The “Fraud” of Guaranteed Minimum Withdrawal Benefits

In response to Mr. Callahan’s article in the March issue, I would like to present a dissenting, and perhaps more realistic view of the merits of the Guaranteed Minimum Withdrawal Benefit. It can look good on the surface – income for life! You can never outlive your money – we guarantee it! That’s quite a promise. No matter what happens to your investments or how long you may live, you will never run out of money. And the illustration that accompanies the sales pitch convinces you that total financial ruin is just around the corner. But if you look beyond the hype and fear-mongering being perpetrated by the Canadian insurance industry (as well as at least one of the major chartered banks), you will discover much to your dismay, that the implied promise is expensive, and in many instances, may be of little value! It is important at the outset to understand the nature of the “guarantee” included in the current GMWB offerings. For an annual fee, which ranges from about .40% to almost 1.0% (depending on the company and asset class being insured), the insurance company will guarantee a fixed annual percentage payout, usually around 4.5 – 5% of the initial investment, depending on the age at which payments commence. This fee would be in addition to the base fee of the underlying investment, which itself could be 2.25 – 3.0% per annum. This annual payment may, under some circumstances, increase but will never decrease. That is regardless of future investment returns on the underlying assets or your longevity. Sounds great! That is, until you analyze the guarantee, how it is structured, and the magnitude of the premium you must pay for it. No funds are actually received from the insurance company until the investment account is completely exhausted, which may be many years in the future – if at all. For example, if investment returns exceed 5% per annum (i.e. sufficient to cover the annual payment), no “insurance” is necessary. In fact, returns can be as low as 0% per annum, and if the policyholder dies before the end of the 20th year, no “insurance” is provided either. Until the fund is reduced to zero, the fund is able to pay all of the annual payments. The premium described above is paid every year as long as the plan continues in force with the insurance company.

The guarantee in the GMWB applies to two mutually exclusive contingent events – investment rate of return and life expectancy. The following chart may be helpful:

In only one of the four quadrants – low rates of return (something less than 3.0% per annum) and long life expectancy (over about 25 years) - would the guarantee have any value to the purchasers. In all other instances – higher rates of return or shorter lifetime of the annuitant, the guarantee is of no value whatsoever. With higher rates of return, the investments generate sufficient income to meet the annual payout requirements. Persons with shorter lifetimes will die before the fund is exhausted. It should be noted that life expectancy for males and females at age 65 is respectively 18 and 21 years. As mentioned earlier, even an annual return of 0% every year for 20 years wouldn’t require insurance should death occur before 20 years. Furthermore, since 1960, when data was first collected, there has NEVER been a 10-year time period when rates of return on balanced pension funds have been below 5.0% per annum – and that includes the most recent 10 years ending December 31, 2010. In fact, there has never been a five-year time period that experienced negative returns. Should the rates of return shown in the charts accompanying Mr. Callahan’s article come to fruition, there is likely to be a much more serious problem to be faced, namely the very survival of the Insurance Company that issued the GMWB. Could any insurance company survive a 10- year period with an annual compound rate of return of -7% as indicated in the illustration? Assets would lose 50% of their value in less than 10 years! Unless a government bail-out is provided, many Canadian insurance companies would go the way of Confederation Life under this investment scenario! The illustration included rates of return that have no basis in historical fact. Each year, the Canadian Institute of Actuaries compiles a “Report on Economic Statistics” which covers data back to 1924. In particular, the Report includes data on the rate of return of Canadian pension plans, with data from 1960. I have used this data as a proxy for the rate of return that might have been earned by balanced mutual funds. The lowest median rate of return earned by Canadian pension funds occurred two years ago in 2008 when a rate of return of -15.9% was recorded. The previous low return was in 1974 when the median balanced fund earned a rate of return of -12.7%. The only instance of two consecutive negative years was in 1973 and 1974 when a return of -2.1% preceded the loss noted in the following year.

People often make investment decisions based on such illustrations. It is, in my opinion, disingenuous and very misleading to show investment scenarios of the sort included in this article. The chart below provides, I believe, a more plausible illustration. To be fair, it begins with a negative return in the first year followed, as is usually the case, with a strong recovery and then an assumed rate of return (net) of 5% per annum for the next six years, followed finally by a 4% return until the fund is exhausted - when the annuitant is age 101! In much of the marketing material used by the insurance companies, illustrations are shown which are based on remote or highly improbable events and returns. While “anything is possible” in the realm of financial markets, the scenarios put forward in the marketing material are remote, at best. This is an example of an insurance product that preys on the ignorance and fears of retirees. So as not to exclusively pick on the insurance industry, the Bank of Montreal has also recently entered this market with a product which pays out 6% of the initial invested amount after a 10- year deferral period. They guarantee this level of payment for life. For the first 15 years, payments are deemed to be a return of capital, and are received by the annuitant tax free. Following the first 25 years (10-year deferral period and 15-year payout), all payments would be fully taxable. Besides being an illiquid investment for 25 years, the product comes with an annual management fee of 2.75%, almost 2.0% higher than many similar mutual funds that don’t offer this so-called “guarantee.” The insurance industry has recently taken exception to this product being offered by a bank, claiming it to be an annuity, which is their exclusive domain. So what are the options available to retirees who are looking for a “guaranteed” or at least a reliable source of income in retirement? The traditional annuity products are still available from the same insurance companies, but at today’s historically low rates, they may not be an attractive choice. (This is the subject for a future article!) Alternatively, many financial advisors recommend to their clients a “high income” fund which consists of fixed income securities, both government and corporate, as well as dividend paying equities, income trusts and preferred shares. The return from this type of investment, from both income and capital appreciation, is usually targeted to be about 5 - 6% per annum, or about the same as the payout from the GMWB, but obviously without the guarantee. This type of financial product would also be available at a lower cost that the costs associated with the GMWB products. Limited data suggests that persons who purchase funds which are subject to a GMWB are less inclined to sell their holdings when returns are poor. This is in contrast with investors who are unwilling to hold onto their investments when markets are in decline. To that extent, the benefit is worthwhile, since it keeps people invested through market downturns. For security-conscious individuals, GWMB may provide a means of obtaining lifetime income at a modest level with complete certainty – albeit at, in my opinion, an expensive price. The added fee that is paid for the GMWB reduces the return to the investor and increases the likelihood of failing to meet the return objectives of the investor.

To summarize, my concern with the GMWB is both with respect to the high fee that is charged for the underlying guarantee, and with what I think is a fundamentally flawed product that exploits the fears of retirees by using misleading advertising illustrations. Insurance companies create products that (ideally) satisfy a need, and generate a profit for the insurance company. In this instance, the insurance industry created the need where perhaps one did not previously exist! No, I’m afraid I would put GMWB in the same class as such other ill-conceived insurance products as product insurance (the insurance they try to sell you when you buy an electronic gadget), accidental death and dismemberment and critical illness insurance. Quite frankly, I would recommend taking a pass on all of these!