Structured products: BMO Life Stage Retirement Income Portfolios

Background

In the January 24, 2011 Hot Off the Web blog I mentioned a new product from BMO, which I described as fitting into the category of products of expensive and opaque nature, the “BMO Life Stage Retirement Income Portfolios” . At the time, I also had to admit that after reading it once, I didn’t fully understand it. In fact I had to update my last week’s comments after another reading of the information document to “main selling point appears to be after the first 10 years of accumulation (assets locked in from age 55-65) you will be receiving back 6% a year of your own capital (ages 65-80) so that the ‘income’ will not be taxable. Beyond age 80 income appears to continue at the rate of 6% of original capital, now fully taxed as interest, with potential upside, if any, to be determined by the remaining assets after 25 years of 2.75% fees and 75% participation on the assumed underlying portfolio (corrected January 26, 2011). I didn’t notice in the documentation a side by side comparison of this product against GICs, annuities, or just investing in an ETF based portfolio of similar risk over a similar horizon with a systematic withdrawal plan. Overcoming 2.75% fees is not easy.”

Update

Well, I did spend a little more time with the information package, and to the best of my understanding (which, no doubt, is still not complete) here are some additional points and thoughts about it (anyone considering buying such structured products is advised to seek independent professional advice):

-2.75% annual fee

-May be bought between ages 55-70

-Investment locked in for 25 years. There is no apparent way to access capital beside the scheduled payments between years11-25.

-First 10 years (accumulation phase) no income, next 15 years (de-accumulation phase) 6%/year of original investment capital distribution, indicated as no tax due on these capital distributions, after 25 years (at maturity) the funds are available for withdrawal or may be left (in an extension phase). At maturity in addition to the residual 10% capital, there may be a variable return portion. Investors can remove residual funds or continue to receive the 6% of the original investment for life (Not sure if what happens if some or all the variable return is removed).

-The 6% income stream beyond maturity (i.e. after 25 years) as well as any variable gains remaining at maturity would be taxed as interest income (so we succeeded in converting capital gains into more highly taxed interest income)

-The underlying investment works like a life-cycle fund which start with 80% equities in year 1 and reduces risk to 35% equities in year 25 (at age 80-95, depending on the age, 55-70, at which it was purchased.)

-75% participation rate- i.e. investor gets only 75% of the (total?) returns, i.e. gains or losses (including dividends?) of the underlying funds

-after the 10 year accumulation phase, the 6% annual payments of the original investment,  is deducted for 15 years from the capital so at maturity 90% of the capital has been returned.

-No CDIC guarantee; the cash flow is an unsecured debt of BMO

Some additional considerations are the following:

-If you assume nominal average 7% total return per year on the underlying funds, then with 75% participation the return drops to 5.25% from which subtracting a fee of 2.75% leaves an annual return of 2.5% nominal (i.e. not real buying power; assuming 3% inflation per year we are now looking at an annual -0.5% real return)

-Consider comparing this product with GMWBs (which as you know I do not recommend, see earlier blogs on the subject GMWB I , GMWB II). GMWBs, appear superior from a guaranteed income perspective (at least on a pre-tax basis; I don’t’ know how GMWB cash flows are taxed). Essentially for some GMWBs if withdrawals start immediately 5% of original investment is guaranteed for life; furthermore each year of deferral of income increases guaranteed income by 5%. (i.e. after 10 years of no withdrawal on a $100,000 initial investment the guaranteed lifetime income would not be $5,000/year but $7,500/year. However in the BMO product, 10 years after making the investment, the guaranteed payments are at a level of $6000/year (vs. $7500 for the GMWB, which typically also has a 3 year ratchet feature on the income in the (low probability) event that there is in fact an upside after the fees and withdrawals. The GMWB though has higher fees but 100% participation rate.

Bottom Line

These types of products are best evaluated in a side by side comparison using Monte Carlo techniques or scenario analyses (typical, best worst, etc) against annuities, a passive implementation of a balanced portfolio with a systematic withdrawal plan, and even a specific GMWB (e.g. Manulife’s Income Plus). I haven’t convinced myself that it’s a good use of my time to do this side by side comparison, but it’s not clear that this product is superior even on an after tax basis to a GMWB (but perhaps it is as good/bad or even a little better).

This type of complex, opaque and high fee products are unlikely to be advantageous because the potential upside after fees is usually a low-probability event. Getting your own money back without tax over 15 years after first waiting 10 years doesn’t sound like a great opportunity to me, especially if you look at the expected cash flows in real terms. For those with average risk tolerance a systematic withdrawal approach from low-cost balanced portfolio would likely be superior; whereas for those with low risk tolerance, annuities lead to higher guaranteed lifetime income. The corrosive effect of 2.75% fees over 25 year takes its merciless toll, since the available market returns are the same for everyone (of the order of 7% nominal on a balanced portfolio) and getting only 75% of the market return (i.e.5.25%); then taking 2.75% (52%) of that for fees leaves little for the investor (2.5% nominal or -0.5% in real terms, if inflation is 3%)

So, if you don’t fully understand the product, then don’t buy it! In fact anyone considering buying such structured products should seek independent professional advice, and ask your advisor for that side by side comparison that I mentioned before.