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Investors nervous about how high inflation and market volatility will affect their retirement income may be considering the security that segregated funds provide as they invest like mutual funds but guarantee part or all of the principal.
But some advisors warn that these products have their drawbacks including the high cost – making it important for clients to consider the entire picture.
A recent RBC Insurance survey found almost half of the participants (47 per cent) said a lack of guaranteed income and outliving their savings is a concern in retirement.
And for good reason. Canadian retirement nest eggs have rarely had as much exposure to volatile equity markets. Insured payout defined-benefit (DB) workplace pensions that were popular a few decades ago have given way to defined-contribution pensions invested entirely in the broader markets.
Meanwhile, those going it alone without a workplace pension see paltry yields on guaranteed fixed income such as guaranteed investment certificates (GICs) that are being swamped by inflation – pushing investors up the equity market risk-ladder for unpredictable dividend income.
Selene Soo, director of wealth products with RBC Insurance in Mississauga, says there’s a growing demand from aging baby-boomers looking for retirement security, In turn, the firm is offering portfolios that combine investments with insurance products that provide guarantees.
Its model portfolio splits three ways between traditional equities, annuities, and seg funds.
“The guaranteed source of income would come from the payout annuities,” Ms. Soo says. “The segregated fund is used more for protection of your money and growth. It’s like a mutual fund with guarantees.”
Like mutual funds, seg funds invest in a wide variety of asset classes on broader markets, but 75 per cent or 100 per cent of the principal investment is guaranteed over 10-year periods.
Meanwhile, payout annuities can include various features but basically provide guaranteed income for life in retirement – much like a DB pension plan. Holders pay a premium and receive a regular allowance no matter what the markets do.
“Annuities can supplement other guaranteed income streams such as Old Age Security (OAS), Canada Pension Plan (CPP), or Quebec Pension Plan (QPP),” Ms. Soo says.
Furthermore, seg funds can also include death benefit guarantees and creditor protection in the event of bankruptcy, which can be appealing to business owners.
“Because it is an insurance contract, your money has creditor protection on your investment savings,” she adds.
Is the guarantee worth the cost?
However, that level of safety has a price. Annual fees on RBC Insurance’s line of seg funds can top 3 per cent of the amount invested each year – roughly a full percentage point higher than a typical mutual fund.
“There is the added cost for the guarantees but you’re getting the peace of mind that if you were to pass away, your loved ones would be taken care of,” Ms. Soo says.
David O’Leary, founder and principal at Kind Wealth in Toronto, and a former mutual fund analyst, warns the added cost of security from insurance products leaves investors with less money invested to grow their portfolios in retirement.
“You could have a situation in which segregated funds are five or six times the fees of the non-insurance side of the portfolio,” he says. “You need to think about how much protection you really need and if it’s worth the cost.”
Mr. O’Leary even questions the usefulness of the principal guarantees on seg funds.
“In the case of 75 per cent principal protection, I don’t think you could find a 10-year period in North American markets during which they have been down 25 per cent. It’s a worthless benefit. Even 100 per cent is highly dubious,” he says, adding that most tax and estate planning issues seg funds claim to avoid can be resolved without insurance products by simply appointing a beneficiary.
He thinks even the creditor protection features in seg funds are redundant.
“People have creditor protection in a number of areas like pension funds and [registered retirement savings plans],” he says.
Other ways to protect investment income
Mr. O’Leary says conventional investment advisors can duplicate the income security from insurance products without the added cost by incorporating the security of CPP/QPP and OAS benefits into a portfolio and practising basic risk management.
The first step, he says, is diversification to ensure investments are spread out according to sectors, geographic regions and risk levels to stabilize overall portfolio performance while maximizing growth opportunities.
He also says advisors can provide a similar level of income security, hedge against inflation, and avoid having to sell when equity markets are down by investing a portion of the portfolio directly in bonds or GICs. As the Bank of Canada raises interest rates to combat inflation, fixed income yields are currently rising.
“You can construct the portfolio in a way that the client, at any given time, has up to two years worth of income they can withdraw from low-risk assets like short-term bonds or high-interest savings accounts,” he says.
It’s worth noting that most insurance companies offer inflation-linked annuities at an extra cost proportional to the current level, and future risk, of inflation.
Mr. O’Leary is critical of insurance products because they’re regulated differently from conventional investments. For example, the recent crackdown on deferred sales charges for mutual funds has not affected insurance products yet.
He says the fee structure for products provided by insurance companies is less likely to work in the best interest of the investor.
“The insurance industry is worse than the investment industry when it comes to conflicts of interest,” he says. “The entire model of the insurance industry is sales commissions. You can’t buy a segregated fund or insurance product without going through an insurance broker.”
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