Allocating your client’s buyout

The latest wave of labour buyouts, particularly in the Canadian manufacturing sector, presents complex challenges for employees and the advisors who have them as clients. Probably the most pressing issues are what proportion of their severance package should be allocated to guaranteed income and what products should be used.

“I think the topic is part of a bigger personal finance issue regarding how much retirement income should come from defined benefit pensions and their implicit life annuities, versus income from discretionary liquidation of an investment portfolio,” says, retirement expert Moshe Milevsky, director of the Individual Finance and Insurance Decisions Centre and an associate professor of finance at the Schulich School of Business at York University.

Milevsky says advisors are going to have to be looking hard at the product allocation of employees who take a retirement package buyout, to ensure they have a combination of guaranteed income in conjunction with an investment portfolio that can provide a rate of return to protect the client against longevity risk.

This can be complicated. If you take the example of the recently-announced buyout deals for General Motors workers in Oshawa, Ontario, you have a range of employees in different situations, although most are middle-aged. At the top end, you have some workers who are receiving generous lump-sum payments of more than $100,000 retirement incentive payments on top of guaranteed defined benefit plans. More likely, most of the employees come out with a combination of a lump-sum severance buyout and partial pension plan benefits.

“As a rule of thumb, I would look at one’s total investment assets, including the present value of the DB pension income, and would counsel that at least 50% to 60% of assets be allocated to guaranteed sources of retirement income, such as DB pensions and income annuities,” Milevsky says.

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The one constant advisors need to remember for workers who take early retirement is that their money has to last. Since they were likely not of eligible retirement age, advisors must take into account the clients’ extended income horizon. Milevsky highlights they will have to maintain a large chunk of their portfolio in equities, to offset inflation and longevity risk.

“A typical 50- or 55-year-old worker still has sufficient time until they need the funds — and quite a bit of time in retirement — that they can afford to take on some more financial risk, especially if they can rely on a DB pension for some of their income. With inflation rates at 3% to 4%, and possibly higher for retirees, I’m not sure how a conservative bond-based portfolio will keep up with retirement needs,” he says.

If a client doesn’t have a DB plan or it doesn’t reach the 60% guaranteed threshold, then they are most likely going to want to consider using some sort of life annuity product. Guaranteed minimum withdrawal benefit products, a type of variable annuity, will be a natural choice for some advisors, since these products will offer guaranteed income for life, alongside an equity component that can work to reduce inflation and longevity risk.

“These are excellent pension substitute products for risk-averse clients who are willing to give up some upside return because of higher MER fees in exchange for the peace of mind that comes with the guaranteed products,” says James Kraemer, a Winnipeg-based CFP with TFI Financial Services. “These are especially useful for people who may be close to retirement but not quite there, as a 5% simple return is guaranteed in years prior to drawing on the investment and a lifetime income guarantee is available after age 65.”

The high-fees on GMWB products do concern advisor Jim Otar, who runs RetirementOptimizer.com. He says advisors who opt for a GMWB should plan for it only as a guaranteed source of income for their client and should not expect there to be much upside growth in the portfolio that can be reset.

“When you add the fees and when you add the withdrawals, the probability of resets going up is minimal,” he says. “You need to have about a 25% return over three years in the portfolio before you see any possibility of [a positive] reset. It’s very unlikely when you look at historical rates of return that it will happen. You need a 25% three-year return to essentially break even. Over the course of three years, the withdrawals will be15%; the insurance company takes roughly 3% each year, so that’s 9%. That’s already 24% [of the portfolio depleted].”

Otar says the first product he would be looking at to create a guaranteed income stream for a client is an inflation-indexed annuity.

“My first choice would be a life annuity, and short of that it would be a GMWB product,” he says. “With the indexed annuity, you give the money to the insurance company and the insurance company pays you as long as you live. You could choose to take 3% inflation growth or even have it indexed to the consumer price index — anything you want. You know exactly what you’re getting for the rest of your life, guaranteed.”

With these types of annuities, the client gets paid less in the beginning, or in some cases payouts may be deferred for a number of years. Also, clients lose the flexibility of being able to access their money.

“The money goes to the insurance company. It doesn’t belong to you anymore,” Otar says.

If the client is looking for a steady income stream alongside equity exposure, they might want to consider using a non-guaranteed retirement payout product in tandem with a guaranteed form of income. Products such as Fidelity’s Income Replacement Portfolios don’t have the principal protection, but they do offer marginally lower fees and flexibility.

Darren Farkas, vice-president of product solutions for Fidelity Investments Canada, suggests that such a product may be the right fit for clients who take a retirement buyout, since they are designed to work as an income solution in conjunction with guaranteed sources of income.

For instance, a 55-year-old client with an early retirement package could buy a 10-year target date income replacement portfolio alongside a GMWB, with the former providing income until their GMWB payout kicks in at age 65, Farkas says.

“For the ten year, 2017 portfolio, the first year annualized payment is just under 11.5%. That may provide that additional cash flow they need during this additional time period until retirement,” Farkas says. “There are certain benefits with GMWB when you delay taking payments from them. One of the approaches we think is very worthwhile for many is to buy a GMWB and maximize those bonuses by using the income replacement portfolios to delay taking the payments. You use the income replacement portfolio to bridge that income gap until you need to start taking the money from the GMWB.”

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

(07/30/08)

Mark Noble