Toronto Star: Hanging on to Your Nest Egg


Sat., Nov. 1, 2008

Note: This article has been edited to correct a previously published version.

The shocking crash of stock market prices – in Canada an average of about 40 per cent between June and October – could spell financial ruin for someone who retired recently with a large proportion of his or her savings invested in equities.

While prices have recovered somewhat since world governments moved to stem a mounting financial crisis, they still have a long way to climb for retirees to feel confident they will have enough money to last the rest of their lives.

The market carnage, says finance professor Moshe Milevsky of York University's Schulich School of Business, has proven the economic value of a new generation of guaranteed income products sold by life insurers.

At the same time, however, the extent of market losses could foil plans to enhance guarantees in these same products and force insurers to restrict the percentage of equities a client may hold and bolster their capital reserves.

"It has become the best of times and possibly the worst of times" for these wealth management products, says the author of the recent U.S. book Are You A Stock Or A Bond?Create Your Own Pension Plan For A Secure Financial Future.

Fitch Ratings warned last month that life insurers in the United States and Europe could soon see their financial strength ratings reduced, in part because of the potential cost of guaranteeing customers against losses on stocks.

Even Canada's Manulife Financial, rated as one of the two strongest life insurers in the world, felt compelled to arrange a telephone conference call with stock analysts before it was ready to release its third-quarter profit figures.

The holding company for Manufacturers Life Insurance Co. rushed to dispel rumours about its ability to afford the capital and income guarantees on about $72 billion worth of stock and bond portfolios in Canada, the United States and Japan.

"We became aware of concerns swirling in the marketplace," said company president Dominic D'Alessandro, before his chief actuary argued that Manulife could well afford an estimated $12 billion in guarantee costs based on the level of stock prices at the end of September. Most of those guarantees will not cost the company a penny for several years, unless a million customers happened to die tomorrow, Simon Curtis pointed out. And, despite the low level of stock prices, he expects fees paid by investors on their much-reduced portfolios will more than cover the cost of those guarantees.

Manulife became the first life insurer in Canada two years ago to add an income guarantee or minimum withdrawal benefit to the traditional guarantees of capital it provides for segregated investment funds, the life insurers' answer to mutual funds.

Now five other life insurers are competing for sales in Canada. (See chart  that compares the major features and costs of most of five of these products, as well as the financial strength of the insurers selling them.)

Life insurers have long guaranteed to return 75 per cent of a person's original capital after 10 years, or sooner if the investor dies during a period of low stock prices.

They enjoyed a flurry of sales when they stepped up the guarantee to 100 per cent and allowed investors the right to more frequent resets of their capital guarantees. That was just before the tech-stock bubble burst earlier this decade. Two years ago Manulife went further when it also began to guarantee – for an extra percentage fee – annual withdrawals equal to 5 per cent of an investor's capital for a total of 20 years.

Those withdrawals could become somewhat larger, and be extended for a longer period if investment returns (minus fees) happened to be good.

Later, in response to competition, Manulife extended the 5 per cent minimum withdrawal benefit for a lifetime, thus turning its investment funds into something closer to a company pension plan or an old-fashioned life annuity.

Investors can now be confident that a $100,000 investment will assure them $5,000 of income each year from age 65, plus they have the potential to collect a larger sum if their investments do well and thus have their income keep up with rising prices.

In addition, Manulife and other insurers now guarantee investors who sign up years ahead of retirement will get a 5 per cent bonus that will increase their potential income in retirement for each year they do not make a withdrawal.

These new guaranteed income products have become so popular they now account for the majority of Manulife's sales of segregated funds.

Empire Life Insurance Co., of Kingston, Ont., is the latest insurer to enter the market, and Desjardins Financial Security and Industrial Alliance Insurance and Financial Services Inc., have recently improved their offerings, which allow holders to draw a guaranteed income starting earlier than age 65.

Yet some investors question how well they would do after paying the guarantee fees that insurers layer on top of some of the most expensive mutual fund fees in the world. Deep inside the contracts are provisions that allow the insurers to increase charges, which could leave even less room for whatever upside potential the stock and bond markets might provide.

Others realize that a retiree could guarantee more than $5,000 of income with less than $100,000 by buying a traditional life annuity from one of the same life insurers.

Manulife charges men about $64,211 at age 65 and women $69,670 to provide an annuity that would pay $5,000 a year for a minimum of 10 years, and for as long as the person lived beyond 10 years, according Kirk Polson of Polson Bourbonniere Financial Planning Group Inc. The hang-up some consumers have with traditional life annuities, even those with a 10-year guarantee period, is that you cannot change your mind and ask for your money back the way you can with the new guaranteed income products. Also, with the sort of life annuity just mentioned, if you live 10 years plus a day, you will have received only $50,000 of the money you paid. There's also no provision for your income to rise and thus keep up with the escalating cost of living. Even so, Milevsky points out that someone who made an unprotected investment in equities before losing about 40 per cent this year would now be worse off for having waited to buy a traditional annuity for retirement.

"Any financial advisor that shunned (the type of product) with a guaranteed-minimum withdrawal benefit in the last few years simply because they were expensive or charged an extra (percentage point) in fees is looking pretty foolish," he says. "For their sake, I hope clients don't remember the conversation in which that particular product was dismissed."

Milevsky does not discard traditional annuities out of hand. In fact, in his book he uses sophisticated methods of calculation to show how a financial planner could help a client choose an appropriate mix of guaranteed minimum withdrawal plans, life annuities and conventional investment portfolio.

Some advisors' recommendations could be different today. Capital guarantees may seem less relevant to clients now that we have already seen a massive decline in stock prices to the levels in some countries of four or five years ago. D'Alessandro told analysts recently sales have dipped 20 to 30 per cent in recent weeks.

One of Milevsky's star graduates from the Schulich MBA program, Jason Pereira, researched the advantages of the guaranteed minimum withdrawal plans as one of his assignments.

He concluded that, depending on the mix of equities in a retirement investment portfolio, the risk of financial ruin is greater than 10 per cent if you have no insured income guarantees. Now he works as a financial adviser with Woodgate Financial Partners and Investment Planning Counsel and sells the SunWise guaranteed income products offered by Sun Life Financial Corp., and CI Investments.

"When it comes to buying individual equity funds, there is significant and very visible value to this (product)," he insists. "However, if you diversify properly, it actually reduces the net benefit (of the products) to the client significantly."

Pereira is skeptical about the quality of advice provided regarding a rather complicated investment decision. For example, he argues it's ludicrous to buy these guaranteed funds and pay the high fees years ahead of retirement.

The 5 per cent bonuses that guarantee a steady increase in the base used to calculate the minimum income withdrawals are less than meets the eye.

Bonuses are based on your guaranteed capital – the original amount invested or any increase due to periodic resets – and ignore increases due to earlier bonuses. So, this is equivalent to a lesser percentage of compound interest than 5 per cent.

"Some agents are saying to people at 50, here is what you need to put in to guarantee a certain income at 65," says Pereira.

"It sounds wise, but at the same time, over 15 years you are looking at a potential of two market cycles, in which case you are taking a one percentage point hit a year. You have the potential over 15 years to at least double, if not triple the asset base."

When clients are nearer retirement, he suggests they select a segregated fund with the minimum 75 per cent capital guarantee at death in order to qualify for lower fees.

"I think the product is wonderful, that it was necessary in Canada and that it is going to be around for a long time, if not become one of the most dominant areas in the industry," says Pereira.

"However, I do believe there are a lot of pitfalls due to the complexity of this product that a lot of advisers are going to burn themselves on due to misunderstanding with the client, because I don't think a lot of advisers understand what is going on with this thing."

Regardless of the extra cost, the experience with the stock markets this year may drive more clients to look for guarantees so they can sleep at night, he says.