FaceOff: Conventional annuities versus GMWBs

Participants: Bruce Cumming, president of Cumming & Cumming Wealth Management, David Wm. Brown, certified financial planner and partner at Al G. Brown and Associates.

Bruce Cumming: The biggest argument for conventional annuities is that you get a 5% guaranteed return and the prospect of even higher returns if the markets perform well. Though research shows there’s very low likelihood of exceeding the 5% threshold amount.

It would, however, be nice if it were possible. And it is; here’s how we can do it. Let’s say we’re dealing with $100,000. The conventional annuity promises a 5% income or $5,000. But if my client retires in his mid-60s and buys a life-only annuity, the cash flow would approximate 7.5%. So if we were to invest only two-thirds of the $100,000, for example $67,000 in a variable annuity, it would still deliver $5,000 for life (7.5% earned on $67,000 equals $5,000 annually). The remaining $33,000 could be used to buy a basket of ETFs with a strong equity bias since the annuity provides the fixed income. Over the years, the basket of ETFs would provide overall inflation protection—even liquidity if required—a partial return of capital, and general flexibility.

This strategy vastly exceeds the GMWBs, which only offer a hope, a prayer, and an unknown promise. I’d be much more confident in my annuity income and my low-cost ETFs for some growth. Plus, if advisors – let alone clients – fully understood the actual death-benefit guarantee in the variable annuity, they wouldn’t argue a conventional annuity chews up capital that variable doesn’t.

David Wm. Brown: It’s hard to recommend one over the other without looking at people’s individual circumstances, age, risk profile income requirements and assets. For example, I wouldn’t recommend variable annuities to younger clients.

That said, I agree for some combining conventional annuities and ETFs is a good strategy. You might end up with the same results as a variable annuity, except you may do a little bit better because you won’t have so much of a drag due to the cost of running the variable annuity.

However, variable annuities provide an administrative system designed and put in place for people who aren’t prepared to follow that other route. The question is: do you want the administrative services provided by the insurance company that has already packaged the product or do you have an advisor who will put it together for you and monitor it.

Who should buy what?

Cumming: The conventional annuity is for people who seek safety and guarantees, and don’t want any management responsibilities. They are prepared to forfeit the flexibility that is lost in purchasing an annuity. These are also clients who’d like a potential tax advantage, assuming their money is parked in non-registered assets.

The conventional annuity tends to be outstanding for the healthy couple that believes longevity is on their side. It’s also compelling for the unsophisticated or unbalanced couple where maybe one is financially astute, the other isn’t. There are no worries for the surviving spouse even if he or she outlives the more financially astute one.

Then there are a whole bunch of people in their 60s who have been hurt, damaged or made afraid by the extreme uncertainty of equity markets. Locking part of their money in conventional annuities makes them more or less risk-free, in addition to providing them a very high rate of return.

We have a massive problem today trying to find fixed-income investments for investors. For the 60-year-old investors bond yields and GICs are dreadful choices. So if you can get a 7.5% cash flow (assuming interest rates remain low for a period of time) and you tumble the math, it becomes quite compelling because of the spread between the annuity and current fixed-income rate.

It also depends on the profile of the individual. Take for example a civil servant who’s lived paycheque to paycheque and built his or her life around that level of income. If the pension provides two-thirds of that income, they can take their savings and buy annuities, and their paycheque will be extended permanently into retirement.

The lack of liquidity in conventional annuities, to me, is a complete non-issue. If clients need liquidity they can use a secured line of credit against a house, or they can collaterally assign the annuity to either, say, Manulife Bank or TD Bank. They can get back a fair bit of access to their capital, it’s just that they have to go through some hoops.

Brown: Variable annuities tend to attract people who’d like to feel they can guarantee the floor—where their income is going to be in the future—and the notional account created in the variable annuity over the years. If they’re dealing with a variable annuity that gives them a notional interest of 7% a year, and you use that as a base to buy the annuity in the future. Then they know whatever they’ve deposited now, ten years down the road its value is going to be 70% more, at minimum. Depending on their age, they’ll be able to throw off a certain amount of income that creates a guaranteed floor. People interested in variable annuities tend to participate in the equity market as much as possible, knowing full well what the downside is. In addition, if the market spikes they’re able to lock in the gains.

Age is a big factor in who we recommend variable annuities to. We’re using these annuities in corporate scenarios for older clients – sixty and over. There are also scenarios where you get a couple with one person more aggressive and the other less so. The variable annuity seems to satisfy the needs of both. Unfortunately, sometimes the one who’s more astute may pass away earlier, or vice versa. But because of the rollover feature the continuing income for the surviving spouse is already determined.

Besides, a variable annuity isn’t mutually exclusive of other products such as systematic withdrawal plans. There are some additional advantages to using non-registered funds in the variable annuity because of the characteristic of the income that comes out—primarily capital first, and then capital gain.

Are GMWBs recession-proof?

Brown: That depends on the definition of recession and proof. My concern about GMWBs in general is that they aren’t very well understood as a product. Most GMWB products come with a booklet that you send out to your clients and review the fine print with them. The troublesome part is that some of the fine print gives a lot of latitude – a lot more than conventional annuities do – to people who administer and build the product. In a conventional annuity, you get a contract and about seven pages that very clearly explain the obligation of the company and the client’s flexibility. GMWBs have a lot of fine print that allows the company to readjust the product offerings if there are significant challenges. We’ve seen some companies change the design of the contract and some of the percentages that can be invested in equities and incomes, in the past.

Shortcomings of using one or the other?

Cumming: The only major shortcoming of a conventional annuity is its lack of flexibility. Some would argue there’s lack of liquidity, but I don’t think that’s an issue. Don’t put all your money in the annuity. Keep capital at hand for any eventuality in an RRSP or open account.

How many people would be satisfied with an 8% annual return? That’s what you can get today from a back-to-back annuity or a client in a high tax bracket with non-registered dollars. And ratchet it down to 6%, for someone who is in a low tax bracket and healthy enough to be insured. You can’t get products like that in the conventional marketplace. There has never been a greater need or demand for conventional annuities. It should be the number one selling product to the retiree.

Brown: The conventional annuity has been a very large piece of our planning for many years; however, greed unfortunately gets into the picture sometimes. Today, a 6% to 7% rate of return looks very good but down the line when the market moves up, people start to wonder why they’re locked in this rate of return when they can possibly do a lot better in the market.

The variable annuity gives people the opportunity to do both. They get a 5% to 7% rate of return on their notional account that they can use for their income, plus an exposure to the market if that’s what they want. They have the flexibility to cash out if that’s what they decide they want down the road. Both are good products, they just offer different visions and goals to different people.

The major shortcoming of a GMWB is the latitude it provides the issuing company with reference to guarantees in the product. The GMWBs could come back to bite a lot of advisors because they can be easily misinterpreted and misunderstood. For example, a lot of people believe the bonuses credited to the notional account are real money, but they aren’t. You can’t walk away and get the value of your notional account unless the money in your real account is up to that value.

Cumming: I agree there’s a great deal of misunderstanding surrounding this product. For example, if you ask six different advisors about the death benefit you’re likely to get six different opinions on how it will be credited, calculated and actually delivered. There is a basic lack of knowledge and certainty around these products. I’ll wait and watch this product evolve. In its current form it’s so far away from what the American variable annuities look like. Ultimately, GMWBs will have to become more competitive and a better deal for the consumer.

Brown: Conceptually, I like the idea of a guaranteed minimum withdrawal product but it has a long way to go. The concept of resetting on an annual basis is an interesting enhancement to the product design. That’s how most of the American carriers operate it. That’s what we too will see because the Canadian product will eventually resemble its originator, the American product.

Will GMWB offerings change?

Brown: As the world gets smaller and smaller and information travels quicker, and global transactions impact us all, we’re going to see a different type of economy based on some of the newer types of theories. These products too will evolve as a result. There are political and economic factors that will impact these projects down the road. It’s going to be a continual evolution.

Cumming: We’ve seen massive volatility in the markets; that isn’t going to change. We’ve seen governments around the world incur unprecedented amounts of debt. There’s fear of inflation, and potentially, of rising interest rates. With the mounting debt and current consumer spending, increased interest rates will be very difficult to achieve; they could actually push us right back into another recession. The need for safety, security, and guarantees has never been more important to people on the verge of retirement. They must insulate themselves from this type of volatility and if they can collect that 6% to 7% guaranteed rate of return they should be fine.

The changes I anticipate are lesser equity exposure and one-year resets. But if MERs start to go up on GMWB products and people are locked in, there’s going to be many unhappy people. I also despair for the traditional life market. These money products have hugely impacted the life insurance business. I’m really unhappy about that.

Brown: I fully agree with Bruce about the impact variable annuities are having on the life product. But I believe these are good products that need to be designed in a way that they are advantageous to clients and that companies are careful to design them responsibly and not try to give away too much, or make them too competitive. At the end of the day, if someone wants a GMWB product and is prepared to pay charges for the guarantees, they should be afforded those guarantees without any questions asked. If that means increasing the cost, well, the consumer has an option to purchase or not to purchase them. I’m a big believer in making sure what you buy is what you get. At the end of the day if you don’t want to buy that particular product you have the option not to.

(03/02/10)