MUTUAL FUND ROUND TABLE: The following is the edited transcript of the round-table discussion.

InvestmentNews: As baby boomers move from accumulation to distribution, what kind of products do you expect the mutual fund industry to introduce to meet the new demand?
Ms. Fahlund: Certainly one product everybody’s looking at closely is annuities. The insurance companies are working very hard at coming up with the magic bullet, and I don’t think they’ve found it yet, but the living benefit annuities are certainly a good step in the right direction.
You are going to get some guaranteed income for life, hopefully, and you also get some flexibility. So I think we’ll see a lot more of those products and certainly enhancements to them as we go along.
Mr. Bhatia: From a mutual fund perspective, the life cycles clearly work for the accumulation phase. You have a lot of retirement income funds that are also package products.
The challenge is very different, because you don’t have a target date in mind. It is an actuarial challenge. It’ll be a difficult proposition to come up with the right retirement income fund if you just use the mutual fund structure.
Mr. Rampula:You’ll see a lot of interesting, more-guaranteed-type products. People forget the mutual fund industry serves investors pretty well now. We’ve got a lot of fixed-income products out there, and if you get an adviser or investor to put together a solid portfolio, that can be enough.
Now there’s a lot of uncertainty; a lot fewer people have pension plans or defined pension benefit plans, so probably you’ll have an increased interest in guarantees.
The one thing you have to remember is: There are trade-offs. If I’m going to get a guaranteed product, I’m giving up liquidity, and I’m paying a little bit more. Advisers need to educate their clients about those trade-offs.
Mr. Gallagher: It’s about converting into an income orientation. Advisers are really looking at how they can help orient and monetize portfolios they’ve spent all their time helping clients to accumulate. You’re going to find the biggest set of new product innovation around income generation.
InvestmentNews: What are these income products going to look like?
Ms. Fahlund: We know from the Monte Carlo analysis that we’ve been doing for years that you have to have a lot of equities in that portfolio. So you really need to turn away from an income-only type of strategy to one where it’s more of a total-return concept.
You’re withdrawing income, if that’s available, and you’re withdrawing principal, if that’s what you need at that time. But in order to generate a smooth stream of income with continuing purchasing power for 30 years, you’ve got to have a lot of growth, and then you’re simply withdrawing — ideally, the same amount each year increased for inflation so you maintain a lifestyle. You maintain an income stream that’s predictable year to year.
InvestmentNews: How important will partnerships be in creating these new products?
Ms. Fahlund: Many of us have those partnerships in the sense that we have subaccounts. Our mutual funds are subaccounts within variable annuities. So we have lots of partnerships already. At T. Rowe Price, we haven’t gone the Fidelity route, but we have partnered with at least one insurance company, and we’re always talking about new products where we would do the same thing again.
Mr. Gallagher: I see a lot of us partnering with the insurance space, particularly on the annuity side.
Mr. Rampula: We’ve done that at Vanguard. We’ve partnered for years with insurers, and we are looking out for these new products, whether it’s on the direct retail side or the DC side.
Mr. Bhatia: For TIAA-CREF, the challenge is simple. We already are an insurance company, and that’s a foundation of the organization, which is both unique and very compelling, because we’ve managed money for a fairly long time, focused on the retirement income needs of most of our participants.
InvestmentNews: Do you think that having the insurance background gives you an edge?
Mr. Bhatia: It is both a challenge and an opportunity. The opportunity is that we can use what we’ve learned through having annuity products on our defined contribution platforms for participants. We have a good sense of people’s behavior prior to retirement and post-retirement, a sense of how many people annuitize, and their income stream expectations. The challenge is going to be reaching out to a broader universe, who weren’t TIAA-CREF participants, and having them say, “I want to buy something from you.”
Price sensitivity
InvestmentNews: There can be a lot of fees in pricing annuities. Do you think that some of these fees will be squeezed out?
Mr. Bhatia: Price sensitivity will drastically increase, because when you’re in the accumulation phase and assets compound, fees are not an important consideration. But we see fee sensitivity clearly increasing in the distribution phase.
We are a very low-cost provider of investment services, and I think that’s going to be key in the retirement area, particularly where fees can have a significant impact over a 30-year period when assets are not growing as fast and you want income.
Ms. Fahlund: We offer 401(k) plans, and we see that as an area where many of the plan sponsors are just begging for annuities as options, and the whole industry is talking transparency. There’s going to be so much competition, with the folks at this table, actually, for those assets, and so, inevitably, if the insurance companies want to play in that sandbox, they’re going to have to really find ways to squeeze the costs out of their products.
Mr. Gallagher: What you’ll find is that fee sensitivity is very much a real concern and desire. Also, you’re going to begin to see unbundling of the guaranteed death benefit from the actual annuity, and people are willing to basically pay something lower to give up that in return for the income annuities. So you’re going to see more of an unbundling of historical products.
InvestmentNews: As an adviser, [Mr. Raines], what do you think about what these folks are saying about things such as unbundling and fees?
Mr. Raines: Well, there has been unbundling already for many annuities. The problem is one of public perception and public education. The fact is that the public buys high, sells low and doesn’t hold long enough. There’s some research by Dalbar [Inc. of Boston] that shows the average holding period on mutual funds is well under a year, and it’s very hard to picture the public doing well in that kind of scenario, regardless of the type of product they hold or how low the fees are.
The fee focus, while admirable, detracts from the necessity of getting people to understand asset allocation and that when somebody on TV gyrates, it doesn’t mean you have to sell that day.
Clearly, investor education is part of it. The public media is part of it. You can’t manage your portfolio by watching CNBC and then looking for the lowest-cost product to plug into what the announcer just said five minutes earlier. Clearly, that doesn’t bring success.
Ms. Fahlund: T. Rowe has taken a little bit different tack. For years, we’ve gone out and talked to our plan participants and educated them, and it requires so much staff and so much energy to go out and talk to 30 people at a time — and then half of them aren’t listening.
We’ve changed our approach now, so we’re creating a report to educate plan sponsors. We run analysis using Monte Carlo on every single participant in the plan, and we end up telling the sponsor, “Here’s how your folks are doing. If they keep doing what they’re doing now, based on how much they’ve saved, how they’re allocated, so forth, this is the kind of replacement income they’re going to have when they retire.”
That really is waking up the sponsor, because in many cases, while they had 80% participation, participants were only contributing 2%, and they were invested all in stable-value funds.
Target date funds
Not only are we showing them where these people are today, but on top of that, we’re quantifying what would happen if the sponsor changed the plan. So instead of educating the employees, you get into auto-enrollment where you enroll them, whether they want to or not, and then they can opt out.
You also auto-increase. You increase by 2% a year their contributions, whether they like it or not. They can opt out, or they can increase it to 3% or 4%.
So the default for the investment is becoming the target date fund, so they don’t have to decide on the allocation, either. We’re doing a lot of the work of those who can really make a difference, which are the sponsors.
InvestmentNews: So many companies are coming out with target date funds now that some are saying, “Well, ours are riskier, so therefore, you’re going to be wealthier at the end.” Who’s going to win that race? Can it be won on fees?
Mr. Rampula: You have to educate investors — whether they’re plan participants or direct investors through advisers — about the differences so that they can make informed decisions. The popularity of these things is incredible. It really is advice in a box, a no-brainer: “I’m 22 years old. I’m enrolling. I don’t know what I’m doing. I don’t have enough money for an adviser, but I can throw it in there, and it can run its course.”
Mr. Gallagher:The Pension Protection Act has done a lot to help support the viability of these, as well. In many ways, all boats are floated by the fact that people are now engaging more actively in their retirement and not keeping money in stable-value funds or too much in asset allocation funds. It really helps get people to their goals.
Mr. Bhatia: Fees are important, but consistency and style parity are more important. The philosophy around these packaged products is that certain asset classes behave in a certain way over a period of time, and all of us are using the same basis of finance theory to come up with these products.
Most people are using benchmark- centric indices to say, “You should be X% in large-cap growth versus small-cap, because this is how those asset classes behave over time.” So it’s going to be key that the products stay pure to the philosophy that drove them.
Ms. Fahlund: When we launched our target date funds, we had done extensive research using Monte Carlo analysis to come up with what the glide path should look like, and we were way out there in front, in terms of saying you need a lot of equities.
One thing that you can compare is what the glide path looks like in terms of the equity position at the target date and then in the retirement income sphere. What happens is, some of the funds actually flatten out and stay at a fixed asset allocation, and others keep dropping, and they drop at different rates.
So especially in the distribution phase, you will see more differences between the approach that the different companies are using. You need to understand the philosophy. Why did the company design the fund the way they did? And that’s well worth investigating and reading the fine print to understand that.
Invasion of the hybrids?
InvestmentNews: What about portfolios with an active component? In other words, when you got to age 50, you could add more of a passive component, as opposed to straight active equity. Do you think we might see some more of those hybrid types of things?
Mr. Bhatia: As long as the person making the decision has a true understanding of why that decision is being made. The reason these products are a success is that you, as a participant, are trusting the expertise of an adviser or investment manager to assess how these asset classes will perform. If the individual starts tweaking it, the risk is what you see in a lot of programs today: People will end up buying a certain fund or selling a certain fund, and the impact of that is probably a bigger negative than a positive. I fear it may not be the right thing.
Mr. Raines:There’s a paradox. The same person who wants the fund to work on automatic is going to be reading subordinate clauses in the footnotes to understand how the model works. Clearly, that’s a paradox, because the point of the simplified funds is that they work easily. When I drive a car, it doesn’t mean I have to be an expert in internal combustion; I just have to know how to shift gear and turn the engine on and off, and have some expertise in driving, for which I get a driver’s license.
But there’s a paradox if we expect people to actually understand how these funds work, and the simulations and the models behind them, and then we promote the funds as a simplified way of investing.
The other thing is, it’s an empirical issue which ones do better. I think everybody’s going to make their best effort to ensure that theirs do better than the person sitting next to them.
InvestmentNews: Since the first target date funds were designed, has the equity component percentage changed?
Mr. Bhatia: In our case, it has increased. Also, the international markets have matured and provide a certain risk-adjusted return which wasn’t available 20 years ago when the first ones were created. We didn’t have as much of a comfort level in investing in international markets. So I think that has gone into most of these target maturity funds.
We’ve also seen the [Treasury inflation-protected securities] market level up, which wasn’t in existence many years ago, and provides a good inflation-adjusted fixed-income allocation.
Mr. Raines: We have to be careful about investments’ being popular. Today, the dollar’s weakening and international investing clearly is a good place to be. It may be that the popularity of including international equities in the model is due to their recent success. On TIPS, you’re right — they didn’t exist 20 years ago.
InvestmentNews: At a recent Investment Company Institute conference, Buddy Donohue, director of the division of investment management at the Securities and Exchange Commission, raised an interesting point. He said it is imperative that funds and those who sell fund shares are clear about how yield is generated, and clear about the risks associated with yield generation techniques. Do you think he’s right to be worried? What are the risks he mentions, and do you think the industry is doing enough to address those risks?
Mr. Gallagher: As new products get brought to market, transparency is going to be key, as well as educating investors and — equally important — the advisers who sell these products. We spend a lot of time educating both advisers and consumers about what we consider to be the key risks of retirement, which involve longevity, inflation, asset allocation and health care.
Particularly, as products move more into guarantees and things like that, it’s going to be critical that they’re backed up with all the right kind of disclosures and transparency around how the products work.
Mr. Raines: I have an answer to your question, and it’s yes. There’s a great concern. It’s one of the reasons why, in closed-end funds, there
are stipulations about managed-
distribution policies, about sending out capital that wasn’t generated from the fund’s activities, and why it’s restricted, although there are some that are grandfathered.
There is some concern in other cases about funds that are distributed through covered-call writing, put writing, other techniques using derivatives, inverse floaters and other ways of generating extra returns that involve extra risks that clearly are not understood by the majority of people who are taking on those risks.
Mr. Rampula: It’s not just about distribution products; it’s about any product that’s out there. It’s incumbent on the industry to make sure people know what they’re getting into. I spent a lot of time in the exchange traded fund world, and I was on an ICI panel a couple months ago, and the weekend before in The Wall Street Journal, there was an article about a 79-year-old gentleman from Florida who sold all his mutual funds and invested in ETFs, because he’d get 15% in ETFs and only 4% in mutual funds.
Yet he was in balanced mutual funds, and the ETFs he bought were single country. As an ETF sponsor, you’re just ready to hang yourself when you hear something like that. And that’s a pretty simple product.
When you look at something like this on the distribution side, it really brings up the level of risk that we have. It can change the entire industry. We really need to make clear what the risks are and where the income’s coming from.
Mr. Raines: I second that. I’ll add that certain mutual funds are almost like hedge funds in drag. Clearly, it’s an obligation for all of us as advisers, as portfolio managers and as product originators, to be particularly clear on the distribution phase, because the potential for abuse is even greater.
Mr. Bhatia: I hope there’s going to be more focus and education on differences between total return and yield, because typically, in the accumulation phase, there isn’t much understanding of the concept of total return. When you get into retirement, people are going to need to understand their goals. Will they try to hold on to their assets and transfer wealth? Will they want to draw down assets? Will they want a certain percentage to be available whenever they want it? I don’t think yield alone can answer those questions.
There’s going to be more education of participants and retirees to explain the concept of total return. If you want to make 5% from your retirement portfolio, that doesn’t simply equate to 5% yield. And that’s the key here, because the total-return-versus-yield issue does not really exist in the accumulation phase.
Yield’s going to be important. People would truly like to understand what component of their total return comes from yield or dividends, versus from asset growth or asset liquidation. That’s going to be an evolving theme in the next few years.
Ms. Fahlund: A lot of products sold today offer a fixed-income stream, and we’re very concerned about that, because what usually happens with the sale is that you may be offered a fixed-income stream or a [cost-of-living adjustment], and the COLA will always be much lower, so the average investor is obviously going to go for the higher payout now, today.
How you educate people that less is more can be very difficult. But as an industry, we must bring the inflation issue to the table. In the abstract, if I were talking to a friend who had a pension and asked, “Does your pension have a COLA?” If they said yes, I’d say, “That’s great — lucky you.” And if they said it was fixed, I’d be sorry but probably not say anything.
Note that I never asked how much money they were getting. Instead, I asked about the concept: Is your income going to keep rising so you can maintain your purchasing power? That’s what was important to me. Unfortunately, that’s not the way people buy products. They’re looking for the highest payout, and that’s not going to be in their best interest.
Mr. Raines: If I were speaking to a friend who had a defined benefit pension, I would say, “Lucky you,” before I even got to the next question about having a COLA. Clearly, one of the reasons we’re talking about income in retirement is because there’s going to be so few people going forward who have defined benefit pensions. And the issue is going to become more acute over time, because we’re going to have to learn how to manage what could be a very long lifetime in retirement. We may even have to look at defining retirement differently than we did in the past.
Mr. Gallagher:We actually publish a retirement index that we update every year, and basically, it says [that] the average investor’s woefully unprepared for retirement. On average, they’re replacing only 58% of the income they need in retirement. So that’s got to be brought out to the forefront, too. Retirement’s a lot longer than we would once have thought, and that you have to plan for it up to 20 or 30 years beyond retirement. So it’s a very different mind-set.
Concern over derivatives
InvestmentNews: What do you think of the concern that derivatives may not be understood by investors and that many fund firms’ systems, particularly compliance systems, may not be sophisticated enough to handle synthetic instruments effectively?
Mr. Rampula: I’m concerned not just about distribution products but across the board. We try to be pretty selective in what we offer to certain segments. What we might offer to an endowment or foundation would be very different from what we’ll offer to our direct investor who doesn’t have an adviser to help him. We just won’t offer something that’s that complex.
Mr. Bhatia: I agree. I get concerned, because derivatives were created as an instrument to manage risk. But since the biggest opportunity for the financial services industry is this retirement problem, you see banks and others trying to use derivatives to solve problems they weren’t meant to solve.
You have to understand a product’s purpose. Derivatives are awfully complex, so explaining how to use them is extremely difficult. We clearly believe that people need simpler, more transparent and easier products to help them manage their retirement problems — not something that the industry itself doesn’t understand thoroughly.
Mr. Raines: I’ll put it slightly differently. I understand a hurricane, but being in one is a different story. And there are many people who will retire and discover that they’re in a hurricane rather than just reading about one far away. Derivatives have the potential of being very useful tools and also very dangerous.
And we’re seeing them in products that are growing now. They’re used in structured notes, for example, as well as in reverse convertibles and other areas. Sure, they can perform a very useful function, but they have risks that are not commonly understood.
Ms. Fahlund: And even not commonly understood among a lot of advisers. If you’re a new adviser, and maybe just earned your CFP, you probably are clueless as to how those vehicles work. The truth is, you could be many years beyond entry level and still be clueless. But there’s so much appeal and cachet around the new and the latest that we have to be cautious.
InvestmentNews: What new tools or programs are you providing to your wholesalers to enhance their value to get in the door of advisers?
Ms. Fahlund: We have an entire division of the company that does nothing but work with wholesalers, and they are always asking for new sales tools and ways to explain issues. Among the tools the group created are slide rules, which are nice because the adviser doesn’t have to use a laptop or anything else to make his point.
One of the slide rules is all about deferral. It shows the impact on my retirement if I continue working two or three more years. It relies on Monte Carlo analysis, which is pretty cool, and it’s all been condensed to something this simple. It even shows median purchasing power at the end of retirement, so it’s good for clients who are concerned about a legacy and how that can differ.
Wholesaler changes
Mr. Rampula: We’ve done a couple of things. We partnered with Age Wave, Ken Dychtwald’s [San Francisco-based] organization, and put together what’s basically a seminar in a box. It’s a great program, and we partnered with Smith Barney [of New York] and [Linsco/Private Ledger Corp. of Boston and San Diego] to distribute it to their advisers. The program’s got great music and great pictures, and it really gets the baby boomers thinking about retirement in a very different way. That’s the big theme.
We talk about how retirement is going to be different. You’re not just going to get a pension plan and go away somewhere. You’re going to be working. You’re going to be living a lot longer.
We also partnered with another group to create a life-planning program that’s similar to the retirement program. We’re providing life planning to advisers, as well, and it gets folks thinking about their life, their financial picture and major life events. We find that advisers really value these programs, which help them engage clients and prospective clients.
Mr. Gallagher: We’ve put together a really comprehensive effort to do a couple things. One is to raise the education awareness of the direct client, as well as the advised client. That started a couple years ago with the whole notion around Fidelity’s Retirement Income Advantage, which is a comprehensive program.
It talks about first educating around the retirement risks and making people aware of the need to reorient their thinking. Equally important, we’re trying to help the adviser build a practice around retirement expertise.
We think that one of the things that will help advisers really become successful is having the extensive knowledge necessary to conduct themselves as retirement specialists. We run retirement days. We’re creating new tools based on our technology that allows them to more simply create retirement income plans, as well as white papers and things like that. Overall, advisers are beginning to realize that this is a tremendous opportunity that more of their clients are looking for help on. It’s incumbent on all of us to help advisers and direct clients understand the importance of retirement planning.
Mr. Bhatia: At TIAA-CREF, we’re newer to the adviser business than T. Rowe Price, Fidelity or Vanguard. But one of the things we always are asked about and plan to do more of is consultative education. Many TIAA-CREF participants who hold us in high regard and also are clients of outside advisers are looking to us for help with their retirement problems.
We have other challenges. For example, most of our participants have had a direct real estate account with us. But how do you take TIAA-CREF’s unusual real estate expertise further into the adviser marketplace? How do we take some of our private-mortgage experience and convert it into a solution that’s going to add value beyond the typical stock and public-fixed-bond mix? That’s why we have to start a series of consultative education discussions, understanding how this would fit in their portfolio.
InvestmentNews: Baby boomers are very familiar with mutual funds. When they take their money at retirement, are they going to go into separately managed accounts?
Ms. Fahlund: We work very hard at trying to capture that money when it rolls over. We’re also seeing some sponsors decide that maybe they don’t want to lose this business. They feel that if they can keep their fees down, perhaps they can keep their employees on the books through retirement and not have them roll over.
So we’ve had a two-pronged approach to this on the retail side. One is, capture the rollovers, if we can, and at the same time, work with sponsors who want to keep their employees in the plan even after retirement.
A key issue that we have to all address is: How are we going to help these sponsors? Because I think they’re fairly naive in terms of what it takes to manage that book of business. You have people who have a lot of needs and are withdrawing money at different rates, and it’s not the same as just having employees sign up for payroll deduction.
Mr. Rampula: Moving to an SMA is an interesting question that I don’t really know the answer to. The wealth effect — or people recognizing the large pool of their own assets — might cause them to move to SMAs. But they’re at lower tax rates when they retire, so that obviates one of the big advantages of an SMA, which is tax efficiency, right? So I guess if it’s a better product in the long run, maybe they will replace funds. But I’m not sure what the real driver of change would be.
Mr. Gallagher: When you begin to see a migration like that, it typically surrounds the need for broader advice. So I would echo that tremendous focus on retaining the rollover, as well as understanding that at the rollover event, there’s typically an advice need that may or may not be met directly. Or perhaps clients want more information. The stakes are higher obviously with their money.
Advice seen as key
McKinsey [& Co. of New York] did a study in 2006 that said the 15 years preceding retirement is the time when most individuals change advisers, and the upcoming retirement is a big reason for the change. All those events coincide with the need for advice and the products that come out of that.
Mr. Bhatia: It’s the advice component that’s going to be key, particularly how you give advice in retirement. It’s a difficult problem, because even the advice providers are struggling to come up with a solution. In the accumulation phase, you understand that the investor has a date and goal in mind, and is working toward them. The vehicles probably will not be as important as coming up with advice that meets client needs. If the investor doesn’t have a good advice model, it doesn’t matter whether he is in an SMA, a mutual fund or an ETF — he’s not going to meet his goal, and that’s going to be a big problem.
The chief challenge the industry faces is determining the kinds of models that work. And once the model is figured out, vehicles can be changed to fit the model. But the vehicles alone are not going to solve the problem.
Mr. Rampula: It’s a lot less about investment products and more about relationships.
Ms. Fahlund: We launched our retirement income advisory service back in 1999. An interesting dynamic is that when you first start designing the advisory service, you’re focused on what the advice is going to be, and that happens fairly easily and fairly quickly, because we’re pretty good at that.
But then it’s the implementation, which is ongoing. Investors approaching retirement are likely to ask all kinds of questions: “I’ve got all these funds in my account. Which one should I draw from first? Which one second? From which account, the taxable or the tax deferred? I’ve got [required minimum distributions] coming up next year. How do we do that?”
You answer their questions, and then the next year, you have to tell them they’re out of balance. So they have more questions: “What’s out of balance? How do I get back in balance?”
Portfolio re-balancing may be pretty simple for somebody who does math every day, but if you don’t — and if you haven’t taken algebra in 20 or 30 or 40 years — and you don’t have Excel, you’re just not going to be able to do it. So there’s so much more to the advice offering than the recommendation. It’s really all about the relationship, and having somebody to go to who can actually help transact all the different trades that must take place.
Mr. Bhatia: It’s going to get more complicated, because today, when you compare an SMA to a mutual fund, at least you have some sense of how they compare to each other. Imagine people having annuities, mutual funds and a couple of CDs in their account. How do you build an advice model that takes all of this into account? That’s going to be key.
Mr. Raines: The fact is that a model doesn’t replace individual advice given in a timely way with due deference to the person’s risk parameters and their personality. If somebody’s going to watch TV and sell at the bottom each time, you have to take that into account when you give advice to that person.
It doesn’t matter whether they have a mutual fund or individual stocks, or stocks and bonds. You basically must provide ongoing advice, because retirement could be a period that may last as long as 40 or 50 years for some people and will quite commonly be 20 to 30 years. You have to talk about advising over time.
InvestmentNews: Do your clients look at you as an investment person or someone who they go to about retirement?
Mr. Raines: I work with other people as part of a small group, and we discuss personal issues. We get to know clients and their personalities quite well, and we find the biggest challenge is not the investment questions but investor psychology and behavioral economics. Those issues should be the gist of customer discussions. Anything that keeps people invested longer and acting more sensibly and less emotionally is a good thing. In that sense, some of the products that have been developed are good, because they encourage people to look at the problem more analytically.
Popping the question
InvestmentNews: Do investors raise retirement questions or do you?
Mr. Raines: Both. Sometimes they beat me to it. Other times, I bring it up. And we have to bring up other issues, too, because you have to find out whether people want to spend what they have, or leave a nest egg. One of the first things I tell people is that on their deathbed, they can be only one of three things: a philanthropist, a family person or a taxpayer. Try to be more than one, and you’ll get into trouble. What you should do is minimize the ones you don’t want to be and maximize the one you do.
We devise plans that do that. For example, an investor could use annuities to pay out a higher stream of income, but then the principal disappears. Or he could use a vehicle that I tend to go for and seek total return. I favor that tack, because my perspective is that of a portfolio manager, and I like to see balances grow and people take distributions off a growing amount.
The total return approach makes most clients comfortable, and it makes me comfortable. But there are cases where people don’t want to leave their children anything and would rather that the Lung Association or Heart Association or some other charity gets everything. People have different objectives on their deathbed.
The last point is the issue of long-term care. You could accumulate a tremendous amount of money and essentially have it decompose as a result of long-term-care expenses. A friend of mine is talking about putting his mother-in-law in a facility, and they’re asking $140,000 a year. That will dissipate the estate he and his brother thought they were going to inherit very, very quickly.
Ms. Fahlund: All we need are a few medical improvements that extend life, and we’re going to see the number of cases like that shoot way up. It always shocks me when I’m talking to somebody who sells long-term-care insurance, and they’re saying that clients really only need enough coverage for two and a half years, because that’s the average. Sure, I’m thinking, that’s the average yesterday — what’s it going to be tomorrow?
I advise everyone to buy long-term-care insurance if they can possibly get it. If you look at the number of insurance companies getting out of that business, you can imagine that the insurance is a better deal for customers than it is for insurers. After all, they’re the risk experts, and they’re not selling it anymore. Just find a very strong company that is still selling it and buy it, because it is not going to be around forever.
InvestmentNews: How will the proliferation of exchange traded funds fit into the retirement landscape going forward, especially now that we have things such as fixed-income ETFs and funds of ETFs.
Mr. Rampula: In the accumulation phase, there are a lot of folks still trying to figure that out, because while ETFs are low-cost vehicles, they don’t necessarily lend themselves to folks who dollar cost average, due to commissions and spreads. On the distribution side, they’re very similar to mutual funds, so I think they certainly play a role there.
InvestmentNews: Are ETFs a potential threat to conventional mutual funds going forward, if issues such as dollar cost averaging can be ironed out?
Mr. Rampula: Potentially. In the retirement sector, we’re seeing transparency of fees. To the extent ETFs would help with that, it would be a good thing. But one of the biggest advantages of ETFs is the ability to buy and sell throughout the day. I’m not sure that’s a real point of interest in retirement. If I’m retiring in 40 years, do I really care that I can buy and sell an ETF before 4 o’clock? That’s why I’m not so sure that ETFs necessarily lend themselves to the retirement market.
Mr. Bhatia: ETFs have one characteristic that helps in retirement and another one that doesn’t. The negative is that you have to pay a trading fee to buy them, and when you’re in retirement and you’re drawing down periodically, you would pay a lot of trading fees, especially if you have a decent portfolio that you’re drawing from.
The good thing is that ETFs are more tax efficient, and in retirement, taxes matter a lot. So I’m not sure where they’ll fit in, because the positive and negative tend to cross each other out, unless somebody came up with a product that
doesn’t have the trading element.
Mr. Raines: Actually, there is such a product — it’s a fee-based account where you can trade ETFs without cost.
Mr. Rampula: You don’t pay commissions, but there’s still the bid-ask spread, though.
Mr. Raines: Yes.
Mr. Rampula: And that bid-ask spread will clearly eat away at returns.
Mr. Raines: Clearly. But you do have an advantage when the markets are volatile. The key problem with ETFs, in my opinion, and I think they’ll account for a growing share of portfolios, is that you can’t dollar cost average on the way in and then reinvest regularly in small amounts.
Mr. Rampula: That’s right. That’s what I was speaking of when I was talking about commissions. Your typical 401(k) plan is a tough nut to crack for ETFs. The benefits don’t lend themselves to that marketplace so much. Yet ETFs are great products. They’re low cost, and they’re very diversified. Some are getting a lot less diversified, but that’s another issue. But they are good investment vehicles and should be playing a greater role in portfolios.
Mr. Raines: ETFs will grow over time, because of their cost and transparency advantages. They’ll also grow because advisers — who can take a rollover and manage it for a fee, give continuous advice for many years and develop a personal relationship with a client and understand her goals, personality and risk-reward profile — can use ETFs effectively and sell them appropriately.
The old and the new
InvestmentNews: Is there any crazy new product out there, like a tontine or something we haven’t discussed?
Mr. Raines: There’s one old thing that’s new, and that is buying closed-end funds at discounts. Clearly, that’s one area where you could compare investments if you have a strategy.
Let’s say you’re interested in India. You can look at a closed-end India fund and see if it’s trading at a discount or premium. You also can compare its assets and cost structure to a comparable ETF, and then decide whether the ETF or the closed-end fund makes more sense.
If you’re a value investor, the closed-end fund has an advantage, because the discount to net asset value tends to widen the more out of favor it is. As the fund returns to favor, the discount could shrink and then disappear, and eventually turn into a premium.
I’ll take one extreme case: a Cuba fund that once traded for long periods of time at significant discounts. When Fidel Castro was ill and there were rumors he was going to die, the discount vanished, and the premium went to something over 2,000%.
Ms. Fahlund: I think we’ve talked a lot about product and maybe not enough about service. Our focus is really around getting a strategy that can put you in the ballpark, recognizing that the strategy in retirement is a lot more than about investments. We’re an investment company, and we provide excellent risk-adjusted performance, but frankly, the way you run out of money is withdrawing too much. It has nothing to do with the investments. They could be doing super well, and you would still lose the ballgame.
So we get you in a good place, and then every year, if not more often, we check to make sure your circumstances haven’t changed and that you are no more likely to run out of money. If you are, we’ll cut back on the amount you can withdraw. It’s an ongoing process. You’ve got to have that forecasting. You’ve got to use Monte Carlo analysis or something similar. It’s not a one-shot deal at all. It’s definitely a monitoring situation.
Mr. Bhatia: Investment managers by themselves cannot solve the problem. It’s going to be a partnership. You have to have products that integrate services, and since most of us as investment managers do the investment management piece well, we need partnerships to handle other aspects of the equation. Partnerships with an insurance company, for instance, to manage the longevity issue. And partnerships with adviser firms to deal with service issues. Clearly, the adviser will become more integral to the structuring of the investment vehicle.
Mr. Gallagher: It’s critical that it all start with having a retirement income plan. We talk a lot about creating a financial plan, but a retirement income plan is equally important, and in many ways — based on research we did with advisers — it’s actually more complex, because you can’t have one without addressing health care and long-term care.
A retirement income plan is an ongoing, living plan that must be monitored for 30 years and beyond. As consumers think about retirement, advisers need to think about how they will create a retirement income plan for their clients and really tool up for it. Product becomes a secondary focus.
Mr. Bhatia: Another thing that’s happening is that many institutional managers who have serviced defined benefit plans are trying to enter the mass affluent and defined contribution marketplace.
That’s going to be challenging, because they’ll have to do it in a cost-sensitive and a scalable manner. Managing a $2 billion pension plan is very different from managing $200,000 for a plan participant. There’s going to be a lot of work done in that space to see what can scale down, and some interesting products may come out of the process. After all, there is a lot of investment acumen in the endowment/foundation, DB and plan sponsor marketplace.
InvestmentNews: Do you think the SEC’s interest in this area will hamper efforts to come up with new products?
Mr. Bhatia: The SEC is rightfully looking at it, because it’s very important to take care of the small guy. When you’re a large provider to a pension plan, you have only one very large client. Many large providers haven’t worked in the world of many small investors, who have a different level of understanding of investment policy and how investment products work. Transparency is at a very different level.
We at TIAA-CREF strongly believe that participants of all sizes should be able to truly understand new investment products. You cannot just lift out an institutional product and sell it to the individual-investor marketplace; you have to be very investor sensitive.
Mr. Gallagher: The challenge will be to take something that’s inherently complex and make it simple. As you add layers of guarantee, stable income and what have you, complexity increases. Creating transparency and keeping it all simple really has to become the focus.
Ms. Fahlund: We had an interesting experience when we first launched our adviser services back in 1999 or 2000. A client came in for his annual review, and everything was going hummingly. He was withdrawing exactly what we had recommended, and he was right on target as far as goals and targets.
As we were congratulating him, the counselor happened to look at the investor’s emergency-fund balance. The sum, which was $25,000 the year before, had dropped to $4,000. It was like, “Ooh, this picture just changed.”
And so one of the things we grapple with a lot is, honestly, how do you describe an emergency fund for somebody who has 30 years of retirement ahead of him? If they have saved only $100,000, should you be helping them annuitize that in any way, shape or form, or is that your emergency fund for 30 years? I’m inclined to think we’re doing investors a disservice when we help them create an income stream from an amount that is too small.
Washington wish list
InvestmentNews: The Pension Protection Act was a big win for the fund industry. As we move into the 2008 election cycle, what do firms like yours want from the next administration?
Ms. Fahlund: Well, the industries wanted not to have to have taxes paid on distributed capital gains. That’s certainly been a wish for a long time. But who knows? And whoever’s in power, they’ll have a big part to play in that decision.
InvestmentNews: What’s the Holy Grail, the diversifier that we haven’t all figured out yet?
Mr. Rampula:Just be broadly diversified across asset class.
Mr. Bhatia: Get good advice and stick with your goals. Diversification and asset allocation are all good things that only work if you have a good plan, and you stick to it.
Mr. Gallagher: Have a plan. You’ve got to have a plan.
Mr. Raines: Cicero put it best when he talked about right reason. I agree you have to have a kind of a plan, implicit or explicit, but you also need to use your common sense and avoid the extremes of pessimism and optimism.
Ms. Fahlund: I don’t know if I’d call it a diversifier, but I think the ultimate asset that you have is your home, and I think that we’re going to see many new varieties of reverse mortgages. The banks are going to be in a wonderful position to capitalize on the retirement income business.
Mr. Bhatia: People are going to ask for help from someone they trust who has a skill set and a competence in a particular type of risk management. In the case of annuities, for instance, people are trusting somebody to manage longevity risk for them.
InvestmentNews: So in that situation, who has the edge? Will people go to a bank because they deal with banks on a daily basis, or will they go to a TIAA-CREF?
Mr. Bhatia: That’s a tough question. People are comfortable having a relationship with a trusted adviser who can reach out to multiple providers of other services. I think that model would have an edge as more people move into retirement and seek out advisers they trust.
My sense is that people will go to a trusted adviser whether that person is an investment manager, an insurance company or an individual financial adviser. If you don’t have trust in an organization, even if it has the best product, you’re not going to go there.