of an ever-softer VA market, where generous commissions drove the bulk of sales, this product will find a home.

[A formal written response to that issue can be found in a statement from Transamerica senior vice president Joe Boan. You can find it here and on this week’s homepage.]

For the record, Transamerica is a unit of Netherlands financial giant AEGON, whose shares trade in Amsterdam. Although AEGON still owns the 45-year-old, 48-floor “Pyramid” in San Francisco, Transamerica’s official U.S. headquarters are in Baltimore and Cedar Rapids, Iowa.

Rapping about VAs

Many AUM-based advisors have faulted VAs for their high costs (both insurance and investment expenses), and this product is true to type. Its combined fees for mortality expense risk, administration, a living benefit and death benefit riders, along with the broker-dealer distribution charges and the expense ratios of the funds (or funds of funds), could easily 300 basis points per year, according to the prospectus and the product spec sheet.

The other traditional rap on VAs is that they are complex. This product’s prospectus is challenging to unpack. It has four living benefit riders, three death benefit riders, and a profusion of investment options and enhancements at different price points and/or risk levels. That’s not necessarily bad—complexity often means flexibility, which advisors tend to like. But it’s difficult for clients to understand complex products, and opacity could be perceived by reasonable people as unfiduciary.

According to the prospectus, separate account expenses charged by the issuer run between 90 and 120 basis points, including a tiny five basis point mortality and expense risk fee; a 15 basis point administration fee, and death benefit fee (10 – 40 basis points). Enhancements to the death benefits are also available for a fee.

Living benefit fees, which cover the cost of guaranteeing income in retirement, range from 70 basis points to 145 basis points, depending on the riskiness of the underlying investments. The expense ratios of those investments range from 16 basis points to 286 basis points. There’s currently a 5.5% compound annual deferral bonus for the first 10 years of the contract (with re-sets after step-ups in the benefit base, if any), payable in any year in which withdrawals aren’t taken.

Flexibility—within constraints

Investors can choose any of the following four living benefit options, which offer single and joint contracts. One or more of them requires the use of funds that use volatility control mechanisms, or funds that are traditionally less volatile, and/or rebalancing strategies to reduce risks and protect the guarantees. Transamerica is also reserving the right to make changes to the payout rates and deferral bonuses of the riders for new purchasers. The riders are:

Transamerica Income Edge. Clients who choose this rider must agree to allocate a certain percentage of their premium to a stable value account and the rest to certain prescribed or optional investments. They can’t move money into or out of the stable account after purchase. The key risk-mitigation factor for the issuer is that, if the risky assets go to zero while the client is living, the guarantee is subsequently met by withdrawals from the client’s stable account—not from the insurer’s general account. The annual expense ratio is 1.40%.

Retirement Income Choice 1.6. This income product is available at three different price points—1.45%, 1.10% and 0.70%, depending on which group of investment options is chosen. It offers the above-mentioned 5.5% roll-up, and there’s a special income enhancement if the policyholder(s) go to a nursing home.

Retirement Income Max. As its name suggests, this rider, currently available for 1.25% per year, is for those who want the highest possible payouts and are willing to accept a narrower investment portfolio in exchange. It offers the 5.5% roll-up.

Guaranteed Principal Solution. This rider offers a guaranteed minimum accumulation benefit for those who hold the product for at least 10 years, and a guaranteed minimum withdrawal benefit that allows for distributions of either 7% per year (until the effective principal is used up) or 5% per year for life. It uses a risk control technique, the Portfolio Allocation Method, that allows Transamerica to move client money into safe assets when the account value drops or when volatility spikes.

With the exception perhaps of emergent leaders like Jackson National and AIG, variable annuity issuers have been in retreat for several years, and sales in 2017 is expected to be even softer, according to LIMRA. Traditionally, advisors have sold them because of the strong commissions they offer. Registered investment advisors (RIAs) and other fee-based have used VAs primarily for tax deferral, or for access to alternatives or for active trading, but less so for their insurance features.

In that context, the distribution strategy for this product is a bit of a mystery. It’s not clear exactly who would want to sell it. Advisors who pride themselves on customized advice wouldn’t be drawn to a packaged product. Fiduciary advisors (including RIAs and many independent advisors) wouldn’t want a product that could cost investors so much and whose fees are likely to prevent income increases in retirement. The remaining commission-paid advisors have no obvious incentive to sell a no-commission product.

On the one hand, you could say that this product has something for every client—at a price. On the other hand, it’s unclear if it will strongly appeal to any particular type of advisor. We’re in limbo right now, on many levels. Preparation is always possible, prediction less so.

Anecdotal Evidence: The 10% Solution

Posted on January 20, 2017 by Kerry Pechter -

There’s a straightforward solution to the retirement savings problem in the U.S. Forward-looking companies and organizations already use it. It doesn’t rely on auto-escalation, peer pressure or other behavioral nudges. When done right, it enables employees to turbo-charge their tax-deferred savings.

The secret? Carve out 10% of each employee’s salary and put it in their retirement accounts—in addition to a matching contribution. This was Vanguard’s policy when I worked there 10 years ago and I hope it still is. Many colleges and universities practice this. Anecdotally, participants embrace this policy where it’s available.

This contribution level is what policymakers recommend. It’s what millions of Americans will need for a financially low-stress retirement. The challenge is to make employers and employees see the logic of trading consumption now for consumption later.

There’s nothing wrong with nudges. Take auto-enrollment… Wait, I take that back. Participants who are auto-enrolled tend to become locked (“anchored” is the term-of-art) into a low contribution rate. Auto-enrollment alone, if not accompanied by an employer contribution, won’t solve the retirement savings crisis.

When I was hired at the aforementioned company, I bridled a little at the modest base pay. (My self-help career books recommended that applicants ask interviewers, “Is that the best you can do?”) The HR rep encouraged me to “look at the whole package,” including retirement, health insurance, the potential for tuition reimbursement, and annual profit sharing.

Of course, not everybody will prefer a smaller paycheck. Some people can’t commit to deferred gratification, even if they know they should. But big stable firms like Vanguard, and many universities, tend to attract conscientious long-term thinkers. I admit that it may not work everywhere.

But it might. If we (savers, employers, and the nation) are serious about tackling the retirement savings crisis in the U.S.—where a minority saves a lot but the majority saves very little, desperate measures may be required. The 10% rule is the most direct way to attack the beast.

Transamerica’s statement on its new no-commission VA with income benefits

Posted on January 20, 2017 by Editorial Staff -

Transamerica senior vice president Joe Boan offered the following written response to RIJ’s question about the strategic business rationale for the insurer’s new no-commission annuity contract, Variable Annuity I-Share, which is the subject of a feature article in today’s edition of Retirement Income Journal:

Transamerica has built the Variable Annuity I-Share (and all of our products) with an intent to be fully compliant with existing regulations and the coming DOL fiduciary regulations.

We believe that the market will respond positively to the introduction of the I-Share, given feedback we have already received from advisors and broker-dealer firms, including that the I-Share structure will offer more flexibility for their clients in planning for retirement income.

Transamerica sees the DOL Rule and the requirement to do what is in the best interest of the client as an opportunity to introduce solutions to financial advisors who haven’t considered these products in the past. The need for lifetime income is as strong as it has ever been.

The benefits of tax deferral and lifetime income can only be found in an annuity. We believe fee-based variable annuities with investment flexibility will be one of the few opportunities for clients to plan for guaranteed income and market-type returns.

The Variable Annuity I-Share is designed to be flexible. The client will only pay fees that he/she and the advisor believe are valuable and help solve his/her individual needs. The product is structured similarly to other fee-only products that the industry is driving toward. Transamerica is committed to making our annuities as simple to understand as possible, because we believe that advisors and clients both want and need this type of structure when planning for retirement income.

LIMRA is seen as bearish on the VA market as it currently exists. We think that the outlook for 2017 is too soon to tell, given that the new administration is being inaugurated tomorrow. We are confident that there is a market need for this structure in planning for retirement income. Investors’ need for guaranteed sources of income in retirement is not diminished. In fact, it’s as strong as ever.

Hope trumps fear in new Ed Jones survey

Hanlon Investment Management links to BlackRock’s iRetire methodology

Private equity firm eyes DC market, offers ‘performance-based pricing’

Many in the ‘gig economy’ plan to work indefinitely

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