While guaranteed minimum withdrawal benefits have mostly fallen out of favour, advisors should know how they work. More recently, a new twist on the old-fashioned annuities known as advanced life deferred annuities has hit the market.marchmeena29/iStockPhoto / Getty Images
This is the second in a four-part series examining the decumulation product landscape in Canada and how advisors can explain the options to clients. Read Part 1 here, Part 3 here and Part 4 here.
In the mid-2000s, a new longevity product hit the Canadian market: a segregated fund that came with the standard maturity and death benefits of 75 per cent or 100 per cent, plus an additional benefit – guaranteed income for life.
These were called guaranteed minimum withdrawal benefits (GMWBs). While these products have mostly fallen out of favour, advisors should know how they work for clients who still hold them.
More recently, a new twist on old-fashioned annuities known as advanced life deferred annuities (ALDAs) has hit the market, albeit slowly. Here’s a breakdown of how these two options fit into the decumulation toolkit.
GMWBs: still a relevant option
Introduced just before the global financial crisis, the pitch for GMWBs was essentially a minimum income for life that could go higher with market performance, all for an additional 0.4 per cent to 1.15 per cent fee, depending on how volatile the underlying seg fund was. Actively managed seg funds already came at a premium, but even with this additional fee, this mutual fund/annuity hybrid was attractive.
The timing couldn’t have been better as panic about the market crash in 2008-09 increased consumer demand for guarantees. GMWBs were the hottest-selling innovation for several years until their guarantees proved too rich for the insurers. Then, in light of new regulatory reserve requirements, guarantees were first reduced on newer versions of GMWB contracts before they eventually disappeared from the market.
In 2017, The Empire Life Insurance Co. brought these products back. This new version hasn’t caught the attention of the market the way previous GMWBs did, likely due to the combination of higher fees and lower payouts.
While the newer GMWBs aren’t widespread, many clients are still invested in the older versions. So, how should an advisor approach existing GMWBs?
Given these products provide guarantees at levels no longer available, a move away from them requires careful consideration. Too often, these products are dismissed solely based on cost. Advisors must consider the client’s age, health, life expectancy, assets and need for guaranteed income.
Clients who bought GMWBs when they were near or in retirement are probably at least in their mid-to-late 70s and have been taking income distributions for more than a decade. As such, their market values are likely considerably lower by now, while the payments received haven’t changed.
Even in the case of partial withdrawals, special consideration needs to be made. A cash withdrawal beyond the GMWB’s scheduled minimum payments is a gift to the insurer, as it allows the insurer to recalculate the GMWB payments based on today’s account value.
Advisors should also assess the client’s situation in a financial plan. Unfortunately, financial planning software doesn’t support GMWBs and is incapable of modelling the impact of volatility on the market value or guaranteed income from the seg fund.
The safest route is to replace the investment in the planning software with a life annuity equal to the guaranteed payout. This approach has its limitations, but a good starting point is determining the Monte Carlo score of the client’s situation with GMWBs, and if the GMWBs were sold and reinvested. The difference between the two scores will inform the discussion about whether this product is needed.
ALDAs: The newest longevity product on the market
Despite being announced in the 2019 federal budget, Desjardins became the first insurer to issue the product in December, 2023.
An ALDA is a registered annuity that can be purchased from age 55 to 80 and must start paying out income at 85. The earlier a client buys and the later they start receiving income, the higher the payout. On death, there’s a guaranteed refund of premium of net deposits, meaning the annuitant will get back at least what they put into it. The limit on ALDA purchases for 2024 is a maximum of 25 per cent of an RRSP’s value, up to $170,000.
The ALDA’s use of registered assets and deferral of income to later years accomplishes two things:
- It reduces the amount invested in a RRIF, thereby reducing minimum payment distributions. For people working past 71, this can be an effective tax management tool.
- It focuses on tail risk. Those who live the longest benefit most, but these are the same people most at risk of running out of money.
Here’s how ALDAs can impact a client’s situation.
Let’s take the example of a 65-year-old couple retiring today with full CPP and OAS benefits, combined RRSP assets totalling $1.36-million and earning 5.22 per cent annually, who spend $100,000 a year adjusted for inflation. They would bounce their last cheque in the year they turn 95.
When you factor in sequence of return risk, at age 85 (approximate life expectancy) they have a 12.5 per cent chance of running out of money. This increases to 35 per cent at age 90 and 63 per cent at age 95.
But say this couple purchased the maximum ALDA ($170,000 each) on Jan. 1 of this year. They would have guaranteed $6,010 a month for the husband and $4,977 a month for the wife starting at age 85. Their RRSPs would be reduced to a total of $1,020,000, thereby reducing the pool of assets available – and the dollar value of the potential return earned by those assets – to finance their lifestyle prior to age 85.
On a linear basis, the plan works better than the baseline plan. Not only are they able to meet their spending needs, but when combined with CPP and OAS, the ALDA results in surplus income from age 85, which gets reinvested and results in an account value at death (assumed at age 95) of $238,200, versus $0 in the baseline case.
However, something very different happens when the plan is subjected to Monte Carlo analysis. At ages 85, 90 and 95, the use of ALDAs results in a 100 per cent success rate versus the 12.5 per cent, 35 per cent, and 63 per cent probability of failure without it. However, it’s not the advanced years that are the concern – it’s the years prior to the ALDA kicking in. The reduced asset base to finance the earlier years of retirement increases the possibility of ruin between age 75 and 84: what starts as a 1.2 per cent probability of ruin at age 75 increases to 49 per cent at age 84.
So, why would anyone chance running out of investment assets in their late 70s to early 80s? First, the shortfall is short-lived. The probability of ruin only starts to hit concerning levels at age 81 (25 per cent). Should this short-lived deficit happen, shortfalls could be financed through a home equity line of credit or other forms of debt until the ALDA payments start. Second, the ALDA produces an annual surplus. If there’s a short-lived period of ruin and the need for debt, the debt can be repaid with that surplus.
Next week, we examine tontine products.
Jason Pereira is a senior partner and financial planner at Woodgate Financial Inc. in Toronto.