A Retirement Product That's Guaranteed, but Not Very Attractive

09/20/2010 3:35 pm EST

Focus: MARKETS

Rob Carrick

Columnist, The Globe and Mail

One of today’s most successful investing products has lost the potential it had when introduced, says The Globe and Mail columnist Rob Carrick.

Retirement income, guaranteed.

That got your attention, didn’t it? After two straight years of stock market drama, what a relief it is to know there’s such a thing as a retirement investment you can count on.

On this simple sales pitch, the guaranteed minimum withdrawal benefit (GMWB) has quietly become one of today’s most successful investing products. This trend has occurred even while GMWBs have become less attractive than they were when they were introduced. And truth is, they weren’t that great to begin with.

In March 2008, this column looked into GMWBs as they began to emerge as a phenomenally successful addition to the insurance industry’s repertoire of investment products (Read: Peace of mind, but it doesn't come cheap). Our guides back then were Ted Rechtshaffen and Asher Tward of TriDelta Financial Partners, an independent financial planning firm that at that point wasn’t selling GMWBs because its advisers saw better, cheaper, more flexible alternatives.

Now, let’s check back with Mr. Tward after two and a half years of strong GMWB sales. The financial research firm Investor Economics reports that assets of $17.9-billion were held in these products at June 30, compared to $16-billion at the end of last year and $8.1-billion at the end of 2008.

It turns out that intense competition between insurance companies did briefly result in a product that TriDelta liked enough to sell to some clients. But today, the firm is back to not using this product.

“In order to get penetration when they brought these things a few years ago, they had to offer lots of bells and whistles,” said Mr. Tward, Tri-Delta’s vice-president of estate planning and specialist on insurance products. “What’s happened since then is that everything’s been diluted.”

GMWBs are built on a foundation of segregated funds, which are an insurance-mutual fund hybrid where all or part of your investment is guaranteed after a 10-year period and on death. Additional guarantees are added so that you can withdraw a minimum amount of income every year for life, typically 5 percent of your investment starting at age 65. Worried about a stock market crash? With a GMWB, your savings are protected.

There’s the potential for growth as well as security with a GMWB. If you have money in a plan but don’t start withdrawals, you get an annual bonus of 5 percent of your contributions. Note: the bonuses increase the base used to calculate your yearly retirement income, but they don’t raise the market value of your holdings.

Every three years, you get another opportunity to increase your savings. If the investments in the GMWB have been good to you, the balance in your plan may be reset higher to lock in your gains. Resets are a big deal because they increase the value of the bonuses you get in the years before you start making withdrawals.

Mr. Tward said he recommended GMWBs to clients at a point when one particular company was offering to bump up the annual bonus to 7 percent. “It was opportunistic,” he said. “If we didn’t take advantage of it then, we weren’t going to be able to do so in the future.”

That view was right on the money. This particular insurer has since lowered its annual bonus to 5 percent, just one of several changes made in GMWBs in the aftermath of the financial crisis that took hold just as these products began hitting their stride in sales.

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To back up the guarantees provided on their segregated funds and GMWBs, insurers are required to maintain certain levels of financial reserves. These reserve requirements became more onerous as the stock markets sank, and that necessitated what Investor Economics described in a June 30 report as “a period of policy revisions and dialling down of features....”

IE said the revisions were not as severe as those seen in the US market. However, Mr. Tward’s view is that they nevertheless have reduced the attractiveness of GMWBs.

For example, the selection of segregated funds investors can choose from has become more conservative through greater emphasis on bonds at the expense of stocks. This is an issue because of the high fees on GMWBs—3 to 4 percent, including both the fees on underlying segregated funds and an additional guarantee costs.

Returns of more than 3 percent are hard to come by in the bond market these days, which means you’d want a heavy helping of stocks. That way, you’d have a better chance of getting the benefit of those three-year resets while enjoying guarantees against market losses.

“It basically destroys the whole basis of the product.” Mr. Tward said of the limitations on stock market exposure. “Why bother?”

Fees, the original problem with GMWBs, have only become more of an issue in some cases. One insurer increased a fee component of its segregated funds by as much as 0.3 of a percentage point. The fees associated with using these funds in a GMWB format has risen by the same amount, which means clients have an additional drag on their returns of up to 0.6 of a point.

There have some improvements to GMWBs, but they’re not significant enough to offset the negatives. One example concerns the 5-per-cent bonuses that are paid in the years before you start making withdrawals. It used to be standard for the bonuses to be paid for up to 15 years; now they may be paid for longer periods or even indefinitely.

Mr. Tward played down this change, noting that the optimum period of time to buy a GMWB is about a decade before you need to start withdrawing retirement income. “I don’t think these products make sense unless you can get ten years’ worth of bonuses,” he said.

From the insurance industry’s perspective, GMWB’s are a fabulous product because clients tend to hold them for much longer periods than regular mutual funds or segregated funds. Investor Economics said that in the 18 months to June 30, investors redeemed 81 cents of every dollar of gross mutual fund sales. The comparable figure for GMWBs was just ten cents.

“These products were manufactured for a particular purpose, which is to keep clients sticky for a very, very long time,” Mr. Tward said. His final verdict on GMWBs: “Not very attractive.”

Coming Soon in Portfolio Strategy: Alternatives to guaranteed minimum withdrawal benefit products.

Guaranteed retirement income

Guaranteed retirement income Insurance companies have been selling a lot of guaranteed minimum withdrawal benefit (GMWB) products since they were introduced in Canada back in 2006. Here’s an example of how they work:

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