Ask an Expert - Retirement Income
Ask A Retirement Income Expert By:
Christopher O’Neill
Chief Investment Officer & Director of Research, Investment Strategies Group
Mesirow Financial
356 N. Clark Street
Chicago, IL 60654
Phone: (312) 595 7282
Fax: (312) 595 6139
Email: coneill@mesirowfinancial.com
Web: http://www.mesirowfinancial.com/investmentstrategies
Christopher M. O'Neill, Ph.D., CFA, CFP®, FRM and ChFC is the Chief Investment Officer and Director of Research for the Investment Strategies Group of Mesirow Financial. Investment Strategies is an independent, third party consultant that provides robust asset allocation strategies and fund selection to insurance companies, 401(k) providers, broker/dealers and mutual fund companies. With over two decades of experience in finance and scientific research, Dr. O’Neill has expertise in the areas of quantitative investment manager selection, Monte Carlo simulation and quantitative finance. At Mesirow Financial, Chris has been responsible for developing innovative manager selection and portfolio construction methodologies, as well as a retirement income framework that optimizes both the product allocation and asset allocation for traditional investment products and advanced retirement income products. Prior to joining Mesirow Financial, Dr. O’Neill was a research consultant for Ibbotson Associates, where he applied quantitative analysis and product development experience to support the efforts of the Investment Management Services, Fund of Funds and Financial Communications groups. Earlier, he offered investment advice and methodology to other financial advisors as president and founder of Quantalent Investment Consulting, LLC, an independent Registered Investment Advisor. Additionally, Chris dedicated five years to financial planning, which culminated in a senior product management role and the development of an online investment advice tool for a major mutual fund company. Dr. O’Neill earned his Ph.D. and M.S. degrees in theoretical physics from Cornell University and an A.B. degree in physics magna cum laude from Princeton University. He is a CFA charter holder, a Certified Financial PlannerTM Professional, and holds Financial Risk Manager (FRM) and Chartered Financial Consultant (ChFC) designations. In addition, he has published a variety of papers and academic reports in theoretical particle, accelerator and gravitational physics.
Q: Given the availability of institutionally priced immediate annuities from top rated carriers, why would a plan sponsor want to go through all the hassle and liability of an in-plan guaranteed type option?
I believe this question touches on a key underlying reason behind the proliferation of guaranteed products in general over the past decade, both in the non-qualified arena and more recently in-plan. Immediate fixed annuities have a much longer history as effective instruments for generating lifetime income than their variable product cousins, but one fact that history has demonstrated is the general reluctance investors experience in giving up control of their investment principal to an insurance company in exchange for the promise of future income. This phenomenon persists despite the guaranteed nature of the payments and the superiority of the annuity rates relative to prevailing interest rates for liquid investment alternatives. In-plan products that require annuitization (either fixed or variable) are also available today, but face behavioral barriers similar to those of institutionally priced immediate annuities. While investor education and the general dialogue regarding retirement readiness should enhance the use of immediate annuitization as a payout option in the future, the combination of access to principal, potential equity exposure, and lifetime income guarantees of variable products with income riders has proven to be a powerful one. In addition to offering liquidity throughout retirement, the flexibility of the income stream and the possibility of a balance remaining for beneficiaries at the death of a participant are also attractive relative to a reduced payout under the joint and survivor option typically available for institutionally priced immediate annuities. That said, adoption rates for in-plan guaranteed options have been disappointing for a variety of reasons. The complexity of variable products with income riders and concerns about the long-term solvency of product providers in the wake of the financial crisis appear to have given pause to participants who currently have access to such products, while the operational and fiduciary challenges facing plan sponsors have stymied the addition of such options to plan line-ups. I expect these issues to be mitigated gradually as the financial industry grapples with the dual challenges of investor education and effective operational and fiduciary solutions for in-plan guaranteed products, but the behavioral barriers to immediate annuitization are likely to persist longer. For that reason, the short answer to the question why plan sponsors would want to offer in-plan guaranteed options is that plan participants are more likely to utilize them and therefore benefit from them in retirement. However, I would like to see the behavioral barriers to annuitization crumble under the weight of more effective, long-term investor education. |
Q: Because many retirement plan specialists that act as fiduciary advisors face conflicts that lead to prohibited transactions when trying to meet the needs of terminating participants, how do you feel about “in plan” solutions?
Excellent question. Providing advice to terminating plan participants is a gray and somewhat challenging area for fiduciary advisors. Prestigious ERISA attorneys have often noted that “If you act like a fiduciary, you probably are one." As a result, many recommend that plan level advisors not approach participants until they leave the plan. Plan level advisors may also wish to service only those participants who approach them. In any event, both approaches should be teamed with disclosure and clarified in the plan sponsor agreement. From a practical perspective, plan level advisors should perform a "needs" based analysis. Based upon what is in the participant's best interest, they may then recommend an in-plan or outsourced solution. For example, a terminated person still in the accumulation phase may NOT benefit from an outsourced solution while someone in the distribution or income phase may benefit. When determining suitability and appropriateness, participants who have been investing in a plan's retirement income option pose a special challenge because portability of "in-plan" options remains one of the hurdles to increased usage. Regardless of the solution, they should assume they are functioning as a fiduciary and subject to ERISA statute and regulations. Unlike non-fiduciary wealth managers, fiduciary advisors risk engaging in a prohibited transaction tied to a conflict associated with using their fiduciary influence to increase their compensation, i.e., they can't sell whatever they want to a participant taking a distribution. Unfortunately, opinions about cross selling, prohibited transactions, allowable compensation, referral fees and revenue sharing under the same BD umbrella vary widely at this time. One thing for sure, a formalized approach to wealth management business that has been approved by your BD and is wrapped in full disclosure is essential. Many true retirement plan specialists and their firms are out in front of this issue and go to great lengths to eliminate any conflicts by rebating firm-level revenue sharing, offsetting 12b-1 fees, etc. Fiduciary advisors are also increasingly working for a flat dollar fee and regardless of whether a terminated participant's balance stays in the plan or rolls out, it doesn't affect the advisor's compensation. If the advisor is charging the plan an asset-based fee, best practice dictates offering a rollover IRA solution that incurs the same fee, thus avoiding a PT. On the other hand, providing individualized services for the same low institutional fee may not be feasible. The DOL is currently focused on advisor compensation rather than participant “needs.” As a result, there should more discussion about what the participant needs and fiduciary or not, the compensation should be aligned with the appropriate services |
Q: Why are target payout and absolute return funds not selling?
The statement that target payout and absolute return funds are not selling is an industry misnomer. Putnam's track record on absolute return funds refutes the statement. Since inception fifteen months ago, the firm's four funds have raised almost $1.5 billion. Putnam has been aggressive in marketing the funds as risk focused investments. They also benefited from launching the funds right after the 2008 meltdown, a period in which investor focus on risk soared and returns have been good. On the other hand, target payout funds have not sold well. Most of these funds were launched just before the market meltdown. This poor timing exposed the flawed concept and construction of these funds. Target payout fund investors are motivated by "not running out of money." Ironically, these funds don't address this element and the meltdown exposed it. At that time, investment firms naively believed they could manage away sequence of return issues as well as purporting that the distribution mechanism to create the income was a matter of convenience. Given that the biggest risk to these funds is the distribution mechanism, the thought process proved wrong. Indeed, the distribution mechanism is far more important than the asset management model and when correct, almost any asset management model will work. If the ratio is incorrect, very few will perform as expected. Until these concepts are thoroughly understood and employed, the industry fails to address the risk related concerns of investors. Consequently, the absolute returns funds are selling because they focus on risk management while the target payout funds are not selling because they ignore risk. |
Q: Putnam recently introduced a series of absolute return funds designed to deliver positive results with less volatility than traditional funds over a three year period. The 100, 300, 500 and 700 funds were designed to outperform the rate of inflation by a similar amount in basis points. These funds have captured about $500 million and they are now adding them as components of their target date RetirementReady Funds. Is this the Holy Grail or another gimmick? I still remember the disaster called "Government Plus Funds."
Tough question! Putnam has a disappointing history of new concepts for fund management. However, under new leadership, the Putnam of today is a very different company. Robert Reynolds recruited Rob Bloemker and Jeffrey Knight to manage the funds, two of the strongest teams in the Putnam stable. Absolute return funds are not new and because they underperform relative return portfolios over time, they have delivered uneven results. Frankly, if time is not an issue, why sacrifice return? It is also important to note that absolute return is a goal, not a guarantee. Critics suggest the name implies a guarantee and as a result, some feel FINRA should consider restricting the use of the term. Nevertheless, it does not invalidate the strategy as a way for investors to control volatility. Historical data suggests that most responsible withdrawal strategies (4-6%) from multi-asset portfolios will work in the absence of dramatic portfolio draw-downs and that is the primary goal of retirement age investors. Reducing volatility is also the foundation of the target date glide path. Recent market performance confirms that adjusting the relationship of equities to fixed income in relative performance based portfolios is not enough. Non-traditional asset classes such as real estate, commodities and currencies have been added to portfolios in an attempt to reduce volatility. Managers are no more likely to meet the goal of absolute return than they are to beat an index, but transitioning from relative performance based strategies to absolute return based strategies makes sense. Putnam's inclusion of the Absolute Return Funds as components of their RetirementReady Funds also represent a logical evolution for target date funds. In short, the final determinant will be execution. If Bloemker and Knight can execute their models, time sensitive investors may be well served. Nevertheless, Putnam would be wise to undersell absolute return portfolios and focus on portfolios with sustainable withdrawals. After all, that is what investors are really seeking. On a final note, real analysis requires a real portfolio. Back testing has never been an accurate predictor of performance. As asset managers shift resources to lifetime distributions, i.e., the ultimate end game, many similar products will be introduced in the years ahead. |
Q: Managed payout funds were launched just before the market collapsed. NAVs are down 30-40%; distributions have declined 20-30% from projections and represent return of principal. What happened to these funds and is there any reason to consider them?
The failure of managed payout funds has not been a failure of execution, but rather a broad market decline across almost all asset classes. Most of the funds will no doubt recover when the markets recover. A lack of conceptualization and design is the real failure of these funds. What most investors and advisors want is multi-asset portfolios that are managed for the added risks of consistent distribution demands. What they got is traditional asset allocation portfolios with an internal systematic withdrawal plan attached. I would be cautious with these funds until their sophisticated asset management techniques focus on risk reduction rather than performance. These funds should be focusing on absolute returns rather than beating an index. |
Q: The current market has decimated retirement accounts. Target date funds have done little to protect one’s ability to retire on schedule. The recently launched managed payout funds have also not done well and annuity providers are raising fees and lowering benefits for GMWB riders. What are the best options available for advisors that will help individuals plan for and survive retirement?
The most important lesson of the 2008 market meltdown is the realization that the industry can’t meet the needs of the retirement income market by teaming guarantees and/or distribution mechanisms with accumulation oriented portfolios. As the maturity date approaches, target date funds must change both the asset allocation model as well as the asset management strategy. The tools may be similar, but the design, structure and implementation must be focused on risk/volatility control rather than outperformance. The current financial market conditions are extreme. The outcome is unknown and all approaches are facing extraordinary pressure. The current models were designed to maintain integrity during normal market cycles. This is not a normal cycle. All markets are dynamic and follow a pendulum swing from undervaluation to overvaluation and back again. This principle is also applicable to financial equity, debt, real estate and commodity asset classes along with growth, value or dividend income strategies. The greatest safety mechanism is perhaps the acceptance of uncertainty. Meanwhile, advisors should seek solutions and products which are flexible enough to meet today’s challenges and adapt to future needs. |
Q: Are there any guaranteed income options available in the 401(k) plan market? What is on the horizon that may help?
With the caveat that guarantees are only as good as the guarantor, there are some new product offerings for the qualified retirement plan market which offer selected portfolios and come with a lifetime guaranteed minimum withdrawal benefit (GMWB). For example, the John Hancock Guaranteed Income for Life (GIfL) product is similar in concept to the GMWB riders offered in retail variable annuity products with the exception of costs. The John Hancock retirement program is a group annuity and the GIfL takes the form of a participant selected rider to the group annuity. Thus, there are no additional M&E fees, resulting in attractive pricing. The guarantee for single coverage is a 5% annual lifetime withdrawal benefit, which is reduced to 4.5% when including the life of the spouse. Participants have a choice of John Hancock lifestyle asset allocation portfolios and John Hancock managed fund of funds portfolios. |
Q: I have been hearing about low volatility portfolios. What are they and who offers them?
The current market conditions have put new focus on low volatility (also called managed volatility) asset management strategies. These strategies invest in low volatility stocks to control risk while attempting to earn market returns. State Street Global Advisors, JPMorgan Asset Management, Analytic Investors and Acadian Asset Management have recently developed portfolios based on this concept. Ric Thomas, Managing Director of Enhanced Equities at State Street Global Advisors, has developed some compelling data on domestic and global low volatility portfolios. Advisors might be well served by considering portfolios of this nature in retirement plans. The strategy may underperform benchmarks during bull market conditions, but the risk management should appeal to conservative investors. Going forward, low volatility strategies could play a bigger role in the equity exposure of multi-asset allocation portfolios in the retirement income market. Retirement income portfolios should focus on managing volatility and not on outperformance. The inclusion of low volatility strategies that reduce the sequence of return issues seem to be an obvious choice. Because low volatility strategies tend to have a high degree of tracking error, benchmark oriented investors may prefer other strategies during bull market conditions, but income oriented investors should remain comfortable with the consistency of their returns. |
Q: I have been using retail annuities with Guaranteed Lifetime Minimum Withdrawal Benefits (GMWB) as a rollover vehicle for my clients. Now that the markets are down 40%, clients taking the 5% annual withdrawal at the original contract value are happy to have their income protected. What do I do for the clients who aren’t taking distributions? The original plan was to wait for annual step-ups before starting withdrawals to meet RMD requirements at 70 ½. If possible, should I have the client add to the accounts? I also have clients with non-qualified annuities. What would be the best strategy for them?
Adding to an account that is down 40% because of market conditions is normally a sound idea, but not in this case. If the client is eligible, it would make sense to immediately start taking the 5% GMWB payment and reinvesting the distribution into a new contract, assuming of course the client still wants a guarantee. The dollar value of the 5% GMWB will not increase until the current market value of the contract increases 60%. Using an example of a 64 year old with a rollover of $100,000 reduced to a current market value of $60,000, the GMWB would be $5,000 a year for life. Until the $60,000 recovers to above $100,000, there is no increase in the $5,000 distribution. However, if the GMWB is taken every year until the client reaches 70, the $30,000 reinvested in a new contract with a 5% GMWB would have an additional $1,500 per year guarantee without growth in the market value. This would be true in both a qualified and non-qualified annuity contract. In the qualified annuity contract, the GMWB distribution would not be taxable if it is taken as a distribution into a rollover IRA. In the non-qualified annuity contract, the distribution of the GMWB would not be taxable until the value of the annual distributions and the year end market value of the contract exceed the original $100,000 contract value. Should the investor want to add more, the additional money should be invested in a new contract. |
Q: With talk of an extended recession and even a depression, my clients are scared. To protect against a worst case scenario, I have been considering principal protection funds. What is your opinion?
These funds typically draw attention when fear is great. However, it is important to remember that the principal protection only relates to a specific future maturity date. In other words, the investment has market risk until that date. These funds tend to have high fees and asset management is constrained by the principal protection goal. You can accomplish the same goal by split funding a period certain fixed rate annuity and an index fund. For example, $78,353 invested in a five year fixed annuity at 5% (you can shop for the most competitive rate) matures at $100,000. The balance of $21,647 could be invested in an S&P 500 index fund. If the index fund drops to zero (highly unlikely), the client would still have the $100,000 protection at maturity. (The amounts can be adjusted to cover taxes.) The fees would be lower with this approach and the client gains liquidity on the index investment component. |
