Investment hybrids

(July 2006) The theorem “keep ’em separate” no longer applies. As baby boomers begin to retire, expect to see more product innovations that combine investments with insurance.

Annuities or segregated funds are only the beginning, says Moshe Milevsky, executive director of the Individual Finance and Insurance Decision and associate professor of finance at York University in Toronto. “These are products that will attempt to create systematic withdrawal plans that last for the rest of your life,” he told attendees of the Morningstar Canada investment conference in early June.

As clients retire, advisors will need to shift from being wealth managers to risk managers, he adds. They also will need more holistic advice since proper risk management is a combination of asset allocation and product allocation. “Once you’re in retirement mode and withdrawing money, suddenly the insurance and financial decisions need to be taken together,” Milevsky explains.

Accordingly, to help clients prepare for the transition, advisors need to make sure their clients understand all the risks, Milevsky adds. The risks include:

1. Longevity: This is the risk of outliving your money. Many advisors tend to underestimate the lifecycle of a person, so consider the various mortality rate tables, as well as other factors, such as family history, health and gender, to ensure retirement income lasts as long as clients do. Mortality credits are at the heart of every annuity product, Milevsky notes. “There are behavioural risks associated with longevity,” he explains. “It’s not just about assuming you’re going to live for another 20, 30 or 40 years. The odds of living to any given age are random and that randomness needs to be taken into account.”

Milevsky cited a National Bureau of Economic Research study that showed investors’ perceptions of their own mortality risks are systematically biased. The study found that people with relatively low life expectancy tend to be over-optimistic while those with relatively high life expectancy tend to be more pessimistic. Meanwhile, according to some longevity tables, “the odds that a 65-year-old female will make it to the age of 90 are about 34%,” Milevsky cites as an example. “That’s about a third chance you’ll live and that’s 25 years of retirement income that you’ll need.”

So, how much of clients’ income is longevity-insured or needs to be? In the case of someone like Milevsky, he already has his longevity insurance covered since he will receive a defined benefit plan — inflation-adjusted income for the rest of his and his spouse’s life. Someone who isn’t in that situation may need a significant portion of their portfolio in a fixed withdrawal product.

2. Inflation: Is the income keeping up with cost of living? Clients need to know that over the long run, the purchasing power of income will be eroded without any inflation adjustments. “Too many people think of income in nominal terms,” explains Milevsky. “We have to pay more attention to real income and, in some sense, income that’s after inflation for retirees as opposed to for the population as a whole. Over a 30-year period, inflation can slice a half to three-quarters off your income.”

Jamie Golombek, vice-president, tax and estate planning, at AIM Trimark Investments, concurs. While seniors generally like GICs because they are deemed “risk free,” an AIM Trimark study shows one-year GIC returns for the years 2000 to 2005 failed to keep up with tax and inflation.

Golombek recommends clients consider insured annuities as part of their portfolios instead because they will have more monthly after-tax income than they would with a GIC — for the same amount of investment (see Insured annuity vs. bonds/GICs below).

Annuities may also bring more peace of mind to certain clients. “When you buy a GIC, you are subject to reinvestment rates. You have no idea five years down the line what your reinvestment interest rate might be,” he told attendees of the Morningstar conference. “But if you buy that annuity today, you know forever. You’re guaranteed to know how much money you will get for the rest of your life.” He only recommends a portion since once an annuity is purchased, it’s an irreversible decision.

3. Timing of Withdrawal: When a client retires affects how long his money will last, even though he has the same asset allocation, investments and advisor as someone else who retires three years earlier or later. “While proper asset allocation reduces risk and improves the sustainability of a portfolio, there is a certain amount of financial risk that cannot be removed by asset allocation alone,” Milevsky says. “When I’m sitting at retirement on this enormous amount of wealth and I’m starting to withdraw, I’m taking a risk here that the asset allocation isn’t going to be able to help me. It’s not a matter of ‘OK, let’s move to bonds’ because it’s not about asset allocation anymore, it’s about protection and risk management.”

Accordingly, you want the first few years to be positive returns, even if it means delaying retirement and investing more for this to happen.

Product developments

Many product innovations have already emerged in the U.S. that may likely make their way to Canada one day. Long-term care insurance merged with an annuity is one example, says Milevsky. So, if a policyholder has to go into a nursing home prematurely, the expense is covered. But if the policyholder doesn’t have to go to a nursing home and is healthy for the rest of her life, the policy will still pay out.

Another product development is what Milevsky calls advanced life longevity insurance, which only pays out if you exceed life expectancy. So if you purchase this policy in your 40s, it won’t pay out until you reach age 85. “If you don’t make it to age 85, you get nothing,” he says.

Why bother paying for a policy that you either won’t receive for over 40 years or not at all? Milevsky says the monthly premium will be so trivial — around $30 — and if you do make it to age 85, you will end up with an enormous payout.

Finally, the U.S. has a guaranteed minimum withdrawal benefit on some products where clients pay 5% to 10% a year to protect their assets. “This mitigates the risk where early in the retirement, you don’t want to worry about having -13%,” Milevsky explains.

INSURED ANNUITY vs. BONDs / GICs
	Bond/GIC option	Insured annuity option
Amount of investment	$300,000	$300,000
Monthly income	$1,250	$2,350
Monthly taxable income	$1,250	$433
Income tax	$375	$130
Monthly insurance cost	0	$1,076
Net after-tax monthly income	$875	$1,144
Increase in net after-tax annual income
• $ increase		$3,228
• % increase		31%
Guaranteed bond / GIC rate required for same after-tax income		6.5%
Designed for: male, non smoking, age 70 Assumptions: bond interest rate 5%, marginal tax rate 30%, annuity (no guarantee), life insurance (T-100, gurantee premiums)
Source: AIM Trimark Investments

This article originally appeared in Advisor’s Edge Report. Filed by Deanne Gage, Advisor’s Edge, deanne.gage@advisor.rogers.com

(07/01/06)