Holiday Cheer
Conventional wisdom tells us that last winter's collapse in equity and housing prices devastated the finances of millions of Baby Boomers and left their dreams of a secure retirement, let alone an early or ideal retirement, in tatters.
But several research studies published by authoritative sources in recent months show that the situation isn't necessarily as dire as the mass media or the latest end-of-civilization movies like “2012” and “The Road” would have us believe.
These new studies suggest that, contrary to myth, most Boomers didn't blow their home equity on plasma TVs, most Boomers didn't lose most of their wealth in the equity and real estate crashes, and most Boomers will be able to retire on time or close to it.
To be sure, suffering exists. People in their 50s who lost their jobs and people who lost their homes to foreclosure face difficult futures. And if the stagflation of the 1970s returns, many of us may find ourselves clipping coupons and looking for senior discounts at theaters and restaurants in retirement.
But the data shows that most of the people that financial advisors and investment companies focus on—over 50, college-educated, and in the upper wealth tiers—came through the crash with a great deal of their wealth intact. If you count the present value of pensions and Social Security as part of household wealth, a surprisingly small percentage of anyone's wealth is tied up in equities.
Hold the apocalypse
In their study, “The Wealth of Older Americans and the Sub-Prime Debacle,” Barry Bosworth and Rosanna Smart of the Brookings Institute start out on a somber note, saying that “no demographic group was left unscathed” by the 2008-2009 financial crisis.
But the data itself offers a less apocalyptic view. For one thing, there's no evidence that Boomers “used their homes like ATMs.” Of the 44.9 million homeowners over age 50 in the years 2004 to 2007, 24% extracted money from their home equity.
But of the $12 trillion that their homes were worth, they extracted only $479 billion, or four percent. Almost half (45%) used the money for home improvements. Only 10% financed “consumption”—those proverbial plasma TVs—with home equity.
At the market bottom last March, Smart and Bosworth show, Americans households had lost about a quarter of their wealth. But, even before the upturn, the households that advisors and financial services companies focus on—college-educated people over age 50 and in the upper-third of wealth ownership—still had significant wealth.
If housing wealth and the present value of Social Security and pensions are included, older, wealthier households had average wealth of $1.33 million at the market bottom. That's down from $1.77 million in 2007, when real estate and stock market values were inflated, but it's far from total ruin. In real terms (2000 dollars), this segment had almost twice as much wealth in 2009 as in 1983.
By contrast, younger, middle-market people fared worse. That happened not because they lost money in the stock market; they don't own many stocks. It happened because they were more likely to have purchased homes more recently and had less home equity.
Households headed by someone under age 50 in the middle-wealth tercile, for instance, lost 41% of their wealth in the crash. The average wealth of that group—including housing and the present value of public and private pensions—fell to $45,000 in 2009 from $76,000 in 2007 (in 2000 dollars).
“The percentage losses are larger for younger than for older households,” commented Bosworth and Smart. “The larger loss among younger families is concentrated in housing wealth, which reflects their lower ratio of home equity to value. Thus, a 20% loss in home value became a 45% loss in home equity. Older households have a larger equity position and that translates into a smaller 30% loss of housing wealth.
“[We found] that the losses have been larger for younger households and that less-educated and lower-income households below age 50 have suffered particularly large declines in wealth," they added. "Younger middle-income households show the largest losses, 40%, because their wealth holdings are dominated by housing with a low equity share, and reliance on defined-contribution retirement accounts, which also were hard hit by the fall in equity prices.”
Averages can mislead
In a similar analysis of the impact of the Great Crash, economists at Dartmouth College and Texas Tech University delve below the statistics on average market losses and show that, although stock ownership in U.S. is highly concentrated among the wealthiest Americans, even they don't have very much of their household wealth tied up in equities. As a result, the crash by itself shouldn't ruin their ability to retire as planned.
Looking at the distribution of assets in 2006 of households with at least one member born from 1948 to 1953 (excluding the top one percent, which skews the averages upward), the study showed that on average the households held $115,400 in stocks and that 13.2% of their total wealth (including homes and present value of Social Security and retirement benefits) was invested directly or indirectly in stocks.
But the averages are misleading. The richest nine percent of this group had an average of $561,000 in stocks (8.4% directly and a total of 20.7% if retirement plans are included) while those in next wealthiest decile averaged $237,000 in stocks (5.1% directly and 15.1% overall). No other group had more than 2.6% of their wealth invested directly in stocks.
“We find those nearing retirement had only limited exposure to the stock market decline,” say the authors of “How Do Pension Changes Affect Retirement Preparedness? The Trend to Defined Contribution Plans and the Vulnerability of the Retirement Age Population to the Stock Market Decline of 2008-2009”.
“When direct stock holdings, and stock holdings in IRAs, are added to stock holdings in DC plans, in 2006 total stock holdings of the early boomer cohort averaged 13.2 percent of total wealth. This greatly limits the direct exposure of the early boomer population to the decline in the stock market," they add. “We also show that as a result, despite speculation to the contrary, those approaching retirement are not likely to substantially delay their retirement in reaction to the stock market decline, probably postponing their retirement by no more than a couple of months.”
Equities and retirement
In a new paper, “Retirement Security and the Stock Market Crash: What Are the Possible Outcomes,” three Urban Institute researchers take the analysis a step farther and compare how early, middle and late Boomers might fare under a variety of stock market scenarios over the next decade or so.
The authors, Barbara A. Butrica, Karen E. Smith and Eric J. Toder, compare several alternative futures for the economy, including a “no recovery” scenario where stocks resume their historical growth from a low, post-crash base; a “full recovery” scenario where stocks make up all their 2008 losses by 2017; and (the worst case scenario) a repeat of the 1970s.
Future market behavior, they find, will mainly affect people who own a lot of stocks, which means those with highest incomes and the most education. If there's no recovery, those in the top wealth quintile who were born between 1951 and 1955 can expect an 11% drop in income by the time they reach age 67. If there's a repeat of the 1970s, their retirement incomes could fall 20%. That's about double the impact on any other group.
“Major income losses from the crash are concentrated among high income groups who own the most stocks. Pre-boomers will on average be worse off, regardless of whether or not the market recovers. Middle and late boomers will also be worse off on average if the market fails to rebound to its previous growth path, but may be net winners if the market drop is temporary and they can benefit from the opportunity to buy low and sell high,” the Urban Institute researchers said.
“Another year of work, however, virtually eliminates any big losers among individuals in the bottom three quintiles in the middle and late boomer cohorts,” they added. “Because low-income individuals receive a relatively small share of their retirement income from DC plans assets and other financial wealth, working another year wipes out most of any losses that they might have sustained, even if the market fails to recover or continues to decline as it did after 1974.”
What's the big lesson of this research? Most Boomers in higher income groups still have enough pension, housing, and stock market wealth to be able to retire with no dramatic reduction in income, barring anything but an extended bear market in stocks. Those who are most exposed to stock market losses are also the most well-equipped to withstand them.
There's plenty of pain, particularly among people who have lost their jobs and those who lost their homes. But, generally, as long as there are enough jobs and as long as Social Security is funded, most people will retire as planned. By and large, American retirement doesn't rest on equities.
© 2009 RIJ Publishing. All rights reserved.
Ally, Ally, InFRE
If you've attended a retirement income conference anywhere in the continental United States recently, you've probably met Kevin S. Seibert, CFP, CEBS, CRC, managing director of the International Foundation for Retirement Education, or InFRE.
A tall, sandy-haired Midwesterner, the Barrington, Ill.-based Seibert logs many thousands of air miles each year, delivering slide presentations at retirement conferences and teaching workshops on retirement income to groups of financial advisors, often at banks and insurance companies.
You may even have heard Seibert describe his epiphany when he broke with the orthodoxy of conventional financial planning and realized that life annuities, by virtue of their mortality credits, can be an important source of retirement income.
If you've seen Seibert lately, you may also have heard him announce that the Certified Retirement Counselor designation, which InFRE confers, is now accredited by the National Commission for Certifying Agencies, after two years of work by Seibert and his colleague, Betty Meredith, CFA, CFP, CRC.
So-called "senior designations," as you probably know, have become objects of controversy. Two years ago, a number of self-described “senior specialists” used flimsy credentials and free lunches to hustle retired investors. Several states began prosecuting them.
Regulations soon followed. The State of Massachusetts eventually banned the use of senior certificates except for those accredited by either the NCCA or the American National Standards Institute, two organizations that certify certifiers.
Financial advisors clearly benefit from having the right acronyms after their names. In the retirement income sphere, several certifying bodies are vying for advisors' attention. To help advisors understand their options, RIJ has initiated an occasional series on organizations that offer certificates in the retirement space.
A few weeks ago, we reported on the Retirement Management Analyst designation, which is currently in development by the Boston-based Retirement Income Industry Association. This week we report on InFre's Certified Retirement Counselor designation.
Non-partisan manual
Depending on how much you've already read about or know about retirement income, the topics that InFRE's manuals cover and the skills that are assessed during the four-hour, 200-question CRC exams may either be familiar or entirely new.
InFRE's 276-page, spiral-bound study guide, “Strategies for Managing Retirement Income,” written by Meredith and Seibert in partnership with NAVA (now the Insured Retirement Institute), presents a six-step process that covers all the basics—client assessment, management of retirement risks, income generation, etc.—in thorough and even-handed detail. It doesn't push any particular philosophy, other than perhaps the assumption that retirement income planning is quite different from financial planning in mid-life.
“We took a lot of the information that's already out there, we researched it thoroughly, and we used it to develop Strategies for Managing Retirement Income,” Seibert told RIJ. “That's our main course of study, but it's separate from CRC. It goes into more depth than the study guides for the CRC examination.”
The distinction between the educational materials that InFRE promotes and the CRC study guides or “Test Specifications” is an important one. To be NCCA-accredited, a certifying body must show that it isn't merely using a designation as an excuse to sell textbooks or other paraphernalia. Nor does the NCCA accredit an organization that simply awards a framable “diploma” to people who have completed a specific course of study.
“A certification program isn't based on the education, it's based on knowledge,” said Jim Kendzel, executive director of the Institute for Credentialing Excellence, or ICE, of which the NCCA is the accrediting arm. “It's always linked to an assessment tool, and it always involves a continuing education requirement.”
(The credentialing process presents a kind of infinite regression. InFRE is accredited by NCCA, which is part of ICE. ICE, in turn, is accredited by the American National Standards Institute, whose board consists of officers of major U.S. corporations, academics, and federal officials. ANSI represents the U.S. at the ISO, or International Organization for Standardization, which governs the ISO 9000 quality standards.)
InFRE met those requirements in September, after a two-year application process—and twelve years after the CRC was created. InFRE first developed the designation in 1997 in partnership with the Center for Financial Responsibility at Texas Tech University in Lubbock and with help from a federal grant. It has been certifying and re-certifying financial professionals since then.
“About 2,000 people are accredited or in the process of being accredited, and we're hoping to go to 3,000 by end of 2010,” Seibert told RIJ. “About 60% to 70% are in financial services. Our growth slowed down last year, as anticipated, because state compliance departments were saying, ‘We're not going to let you use your retirement designation until it's accredited.’”
One of the first to receive the CRC from InFRE was Linda Laborde Deane, CFP, AIF (Accredited Investment Fiduciary) of Deane Retirement Strategies in New Orleans. Her son Keith, a 2008 University of Georgia graduate, is among the most recent to start the CRC process.
“The more credentialing you have, the more clients respect you and the more confidence they have in you,” she told RIJ. “It's important that CRC has continuing education requirements because clients are aware of that—that is, if you make them aware of it.”
Deane sees no need for annuities for her retired clients, preferring to rely on prudent, adjustable systematic withdrawals for income. She advises her clients each year on how much they can afford to harvest from their accounts. Though not a market timer, she watches the markets closely. In July 2006 she eased back to a 50/50 balance of stocks and bonds, then stood pat. “My clients went through 2008 without any decrease in their income,” she said.
Annuity revelation
Seibert joined InFRE in 2003. A graduate of Miami University of Ohio with an MBA from the University of Wisconsin, he founded and operated Balance Financial Services, a Chicago financial planning and consulting in 1988. Earlier, he'd been a consultant at William M. Mercer Inc., specializing in employee benefits.
His financial life includes a conversion of sorts. “When you grow up in the fee-only CFP world, you're taught to think that annuities are bad." He had not considered the mortality pooling effect, however, which enhances the wealth of the surviving annuity owners.
“That was something of a revelation,” he said. “And you're not just getting more income than you would otherwise. You're preserving your managed assets as well by making sure that your basic needs will always be met. One of the cons of annuities is that they take away from your estate. But the opposite is true. If you live a long time, they can preserve your estate.”
You might notice that Seibert and Deane don't hold identical views on the value of income annuities. But then, there's nothing in the CRC designation that says they have to.
© 2009 RIJ Publishing. All rights reserved.
Thoughts on the Future of Retirement Income Products
In the past few years, we have seen the emergence of many new retirement income products. With the exception of guaranteed minimum withdrawal riders on variable annuities, however, we have seen very little in the way of sales of any of the products. In this article, I'll discuss pros and cons of the various products from my perspective as a financial planner, assess the prospects for these products, and recommend what I believe would be an optimal solution for many people.
The Immediate Annuity
This product has been the “product of the future” for more than a decade, but the future never seems to arrive. Sales limp along at an annual rate of $10 billion or so, compared to $250 billion for deferred annuities. One rationale for the low sales is consumer aversion to large, irreversible financial commitments, particularly where shorter-than-expected longevity would result in a retrospectively bad investment. Sales may also be low because financial salespeople are loath to sell a financial product that kills the prospect of any future rollover commissions. Given the lack of sales push or customer pull, insurance companies don't devote a lot of resources to developing or promoting such products.
However, despite all the negatives, the immediate annuity is a simple product that can match up well with retirement income needs, particularly if payments increase with inflation. Prospects for this product may improve if 401(k) plans are enhanced to make it easy to convert savings into retirement income. It could become attractive for fee-based planners, but few fee-based planners serve the low- and middle-income clients who could best use the mortality-pooling benefits of an immediate annuity to stretch scarce retirement savings. Also, most financial planners have focused on accumulation and not retirement income products.
The following changes might allow immediate annuities (and other retirement products I'll discuss later) to play a more prominent role in retirement planning:
- Requiring that retirement savings plans offer an immediate annuity option.
- Providing tax subsidies for financial planning to spur the development of a fee-based financial planning industry serving participants in retirement plans.
- Providing planners with the training and software they will need to incorporate immediate annuities and other guaranteed products in retirement plans.
Longevity Insurance
This product also goes by the longer name of Advance-Life Delayed Annuity (ALDA). It's an income annuity where the first payment is delayed for a number of years. For example, a 65-year-old man could purchase longevity insurance that pays an income for life that begins at age 85. If the individual dies before reaching age 85, no payout occurs. The individual would need to plan on making retirement savings last to age 85 and then rely on the longevity insurance for income thereafter. The individual would be freed from the planning challenge of trying to make retirement assets last for an unknown future lifetime.
Because of the income deferral, this product costs less than an immediate annuity. An immediate annuity paying an inflation-adjusted $20,000 per year might cost about $290,000, while longevity insurance paying the same benefit would cost only about $40,000.
This product first came on the market a couple of years ago and I'm aware of two companies that offer it. Anecdotal evidence suggests that sales have been miniscule. As with the immediate annuity, the retirement marketplace doesn't seem to be set up to pay much attention to this type of product. Also, the financial crisis and the problems faced by a formerly AAA company like AIG have made individuals nervous about buying a product that delays income for 20 or more years.
The product also has a fundamental design problem. Going back to our example, let's say the individual buys the product and then needs to make other savings last until age 85. If individuals make overly aggressive assumptions about investment growth, they may run out of assets before age 85 and then face a period without income. If they are too conservative, they may reach age 85 with more assets than they need, and may regret not spending more money when they could have enjoyed it.
The fix for this problem would be to combine longevity insurance with a product that guarantees withdrawals until age 85 regardless of investment performance. This would be an acronymic marriage of a limited-term GMWB or RCLA (discussed next) with the ALDA. I believe that longevity insurance has potential as a component in building retirement guarantees, but I don't foresee strong prospects for it as a stand-alone product.
The Guaranteed Minimum Withdrawal Benefit (GMWB)
This product is offered as a variable annuity rider and has gone through a number of transformations over the decade or so of its existence. The latest version, called the Guaranteed Lifetime Withdrawal Benefit (GLWB), guarantees the annuity purchaser certain minimum withdrawals from the annuity for life (5% of the initial purchase amount is typical), regardless of investment performance. The purchaser pays .50% to 1.00% per year for this rider.
I like this concept for its guarantees, but I have these concerns:
Complexity. This is an “actuaries-gone-wild” product where instead of offering a simple income guarantee based on an initial purchase amount, the product's guarantees vary with a ratcheting provision based on underlying fund performance. As a financial planner, I would rather show the client something simpler-“Pay X, and y ou're guaranteed Y-end of story.”
Lack of Inflation Protection. At 2.5% inflation, a 5% fixed guarantee is worth only about 3% in 20 years, and 3% isn't much of a withdrawal guarantee. I would like to see a product whose guaranteed payouts increase based on actual inflation. Products offered today provide some upside based on underlying fund performance, but the correlation with actual inflation is tenuous.
Cost. A typical variable annuity costs about 2.25% per year. If we add .50% to 1.00% for the rider, we're near 3.00%. Recent estimates for the premium of future stock returns over bond returns range from 3% to 6%. If that's the case, a client who uses a variable annuity with a GLWB rider might end up paying out between 50% and 100% of the equity premium in fees.
Rider Utilization. At least one study has shown that, to make best use of the GWLB rider, the customer should take withdrawals at the maximum allowed level immediately after purchase and continue them for life—that is, turn the product into an immediate annuity with an equity-linked refund feature. My impression is that most customers will use the product for accumulation and never call on the income features at all—thereby turning the product into a very expensive mutual fund investment.
In some ways, the GLWB is ideal for guaranteeing retirement income. But its effectiveness in meeting customer needs is seriously compromised. Given the attractive commissions offered on variable annuities, I expect sales to remain strong. But I think there is a better way forward for the customer, and that takes the form of the next product.
Ruin Contingent Life Annuity (RCLA)
This product is the brainchild of Professor Moshe Milevsky of York University in Toronto. He has noted that it is basically an unbundled version of the GLWB. The product was described in detail in Retirement Income Journal so I'll provide a simplified example here.
Begin with a block of assets that will be used to provide inflation-adjusted withdrawals at some set percentage of the initial amount. The customer purchases a guarantee that if the funds are depleted-due to longevity, poor investment returns, or an adverse sequence of investment returns-the guarantee will kick in and inflation-adjusted payment will continue for life. Because payouts are a function of multiple contingencies-longevity and investment related-the product will cost less than a longevity insurance policy that pays out based on longevity only.
Before illustrating how the RCLA works, I'll show results for other product solutions. We'll start with a 65-year-old man with $325,000 of savings and the desire to withdraw an inflation-adjusted $20,000 per year for life. One solution would be simply to invest the money, take systematic withdrawals, and hope the money lasts a lifetime. Assuming 2% inflation, 4% bond returns, 8% stock returns, and a 50/50 stock bond mix, the portfolio would last until age 91. The risks with this approach are: (1) living beyond age 91, (2) experiencing returns lower than assumed, or (3) experiencing a bad sequence of returns, i.e. low returns in the early years of retirement.
A very different solution would be to guarantee a lifetime income by purchasing an immediate annuity. At current rates, an inflation-adjusted annuity generating an initial income of $20,000 might cost about $290,000. That would meet the need for guaranteed lifetime income, but would lock up all but $35,000 of the available funds and leave disappointed heirs if the retiree were to die early.
What about longevity insurance? An ALDA purchased at age 65 and providing $20,000 per year (in today's dollars) beginning at age 85 would cost about $40,000. That would leave $285,000 to provide income for 20 years. Based on the inflation and investment assumptions used in the systematic withdrawal example above, we would expect the $285,000 to last 22 years-not much margin to guard against bad investment experience. Based on some Monte Carlo analysis, there's a 44% chance the assets would not last the needed 20 years.
Now let's look at the RCLA. An RCLA able to produce the required income might cost roughly $20,000, leaving $305,000 as the portfolio on which guaranteed withdrawals would be taken. In effect, we have created the same lifetime guarantee as the immediate annuity, but with $305,000 of initial liquidity for heirs vs. $35,000 if we purchased an immediate annuity. Among legacy-minded retirees, this may lessen the resistance to the initial purchase. (Of course, the $35,000 would be expected to grow over time and the $305,000 to decline, making the immediate annuity potentially the better investment if the retiree lives a long life.) I have not provided an example based on a variable annuity with a GLWB because I am not aware of any that provide a simple inflation guarantee. But with their high expense charges, GLWBs would not produce results as attractive as with the RCLA.
Compared with the RCLA, a disadvantage of annuities and longevity insurance is that the pricing reflects the insurance companies' cost of holding reserves for such products in fixed income investments. Even though these represent long-term commitments, insurers are not allowed to support them with a mix of stock and bond investments. GLWB and RCLA pricing allows for equity investing and equity option pricing, which means a lower price for consumers.
Conclusion
Both immediate annuities and the RCLA can help clients build secure retirement plans. But neither of them, as I suggested earlier, is likely to get off the drawing board and into retiree portfolios without major changes, such as mandating that retirement savings plans offer the product, subsidizing the growth of the fee-based planner industry, and providing software and training that supports the use of this product. Existing product delivery systems won't suffice.
© 2009 RIJ Publishing. All rights reserved.
Industry Views,
Annuity Firms Turn Their Focus To Online Client Security
Annuity issuers are finally beginning to beef up the security of their client sites. Firms have bolstered login requirements, strengthened security measures and educated users about online crimes. A number of annuity client websites now offer detailed tutorials on phishing and other online scams. Several firms have ramped up their login security features.
Pacific Life, for one, has overhauled its entire client login process. The firm implemented computer recognition, which allows only users logging in from verified IP addresses to access account information.
Users can verify their computer by successfully answering a predetermined security question. Clients are also asked to select an image and create a custom caption that will appear on the password screen in order to confirm the page's authenticity.
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| Private Enhanced Security Login |
Allianz and TIAA-CREF also enhanced their respective client login processes. Allianz tightened its password criteria, forcing clients to choose more secure passwords. Clients are required to change their password every 90 days; Allianz is the only firm we track that requires regular password updates. In January, TIAA-CREF introduced a new login system that incorporates security questions into the regular username/password login process.
More firms are also employing automatic logouts. This simple but effective feature automatically ends a user's session after they have been idle for a set period of time (most of our firms will now automatically log a client off after 15-30 minutes of inactivity).
Such improvements are more the exception than the rule, however. Pacific Life and Vanguard are the only firms that have incorporated computer recognition as well as customizable security imagery and captions into the login process. Most of the firms we track continue to use barebones login requirements. Too many firms have neglected to make online security a priority.
Although annuity firms have improved client security, they lag behind brokerages and banks. When Corporate Insight launched annuity coverage in 2006, for example, all of the firms in our roster simply required clients to enter a username and password to gain access to online account information. At that time, many banking, credit card and brokerage firms had already added stringent two-factor authentication methods to their login processes.
The speed at which annuity transactions are processed may help explain why annuity firms have short-changed security. Unlike transactions on brokerage websites, where trades are completed instantaneously, annuity transactions take at least one business day to clear. There's significantly more time to detect fraud.
Because most investors purchase annuities through advisors, there's usually a second set of eyes monitoring the contracts for suspicious activity. The heavily regulated nature of the product provides additional layers of protection. But these are not reasons for complacency or lax security. The sensitive personal information found on annuity websites will always make them potential targets for identity thieves. More than ever, firms must stress safety and prevention.
© 2009 Corporate Insight, Inc. All rights reserved.
Industry Views are special reports that are sponsored and independent from RIJ's editorial content.