Evolution of a Guarantee by Mike Berton

mike-bertonDuring the financial crisis, many clients jettisoned their well-balanced portfolios in favour of fixed investments that, while secure, cannot possibly meet inflationary pressure. Whether clients make choices that are too conservative or too aggressive, poor investment decisions made between the ages of 60 to 65 can negatively affect their standard of living for several decades.

Today most advisors are familiar with the three main threats to retirement income: longevity, inflation and market risk. Traditional retirement income solutions have included, fixed income options like guaranteed income certificates, bonds, life annuities and dividend paying stocks. While all can play a part of a solution, each has limitations. Recent prevailing low interest rates negatively affect the ability of GICs to keep pace with inflation. For similar reasons, yields available from life annuities are also lower, and while secure, annuities do not usually provide for an estate. Dividend-paying stocks can provide a tax-efficient income and potentially an estate but do not shield investors from market volatility.

The most recent innovation, the Guaranteed Minimum Withdrawal Benefit (GMWB) plan, offers a hybrid solution, combining the potential for capital appreciation with the income security of a fixed income investment. Built upon traditional segregated fund investments, with their various maturity and capital guarantees, the GMWB is basically an overlaying product feature. They are offered as a policy rider that can be applied to new or existing segregated fund contracts up to certain age limits, usually age 80.

The essential feature of a GMWB is a guaranteed annual income promise, in most cases five percent of the Guaranteed Withdrawal Base (GWB), a notional capital amount based on the original invested capital. This GWB amount may be increased by bonuses and/or resets over time, raising the GWB and the income based upon it. There are two phases to the plan; an accumulation phase and an income phase.

In the accumulation phase, clients receive a five per cent simple interest bonus to the GWB each year as long as they do not take income. For example if Harvey invests $100,000 at age 45 and does not withdraw from his policy for 20 years, the GWB would grow to $200,000 doubling the GWA from $5,000 to $10,000 regardless of the market value. If the GWA is not withdrawn during the retirement years, a bonus will similarly be applied to the GWB. Most plans limit the number of years such bonuses can be received prior to age 65 between 15 and 20 years.

Up to age 65, clients can contribute to their GMWB plan and receive bonuses. After this, they must begin to receive income based on the attained GWB, often referred to as the Lifetime Withdrawal Allowance (LWA).

For example if a person invested $100,000 into such a plan on January 1, the GWB would be $100,000 and they would receive the promised five per cent income payment of $5,000 at the end of the year. Usually if the income, or a portion of it, is not withdrawn, it is applied to the GWB as a form of bonus. While most policies throw the income switch on at age 65, some newer plans allow flexibility with the commencement of income from age 50 to 75, with income promises ranging from four to six per cent. Other policies allow some flexibility with the percentage of income withdrawn from two to seven per cent.

Scheduled market value resets have become common in many segregated fund products and they may potentially play a large role with GMWB plans. Resets generally are offered after an initial three to five years, and then every three years thereafter. If the market value of the underlying investment has increased in excess of the notional GWB at the reset date, the GWB is increased to match. This may allow for future increases to the guaranteed income, or to allow for a recovery in a portfolio purchased in a low market period such as early 2009. With the additional GMWB fee and management expense, one should consider how likely such resets might actually be and whether they can be realistically considered as a source of income indexation.

These products are taxed like the segregated fund policies they are based upon. Policy holders receive a variable mix of income, capital gains or losses. In many cases the losses will offset any gains, making the policies relatively tax efficient. If the policy owner has redeemed all the units of the underlying portfolio, the income is characterised as capital gain. Any capital guarantee benefits on death or contract maturity are taxed as a capital gain in the hands of the annuitant.

The original plans introduced in the fall of 2006 offered a 20-year guaranteed income payment schedule. A year later, a guaranteed income for life was added, sometimes called Guaranteed Lifetime Withdrawal Benefit Plans (GLWBs). Beware; in most cases plan members who take income from the plan before January 1 of the year after they turn 65 will automatically receive the 20-year income guarantee. This can be switched to a guaranteed lifetime income benefit after age 65 with a recalculation of the guaranteed amount to reflect a longer annuity period. At age 65, most plans switch to the income phase and begin to make income payments.

Advisors should ensure that the guaranteed income is sufficient to their clients needs as withdrawals in excess of the GWA income benefit are unwise. Any excess withdrawal reduces the all important GWB adjusted base amount and thus all subsequent guaranteed income payments. A transfer to another carrier would forfeit the GWB as well as its income promise, not to mention the death and any maturity capital guarantees. In this way, the structure discourages an investor from large withdrawals, leaving the plan or switching to another carrier. For this reason, the GMWB should not form the sole retirement income tool for clients. Provisions should be made for special liquidity needs and emergency funds.

Owners may choose between appointing either a beneficiary or a successor owner. On the death of the primary annuitant, a beneficiary would receive the proceeds of the market value of underlying asset, if any. In the case of a successor owner, there will be a recalculation of the income benefit to the successor owner to reflect the change in mortality assumptions. Some insurers offer a joint survivor policy with income based on the age of the youngest spouse or a lower income percentage (i.e. 4.5 per cent). A corporation may own a GMWB policy but there must be an annuitant person upon whose life the income benefit will be based.

GMWBs work ideally as non-registered investment plans; however, they can also enhance registered portfolio income. In the case of Registered Retirement Income Funds (RRIFs), GMWB policies provide for the minimum RRIF payments to be paid when in excess of the regular five per cent. In this case, the scheduled higher payments will not affect the all- important GWB. In large downturns like 2008/09 the GWB remains intact and clients need not fear the negative effect of the minimum RRIF withdrawal on capital of their portfolio. While the RRIF withdrawal schedule might well deplete a normal retirement portfolio before the end of life, the GWA ensures the RRIF will indeed last as long as the client
does and continue to pay a level or potentially higher reset income.

Use with Life Income Funds (LIFs) is not generally recommended. As the maximum withdrawal under LIF rules is based on the market value of the underlying portfolio, a market value decline increasingly lowers the LIF maximum. Nevertheless the policy contractually requires the fixed GWA to be paid out. In the worst case, if the market value fell to zero, the LIF maximum would also be zero, yet the policy would be required to pay out the GWA. Some companies have built a work around for this by converting any guaranteed income benefit that exceeds the LIF maximum to a separate annuity policy. There is no clear confirmation from the government condoning this practice.

While the many benefits of GMWBs sound attractive, they are not without a cost. First of all, segregated funds tend to have relatively higher management fees than regular retail mutual funds by an average of 75 basis points for a growth-oriented portfolio. On top of this, the GMWB rider will add 25 to 85 basis points, depending on the risk level of the underlying investment choice. This can create loads of up to 4.5 per cent, impacting long term portfolio returns and reducing the likelihood of future market resets. None of the fees have caps in place and could be based either on the market value of the underlying portfolio or the protected GWB. However, if the market value of the underlying assets fall to zero, the GMWB fee is usually waived.

A 2008 RBC Dominion Securities study tested GMWB plans against several market return scenarios and concluded that, in most cases, GMWBs did not provide a benefit that clients would not have received anyway had they simply remained invested. In addition, the study estimates that the costs of a GMWB over 30 years could add up to several times the value of the initial investment, actually reducing income. At the same time, the study estimated that the income guarantee only was needed in five per cent of the market return scenarios tested.

Most contracts cannot be altered once issued; however, where contracts allow the insurer to make changes to their existing guarantees, clients usually have an option to terminate the contract without penalty. We have already seen some insurers make changes to future contracts while grand fathering their existing contracts. As with any complex financial product, it is prudent to investigate these details carefully in the Information Folder.

As these products offer guarantees on maturity and death values as well as income, advisors and prospective purchasers will want to investigate the security of the offering institutions. This is particularly true in recent months, as the security of many financial institutions has been put to the test. The good news is that Canadian insurers offering GMWB plans all maintain healthy capital reserves and credit ratings in spite of the global recession.

GMWB plans are supported by a strategy employing Principal Protected Notes, to provide the protected guarantee. These provide the base for the future guarantee as well as the resets. In the long-term, growth of the markets will eliminate much of the need to tap into reserves to fund income. Similarly there is a distribution of risk on client mortality that will reduce risk on the death guarantee. Assuris, the industry back stop, offers a guarantee of the higher of $60,000 of 85 per cent of the GWB on the accumulation phase and the higher of $2,000 per month or 85 per cent of the guaranteed income benefit during the retirement phase.

Possibly the largest challenge with GMWBs for advisors is that they are complex to explain to clients. Although they may have grasped the functionality of the GWB and distinguished it from market value at the time of purchase, they may later become confused or misinterpret the important essentials of their policy. Advisors will have to make ongoing efforts to ensure that their clients continue to fully understand their income policies. In response, product suppliers have recently improved how they report to their clients on these plans.

As the principal purpose of the GMWB is to provide a long-term guaranteed income stream, it may be appropriate as part of a solution for clients who are retiring or are approaching retirement where market risk is a special threat to income security. They may want the growth potential of equities but with protection of income from volatility. They may wish the carefree income of a life annuity, yet wish to also provide the potential for an estate benefit. Subject to account minimums, a GMWB may also work well within a Tax Free Savings Account, providing tax free income for years to come.

GMWBs should be considered for clients who are planning for a long retirement, have minimal guaranteed income from a pension or other fixed base. They may not be appropriate as a sole solution for clients with small asset bases, who may need to make excess withdrawals. Due to their long-term design and higher cost structure, they are less appropriate for anyone with a short life expectancy, for those who have assets that are unlikely to be depleted in their lifetime, or those who have a significant pension that already provides a sufficient annuity base.

With all its complexity aside, the GMWB does offer an innovative hybrid retirement income solution to retiring clients. It offers a potential hedge against inflation, protection against market volatility, elimination of longevity risk and the potential of an estate. It addresses investor psychology, in particular that of retiring investors, where the competing desire for capital preservation and need for inflation protection are in conflict. It does have significant costs and limitations. However, if the promise of an income guarantee can help to keep a security-conscious investor invested for moderate growth, then the plan will have made a difference.

Judging by its popularity, the GMWB market will continue to grow and evolve for many years, offering future refinements. Whether advisors choose to offer these products to clients or not, they should be brought to clients attention as a potential piece of the income solution.

Mike Berton is a Senior Financial Planner with Assante Financial Management Ltd.

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