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Friday September 8, 2017

Annuities, Bonds, and Bad Advice

Recently I was working with a client on analyzing and reallocating his IRA investment portfolio. The portfolio was substantial (over $3M) and was 40% Equities, 40% Bond, and 20% Cash. I really liked this allocation for someone his age (70) and told him that the only real improvements would be using a responsive, tactical investment management platform and to improve his Bond Allocation. The fees on the products and funds he held were already low at an average cost of 1.14%.

In assessing the Bond Allocation, using Morningstar’s X-ray Analysis, we found that over half the total was held in High-Yield or junk bonds. While there is nothing inherently wrong with holding a portion of one’s Fixed Income allocation in High Yield Bonds as a means of diversification and improving the overall yield, a 60% allocation seemed a bit high. Moreover, the total yield on his Fixed Income/Bond allocation was only 3.4%.

I came back to this client with the suggestion of replacing his Fixed Income/Bond Allocation with a combination of Fixed Index Annuities. The criteria I used for my recommendations were that any fees associated with these FIA’s should be comparable to his current annual cost of the Bond Allocation, which was .96%., that any annuity carriers we considered should have a credit rating of A+ or better, and that we could reasonably expect to exceed the current yield of his Bond Portfolio.

Many leading advisors (myself included) view a fixed indexed annuity (FIA) as another fixed income asset and allocate them accordingly:
• An alternative to low yielding bond allocations.
• Allows the investment professional to be as “active” as necessary in other areas of
the wealth management process.
• Provides a range of interest crediting methods with both capped and uncapped
strategies managed by leading investment banks.
• Provides for an ongoing guaranteed income stream for the client and spouse if desired.

The two FIA’s I recommended for this client had internal fees of .95% and .4% respectively, for an average cost of ownership of .675% annually, lower than the current cost of his Bond Funds. The performance of these annuities were tied to underlying diversified stock indices that were managed with volatility controls and had the ability to shift allocations monthly. Disclaimer: Index Annuities are never meant to be a competitor for true equity investments and are not direct investments in the underlying market indices. A reasonable return expectation for this type of product would be between 3½% – 5% over time, with negative index periods earning a 0% return. That’s why they are a viable substitute for bond positions.

This would remove the Market Risk, Credit Risk and Interest Rate Risk associated with his current Bond Allocation, lower the overall annual cost and potentially improve the annual returns. In addition, there is the option of a guaranteed lifetime income that would protect the client (and his spouse) from the risk of extreme longevity. While there are substantial surrender charges in the early years to withdraw more than the annual free amount, Required Distributions from IRA’s are never penalized and that’s all the client anticipated ever withdrawing. Seemed like a no-brainer. Except that it wasn’t.

When we finished with the analysis of the FIA’s, their performance data, reasonable projections, and the financial data on the carriers that offer the products, we scheduled our next meeting for the following week to begin the transfers and implementation of this strategy.

This next meeting is where the process fell apart. Why? Because his (adult) kid heard somewhere that annuities weren’t a good thing to do. While I’m sure that this child is smart, expertise as an elementary school teacher doesn’t qualify one to render complex investment advice. But that’s sometimes how it goes; blood is thicker than 25 years of experience and numerous advanced planning designations. In these situations I just have to let it go or run the risk of insulting the client by impugning the intelligence of their oh- so-smart progeny.

In my opinion, Index Annuities are actually over-hyped and oversold by agents (often posing as fiduciary advisors) as the silver bullet for everything investment related. Cable stations and weekend radio shows are filled with agents dispensing advice about how Index Annuities are the answer to whatever ails you. Market-like returns? Index Annuities! High Growth, No Risk? Index Annuities! Erectile dysfunction? Index Annuities! The only thing more annoying is former TV stars telling people to stockpile gold for the coming financial apocalypse.

Why are annuities so over-hyped? Because they pay commissions. Earning commissions on these products is not inherently wrong or against the best interest of the client, unless the product is not properly positioned and/or sold for the wrong reason – strictly for earning a commission.

But there’s no doubt that annuities can and do solve many of the challenges faced by retirees. The puzzle has been that consumers, and advisors to a large extent, don’t understand where annuities fit or how to use them effectively.

For me there are three primary uses for annuities in my practice – replacing Bonds or Bond Funds with a more efficient alternative in a client’s comprehensive financial plan, filling a defined need for current or future income, or for that client that just can’t stomach any real market risk.

A Wall Street Journal article once referred to income annuities as “super bonds,” which is not the most accurate term. A more appropriate term would be “actuarial bonds.” Extensive research in the field of Retirement Income Planning concludes that income annuities significantly improve retirement outcomes over what is possible with bonds or bond funds.

Unless of course your clients’ kids heard something from somewhere and doesn’t like them.

But for actual research, I suggest the following blogs:
https://retirementresearcher.com/
http://www.theretirementcafe.com/
http://squaredawayblog.bc.edu/

Tuesday August 4, 2015

How 401(k) Plans Have Failed Us

The following is excerpted from an article in Think Advisor Magazine by Alicia Munnell of Simply Money:

The 401(k) is America’s most common retirement plan and is also its most misused plan.  The 401(k) is a ‘failed experiment’ in retirement planning and there’s plenty of blame to go around. Let’s declare 2015 the year we officially recognize 401(k) plans as a failed experiment in retirement planning. And let’s give some credit for that to plaintiffs’ attorneys, the Supreme Court and the Department of Labor.

To be fair, lots of credit also goes to the CFOs and HR professionals who cut costs on 401(k) plans to bare bones and failed to educate employees about how to use their investment options. Let’s not forget the fund companies that enjoyed years of large fees without scrutiny, or third-party administrators who used higher internal expenses to rebate the company’s costs back to the employer. Financial advisors who pocketed 12b-1 fees and other forms of trailing commissions can’t be completely overlooked, either.

Imagine how recent lawsuits would have gone if the 401(k)s had done a good job. What if the plaintiffs had sued about plan expenses and the companies’ response had been “We use those fees to cover advice services to all plan participants, with advisors who come on-site once a week”? I did this in the early 2000s for a $100 million plan. We gave the company relief from fiduciary responsibility. We were on-site, did financial plans, asset allocation, explained rebalancing—at no additional cost to the plan participants. We were paid with 12b-1 fees, which we split with Putnam, the plan provider—we took 12.5 basis points and didn’t feel underpaid.

So what’s the problem? Maybe it isn’t the fees workers pay but that they don’t get the service they deserve.
The 401(k) has become a feeding trough for financial institutions and service providers that routinely rip off participants. Why? Not because of the fees, but because participants don’t know how to use them—and no one is willing to take responsibility for guidance.

Just this year we have the following facts to ponder:

  •  • Participants left $24 billion in company matching funds unused because they didn’t save enough to claim the full match.
    • In 2014, only 10.5% of plan participants changed the asset allocation of their account balances, and just 6.6% changed the asset allocation of their contributions.
    • Approximately 21% of savers who can borrow from their 401(k) plan have outstanding loans—so they’re using their retirement funds as a piggy bank.
    • Roughly two-thirds of investors think they pay no fees for their investments, or have no idea how or how much they pay.
    • At the same time, 53% of households are at risk of being unable to maintain their standard of living in retirement.

What if participants in large plans are paying too little to have their assets managed and, therefore, are not getting the help they need? If you doubt this, just grab a copy of the yearly report from AON Hewitt—or any retirement plan consultant—about participant behavior in the plans they administer. This is not a survey; it’s a report on the millions of accounts AON Hewitt administers and what their owners do or don’t do with their funds when they get no real input or advice.

It’s not a pretty picture. Inertia rules. Did none of these employees have any reason to change their investment choices? Did none of them get a few years closer to retirement? Get divorced? Have children? Did the allocation they picked five years ago not need rebalancing after the supersonic run-up in large U.S. stocks?

More troubling, AON’s clients—the plan participants surveyed for the report—make up approximately half of the Fortune 250. Assume for a minute these companies have their pick of the smartest people around, and pay better compensation and benefits than many other firms. If these workers can’t get investing right, what does that say for the rest of us?
Where did companies go wrong? Ironically, it started with fiduciary concerns about their liability for investment returns if they, the employers, invested on the employees’ behalf.

To solve the problem of liability, companies chose to give their employees self-direction, rather than take responsibility for performance. They had a choice and took the easy one. It seemed like a simple enough strategy for getting the employer off the fiduciary hook, but it was a mistake as far as the workers’ financial well-being was concerned. For every worker who succeeded with a 401(k), there were scores who never signed up, never invested beyond the default or, worse still, bought high and sold low in a panic. If the employees had gotten help, guidance, direction—would they have brought these lawsuits?

That brings fees back into focus. If you pay a fund company very little, that’s what you’ll get from them in service. These are organizations set up to manage money, not educate Americans about financial planning. But if the fees were well-spent, employees would benefit.

No one has been putting the plan participant—the worker, the consumer—first; not the plan sponsors, the plan providers, the asset managers nor the government. The Department of Labor has been trying for a few years to figure out how to have a fiduciary standard that could be functional at the worksite.

It’s time to call it like it is and redo the 401(k). That’s going to require more time and expense on everybody’s part, but this is a case where you get what you pay for—or at least you should.

401(k) participants deserve a real plan. I personally would recommend charging everyone a fee that came out of plan assets and covered a basic level of advice for every participant. Participants should then be able to choose from a fee-for-service menu that could include more frequent financial planning, advice on assets held outside the plan, asset allocation, rebalancing, etc. The extra fees would be deducted from their 401(k) balance. The cost of these services, given the scale of most investment firms, would be modest compared to what they might cost an individual investor, owing simply to scale.

A plan that used a robo-advisor could set fees at a very low level, probably around 20 basis points. A hybrid version would couple a robo-advisor with human beings at the local level and cost more.

These options all have one goal: get participants’ investment behavior to match their investment goals. That will translate into growing account balances and shrinking lawsuits. And yes, whoever provides the service would be held accountable for the job they do. Isn’t that how it should be?

Wednesday February 5, 2014

401(k) Plan Review – Lockheed Martin Corp.

Periodically I will offer reviews of the 401(k) Plans offered by the larger employers in my home areas – North Georgia and Baton Rouge, LA. The first in this series is Lockheed Martin Corporation.

Lockheed Martin Corporation’s Marietta, GA, location is one of the largest employers in Cobb County; although it’s not nearly as large as in years past with approximately 7,028 current employees versus its Cold War peak of 33,000+.

Participants in Lockheed Martin’s 401(k) defined contribution plan have one of the highest rated 401(k) Plans available based on ratings across its Peer Group. Lockheed gets an overall 83 rating placing it in the top 15% of 401(k) plans in its Peer Group. The Peer Group is composed of companies of like size, industry, and number of employees.

Areas where Lockheed Martin gets high marks are:

  1. Total Plan Costs – among the lowest in cost plans for its participants
  2. Account Balances – high, versus other Peer Group plans
  3. Salary Deferral – high, participants are contributing more as a percent of salary than most
  4. Company Generosity – company matching contributions are above average
  5. Investment Choices – 28 investment options are offered

Other components of Lockheed Martin’s Employee Savings Plans include a stock bonus component and an Employee Stock Ownership Plan (ESOP).

One of Lockheed Martin’s most attractive benefits, the Defined Benefit Pension Plan, has been phased out. Employees hired after January 1, 2006, no longer have this benefit available.  Long time employees who are nearing retirement today will still enjoy the benefits of the Pension Plan.

For many years one of the primary attractions of a career at Marietta, Georgia’s Lockheed facility was its generous Pension Plan. Lockheed at one time also offered a Social Security Pension Supplement that was paid if an employee retired prior to age 65 and was paid until reaching Social Security Full Retirement Age. Those were the days. Currently only about 10% of employers in the U.S. still offer a traditional Pension Plan to their employees.

One issue facing those employees who still have Lockheed Martin’s Pension Plan benefit is that the Plan is somewhat underfunded, which could mean a potential shortfall in future benefit payments to those eligible.  For many Lockheed retirees in years past the 401(k) balance was a bit like having this large pool of money that they might not really need to tap into until they had to take Required Distributions after age 70.  The monthly Pension Benefits combined with Social Security were usually a more than adequate Retirement Income. Now, especially for those hired after January, 2006, the 401(k) plan has taken on much greater significance in planning for future income sources. Social Security benefits should be maximized by using optimal claiming and spousal coordination strategies.

Lockheed is not the only company facing record-high pension obligations. A January, 2011, report by Credit Suisse Group AG estimated that 97 percent of the pension plans of companies in the S&P 500 are underfunded, with liabilities exceeding assets by $458 billion by the end of 2011.

Although Chief Financial Officer Bruce Tanner describes the $12.78 billion in unfunded pension liability as artificially high, Moody’s Investors Service Inc., signaled on Aug. 8, 2012, that Lockheed and other government contractors will likely fully or partially terminate their pension obligations.  The unfunded liabilities “sounds like an enormous number, but contextually, we think it’s manageable,” said Tanner, who estimated Lockheed’s pension plan to be about 70 percent funded, compared with about 97 percent before the market collapse in 2008.

Are You Ready to Retire? Find out with this interactive quiz: https://www.ready-2-retire.me/WilliamTucker

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My Company Website:  www.thewoodvillegroupllc.com

Contact Number: 770-778-5242