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What’s in store for the indexed annuity industry if- as I believe it will- the SEC’s proposed rule becomes law?

Continued turmoil in the fixed indexed annuity distribution channels, for one. As the center of gravity for distribution turns permanently toward broker-dealers, many independent marketing companies that wholesale these products may become marginalized.

Non-registered agents will be factored out of the distribution of fixed indexed annuities unless they opt to become registered representatives or Registered Investment Advisors. The RIA option is one fraught with peril for insurance agents, however. For more, click here.

Insurance carriers that manufacture fixed indexed annuities will fall into two camps. Some will see sales decline dramatically as their market share is taken away by others that adopt new business models, new technology and new (FINRA-reviewed) sales tools.

Consumers- especially millions of individuals entering the “Transition Management” phase of retirement- will be the big winners as improvements in indexed annuity contract designs in terms of greater transparency and improved pricing lead to the indexed annuity finally becoming a mainline product.

As I’ve always stated, wipe away the bad sales practices, overly complex contract designs, and too high fees and you are left with a value proposition- downside protection combined with upside growth potential- that is as important as any found in a financial product.

Two years ago Wealth2k introduced www.FIAToday, a compliant, technology-driven solution to the problem of poor fixed indexed annuity sales practices. Arguably, it was ahead of its time. The SEC’s action has just increased its value to all parties. Exponentially. FIAToday is available at no cost by clicking here.

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Structured Products Americas Conference
The Biltmore Hotel
Coral Gables Florida
May 9, 2008

Good Morning.

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:”

Confidence

Clarity

Comfort

Compelling

Context

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.

***
Copyright 2008 David Macchia. All rights reserved.

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Yet it would be unfair to presume that Allianz Life’s traditionally aggressive, sales-driven culture couldn’t change. And that its perceived commitment to the best interests of consumers couldn’t improve. When I spoke with Tom Burns I came away from the conversation with exactly this belief. Corporate cultures can change. Such change, when it occurs, is generally driven by a changeover of top management. That’s what’s happened at Allianz Life.

I found Burns to be quite candid considering the scope and sensitivity of his responsibilities at Allianz. In fact, Burns struck me as coming from a background similar to my own; one rooted in the values-based mindset engendered in young life insurance agents. So, it would seem that Allianz Life has turned a corner.

I was most surprised with Burns’ calling for annuity providers to “work together” in the best interests of the annuity industry. This is certainly a change from the past. Judge for yourself as you read the interview.

DAVID MACCHIA: Tom, to begin, my readers would be interested in knowing about your background. Will you tell me about your life before entering the life insurance business?

Tom Burns: I’ve been around awhile. My father was an agent with Prudential in a small community in southwestern Minnesota for 30 years. I really wanted to be a professional baseball player. I decided I’d play college ball and if I’m really good, the scouts would be there. Guess what, the scouts were not there. I played four years of college baseball, ended up with a degree, joined my father in the business and, unfortunately, he passed away three months later.
I found out real quick at age 21 how important life insurance and planning for a family really are, especially for my mom and the rest of the family. I ended up running an agency for 15 years here in the Twin Cities, the largest agency for Prudential Preferred. And then in a weak moment they talked me into the home office. I managed the whole country on the brokerage general agency side. And then I got a call from Securian Minnesota Life about five years ago, and I went over there and ran all their distribution for about four and a half years. And I was very fortunate with some help of a lot of great people to turn it around and they had three record years. And then I got a call from Allianz about 14 months ago – and you know the challenges that we’ve had here.

DAVID MACCHIA: When I think about you coming into Allianz now, considering the new leadership that’s taken charge, I make an analogy, based upon years of observation of Allianz, that it’s like sort of having a close relative who just goes a little sideways for a while, and then at some point, somebody is able to bring him back to center, and puts him on the road to growth and happiness again. Does that analogy ring true to you?

Tom Burns: In the time I’ve been here, I’ve found that this company had such rapid growth, and with such rapid growth you start looking inward. And, you know, I think you’re right that with rapid growth comes challenges. Any business that grows that fast will present issues to deal with. We have been able to streamline some things recently and are continuing to put additional measures in place.

DAVID MACCHIA: Let me ask you about what you obviously know, which is that a lot of damage has been done to the index annuity business.
And the result of that is that some segments of the annuity business – especially indexed annuities – plummeted in terms of public perception. Now, here you are with this huge responsibility in a company that’s been a market leader for a long time in this line of business. From your vantage point what measures can be taken to improve the public image of the index annuity industry?

Tom Burns: The whole industry needs to work together on this issue. One thing that we need to do is more effectively convey the value of annuities as a part of overall retirement planning. As a society we have yet to fully come to grips with the implications of people living longer but with much less of the income protection that we used to see from traditional pension plans and, at the same time, more people relying on social security income while fewer workers are available to support it.
At the same time, we need to continue to improve our processes to ensure that the products are marketed appropriately. Suitability review is a very important part of that. We launched our suitability program nationwide in 2005. Our program today is much improved since then, and we are committed to continuing to make it better. We’re working through industry associations on “suitability” standards. I want to make absolutely sure that our suitability is the best it can be.

DAVID MACCHIA: I want to come back to the question of the past, which I recognize is not your responsibility, but it is your legacy to some extent. You’ve inherited a mantle and I think that you’re simultaneously blessed, blessed to walk into such a robust sales organization with so many agents and such a heritage of sales leadership, but also cursed because you’re also saddled with some of the negatives, the baggage that is a hold over from the past. So in terms of the marketing and sales activities, I don’t have to tell you that Allianz has been criticized by regulators and it’s been the subject of civil litigation and regulation at the state level and actions that you’re aware of. I imagine that it would be more enjoyable for you to be able to look forward only and not have to look at the past. How do you balance the legacy issues with an eye toward the future?

Tom Burns: We can use the experiences of the past to inform what we do today and how we can make it better tomorrow. Let me go back to suitability as an example. When we first launched our suitability program nationwide, we allowed policyholders to opt out of providing financial and other information to us. This opt-out is allowed by state suitability regulations. But after working through the program, we grew increasingly uncomfortable with opt-outs because without that information we could not do our own assessment of suitability. So last year we eliminated the opt-out option. If a policyholder is not comfortable providing us with the information we need to assess suitability, we understand that, but if we cannot independently assess suitability, we will not issue the policy. We will continue to use the experience of the past as a guide to how we can improve in the future.

DAVID MACCHIA: Wealth2k for years has enjoyed a robust business making the preeminent multi-media presentations for a number of indexed annuity providers. I also owe it something else in the larger sense of the annuity business, namely that the annuity business gave me more financial reward, more education, more professional opportunity than I had any right to expect as a young man entering the business in 1977, a rookie agent selling tax sheltered annuities. So when you consider – I mean your words resonate with me – companies working together, prioritizing the consumer, not so much always worrying about distribution. Why then, given what you just said, would it be hard to get companies behind an effort that is so manifestly pro-consumer as placing unbiased consumer education in the very center of the process. Why would you imagine it would be difficult to do that?

Tom Burns: After 29 years, I want to be known as someone who made a difference. This is new for me to have the negative press. So what can I do personally and professionally to change that? First of all, it’s reputation. Secondly, it’s adding customer value. So, when I talk about a legacy, that is so, so important for me because I’ve been blessed, too. My father was a good agent, and the opportunities that this industry has afforded me and my family are unbelievable. And I’ve seen life insurance work in people’s lives.

DAVID MACCHIA: I can’t disagree with anything in your answer, but you didn’t address the question I asked. Can the industry progress from an ideal that says companies should get together and prioritize the consumer in a functional, demonstrable way? Can we go from the ideal to a reality that actually shows that?

Tom Burns: Well, I think we can. I really believe we can. I know that we wholeheartedly support unbiased consumer education. That’s what our new Partnership for Consumer Trust is all about – making sure consumers are fully informed about the products they are purchasing, which, by the way, we believe are incredibly useful to them. The industry knows that this is important and that we can’t let it slide.

DAVID MACCHIA: I agree with that because it will be at the industry’s peril. And one of the ways it imperils the business’s future success is something that I’m deeply involved in for a number of years – of boomer retirement security. One of the reasons that I have been so aggressive in my comments, and critical of poor sales practices and inferior contract designs, has to do with boomers approaching retirement and what their march toward retirement means in terms of a business potential for the annuity industry. What I’m getting at is, and I’m sure you know this, that it’s been academically demonstrated that as people approach retirement, in those years leading up to retirement, it becomes very important to put a principal guarantee under accumulated retirement assets while also maintaining upside growth potential.

Similarly in the first few years after retirement the same protection is called for. And the reason is if you have investment losses in those two periods, the result is, at the very least, you will have less retirement income than you otherwise would have had or, depending on when the loss occurs, you may run out of money entirely while you’re still alive.

Tom Burns: Yes.

DAVID MACCHIA: So, given that the value proposition I describe – downside protection combined with upside growth potential – is the value proposition of an indexed annuity which the industry has allowed to get so clouded and camouflaged through such a poor level of transparency, and so much misleading sales practices activity, that the pristine value proposition got lost. And so what I’ve been trying to do, in my own way, with limited resources, is liberate that value proposition. Because, as I’ve said often and publicly for two or three years now, the $28 billion dollar high water mark for indexed sales could easily be $100 billion.

Tom Burns: I Disagree that there has been a lot of misleading sales practices. Obviously there has been litigation alleging misleading sales practices. The problem here really ties back to the need for more and better public education about annuities. One of the challenges in selling annuities is that people don’t start out with a solid baseline of knowledge about annuities, compared to other financial products such as CD’s and mutual funds. So in some cases selling these products presents a challenge in getting people to understand the fundamental concept of an annuity.

DAVID MACCHIA: If I’m reading you right, it sounds like Allianz is committed to altering course and really changing that.

Tom Burns: I would say as a business there’s leadership here that absolutely wants the consumer first. And also we value distribution, but the consumer first.

DAVID MACCHIA: Now, let me ask you this: Do you worry about the onslaught of negative that continues around the annuity business – and specifically the indexed annuity business? And we’re aware that — I’ve read where Dateline NBC has, done a story on annuities using hidden cameras taping the annuity presentations. It sadly reminds me of the approach they take with the child predator programs that they’ve run. I mean you open up the cover of Parade Magazine and you read a headline like, “Don’t Make A Costly Mistake.” And a lot of this was driven by a liquid contracts and two-tier contracts and I’m mindful of the fact that you mention that the focus now is on single share contracts. My point is — my point is do you fear that the negative press and the deteriorating public perception can sink so low that the annuity business may not be able to turn the corner and start to go the other way?

Tom Burns: I don’t fear for the future of annuities because the need for them has never been greater, and will continue to increase. And we will continue to offer two-tier annuities because for people who are looking to the long term, and who want a product that offers periodic payments for the long term, they can be a very good alternative. We will turn the corner and go forward. I don’t know if you remember, but Metropolitan went through it and Prudential went through it in the old life insurance days. Painful, but I think you become a better company and a better industry as you get through it. You look at all the wonderful agents and registered reps who do such wonderful work, and you believe we can get through it.

DAVID MACCHIA: Other large financial industries are obviously very aware of the baby boomer retirement opportunity, and they’re aware of the financial need that I mentioned earlier in terms of the importance of providing principal protection combined with ongoing growth potential. And companies that are not insurance companies have clearly set their sights on the core annuity customer. Now, what does it mean for an annuity provider, such as Allianz, say, when companies perhaps with names like UBS, Merrill Lynch, Morgan Stanley, Deutsche Bank, and others are developing and offering products aimed at the same core customer, products which develop the same essential value proposition? Does that make this a special urgency for the annuity business to align itself more appropriately than it is right now?

Tom Burns: Yes and yes. Competition is challenging for us but in the long run good for the consumer. But keep in mind that annuities offer something that the others don’t: that option of a guaranteed income for life. So the value proposition being offered by some of these competitors may be similar, but it isn’t the same. Every Tuesday for 2 hours we get together – the chief actuary, the chief distribution officer, the president of North America, I mean the senior-senior most people of this company – and we look at today’s products and what the future products are going to be 12 to 24 months down the road and who is going to be selling them. The future is going to be really exciting to see, and I want to be part of that versus being complacent, being innovative versus being reactive. We’re developing some products right now that I can’t share with you, but it’s going to be really exciting.

DAVID MACCHIA: Let me ask you this: If we were to be speaking again three years from today, looking back over those three years, what would have had to have happened in order for you to feel great about the progress you made?
Tom Burns: We would be a company that consumers, agents and registered reps would really treasure doing business with. Secondly, our employees would continue to feel that there is great opportunity here for growth and development. And then lastly, we would be known as an innovator. When we walk into an industry meeting, not only are they excited to see us, but they say, “’Wow,’ Allianz is quite a company.”

DAVID MACCHIA: An admired company?

Tom Burns: Yes. Look at the great opportunity we have for all the people who are going to retire, but who don’t want to retire with less money, or less income than when they were working. We’re calling that stage “decumulation” because it’s different from all the working years when people were accumulating assets. So, what we’re thinking about is how do we position ourselves in our industry to be the company people choose to help them with their income needs for the rest of their lives.

Tom Burns is chief distribution officer for Allianz Life Insurance Company of North America. He is responsible for sales, distribution, and marketing.

©Copyright 2008 David A. Macchia. Al rights reserved.

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©Copyright David A. Macchia. All rights reserved.

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To explain the magnitude of the difference between investing for accumulation versus investing for retirement income distribution, I’ve often used the analogy of the beginning of retirement as being the economic equivalent of puling up stakes and “Moving to Tibet.” In other words, leave everything you know behind and enter a strange, new world. I think the “Tibet” analogy is relevant to describe the extent of the disparity between the websites of financial services companies and those of large companies in other industries. If you would like to see some examples of how non-financial companies create engaging website/microsite experiences designed to better convey their value- and help their intermediaries, just visit Mercedes-Benz.TV, Calloway Golf, the Boston Pops and Cadillac.

Until the equivalent of these communications vehicles emerge in financial services we’ll see the dangerous gap continue to widen with the result that the definition of retirement income success” will be driven lower. To learn about my recommendations on how to Catch a Digital Wave (close the gap), click here.

©Copyright 2007 David A. Macchia. Al rights reserved.

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MacLeay – You’ve had some great interviews on the blog.

Macchia – Thanks. It’s been a wonderful learning experience. Is it okay to begin?

MacLeay – Sure.

Macchia –To begin, would you be kind enough to describe your title and the specifics of your role at National Life Group?

MacLeay – Okay, well, I’m Chairman of the Board, President and Chief Executive Officer, so basically I’m heading-up the holding company for our life insurance companies and our asset management group.

Macchia – I’d like to ask you a little bit about the long-term and then the recent history of National Life. I know National Life as a company that for many years has been considered to be one of the top tier, most prestigious life insurance companies, one with a very long and fruitful history. Could you just talk a little bit about the history of the company, its beginnings and what has occurred- over not just decades- but even centuries?

MacLeay – The company was founded in 1850, so it was one of the earliest life insurance companies in America and it was founded by a combination of a local doctor, by the name of Julius Dewey, who saw the need that families had when they lost a breadwinner. He teamed up with a group of prominent business people from New York and Boston who were looking to establish a life insurance company that was not focused locally or in a region, but had more a national scope.

That founding group including people like Henry Clay of Kentucky and Henry Cranston of Rhode Island. This was certainly a group of very prominent business people. Interestingly, this company was founded with the notion of providing for death benefits. Not just in the local area, but across the country. In fact our first death claim happened in San Diego harbor when one person was traveling by ship to the gold rush in California. So, the roots of the company are strongly here in rural Vermont, but we’ve always had this kind of national vision. In its early days the company established agency operations virtually across the country and this was at a time that travel was very, very difficult and communications were slow and difficult.

It’s really amazing to think about this today because I don’t know how long it took that claim to get filed or paid. Part of the story about that is that with that first death claim the company didn’t have a lot of capital at that point so the founders had to really scratch to make that claim and we’re very proud that they were able to do that. We’ve obviously reached or met all of our claim obligations since then.

So, it started with that idea and then it grew over the years, and was a mutual company. For many, many decades, a century probably, the primary product was participating whole life insurance. A very strong career agency operation really flourished in the 50s, 60s and 70s as the products became a little more sophisticated and the growth of the industry really took place during that period, particularly in the upper end of the industry. More estate planning and sophisticated use of insurance and in fact, financed insurance was a big thing for this company early on.

The company has also been known through the years as an innovator of products with lots of focus on the upper market and designing sophisticated products to meet the needs of that market. When the industry started to really transform from a whole life focus to the introduction of things like universal life and then variable life, National Life did not grow as fast in the 1980s and early 90s. In the mid 1990s National Life decided to diversify its products as well as its distribution. That’s when we started to not only sell through our career system, but also through an independent marketing organization. When these product innovations came out we did introduce universal life and variable and, in fact, our strategy today is to have a full complement of products. So we have fixed, variable and equity indexed versions of our universal life programs and we have variable life as well as traditional whole life, and really a mirror of that in the annuity market place.

The strategy is that we know that each of those products has behind it a particular attractiveness to different market segments with different needs, but also that consumer desires change over time. We take a very long -term view of our business and feel that our job is to meet the needs of those clients and to provide the kind of solutions that are best designed to meet those needs - and that changes over time. So, we can’t say that we’re a whole life company and that’s it. Over the last 10 years we have diversified significantly both our products and distribution.

In terms of the history of the company, part of that diversification was the acquisition of Life of the Southwest, which brought fixed annuity experience and the 403(b) market focus. LSW is also a product innovator and an early, early provider of indexed annuities, a consistent and long-term player in the marketplace. That’s been an important part of the organization for about 11 years now. We continue that product innovation push in those product lines where we think we can bring something to the market, most recently, indexed life, which we’ve had since 1998, I believe, but we came out with a new version last year and that’s gotten a very good reception.

Macchia – Let me ask you this: when you have a board meeting and you sit in the chair as Chairman of a company now in its 16th decade, does the history and the lineage convey to you a special responsibility of honoring the past, and maintaining the integrity and bright outlook for the company going forward?

MacLeay – Absolutely. The leadership roles in an organization like this are more stewardship roles. In other words, we have an organization that has been here a good time before us and our forward looking approaches- you know, we plan for a very long future- so the current leaders are really here to both build on that history and strengthen the organization, and will turn it on to the next generation of leaders at some point in time. There is a special obligation to an organization that has the kind of history or market presence that National Life Group has. It’s more of an obligation to further strengthen the organization and move it forward. Of course, a great benefit of being a non-public company today is that you can take that longer view. We’re very cognizant of the need to be as profitable as we can be, but that’s only to strengthen the organization, not to satisfy a Wall Street analyst. So we don’t look at monthly profitability as being something that is the metric. Well, that’s probably not true, we do look at it as a key metric, but we’re not under pressure to perform in that short term.

Macchia –I’d like to come back to the corporate structure a little bit later, but one of the wonderful things that I’ve observed about the life insurance industry, in terms of some companies such as National Life, with such a long history, is that over a 150 plus years just about everything bad that can happen, happens. Whether it’s man-made disasters, wars, natural disasters, relative to anything that nature can conceive in a negative way, and to see the companies endure throughout all of these challenges is a very special thing and very noteworthy in our economy. I sometimes think that it’s underappreciated. Do you agree with that?

MacLeay – I do. I think it’s hard for people to, in today’s world, necessarily think of an organization as being an organism itself. In other words most people think of organizations in terms of ultimate transaction. Founders, for example, if you found a company, the typical track is that you found the company, you grow it, you must have an exit strategy. You end up selling it or maybe it becomes an independent public company, for example, but you’re thinking is really limited somewhat to your own personal needs. Whereas leadership in these kinds of companies are thinking about bringing the company to the next level of performance and making sure that we are delivering the value that we deliver to our customers and really building and maintaining the relationships that last way beyond any one particular person. I think that’s very hard for most people to understand about these businesses.

Macchia – For many years National Life was, as you indicated earlier, a mutual company. Then some years ago it made a decision to adopt the mutual holding company structure. I’m wondering if you feel that has given you the long-term view and staying power you need in the context of some who argue that size is all that matters and that smaller to midsize companies are going to be a challenged going forward, and you need $100 billion plus of assets to really be a strong player in the future. What’s your view on that?

MacLeay – Well, first off, bigger can help, but it’s not by definition better. We look at that and say we think that the key to success is being able to provide products and services that deliver real value. If you can do that then you have the ability to be a competitor and an independent company.

So the issue of size really comes down to the question of can the big companies leverage you or basically out-compete you, and the only way they could would be on price or reach. And so it creates a pressure for smaller companies because bigger companies can sometimes have more favorable price points, and it’s their time to grab market share. They can sometimes under-price products and gather market share.

We have been in a consolidating business, but I don’t think that means that there are going to be three big life insurance companies in the United States because our market is really driven by relationships that people build one-on-one. Our business is so very, very personal. So it comes down to being able to provide the products that have real value and building the relationships that can connect the customer with the company through an intermediary. That intermediary is where a lot of us compete for the relationships that we know kind of drive the business.

It’s kind of a long-winded answer, but we think that there is plenty of room in this country for companies who can be really good at a selected number of things and that being big gives you a little bit of credibility with the rating agencies and that kind of thing, but we’ve seen some pretty big, pretty bad companies over time. Not just in this industry, but in lots of industries. We think that we can grow and we need to grow.

Back to the mutual holding company, we think that the mutual holding company is a great structure because it makes you more flexible with respect to financing and the ability to grow through non-organic means, doing acquisitions and things like that.

But, it maintains at the core that it’s still a mutual organization, so what that means is that you basically reinvest the profits for the company in further growth and strengthening of the company rather than paying it out to some owner out there. We think that companies with a mutual structure are better for a long-term view than a public structure because in a public structure, frankly, money talks. At some price somebody can change your game. If you have an obligation to shareholders to do the right thing for shareholders, if you look out there today and see who the shareholders are and why they are shareholders, they are people who are making an investment and looking for a return. At any point in time there would be a price where that organization will be sold to some other organization to do with what they want if they have enough money to hit your price.

A mutual organization doesn’t have that consideration. We are building the company for the benefit of policyholders over a very long period of time. It’s not a matter of if somebody comes in with the highest price tomorrow morning saying that that’s necessarily the best thing for all of our policyholders.

Macchia – We’ve covered in great detail the past and the present. Now I want to ask you about the future. How do you personally see the outlook for life insurers over the next 5 to 10 years?

MacLeay – Well, let me say first off that a lot of companies that we think qualify as life insurance companies in the US, particularly the big ones, are doing an awful lot more than life insurance in the U.S. I think people get a little confused about what some of the bigger companies really are. There’s a lot of opportunity and a lot of activity for those companies who chose to be international or global. Those opportunities in terms of the growth are bigger overseas than they are here.

I think that the outlook for the U.S. market, in my view, is quite bright and it’s driven by this Baby Boom phenomenon. To which I have to say it’s kind of interesting how much press that is getting now because this has been the most predictable wave in our lifetimes, from the time we were born. At least I’m a Boomer. I’m kind of on the leading edge, I guess. This is not a surprise, but what’s different though is that the amount of press that the aging of the Baby Boomers is receiving, I think is a very, very good thing for the financial services business altogether, but for life insurance companies in particular.

I think it’s not just for the reason that they are approaching retirement. If you think about it the Baby Boomers are now 44 – 62 and those are the sort of sweet spot years for everything that life insurance companies provide. Protection, accumulation, distribution, wealth transfer; all of these things are very important to people who are 44 – 62. When I think of the opportunity right now I think these people are now in their peak earning years. They are now barraged with information that tells them that they have needs that they may have been ignoring. What this does is sensitizes them and conditions them to have a discussion with a trusted advisor and develop some relationships. That trusted advisor we think of as a person, normally, but I use that even more broadly.

What I feel is people now know that they have needs that they have either been ignoring or didn’t know they have, and that makes them a very, very good market for financial services companies and life insurance companies in particular. I see that as a huge plus and it’s not just about retirement distribution. It’s about understanding that you have these financial needs and there are ways to start your financial program to address those needs. Having said that, those needs are very personal, which means there’s not a one size fits all solution, which means you have to have the ability to do a comprehensive financial analysis, financial plan for individuals that have these needs.

I further think that it’s not just the Baby Boomers that are now sensitized to that because younger people read the same publications and watch the same programs on cable and hear the same things and are barraged with the same things over the web or however they get their information. I think there is just a heightened sensitivity to financial needs and that to me puts in place something that’s really positive for life insurance companies in particular. There are plenty of risks and challenges when you think about that, but just the conditioning, the fact that the Baby Boom market is there and the entire marketplace is much more conditioned to talk about their financial situation and their needs.

Macchia – I think that this is very important insight that you raise, and you hit upon a subject that’s very much a passion of mine right now, which is the notion of trying to help insurance companies realize their potential in this thirty- trillion dollar opportunity of Boomer retirement.

That said, I can recall since entering the life insurance business in 1977 that, back then, insurers controlled the pension business in the US. They then seeded that business away to the mutual fund complexes, which came to market with an arguably superior model for the consumer, greater transparency and those trillions of dollars were lost. Now we see the large asset management firms with trillion dollar asset bases.

The stakes for life insurance are very, very high in my judgment and what I try to focus on is quite vocally trying to publicize, in terms of essays in this blog, and also in other writing that I do in numerous journals, some of the inherent, almost disease state that exists in the insurance business. I feel as though if that disease isn’t cured the insurance industry is not going to seize upon the Boomer retirement opportunity in spite of the fact- as you correctly state- that its natural product set, competencies, and financial experience, would lead it to be the natural provider for this large group of customers. Do you ever think about that? Do you buy into what I am saying?

MacLeay – Yes, I do. I agree that, number one, we used to control more of the pension assets and we lost that battle to the asset management companies. I would say that many of us have asset management companies primarily for that reason. The product sets that are offered by asset management companies and the whole notion of a simpler, more transparent product has really taken hold, obviously, and grown that marketplace. I know you’re well aware of how that has happened.

Looking forward, the needs are similar, they haven’t changed, there’s just a better understanding of what those needs are. Some of those needs are well met by simple asset accumulation investment type product, but the ability to guarantee things and to pool risks is the domain of the life insurance business. The inner section of that core competency with the marketplace and communication of how these products and services fit people’s financial needs is kind of the area where I know that you’ve spent a lot of your time, and I agree, that’s where we have, in essence, fallen short. There are a lot of reasons for that, not the least of which I think, is how people get paid. I think that’s at the root of product pushes that are not necessarily in all cases well thought out and responsive to the customer’s needs or their situation. The industry has frankly struggled with how to be more transparent in what we’re doing.

I believe that the products as we move forward, the kind of disclosures and transparencies that will be in the market will look much more like securities disclosures and so on. Technically, that information will all be out there, but it’s kind of like looking at a prospectus and a statement of additional information for a mutual fund. You can find anything you want, but customers don’t go there. So, who is actually making that interpretation is the advisor or wherever that communication link is happening. I think that’s where we have probably one of the biggest challenges. That is: how do we get that communication link that’s clear and in the customer’s best interest? I don’t have an answer for that, except that we try to be very specific in the way that we train people and the way that we roll out our products to make sure that they can be clearly communicated and we can identify those areas where the products really fit the best. It’s a big challenge and I think that especially on the leading edge of the Baby Boom you’ve got more traditional methods of one-on-one consultation and brochures for a lack of a better term.

At the younger end, and the generations to follow, electronic communication is kind of the expected communication and paper is more to be thrown away then it is to be read or anything like that. I think part of the opportunity is to get that information, that set of information, whether it’s hard copy or electronic, get it to be able to be much more responsive to individual situations, and frankly viewed in a broader context than a single product sale. I think that the challenge for the industry is that a lot of the distribution and a lot of the sales efforts are for a particular product as opposed to creating solutions around a specific individual needs. I’m really talking about the upper-middle and upper markets. I think we’re talking a whole different challenge for the middle markets and down. There’s not enough money, there’s not enough incentive or reward for the kind of tailored response or tailored solution that I think you need in the upper markets. We do some in the middle markets; those are much more packaged. I think that those packaged solutions have to be clearly defined with the product features disclosed very carefully, and with as many tools, as many communications tools as you can, electronic as well as hard copy.

Macchia – Let me ask you this Tom, because the magnitude of the Boomer opportunity is obviously apparent to sectors of the financial services industry beyond insurers. There is a competitive threat that I foresee to life insurance companies which may emerge in the next year or two or three. It’s the migration of structured products in the institutional market to the consumer market.

There are large asset management firms that have been talking about this for some time. I heard a senior executive of a bank, a very large bank, say quite pointedly that he felt that insurance products were less likely to be used by his institution whereas a reliance on structured products in the future was where they saw their vision taking them. I asked Moshe Milevsky about this point specifically, recently. It was his projection that within the next couple of years there could be, perhaps, two dozen new players on the street offering products that directly compete with some of the individual annuities that life insurers offer. Is this something that you think about? If so, is it something that worries you? And if not, is it something that you think insurance executives should be worried about?

MacLeay – Yes, I think viewed broadly the capital markets are very creative and very responsive to opportunity. When you think about our products which are basically financial promises, they are financial instruments that are of a long-term nature. There are a ton of very smart people sitting around Wall Street everyday looking for opportunities in that arena, so I think that it is definitely a trend or a risk, I guess. The other side of that is that I think that the more kinds of alternatives that get developed and the more people become aware of their needs and the alternative ways of solving those needs that creates, if you will, a bigger pie. I’m not as concerned that the capital solutions are going to come overtake life insurance, but we have to be equally as creative and responsive in terms of the things that we can provide.

So, the short answer of your question is, yes, I see it, I think there’s something to it. What we have to be is looking for where is it that we can provide value. We can’t just play defense and say somebody has come up with a better solution for what we have a product for. We need to say where is it that we can provide better value, because frankly in any business at any time if you can’t provide better value, and that doesn’t mean necessarily just the dollar and cents part of the product, but the whole experience and the whole customer relationship and all. If you can’t, if you get people coming in and providing better solutions, then you better sharpen your game. I see it, but I’m not as concerned about it as a threat. I think it’s actually more of an opportunity to open a horizon that we haven’t opened up yet.

Macchia – When I hear you use terms like responsive and creative it reminds me of another issue which is very close to my heart. It’s the assertion that I make that, in the final analysis, the winners in Boomer retirement are not going to be those which necessarily have the “best” product, but rather are those organizations that are the best, the very best, at communicating their value to a large and fluid marketplace. I wonder if you buy into my belief on this.

MacLeay – Well, I would state it a little bit differently. I think that the winners are those who can connect the best to provide solutions that people need. I think we’re saying the same thing, but what you’ve done is focused on the communication link, and that is the connection. I don’t know that there is much of a difference to what we’re saying. I think of it more as, if people respond best to an individual sitting down with them and visiting with them each quarter and providing a set of recommendations, if that’s the way that people want to be served, that’s what we need to do in that segment. If there is another segment of people who says, I like to sit down at my computer, I’ll figure it out, then I like to be able to call somebody up and I like to be able to do this or that and then I like to be able to go someplace and figure out what all of my values are and all of that. So, to me, it’s not like there is necessarily one crystal clear answer, and in fact there probably isn’t because there are different sets of fluid markets.

People think of the Baby Boomers like it is some kind of consistent group. All they are is a certain age, but there are all kinds of different sub-segments in there. I think the difference of what I’m saying is that there has to be, for a lack of a better term, mass-customized ways of dealing with different segments within the market. Those companies that are successful are those who are going to be able to make those connections in those segments of the market that have great opportunity for the organization.

Macchia – I agree with your take on that, agree with you completely. When I see the fulfillment of what you just described, that vision, I see that it’s not possible to avoid the inclusion of technology to aid and abed intermediaries to better communicate with people. Do you agree with that?

MacLeay – I do agree with that, absolutely.

Macchia – Let me ask you about another issue that I’ve been very much focused on over the past year. Again, out of the desire to try to galvanize industry leaders into recognizing that there are some foundational problems within the industry that have to be addressed in order to set it on the right course to enjoy what should be its greatest business opportunity ever in terms of working with the Boomers.

I’m describing the individual annuity business and specifically the sub-segment of that which would be the indexed annuity business. When I look at the indexed annuity I look at the essential, inherent value proposition and I say here is a vehicle that places an underlying guarantee under a principal asset, and also simultaneously provides upside growth potential. Then I think about that value proposition in the context of some of the that Moshe Milevsky and others have done- that the Retirement Income Industry Association has explored- which is this notion of the transition management phase where say roughly ten years before retirement to ten years after retirement, that during that 20 year period it’s critical to place underlying guarantee under the retirement asset, yet maintain upside growth potential.

I say, oh my God, isn’t that a natural fit for the equity indexed annuity. Then we have the reality where we’ve seen the product morph since its introduction in 1995 from a 5 year contract which would be viewed as having obvious, strong consumer value to variations of that which have surrender charges as much as 25 years, loads as much as 35% or 40%, commissions as much as 20% or more. It’s one of the rare examples in modern financial services where a financial product is introduced and then dis-innovates consistently year after year. I wonder what you think about this. First, about the product’s inherent value proposition, and then what’s happened to the product over a decade plus?

MacLeay – Well, I think the inherent value proposition, from my point of view, is that the opportunity is active. I still view it as a fixed annuity. The opportunity is greater return than a fixed interest annuity and the mechanics are, well, we know what they are, equity participation and underlying guarantee, but I think of it more as a higher potential fixed return.

I think in some ways some of the issues around the product and some of the concerns that the FCC and the NASD have with it are that these returns are dependent upon stock market movement. We’re careful when we talk about them to think more in terms about them than to think more in terms of the potential for a greater fixed return because it’s a guaranteed product. It has an interest return and not a change in underlying principal value. That may be too technical, but it’s another way of looking at it and we have been in the business since 1996, so we’ve seen all this.

Our products have evolved to remain competitive and I think that what it is, is those changes that you mentioned are a change of the reflection of the power of distribution, the power of people who can get out and make the relationships they do in order to sell the products and that’s what’s driven it. It’s not like companies are saying, gosh, we should pay 20% commission on this. It’s been that tremendous battle in the market place for those folks who are successful at reaching people that have a need for product like this and the leverage that they have coming back, and that’s driven a lot of that. We were an early provider and we were in the top 10 companies for the first few years and then we dropped out of the top 10 for a long time and we’re not back. The reason is simple. It’s because we’re not going to play those games of pushing product features and commissions and all that beyond the point of reasonableness. I think it’s a great example, but it’s not the only example. Many products in our business, when they are innovative and when they are first introduced, have very strong features and then those features and structures get competed away in the market as the folks who are in the distribution end demand more of a bigger piece of the pie, they get a bigger piece of the pie.

Macchia – The power of distribution to alter an insurance company’s behavior, even when it’s working against its own self interest, I think, has been proven beyond doubt, certainly with this example. It leads me to think about the future and where the real opportunity is. That is, if I try to think back over my own career, which has been somewhat unique, Tom, in the sense that I spent many years in the distribution business as an agent, as an agent trainer, as an agent manager, recruiter, IMO principal for two large IMOs, simultaneously for the last 20 plus years as a marketing consultant. I see that the root problem is that over the past 25 or 30 years agent productivity has consistently fallen off. When I started in the insurance business I was told that the smallest acceptable productivity that I could have was one sale per week. There were many people in the agency where I was recruited that sold 2 and even sometimes 3 policies per week.

These days there are agents who make a respectable living on 3 sales per year. The lack of productivity has caused agents to continually and more aggressively seek out products that pay higher and higher individual commissions, which has forced the companies to design products that have been less and less consumer oriented, which to a large extent has put us in the bad position where the industry finds itself.

So, I believe that where a splendid opportunity exists for insurers is to do some imaginative and creative things that help agents increase the volumes that they are able to sell, so that they don’t have to make as much individually on each sale, but still can earn a very respectable living and stay in the business over the long term. That can’t happen in my judgment unless there’s a wholesale change in the way that agents communicate and prospect with clients with a heavy reliance with creative and compliant technology to help them. I’m wondering if you buy into this vision.

MacLeay – Well, I’ll tell you, David, one of the very consistent things that I see, which is probably not obvious until you see it enough times, is the motivation often in agents and field reps is more around points then it is about dollars. It continues to amaze me that your point is if you could increase the volumes obviously you don’t need to pay as high of points of commission or whatever it is, but the world out there is still very points driven so you talk to people about a contract that has huge consumer appeal and low commissions in terms of percentages per point. How many examples have there been out there of these things that just don’t go anywhere because people in the field forces seem to be so hung up on, you can give me a contract that has 8 points for an annuity, that’s got to be better than 4. Well, no it doesn’t. Four could be a heck of a lot better if the product was really much more consumer friendly and was supported in a way that was selling in huge volumes. Some people get that, but most people don’t. It’s very, very frustrating.

Macchia – I would think that part of the reason that we have this reaction is that it’s not enough; I think it’s manifestly proven that it’s not enough to put a superior product in the producers’ hands. You have to put an infrastructure and a context around that product that enables him or her to market and sell it successfully in higher volumes. I think that’s what’s been the missing element up to this point. Which reminds me of another thing that I think is going to happen and I’d like to know if you agree with me. The industry right now is beset with a number of challenges in terms of potential financial liability.

Because of the sales of some of these products that are really anti-consumer, you’re well aware of the fact that some class action suits have been certified against large annuity providers. The implications of these financial liabilities run into the hundreds of millions of dollars, perhaps even billions of dollars, and could make a market change in the way things happen. I think what this proves is that for an insurance company to be a quote, unquote manufacturer and put products out into the hands of its agents and then rely upon those agents to self-create the way that they sell those products. Realistically there is no way to provide oversight and the insurance company cannot know what expectations the client is receiving out of that process and can’t really know what he agent in saying.

Over a channel of 1,000 or 2,000 or 10,000 agents you literally could have 10,000 different explanations of a product. What’s going to have to happen in the future for the company to protect itself and its agent is that products are going to have to be introduced simultaneously and linked to a context that is compliant from the very beginning, that consumers can understand in a fair and balanced manor, and from that can get realistic product performance expectations. This comes again out of the creative utilization of technology and media, which is largely not being done right now. I see this as a solution of a myriad of problems, especially this one of cleaning up the problem where agents are explaining products with such great variability that the insurance company is unable to have a consistency of message. I’m wondering if you buy into my vision of this and if so, why?

MacLeay – I think you raise an excellent point. I think that the solution to it is very complicated. I agree with philosophically with what you’re saying. I think it’s going to be a long and difficult road. I still think that the primary thing that people need is that advisor, you know, that person that they are talking to, has to be delivering a message that has their interest at heart and is responsive to their needs. This happens a lot and I think that by and large our industry has been very good at that and then you have this other situation which is really the product push type sale where you say, my job is to sell anybody who breathes this product this afternoon. Well, none of the products today are that generic.

I guess term insurance might be. But, these products are only really suitable in certain situations and they are very good at doing certain things. How do we get people to communicate those to make sure that they are offered to the right people for the right reasons? I do agree with you that that is a huge communication challenge that is going to become more and more driven by the life companies and the product providers because they are the ones that have the deep pockets that have to pay up at the end of the day in these class actions or whatever happens. I think that generally I agree with you. I think it’s a huge challenge. We have, in our history, when you have a career agency system you are able to deal with that a bit better, and it’s the reason by the way that we deal with marketing organizations rather than just general, broad brokerage, one-off situations. Because we know it’s important that people understand what the products are, where they are useful and where they are appropriate and where they are not. You are absolutely right. We are going to need much better communication capability and the technology has got to be part of this and we, of course, as everybody is, we’re doing a lot of that with everything, product rollouts, all the rest of that, tools that we have, compliance cleared tools to use with customers to describe products and where they are appropriate.

Macchia – My wife is going to be pleased with your answer given all of our money that I’ve invested in this belief.

MacLeay – I think it’s true. Some things are obvious, but not easy. It’s pretty obvious, but it’s very, very difficult to implement and to use consistently. What it comes down to is that you have to have good, honest people trying to do good things for the folks that they are working with. I’m not discouraging anybody here, but that’s really what it comes down to and any time that you’re totally driven by your pocketbook or whether you make the next sale or not that’s what leads to the problem, that’s what leads to pushing products where they don’t belong.

Macchia – Tom, this has been very enlightening and enjoyable. I think I’d like to ask you a couple of personal questions, if you don’t mind. The first one is, if I could somehow convey to you a magic want, and by waving this magic want you could make any two changes in the financial services industry that you wish. What would they be?

MacLeay – Oh…the magic wand question, huh? Okay. Well, I guess the first one would be to have people more receptive to planning their financial needs. Particularly in respect to life insurance. Life insurance is a fabulous product, it’s way under-penetrated in our market and it’s too hard to sell and it shouldn’t be. It’s something that people need and if we could wave the magic wand and have people wake up in the morning and say, I do need that, I do want to talk to someone about that, and I do want to act on it. I think that would be very positive, and not just in terms of being self serving as a life insurance company, but it would help a lot in a societal sense as well. So that’s magic want number one. And magic wand number two, I guess is if we could connect better. You’ll like this answer David. People need advice, they need to trust someone.

I’m talking broadly. I’m not talking just about National Life or life insurance agents. But if we could wave a wand and people could figure out that they can make this connection, I think that would be a huge plus for the industry overall because I do think that life insurance on the one hand, but even more broadly in financial services, there are many more solutions or way more things that we can do to help people if they were open to it.

Macchia – That’s a wonderful answer. Let me ask you the next personal question which is, if you were not the Chairman, President and CEO of National Life Group and you could be anything else in any other field, what would you choose to be?

MacLeay – Well, if I could be anything else in any other field…I don’t know if you’re used to that long of a pause on this one…

Macchia – Take your time. There’s no wrong answer.

MacLeay – I know, but there are so many possibilities. It’s tough; I would say if I could do anything it would be something that had a significant value to people somehow. I don’t see myself as a social worker, you know? Let me keep mulling this one over.

Macchia – Alright. Here’s the next one. I want you to imagine your own retirement in its most conceivable ideal and perfect form. Where will you be and what will you be doing?

MacLeay – I will be here. I’ve grown up in Vermont. I will be doing a lot of traveling. We’re part of a community, we like being part of a community, we’ll continue being part of a community and I think one of the dangers of retirement is going off somewhere and being behind a gated community and then trying to figure out what you’re doing there. We might have another location at some point, but I would be based out of home, as home is important and relationships are important and we’ll be very active with our family as well. We would be using travel as a way to get involved in things. Some of that travel may be many, many months getting involved in something. I don’t see sitting around playing golf forever as an idea.

Macchia – Good answers. I’ve got to tell you. This has been a magnificent interview. Very enlightening for me, and I can’t thank you enough. I’d love to catch up with you for a lunch or dinner the next time you’re in Boston.

MacLeay – We’ll do that. I get down there once in awhile.

Macchia – Thanks, again, Tom.

©Copyright 2007 Daviod A. Macchia. Al rights reserved.

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Macchia: Mark, I appreciate you sharing your time with me. Although you are a very well known figure in financial services, I’d like to start by asking you to explain your title, role and responsibilities at LPL?

Casady: Absolutely. I’m the Chairman and CEO of LPL and have been since the end of ‘05, when I assumed the chairman’s title. I was CEO, I believe a year before that, and came in as COO about five and a half years ago. So that’s the title and a little bit of the timeline. And responsibilities are sort of typical for a chairman and CEO; setting the strategy for the firm, and determining a whole range of what I would think of as operating principles and goals for the company, even in conjunction with the Board of Directors and the shareholders. And then execution against the plan that we set forth.

Macchia: In terms of questions I don’t quite know where to begin, I’ve been so much looking forward to this conversation. But I’ve got some down-and-dirty sort of issues that I want to ask you about, and let me just sort of peel them off if I can. Number one is this: with the frequency of compliance sweeps and the severity of the fines that we’ve seen levied, and how each has been increasing, has this caused LPL to change or adapt its business model in any way?

Casady: Our founder, Todd Robinson, was always very innovative. And so he built a culture here that we very, very much try to make sure is alive and well and growing. And part of that culture is about flexibility and trying new things. So he just built a very open place for dialogue, a very open place for trying new things.

The other thing that he did was really build a meritocracy, and really kept, for his 20-year tenure here, what I would describe as a real significant pruning shear. Meaning he looked at the tree and said, “I feel a little deadwood going up there; I’m going to trim that.” Or, “I don’t see a branch quite as strong as I’d like it be, I’m going to reinforce it or change it in some way.” And those are legacies that allow us, I think, to be quite flexible and innovative when it comes to changes in the industry or changes in our business, and thoughtful about how to approach them. This really comes from that core culture.

Macchia: This culture that you talk about emanated originally from the leadership of Todd, a mantle that you’ve inherited, obviously. You’re acknowledged to be an exceptional leader and CEO.

Casady: And who said that? My mother? You talked to my mom?

Macchia: Yes, I have. But what I want to know is, what you define as the component parts of a great leader.

Casady: That’s a good question. I think that the first part is to not confuse brains with a bull market, to be blunt. And that everything in life has a rhythm to it. Whether it’s sports or whether it’s a business situation or whether it’s a relationship, there’s a rhythm to these things. There’s a rhythm to business. And I think success in part is about understanding that rhythm, that’s a natural part of the business, and understanding the way to know when you’re in the right vein of that rhythm and when you’re not.

It doesn’t mean that you should just be set to the forces of the wind. You can definitely change a rhythm to a business; you can change a rhythm to a cycle. But there are certain cycles you can’t change. We here at LPL cannot affect the American economy much. Inasmuch as I expect we could, we really can’t. We can’t make the stock market go up and we can’t make it go down much. It is important for a leader is to understand when they’re in the right rhythm with the forces that are beyond their control.

Macchia: And that implies, as you said, a recognition of one’s limits.

Casady: Yes, exactly. I think the second thing that’s really important in a great leader is humility. And I will say that I try every day to make sure that as a leader I guide with humility. There was a time when I thought that with enough muscle and brain power or just sheer nerve and raw will you could change anything. But as I mentioned earlier as you mature as leader it really is about being aware of the rhythm of the business and the opportunities that presents.

The CEOs that you and I might have grown up knowing, the Jack Welches and others — were known as very dynamic leaders who were very strong willed and really commanded, even in the military sense. I think today we manage companies in very different ways. I think we have to ask people to serve and we have to think about ourselves as leading a fairly massive effort towards specific goals and you’ve got to help people see the goal, envision it and want to be part of it.

Macchia: I think that’s a great insight. Notwithstanding the importance of humility and the coordination of a massive effort, that massive effort at LPL has led to it being the number one firm. And it occurs to me there must be many advantages with being number one. But I’m wondering, what are some of the disadvantages?

Casady: That’s a good question. One disadvantage is that you can believe that you’re number one, for some reason, beyond the day to day work you do. We’ve been number one for, I think, 12 years now. When I arrived five years ago, what I said to the management team was, “Hey, you’ve been number one for seven years. Pat yourself on the back and forget about it.” Because if you let yourself fall into the belief that that somehow gives you a privilege in the marketplace, you somehow fall into the belief that you don’t have to work as hard because you’re number one, you are sadly mistaken.

And so the downside is that it tends to foster a lack of humility and it tends to foster a comfort that really masks the reality of it, which is being number one attracts a lot of attention and it attracts, therefore, a lot of imitators. And it demands a need to really be very constant and innovating and staying ahead of those people who are very close behind you. So you have to, I think, really be proud of the fact that you’re number one, but you’ve got to realize that it also makes you an easier target.

Macchia: After setting a record price multiple in your recent private equity buyout, do you feel that more firms are strategic takeover targets for LPL?

Casady: Well, I don’t think it really has to do with our price. I think our price is quite appropriate by any measure. I’ve done probably 22 or 23 transactions corporately, taking companies public. I’ve bought and sold them. I didn’t set out to do that 26 years ago in my career, I sort of happened into it. And so I’ve gotten some deal experience.
I think what really happened was that people realized that it was a moment in time. 2005 was a moment in time, we’re past the bubble, we’re in a different phase, and there must be something about LPL that’s different.

So conversations that we’ve been having for years with organizations about acquiring their B/Ds or how they were thinking about their business, I think really changed after that. Because they said there’s something different at LPL because TBG, one of the world’s largest private equity firms, and Hellman and Friedman, another one of the world’s largest private equity firms, paid this level of money which