Benefits Products & Services

Conquering market volatility

Demand grows for protective strategies and guaranteed income products

By Thomas A. McCoy, CLU

The stock market drop toward the beginning of the financial crisis in 2008-2009 was a warning shot fired over the bow of baby boomers. Just as this large flotilla of 50- and 60-something workers was starting to point toward the retirement harbor, they suddenly realized how vulnerable they were to dramatic market forces. Even those in this age group who were using target date funds to cut back on their equity exposure took a hit.

What is unsettling for baby boomers about the financial crisis is that it signifies an ongoing exposure to volatility. Bonds, while less volatile than stocks, are producing record low yields today, and their prices will likely fall if inflation begins to rise.

Sizable market jolts, like the one that occurred in '08-'09, are nothing new, of course. There was the burst of the Internet bubble in 2000, the market crash of '87, and other periodic large reversals dating back to the Great Depression. What has changed is that with each new shock, fewer and fewer people are covered by defined benefit plans. They're in 401(k)s and other defined contribution plans at work and IRAs outside of work. Giant pension funds are not guiding most baby boomers into port. These are amateur investors at the helm.

The volatility problem for benefit plan participants will be magnified after they retire, when they must withdraw funds regularly for living expenses. Funds that are withdrawn during a market decline are not “recovered” when the market turns up.

Pre-retirees are looking for a safe entrance to the retirement harbor. Retirees need calm financial moorings throughout their retirement. Both groups are likely to be attracted to products and strategies that address the volatility issue—ones that go further than simple adjustments to stock/bond ratios. They'll be looking for new ways to protect their principal balances and also for ways to provide lifetime income guarantees.

In the former category, Milliman, actuarial consultants to insurance companies and other financial institutions, has created the Milliman Protection Strategy™—a hedging tool for stock market risk which currently is being utilized by financial institutions in the management of more than $7 billion of assets. Users include 401(k) plans, defined benefit plans, retail mutual funds, and the retirement savings products sold directly by life insurance companies.

Milliman created the strategy in 1998 to help life insurance companies protect their balance sheet assets, mostly for their variable annuity business. Ken Mungan, risk management practice leader and the creator of the strategy, says, “The good news is that as we went through the financial crisis, these companies actually did quite well.”

So well, in fact, that by 2011, a number of these insurance companies began to include the strategy as part of the investment management of their regular retirement products. “Lincoln Financial was one of the early adopters,” says Mungan—originally for the variable annuity market and later as part of their 401(k) funds and regular retail mutual funds.

Daniel Hayes, president of Lincoln Investment Advisor Corp., the registered investment advisor subsidiary of The Lincoln National Life Insurance Company, says the objective has been to provide a more consistent return on retirement savings assets both before and after retirement. “We want people to be able to sleep at night and feel comfortable with their exposure to the capital markets.”

New York Life, Prudential, Ohio National and Jefferson National also have used Milliman's strategy in products ranging from regular mutual funds and target date funds to variable annuities with guaranteed living benefits. In the banking space, Wells Fargo and Huntington have also adopted it.

The strategy gives individual investors access to retirement products that use “the same risk management techniques that major financial institutions have been using for years,” according to a white paper at Milliman's Web site. This means the purchase of futures contracts linked to major equity indices, U.S. Treasury bonds and currencies that are traded daily on major exchanges. The liquidity of these instruments keeps the cost low, Mungan says.

Detailed portfolio performance models shown in the white paper demonstrate over the 2000-2012 period how the strategy's implementation can minimize volatility, in keeping with the interests of many older retirement plan participants.

Milliman acknowledges that although its strategy has proved to be an effective tool in reducing equity-linked volatility, “ultimately it is simply a strategy.” Milliman points out that it doesn't provide guarantees.

“What we're seeing in the market is that there's far more demand for retirement income guarantees than there is supply,” says Mungan. “We need to come up with ways that insurance companies can supply these products on a sustainable basis on a larger scale.”

One indication of this demand comes from New York Life, which a year ago introduced its Guaranteed Future Income Annuity for the individual market. It is specifically targeted at individuals who are 55 to 65 years old who plan to retire in five to ten years. After the initial premium payment, buyers of the product can continue to make additional premium payments until their retirement start date, thereby adding to their guaranteed future income.

Within seven months, this New York Life annuity had taken in
$230 million in premiums to become the fastest growing annuity product in the company's history. “We're proud to give Americans their pensions back,” said Matt Stone, New York Life's vice president in charge of annuity products—a theme that is likely going to be echoed by a number of carriers in the annuity market.

“We are at an interesting crossroads,” says Sarah Becker, an employee benefits consultant and financial advisor with Future Value Associates in Pound Ridge, New York. “Years ago people thought life annuities of any variety were something to avoid at all costs as they were thought of as 1) being irrevocable, 2) leaving no money to beneficiaries, and 3) providing fixed payments that did not keep pace with inflation.

“For that reason,” Becker continues, “only those people with no spouse or no heirs (or those who didn't want to leave money to the next generation) took that route. But the world has changed and now we have a whole generation of baby boomers who didn't realize until recently that their parents retired on pensions that they (the boomers) don't have. The realization hits way too late that they should have saved more all along. Retirees today have tough decisions to make to meet their income needs.

“Fixed annuities and deferred annuities now have options that allow you to get a higher payment without disinheriting the next generation, so for someone whose income needs are higher than an investment portfolio can comfortably support, they are becoming more attractive to consider as part of a portfolio.”

Uncertainty about the investment markets and longer life expectancies have altered the perspective of this age group, Becker believes. “Each person's needs are different, but the tools are more robust now to help each person generate a retirement income that makes sense for them.”

The development of these annuity products on the individual side and their reception in the marketplace has promising implications for employee benefits brokers. Annuities are offered only on a limited basis within employers' defined contribution retirement plans now. But market demand bodes well for the creation of more.