Remember Alan Greenspan? One morning as I was pedaling on my stationary exercise bike, I was watching a piece about the credit crisis on CNBC. This particular blurb showed Greenspan exhorting the financial community to figure out new ways to encourage home ownership. As Fed chairmen, politicians, bankers and investment bankers now know, it's not always a good thing to get what you wish for.
The TV show presented a retired Greenspan a few years later, a man more reflective and perhaps contrite. That Greenspan talked about, in not many words, the human condition -- that things like the credit crisis would happen again, and again. Why? Because human beings are built a certain way, and he does not think that we will change. It was almost as if he had read The Ascent of Money, discussed here a few months ago. The thesis in Niall Ferguson's wonderful book is that we keep repeating financial history, again and again.
The more obscure, the better
Clearly, the more complicated the financial product manufacturers make things, the more people want them. Twenty-two years ago (according to Wikipedia), I can remember brokers touting collateralized debt obligations (CDOs) and explaining them as "tranches" of mortgages. How many of their customers even understood the word tranche?
The original came from Drexel Burnham Lambert, which makes sense, since it's the same shop where Michael Milken capitalized on high-yield (junk) bonds. Milken would help Company A, which wanted to acquire Company B, issue junk bonds. Company A would get lots of cash from investors who bought the high-yielding debt, and then Company A would use the cash to buy Company B through a hostile takeover, since Company B had no wish to be acquired. Once Company B was acquired, A would sell off B's parts and get enough to cash retire the high-yield debt. Cool, huh?
Not always so great, though -- Milken indirectly caused me, through an operator in New York City, to lose my largest Tulsa customer, once a Fortune 500 company that no longer exists. At the end of the Milken years, the turbulent 1980s, one did not need a Company A: One or two people could start what we might call an investment club and simply issue debt (or shares of stock) to investors who wanted to acquire Company A and sell off valuable parts for a profit. It was this kind of operation that took down the 5,000-employee company here in Tulsa that used to provide about 60% of my company's revenues.
High-yielding junk bonds (lower-grade debt) are now mostly used by small and mid-size companies to raise money. The 1980s' excesses are over; now we are paying the price for the 1990s-early 2000s' credit and mortgage debacle. Drs. Ferguson and Greenspan are right -- we never learn.
Forget the housing bubble, what about the investment annuity living benefits bubble?
Remember the old joke about the anomaly that astronauts saw when they looked down on the United States from a spacecraft in 2001? The punch line was that it was customers lined up to redeem their shares in Janus funds. Janus is back on track now; today's "anomaly" seen from space would be a line of former investment annuity wholesalers looking for work.
The reason for all the brouhaha is simple: Many insurers thought the market, over the long-term, would go up forever. There's that bubble behavior exhibited once again -- where most of us think we can't lose. In this case, the bubble mania infected U.S. insurers and they traded benefits for the profits made by sending money onto outside managers and fund companies.
The profits and fees from sub-accounts inside investment annuities are enormous. About 18 months ago, investment annuity assets were over $1 trillion, but I'm afraid to look now, and the companies may be, too. When a number of key players are reaping income from $1 trillion, that money, combined with the fees charged for living benefits, covers many sins, including bad pricing. When the $1 trillion shrinks by, at a guess, 40% to 50%, and new business stops coming in the door, trouble is on the way.
The major players are still out there, and have retained wholesalers. However, some of the external1 varieties have been instructed to stay at home until things are sorted. At least one investment annuity issuer continues to pay wholesalers for staying in touch with customers, even though the company itself has taken its products off the market.
The basic living benefit in an investment annuity insures that no matter what happens in the market, and, as a result, to the sub-account investments it contains, the annuitant or owner will have an income that is based on a phantom account that grows at some compound rate, usually 4% to 6%.
In an outlier example, a person who pays $100,000 at age 55, is guaranteed to be able to take 5% income at 65, and phantom will double (I know, I know -- that's a 7.2% compound rate for 10 years, but stay with me), based on $200,000. However, if the person retired earlier than the 10th year, the only guarantee would be that the phantom benefit would have grown at a 5% compound rate. And, if the person retired, a few years after the 10th year, the doubling part usually does not continue, although there is an exception or two to that rule. I call these benefits phantom for a reason -- they do not have an actual cash value, and are only used to produce income for life for one, or for a husband and wife.
Some of the phantom benefits are just out there enough that I think there have been unexpected consequences; one or two annuity issuers have benefits that seem to be hard for even company executives to understand and explain. The main issue is that the hit from March 2000 to March 2003, combined with the current credit crisis, created a flat nine-year period. Therefore, any investment annuities are going backwards, or in other words, in the absence of growth, the expenses and bad investment choices are eating up the "real" cash accounts, which leaves only living benefits. The thought that teeming hordes of annuity buyers might all -- and maybe all at once -- actually have to use living benefits is enough to make even the strongest actuary run for the hills.
There are a few companies, Prudential among them, that offer cash guarantees -- a separate kind of living benefit. For example, Prudential guarantees that if a customer pays 25 extra basis points each year, it will return 100% of the original deposit in cash, at the end of the 7th year. That 7th year can "roll" if the customer wishes and wait until the 8th year, when the benefit will equal the value at the end of the 2nd year. One can roll forward with the strategy for a long, long time.
Prudential does all this by managing the investments, to a point. A customer initially may use his or her own portfolio without restriction, or one designed by a financial professional, also with no restrictions, but Prudential has the right to insert fixed income (bond fund investments) if its algorithm, which runs 250 nights a year2, suggests it.
Zero complaints with living benefits
When the credit problems began, a few senior officers at insurance companies asked for my advice. I said, "Do nothing, nothing at all. Keep your wholesalers, keep selling, and change not one contractual word of a living benefit." None of the companies where those executives worked followed my advice. Fortunately, are a number of other companies are still offering solid living benefits in their investment annuities -- SunAmerica, Prudential, AXA Equitable, MetLife, Genworth, Pacific Life and Jackson National, among others.
Among my customers who have living benefits, I have had zero complaints during the credit crisis. Now that's food for thought!
Broker's Bookcase
Trade Your Way to Financial Freedom, by Van K. Tharp (McGraw-Hill, 2007). There are many kinds of investment professionals. There are portfolio guys like me, there are wholesalers, analysts and more. Then, there are traders. They might work one hour daily, or they might work lots more. If they work for one hour, you can bet that the trader is at his or her computer at the same exact time each day. If you read Dr. Tharp, you'll learn that a system has to be just that -- a system. One can't get into trading willy-nilly; there has to be a system with checks and balances.
Van Tharp also has written extensively about day trading, and, in this volume, he also introduces another system. He writes about William O'Neil's fundamental 20% profit-taking rule, and points the reader towards O'Neil's book, which details 36 other rules. The key is that no matter whether the trading system is our own, or one devised by others, one needs to follow the rules, and many of us don't.
A good example of a "rule" is the discussion about Warren Buffett. His trading strategies are detailed in a vast number of books, but Dr. Tharp points out that none of the books are written by Buffett himself, and none seem to detail an exit strategy. In other words, what is detailed is that Buffett buys and holds. He does this because he does not like to sell, due to taxes and transaction costs. But Dr. Tharp asks, how can that be true? In 1998, Buffett owned about 20% of the world's silver. Does he still? If he never sells, wouldn't he still own all that precious metal? In reality, Buffett actually does speculate and he does sell things; it's just that no one writes much about that. If he did sell the silver, chances are it was for a huge profit.
If you want to do the heavy lifting of trading, read this book first and lighten the load. Dr. Tharp has been through a zillion systems, and he'll teach you how not to waste years reinventing the wheel.
Stock Trader's Almanac 2009, by Jeffrey A. Hirsch & Yale Hirsch (John Wiley & Sons, Inc., 2009). If you are going to get into trading in a big way, or even in a small way, you'll need this book and a subscription to the annual e-mail notifications of market updates and Web site postings at www.stocktradersalmanac.com.
Messrs. Hirsch and Hirsch are slicers and dicers of data and time as it relates to investing and markets, and they do so with humor and skill. With 40 years of Almanac history behind them, they save the trader eons of time.
In the Almanac, the trader will find scads of data, including charts about the best six months and the four-year cycle. A friend sent me this one year, pointing out how much more one would have made, after investing $10,000 years ago, only investing in the best months, using MACD (moving average convergence/divergence), and staying out of the market during the bad six months each year. It was impressive, but you know me. I had to point out that if one had invested the same amount in Berkshire for about the same period of time (I think a year less, actually), that he or she would have quadrupled the result. That misses the point, of course. The point is, if you want to trade, this book is one of the most valuable tools you can buy.
Readers may e-mail Richard Hoe, ChFC, CLU, AEP at richardhoe@richardhoe.com. Mr. Hoe has been an investment professional for 40 years, and is a registered representative and investment advisor representative. He is a member of the adjunct faculty at the California Institute of Finance, a graduate school at California Lutheran University that offers an MBA in financial planning.
This information is intended for financial professionals only, not the general public. This is not a solicitation to buy or sell any specific security. Mr. Hoe may have positions in the securities or other investments discussed.
Footnotes:
1. There usually two wholesalers for each region of the country: An internal, deskbound one at or near the home or field office, and an external, often titled regional vice president. The latter usually travels from his or her home, which is often near the center of the area traveled.
2. The number of days that the stock markets are open for business, on average, in a year.
From the June 01, 2009 issue of Life Insurance Selling • Subscribe!
