Fixing fixed income

By Bruce Cumming and Peter Hanson | July 29, 2013 | Last updated on July 29, 2013
4 min read

Uneven market performance and the current low-interest-rate environment have left many Canadians expecting to retire in the next 10 years without sufficient nest eggs.

An optimal asset allocation has always been the backbone of investing retirement savings, but the old way of going about it needs to be left behind, especially when it comes to fixed income.

Say a client is about to retire and would like a 5% return, but doesn’t want to take on a lot of risk. So you put her in a 50/50 asset mix. The current yield on fixed income is close to 2%, meaning the equity component needs an annual return of 8% if the portfolio is going to earn the requested 5%. This is very unlikely. The problem is not the equity return, but the measly fixed-income return of 2%.

So let’s rethink fixed income.

Look to annuities

Annuities can help build guaranteed portfolio returns. We’re aware of the aversion some have to annuities so let’s address some myths.

Destroying capital

Some claim life annuities kill clients’ capital. But what does it mean for clients’ retirements if you continue to put half their money into investments yielding 2%? A small yield like this will destroy capital. Earning a 6%-to-7% cash flow (not rate of return) from an annuity will help to avoid or slow down that inevitable capital erosion. One of the best attributes of a life-only annuity is that the client will never run out of money.

Low interest rates

With interest rates so low, we constantly hear this is the wrong time to recommend annuities. But the reverse is true. An annuity purchased today does not become a bad investment until fixed-income yields go above 6%. Interest yields will probably not go north of 6% soon.

Also, the investors will have peace of mind knowing she has guaranteed monthly income she won’t outlive. When rates rise, traditional fixed income will take it on the chin. And those rate hikes will likely result from rampant inflation. In this case, the other 50% of the client’s portfolio, which was invested in equities, should perform well. Get that annuity yield before interest rates go up.

Term-certain annuity

The term-certain annuity offers even more opportunities. This is a great option if the client is younger or getting ready to retire, but does not have the best health history. A client in his 50s wouldn’t be a good fit for a life-only annuity, but a 20-year term-certain annuity is worth considering. If she is worried about losing capital, the term-certain annuity is a good fit.

If she dies before the end of the annuity term, the beneficiary will receive the remaining payments in a commuted lump sum. A client with an uncertain health history could take advantage of the term-certain annuity.

There are many benefits when considering annuities, including a guaranteed monthly income. It’s a simple product that’s easy to explain, and we’ve never seen the payments from an established annuity dry up. Plus, you never have to do a portfolio review, and clients don’t have to watch the newspaper to see how it’s doing.

They’ll never have to worry about stock markets, interest rates or currency fluctuations. Non-registered and term-certain annuities enjoy compelling tax advantages (see “Annuities at work,” this page), because some of the income represents return of capital. (Note term-certain annuities cannot be purchased with registered funds.)

We’re facing a unique situation: because interest rates are so low, it’s the perfect time to buy annuities. Yet our industry puts down annuities because interest rates are low and people think the client’s original capital is destroyed. But if we keep investing the way we have, capital will be destroyed anyway.

Annuities at work

Imagine you’re dealing with a new widow, Merle, who is 70 years old and in good health. She owns some real estate but suddenly finds herself managing a $1-million portfolio invested exclusively in GICs and bonds. Her husband had been burned in the stock market and thought this was a riskless strategy.

For simplicity, assume the $1 million is in non-registered funds and she needs $70,000 of income from her portfolio. Given Merle’s low risk tolerance and minimal financial knowledge, a 50/50 asset mix is appropriate. Her aim is to generate $35,000 from her fixed-income portfolio and another $35,000 from the equity component.

On the fixed income side, investing $500,000 in a bond/GIC portfolio earning 2% produces $10,000 of annual income. Since Merle needs to generate $35,000, she’ll need to withdraw $25,000 of capital. This means Merle’s fixed-income funds will be exhausted in 17 years. Alternatively, if she purchases a life-only annuity, her annual income would be $35,000 and she’d never run out of money. And less than $5,000 of this income would be taxable (prescribed taxation rules). Plus, she still has financial flexibility with her equity and real estate assets.

If Merle’s advisor waits for interest rates to rise, more capital will be consumed. When rates do rise, her capital will be depleted to the point where she’ll only be able to afford a smaller annuity, and the long-awaited interest rate hike will provide no benefit.

$500,000 Investment Options

Traditional Investment @ 2% Life Only Annuity 70-Year-Old Female (1)
Annual Income $10,000 $35,184
Taxable Income $10,000 $4,884
Required Income $35,000 $35,000
Capital Shortfall $25,000 $0
# of Years Sustainable 17 Lifetime

(1) Annuity Quote provided by CANNEX Financial Exchanges Limited and is effective February 6, 2013. Payments commence one month from the rate effective date and are made to the annuitant until her death with seven years guaranteed.

Bruce Cumming, RFP, CLU, CHFC, CIM, CHS, TEP, EPC, FCSI, is a Director, Private Client Group & Senior Investment Advisor with DWM Securities Inc. and Peter Hanson, MBA CFP, FCSI, is an advisor with DWM. This is not an official publication of DWM Securities Inc. The views (including any recommendations) expressed are those of the authors alone.

Bruce Cumming and Peter Hanson