Sunday, March 01, 2009

Good Piece on AIG 
If you're curious to learn more about AIG and why they required a lifeline of hundreds of billions of dollars, there's a good piece in the New York Times today on the rotten trades they were making.

These guys are the Enron of the insurance world. Not because they committed fraud, mind you. I haven't seen any evidence that their transactions were fraudulent. I'm speaking simply of their sheer hubris and recklessness in their investment decisions, considering the sacred trust they had with thousands and thousands of annuitants and life insurance clients depending on them for one thing and one thing only: maintain their continued solvency so they may keep their promises to their customers in 5, 15, 30 and 50 years.

AIG put their future in doubt for what? A few basis points more for stockholders and a handful of bonus-hungry executives.

For regular folks, the lesson to take home is this:

There are two kinds of insurance companies: Stock companies and mutual companies.

Stock companies are owned by their shareholders. Mutual companies are owned by policy holders.

The advantage with stock companies is that they are frequently cheaper, in the short run. The disadvantage is that there is an inherent conflict of interest within the stock company, between the interests of the policy holders and the interests of the stockholders.

The stockholders are constantly hungry for dividends. They want dividend payments because if the company skips one, then the stock price frequently goes down, since stock prices are simply the baked in value of the expectation of future dividends. The quarterly shareholder report is king. Policy holders are a means to an end.

Large cash reserves benefit the policy holder, whose primary interest is in the claims-paying ability of the insurance company in future years. Large cash reserves do not benefit the stockholder, because they don't kick off much in the way of dividend payments. The stock company does not pay a dividend to the policy holder, but to the stockholder. Stockholders, in turn, pressure management to maximize short term dividends. Managers who resist their impetus are frequently weeded out in favor of management who are more shareholder-friendly - frequently at the expense of policy holders.

A mutual insurance company, on the other hand, still seeks to turn a profit. But when the company is profitable, then earnings are either put to reserves and surplus, which benefit policyholders because they provide an increased margin of safety for tough times, or they are returned to policyholders in the form of dividends.

Premiums can be lower in stock companies - initially, anyway. Because their policies are worth less. They don't earn dividends. Dividends are routed to shareholders, not policy owners.

AIG fell into the stock company trap: They succumbed to the temptation to chase returns on risks they didn't understand, jeopardizing policyholders and the future viability of the company, in order to please stockholders one quarter at a time.

Splash, out


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Probably not appropriate for you to answer via Counter Column, since you get paid for advice like this, but: Is there a trigger point, to bailing out of a 401k these days?

I know you are supposed to think long haul, but is there a prudent time to stem principal loss (or jump ship at that point where taxes / penalties would drive over that edge)?

Or does one just burn in all the way?

Thanks for writing. The answer to your question is: It depends. It depends on what the individual's risk tolerance is, their life expectancy, their age, time horizon to retirement (or other planned need for the money.)

One criticism I have of the financial press - of which I was once a member, too, and a criticism which I am just now formulating in my own head - is that they are too retirement focused. The reality is that in an unsteady job market with multiple job and career changes the norm, along with the regular need to relocate for jobs, and along with the periodic need to reeducate oneself for new careers, longer life expectancies, etc. the old do-it-yourself paradigm using mutual funds and relying on compound interest funding a 35 year retirement is wrong. It was always wrong (we just didn't realize it.)

We were underestimating risk, and undervaluing safety the whole time.

Is there a trigger point? That's an individual matter and I can't begin to answer it for strangers on the internet, and nobody else can, either.

As a journalist, and I was guilty of it as well - I was too focused on mutual funds, and not focused at all on guaranteed vehicles - such as whole life insurance, annuities, EIAs, GICs, pensions, Waiver of Premium, etc.

Looking at my reporters and editors in those days, most of us could barely spell those words, much less understand those tools and how they're used and how they interact.

Some of my colleagues and friends are still journalists, and I recently did a content search on what they've been writing over the years. And they still barely address these issues, if at all.

The public has been poorly served by us. I just commented on McArdle's blog this evening that I shudder to think of the devastation wrecked on America's families because they listened to the disastrous advice of Dave Ramsey and Suze Orman and their expectations of 10-14% returns in mutual funds and their advice to shun annuities and whole life insurance. Annuities have been a godsend to their investors this past year, as have whole life insurance policies with some accumulated cash value. But even when times were looking good, the financial media lemmings were all advising people to shun annuities, with their significant and solid guarantees and downside protection, all to save a few basis points in fees.

I've been slowly awakening to that over the past couple of years. If you do a search on this blog for Dave Ramsey you can find me sounding the alarm bell about his 10-12% projected returns in mutual funds back in 2006.

But I didn't have conceptual clarity then. I was still seeing it through a glass, darkly.

Not much of an answer, I know. Or maybe too much of one to be useful.

Talk to an investment professional AND an insurance professional, who can take in your overall situation.

Above all, be strong and of good courage.
Thanks for the great response. You are right: I bought the no risk angle of Mr. Ramsey, et al.

They'll preach the long haul, of course. I'm 20 years from retirement, so maybe they have a point?

Though I can't see how I'll see even a 5% return, as my 401k dries up in these recent times, via the death spiral we're seeing now.

It is that whole 'how much risk are you willing to take?', and 'do you want to risk losing principal?' questions I've never asked myself. I saw 'free' money.

But as I auger in, wondering when do I pop the canopy and save something - the bit of hide that remains?
Yes, and there was quite a bit of support for that idea...that over time, equities would outperform bonds. And of course, that makes sense: Why would a business borrow money at X interest rate if it didn't project that it could get return on that money greater than X?

The theoretical underpinning for that idea was presented by Dr. Jeremy Siegel, of the Wharton Institute at the U. of Pennsylvania. He demonstrated that equities easily out performed bonds from 1807 through 2006 or whenever his last edition was.

So if you have to run a fund with an unlimited time horizon, and it doesn't have to generate an income in the meantime, then equities make terrific sense.

The problem is in real life, real people DON'T have unlimited time horizons, and real people have a need for income in the meantime.

That time horizon, and the need for income that forces people to sell assets during down markets (when layoffs are abundant and unemployment high) is what shoots a hole in the Siegel/Ramsey logic.

And we can see that hole now. Even people who are not near retirement now are seeing their retirement funds devastated by the need to sell stocks cheap to make short-term expenses.

At least an income-generating vehicle, such as a bond, bond fund, annuity or participating whole life plan, or an annuity in the distribution phase could have filled in some or all of the gap.

Any monkey can look at numbers. But the best advisors look at the interface between the numbers and life. And timing counts. The TIMING of a bear market, and whether it happens at the beginning or end of a bear market, can matter a great deal.

This is where Monte Carlo analysis fails. Lots of advisors use Stochastic modeling... and they can tell you based on backwards-tested market data (snicker) that a 60-40 bonds/equity portfolio might have a 90 percent chance of lasting to age 90, based on a 4 percent withdrawal rate.

Ok, fine. Can you afford to be the outlying 10 percent?

No. In real life, you can't.

Traditional financial planning fails at that point. That's where the life insurance guys have them, and they kick the shit out of the Suze Ormans and Dave Ramseys of the world.

Retirees don't need projections and scenarios. They need promises, protection and guarantees. So do families at all stages of their lives.
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