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wealthtech on deck podcast - Mark Paulson

The Value of Adding Annuities to a Portfolio with Mark Paulson

Annuities have long been acknowledged as valuable financial instruments that provide the opportunity to effectively manage risks, making them a cornerstone in a well-rounded retirement strategy. By incorporating annuities into a portfolio, individuals can help mitigate their exposure, thereby enhancing their financial security.

In this episode, Jack talks with Mark Paulson, VP of Global Hedging Business Development at Allianz Investment Management U.S. LLC. In his role, Mark leads the development of global fixed index annuities, registered index-linked annuities, and fixed indexed universal life insurance businesses from a hedging perspective. He leads the interaction with global clients, translates client business goals into projects for the various Allianz Investment Management (AIM) hedging functions (strategy, systems, portfolio management, and trading), and oversees AIM hedging’s involvement in global business development.

Mark talks with Jack about dynamic hedging strategies and the value of adding annuities to a portfolio. He discusses the concept of the efficient income frontier and how adding an annuity can shift this frontier, allowing for more efficient income generation in retirement. Mark emphasizes the importance of risk management and the need to shift the mindset from accumulation to decumulation when planning for retirement.

What Mark has to say

“An annuity can really help manage a lot of risks. It can help reduce your exposure to longevity risk, reduce your exposure to inflation risk, reduce your exposure to market returns and market shocks.”

– Mark Paulson, VP of Global Hedging Business Development, Allianz Investment Management U.S. LLC

Read the full transcript

Jack Sharry: Hello, everyone. Thank you for joining us on this week’s WealthTech on Deck podcast. As our listeners know, we cover stories across the wealth and asset management spectrum, insurance and annuity industry. And of course, we look at how all this plays out in terms of technology. An area we haven’t talked much about is the growing interest in dynamic hedging products offered by insurance and annuity companies. Today, we’re talking to Mark Paulson. Mark works for Allianz Investment Management. He’s the VP of hedging business development. I’ll let Mark fill us in on what Mark and Allianz are up to around hedging strategies. They’re clearly a leader in the industry in this regard. But in the meantime, Mark, welcome to WealthTech on Deck, good to have you aboard.

Mark Paulson: Thanks for having me here, Jack. Very excited to be here and to talk with you today.

Jack Sharry: Terrific. So let’s start with you providing some detail on your role. What do you do? How does it work, fill us in a little bit on what you do and how that plays out in terms of the products that Allianz Life offers?

Mark Paulson: Sure, thanks, Jack. So I work for Allianz Investment Management, US LLC. So we’re the wholly owned investment company of Allianz Life Insurance Company here in North America. And that is obviously ultimately owned by Allianz SE, our parent company in Munich, Germany. I’ve been with Allianz since 2007. All… I spent that whole time on the hedging team. I guess with a little two year break, I did leave Allianz for two years and went to work at a hedge fund here in Minneapolis, but ended up coming right back because it’s such a great place to be. But my role on the hedging team is actually to be a business development person. So to actually go out and help explain to our distribution partners how hedging works and what we’re doing it makes Allianz unique in that regard, as well as to help other entities in the Allianz group get access to the hedging team. So our team here in Minneapolis, we do the index hedging for Allianz Life Insurance Company here in North America, obviously, but we also do the hedging for our sister company, Allianz Leben in Munich, Germany and Allianz Global Life are another company that Allianz owns in Dublin. Allianz France, Allianz Italy, Allianz Retire Plus in Australia, anywhere in the Allianz group that offers these index interest type products. All that hedging runs through our team here in Minneapolis. And so kind of half of my role is out helping the Allianz group members get access to the hedging team, and the other half is kind of spent helping our distribution partners understand how hedging works and how it’s a competitive advantage for Allianz.

Jack Sharry: Mark, thanks for that overview. Why don’t you talk about how that plays out, if I’m an advisor, I’m going to wind up potentially offering Allianz product to a client, you’re helping the advisor get comfortable with it, you’re helping the firms get comfortable. Talk a little bit more about what you do in terms of the educational process and what you do in terms of explaining the benefits and advantages. Also the risks because there’s nothing that’s without risk, at some level. So talk a little bit about how that plays out, how you present and explain and then position also terms of how a client might benefit.

Mark Paulson: Sure. Yeah, and oftentimes that process involves myself and an actuary kind of talking through what we call our strength of Allianz type presentation. It kind of starts by understanding the annuity economics. So how, how Allianz makes money an annuity, and how that benefits helping the policyholder. So we kind of start with, let’s say, we have a policyholder that makes $100,000 investment into an Allianz product, we’re gonna put that $100,000 into our general account. Our general account is a high quality bond portfolio basically. Now that $100,000 is sitting there and as long as those bonds mature, we’re going to have that principal back to kind of provide a floor, that guarantee for the policyholder. Now, those bonds are paying coupons, and that’s investment yield. So we’re going to earn a yield on those bonds. And that’s what is actually the revenue for the insurance company. We’ve got, let’s say today, we’re investing those bonds and earning 6%. That 6% is revenue for the insurance company to use to pay for our expenses to pay for, you know, some of our products offer commissions, some don’t. Some of them we have a profit target we want to hit. Let’s say that that all those expenses and that profit, maybe it’s 2% of that 6%. We’ve got 4% leftover to offer as policyholder benefits. Okay, so that could be the form of a death benefit. It could be in the form of a guaranteed lifetime income benefit, or once you take care of some of those other benefits off and what’s left, we could just offer that say it’s three, three and a half percent. We could offer that back to the policyholder in the form of a fixed, fixed account. If we’re just a fixed annuity provider, we would take what’s left and offer that back to the policyholder in form of a fixed rate. Obviously, at Allianz we’re more interested in indexing. So it’s we take that, that amount and we actually invest that into derivatives to provide a different return profile for the policyholder. So maybe the policyholder might get a zero if the index goes down, or they’re gonna get the performance of that index up to a cap of, say, 9%, for example. So now we’ve got this differentiated payoff profile between 0% and 9%. That’s a liability for the insurance company. It’s something that we have to pay to the policyholder at the end of the year. But we don’t know what it’s going to be. So it’s a risk for the insurance company. And it’s actually the hedging team’s job to turn that 3.5% hedge budget, let’s say, into whatever index credit the policyholder gets. Be it a zero if the index goes down, or a six if the index goes up 6%, or nine if the index goes up more than 9% above the cap. So it’s our team’s job to buy and sell those derivatives in the right ratio and to replicate those payoffs that the policyholder will get based on the underlying index and credit method that they chose for their policy.

Jack Sharry: Gotcha. So how did you get into this? How did you wind up being, probably not a technical term, but hedge-meister? How did you… or an explainer of hedge… of all things hedging?

Mark Paulson: Yeah, so my background is very mathematical, right. So I had undergraduate degrees in mathematics and actuarial science. Not an actuary, I started off kind of on an actuarial track, really liked the mathematical side of it didn’t so much enjoy the regulatory and all the exam side of it. So passed a whole bunch of actuarial exams, but I’m not an actuary, actually went to school then to get a master’s degree in financial mathematics. So more on the derivatives and investment side of things. And that’s just been enjoying that my whole career, is kind of being involved in the investments and the derivative side of things. The people I work with on the hedging team, you know, we’re probably more on the mathematical side of the spectrum. So we’ve got a lot of quants. So people, you know, PhDs in statistics and physics on our team, people with a master’s degree in financial mathematics, CFA, charterholders, actuaries. We’re typically not known for being the most outgoing people, you know, if you got that side of the brain, you’re not always, you know, the most social. So I’ve got the ability to, you know, be out here and talk to you guys and explain kind of what we’re doing. And I enjoy that side of it as well. So that’s kind of how I morphed into this distribution support role within the hedging team.

Jack Sharry: Gotcha. So talk a little bit about your role. You’re kind of a road warrior. That’s… we met at a conference not too long ago. And it sounds like your central job is explaining complicated stuff to people that may not fully understand all the detail of what you’re saying.

Mark Paulson: Yeah, that’s kind of part of it. Yeah, my job is to kind of simplify the story and explain it in a way that people understand. So yeah, a lot of my job now is, you know, on the conference circuit explaining how dynamic hedging works, how the economics of annuities work. We’ve worked recently on what we call our Portfolio Impact Report. So we’d actually quantify the value of an annuity inside of a portfolio. So I’m out on a lot of different conferences, investment committee meetings at specific firms, just again, trying to help educate and understand… helping people to understand how our products work and what makes Allianz unique in the way that we approach risk management basically.

Jack Sharry: So let’s say I’m an advisor, and I’m, I’ve heard what you had to say, I’m intrigued by what you have to say, sounds like you got some very smart stuff. And then I say, “Well, I don’t understand it. How would I explain this to my clients?” How do you help advisors explain it to their clients in a way that’s both accurate and clear? And from what I can hear about what you’re offering, attractive? So how do you… explain what that looks like, or sounds like?

Mark Paulson: Yeah. Oftentimes, you know, when we’re talking to an investment committee or a group of advisors, the message that we you know, try to start with is kind of the kind of maybe a longer version of the story that I went through around annuity economics and hedging, myself and an actuary usually will kind of walk through that process. And ultimately the feedback that we get from those types of meetings, especially if it’s people that are familiar with annuities, they, okay, they already understand… people that are familiar with annuities already understand the value of adding them to a client’s portfolio, they’re already using them. This just kind of helps them on, you know, maybe why they would look at an Allianz annuity. When we’re talking to groups of advisors or investment committees that maybe don’t use annuities currently, they like what they hear around the qualitative reasons about why Allianz is better, why our dynamic hedging approach works or how these products work. They’re intrigued by that. But they actually want more more evidence and more kind of a quantitative view around how actually adding an annuity to their clients portfolio is going to improve outcomes for their client.

Jack Sharry: Yeah.

Mark Paulson: We heard that feedback from a lot of different investment committees and groups. And what we realize is what, when you’re looking for a quantification around how an annuity impacts a portfolio, it’s very similar to what our hedging team is actually doing on a daily basis managing institutional risks for the insurance company. On the hedging side, we’re looking at our assets, we’re looking at our liabilities, we’re looking at current market conditions. We’re using those current market conditions to forecast potential paths in the market and doing a Monte Carlo analysis to help us manage the risk for the insurance company. It’s a very similar process to what the investment committees or these advisors are looking for, but on a more of a personal level. So they’re looking at an individual’s assets, an individual’s liabilities in the form of an income stream that they want to generate in retirement, they’re looking at their own set of capital market assumptions where they, you know, they think that the equity markets will return 7% per year with a 16 vol going forward, or the bonds will return 3% per year with a five vol going forward, they’ve got their own set of these assumptions. And what we realize is that we can take their assumptions, their demographics for their clients, and we can build a tool that will help them analyze the value of adding an annuity to a portfolio. They call that our Portfolio Impact Report. But it’s actually a way to do a kind of a side by side comparison of a portfolio without an annuity versus a portfolio with an annuity and how efficient and effective they are at delivering income in retirement for a client.

Jack Sharry: And is this report, is this a tool that’s available through wholesalers, how do they access it?

Mark Paulson: Right now, it’s a tool that we’ve built internally. So we’ve been working on this for the maybe last four or five years, just kind of developing and iterating upon it. When we started out, we were trying to build a tool just to show a probability of success metric and show that by adding an annuity into a portfolio, you can improve a client’s probability of success. And this, it does that. If you have a given level of income in the portfolio without the annuity, you might have an 80% probability of success versus a portfolio with the annuity might have a 90 or 95% probability of success. So you can show that for the same level of income, you can take less risk. Or conversely, if you wanted to have the same level of risk, if you wanted both portfolios to have a 90% probability of success, your portfolio with the annuity could actually take more income. So that’s what we started out to build. The tool’s goal was kind of quantify that. And it does. But what we realize is that just doing that, there’s so much more to it than just probability of success or income. There is exposure to you know, longevity risks. What if your client lives beyond age 95, you’re planning to, if you live to age 100? Or what… there’s market returns risk, what if you don’t get that 7% market return? What if you only get a 6% return in the equity markets going forward? What about inflation? You know, if a client’s spending needs need to increase by 3% per year, because inflation is higher than we forecast at 2%, how does that impact the probability of success for these different portfolios? So we’ve actually wrote a white paper digging deeper into the, what I’d call like the first order Greeks, you know. To have it by… with my hedging brain here, it’d be like the sensitivities of each of these probability of success metrics to these different assumptions that we’re making. So, we’ve done some of that work. But ultimately, this tool, what we’ve started out to build in sort of that proability of success improvement, we thought maybe this could be something we could put into the hands of, not necessarily clients or even advisors, but help investment committees look at this stuff with access to the tool. What we’re realizing is that it’s actually a little bit better for us to use it as a marketing… as a source of marketing material. So we’re able to quantify all these improvements. And we can kind of package it as a story and talk about it out in the field. And that’s what most of my conference attendance is talking about now, is the quantification of adding an annuity to a portfolio and looking, using the tool to create the data, but then packaging it up in a way that is understandable for the audience that we’re working with, be it advisors, being at investment committees, being at a conference. So it’s not something that’s available, you know, outwardly, it’s something that we can and will run for, for groups that want to analyze their own, maybe their own demographic for their clients, or they have their own set of capital market assumptions, we’re happy to recreate all this material for them with their view of the world. No one should believe in the Mark Paulson view of the world or the Allianz view of the world. It’s, that’s just one potential thing that could happen. Everyone is out there is far smarter than I am. And they can have their own view of what might happen going forward.

Jack Sharry: Gotcha. So I’ve heard you guys talk about efficient income frontier, is that what you just described? Or is that something a little different?

Mark Paulson: Yeah, that’s you’re kind of hitting it right on the head there, Jack. Yeah. So if we think about maybe during accumulation, right, when you’re accumulating your assets, most people are probably familiar with Markowitz’s efficient frontier. So you’ve got the risk reward framework, where Markowitz defines risk as standard deviation or volatility of a portfolio and reward as your expected return on that portfolio. If you take the universe of assets and mix up all these different portfolios, you can create kind of a maximum return, maximum expected return for a given level of risk, of volatility. And you can create an efficient frontier based on that. And if you add in another asset class, that’s maybe uncorrelated, you can actually shift that efficient frontier. You can get more return, more reward for a given level of risk, for a given level of standard deviation or volatility. Or for, conversely, for a given level of return, you might be able to take less risk, kind of shifting that efficient frontier. And that works great during accumulation, that risk reward framework works wonderful when you’re trying to accumulate assets. You start to think about decumulation, right, starting to think about taking income from your assets. Your risk isn’t necessarily standard deviation of your portfolio anymore. Your risks are longevity, outliving your portfolio. Your risk are inflation being higher than what you plan for. Your risks are lower market returns or market shocks. And you can kind of boil all those risks down into a probability of success score. And then in decumulation or income, your reward isn’t necessarily how much your portfolio returns, it’s how much income can you take from that portfolio, that’s what you’re looking for in retirement is how much income can you take. So I like to think of shifting that risk reward framework from an accumulation mindset to a decumulation or an income mindset by just changing how we define risk and reward. Risk becomes… success, which incorporates your longevity, your inflation, your market returns and market shocks, and your reward is income. And then getting back to you know how we can shift that efficient income frontier, if you look at just like, you know, adding an asset class in accumulation can move that efficient frontier, by adding an annuity that has guaranteed lifetime income in it, you can shift that efficient income frontier and allow you to basically for the same level of risk or the same probability of success, you can take more income, or for a given level of income, you’re gonna have a higher probability of success, take less risk. So we’ve been talking a lot about that recently, where just by adding another asset class, in this case an annuity with guaranteed lifetime income, you can shift your efficient income frontier.

Jack Sharry: Normally, in our show, we don’t get under the hood and talk about every aspect of how the engine operates. But this has been fascinating. It’s, I’ve been talking for a long time about how the role of an annuity, both for accumulation and for income as part of a household portfolio, how important that is. But you’ve you’ve kind of deconstructed it with all the critical elements it sounds like in terms of the risk reward, the efficiency of how you manage the assets, and then also, how you personalize it. So anything to add, before we look to wrap up? Anything else we haven’t covered? That sort of sums up what we’ve been talking about?

Mark Paulson: No, I mean, nothing, nothing too much. I mean, to add beyond just kind of the again, I think it’s the, that efficient income frontier and switching the mindset, right, like, we’ve all heard about risk reward and the efficient frontier our whole lives as far as accumulation. You know, that’s something that, I think, Markowitz he won the Nobel Prize for that work in 1990. And his co-Nobel laureate that year was William Sharpe, obviously famous for the Sharpe ratio, but also very famous for having said that decumulation is the nastiest, hardest problem in finance. Right. And so as we’re seeing this generational shift from Baby Boomers, you know, hitting their peak retirement years coming up here, the mindset needs to shift from accumulation to decumulation. And I think that this efficient income frontier framework, which is very familiar to everyone, people are familiar with the framework, just making some small tweaks to it can actually really change the mindset as to how we’re looking at retirement, what types of assets we should be holding in our accounts during retirement or leading up to retirement? I think that it’s a great way to just kind of conceptualize it.

Jack Sharry: Yep. I think you’ve done a wonderful job of explaining that. So, Mark, as we look to wrap up at this point, what are three key takeaways you’d like to have our audience go away with?

Mark Paulson: Yeah, first, I’d say you know, risk management is as important as ever, right? Like, whether it’s on the institutional side, you know, when we’re managing these index interest credits for Allianz Life and Allianz Group around the globe, or for an individual. Like, risk management inside of a portfolio is as important as ever. I think that in the individual portfolio, secondly, I think an annuity can really help manage a lot of those risks. An annuity can help reduce your exposure to longevity risk, reduce your exposure to inflation risk, reduce your exposure to market returns and market shocks. And then third, I think the best way to kind of quantify this and to think about it is by shifting our, our framework for it. Kind of looking at risk and reward in a little bit different way, right. Let’s look at risk as kind of this… taking all those different longevity, inflation, returns risks into one metric, being the probability of success. And then let’s redefine reward. Instead of expected return, it really should be income when we’re looking at decumulation. So by shifting that risk reward framework, you can look at adding a new asset class in the form of an annuity and shifting that efficient income frontier, and ultimately, kind of reduce your client’s exposure to some of these these risks that we all should be thinking about as we start to transition into into retirement.

Jack Sharry: Terrific. Very well said. So, one last question. Always our favorite question to ask on the podcast is, what do you do outside of work that you’re excited or passionate about, that people might find interesting or surprising?

Mark Paulson: Sure. Well, I’ve got two young kids so most of my time is actually spent coaching on the basketball court or the baseball field or my wife’s the volleyball coach. So most of my time is definitely spent helping out with youth sports around our community. But maybe something more interesting and surprising is, I like to work on classic fiberglass boats. Great. And that’s, I’m assuming the body as well as the engine.

Jack Sharry: Oh really?

Mark Paulson: So fiberglass boats from the late 60s, 70s, you know, early to mid 80s. Typically you can pick them up pretty cheap, they’re not, oftentimes not the most desired boats out there. But if you are able to, you know, kind of clean them up cosmetically, work on the engines, the engines are typically you know, V8 small block Ford or small block Chevy engines which have plentiful parts out there. They’re easy to work on. I can clean them up, get the engine working, use them and enjoy them for a season or two, and then let someone else work out and enjoy it. So I’ve done 1970 16 foot Century Cheetah, I’ve done a… working on a 1973 Chris-Craft Lancer right now. I’ve had a had a Lehman, I’ve had mid 80s ski boats, I just enjoy kind of tinkering on an old boats when I, when I have the opportunity to. Yes. Yep, do a little bit of fiberglass work, you know, clean them up, make them look pretty.

Jack Sharry: Yeah.

Mark Paulson: And then get the engines working good and go out and enjoy it.

Jack Sharry: That’s great. Good for you. That’s wonderful. So, Mark, thanks. This has been a lot of fun to get caught up with you. For our audience, if you’ve enjoyed our podcast, please, rate, review, subscribe, and share what we’re doing here at WealthTech on Deck. We’re available wherever you get your podcasts. Mark, thanks again. This has been fun.

Mark Paulson: Thanks, Jack. I appreciate it.