Although they have been on the market for just over two years, segregated Guaranteed Minimum Wage Benefit (GMWB) funds have made a significant impact on the Canadian market. The introduction of an investment instrument offering the opportunity to participate in investment markets while guaranteeing lifetime income turned out to be so attractive to the market that in a short period of its existence it grew from zero to over USD 10 billion.
The product guarantees the customer 5% of the deposit for life, even if the account value reaches zero (ruin scenario). This amount is adjusted upwards if the portfolio value is higher than the guaranteed value on specified reset dates (every one to three years), and downwards for any withdrawals above the designated 5%.
However, with one exception, an investor can receive more than 5% of the portfolio value in a year – when GMWBs are held in an RRIF account.
At issue are two competing interests. The first is the 5% GMWB guarantee. The second is the government required minimum percentage of RRIF withdrawals. All RRIFs are, of course, subject to the government’s minimum distribution schedule, which every RRIF investor must start receiving no later than age 71. This minimum payment starts at 7.38% and then increases each year, reaching just under 10% at age 84 (9.93%) and a level of 20% annually from age 94.
So let’s consider what happens at age 71 if an investor converts a $100,000 total RRSP account to an RRIF and invests in GMWB funds. The RRIF schedule states that he must receive 7.38% ($7,380) of the account value. Meanwhile, GMWB is only expected to pay out 5% ($5,000). Typically, the difference of $2,380 (or 2.38%) will be subtracted from the customer’s guarantee value and will reduce the guaranteed income for the following year. This means the $100,000 deposit on which the guarantee was based will now be reduced to $97,620 and the guaranteed lifetime payment will be reduced to $4,881. This pattern will repeat every year when the minimum RRIF fee exceeds the guaranteed income, resulting in an annual erosion of the value of the guarantee and providing no reason to pay additional fees associated with this product. Fortunately, this is not the case with RRIFs.
Each GMWB has written in its contract that, in the case of RRIF, the accounts will pay the greater of the minimum RRIF deposit or guaranteed income. Where the RRIF minimum is higher than the guaranteed amount (5%), any withdrawals above this 5% amount will not be considered additional capital withdrawals and therefore will not reduce the income guarantee. This provision creates a floor on a client’s RRIF income – in the context of the example, if the RRIF schedule specifies a minimum withdrawal amount of $10,000, the investor will receive $10,000. If the scheduled payment was $3,000, the investor will receive a minimum guaranteed income of $5,000 with no impact on future guarantees. Essentially, this benefit allows investors to withdraw more income from their investment in GMWB than if unregistered funds were used.
One thing to keep in mind, however, is that this doesn’t necessarily work for locked RRIFs. Since these accounts also set a maximum payout percentage, if the guarantee amount exceeds the maximum locked RRIF payment, the lower of the two will be paid out.
While the concept of having a minimum guaranteed income from your RRIF seems like a good idea, how necessary is it? To answer this question, ask yourself the following question: If someone were to withdraw either the minimum RRIF deposit or the 5% guaranteed amount, whichever is greater, what is the probability that the RRIF account would break the bank (run out of money) )? To answer this question, I performed a Monte Carlo analysis that assumed a sustainable return of 7%, a standard deviation of 9%, and a reset every three years.
The results of this analysis are shown in the upper left corner.
As we can see, based on the assumptions used, the probability of portfolio destruction in the years before the age of 85 is small or non-existent. However, this risk escalates rapidly over the next 15 years as the probability of ruin drops from very unlikely to almost absolute certainty. These numbers would be even worse if we take into account the possibility of a significant market downturn that occurred last year.
The next factor to consider is mortality. After all, even if the probability of being ruined at the age of 100 is 95%, is it worth insuring against this event if so few people live that long? To find the answer, let’s look at life expectancy for each age increment – remembering that life expectancy only measures the average life expectancy of a population. The worst thing an advisor can do is plan for a client’s death within their life expectancy. If they did, half of their customers could run out of money. (See tables.)
We see that a 70-year-old can, on average, expect to live to be 84 years old. At first glance, these guarantees appear to be of little value because the probability of ruin only becomes significant later in life. But remember that life expectancy is an average. This means that half of the 70-year-old population will live to the age of 85.
So how many 70-year-olds will experience a significant chance of ruin in their lifetime? If we combine the conclusions from the tables, we will be able to answer this question. According to the third table, almost 50% of the population will live to be at least 85 years old, and almost a quarter will live to be 90 years old. If we combine this with the results of the first table, we can determine:
• 50% of 70-year-olds will die before the age of 84, and the probability of ruin is less than 3%; • 27% of 70-year-olds will die between the ages of 85 and 90, with a chance of ruin ranging from 3% to 28%; • 16% of 70-year-olds will die between the ages of 90 and 95, with a 28% to 65% chance of ruin; and • 7% of 70-year-olds will die after age 95, with a probability of ruin greater than 65%.
This leads to the conclusion that more than one in four 70-year-olds will experience a significant likelihood of RRIF ruin during their lifetime, provided all assumptions hold. Portfolios with lower returns, higher volatility, or large market downturns will only increase the likelihood of ruin. But given that the risk of ruin is no less than one in four, they are tangible and significant. Given the consequences of losing a source of income at this age, setting up a guaranteed RRIF is highly advisable.
In my opinion, GMWB is longevity insurance. And while it seems a bit ironic that we would need to protect ourselves from living a long life as mortality rates rise and retirement lengthens, it is certainly something all advisors and clients should consider. We don’t know how long any of us will be around, so it’s best to prepare for a long life.
