A look at new products that are supposed to create "personal pensions" for your clients.
With the baby boom generation-and many clients of advisors-reaching retirement age, concerns over generating enough income to last for the lives of their clients are becoming more and more pressing. Indeed, a recent Financial Planning Association survey found that over the next five years, advisors expect that retirement income and planning will be by far the most important driver of their practices. "As the first baby boomers hit 591?2, a light went off," says consultant Heywood Sloane, whose Wayne, Pa.-based Diversified Services Group conducted the survey for the FPA.
Reflecting this heightened interest in income solutions, there is a rapidly expanding array of financial instruments intended to generate steady income checks-and, in many cases, produce capital gains as well. These instruments are part of a broader movement to create what Laura H. Varas, a research partner at Boston's Financial Research Corp., calls "personal pension products." Among the latest offerings are variable annuities offering guaranteed income benefits; discount-priced immediate annuities for participants in defined contribution plans; exchange-traded funds (ETFs) focusing on dividend-rich, high-quality stocks; and mutual funds from several giant asset managers that aim to provide generous monthly dividend checks while preserving and even growing client assets.
In this, the second of our two-part series on income strategies, we will hone in on these four areas. Despite the product sponsors' marketing hype, each has some drawbacks and none offers a single solution for your clients' retirement income needs. But they are worth a look nonetheless.
Dividends Galore With ETFs
When we asked Financial Advisor readers in September about the products and services you choose to help clients generate income (see sidebar, page 126), a third of you said you use dividend-paying equities or mutual or exchange-traded funds. While this strategy is subject to the same volatility that affects the entire stock market, it has produced generous current income as well as long-term capital gains for patient investors. In fact, Standard & Poor's Corp. analyst Howard Silverblatt estimates that dividends have made up more than 40% of the S&P 500's total return since 1926.
Dividend-paying companies can be attractive to long-term investors, such as retirees, because they are often larger and more stable and mature than volatile growth companies that prefer to pump more of their profits back into expansion. And dividends classified as "qualified" (among the exclusions are those paid by real estate investment trusts and many preferred issues) are doubly attractive because Uncle Sam taxes them at a low 15% rate. But not all dividends are alike.
To winnow out lower quality companies or those with meager payouts, a number of financial firms including S&P, Dow Jones and Wisdom Tree have brought out indices that focus on higher-quality or higher-yielding issues. Several exchange-traded funds now track these indices; according to Morningstar ETF Investor, all fetch a modest forward price-earnings ratio of around 14-a substantial discount to the broad equity market-and trade at a price-to-fair-value ratio of around 0.9, about 10% below the level that Morningstar Inc. believes is the true worth of the stocks making up each fund.
The granddaddy of dividend ETFs is iShares Dow Jones Select Dividend (DVY). The largest such fund (with $8.5 billion in assets) and the most liquid (with an average trading volume of 914,000 shares per day, according to Morningstar), it was yielding 3.4% as of early October, nearly double the average dividend yield of 1.8% for the Standard & Poor's 500 index.
DVY, which posted a total return of 9.3% over the 12 months ending in early October, is based on Dow Jones' Select Dividend Index, which selects candidates from the entire U.S equity market. To be included in the index, a company must have maintained or increased its dividend for each of the last five years; must have an average five-year dividend payout ratio of 60% or less; and must have an average daily trading volume of at least 200,000 shares. Advisors choosing DVY need to be aware of the ETF's high concentration in financial stocks-which represent nearly 41% of its assets-as well as in utilities and consumer goods makers. At 50 basis points, its expense ratio is also higher than those of some other dividend-oriented ETFs.
The S&P SPDR Dividend ETF (SDY), meanwhile, is newer and cheaper (with an expense ratio of only 35 basis points) and is less heavily weighted in financials (34%), but has a similar yield (3.5%). It has $256 million in assets and is up 8.1% for the 12 months through early October. SDY is based on Standard & Poor's High Yield Dividend Aristocrats Index, another broadly based market measure whose members have consistently increased their dividends annually for at least 25 years. State Street Global Advisors, which manages SDY, notes that the ETF has "both capital growth and income characteristics" as well as screens to ensure that the stocks making up the fund also have a minimum market capitalization and ample liquidity.
Another newer ETF focusing on dividends is the Wisdom Tree High-Yielding Equity Fund (DHS), which notched a tidy 12.6% annual return for the 12 months through early October. It is also modest in size, with $218 million in assets, and shares DVY's high concentration of financial stocks, which make up nearly 40% of the Wisdom Tree ETF's assets. But it does feature an attractive yield of 3.7% and an expense ratio of 38 basis points-nearly as cheap as that of SPY.
Mutual Funds Aim For Payouts
Since their creation in the 1920s, mutual funds have been viewed more as a vehicle for asset accumulation than as one producing current income. Even shareholders of bond mutual funds tend to reinvest their dividends, rather than take them in the form of regular payments. But the boomer retirement boom is prompting mutual fund sponsors to rethink their mission. This year alone, several providers including Fidelity Investments, Russell Investment Company and Vanguard have all introduced or filed prospectuses with the Securities and Exchange Commission (SEC) for funds that are specifically designed to deliver predictable monthly payouts to shareholders-"non-insurance approaches to guaranteeing income," says FRC's Varas. Because these funds' payouts will ultimately depend on the performance of the stocks, bonds and other asset classes they invest in, Varas concedes that they can't actually offer guarantees. But they can "offer some expectations," she adds.
Each of the filings from Fidelity, Russell and Vanguard indicates that the sponsors have developed differing methods of achieving their goals. According to its SEC filings, for example, Russell intends to offer three annual payout objectives in its series of LifePoints Retirement Distribution funds: 6%, 7% or 10%. The first option is a fund designed to last for a term of 20 years from its inception; the latter two are planned for ten-year terms. Russell warns, however, that if any of the funds' dividends, interest and short- and long-term capital gains fails to cover the chosen distribution, the gap will be made up by returning capital to shareholders. Given a poor enough market performance, Russell concedes, the funds would eventually be liquidated.
According to its federal filings, Russell plans to invest the balances in its retirement funds in several of its own equity, fixed-income, money market and real estate mutual funds, shifting assets among them to achieve the best returns. Explaining the philosophy behind Russell's dynamic hedging strategy, Richard K. Fullmer, a senior strategist at the Tacoma, Wash.-based asset manager, says, "At the beginning, we would have a portfolio that has a high probability of making it. Our strategy would tend to start out more conservatively and, depending on how markets move, get more or less conservative over time. You're at the greatest risk of your portfolio not making it in the early years-the first five or seven."
B oston-based Fidelity's federal filings for its family of Income Replacement Funds, whose launch was announced in October, are more explicit about the funds' future. Fidelity indicates that they are designed to provide monthly payments over 11 time periods that end from 2016 to 2036. Each fund will be invested in other Fidelity equity and fixed-income funds. The longer the duration of the fund, the more it will be exposed to stocks, with the 2036 fund having a 61.7% allocation to equities, versus 36% for the 2016 offering. The funds' asset allocations will become progressively more conservative as they reach their target dates.
Fidelity notes that all the funds "are designed for investors who seek to convert accumulated assets into regular payments over a defined period of time." In fact, Fidelity says in a prospectus, shareholders receiving monthly payments can expect to see their money returned to them over time via the gradual liquidation of their entire investment by a fund's target date.
A ccording to a marketing brochure that Fidelity presented to registered representatives at one financial firm, as well as a longtime advisor who attended the briefing but asked not to be identified, the asset management firm expects to reset each fund's payment rate once a year. While Fidelity said it hopes that the amount will rise to keep pace with inflation, it conceded that the actual payments would depend on how well its managers had performed over the previous 12 months. A table of hypothetical withdrawal rates provided to the advisor lists initial annual target payment rates of 11.15% for the shortest-duration fund to 5.09% for the 2036 variety.
But depending on how well the funds perform, that number could go up or down. Thus, according to the marketing material, an investor putting $100,000 into the fund maturing in 2026 could expect to receive a $525 monthly payment in its first calendar year. That could rise to $560 if the fund notches a 10% return in year one. But it could drop to $458 if the fund declines by 10% during the period.
Vanguard is taking a somewhat different tack with its Managed Payout Funds, for which the Valley Forge, Pa.-based financial firm filed papers with the SEC in September. Vanguard plans three funds. Real Growth and Moderate Growth will have long-term annual total return targets of 5% over the Consumer Price Index, currently averaging around 3%. Vanguard hopes the returns will support annual payout rates of 3% for Real Growth and 5% for Moderate Growth. In its Capital Preservation fund, meanwhile, Vanguard will seek to achieve an average annual nominal total return of 7%, sufficient to support a 7% annual distribution rate but not necessarily enough to preserve the value of a shareholder's initial investment. To inject a measure of predictability to its payouts, Vanguard says it will base the size of each year's monthly checks on the funds' performance over the previous three years. At the funds' outset, however, the payout will be based on their initial per-share value, while the second year's payout will be determined by the funds' record for the prior 24 months.
Like the Russell and Fidelity entries, the assets in Vanguard's three funds will be invested in other Vanguard funds. However, Vanguard adds alternative asset classes to the mix of stocks, bonds and cash that dominate its competitors' offerings. While adding some hedge-fund-type strategies to the asset allocation, Vanguard still plans to charge its typical bargain-basement expense ratio: 0.34%, compared with Fidelity's charges of between 0.54% and 1.65% (depending on the class of shares). Russell's SEC filings do not disclose estimated expenses.
In addition to equities, fixed income and cash, Vanguard says it may invest the payout funds' assets in its Market Neutral Fund, which takes long and short positions in stocks; its REIT Index Fund; and a variety of instruments linked to commodities, including futures, options, swaps and structured notes. In addition, Vanguard says it intends to put some of its shareholders' assets into "absolute return" investment strategies, which are also used by many hedge funds. These strategies attempt to produce positive returns with low or negative correlation to the broad stock market, and often use leverage or short-selling to achieve their goals.
Advisors Warm To Immediate Annuities
Although their basic structure dates back to the 1600s and, if anything, have stood the test of time, advisors have tended to look askance at immediate income annuities, citing their low returns, illiquidity and lack of pricing transparency. In fact, a mere 15% of advisors in the Financial Advisor survey said they use the product for clients. But as they grapple with their clients' desire to replace a paycheck and a 401(k) with a regular stream of retirement income, some advisors are reconsidering their stand on annuities. "Years ago, I said I'd wash my mouth out with soap before I said the words 'income annuities,'" admits Harold Evensky, president of Coral Gables, Fla.-based Evensky & Katz Wealth Management (see sidebar, page 129). But now, he adds, "I have no question that within a few years, they will be a significant part of our practice."
Evensky notes that immediate annuities include a unique feature known as a "mortality return," or the return of a buyer's capital over his or her expected lifetime. To take maximum advantage of this feature, he suggests waiting until a client is 70 or 75 before considering the purchase of an immediate annuity. He also thinks that an annuity should consume no more than 20% to 30% of a client's assets and that contracts should only be purchased from the highest-rated insurers. "One of the real issues from the advisor standpoint is what faith they have in the quality of the issuer," he says. "Will they be around?"
Though another risk is that some of a client's principal will be lost if he or she dies before all of the contracts' premium is returned, Washington-based consultant Matthew Greenwald figures that an immediate annuity can still be a good deal. At the recent annual meeting of the Retirement Income Industry Association, he observed that $100,000 invested in a certificate of deposit will produce around $5,000 in annual income. But generating the same amount of income with an immediate annuity requires plunking down only $54,000 up front. Do that, "and you can have fun with the balance," he noted.
One new wrinkle in the immediate annuity market is the advent of a Web-based competitive marketplace for contracts. While a consumer or advisor can currently obtain quotes and purchase contracts online from a handful of providers including Vanguard Group, getting immediate competitive bids directly from multiple insurers is more difficult. In September, however, the Hueler Companies, a Minneapolis-based technology and consulting firm, announced that it would open its online Income Solutions discounted immediate annuity service (www.incomesolutions.com) to the 1,700 members of the National Association of Personal Financial Advisors (NAPFA). Before the deal with the fee-only advisor group, Income Solutions was available only to corporations or institutions wishing to offer immediate annuities as a tax-deferred rollover option for their employees participating in qualified retirement plans. Hueler President Kelli H. Hueler says that the NAPFA deal will be similarly limited to qualified rollover assets.
At a typical corporation offering access to Income Solutions, plan participants have access to eight or nine institutionally priced immediate annuities from major providers including American International Group, Metropolitan Life Insurance, The Principal Financial Group, Mutual of Omaha, The Hartford Financial Services Group and Prudential Financial Services. Noting that, "We want to make sure the providers are committed to competitive pricing," Hueler says she conservatively estimates the cost of annuities on Income Solutions to be 3.5% to 5% better than what is currently available on the retail market. "Sometimes it's substantially better than that," she says. A recent request for quotes on a $200,000 joint and survivor immediate annuity that offers inflation-adjusted payments yielded three quotes within minutes from Mutual of Omaha, AIG Life and MetLife.
Variable Annuities With Monthly Checks
While variable annuities have long been viewed as a way to shoot for long-term capital gains inside a tax-deferred insurance policy, the latest class of VAs concentrates more on guaranteed monthly payouts. To obtain the guarantees, however, investors have to pay higher fees than they would face on mutual funds and also accept limits on liquidity, which may be seen as an opportunity cost. Those conditions are understandable. "There's a price for the benefit," says Mark Constantini, president for variable annuities at John Hancock Financial Services Inc. in Boston. Nonetheless, he observes that today, "90% of the [variable annuities] we sell have some kind of income guarantees."
Although only 20% of Financial Advisor readers say they recommend annuities offering guaranteed income benefits, many insurers say that such policies are their hottest sellers. And while comparing the costs and features of competing VA policies can be mind-numbingly difficult, all the policies tend to hedge the risk of offering lifetime income guarantees by forcing policyholders to keep a substantial portion of their assets in equities. Prudential's HD Lifetime Five VA family, for example, pledges a 5% annual payout. Prudential guarantees that a policyholder who can wait ten years for her first withdrawal will see the value of her policy set at the highest level reached in that first decade. To help achieve that, the policy's assets go into a balanced fund managed by T. Rowe Price that can shift back and forth between stocks and bonds, depending on the market's direction.
Hancock's Venture Vision VA, meanwhile, offers a choice of mutual fund portfolios with asset allocations to equities ranging from 20% to 80%. While policyholders can withdraw 5% of their initial investment annually at any time after they reach 591?2, Hancock offers to double their assets if they leave them alone for ten years-a compounded annual rate of return of around 7%. For each additional year policyholders elect not to take withdrawals, Hancock adds another 6%.
Down the road, Constantini sees the financial services industry producing more integrated solutions to assuage clients' financial concerns during retirement, including their worries about health care. But for now, advisors will have to keep reaching into their toolkits to build the best strategies. Fortunately, the list of useful tools is lengthening by the day.
Bill Glasgall is a freelance writer specializing in financial topics. He can be reached at mailto:firstname.lastname@example.org.