Guaranteed income funds can't offer you certainty

Guaranteed income funds www.wealthandrisk.nz

I was really pleased to see Lifetime Retirement Income develop a "guaranteed income" investment product in 2016. This was followed by Simplicity's Guaranteed Income Fund the following year, which is available to KiwiSaver members. 

I lump these products together because despite their differences, there are fundamental similarities between them. By investing in these products, the providers are guaranteeing that you'll receive a fortnightly payment for as long as you live - even if your capital runs out. 

Another similarity between the products is that income payments are insured by Lifetime Income Limited for an insurance premium of 1.3% per annum.

These products fill a gap in the market that was missing in New Zealand. They are definitely appropriate for certain people, in certain circumstances. I expect I will recommend one of these products to clients at some point in the foreseeable future. 

But in doing so, I'll be pointing out some of the risks and uncertainties associated with these investment options.

Because for all of the "certainty" they offer, they are not an investment panacea. 

Inflation

One of my key uncertainties relating to these products is inflation. 

You'll get a guaranteed income that is set in today's dollars. The dollar figures that lands in your bank account will be the same each fortnight now, and into the future.

But the buying power of that money is going to decrease with time, thanks to inflation.

These products are aimed at people with long time horizons. So let's look 30 years into the future. $1 in today's dollars is worth $0.55 in 30 years' time, in terms of what it can buy if the inflation rate is constant at 2% per year. If inflation is 2.5%, that $1 is worth $0.47. At 3% it's worth $0.40.

All bets are off if inflation escalates to higher levels. (Which is unlikely, but you can't rule anything out.)

So you actually don't have certainty. As inflation continues to eat away at the buying power of money, you'll find the value of your guaranteed income - in terms of what it will buy for you - decreasing over time.

An annual insurance premium of 1.3% is a lot of money

Even with the Simplicity fund, which has a modest base fee of $30 per year plus 0.31% annual management fee, there is an additional annual insurance fee of 1.3%.

Fees are handbrakes to building wealth. Fees of 1.3% will reduce the returns from your investments fairly substantially over time.

If your investment portfolio generates a 5% return each year, more than a quarter of your returns are being eaten away by the insurance fee - without factoring in the additional fees charged by Simplicity or Lifetime. 

In short, if you take advantage of these funds, you'll get to a point where you need to rely on the guaranteed income far sooner than if you'd simply invested in a balanced fund with lower fees. 

And will the fees stay the same? Given Simplicity's ownership and business model, I'm pretty confident that its base fee will reduce over time. I can't say the same for the 1.3% insurance fee. 

How secure is the product, really? 

A "guaranteed" income product sounds pretty secure. 

But it's important to note that this product isn't guaranteed by the Government. Your income in these products is only guaranteed to the extent that the insurer, Lifetime, can make payments to you after your balance falls to $0.

Lifetime is licensed and regulated by the Reserve Bank, and is required among other things to retain capital to pay liabilities to owed to members.

If you have faith in the Reserve Bank to be all-knowing and predict exactly what the future holds, which will in turn inform the capital requirements it imposes on Lifetime, you might be confident that the product is safe. But as smart as the people at the Reserve Bank and Lifetime are, they are still human beings and don't have a crystal ball. These are smart, well-educated, people who probably have all the right intentions. But Financial institutions and regulators have been known to get things wrong in the past.

It's also worth noting that Lifetime Income Limited has a “Fair” credit rating. This isn’t as high as I’d like for an organisation guaranteeing my retirement income.

Another thing to keep in mind is that if you’re relying on Lifetime to be paying for your income, it is likely to be at a time where investment returns haven’t performed as well as you’d have liked. You wouldn’t be the only one, and many people would probably be relying on Lifetime for your payments.

In the event of a significant downturn (which in many ways is when you would most want the guaranteed income), there would be many others, and additional stress on Lifetime at that point because its capital reserves are likely to be similarly impacted. 

This is a good set of products

Don't get me wrong - these products are valuable for certain people, in certain circumstances. I will probably recommend one of them to clients at some point in the future.

It won't be for their entire portfolio - it will probably be for a portion of their portfolio, relating to their known constant expenditure. And/or clients who won't have any major capital commitments in the future and don't have the capacity to deal with their investments (because of lack of interest and/or increasing vulnerability).

When the time comes for me, one factor that might convince me to invest some of my own funds into one of these products is that there is some overseas research suggesting that people with annuity-like investments live longer! 

These products may provide some peace of mind and a degree of certainty. But no one can offer you certainty in life, especially over timespans of decades. 

Sonnie Bailey

Sonnie is the founder and principal of Fairhaven Wealth.

Before founding Fairhaven Wealth, Sonnie worked in the legal and financial services industries for over a decade.

Sonnie first became involved with financial advice as a specialist financial services lawyer. For many years, he was an “adviser of advisers”, reviewing thousands of advice files prepared by hundreds of financial advisers, and providing feedback in relation to the quality and appropriateness of advice; industry best practice; risk management; and regulatory compliance. He has published work in industry publications and spoken at various financial advice conferences.

Sonnie has also worked with banks, investment management firms, insurers, and derivatives providers.

Sonnie has worked as a private client lawyer, focusing on succession, estate planning and trusts. He ran his own legal firm in Australia before relocating to New Zealand. He has also acted in independent trustee and company director positions.

Sonnie is passionate about helping people achieve their goals and manage the risks to which they are exposed.

He has written extensively on his blog, New Zealand Wealth and Risk, which can be found at www.wealthandrisk.nz.

Sonnie is married to his wonderful wife Chrissy, and has two young children, Ben and Anna.