By their sheer numbers, boomers have changed every market they’ve ever entered or worked their way through. They’re about to re-write the book of financial planning, strategies and sales, as well.The year 2008 gave us a taste of things to come, when it was discovered that asset allocation and standard portfolio diversification practices aren’t enough to shield clients and their hard-earned assets.
“Everybody talks about asset allocation,” says Peter Wouters, director of tax and estate planning and retail insurance products and marketing at Empire Life. “What more advisors and boomers are learning is that you’ve got to start thinking a lot more broadly about investing.”
The typical diversified portfolio doesn’t need to be abandoned, but it doesn’t offer downside protection, he says. There is also a major shift in thinking that isn’t easily grasped by a lot of people: The rules change completely when you move from accumulating assets into the years when it’s time to draw income.
During the accumulation stages of a client’s life it’s assumed that things will work out, on average, over a 10-year period. “What if that tenth year happens to be in 2008?” says Mr. Wouters. “Ten-year averages don’t necessarily work.”
When drawing down assets, there are different mathematical assumptions which need to be applied and considered when looking at gains – the order of returns is a fundamentally important concept that isn’t the easiest thing to grasp – and assumptions about using averages don’t work the same way; the averages actually work against clients, instead of in their favour.
Managing this, advisors and their clients need to diversify the client’s holdings, but also the products and strategies being used as well. “That involves more than just saying so much will go into bonds and stocks and never more than this percentage in one stock,” he adds. “It actually goes well beyond that.”
Client circumstances have changed dramatically too. Kevin Strain, senior vice president of individual investments at Sun Life Financial points out that just one short generation ago, many retirees had defined benefit pension plans and many had health insurance coverage, even in retirement. “It’s a more complex story today,” he says. “Only around 20 per cent of Canadians now retire with a defined benefit pension plan and fewer are retiring with health benefits. Most companies are eliminating post-termination health benefits. It’s a more complex retirement – a shift in the financial burden at retirement from companies, defined pension plans, health care plans and the government to the individual.”
Clients are more educated too. Mr. Wouters points out that some are completely focused on tax-efficiency while others could care less, as long as their options and sources of cash flow remain as flexible as possible.
Fortunately, there is still time for the majority of boomers to work things out, and to diversify by product and strategy as well, in order to find themselves in a more stable position when the time comes to draw income.
Boomers started turning 65 this year. Mr. Strain says there are close to 1,000 boomers each day who are hitting that milestone in Canada – but the large majority of those in this cohort are still in their late 40s with between 10 and 20 good working years left until retirement.
There is a whole new set of products this generation needs as they head into the stage of their life where managing asset “deaccumulation” becomes an issue and the insurance industry appears to be well poised with solutions to help.
“You’re getting people who are becoming a little more risk averse,” agrees Mr. Wouters. “They’re looking for guarantees. They’re looking for some downside protection and there are some creative solutions that are available. The insurance industry is perfectly poised because that’s the business we’re in.”
Interest rates are one of the first problems this group of clients needs help getting past.
“A lot of people creating their financial plans over the last 20 years or longer were expecting a certain rate of return in retirement. That rate of return is simply not available to them,” says Sun Life advisor, Matt Wilhelm.
“A lot of baby boomers may have been thinking that they would just put all of their money in guaranteed products when they retired and maybe earn six or seven per cent without any risk. Those products aren’t available these days.”
Moreover, alongside the drop in guaranteed rates, stock market volatility has increased as well. “When I started in the early ‘90s we saw guaranteed interest rates up over eight per cent for a five year guaranteed investment. Today we’re less than three per cent in the market for that same type of product.”
Volatility and actual negative returns – not just returns that came in lower than targets – force people to understand a few relatively new mathematical concepts as well.
Order of returns
Just one year of drawing on accumulated assets (or not), no matter how large the pot of money is, can make all of the difference between a client having sufficient assets in later years or not if markets and the client’s portfolio is in the red or underwater. The order of returns – the specific years in which client assets earn or lose money – is more important in retirement than average returns overall.
If negative returns and inflation reduce a client’s portfolio early on, in the first two or three years of retirement, when the pot of money is largest – it hasn’t been drawn from yet – the losses are significantly larger than if losses had occurred later on in retirement. Taking retirement distributions in these early years when markets and investments are in the red crystallizes the losses. Not only is there no opportunity for the assets to regain their value, clients also forfeit any future growth opportunities as well.
“If I’m accumulating money over a 10-year period, I’m going to have an average (return),” says Mr. Wouters. Markets move higher and lower than the average over time. “When you’re accumulating money, that’s okay. Those averages are okay and it doesn’t matter what the order of returns are. The order of returns, whether you start off making positive or negative returns makes a huge difference when you start taking money out.”
The combination of retirement withdrawals, coupled with lower returns, can cripple a portfolio’s ability to recover from market fluctuations and still make sustainable income distributions.
“If I start off losing seven per cent, even if I make seven per cent in each of the next two years, I’m not in the same place…because I lost money in that first year,” says Mr. Wouters. When taking retirement distributions, “whether or not you make or lose money in the first year makes a big difference as to whether or not that pot of money will still be there 10 years down the road.”
This is where product and strategy diversification will ultimately help the situation – having sufficient options in place is what will allow advisors and clients to manage withdrawals and hopefully avoid drawing on assets while they’re down in the future.
Making the shift to include strategy diversification means looking at products that offer downside protection, including those which offer minimum guarantees at maturity, a floor for bare minimum rates of return and the opportunity to lock in gains if markets go up or temporarily spike.
The price or cost of such products will undoubtedly be a concern for those who object to higher management fees. Proponents, though, say the strategy is not an all or nothing game.
“It shouldn’t be an issue of a segregated fund or a mutual fund. You need both,” says Mr. Wouters. “I’ve got a floor in one that I don’t have in the other. It’s a fallacy to say one is more expensive than the other. There is a cost to it. It’s not free but you can get them for the same you would get a typical advisor-sold mutual fund. Same cost, not extra and you get the guarantees. It’s an important consideration. There are an awful lot of people who hit 62, 68 and age 71 in 2008 who are glad they took that option.”
He adds that product diversification can make sense at just about any age, depending on the client’s risk tolerance but that it makes even more sense as clients get closer to the time when they will move from accumulating assets to spending. “Probably in those last 10 or 15 years before you start digging into income flow would be a good time to explore plans that offer these benefits,” he says.
Steady cash flow
In addition to segregated funds, some with automatic reset options, principal protected notes and other guaranteed products, insured annuities are a popular choice for setting a guaranteed income in place for clients. Although interest rates make them less attractive than they have been in the past, annuities can create a predictable and steady cash flow that is sometimes double what a client would normally be able to pull out of their portfolios or term deposit accounts.
For those who are concerned about leaving a legacy, part of the excess cash flow can be used to pay for an additional life insurance policy. Impaired annuities for clients with a reduced life expectancy, meanwhile, can provide even more cash.
Mr. Strain says studies suggest people who already own life insurance are more open to owning payout annuities.
He goes on to break retirement and income planning down into four objectives: First, create a base level of income that will last for life using a payout annuity. “It’s not new or innovative but it’s very effective,” he says. “It’s the equivalent of a defined benefit pension plan for an individual – it creates an income stream that lasts for life.”
Second, he says a variable annuity or a segregated fund, like a payout annuity, creates an income stream for life, but this time with some variability, depending on market performance. This second stream can be used to fund retirement activities. Third, Mr. Strain points to critical illness and long-term care insurance to cover foreseen and unforeseen health events. Finally, life insurance is used to cover estate planning needs.
“It really is necessary to sit down and look at each situation,” he says. “Someone with a DB pension plan may not need the payout annuity,” for example.
“Canadians should understand that there is a risk to outliving your assets,” he adds. “There are really only two products that help you protect against that risk. The paid annuity and the guaranteed minimum withdrawal benefit product. If you don’t have a DB pension plan, those are the only two that provide for longevity risk.”