The risk tolerance level many investors expect to achieve over the long term rarely equals the same tolerance investors actually experience over shorter periods. This paper by Ken Mungan and Matt Kaufman describes this paradox, explores the main reason it might exist, and introduces a risk management strategy that seeks to solve the problem.
As more “low volatility” and portfolio risk management strategies hit the marketplace, it will be imperative that advisors and investors explore each strategy to uncover how risk is actually being addressed. Identifying those techniques that address both diversifiable and systematic risk is likely to provide better overall results for investors.
“Market declines combined with withdrawals can deplete investors’ portfolios,” Mungan says. Investors face what Milliman calls the “sequence of returns risk” that is, the combination of withdrawals and market declines. [He] describes this combination as “toxic.”
Mungan says a protection strategy is absolutely critical to make sure an investor’s income lasts for as long as possible. In fact, by protecting a portfolio from the “toxic combination” of withdrawals and market falls, an investor’s total return over time can be improved compared to an unprotected portfolio.
The Milliman Managed Risk Strategy™ aims to stabilize the volatility of an investment portfolio during periods of significant and sustained market decline. Investors now have access to the same risk management techniques Milliman provides to major global financial institutions around the world—techniques that currently help protect more than $500 billion in assets.
A longstanding beef against variable annuities is their steep cost. A big plus of exchange-traded funds is their ultralow cost.
Finally, momentum is growing to pair the two financial products in innovative ways, a trend consultants say is good for many people who are trying to save for retirement.
The products now emerging have lower fees, though it’s important to understand that the participant still needs to fund the guarantee:
The ValMark-Milliman approach still awaiting SEC approval is innovative in that it moves part of the financial-hedging program from the insurer’s balance sheet into ETF portfolios. By taking that off the insurer’s books, costs can be lowered for consumers, [Milliman principal Ken] Mungan says. That’s because the insurer doesn’t have to raise prices to compensate for the punitive effect on reported earnings per share that sometimes results from holding financial hedges, under generally accepted accounting principles.
“The consumer is paying for the hedge asset no matter what,” Mr. Mungan says. “But here, the consumer buys and owns the hedge asset at a cheaper price” through the ETF portfolio itself.
For more on exchange-traded funds, go here. For more on the potential for retirement security from variable-annuity-like products, go here.
Penton Insight looks at the resurgent popularity of variable annuities, and in particular the desire for guaranteed lifetime withdrawal benefits. Here is an excerpt:
One of the most popular variable annuity features is the guaranteed lifetime withdrawal benefit. No matter how the underlying investments perform, policyholders typically are guaranteed at least 5 percent of their benefit base in income annually for as long as they live. Eighty-seven percent of those who buy variable annuities elect this rider, LIMRA says. “From my perspective, variable annuity sales are definitely picking up,” says Kenneth P. Mungan, actuary with Milliman, a Chicago-based actuarial firm. “Customers are clearly attracted to the guaranteed living benefits, and I expect that trend to only increase over time.”…
In terms of equity-market risk, insurers fared better during the financial crisis that started in 2008 than during the market collapse in 2002, said Scott Hawkins, vice president and annuity analyst at Conning Research & Consulting. In 2008, separate accounts in individual annuities decreased by 21%, and general reserves increased by $75 billion. By contrast, in 2002, when fewer contracts were in force and account values fell by 13%, general reserves had to be increased by $92 billion. “What happened between those years was that insurers created hedging programs,” he said. “Milliman did a study of those hedging programs and concluded that more than 90% of those they evaluated were successful.”
In a recent white paper on financial risk management, Prudential Annuities identifies common risks as market, actuarial and investor behavior. Market risk includes equity, interest-rate and credit risks. Actuarial risk includes both longevity risk–that the policyholder may live longer than expected–and mortality risk–that the individual will die sooner and that the company will have to pay a guaranteed minimum death benefit. Investor behavior risk has to do with how investors utilize product features, such as when to begin drawing a GLWB, and asset allocation risk, the chance that an investor will choose an aggressive allocation that could cause a big difference between contract value and the protected withdrawal value.
As Warren Buffett is fond of saying about the recent financial meltdown, when the tide goes out you see who’s been swimming naked. Commonly accepted assumptions about the behavior of markets and people have been called into question. A new reality has emerged. And it’s going to take a while for things to sort out.
Nowhere is this more true than with respect to variable annuities (VAs). VAs have been made and marketed as ways to participate in the financial markets through investment portfolios diversified among stock, bonds, and other instruments, with protection against severe, sustained declines in the market. Until recently, diversification along these lines has worked pretty well.
However, as Ken Mungan and Deep Patel point out in a recent article, the VA business contains several market-sensitive elements that make them vulnerable during times like the recent past, when across-the-board declines dilute the protections of standard diversification. Clearly, if it is to succeed, the life insurance industry will have to fundamentally change the way it creates and manages variable annuities.
Although “insurers have taken many actions to address these issues . . . all of these actions assume the continuation of the existing VA business model.”
Instead, Mungan and Patel think an entirely new approach is needed—”The Sustainable Manufacturing Model”—which seeks to escape high volatility and unsustainable risk by including capital market hedges directly with VA funds, targeting volatility directly as a goal (rather than using equity allocation as a proxy for risk), and redesigning guarantees to reduce interest rate risk.
As simple as this sounds, Mungan and Patel realize that implementing the model faces many challenges—material, technical, and not the least, human. It will require, that is, a fundamental change in the way we look at assessing and assigning risk.
Ken Mungan, Milliman’s Financial Risk Management practice leader, is quoted extensively in an article about Milliman’s customized hedging strategies for individual accounts, in the March 16 edition of Retirement Income Journal (access to the entire article requires login).
“We’re seeing the emergence of a client account on a platform with a protection strategy that would contain hedge aspects,” according to Mungan. “So many people have withdrawn from the market. This would give them protection.”
Milliman’s new service is driven by three factors: the failure of diversification during the recent global financial crisis, low bond returns, and the need for Baby Boomers to invest in equities in order to make up for their failure to save enough for retirement.
Mungan explains that Milliman’s approach offers investors a middle path—between advisory services with unprotected portfolios and complete market exposure, on one hand, and variable annuities with living benefits, on the other. Individual investors can participate in uncomplicated hedges that protect against severe downturns without abandoning gains if markets rise. It’s an approach uniquely suited to investors with anxieties about entering a volatile equities markets still feeling the effects of the recent financial crisis.
Does this service compete with some of Milliman’s traditional clients, such as insurers offering VA products?
Not really. In fact, Mungan thinks Milliman’s approach will actually create new business for insurance companies—by increasing the demand for unbundled living benefit riders, aka stand-alone living benefits (SALBs).
More details on the approach can be found at “Overcoming challenges through portfolio protection” on the Milliman website, an article Mungan co-authored with his Chicago colleagues Ghalid Bagus and Matt Zimmerman (who is also quoted in the RIJ article).
Even before things went sour in the financial markets, individuals were having to take on more responsibility for planning and funding their own retirements.
The decline of defined benefit (DB) pensions over the past two decades—and corresponding rise in 401(k)-type retirement savings programs—has been accompanied by an explosion of financial planners, planning tools, and products, all aimed at helping individual investors navigate an increasingly complex financial marketplace.
Ken Mungan, Ghalid Bagus, and Matt Zimmerman, from Milliman’s Financial Risk Management practice, discuss new approaches to risk management that help overcome challenges for portfolio protection in the post-global financial crisis environment.
Risk management based on asset diversification has been central to these innovations.
However, as the authors point out, traditional asset diversification failed to mitigate the effects of a financial marketplace where most asset classes declined simultaneously. Clearly, financial advisors need new risk management protection strategies that “involve assembling and managing a portfolio of hedge assets tailored to each client’s investments.”
Such an approach seeks to counteract the natural tendency of the average investor to buy high, when the market is strong, and to sell low, after significant market decline, which, of course, plays havoc with investment returns.
The authors detail a strategy that reduces risk and enhances the overall value of an investment portfolio by locking in gains from underlying investments and harvesting gains from the hedge portfolio during severe market corrections.
Financial risk management in the present environment is even more daunting than it was before the global financial crisis hit full force 18 months ago. The search is on to find simpler ways of anticipating and accounting for risk in an increasingly complex financial market.
That’s one reason why readers may find it useful to revisit an interview conducted in October 2008 with Ken Mungen, Tamara Burden, and Kamillia Svajgl, from Milliman’s Financial Risk Management (FRM) practice.
The discussion focuses on a hedging strategy that helps insurers achieve predictable results by emphasizing execution and simplicity.
And although the authors can speak for themselves, in greater detail, here are a few observations from 2008 that still resonate in 2010:
Many companies are not hedging volatility for long-term exposures.
Complexity is its own source of risk.
There are really four basic dimensions of risk. There is the risk that the stock market will drop, the risk that interest rates will drop, the risk that the market will be volatile or turbulent, and that volatility will persist for a multiyear time horizon. (Think March 2009.)
We come into the office and prepare for massive turbulence in the stock market every single day.
This crisis is affecting everything in the market, not just a few segments. Diversification isn’t the answer to a market like this one; guarantees are. This will drive the interest in variable annuity products.