At last week’s Structured Products Americas conference I spoke about the opportunities and challenges facing structured products providers (and distributors) as they set their focus on the U.S. Boomer retirement marketplace. The potential for structured products is simply enormous. As more advisors and their clients shift their attention to outcome-oriented investing strategies, the outlook for structured notes, ETNs and other structured investment products is bright.
That said, there are several issues that will test the industry before it reaches its full potential in the years ahead. Delivering education efficiently to huge numbers of people (both advisors and consumers) is one. Reigning in the tendency to engineer complexity into product designs is another.
When thinking about the potentially large share of retirement investing dollars that structured products may attract, I’m convinced that their success will not be fully realized unless the structured products industry finds ways to link its products to near perfect context for their selection. If it succeeds at this it will inspire confidence among investors and advisors that yields market share and profitability.
Structured Products Americas Conference
The Biltmore Hotel
Coral Gables Florida
May 9, 2008
I’ve been looking forward to this meeting and the opportunity to describe what I believe is going to be required for a smooth and successful introduction of structured products into the Boomer retirement market.
I think about the issue of Boomer retirement, a lot. and I view it through two lenses.
In my commercial life, my company, Wealth2k, has been in the business of delivering comprehensive solutions for retirement income distribution since 2003. That’s the “ice age” of income distribution. We’ve seen a lot, and learned a lot, all of which is reflected in leading-edge programs such as The Income for Life Model.
In my non-profit life I’m a Director of the Retirement Income Industry Association where I have the privilege of working with a host of talented individuals- from industry and academia- who have come together across industries and business silos to engage in the retirement income conversation.
he role of the Retirement Income Industry Association is to be sort of a retirement income version of Switzerland, a neutral place where all silos can come together in an unbiased fashion. You can see this fact in the diversity of member companies RIIA has attracted. Names like Merrill Lynch, Bank of America, MetLife Financial, Goldman Sachs. Oppenheimer, Wachovia and UBS, to name a few.
I also learn a great deal about retirement through the interviews I conduct with academics and executive leaders in financial services. The interviews appear at my blog, and also as a monthly feature in Research Magazine.
So, I come to this meeting with some pre-conceived beliefs. Including that the Structured Products industry has the potential to define the future of retirement security in the United States. But how the industry gets itself out in front of tens of millions of Boomer customers is the key question. How it educates advisors, regulators and consumers, packages its products, creates vital context for structured products and communicates their value are big questions that I’m going to talk about.
Sometimes looking back over history can help us see things that we should or shouldn’t repeat.
History matters, of course. Recent history has shown that one type of structured product has been offered to retail customers in the U.S. since 1995. And if there ever was an index case to show how the structured products industry should not behave as it targets the consumer market, it’s showcased in the example of the 13-year history of the Equity-Indexed annuity.
Looking very much like a vanilla Structured Note, the first equity-indexed annuity was introduced in 1995 by Keyport Life Insurance Company. The annuity was called KeyIndex. The annuity had a five year contract term. It provided upside growth potential based upon a 95% participation in any potential growth of the S&P 500 over the term.
The annuity also offered downside protection based upon minimum guaranteed interest crediting equal to the original investment compounded at 3%. This meant that, at a minimum, the annuity owner would be guaranteed 121% of the original investment after five years.
What actually happened, of course, is that the people who purchased these annuities in 1995 did very well. They just about tripled their money. Pretty compelling.
If you looked at the structure of this first equity-indexed annuity, you could observe some things: First, it was easy to understand. Fairly transparent, uncomplicated, and uncluttered.
Second, it offered a pristine value proposition that was quite appealing to the consumers it was target to: upside growth potential combined with downside protection.
Third, if the growth in the S&P had not occurred, the annuity owner would not have been particularly disadvantaged. A 21% gain would have been quite acceptable.
Fourth, liquidity was generous. There was a deferred sales charge of 5% grading down to zero at the end of five years. The commission to the retail agent was 4%.
The target market for this annuity was the segment of investors age 60 and over. And so it represented a particularly suitable type of story to bring to people who were nearing or already in retirement.
By year 2000, when the first generation of KeyIndex annuities was coming up for renewal, much had occurred in the equity-indexed annuity industry. Other insurance companies that had seen the success that Keyport was enjoying and they began to develop their own equity-indexed annuity products.
It was at this point we began to see the usual knee-jerk reaction response by insurance companies to their perceived competitive threats: add complexity, bury higher loads and fees, reduce liquidity and play upon agents’ weaknesses in terms of prospecting and productivity by juicing-up compensation.
So by the year 2000, it was possible to exchange the Keyport annuity for another insurance company’s equity-indexed annuity that offered 125% of the upside performance of the S&P 500.
But, as you can imagine, there had to be another dimension to this second-generation equity-indexed annuity. A modifier, if you will. And there was. It was the introduction of daily averaging of index values in the calculation of the ultimate annuity accumulation value.
The effect of adding the averaging formula to the interest crediting calculation was to create an annuity with far less growth potential than the original Keyport annuity. But it also created an annuity which could be marketed and misrepresented as if, in fact, it was actually a superior product. After all, if 95% of something is good, 125% of something must be even better.
This is when we began to see widespread market conduct practices that featured agents explaining only the upside of equity-indexed annuities. Frankly, as time went on, most agents struggled to understand how these ever-more-complex annuity products credited interest.
As sales success followed the introduction of such products, the insurance companies engineered more novel “features” such as two-tiered interest crediting and “bonuses” on the invested premiums. So, before long, an equity-indexed annuity could be sold that provided a 10% bonus on the original investment, on top of the 3% minimum interest rate guarantee, and another 10% paid in commission to the insurance agent. That’s 23% out the door in the first year. How could the insurance company possibly make money on this deal when it was investing most of the premium in bonds paying 6%?
Gimmickry takes care of that issue. The penalty period for early surrender had been effectively made permanent, so the investor couldn’t really liquidate his or her account value. The base interest rate was only credited on 85% of the original investment, and the 10% “bonus” was more cute than credible.
In practice, the only way to get back one’s money without suffering a horrific financial penalty was to take systematic withdrawals over a minimum of five years, to which the insurance company imputed a withdrawal factor based upon a below market internal rate of return. This contract provision effectively reduced the withdrawal penalty level down from horrific to only severe.
A relevant question for us to ask is, “Was this particular annuity a success in terms of sales?” Did consumers really put their money into it?
If fact, this particular equity-indexed annuity was such a success that it became the most popular selling equity-indexed annuity in history of the business. About $20 Billion in total sales since its introduction.
The sales success of insurers offering equity indexed annuities with ever more complex and gimmickry features, low levels of liquidity, extraordinarily high expenses and double-digit commission rates caused something to happen that had never before been thought possible: that is, almost by definition, annuities became viewed as unsuitable for retirees. Having begun my career 31 years ago, and having been taught that the only people who were suitable for annuities were seniors, this was quite a remarkable achievement for the insurance industry.
By 2005, the equity-indexed annuity marketing environment had become so misleading, so predatory and so reckless that FINRA, an organization with no jurisdictional responsibility for oversight of the fixed annuity industry, stepped-in with its Notice to Members 05-50. That notice directed broker-dealers to assume suitability review for equity-indexed annuity sales, for product selection and even for the training of their registered representatives who would continue to market the products.
As you can imagine the consumer press began to notice what was occurring in terms of annuity marketing. So did a number of regulators.
Articles began to appear in newspapers and magazines that cautioned seniors to, “Avoid a Costly Mistake.”
The front page of the New York Times exposed an open secret in the annuity business: agents using specious professional designations to position them as specially trained to manage seniors’ financial needs.
The ultimate reflection of how crossed-up the annuity business has become occurred just a few weeks ago. Using the same format as it has employed to snare child sexual predators, Dateline NBC set up a hidden camera sting operation to catch insurance agents in the act of selling indexed annuities to seniors.
In recent years as the annuity marketing environment became more hostile, the response by equity-indexed annuity providers was to add more and more required disclosure forms at the point of sale. These companies’ legal departments may have advised this approach, but it has been entirely ineffective in mitigating the criticism, poor publicity, class-action litigation and regulatory sanctions that have plagued the industry.
The annuity business today is badly broken. In fact, it’s so broken that its level of success in what should be its greatest sales opportunity, ever- Boomer retirement- may be compromised. This is a fact that the structured products industry should pay close attention to. Not only for what it makes possible, but also for what it teaches.
What’s at Stake Over Retirement Income
All of us understand that there’s a lot at stake in terms the business opportunities around retirement income. When you think about the Boomers’ needs as they approach retirement, when you think about the strategies required for effective management of their post-retirement income distribution challenges, it’s easy to see that insurance companies possess inherent advantages over other industries. Such as, for example, the structured products industry.
It’s insurers who have the historical competency and vast experience in providing lifetime annuity guarantees, asset liability matching and longevitization. But what are these tangible advantages worth if the stench associated with the industry is so strong it repels its natural customers?
This is really a tragedy on a grand scale for the life insurance industry. And, because of guilt by association, the experience of the equity-indexed annuity business is problematic for the other annuity product silos as well, including variable annuities and immediate annuities. The typical consumer simply cannot differentiate between these different types of annuity contracts. They just hear the word “annuity” used in some negative context and they recoil.
Interestingly enough, there’s been one meaningful development that is making a positive impact on the equity-indexed annuity industry. That is an effort called FIA Today. It’s actually my brainchild, undertaken by my company, with the goal to transform the equity-indexed annuity sales process. It’s a web application.
FIA Today utilizes web-based technology, digital media and FINRA-reviewed educational presentations in order, for the first time, to place a neutral, unbiased education at the center of the equity-indexed annuity sales process.
With this web-based application insurance agents are able to explain equity-indexed annuities in a fair and balanced manner, and investors may gain a meaningful understanding of the risks and rewards of owning these products. Before FIA Today, investors only heard about the potential rewards.
There are two things that are very, very important about FIA Today. The first is that it relies upon a delivery format that is meaningful for today’s consumers. Specifically, the key educational tool, a FINRA-reviewed movie that is able to convey a compliant educational story, but do so in a way that doesn’t sacrifice sales appeal. The movie is delivered to the web browser, on-demand. It’s the consumer who is empowered to be able to learn without sales pressure.
The second important aspect is personalization in terms of compliant, advisor-personalized micro sites that function as personalized virtual advisors. These virtual advisors deliver the educational experience direct to the consumer’s web browser while maintaining the advisor’s identity and central role.
In my judgment, the deployment of a similar, technology-driven, advisor-centric educational application is urgently needed for the retail Structured Products marketplace. In fact, Wealth2k is going to provide it.
We have unambiguous indication from some of the largest distributors in the U.S. that they want it. They want it because they have a huge stake in seeing that both their advisors and retail investors are provided balanced, neutral and unbiased education on Structured Products. I believe that the providers of structured products have a similar stake in this effort.
Context and Relevance
Let’s focus on some of the issues that will be relevant to achieving large sales success in the Boomer retirement market.
Here’s a key word: Context
To achieve the greatest level of success, structured products must find the best Context for their selection by advisors and investors.
The logical context for structured products in the Boomer retirement market has two parts. The first is in playing a vital role in retirement Transition Management, and the second is playing a vital role in post-retirement income distribution
It’s in the opportunity around transition management that the equity-indexed annuity industry has blown its chance, paving the way for structured products to take away its market share.
In thinking about transition management, we likely all understand that in the 7-8 years preceding retirement, retirement assets may double. Investment losses during this critical period will cause a lifelong reduction in the amount of retirement income that can be generated.
Similarly, investment losses occurring in the years immediately following retirement will also cause a lowering of retirement income if not portfolio ruin.
If you make an investing mistake when you are still 20 years away from retirement, you have time on your side. The negative effects of the mistake can be mitigated. If you make a poor investing decision one year away from retirement you have a very big problem.
In part, this reality is driving lots of activity across the financial services industry. One reason is that we cannot know the ultimate levels of financial liability that the industry faces as a result of investing mistakes i.e. bad advice or products that crater during the distribution phase.
The Empirical Validation Framework (EVF)
What will the responses be to such mistakes from the courts, from Government regulators or from self regulatory organizations?
To mitigate this liability potential, on the one hand, and to develop a more meaningful approach for retirement investing, on the other, an effort is taking place at The Retirement Income Industry Association- or RIIA, as we call it. Work is underway to create the next-generation framework for retirement income investing.
Called the Empirical Validation Framework- or EVF- this initiative stems from the realization that the Markowitz, mean variance optimization paradigm is just too limited in scope to recognize the multiple risk factors retirees actually face.
We’d all agree that investment diversification has fueled the growth of financial services for the past several decades. However, it will take much more than MPT to power the industry over the next decades.
Moving beyond asset allocation to the new paradigm of retirees’ financial risk management, we can see that we have to add the components of pooling, hedging and risk free asset determination while still incorporating investment diversification.
If you think of this as a triangle you see Pooling, Hedging and Diversified Risky Assets at the various points of the triangle. With an important additional dynamic- advice- right in the center.
This arrangement is important because it more accurately aligns with the actual risks that retirees face, and with the strategies needed to mitigate those risks. RIIA has created a risk matrix in order to map the various risks so that people are able to better understand their full spectrum and how their personal situations may be impacted.
Once the risks are understood, advisors can begin to think about applying risk management approaches to these numerous risk factors.
When we think about investment diversification we think about what we might refer to as a prudent man index case for asset allocation. Call it 60% / 30% / 10%.
But when we think about retirement investing in the context of the EVF, we may think about this differently.
Maybe something that looks more like 40% / 40% / 10% / 10%
Now we’re covering the areas of Diversification, Pooling, Hedging, and the inclusion of Risk Free Asset (advice).
For any given investor these percentages may vary in recognition of individual investor suitability. That’s where the advice component comes in.
Financial services companies may implement the suitability-adjusted EVF with the specific products they offer. The EVF is product neutral. It does not identify the specific products that should be used to implement the risk management mandate.
That said, one can easily see a natural context for the value proposition provided by structured products. For example, in a solution for income generation based upon a strategic combination of products, structured products, for instance, designed to simultaneously grow and protect, and others designed to generate income , offer relevance that’s obvious.
In retirement income distribution there are several methodologies employed to generate income. I call these the religions of retirement income. Let me give you just one example of how the structured products business can capitalize.
One retirement income religion which is rapidly increasing in popularity is time-segmented asset allocation. This approach creates perfect context for structured products, where they me used as funding vehicles designed to meet time-specific targeted rates of return and targeted income levels. That’s a slam dunk if there ever was one
As I said the development of the retirement income EVF is being led by the Retirement Income Industry Association. RIIA’s Founding Chairman, Francois Gadenne, has energized the organization’s Research Committee on this project, and he has enlisted the participation of many noted academics from many universities.
The academics are conducting research in multiple areas that relate to the EVF including:
– The optimum risk management allocations based on utility theory
– The optimum risk management allocations based on consumption smoothing & living standard risk/reward framework
– The impact of Arrow/Debreu State Preference Theory on risk management allocations, and,
– The impact of the Theory of Lifecycle Saving and Investing on risk management allocations
Now the emergence of a new retirement income investing framework implies much, including the imperative to train financial advisors on its use and context.
In fact, the very definition of a financial advisor’s role is in the process of undergoing transformation. Let me read this from one of RIIA’s Education Committee’s decks:
• “As investors move through their lifecycle, approach retirement and live in retirement, a financial advisor is increasingly pressed to acquire new knowledge and to master new tasks that depart from traditional investment accumulation and move towards retirement income management. Such new knowledge and tasks have become sufficiently numerous and complex to require the formalization of new professional job definitions.”
RIIA is well into its development of this new job description, as well as a Body of Knowledge and curriculum for the training of FAs on these issues. It will offer a program for a new professional designation, Retirement Management Analyst(TM)- RMA- that will equip advisors with the skills they need to properly guide their clients through the distribution investing stage.
I’m not here to be a recruiter for RIIA- but I can’t help myself. It’s out of my passion I have for what the organization is contributing to the future health of retirement income businesses. No company intent on maximizing its opportunities in Boomer retirement can afford to not be member, in my judgment.
* * *
Formulating Success with Boomers
Let’s shift to something else. Let me talk about something close to my heart, something that I believe is vitally important to structured products providers and distributors. It has to do with a formulation for success with the consumer market.
Here’s my assertion: The key to success in delivering structured products successfully to the Boomers is not going to be found in a product or a piece of software. Instead, it’s going to be found in an emotion. It’s the emotion of Confidence.
Why is the creation of confidence so important? And confidence in what, exactly?
Here’s what I mean. Over 31 years in financial services I’ve seen one consistent phenomenon repeat itself over and over again during the accumulation phase. That is, investors putting their money into products that, at best, they only had a hazy understanding of. What these investors did have is confidence- in their advisors.
As we now look toward the years ahead in the distribution phase, I see the role of confidence changing in a significant and potentially dangerous manner. Due to financial liability potential that is so significant for all parties, I believe that investors will require confidence not only in the advisors, but also in the products, solutions and investing strategies themselves.
So, if I’m right about this- and I’ve staked a big bet that I am- then we have much work to do in the area of communications. Communications is the key to creating confidence.
Here’s the communications-based formula for the creation of confidence:
Clarity + Comfort + Compelling = Confidence
Clarity isn’t a commodity. Rather it’s the result of artful communications and storytelling.
Comfort is a by-product of Clarity. It’s the sense that clients understand and accept your clearly conveyed value.
Compelling is another word for “Why?” Why should the client select a particular product or strategy out of the universe of many?
The sum of Clarity, Comfort and Compelling is confidence in the particular financial product or strategy you wish to sell.
I see companies commit lots of money to product development. And I see them investing heavily in software modeling tools. These are appropriate investments. It’s the investments I don’t see that troubles me.
What I don’t see is the investments in the sorts of communications tools that advisors really need in order to stimulate interest in and understanding of structured products. Advisors will need a balanced set of hard and soft tools if they are maximize success with non-traditional products.
And here I’ll observe that if a company has a communications department, it doesn’t mean that that company is generating the kinds of communications products that are really called for.
Look at this quote from FPA President, Nicholas Nicolette. He says something that we should all pay close attention to:
• “The resources financial planners value most- in light of the increased retirement income business- are the ones that enable and facilitate their communication and conversations with clients.”
He is describing a need that almost all financial advisors indicate is critical to them. But it’s a need that isn’t being met.
The industry is building a coin with only one side. I see this in many parts of the business. For example, the variable annuity industry is making a huge investment in technology for straight through processing. But what is the advantage to making it easier to purchase an annuity if there is no interest in purchasing an annuity.
The investment in STP needs to be matched with an investment in communications and education that give consumers the context for understanding- and creates the demand for- the benefits of variable annuities.
We must realize that a brochure is simply insufficient to accomplish that objective.
Remember Hillary Clinton’s book, “it takes a Village?” Well, to the Structured Products industry I say, “It takes a Movie!”
You will have to give people the education, the motivation, and the confidence they want in a format that they want to receive it.
Let’s recognize that the digital video revolution is real. More and more people now learn by watching rather than reading. Consumers want to be entertained at their web browsers. On-demand. Maybe at 1:15 in the morning. Whenever they want it.
Web video has already marginalized or transformed large industries like newspapers and broadcasting. It’s had a profound impact on politics. Who would have thought that we’d be watching YouTube Presidential debates?
The adoption of broadband on a wide scale has changed everything when it comes to explain the value of complex financial products. Broadband is the brightest development that has occurred for the industry. It’s opened up the potential for dynamic growth, but it won’t mean much if it isn’t utilized.
This technology can be leveraged to solve many of the challenges we face. It will absolutely solve the compliance and market conduct challenges. It can be harnessed to furnish vital context and create widespread demand for structured products among millions of digitally-centric Boomers.
It can explain the advantages of structured products in a manner that is unimpeachably compliant, timely and convenient.
It’s the key to mass advisor education, and mass investor education. It’s the key to up selling and cross selling.
It’s the key to making people understand that the word derivatives shouldn’t scare them to death.
It’s the key to solving the advisor’s prospecting woes. It’s the key to penetration of the independent broker-dealer marketplace.
All of this is a function of communications and what I call the Retirement Income “C-Words of Retirement ncome Success:”
There one more C-word I want to mention. It’s the not so good C-Word: complexity.
The grave danger for the structured products industry is that complexity becomes such a burden that it turns out to be an impediment to effective communications. The mass market retail customer does not need the most complex, arcane, and exotic structured product that can be created.
The typical advisor does not need the most complex, arcane, and exotic structured product that can be created.
What both groups need are well-designed, easy-to-understand and timely structured products that can be conveyed compliantly and passionately, and with clear and compelling context.
If the industry meets this test it will achieve not only greatness in terms of sales success, it will have served American Boomer investors in an honorable manner throughout the most financial challenging period of their lives.
Before I conclude, one more item from history. Anyone recognize this guy?
Right. This is Bill Gates (photo from 1977). It’s Bill Gates long before he was fully formed (current Gates photo), long before his company’s products were packaged and destined to become part of the everyday lives of millions the world over.
This progression we see in Bill Gates life reminds me of the structured products industry. Not yet fully formed, not yet packaged for the masses, but having the potential for market dominance for a very long time.
Thank you for listening.