MDRT: Are GMWBs worth the cost?

Variable annuities, which are guaranteed minimum withdrawal products here in Canada, represent a unique opportunity to replicate a guaranteed pension plan for clients, tapping into equity gains without being affected by adverse market conditions. But does the cost outweigh that benefit?

According to U.S. variable annuities expert John Huggard, a North Carolina lawyer, GMWBs are worth the price for the right investor profile: an investor over 45 with a substantial nest egg who intends to draw upon it soon, as his or her primary source of retirement income.

Speaking at the Million Dollar Roundtable Annual Meeting in Toronto, Huggard explained the selection of a variable annuity is not about investing; it’s about managing risk. Variable annuities eliminate a portfolio’s sequence-of-returns risk.

If, in the first few years of the withdrawal phase, the client faces a market downturn, the lifespan of the individual’s savings can be reduced substantially, sometimes by more than a decade. Like managing any other form of risk, Huggard says it pays to have insurance, because at this stage in the client’s life, the upside potential of the client’s benefit is greatly outweighed by the downside risk of losing decades’ worth of savings — they simply do not have the time horizon to earn back substantial losses.

R elated Stories

MDRT: Fighting retirement’s foe — inflation MDRT: Failing to offer GMWB could lead to liability

“If you have money sitting in stocks and mutual funds and the stock market drops dramatically — 50% in value over a three-year period — who comes in to insure those stocks and mutual funds against loss? No one,” he says. “There is no insurance for those things. People who had their money in Bear Stearns have lost 90% of their money in less than six months. I would rather have my money sitting in an insured product with Manulife, Sunlife, Hartford or ING. Stocks are not insured, IRAs are not insured and RRSPs are not insured.”

If there is a risk with GMWBs, Huggard believes it is with their misuse. He strongly advocates against selling it to clients in the early stages of the accumulation phase. He also stresses investors should hold the GMWB for the requisite period of time to get the benefit and be wary of withdrawing more than the minimum guaranteed amount, as set out in the contract.

“Depending on the policy, pulling out more than allowed may significantly reduce their income for the rest of the time they hold the policy,” he says.

In Canada, cost is a factor. Huggard says that in the U.S. he finds the average variable annuity with a living benefit like a GMWB rider costs about 2.6% annually. In Canada, fees would appear to be more substantial.

A GMWB’s appeal is that the client can construct a portfolio of equities. If the time horizon is long enough, the historical returns of the market would suggest the portfolio should outperform the rate of inflation and fixed-income investments.

The big question is whether the extra fees on a GMWB will eat up that difference. Industry analyst Dan Hallett, president of Dan Hallett and Associates, says the total cost of a Canadian GMWB product could be 4% to 5%. He is concerned this could substantially stunt the upside potential of the investment.

“Reset features are promoted on a lot of these products,” he says. “If the investments perform well, you can lock in a higher guarantee level, so your guarantee minimum rises. I think that the potential for that to happen is less as your fees get higher.”

Hallett says cheaper alternative guaranteed investments can be constructed. For example, an advisor can construct a portfolio using a traditional annuity and then use fixed income investments with conservative growth rates, such as GICs.

“For a client that has no pension plan, who is relying on their savings for retirement income, looking at some sort of guaranteed product is absolutely a good thing to do — it just doesn’t have to be this kind of product,” he says. “With a cost of 4% or 5% a year on a GMWB, your upside is going to be pretty limited anyway. The decision is really going to depend on the specific asset mix of the client.”

A cost-benefit analysis will become even more difficult as GMWBs offer additional risk management features, such as inflation protection and long-term care conversion. These are features that have just arrived in the U.S. market and make the products much more appealing for protection planning.

Inflation protection is particularly compelling. One of the major criticisms of GMWBs was that if markets are flat or decline, inflation erodes the value of the withdrawal. Huggard says some companies in the U.S. will charge an additional fee to add inflation protection of about 2.5% to 3% on top of the GMWB rider.

“There is an added cost. From what I understand it’s not significant and it is optional,” Huggard says.

Three carriers in the U.S. are offering an LTC conversion option, allowing investors to turn their GMWB into a long-term care policy if they need to enter a nursing home. The underwriting is automatic, although the LTC conversion potential only kicks in after the client has held the product for a set number of years.

“If six or seven years into owning one of these products you have to go into a nursing home, that benefit will work automatically to become a long-term care policy,” he said. “The insurer will immediately double the payout so that the 6% payout goes to 12%. If you’ve got a million dollars in there and you were withdrawing $60,000 before you went into a nursing home, that will ratchet up to $120,000. The insurer will pay that as long as you’re in the nursing home.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(06/27/08)

Mark Noble