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Retire Early, Retire Now!
Episode 21: Annuities: The Good, The Bad, The Ugly
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In this episode, Hunter discusses the topic of annuities, covering general information, the benefits, drawbacks, and potential pitfalls associated with annuities. He also talks about different types of annuities and their features. Overall, the script provides an educational overview of annuities and their role in retirement planning.
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ANNUITIES: THE GOOD, THE BAD, THE UGLY - EXPLORING THE PROS AND CONS (palmvalleywm.com)
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Annuities, the good, the bad, the ugly.
Microphone (2- Shure MV7)-5and welcome to the 21st episode of the retire early retire. Now podcast. I'm your host hunter Kelly owner, a Palm valley wealth management. And this podcast helps higher earning families and pre-retirees, but their money's where their values are. And if this is your first time listening, go ahead and subscribe on your favorite podcasting app. Leave a five star review and share this with a friend. I release these episodes every Tuesday morning.
Microphone (2- Shure MV7)-6So be on the lookout for episodes in the future. today we are going to talk about all things. Annuities, we'll jump into some general information here first. we'll talk about the good things about annuities, the bad things, and the ugly things. And so just to give you a little bit of background, And how I've dealt with annuities in the past. So. When I first got into the industry, I worked for a broker dealer for about six or seven years before starting Palm valley wealth management. I dealt with annuities all the time, whether that is clients coming in with annuities, not knowing what they are or how they work or what they should do with them. Or if we were selling them to clients. So I'm very well versed in the different products. I thought this would be a good topic to cover for those people that are getting ready to retire. or maybe they have been pitched an annuity recently from an advisor they were interviewing and didn't know if that was the correct recommendation. so just to give you some more information to help you make a better decision. And if you do have an annuity or you're not sure about your situation, go ahead and hop on my website, Palm valley, wm.com and schedule a call and I would be happy to talk about your specific situation. on whether you need one, whether it's a good fit for you, or if you should go a different route. And so those are all things that we do at Palm valley wealth management. is helping work through those different types of problems. annuities, there are generally three types of annuities. there is a fixed annuity. Fixed index annuity and variable annuity. And so they all kind of work a little bit differently. But what an annuity is just a insurance product. where an insurance carrier is going to have you put your money, whether that be retirement money or what we call non-qualified or after tax dollars. Into this account that basically has insurance wrapped around it, and it's going to take away some sort of risks. So if you think about. life insurance or property and casualty insurance like home insurance. they are taking risk off the table when you buy that insurance. Right? So if it's home insurance, you're taking the risk of, if my house burns down, the insurance company will pay me some sort of benefit to help rebuild that house. Right. so the same thing is happening here with annuities. we're going to take some sort of risk off the table and if that risk or to happen, the insurance carrier is on the hook for that risk. Some risks that can be taken off the table with annuities. Loss of principle. Sometimes people will put money into fixed annuities. Because fixed annuities will say, okay, well, we're not going to put you totally in the market. We'll give you some sort of guaranteed return. But there is 0% chance of you losing. any principle of, what you put in, right? And so if you put a hundred thousand dollars into that fixed annuity, you're going to, at the very least have a hundred thousand dollars. When you go to take that money out. The next thing that you would be able to kind of take the risk off the table is guaranteed income. So a lot of people buy annuities, whether that be immediate. annuities where you put a hundred thousand lump sum, and then they guarantee you income right away for the rest of your life or some sort of term. they will say, okay, well, we're going to pay you 5% of that. A hundred thousand for the rest of your life. And so now you don't have to worry about the market fluctuating sequence and returns, things of that nature, you know, for the rest of your life. You're getting that $5,000, right. And then in some cases, they can take away liability risks. So just like IRAs, there are some creditor protections and things of that nature. So some people will use annuities to. protect those assets from creditors and particular situations. So those are some general, areas where the insurance company can say, Hey, this annuity will take this particular risk off the table. now let's go back to the three types of annuities, fixed annuities, fixed index and variable. And how do they work? So a fixed. Annuity is going to be okay. I give you a hundred thousand dollars. Insurance company, and you're going to guarantee me some sort of rate. And, a lot of times they'll give you like a teaser rate, they'll say, okay, in the first year, we're going to give you 5% interest guaranteed on this, and then you'll have to renew every year potentially.
Microphone (2- Shure MV7)-7And that guaranteed rate that they're going to give you every year that renews. We'll be based off interest rates. So the last couple of years as rates have risen, those, those rates are probably increased, but what we are. at Lois all time rates I'm here three, four years ago. those rates continued to drop. and the fixed annuities, or not as fruitful as they may be now. Right. And so, um, these particular products, these fixed annuities work a lot like CDs. except for the term of the annuity may be longer. It could be a five-year period or a 10-year period where you have to keep that money in without having penalty of taking that money out. So you just have to be aware of, well, how long do I need to keep this money in here to get the full, rate of return that they're going to guarantee me? On this particular annuity. The next type of annuity is called a fixed index annuity. So again, the insurance company is going to take the risk of generally the loss, our principal off the table. Sometimes you will have some annuities. That you can potentially have some loss in a fixed index. but then your return is going to be, your upside will be more generally with fixed index, you're, you're tracing an index like the S and P or the NASDAQ or something of that nature. And as the S and P goes up, you're going to either have some sort of participation rate. So if you have a 50% participation rate, you may be getting half the return of what the S and P would do. So if it did 20%. and a given year you would receive 10% or they may give you some caps and floors, right? The four may be zero, so you don't lose money, but your cat may be 8%. So if the S and P does 25%, you would get 8%. you can see where yes, that can be good because we can mitigate some loss. But if we have a handful of years with some really good returns, You may be out quite a bit of a potential. Earnings there because you're capped at 8% or what have you. And then the next thing. It would be a variable annuity. So you'll have, what's called sub-accounts within the spirit of annuity. So you put your a hundred thousand in, and these sub accounts are essentially just mutual funds. so you can allocate them. to your risk tolerance and your objective, and then it'll grow with the market. And so a lot of times with these fixed index and these variables you can add on what's called a income rider. Like we talked about just a minute ago. Where they will guarantee a certain amount of income each year. And then if the market outperforms, their guarantee, then they'll give you a bump up in that, that guaranteed income. as we'll talk about here in just a little bit, it can get confusing really quick. And so. W what I think about annuity sometimes, especially from someone that doesn't live it day-to-day and hasn't studied it very often. it's almost like if you're listening to a NASCAR driver after a race, talk about, the adjustments they made to their car and all this and that. And if you're not a guru and you don't know a lot about turning wrenches and fixing cars, Then it seems really confusing, right? There's all these widgets and brunches and this and that. just to get it right. I find that annuities are a lot like cars where. Um, they do a lot of the same things, but if you're driving a Mercedes versus a Honda, it's going to look and feel a lot different. Right. if you're not well versed in it, it can be very confusing. we'll talk about that a little bit here in just a second, but. And so you have your fixed, you're fixing next and your variable, and they all have different purposes. Generally the variable is more for income, um, or some growth. fixing index is like, Hey, I want some growth, maybe some potential income. but I want to mitigate loss a little bit and then fix is like, Hey, I don't want to lose anything. I don't really care about the upside. I just want to make sure that my principal's there no matter what. Let's talk about the good news first cause annuities get a lot of bad press rightfully because a lot of times advisors don't use them properly. but there can be good use cases for annuities. And so the biggest thing that I've found that has been helpful. Is helping clients that are, um, potentially in a spot where. Their rate of withdrawal is maybe exceeding what would be a healthy rate of withdrawal. And so what you can do is you can use these annuities that maybe have a. bloated, guarantee. so something like a 6% income off the amount that you put into the annuity. So if you put a hundred thousand dollars in there, they may guarantee 6% income for the rest of their life. Things of that nature. And so you can use this to leverage the distribution rate that you were going to take off their portfolio. And so having that guaranteed income one gives them a peace of mind that no matter what the market does, I'm going to get this 6%. And I know that I can live off of this. Right. And then if they are in a variable annuity, they have the potential of the market outperforms. They have the potential to continue to increase that guarantee. depending on the type of contract that they get into. Right. Um, the next thing that can be good is defer taxes, right? So if for whatever reason, the money that you have in that annuity, Is not IRA money. then you will still get the deferred tax growth within that annuity until you start taking distribution. So for someone that has a high income, and doesn't necessarily want to split off taxes every year, this could be a potential strategy for you. two. mitigate taxes in the, in the short term so that when your income comes down and you start taking distributions off of this annuity, it may be at a lower rate. And so you just have to be very careful with that type of. strategy because it's not like a Roth IRA. It's more like a traditional IRA where you're going to be. That growth is an accountant as ordinary income. And so, and, and because of its annuity, the rule is, Hey, any growth has to be taken out first. So. You'll have a basis. So if you put a hundred thousand dollars in, you'll have a basis of a hundred thousand dollars, but let's say you have that annuity for 10 years. And it grows to $200,000. Well, that first a hundred thousand dollars. Is going to be counted as growth as you take distributions. And then once you get back to your basis, Then, um, you would be able to kind of mitigate those taxes cause you've already paid taxes on that, that money. And so you said be careful with that deferred tax growth. The strategy there. Oh, and in some scenarios you can get that asset protection. if you're in a. Litigious type career. where there's potential for you to get sued and things of that nature, or maybe have creditor problems potentially. Um, having money in an annuity can potentially give you credit or protection. to avoid, uh, having to pay creditors, right. So let's jump into the bad news. The bad news is, generally these annuities. Or annuities in general have high fees. If you're talking about fixed and fixed index. A lot of times the advisor will say, Hey, there's no cost to these annuities and they're not necessarily lying. There is no cost. But you're losing out potentially on opportunity to cost again. If you put these your dollars into these particular, fixed annuities or fixed index annuities, you're going to be capped on the amount of growth that you will have because, the insurance company has to cover their butt too. if you're capped at 8%, every year on the S and P that you're tracking in your fixed index annuity and the S and P over that time. I did 12% each year. Well, then you necessarily didn't pay a fee. But you lost out on that opportunity to receive the full rate of that return, right? So. If you look at it that way, and then you say, okay, well, what am I really paying, for this annuity? And. Am I okay with potentially giving up. Three four, 5% of red return to mitigate this downside in some way, whether that's 0% loss or buffering the loss, whatever the case may be. And if you're okay with that, then that's good. If it keeps you invested longer and. Increases your overall rate of return because you're not selling at the wrong points or getting into cash, whatever the case may be. That may be a good point there. And then if you move her to variable annuities, they generally have three types of fees. they usually have what's called an M and. E V, which is just like the base, this is just a base fee that you have for having the annuity and that can run anywhere from half a percent to one and a half percent. Depending on what company you have, what type of annuity is, and then you have your rider fee. If you want to have guaranteed income on that particular annuity, that's going to cost the insurance company something because they, they have to mitigate that risk. They have to make that up somehow. So they'll have a rider fee. And generally the rider fee to get guaranteed income is again, somewhere between one and 2%. So on the high end, you're already pushing two, two and a half percent and fees before you even get to the. The mutual fund or the sub-account fees. Right. And so a lot of times I saw very low annuities, two and a half, 3% and fees. And so when you think about longterm growth, you're having to Break even at 3% rate of return every year. just to start making money on, on your money in that particular situation. And so if the income is, is very important and as a, uh, big objective of what you're doing, it may make sense to pay that 3%. But if you're not going to use that income. or you're unsure about. if you need. The benefits of this annuity pain, two and a half, 3% for this annuity, you really have to give that thought, about what you want to do. With that particular money that you're setting aside for the subjective. Right. And so what I saw often is that. Advisors would put clients into these annuities. When they're 55, they've left a job and they're going to a new job. They have a roll over, they put it in to this annuity and they say, okay, well, we're going to get a. A guaranteed increase for 10 years, and then they're going to guarantee a certain amount of income. And then they go on 10 years and then they don't use this income. And so the, the issue I have with some of these annuities is that we don't know what our objective is going to be in 10 years. And I talk about this all the time. Think about your life five years ago. Think about what it looks like now. And they probably look very different. Right. And so we don't know what our objective is. So if you're going for. Um, more income based type annuity. The the closer you are to needing that income is probably the better on like, knowing if you're going to use that annuity or not. Because if you're 10 years out, you don't know how the market's going to perform. You don't know if you're actually going to retire things change. You don't know if you're going to retire earlier. There are so many variables that you can't predict. And so locking yourself in, because another bad thing about annuities is you have what's called surrender periods, which we'll talk about in a second, but you're going to lock yourself in. From either five to 10 years. And, and you're not able to really change without paying a significant fee. Right. I would be very cautious about. Putting money into, some sort of annuity where you think you're going to get income in the future. When that future is. Well over five years, right? Because now you're paying for something that you're not necessarily going to use right away. And then you don't. You don't really know if you're going to, you think you're going to use it, but you're not a hundred percent sure. Because again, things change over that time period. the next bad thing about annuity that I don't like about annuities is that you do have that surrender period. So that can be anywhere from, Five to 10 years. Generally I've seen seven is the most common. you can sometimes pay extra to get rid of that surrender fee. But again, now you're just adding on more fees. So you have to get a better return to get. To get back to zero. so just be aware that okay, if I'm putting this money in. I know that there's going to be some sort of charge if I need to get it out. that charge can be upwards of 10%. So if you put a hundred thousand dollars in and a year later, you want to get that money out, it may cost you $10,000. to get that money out. and so as, as, as used goodbye, that few will go down. And so, um, that's just a way for the annuity company to compensate the agent that sold it because these particular products have commissions. that they got to pay out. And so on and so forth. So that's a way for them to recover that money. But you just have to be aware, Hey, if I get into this product, how long do I have to be in it before I'm not paying penalties to get out right. the next thing that I don't like about annuities, it's just an IRS rules, not necessarily insurance, right. Industry rule, but there's no step-up in basis. So what that means is, so like, if you just open up a brokerage account and you bought a bunch of stocks or mutual funds, whatever. And you pass away and it goes to your heirs. It's likely that they're going to get a step up in basis. So let's say you put a hundred thousand dollars into the stock market. And it grows to $250,000 over your lifetime. And then your son and your daughter inherited that money. Well, it's likely that they will get a step-up in basis and it will be like they bought it at $250,000. So they, if they sold it right away, they're in minimal movement in the market. They owe little to no taxes. On those particular holdings. Whereas, if you did the same thing and you bought it with inside of annuity, They would owe income tax on the $150,000 worth of growth in there. And so, um, these are not very efficient vehicles to help, uh, heirs inherit money. Um, So just be cognizant of that. If you're purchasing the annuity, I would not purchase it to. We've it to your kids. I would purchase it for something else that the insurance company can do better, whether that is mitigate loss. You guaranteed income. Creditor protection, whatever the case may be.
Microphone (2- Shure MV7)-8And one other thing about cost basis. If you put this theoretical a hundred thousand dollars in this contract and you say, oh, I don't really need the annuity in. Let's say you wait the 7, 8, 9, 10 years to get rid of that surrender period. That money grows significantly. So from a hundred to 150 or 200,000, and then you want to move it over to the brokerage account, you're going to owe taxes on that growth and that's going to be ordinary income. So that's just something you need to consider when you start putting after tax dollars into annuities, is that. It is not very tax favorable. When you start taking distributions, whether that's your kids or heirs, inheriting that money, or you taking that money out as distributions or just moving. To some sort of brokerage account to manage it differently for different objective. the next role that, um, is not necessarily a bad thing, but can be, a negative thing if you need the money sooner than you're 59 and a half. And that is. The same rules that apply to retirement accounts apply to annuity. So if you put. Money into annuity. Uh, generally, you're not really going to have access to it until you are 59 and a half. without penalty, right? And so you just have to consider. Is this money more long if you're not close to 59 and a half, is this money more long-term money or is it short-term money? And if it's short term money, then definitely you do not need. You do not need to start taking that money out for distributions. You need to leave it in there. or just not do the annuity in general. So just keep that in mind. Annuities do you have the 59 and a half distribution? Will. so let's talk about the ugly. The ugly is the human factor, right? The advisors that use these and properly. like I said, oftentimes. Uh, I would see advisors do reviews with some annuities they sold or potential clients would come in. And they've had these annuities for a long time. And they don't necessarily fit the objective of what they needed to do in the time that they bought them. So they may have bought them 10 years ago because they were going to use them for income. But they don't need the income anymore. yes, I think the visor was probably doing what they thought was best at the time. But. At least in my anecdotal research is they didn't need the income more often than not. And so why are we paying these two, two and a half, sometimes 3% fees on these annuities when we're not going to use the benefits that they give us. Right. So we just have to be really cognizant of. Why am I purchasing this annuity? What risk am I wanting to take off the table? Is that risk going to be a risk when I get to the age that I think I need it. So am I going to need that guaranteed income when I'm 65 or 70 years old, or my assets going to grow in such a way? Because I'm saving properly or the market did well. whatever number of factors is it is my net worth and to grow in a way that I don't necessarily need the. The guaranteed income because my assets are high enough that my withdrawal rate. Is going to be healthy. And the risk of me running out of money is very low. Right. Those are the things that you need to consider. The other thing is that a lot of times these annuities have very high upfront commissions, right. And so that can cloud the judgment of advisors. And again, there's a lot of good advisors out there, but there are a lot of people that go, okay. I have a client that has a million dollars and I put $500,000 of this million dollars into this annuity. I'm going to get a $35,000 paycheck. Right. you just have to be causing cognitive and say, Hey. Like I understand that you're, you're wanting me to do this annuity. I kind of get it. but what is your compensation from this? Like what's the real motive. For doing this. And if they're getting the $35,000 up front, you really got to consider is the annuity the best thing for me, right? I've seen people try to force annuities because they know that they're going to get paid, that, that commission.
Microphone (2- Shure MV7)-9And liked to have talked about in previous episodes. also ask them what. Type of advisor. They are, they feel only are, they fee-based are they insurance-based? and if they're fee-based and then they probably have the ability to use. other methods to help you with your. financial goals and things of that nature, where they don't necessarily need to use. annuities. And if they're insurance-based the only option they may have is that annuity. If that's the case, if most of their income is coming from commission-based products. Then you may want to interview someone else that has the repertoire of potential products or solutions that. we'll fit your needs better versus just trying to hammer in or an annuity because that's what they have and they need to get the business right. so just, just be aware of that. Phi. At the end of the day, find someone that you trust that is going to, um, look at your situation from a 30,000 foot view and then dive in and do What's. In your best interest, right? That is the, uh, overview of annuities, the good, the bad, and the ugly. Um, if you have specific questions about your situation, maybe you have an annuity, maybe you were pitched that or knew he recently. hop onto my website, schedule a call with me. I would love to just review it with you. maybe it is a good thing that you have the annuity given your situation. Maybe it's not, and you need to go look somewhere else. I'd be happy to have that conversation with you. if it, again, if it's your first time listening, go ahead and subscribe to this podcast on your favorite place to listen to podcasts, leave a five-star review and share this with a friend. Again, these episodes come out every Tuesday morning. and, we'll see you in the next one.
Microphone (2- Shure MV7)-10This podcast is for educational purposes. Only. This is not financial advice. This is not an investment advice. This communication should not be relied upon. As a sole factor in an investment making or financial planning decision. If you would like help, please seek a financial tax legal or insurance professional. Please keep Palm valley wealth management in mind when making those considerations.