Why investment banks stay away from fixed assetsArticle added by Cal Burgess on March 20, 2012
Cal Burgess

Cal Burgess

Austin, TX

Joined: August 24, 2011

The philosophy of an investment bank’s profitability is in direct conflict with offering fixed products that use annual reset interest crediting methods.

Over the last few years, the concept of annual reset, or indexing, has been a popular approach to retirement and income planning. The ability to bypass market volatility within a global recession has proven to be a viable alternative.

Many indexed products such as fixed indexed annuities and indexed universal life have substantially outperformed the S&P 500 over the last decade. Now to be fair, these results are not typical over a 40 or 50 year look back. Truth be told, the average investor does not have 20 years, let alone 50 years, to wait the market out for a favorable return; especially since the last decade has been a lost decade.

Pretty much every planner or financial professional will tell you that the key to reaching your financial goals is to maximize the market upside and try to bypass the market downturns. So if this is the case, why haven’t investment banks been focusing on implementing these indexed products within their portfolio?

The answer is simple — it is a conflict of interest. Today, a strong investment bank will have about 6 percent of capital reserve requirements with respect to leveraged assets. In other words, for every $100 million of financial services offered by a strong investment bank, it has financial reserves set aside in cash of $6 million, or 6 percent capital reserves.

In order for an investment bank to offer indexed annuities or universal life products, reserve pools would have to be put in place as a substitute to the leveraged assets. To clarify, if an insurance company offers $100 million in FIAs that use annual reset, they are mandated by the state to hold cash reserve pools on the side of at least $100 million in order to back, or guarantee, the products (this is one of the main reasons why insurance companies are not required to purchase FDIC insurance).

This is the reason why most FIA or IUL advertisements will say “backed by the financial good faith and credit of the issuing insurance company” as a compliance disclosure. To sum it all up, the capital reserves ratio would be much higher (minimum 1 to 1 ratio) for the investment bank to offer financial products that eliminate market volatility.

To help understand, let’s take a closer look.

According to the SEC, the average fees a consumer will pay in mutual funds is about 1.5 percent annually (an average of all fees and costs associated with all types of mutual funds). Respectively, over a decade these fees come to 15 percent, assuming no interest earned (1.5 percent in fees x 10 years).

Conversely, commissions of a FIA over 10 year period are right at 7 percent up front (assuming no riders are added that incur a cost). So not only will the investment bank lose approximately an 8 percent spread over a 10 year period, it will be forced to stop leveraging their assets (which will cause an additional loss of income).

Think of it this way: if an investment bank offered 20 million dollars of FIAs, the minimum amount of capital requirements would be $20 million. With respect to leveraging assets, the capital reserve requirements for $20 million of financial products would be $1.2 million assuming a 6 percent capital reserve requirement (instead of $20 million needed to offer FIAs).

Now when you take into account that over a 10-year period, the investment bank would lose approximately 8 percent on their spread, it becomes clear why there is a conflict of interest. To put it in layman’s terms, the philosophy of an investment bank’s profitability is in direct conflict of offering fixed products that use annual reset interest crediting methods.

Make no mistake about it, there is a definite need for investment bank services within a portfolio. The intent of this article is to help clarify the differences between the investment banking world and the financial services of the insurance industry, and in no way to discredit the integrity of the investment banking industry.

Let’s face it; knowledge is key when providing sound recommendations with respect to the client’s financial goals.
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