For many people nearing retirement, investing is all about the principal. Such clients are prepared to sacrifice returns and pay higher fees as long as their all-important nest eggs are protected from risk.

Traditionally, the safe choice for these clients was a bond or guaranteed investment certificate. But although these conventional types of investments provide a regular income stream without risking capital, the interest income on bonds and GICs is taxed at the highest marginal rate. In fact, professor Moshe Milevsky of the Schulich School of Business at York University in Toronto has concluded that over time, GICs tend to offer negative real returns.

Alternatives for risk-averse clients include segregated funds, which are appealing to more and more conservative investors, attracted by the blend of mutual fund and insurance components, including the guarantees that apply upon maturity and death. Typical payouts upon maturity (usually after 10 or more years) include the option of cashing in the fund and getting back at least 75% of the original investment. A 100% death benefit guarantee is also standard. Other standard seg fund features that are clicking with more clients include protection from creditors and probate bypass, with death benefits going directly to the beneficiary.

It’s important however, to make sure that your clients appreciate the sometimes substantial fees that go with these added benefits. “The greater the guarantee, the higher the fee,” says industry analyst Dan Hallett, president of Windsor, Ont.-based Dan Hallett & Associates Inc. “Some fees are in the 4% range, which is about double the cost of the underlying mutual fund version of most seg funds, although the two are identical in terms of market exposure.”

Compared with other options, some clients may find such costs too high. It’s unlikely, for instance, that a well-constructed portfolio would lose money over the 10 years it takes a seg fund to mature, Hallett points out: “If you want a maturity guarantee, buy a plain government bond or a GIC that guarantees return of principal and interest.”

Mike Watkins, a financial advisor with Edward Jones in Duncan, B.C., is more positive: “With seg funds, there’s no cap on how much you can grow, depending on the product you’re in, so you combine the security of a GIC with the growth potential of an equity investment. And the underlying securities tend to flow through the dividends or capital gains, so they’re more tax-efficient than bonds and GICs.”

A recent variation on the traditional seg fund is the seg fund with a guaranteed minimum withdrawal benefit, an optional rider on the seg fund policy that ensures the investor can withdraw up to 5% of the investment annually for at least 20 years. The underlying investment is often linked to a mutual fund, and if that fund appreciates in value, there may be a reset option that lets the investor lock in the higher principal amount, which allows larger withdrawals. (For more on GMWBs, see page B16.)

Then there is the newer generation of products designed to balance principal protection with upside potential, including principal-protected notes and target-date funds. These also have generated comments that their associated fees are too high and that the guarantee of principal protection can carry an opportunity cost that is difficult to justify.

“The provider takes 80% of the total investment and locks it into a zero-coupon government bond that’s guaranteed to mature on the same date as the PPN,” says Al Kellett, a senior fund analyst with Morningstar Canada in Toronto. “The other 20% is leveraged up five times; so, in theory, you’ve invested the full $100 in the underlying mutual fund or hedge fund.”

The problem, he says, is that leveraging comes with a cost that erodes the return: “There’s a difference between investing $100 and investing $20 in a five-times-leveraged version. Such investments can easily be wiped out if they start to slide. If they drop by 20%, your equity is gone forever.”

There are many costs associated with PPNs, agrees Dan Richards, president of Toronto-based Strategic Imperatives Corp. But because of a lack of transparency, these can be difficult to isolate. “PPNs have consistently disappointed most inves-tors,” he says, “and the cost structure [has] made it difficult to generate a positive investor experience.”

Last year, thousands of inves-tors learned that because of market losses. They had no chance of ever making money on the PPNs they purchased from financial services institutions, including Bank of Nova Scotia, Royal Bank of Canada and Bank of Montreal. The investments underwent “protection events”; noteholders will only get their principal back when the investments mature.

@page_break@The performance of many target-date funds has also disappointed, says Richards. Also known as “life-cycle” funds, target-date funds are designed to be held for a set number of years; they suit clients who have specific financial goals that carry fixed dates, such as retirement at a particular age.

Target-date funds typically invest in a diversified mix of mutual funds or an index and automatically reduce equities risk as the client’s “target date” approaches. Automatic rebalancing of assets within the portfolio keeps it aligned with the planned asset mix.

Investors are guaranteed either the highest monthly or daily net asset value, provided they keep the funds to their maturity date. If the market falls below a preset trigger point, the provider sells part of the investment and buys government bonds or converts to cash, which protects against the downside.

That’s what happened to some target-date funds from Toronto-based Mackenzie Financial Corp. and BMO, which have shifted into all bonds in the past year. Some target dates were as late as 2025, so investors will have to wait until then to get their fund’s best return.

Such events, along with the market rally, have combined to lower the demand for guaranteed products, says Watkins, who doesn’t expect to see any new offerings in the foreseeable future.

Nevertheless, he believes, they have a place — especially for investors who would otherwise avoid equities — provided the costs and structure are fully understood.

That’s easier said than done, says Hallett: “These are complex products that are difficult to explain to clients. And that increases the likelihood of misunderstanding or disappointment. So, there’s a risk from a practice standpoint.”

Adds Richards: “Guarantees are appealing, especially in uncertain times. But there’s some naïveté, even among experienced inves-tors, who don’t always appreciate the trade-offs. You can’t get something for nothing.” IE