There’s price to pay for guaranteed returns

Opinion

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This article was published 06/02/2010 (5729 days ago), so information in it may no longer be current.

A retirement product providing a lifetime annual income that has potential to grow along with the stock market sounds like a financial unicorn, a magical beast of marketing make-believe. But believe it.

Such a product does exist. It’s a relatively new spin on a variable annuity called a guaranteed minimum withdrawal benefit (GMWB) or a guaranteed lifetime withdrawal benefit. Regardless of how it’s marketed, this hybrid of an annuity and mutual fund investment portfolio has quickly become a popular retirement income vehicle in the short time it has been available to Canadians.

Originally introduced to the Canadian market in October 2006 by Manulife, which has now sold $10 billion worth, GMWBs provide retirees or near-retirees with a future stream of guaranteed annual payments, like an annuity.

But the knock against annuities has always been that you give up the capital in exchange for the guaranteed payment that does not increase over time.

Besides the ability to withdraw remaining capital at any time, with a GMWB you can invest your money in a portfolio of mutual funds — managed by some of Canada’s leading fund companies — which can provide growth of the original deposit over time.

At the same time, the GMWB pays a guaranteed annual income — typically five per cent of the original capital invested. That guaranteed amount, however, has the potential to increase if the original investment grows along with the market.

"(GMWBs) have made me look pretty good in the last couple of years with the volatility we’ve had," says Kerry Knudsen, a certified financial planner with Spectrum Financial Services in Winnipeg.

"I haven’t had a single client that has had a sniff of concern in this last unprecedented period of volatility."

While Manulife’s IncomePlus product is the most popular in Canada, other insurers, such as Sun Life, Empire Life, Transamerica, Desjardins Financial Security and Industrial Alliance, sell similar products. Their features vary, but most guarantee between five and seven per cent annual payments of the original amount invested once an annuitant reaches age 65.

They also offer the opportunity to increase that annual payment over set time frames, typically lasting three years, provided the portfolio’s value grows during those periods.

If a person invested $100,000 in a GMWB mutual fund portfolio, the guaranteed annual payment for life would be $5,000 — even if the portfolio’s value decreases in a bear market.

"So no matter whatever happens in the market, you are assured to get whatever payment you’ve agreed upon," says David O’Leary, manager of fund analysis at Morningstar Canada.

"These plans specifically address shortfall risk — that you will outlive your money."

But with GMWBs, the guaranteed benefit can also grow along with the investment portfolio.

If the $100,000 investment increases by $20,000 by the next reset period (i.e.: over three years), the guaranteed payment will reset to a higher amount based on the increase in value of the portfolio. In theory, the payment will be based on five per cent of $120,000 instead of the original $100,000 invested. The benefit would then increase from $5,000 a year to $6,000.

But GMWBs also are attractive to boomers who have yet to retire. Many near-retirees are buying in because they can elect to have the annual payments deferred, which increases the minimum amount on which the annual payment is based.

In this case, if the $100,000 investment’s withdrawals are deferred for five years, the annual payment would be based on $125,000 even if the original amount invested decreases in value instead of increases.

If the markets perform well during that period and the portfolio increases, the guaranteed benefit payment will reset every three years based on whichever is greater — the increase in value of the portfolio or the sum of the original invested capital and the guaranteed income payment for each year it isn’t withdrawn.

Indeed, GMWBs sound wonderful, but as professor of finance at York University Moshe Milevsky puts it: "Nothing is free.

"If you add up all the different features and fund fees, you’ll be paying about five per cent," says Milevsky, also the executive director of the Individual Finance and Insurance Decisions Centre.

In addition to paying the yearly management fees on the funds within the portfolio, which are about two to three per cent of its value, GMWB owners also pay a premium for the guarantees.

"If you have an account that is primarily equity, then you’ll pay the high end of the GMWB fee, which is anywhere from 35 to 85 basis points per year," Knudsen says about the Manulife offering. "On average, you will pay a half-per-cent per year to have all these guarantees."

It’s a small price to pay for guaranteed returns in the future, says Bob Tillmann, vice-president of product and marketing services at Manulife Investments.

"That’s the huge value in my mind from an income perspective," he says. "People see the opportunity to pre-fund a product that gives them a guaranteed level of income that they know will grow, regardless of the underlying investment."

Once the annuitant begins taking the payments, however, the probability is low the payments will increase in the future.

"It’s a pretty steep hurdle to achieve in today’s environment," Milevsky says. "If you are allowed to pull five per cent from the account every year, and they tell you that you will only get a raise if the market exceeds the withdrawal, how much does the market have to go up?"

Milevsky says the value of the portfolio — which often includes limits on how much equity you can hold — would have to increase by about 10 per cent annually to offset the combined cost of the withdrawals and the fees and premiums.

"People have to be aware they are not buying this product because of the potential for step-ups," he says. "They’re buying it to protect the portfolio; they’re buying it for a lifetime income, and they’re buying it for the professional money management."

He adds GMWB products are risk-management tools more than they are investment products. And you’re best advised not to put all your retirement eggs in one basket — even though it’s insured.

"It’s like saying, ‘I think home insurance is valuable,’ but you don’t buy millions of dollars of home insurance if you don’t need it."

 

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Weighing the options

 

Guaranteed minimum withdrawal benefits might seem like a step up on the evolutionary ladder of retirement income products. But it’s important to look at the alternatives, says certified financial planner Daryl Diamond. "The products themselves do provide that peace of mind and cash flow," he says, adding at most a third of your assets should be invested in a GMWB product.

"The question is when interest rates rise, and they will, how good does the guaranteed minimum withdrawal benefit really look when you could be getting four or five per cent on bonds and keep your capital intact?"

Still, GMWBs are an attractive deal for the time being with interest rates and bond yields at historic lows.

But could you put together a combination of other investments that provides the same income and growth for less cost?

Maybe, Diamond says.

"For a person age 65, it costs about $75,000 for a life annuity that pays $5,000 a year. Then you could take the remaining $25,000 and put it into a flexible account and away you go."

 

In life, there are no guarantees

A lot can happen in 20 years, even the unthinkable. No one predicted Lehman Brothers would collapse two years ago or AIG would need billions to stay afloat. While the chances of a Canadian insurance company defaulting on the guaranteed payments are very, very slim, fund analyst David O’Leary says never say never.

"This product stung Manulife dramatically because they launched it just before the market collapsed," he says. "That was a huge loss on their books and if things had continued to spiral downwards, who knows? We might have got a situation where they would have had trouble meeting those guarantees."

Financial planner Kerry Knudsen, however, says these risks are negligible. "Manulife has embarked on a plan of action with the new CEO to create what they refer to as a ‘fortress of capital,’" he says. "By that, they intend on creating a situation where people will never have to worry about the solidity of the company."

Annuity expert and finance professor Moshe Milevsky says individuals should consider the strength of the insurance company as much as the cost of the product its offering.

"What’s their credit rating? Any fly-by-night operation can charge less. You also want quality," says Milevsky.

 

Don’t gorge at the guarantee buffet

As mentioned, guarantees come with a price tag. Each additional guarantee increases the cost of the product, which can affect the potential for growth of the benefit in the future. While most products offer death benefits so a beneficiary can receive future payments, or a guaranteed lump sum of 75 per cent of the original amount, Milevsky questions the value of this additional cost if what you’re after is a guaranteed income stream for life.

"If you take everything on the investment buffet, you’ll be paying five percentage points a year, which is why I strongly recommend people to not take all the guarantees offered."

 

Don’t insurance companies only offer segregated funds?

For the most part, any mutual fund sold by an insurance company is a segregated fund, meaning the funds are separate from the insurance company’s general accounts and, in that sense, the fund choices for GMWB funds are segregated, Milevsky says. Segregated funds also come with additional fees besides typical management fees. The additional cost provides capital guarantees, ranging from 75 to 100 per cent of the original investment. With GMWB choices for funds, it’s not so much that they only offer segregated funds, but that the entire contract is called a segregated fund, Milevsky says. "It’s opening up a seg fund with a particular rider called a guaranteed minimum withdrawal benefit."