Different versions of guaranteed income products have come to market over the years, reflecting changes in the investment environment, demographics and longevity. Initially, annuities were fixed-level income-generating plans, but they have evolved over time to incorporate features taking into account market fluctuations and inflation. Variable annuities, which are linked to market performance, were introduced in 1952 and have become the dominant guaranteed income product, representing more than $147 billion of the $220 billion annual sales of annuities in the U.S. in 2012, says LIMRA research.
Annuities in Canada have also experienced an evolution and a growth spurt, with different stakeholders promoting and bashing the investment strategy. Common to both views is the idea that annuities are a neglected way to buy peace of mind. Recognizing the primary investment challenge for retirees is to guarantee they don’t outlive their nest egg, annuities are a good tool for creating a guaranteed income for life.
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What’s at stake is loss of control of the funds and a potential loss in growth once a fixed annuity is implemented. Also, a low interest rate environment is perceived, perhaps not accurately, as an inappropriate time to invest in a fixed income annuity because payments might be lower.
While a fixed income annuity does result in loss of control, there are more flexible alternatives, and annuities are not solely tied to interest rates. In the pool of annuitants, there are significant mortality credits (i.e., yields) available to people who outlive those who die prematurely.
In the past 10 years, annuities in Canada have been on a roller-coaster ride. Fixed annuities were affected by actuarial and interest rate changes. And the landscape changed dramatically when Canada’s first guaranteed minimum withdrawal benefit (GMWB) was introduced on Oct. 23, 2006.
The GMWB appeal
With many attractive features, this product accrued more than $2 billion in assets for one Canadian insurer during its first 10 months. It gave investors the opportunity to protect their retirement investments against downside market risk by providing the annuitant the right to withdraw a maximum of his or her entire investment over a period of time until at least the initial investment had been recouped.
The first GMWB included the following:
• a 5% bonus increasing the guaranteed income for every year investors did not make a withdrawal for the first 10 years;
• a 5% annual income until the guaranteed investment was depleted; • the ability to make contributions up to age 75;
• resets to lock in market growth and potential increases every three years for 30 years; and
• easy access to the market value, subject to applicable surrender charges (early withdrawal fees).
The offering also included all of the standard segregated fund benefits, including creditor protection, estate benefits and a guaranteed death benefit equal to 100% of the deposit value. Investors could choose from 22 funds as the basis of the segregated fund investments.
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The product and marketing accompanying the GMWB’s launch opened the floodgates for a product that seemed too good to be true. It also opened a flurry of comments and discussion papers reviewing the merits of the GMWB as well as the additional fees for the guaranteed income. When added to the other fees, the guarantee brought the total cost up to about 3% annually— not an insignificant amount but one potentially warranted for those wanting peace of mind as well as the ability to get in on the stock market action.
Based on its success, the provider made substantial revisions to the original GMWB product about a year later, resulting in a new formula: the guaranteed minimum lifetime withdrawal amount contract. The 5% bonus would be extended for the first 15 years instead of 10. The 5% annual income would be available for life after Dec. 31 of the year the investor turned 65, and deposits could be made up to age 80. Market resets were available for life, and an additional three investment funds were added to the fund selection. All of these enhancements came without any additional fees.
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Concerned about being left behind, most of the Canadian insurance companies quickly developed their own products— and soon the insurance world was flooded with them. There were only minor differences between the product designs but significant differences in the available investments and fees. One provider built into its plan a 7% annual bonus and annual resets—the most robust contract on the market. These new variable annuities with predictable sustainable income, growth potential and downside protection were quickly becoming the new staple in Canadian retirement planning.
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Then came the global financial crisis. During that difficult time, issuers of guaranteed income products—especially those that weren’t hedged—were challenged with an increased requirement for reserves to back up the guarantees. Concerns regarding bank solvency, declines in credit availability and damaged investor confidence all led to a loss of confidence in global markets and a general economic slowdown worldwide. Regulators also required those issuing products with extended or lifelong guarantees to increase their minimum reserve requirements. (Regulators require a reserve for all insurance products that promise a guarantee.)
The financial world had changed, and the companies that developed and first brought the products to market were scrambling to raise capital. Those using a hedging strategy managed to limit the impact temporarily, but the continuing market volatility raised the cost to renew such strategies. The curve on the product’s profitability reversed itself, and the industry responded accordingly. The GMWB became too expensive to maintain.
Fees on these products were increased to the maximum contractually allowed, and some providers discontinued the product completely. Some reduced the amount that could be added to existing contracts to the RRSP maximum or less; others did not allow any additional contributions at all. Companies removed all equity-based funds for new contracts. The darling of investment vehicles and ultimate retirement planning solution— which once represented as much as 80% of all annual segregated funds in Canada—came to a grinding halt.
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GMWBs are still available today, but only a few Canadian providers offer them, and the products are not nearly as robust as they once were. Bonuses are lower, there are fewer investment options, fees are higher, and, in many cases, resets have been limited or discontinued. On the positive side, due to the low yield of other guaranteed investments (such as guaranteed investment certificates, at 1% to 2%), GMWBs are still popular among investors who want peace of mind and guaranteed income for life. In a reincarnated form, these products are slowly beginning to return. As with any retirement or investment plan, investors will have to consider the value of these reincarnated GMWBs and accept that they might change in the future.
Retirees will always be looking for a retirement plan offering performance guarantees and certainty that they will not run out of money in their twilight years. They will also be looking for high rates of return. Risk has its rewards, but retirement is not the time to take chances. In this volatile market, annuity contracts will continue to be popular among those who want peace of mind in their retirement years.
David Wm. Brown is a partner with Al G. Brown & Associates. dwbrown@algbrown.com
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