Day: January 29, 2008

Personal Finance, Part 12 ? Longevity Risk

Personal Finance, Part 12 ? Longevity Risk

When I started this irregular series on personal finance, I didn’t think it would live this long. Maybe it’s appropriate then that this piece deals with longevity risk. After all, my prior piece dealt the the concept of the PRIER [Personal Required Investment Earnings Rate].


One of the main ideas there is that you have to take enough risk so that you earn enough money to meet all of your goals. One of those goals would likely be having enough to live off of if you live to a ripe old age, like 100. 100 sounds old; after all, it serves our fascination with watching the odometer roll over. Old age mortality has been improving, though and the number of centenarians is growing rapidly. The same is true of those living into their 90s. Yet many people plan retirement as if they were only going to live to 85.


The destitute elderly definitely have it worse than those with resources. What if you could eliminate some of the risk of outliving your income? I have a product that could help you — the life-contingent immediate annuity. Life-contingent immediate annuities pay a stream of income for the life of the annuitant (or joint lives of two annuitants). They give an income that cannot be outlived. Today, a number of insurance companies do that one better, and offer inflation adjustments on the payments, with the trade-off being accepting a lower initial payment than the unadjusted annuity. The only remaining risk is insurance company solvency, but only buy from reputable firms. That said, remember that the state guarantee funds stand behind the companies, and the benefit payments they are least likely to cut off in an insolvency are death benefits, disability payments, and immediate annuity payments.


Immediate annuities are bought, not sold, unlike other life insurance products. Why? Because once they are bought, there are usually no ways to surrender the policy. You can only take payments over time. Agents don’t like selling immediate annuities, because they will never derive another commission from that money. They would rather sell a variable annuity with a living benefit rider, because it will be possible to roll the policy at a later date to a “better” policy (surrender charges are low), and earn another commission.


Though I am not crazy about variable annuities with living benefit riders, if you own one, be careful before you surrender it. You may have a valuable option to have the company pay a fixed amount for a long time that is worth more than your surrender value rolling into a new policy. In general, be careful in buying any deferred annuities, because the fees are stiff. Be most careful if the agent comes to you when the surrender charge is gone, and encourages you to “roll” to a new product. His interests are different than your interests. You are likely better off staying in your existing deferred annuity.


Are there any other solutions to longevity risk? There are a few. First, cultivate younger friends and family who will be advocates for you in your dotage. They are necessary for kind treatment on the part of the staff of any old age home that you might enter. Those that have no advocates don’t fare well. (For those who are really young, marry, and have more than two kids! Love them, and they will love you.) Second, have an investment policy that reflects the longer-term, realizing you might live longer than average for those that have attained your age. This means more risk assets (stocks) on average than what is commonly recommended, but I would temper this with two caveats:


1) Remember that the Baby Boomers are graying, and will need to liquidate assets to support their old age.


2) Sometimes the markets are overvalued, and it is time to preserve capital, not go for capital gains. Tweak you asset allocation to reflect asset valuations.


A long life is a blessing, and even more so when you have friends, family, good health, and peace with God. Plan now to live longer than you expect. Save more, invest wisely, and buy some longevity insurance.


PS — Don’t go “hog wild” with any single pecuniary strategy for your old age. This is another area where diversification pays, so don’t put all of your eggs in one basket.


PPS — Some of the larger insurers (Pru, Met, Hartford) allow you to buy future income streams should you be alive to receive them. They are an inexpensive way for younger people to put money away for retirement, though there are risks of early death, company insolvency and inflation.


Full disclosure: long HIG

Could Investors Manipulate the Fed?

Could Investors Manipulate the Fed?

When I began my career as an actuarial trainee in 1986, I didn’t know much. When I began working in fixed income as an actuary back in 1992, I didn’t know much. When I entered my first investment department and bought my first bond (institutionally CMAT 1999-1 A4) in 1998-99, I didn’t know much. When I was made a corporate bond manager in 2001, I didn’t know much. When I went to work for a hedge fund in 2003, I didn’t know much. It is probably still true today, because “the markets always find a new way to make a fool out of you.” I’ve made my share of mistakes, and then some. But for the most part, I have been a fast learner.

So, what I write in this post is a little speculative. I don’t know as much as I would like to. About seven years ago, I had a conversation with a more experienced colleague about Fed funds futures. It went something like this:

David: Fed funds futures do a really good job predicting Fed moves.

Colleague: Yes, they do.

D: What if Fed is using Fed funds futures to set policy?

C: Huh? You mean let the view of market participants set policy? They would never do that.

D: They certainly could never let it be known that they do that, if they did. There would be too much money chasing the Fed funds futures markets in order to influence policy.

C: The Fed would never do that. Why would they give up their discretion?

D: Perhaps Greenspan might do it in a misguided free-market attempt to let the markets dictate monetary policy, rather than removing the punchbowl, as was said in the ’60s.

C: I think you are wrong here. The Fed is a complex institution and can’t be boiled down to a simple futures market. They take a lot of different things into account before making their decisions. The Fed funds futures market is just very good at sensing the various forces that affect the Fed, and the collective wisdom of the market is very good at predicting the Fed. After all, there is a lot of money on the line.

D: Okay, you’re probably right. One last thing. How much would it be worth if you knew that the Fed followed the Fed funds futures markets, and no one else did?

C: If you had enough money to manipulate the Fed funds futures market, that would be worth a lot. But the Fed sets its own policy, and does not want to be manipulated, so that’s not happening.

D: Thanks. I think I get it.

C: You’re welcome.

I’ve talked before about the Fed outsourcing monetary policy before to the markets. I consider it a possibility that the FOMC uses Fed funds futures to set policy. After all, even with the TAF, the Fed uses Fed funds futures to set a reservation yield for the auction. Even if it is not true that the Fed uses Fed funds futures to set policy, the futures work really well when one tries to predict what the Fed will do.

Now, perhaps this is a bad argument for a different reason: the Fed funds futures market trades alongside all of the short-term debt markets — eurodollars, CP, T-bills, etc. In order to truly move Fed funds, you would have to move much more, and it is unlikely that any single player could do that. The market as a whole could do it, though, because it is bigger than the Fed. But if that were true, no one would be manipulating. The FOMC would simply follow the judgment of the marginal short-term fixed income investor, which wouldn’t make the policy correct, because markets a a whole make forecasting errors.

Back to the Present

I will say it now, the FOMC will cut 50 basis points today, the stock market will rally, and the yield curve will steepen. The explanatory language will make the requisite bows to both sets of risks, but will say that current weakness justifies the cuts. Now, I don’t like this forecast for a few reasons:

  • The yield curve has enough slope already. 138 basis points between 2-year and 10-year Treasuries should be enough to allow the banks to make money over the intermediate-term.
  • The NY Fed has left Fed funds on average 6 basis points higher than the target since the emergency cut. Why the incremental tightness?
  • Total bank liabilities and MZM have been growing at 10%+ rates over the last year. That level of credit growth should be adequate for our level ofnominal GDP growth.
  • The Fed hasn’t done a permanent injection of liquidity since 5/3/07, and was sparing with them early in 2007. The behavior there is unusual to say the least. Why not be be more conventional if you are loosening monetary policy?
  • Economic weakness is noticeable, but isn’t severe once one gets outside housing and related industries.

At some point, the Fed has to break with the futures market, and deliver a surprise to the markets as a whole, whether positive or negative. Even breaking out of the 1/4% steps would break some of the models used to analyze the FOMC. How about a 3.1% Fed funds rate? This is a digital era where stocks trade in penny increments. The FOMC can move into that digital world as well.

I was taught in economics class (way back when) that policy moves that were anticipated had no effect. Well, eventually the Fed either needs to take back its mandate that it delegated to the markets, or inform the markets that their best estimate of their policy is wrong, and deliver a surprise. A little confusion, a little lack of transparency would benefit the markets over the long haul, and help to reinstate a sense of risk that has been lost among many market participants.

Eventually this will happen, and it might happen tomorrow, but the money on the line says “Cut 50 bps,” and so I don’t argue.? Compared to the market, I don’t know much.

Theme: Overlay by Kaira