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.