Guaranteed products not interchangeable

(February 2006) With the proliferation of principal protected notes and market-linked GICs grabbing the headlines these days, segregated funds may not be top of mind for many clients. And while they serve different purposes from the new generation of guaranteed products, they could face a challenge from these upstarts within the next couple of years.

“The initial segregated funds were launched with a 10 year period and a 10 year guarantee, they were starting to really take off in 1997 and 1998,” says John Lutrin, executive vice president and chief marketing officer for Hub Financial. “Within the next year or two or three, you’re going to see the first wave of seg funds maturing.”

As these funds mature, will investors leave their capital in the hands of the company that got them this far, or will they seek out the latest in principal protected products?

“Will these eat into the seg fund market? I don’t anticipate that they would, but you can’t tell, because you get investors who see the protection, but maybe want a little better upside too,” says Sandra McLeod, CFP, director of succession and estate planning, Grant Thornton in Toronto. “That’s the way they’re going to get sold.”

“My fear is, do people really understand what these things are, how it affects their current and future portfolio?” she asks. “Because they are so readily available, there is the risk that some people might not know what they are buying. The advisor may be explaining it well, but the client may not understand what the implications are.”

In the late 1990s, some of the most popular seg funds were based around index funds, which provided exposure to the roaring tech rally, while the guarantee provided a level of comfort for investors. As inflows soared, Lutrin says the manufacturers became excessively competitive in the features they offered.

“What happened was the seg funds became ridiculously structured, in that they became more and more attractive as there was less and less regard for the risks on the part of the life insurance companies,” Lutrin says. Maturity guarantees were increased from 75% to 100% and resets were introduced which allowed investors to lock in their gains.

But when the markets crashed in 2000, the manufacturers were left holding the bag. Suddenly they were on the hook for a 100% guarantee that may have been reset at the top of the market.

“The irony of those resets is that they’ve served the company very well,” says Lutrin. “What that’s done is, while they’re still on the hook for the gain, its staggered out the maturity dates. That is going to somewhat reduce the impact of a huge wave of maturities all at once.

“If you asked the carriers two or three years ago what they thought about it, they were really scrambling which is why you saw so many o f these products increasing their MERs, doing all kinds of things to minimize their exposure so as to cope with the onslaught of paying out these guarantees all at once. It’s not going to be as daunting as they originally anticipated.”

Not just another guarantee

The industry has matured a great deal since then, Lutrin says, to the point that seg funds are now essential products which cannot easily be replaced in a proper financial plan.

“Initially the frenzy was in regards to the guarantee, but over time I think there has been an elevation in sophistication on the part of the life advisor on the other features of a seg fund,” says Lutrin. “It’s now being sold as part and parcel of a financial plan.”

While principal protected notes and market-linked GICs may be capturing the mainstream press headlines, clients need to be educated on the difference between the new structured products and the benefits of seg funds.

“The estate planning benefits and life insurance aspect of it is way more prevalent in the conversation with the client,” Lutrin says. Unlike protected notes, the death benefit incorporated into a seg fund allows the capital to be paid out immediately to the beneficiary, bypassing probate and estate taxes.

“Because you’re able to nominate a beneficiary, just as with a life insurance contract, you’re able to bypass the estate,” he says. “Nothing gets wound up in the estate — there are no delays, no probate fees — and so there’s a huge attraction to that aspect of being in a segregated fund.

If the client is simply looking for a guaranteed investment product, though, he admits that protected notes have some advantages over seg funds. The typical seg fund offers only a 75% guarantee on maturity, with the 100% guarantee available mostly as a death benefit.

Also, the new wave of structured products tend to offer shorter maturities than the typical 10 year maturity on a seg fund. A shorter maturity reduces the primary source of risk in guaranteed products: opportunity risk. Because the investor will see their capital returned sooner, they will be able to redeploy their cash sooner.

“The amount of competition that overlaps between seg funds and PPNs, because of the guarantees, is really relatively minor,” Lutrin says. “I don’t think they have enough in common to go head to head against linked notes and other things.

“What I’ve noticed is that all these alternative products that keep springing up are very often attractive to a somewhat more aggressive market, not typically a life insurance client.”

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For more on segregated funds, please read the Segregated Funds eSupplement.

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(02/21/06)