Today’s guest post is courtesy of the author of the Thicken My Wallet blog. You can subscribe to the feed here.
I want to thank Canadian Capitalist with giving me the opportunity to guest post on his well-deserved vacation. If you are a regular reader of this blog, you know that Canadian Capitalist is rightfully a passionate supporter of the KISS (keep it simple stupid) principal of personal finance (my words, not his) and that fees destroy returns over the long term.
As this age of financial excess is unwinding itself ever so painfully, it is interesting to note how the smartest guys in the room are probably not the financial wizards the media makes them out to be.
For example, CC wrote a recent series on Manulife’s IncomePlus products — a stunningly successful product for the company. But, as CC noted, the product had many flaws including an outrageous MER of approximately 3.5%. A moderately educated investor could replicate the product’s return using a portfolio of bonds.
So Manulife has designed a fail-proof product for itself and we should invest in the issuer and not the product right? Well… the Globe and Mail ran an interesting article on Manulife’s recent troubles resulting in part from products like IncomePlus.
In the simplest sense, insurance is like banking without money. Like banks, insurers are regulated and the regulators demand that a certain portion of money be set aside to cover its liabilities. Conventionally, an insurer’s largest liability is that all of the insurance policies it underwrote are called at once (analogous to all the bank’s customer’s withdrawing their money at once). The chances of everyone passing away at the same time are quite remote so an insurer’s risk is, statistically speaking, quite low.
But, insurance companies started dabbling into more exotic financial instruments. One such product is something known as viable annuities. Like a regular annuity, an investor pays the insurance company a sum of money in return for guaranteed payments in the future.
However, an investor in a variable annuity is also asking the insurance company to invest the money in the stock market for them and to participate in any profit the insurance company makes (IncomePlus is a variable annuity). The key attraction is that no matter how badly the insurance company invests your money, the investor will be guaranteed a stream of money in the future- so, theoretically, no down-side, all upside.
If you are a regular reader of this blog, you understand that active management of funds statistically underperforms the board based equity index. Thus, even in regular markets, one is already giving money to the “smartest guy in the room” (sorry, they are mostly guys who got us into this mess) to under perform.
In markets such as this? Remember that the insurance company has to guarantee the annuity payment but it has taken the investors’ money and lost a lot of it in the stock market. The only way to make up that loss is to take profits and top up the reserve fund mandated by the regulators to ensure that the annuities are paid on time.
The topping up of reserve funds can only be accomplished mainly through a couple of different methods: (i) issuance of new shares, creating a dilution issue; (ii) raising debt, leveraging the company more; and/or (iii) move profits into the reserve fund, reducing earnings per share. Manulife has done all three and its shareholders have suffered as a result; it posted its first loss ever since the company went public.
Why didn’t Manulife hedge its position? According to the Globe article, it stopped doing it in 2004 (remember they thought they were the smartest guys in the room).
Is Manulife in trouble? It will most likely feel a lot of short-term pain but its trouble pale in comparison to many of its industry counterparts and the money in the reserve funds can be moved back into earnings over time (to be clear, this is an industry issue not particular to Manulife).
Is a Manulife annuity in trouble? Most likely not since it reserve funds have been sufficiently topped up (in other words, it has the money).
The moral of the story?
The smartest guys in the room are not very smart when it is not their money.
The author is a shareholder of Manulife and, obviously, not a very happy one.