Want some insurance with that managed account? Or how about wrapped around your target-date mutual fund? A number of companies are rolling out new hybrid products that wrap a guaranteed lifetime withdrawal benefit around such managed investment products. These hybrids allow an investor—or, if the policy-holder is deceased, his or her spouse—to lock in an annual withdrawal of 5 percent of principal that lasts throughout retirement, even if the bottom drops out of the market and the account value sinks to zero.
The first of these products was rolled out in March by Phoenix Companies together with Lockwood Capital Management, a Malvern, Pa., investment advisor affiliate of Pershing LLC. Several other hybrid products are now pending before the Securities and Exchange Commission. Called “Guaranteed Retirement Income Solutions” or GRIS, the Phoenix product has an investment minimum of $250,000, and offers both a guaranteed income stream for life and the chance to participate in any asset growth. In other words, as the investor’s assets grow, he or she can annually elect to lock in a higher annual benefit based on the increased account value.
“This has humongous potential,” says Charles Roame, principal with Tiburon Strategic Advisors, Tiburon, Calif., of the new class of products. “It's great idea because people are looking for low-cost protection, but don’t want to buy a variable annuity due to high fees and surrender charges.”
Until recently, it was only variable annuities that offered such minimum withdrawal guarantees. But variable annuities clearly aren’t for everyone: Many high-net-worth consumers and advisors are put off by the complexity, high cost and lack of control over the assets associated with the products.
Roame sees enormous potential in the bank, independent and wirehouse registered representative channels for the new hybrids, and believes they could become more popular than variable annuities with living benefits—for a couple reasons. For one thing, with the hybrid product, an advisor can manage the underlying investments to keep taxes to a minimum. By contrast, variable annuities turn capital gains and dividends into ordinary income that can be taxed at rates as high as 35 percent. Second, the hybrid structure allows an investor to leave the assets held in the product to a beneficiary at a stepped-up basis at the time of death. By contrast, a beneficiary of a variable annuity pays ordinary income taxes.
Phoenix’s GRIS hybrid uses exchange-traded funds as its underlying investment components and offers three asset-allocation models. John F. Sharry, senior vice president of business development for Phoenix Alternative Products, says GRIS is designed to compete with variable and immediate annuities in the affluent retirement income market. The guaranteed payout rate is 5 percent of the initial account value, and an investor must reach 65 years of age before he can begin taking income payments.
So what does it cost? Not surprisingly, it doesn’t come cheap, but it’s about half as expensive as many variable annuities, with total fees coming to 2.68 percent. A 74 basis-point fee goes to the registered rep selling the product, while the rest of the fees break down as follows: a 125 basis-point insurance charge, an 18 annual basis-point exchange-traded-fund fee and a 50 basis-point Lockwood management fee.
Looking Under The Hood
The other products pending regulatory approval are similar to the one offered by Phoenix, but fees and investment minimums vary. Genworth Life and Annuity Company and Nationwide Financial expect to offer a guaranteed withdrawal benefit on managed accounts that invest in asset-allocation portfolios of either exchange-traded funds or mutual funds. Allstate’s SEC filing says the insurer plans to offer the guarantee on target-date retirement funds, while Allianz Life will offer guaranteed withdrawal benefits in 401(k) plans. Finally, the Merrill Lynch Life Insurance Company plans to offer the guaranteed withdrawal benefit on three types of IRA stock fund asset-allocation models.
Brent Hamann, senior consultant with Milliman in Chicago, says that brokers will be able to offer a wide range of investments in these managed accounts with an insurance wrapper. “The wrapper appeals to a wide swath of Americans, including high-net-worth individuals who want to maintain their current standard of living and not scale back during retirement,” he says.
Len Reinhart, a Lockwood former president who now serves as a consultant and helped develop the Phoenix-Lockwood product, says it’s too early to measure advisors’ or investors’ enthusiasm for the new products. “I don’t have a feel for the response because this has never been done before,” he says. “High-net-worth individuals don’t like immediate annuities because their net worth drops by the amount they invest in the annuity. But unlike an annuity, the insurance component of the managed account can be canceled at any time. Investors also can choose to liquidate the underlying account at any time.”
But some money managers say the cost of the new hybrid products is too great. Noreen Beaman, executive vice president with Brinker Capital, a Berwyn, Pa.-based investment management firm with $10 billion in assets under management, says these guaranteed withdrawal benefits will not be popular in managed accounts until costs come down. The insurance charges are often more than 100 basis points, and push the total cost of management to around 300 basis points. Plus, the charges can go higher as new money goes into the account. The reason: The cost of insurance company hedging strategies in options increases as the stock market declines.
“We think it is a good idea for some clients, but we will wait until the benefits are less expensive and more attractive,” says Beaman. “It is a wonderful product at the right price for individuals who may have $500,000 in an IRA and will get Social Security. They can use the guaranteed income from the benefit to cover their fixed costs during retirement.”
Joseph Flaherty, the manager of the MFS 4 Lifetime Funds, says MFS decided against adding the guaranteed minimum withdrawal benefit to its target-date retirement funds. And that’s because Flaherty manages the target funds more aggressively than similar funds during the accumulation stage. The guaranteed minimum withdrawal benefit fees would dramatically reduce a fund’s returns during the accumulation stage, he says. The target funds are designed to preserve and build capital by the time the individual is ready to take systematic withdrawals, for example, in an IRA or 401(k) defined contribution plan.
Another problem is the fact that an investor may never activate the guaranteed withdrawal benefit, says Monica Rutkowski, director of life and health insurance products with the Florida Office of Insurance Regulation, Tallahassee. If the investments perform well over the years, or the person dies early, he or she doesn’t need the benefit, but will still end up paying the hefty insurance charge. For example, someone with $100,000 in a hybrid account with a 100 basis-point insurance charge could end up pay $20,000 in insurance fees after 20 years, but never activate the guaranteed payout, she says.
A Taxing Question
There also are questions about how the income from this type of hybrid product is taxed in nonqualified accounts. Investors, for example, pay dividends, capital gains and/or ordinary income tax on their investment withdrawals from the Phoenix-Lockwood managed account. If and when the account value is depleted, the annuity payments kick in and are taxed as ordinary income.
But the prospectuses for both the Phoenix and Genworth products state that the tax consequences of guaranteed withdrawal benefits have not been addressed by the Internal Revenue Service. So it is possible that the Internal Revenue Service could reach a different conclusion about how the income received from these new hybrids is taxed.
Tax attorneys who specialize in insurance and estate planning said the IRS is currently reviewing the issue. “There are a whole bunch of products the IRS has not ruled on,” said Leonard Witman, a Florham Park, N.J.-based tax attorney and adjunct law professor at Rutgers University. There is always a danger that investors may be taxed at ordinary income rates during the systematic withdrawal stages, he says, rather than at dividends and capital gains rates.
Despite the uncertainty, Witman says insurance companies are taking a conservative stance toward taxation. “If clients need a guaranteed stream of income, I would look at this as an investment option,” he says. “The tax treatment would not be my overriding concern. It would be the product that paid the best income guarantee at the lowest cost.”
Hamann, of Milliman, stresses that registered reps need to conduct due diligence on the insurance company underwriting the guarantee and check the insurer’s financial ratings. The investor must have confidence that the insurance company is going to be around when clients begin receiving the withdrawal benefit. “The credit strength of the insurance company providing the guaranteed withdrawal benefit must be an important consideration,” he says. “The benefit is only as good as the insurance company providing the guarantee.”
Ultimately, the guaranteed withdrawal benefit may become more popular with 401(k) or IRA investors who want a guaranteed source of income similar to the old style defined benefit plans that paid workers a pension. Garth Bernard, actuary with the RISE Report, a newsletter on longevity risk management based in Roswell, Ga., says that a guaranteed withdrawal benefit can be used in combination with an immediate income annuity. For example, let’s say the investor uses the 5 percent guaranteed withdrawal benefit in the early stages of retirement. Later on, the retiree can invest in an immediate annuity for higher income payouts. An immediate annuity pays higher income because the payouts are, in part, based on an individual’s life expectancy. So the older the individual, the higher the payout amount.
Chris Lyon, partner with Rocation, a Norwalk Conn.-based investment consulting firm, expects more interest in guaranteed withdrawal benefits in 401(k) plans and IRAs that offer sophisticated asset-allocation models. Several insurance companies—such as MetLife, Genworth and John Hancock—are offering the benefit in defined contribution plans.
“Over time, you will see more assets go into target retirement funds with guaranteed withdrawal benefits as plan sponsors get more data on how employees are using the funds,” Lyon said. ”And if managed accounts are offered with these benefits, employees’ retirement investments can be customized.”