Guaranteed income products: Eternal optimists

In a perfect world, there would be a retirement product that would guarantee you an income for life even if stock markets plunged into a Great Depression-like sinkhole. In a perfect world, that same retirement product would also give you the potential to grow your money if the markets surged. And that ideal retirement product would keep your escape hatch open, so you could withdraw your money whenever you chose.

Guess what? In this not-so-perfect world, several companies are now offering what looks at first glance like a reasonable facsimile of this perfect product. Manulife was first out of the gate with what it calls GIF Select with IncomePlus. Since then two other insurers have also marched out their own guaranteed-income-for-life products. Industrial Alliance has Ecoflextra and Sun Life has SunWise Elite Plus. More are expected to follow.

Guaranteed income products appear to have all the angles covered. They protect you from the worst that could happen, yet they still offer you a chance to enjoy the best. They’re popular because they combine fear and hope in one package, says Jim Otar, a financial researcher in Thornhill, Ont., and founder of retirementoptimizer.com. Driven by fear and hope, Canadian investors have already poured more than $4 billion into the Manulife product. Investor Economics, a financial services consultant, predicts that guaranteed-income-for-life products will attract more than $50 billion from investors within three years.

So should you jump in? After carefully analyzing these products and talking to some of the sharpest folks in the financial research field, we’ve come to a surprising conclusion. We don’t think you should rush into these products, at least not right now.

We recommend waiting because these products are almost certainly going to get better over the next few years. While the current versions claim to protect you from all the risks that might threaten a comfortable retirement, they still leave something to be desired. You end up paying a lot of money to protect yourself from some risks only to leave yourself open to another risk you never considered.

How do they work?
Make no mistake about it, these products are complicated. Many a buyer has made it only to page five of a 92-page information folder before giving up. So let us explain the essentials in just a few paragraphs.

The products begin with a regular mutual fund, such as the Trimark Global Balanced Fund or the CI Harbour Fund. When you buy your guaranteed investment, you typically pick from a long list of funds that spans everything from money market funds to all-in-one portfolio funds.

But here’s where things get tricky. You don’t actually buy that fund when you buy a guaranteed product. Instead, you buy a contract that goes up and down in value based upon whichever underlying fund you’ve chosen. That contract is commonly called a segregated fund or seg fund. You take this roundabout route because insurance contracts such as seg funds are able to offer you benefits that pure mutual funds can’t. For instance, they can protect your money from creditors, bypass probate in estate settlements, and give you guarantees, such as a guaranteed income for life. The income guarantee, formally known as the guaranteed minimum withdrawal benefit, or GMWB, is what attracts many people to these products. The guarantee assures you that no matter what the markets do, you will get at least 5% of the money you put into these products back each year from the time you turn 65 until you die. In other words, the guarantee covers off your worst case scenario. It assures you that you’ll receive regular payments for life, no matter how long you live.

The seductive aspect of all this is that you also have a chance to grow the monthly income you will receive. Every three years, if the markets have performed well, you get the chance to reset the amount of monthly income you will receive to a higher level. But this only happens if the markets have done so well that your underlying fund is worth more than it was three years ago, even after three year’s worth of withdrawals.

One final feature deserves mention. If you buy one of these products before you’re ready to retire, you usually get a 5% bonus every year for up to 15 years during the period before you start drawing an income. During this period you can get resets too.

The three big risks
Since the only reason to buy these products is to guarantee yourself an income in retirement, you should consider how well they protect you from the three risks that threaten a comfortable retirement.

The first threat to your nest egg is longevity risk, the risk that you live longer than you think, so you run out of money. Luckily, most of these products offer excellent longevity protection, because, in most cases the income you get is guaranteed for life.

Make sure you read the fine print, however. Originally, these products guaranteed only 20 years of income, and even now some products offer fewer years. Otar, the financial researcher, says you shouldn’t buy a non-lifetime version of a guaranteed product, as it could leave you penniless when the guarantee expires.

Your second major risk is market risk, the risk that the market will collapse in a smoldering ruin and take your savings with it. Studies have shown that a market downturn just before or after you start drawing an income can have a devastating effect on how long your money lasts.

These products offer excellent protection against that danger. If the market collapses you may lose all your money, but the insurance company behind the guaranteed product promises to continue paying your guaranteed minimum income for life. In effect, if your core fund’s value gets demolished, these investments turn into a kind of annuity that pays you the exact same amount month after month for as long as you live. The only problem is, the payouts do not rise with inflation.

That brings us to inflation risk. This is the least understood of the three major risks, even though it is just as dangerous as the other two. Inflation risk is simply the danger that your purchasing power will shrink away to a fraction of its original size as life gets more expensive with each passing year. The steady erosion of your purchasing power may seem like a minor worry in the short run, but it can be deadly in the long run. If you had been getting a fixed monthly income over the last 25 years, your income would have lost more than half its buying power over that period.

These new products offer very little protection from inflation. Sure, you’re guaranteed to get back every dollar you put into the product, but those dollars may buy a lot less a couple of decades from now. The risk of not keeping your purchasing power is actually quite high, says Otar. They shouldn’t be making any claims about offering inflation protection.

Otar ran extensive computer simulations to find out what kind of inflation protection these products would have offered over the past century by looking at how often they would have reset their payouts at higher levels. His conclusion? When you look at market history, 30% of the time there is no reset whatsoever, he says. If you buy this product when you are 65, by age 90, you would have kept up with inflation less than 15% of the time.

In other words, while there’s virtually no chance you’ll run out of money completely, there’s a significant chance you could run short. If you put $1 million into a guaranteed product at 65, you might be guaranteed an annual income of $50,000. You could probably live comfortably on that right now, but if this century is like the last one, there’s almost a one-in-three chance that you won’t get a single reset. If you don’t, and the inflation rate over the next 25 years is similar to the rate over the past 25 years, by the time you’re 90, you’ll be getting only $24,000 a year in today’s dollars. Yes, you’ll get paid for life, says Asher Tward, vice-president of estate planning at TriDelta Financial Partners in Toronto. But by the time you’re 90, the purchasing power of your payments could be cut in half. You have to ask yourself, is that enough?

Who should buy them
Otar and several other financial experts say that guaranteed-income-for-life products do have some unique benefits and are appropriate for some people.

Otar says that you might want to consider buying one if you have no other guaranteed source of retirement income, such as a pension, and you have too small a portfolio to hedge the various risks yourself. Buying a guaranteed product makes most sense if you can’t tolerate risk, are prepared to live on as little as 5% of your original portfolio, and don’t mind that the buying value of your payout is likely to be slowly reduced by inflation.

Even then, you should plan carefully to make the most of a guaranteed product. These products carry higher fees than mutual funds, so the best strategy is to start by investing in an underlying mutual fund that’s high in stocks, since stocks have the potential for big gains that can offset the fees. Otar would normally suggest that a retired person put only 40% to 50% of his or her retirement savings in stocks; however, if you’re using a guaranteed product, he recommends that you invest 70% to 80% of your portfolio in stocks, at least to start. The high proportion of stocks will boost your chances of getting a reset during the early years, and may help compensate for inflation. After your fund has dropped to 80% or less of its initial value, there’s almost no chance that you’ll get any further resets no matter what you’re invested in, so you can switch to a more conservative portfolio at that point.

You should keep in mind that since you’ll be taking out 5% per year in withdrawals plus paying 3% or 4% a year in fees, you will be depleting your portfolio by up to 9% per year. That could quickly burn through your funds. Because of the high burn rate, Otar says that if you live a normal lifespan, there’s only a 10% or 15% chance that you’ll have money left when you die.

The burn rate is something to keep in mind if you want to leave your options open for later years. In theory, getting out of one of these contracts is not much different from leaving a mutual fund. Your biggest obstacle would likely be a deferred sales charge, but those charges usually go to zero after about seven years. Problem is, you will also be leaving behind your hard-won income guarantee, and, given how fast you could be burning through your money, you might not have enough funds left to start over with a different plan. In short, says Otar, if you’re not willing to stick to your guaranteed contract for life, you shouldn’t be buying into it at all.

A final consideration when buying a guaranteed product is whether you should buy it in advance of retiring, so you can enjoy that guaranteed 5% annual bonus, plus the possibility of resets, during the period before you begin withdrawals. During this period, you are more likely to get resets because you are not taking out money, and the 5% bonus should pump up your guaranteed minimum withdrawal amount. However, the 5% bonus does not actually increase the value of your underlying fund; it just increases the amount you can withdraw after you retire.

Otar says it can make sense to buy into one of these products five years early to take advantage of the bonuses, but if you’re more than five years away from retirement, you’ll probably do better by passing up the guaranteed product for now and sticking to a standard balanced investment portfolio. Why? Because the fees are so high with the guaranteed product that they slow down your portfolio’s growth to the point where the resets and bonuses can’t compensate for the money lost to fees.

If you’re tempted by these products, your best bet is simply to wait. Chances are that the deals are going to improve over the next few years. Buying now could be like paying $5,000 for a flat panel TV that ends up selling for $2,000 a year later. I don’t think they’re so great right now that you should be rushing out to buy one, says Tward from TriDelta. They’re only going to get better.

Otar agrees, saying that in the U.S., insurers are already offering much better versions. Down south, it’s common to have annual resets instead of a reset every three years. That sounds like a small difference, but making the resets an annual event makes it much more likely that your income will keep up with inflation. J. Roy Firth, Manulife Financial executive vice-president, confirms that his company will likely add new features in the future, possibly including annual resets. There will be lots more features as people get accustomed to these products, he says, but as with any feature, people will have to pay for it.

After looking at all the pros and cons, Tward says that guaranteed products do serve a purpose, but it’s a limited one. I’m not saying that there isn’t a fit in certain situations when the investor is extremely risk-averse, he says. But for the average Canadian investor who undertakes some equity risk, such as a regular mutual fund investor or stock investor, this is not a good alternative.

So what are the alternatives?
No single product can offer you the exact same benefits as a guaranteed retirement investment, but there are other strategies that might be a better fit for you.

Tward says there’s nothing wrong with the traditional strategy, which is to gradually move into safer income-producing investments as you get close to retiring. The right mix of cash, bonds and high-dividend-paying stocks won’t eliminate longevity risk or market risk, but it can significantly reduce both. If you’re mainly living on interest and dividends, rather than cashing in investments every year, you can sail through a nasty market crash with few scars. Plus you’ll have more protection against inflation than with guaranteed income products.

If you want an even safer alternative, splitting your retirement savings between an annuity and a low-cost balanced portfolio, such as the MoneySense Global Couch Potato strategy, can increase your protection against longevity risk. The annuity provides you with a guaranteed income for life, while your investment portfolio gives you the potential to prosper if the market does well. You can also dip into your portfolio for big-ticket items like a new car, without worrying about fees or penalties.

The reality is that no retirement strategy can eliminate all risk. If you decide to buy one of the current generation of guaranteed income products, inflation can erode your purchasing power. On the other hand, if you pursue growth to protect yourself from inflation, the markets could crash. The financial engineers who put together the guaranteed-income-for-life products did a good job, but in this imperfect world there’s still no such thing
as the perfect risk-free investment.