When helping clients with their financial goals, financial advisors need to achieve a balance between facilitating the growth of their investments and protecting them against unexpected twists of fate.
Even fortunate events such as an unusually long life can be challenging to plan for, and advisors need an arsenal of complementary strategies to deal with various possibilities.
It often makes sense to provide for a portion of guaranteed income within the financial plan, particularly for those clients who don't have a defined-benefit pension plan that will provide them with some level of income for life. A useful safety net can be constructed with insurance products offering guarantees on regular income, including products with a guaranteed minimum withdrawal benefit (GMWB) and annuities.
"We include insurance products as an asset class," says David Irwin, certified financial planner and regional director with Investors Group Inc. in Pickering, Ont.
The most effective financial plans often combine these guaranteed insurance products with traditional equities and fixed-income securities in a multi-layered approach that allows for security of income as well as some flexibility and inflation protection.
Recent research from Toronto-based Sun Life Financial Inc. found about 70% of survey participants feel a guaranteed retirement income for life is "very important," but most weren't knowledgeable about annuities or the benefits they provide.
Many clients are more comfortable when at least their basic living expenses can be covered by some kind of steady, reliable income. Canada Pension Plan and old-age security, work-related pensions and lifetime income insurance products can all play a part in creating this secure income stream, leaving clients better able to weather the ups and downs in other parts of their portfolios.
"For some clients, annuities are a good idea as they can protect the principal and provide a safe, tax-efficient income stream," says John Nicola, chairman and CEO of Vancouver-based Nicola Wealth Management Ltd.
Annuity contracts are tied to interest rates at the time of purchase, and for annuities purchased in today's low interest environment, the income will not be generous. However, the client's age also factors into the level of income that annuities provide, and if a client waits until a later stage of life to make the purchase, the terms can be more generous.
Moshe Milevsky, professor of finance at the Schulich School of Business at York University in Toronto, has suggested 65 as the minimum age to buy an annuity, but says this product can even make sense for a 90-year-old in good health. Many advisors find that buying an annuity when clients are in their mid-70s offers favourable terms and potentially lots of time to enjoy the guaranteed income.
"I like the idea of purchasing an annuity around 75," says Fred Vettese, chief actuary at Toronto-based human resources consulting firm Morneau Shepell. "An annuity can be a better option than bonds for the fixed-income side of a portfolio. The terms are better and the income is secure and more tax efficient."
Rather than committing a large lump sum to an annuity all at once, Milevsky suggests spreading annuity purchases gradually over a three- to five-year period to take advantage of any rise in interest rates.
"There is a lot of interest rate risk with market rates going up, and it's wise not to put all your money in an annuity at once, and instead stagger purchases over time — maybe $25,000 now and $25,000 later," Milevsky says.
It's also a good idea if committing a large amount to an annuity strategy to diversify by insurance company, he says, and to check the financial stability and credit rating of insurance product issuers carefully.
Ordinary annuities have their drawbacks. For example, there's no cash-out feature, maturity date or ability to increase the payments. Once cash is committed, it cannot be redeemed; and upon the client's death, the proceeds are usually not available for heirs. However, many annuities offer bells and whistles such as inflation protection through indexing or the ability to transfer to a spouse upon death of one partner, but there are costs for these extras.
One of the key benefits of an annuity, Milevsky says, is that is doesn't have to be managed once it has been purchased, and a predictable stream of income flows to the client for life, whether that is one year or 40, and whether financial markets rise or fall.
Essentially, he says, annuities are "senility proof." As there's no access to cash in annuity assets, the investment is protected from greedy relatives or fraudsters, as well as from poor decisions on the part of the client if, for example, dementia sets in.
"The unquantifiable aspect of annuities is the peace of mind they provide," Milevsky says. "It's income you can't outlive, and once you've bought the annuity there are no ongoing decisions. As the client ages, the cheque will always be in the mailbox. When I'm 80, I may not be as eager to manage and rebalance my portfolio. And when I'm 90 or 95, I may not be capable. I don't want to be thinking about whether I need more international exposure in my portfolio at that stage."
A portion of a client's assets can also be invested in products with a GMWB, which some insurance companies sell. These products typically offer a guaranteed annual income of 4% to 5% and have more flexibility than annuities. GMWBs offer potential for growth in the underlying investment portfolio from which the income is derived, typically a mix of equities and fixed income. However, growth is reduced by product fees that are typically higher than traditional mutual funds.