For members of a defined contribution plan in the "retirement risk zone" five or 10 years before or after retirement, product allocation will have a more significant impact on retirement income than asset allocation, says York University Professor Moshe Milevsky in his latest book, "Are You A Stock Or A Bond?"

"We hope down markets will bounce back, but the problem is that as you get closer to retirement and have to withdraw assets from your nest egg, the negative returns may not be offset by the positive returns you get next year because you are withdrawing money already."

Understanding product allocation

Milevsky characterizes "product allocation" as a catch-all phrase for investment products that are guaranteed by promises, as opposed to products that move with thevagaries of the stock market.

He cites the example of two individuals with assets in a pension plan invested in a 60/40 equity/bond mix. "If I'm in a DC plan, but you are in a defined benefit plan, you have a guarantee and I don't. Our asset allocation may be identical, but our product allocation is very different. Product allocation is about capturing things other than stocks and bonds in our personal balance sheet."

Using the following three acronyms, he describes three completely different silos that can be used to finance retirement:

• SWiPs. Systematic withdrawal plans are collections of stocks and bonds. Retirees manage the portfolios and draw out as much as they want at their own discretion. There are no guarantees how long the money will last if the individual lives for a long time, inflation is higher than expected or if markets go down.
• LPIAs. Lifetime payout income annuities are at the other end of the spectrum. They are irreversible, but they are guaranteed for life. They don't have a market value or upside potential, but they are implicitly a very valuable asset because they protect owners from outliving their resources.
• GLiBs. Guaranteed living-income benefits are modern products that have been engineered in the last 10 or 15 years based on derivatives, and puts and calls. In Canada they are called guaranteed minimum withdrawal benefits, while in the U.S. they are known as guaranteed minimum income benefits or living benefits.

This new generation of products provides income for life - not as much as an income annuity - but if the market increases dramatically so returns are better elsewhere, the portfolio can be liquidated and moved to other investments.

In October 2006 Manulife was the first Canadian insurer to release Guaranteed IncomePlus in the retail market, and since then several improvements have been announced. Subsequently other financial institutions, including Desjardins (November 2007), Industrial Alliance (December 2007), Sun Life (March 2008) and Empire Life (October 2008), have rolled out retail guaranteed retirement-income products with similar features.

Deciding on the right product mix

So how can individuals determine the product mix that is right for them?

"In the absence of anything I know about a particular individual, I think all these products belong in the retirement income portfolio. But as soon as someone clearly defines to me what is important, the allocation shifts," Milevsky explains.

By way of example, he describes two extreme scenarios:

"Let's say I'm talking to someone who says he is not investing for himself, because he'll never run out of money. His goal is to leave as much as possible to his children and grandchildren in as tax-efficient way as possible. I would advise him an income annuity makes no sense because he is wealthy and his preference is to create an estate.

On the other hand, if someone tells me they have no children, and they basically want to die broke with the last cheque going to the undertaker, I'll tell him an income annuity with no guarantee period is ideal. The insurance company will transfer all the risk from his balance sheet to their balance sheet and when he passes away, the asset will be exhausted."

GLiBs that guarantee a stream of payments after retirement are starting to appear on the list of investments available to members of employer-sponsored group retirement programs.

"I'm seeing this trend particularly in U.S. DC plans - 401k plans, 403b plans and the like - that are now putting these products on the menu as savings instruments. So five, 10, maybe even 15 years before retirement, people start to allocate wealth to these investment vehicles in anticipation of the fact that they are going to be retiring," Milevsky notes.

In June 2008, Manulife Canada was again first off the mark with Group IncomePlus, an investment option available to any group retirement savings plan on the Manulife platform [see "The nuts and bolts of Group IncomePlus," page 14].

While Milevsky suggests that in some cases turmoil in the markets has put a hold on this type of innovation in Canada, he says "I think that variations on these types of products will grow, and you are going to see DC plan sponsors, trustees and administrators evaluating whether they should be DC investment options, along with stocks, bonds and mutual funds."

At what cost?

Nevertheless, some industry pundits have given LPIAs and GLiBs a bad rap because, they suggest, fees and other costs associated with them undermine their value as retiree investments.

But Milevsky thinks it is important to differentiate between what the product is trying to do and the fees charged for a particular product from a particular company.

"If the fees are high for guaranteed benefits, it's not necessarily for the guarantees. It is for active money management and because you are getting advice, and hopefully some kind of service. Put options are not free. If you go to the options exchange, a put option is usually as expensive, if not more so, than some of those retail products."

And what if recently retired DC plan members or those close to retirement do not have the downside protection of a guaranteed product and have seen their retirement savings drop dramatically in recent volatile markets?

There is no magic bullet, says Milevsky. "There has to be a realization that every drop in the TSX or the Dow translates into a longer working life. People should sit down and put together a little matrix that says for every 5% drop in their portfolio, how much longer they are going to have to work to maintain their standard of living," he says.

The nuts and bolts of Group IncomePlus

Manulife's Group IncomePlus is currently the only Canadian guaranteed minimum withdrawal benefit investment option available on a group retirement platform.

Manulife's Director of Marketing Lisa Callaghan describes how it works: "If the plan sponsor elects to include Group IncomePlus as an investment option, the member can opt to put some, all or none of his money into this product. Funds are invested in Manulife's Balanced Asset Allocation Fund, but he also gets a guaranteed income of 5% of contributions plus market growth captured each year on his anniversary date. The fee for the guarantee is an additional 45 basis points over the balanced fund's investment fees, which vary from plan to plan."

"Once a member chooses to put a portion of his savings into Group IncomePlus, he immediately starts to build a notional value called the 'guaranteed benefit base' that increases with every additional dollar contributed," she explains. "This GBB is not available as a cash value and is only used to determine the amount of the member's guaranteed income in retirement."

While the market value of the fund fluctuates like any other investment, once a year on the plan member's birthday an annual step-up adjustment is calculated. Any market gains on that date are added to the member's GBB. "Members continue to benefit from equity market exposure but if markets go down, the GBB is not reduced," she says. The GBB will only reduce after retirement if the member withdraws more than 5% a year.

When members have been participating in Group IncomePlus for five years or more, they are eligible to begin drawing their guaranteed annual income of 5% of the GBB as early as age 60.

However if both the member and his/her spouse are at least age 60 as of the member's retirement date, and the five-year holding period has been met, a spousal income option is available that will provide a guaranteed annual income payment of 4.5% of the GBB for the lifetime of both the member and the spouse.

"We did a roadshow across the country for brokers and consultants when we rolled out the group product last June, and the reaction was very positive. It is a top priority for us to provide excellent education to market sources because it is important to us that the right people use Group IncomePlus at the right time for the right reasons," concludes Callaghan.