Jason and Bob discuss the advantages and disadvantages of annuities.


Below is the full transcript:


Announcer: Welcome back, America, to Sound Retirement Radio where we bring you concepts, ideas, and strategies designed to help you achieve clarity, confidence, and freedom as you prepare for and transition through retirement. Now here is your host, Jason Parker.

Jason: Welcome back, America, to another round of Sound Retirement Radio. I want to encourage you and remind you that we have all of these programs archived for you online so that you can go back and listen at your enjoyment. Today’s episode, episode 101, Annuities: The Real Truth is the title. We do, Bob and I … I have the good fortune to have Bob on the program with me. Bob Harkson, welcome back.

Bob: Well, thank you very much, Jason. It’s good to be here.

Jason: Well thank you. Yeah. As many of you may remember, Bob Harkson is a certified financial planner. He’s one of the advisers with our firm. He is our lead adviser out of our Gig Harbor office. He’s just a wealth of knowledge, wealth of information. I wanted to, Bob, ask you about annuities because one of the questions we always bring … One of the questions we always ask people when we’re creating a plan for them is are there any financial tools you would prefer not to work with when creating your plan? Oftentimes the response that we hear is annuities. I thought that was a point that we should dive into.

 Before we do, though, before I get carried away I want to remind our listeners one of the best ways I think we can renew our mind is with the word that comes to us from the Bible. Now, these words have been true and meaningful and lasting for thousands of years, and I think it’s important to recognize that for generations after generations folks have looked to these words for truth and encouragement.

 This comes to us from Joshua 1:9, “Have I not commanded you, be strong and courageous. Do not be afraid. Do not be discouraged, for the Lord, your God, will be with you wherever you go.” That’s awesome.

 Hey, Bob, do you think you would remember me tomorrow?

Bob: Of course.

Jason: Do you think you’d remember me next week?

Bob: Of course.

Jason: Would you remember me in a month from now?

Bob: Well, sure.

Jason: Knock, knock.

Bob: Who’s there?

Jason: I thought you said you’d remember me?

Bob: Very funny. I can’t believe I fell for that. Totally fell for that.

Jason: My son got me with that one over the dinner table the other night. I thought it was awesome. All right, Bob. Episode 101, Annuities: The Real Truth. Let’s start out, I want to ask you, what is an annuity?

Bob: Well, the basic definition of an annuity historically has been it’s a stream of payments over time, over a lifetime, or multiple lifetimes, like a husband and a wife. For example, if you retire from the federal government and you get a paycheck it’ll say retirement annuity on top. Annuity basically means a stream of payment. You have what’s called deferred annuities which are savings vehicles that have the potential for turning into a stream of income over a lifetime over a period of time. That’s basically what an annuity is.

Jason: Okay. Bob, you and I, we have a series of questions we take people through when we’re helping them develop a plan, and one of the questions we always ask is we say, is there any financial tool you would prefer not to work with when creating your plan? One of the nice things about our situation from a planning perspective is because we’re independently licensed, we have the ability to work in the investment world and we have the ability to work in the insurance world, and so when we talk about financial vehicles, we always preface it, we say there’s stocks, bonds, mutual funds, ETFs, annuities, hedge funds, limited partnerships, real estate investment trust, bank CDs, a lot of different financial vehicles out there that people can put their money.

 The two that I probably hear the most of where people say I’d prefer not to use them, I’d say that I hear the most about annuities. Most people say, “I’d prefer not to work with annuities when creating my plan,” and then I also sometimes hear real estate investment trust. Some people have had a bad experience with those. Some people don’t like the sound of hedge funds, so they prefer not to work with those. Some people don’t like individual stocks because they’ve been burned on individual stocks. I think it’s really important to understand that there’s a lot of different ways to help people create a plan. There’s no magic bullet. There’s no financial vehicle that’s perfect. Everything has advantages and disadvantages. We see billions of dollars flowing into annuities every year. In some ways, you want to wonder if all of this money’s flowing into annuities, yes there’s probably some bad about them, but there’s probably some good about them too. What I’d like to do in this episode is really dive into the advantages and the disadvantages of annuities.

 Before we get carried away with time, let’s start with the disadvantages, Bob. As you think about an annuity, what are some of the disadvantages to these different types that you’re talking about, the deferred versus the immediate?

Bob: Well, an immediate annuity is where you take a lump sum payment and you turn it into a stream of income. The advantages, you have a guaranteed stream of income. It’s not subject to the volatility of the market. It’s going to be a regular payment that you get based upon the contract. Some of them will even include cost of living increases or a fixed percentage increase every year. Now, one of the disadvantages, we’re in a low interest rate environment, so they’re not paying quite as well what they were five or six years ago, but they can still be an effective tool to guarantee.

 I remember meeting one time with a retired pilot from one of the major airlines and his retirement was an annuity from Prudential Life Insurance over his lifetime and his wife’s lifetime. The private sector uses these a lot. Most of the time they’re issued by insurance companies. The thing is, you take your money and you pay it out over time. The downside is you’ve given up control of that money or if you want to get it back, you have to pay a significant charge reduction or a surrender charge.

Jason: In most instances … I was just going to say, in most instances on an immediate annuity, you’ve lost liquidity. Let’s say you take $100,000, you give it to an insurance company, the insurance company promises and guarantees that they’re going to pay you income, either fixed income or some kind of inflation adjusted income. They come in various flavors, but they’re going to pay you in income that’s guaranteed to last for the rest of your life. Now, there are little nuances within that guarantee. You can say, I want it to be guaranteed for my life and for my spouse’s life. That would be a joint life annuity. You can guarantee that the income is going to be for a specific period of time, so you can say, “Here’s $100,000, pay me income for 10 years,” and then the income goes away. Basically what you’re talking about with the single premium immediate annuity is a pension. It’s guaranteed cash flow. The biggest disadvantage is if you give the insurance company $100,000, they promise you the income, the trade off is you can’t go access that $100,000 anymore.

Bob: Yeah, exactly. One of the things where people get hung up on is, what if we both die in a car wreck tomorrow? One thing to keep in mind that you can also attach some guarantees that it will pay for at least ten years to your heirs, fifteen or whatever. That’s one thing that needs to be made clear. It’s not just a lifetime stream of income that goes away when both of you die. What you’re doing is you want to make sure that you’re in good health and that you’re making a bet with the insurance company and if you live a long life, they’re a fantastic tool. Even besides that, because none of us knows what our fate is, they’re a great tool for setting an income for.

 For example, social security is a lifetime annuity. You pension, if you’re in the state of Washington, your pension is a lifetime annuity for you or your spouse’s life, whatever you choose. In essence, they may not be issued by insurance companies, but they function exactly the same. I think it really is specific to your situation and what your needs are, and oftentimes immediate annuities will be used as part of a plan to establish and income that’s guaranteed to meet the basic needs of your budget. Social security or federal pension.

Jason: You hit on a real hot topic there. You hit on the topic of a death benefit. The idea that … I think this is where a lot of people say, I don’t want to use an annuity because they say, “Well, if I take money and I turn it into an income stream and it’s a lifetime only annuity, what that means is that if I die in a car accident two weeks later, my heirs aren’t going to get anything,” and that’s a true statement. You want to make sure that you understand there are advantages and disadvantages to those types of pension annuities. Like you say, there are nuances and different things that you can add onto them so that there is money that goes to your estate when you die.

 I think the other important thing that people need to understand about annuities is that they’re contract-driven. You have to understand the contract that you’re purchasing and what it’s intended to accomplish. You talked about some of the advantages there too. I mean, you get a room of economists together and ask them if people should annuitize a portion of their retirement assets and it’s hard to see a room of economists agree on anything, but when you ask the question about mortality credits and annuity contracts, it’s going to be highly unusual to find a group of economists that are going to say that you should not annuitize a portion of your retirement assets because, like you say, it can help create that guaranteed retirement floor. That’s a very secure way of doing income planning without having to worry about the whims of the stock market or the bond market. For people that just really like safety, they don’t want to have a lot of uncertainty in their life, taking some of their money and turning it into a guaranteed income stream can be one way to help alleviate some of the concerns about running out of money in retirement.

Bob: You’re absolutely correct. I think it’s specific to your situation, but it’s creating that income more and more becomes critical with the volatility of the market and a lot of the rules that we had in the past have kind of gone out the window and one of them has to do with the market swings that we’ve had and the fact that we are a low interest rate environment. I think they can be a wonderful tool if used appropriately.

 Annuities aren’t good or bad, it’s are they appropriate or inappropriate. Now, I’m sure there are some bad annuities out there that have high expenses and things, but I think if you’re guided properly and you carefully select an annuity, it can potentially be a good part of a retirement income plan, an immediate annuity.

Jason: Well, there’s people out there that say they hate annuities and they would argue that there’s never a case where an annuity is appropriate. Can you think of a situation, Bob, where an annuity would never be appropriate, where people should hate them and avoid them like the plague?

Bob: Not necessarily. I think you just have … It’s a case by case basis. Now, one of the things is when people say, “I hate annuities,” they’re generally people that are advertising something that they want to sell that’s a different type of investment vehicle. That’s a great way to catch your eye. I think there’s been some negative press. Some of it is legitimate and a lot of it’s very unfair. What happens is we hear the word and we immediately emotionally respond. I think the key is to do the homework and to see what it is, what it means. You’ve got people that say, “I never want to use annuities,” and you ask them why. “Well, my brother-in-law said they’re terrible.” That’s not a good reason just because you brought up your brother-in-law’s opinion. I think do the homework and listen carefully because oftentimes folks will go, “Oh, I like this.”

Jason: Yeah, understanding what the goal is, what we’re trying to accomplish, but at the same time as financial advisers, Bob, our job is to help people create plans the way that they want them done. That’s one of the reasons we ask …

Bob: Exactly.

Jason: That’s the reason we ask the question, “Hey, are there any financial tools you don’t want to use when creating your plan?” You know what? If people have had a bad experience with an annuity or they want to listen to their brother-in-law or they want to read these ads that say you should hate annuities and they just don’t want to use annuities, then I would encourage them, create the plan without using an annuity. It doesn’t have to be complicated.

Bob: Absolutely. Absolutely.

Jason: I think if you’re talking to somebody…

Bob: I absolutely agree. Hello?

Jason: Go ahead. Go ahead. Finish your thought, Bob.

Bob: I’m sorry. I thought we lost our connection there. I would say, and we never ask people to do things they’re uncomfortable with or they won’t sleep at night with, so we always create the plan based on their desires and their needs and there are lots of tools in the tool chest when we’re doing financial planning and income planning. Absolutely, I think if it’s something that people are uncomfortable with, I don’t think it’s something that we push or insist on or try to convince. I think it has to be something that folks are comfortable with. That’s the best way to phrase it, I think.

Jason: Yeah. Our job is to understand there’s all of these different tools that exist, our job is to spend the time to educate people how they work and it’s the client’s job to decide which financial tools they want to use. That’s the way that it should be. Now, if you’re working with an adviser that only has one tool that they have available to them, if their insurance only licensed, guess what, they’re only going to recommend life insurance or they’re only going to recommend annuities because that’s all they have to offer. You just really want to work with somebody that has a fiduciary responsibility to act in your best interest, that has the ability to access all of these different financial tools to help you sort through them.

Bob: Absolutely.

Jason: Getting off topic here a little bit. I want to keep on this idea of annuities. We’ve talked about the immediate annuity. The other type of an annuity is a deferred annuity. You explained that that’s an annuity contract that’s more like a savings vehicle. It doesn’t produce income now, but it has the potential to produce income in the future. Take a minute and help our listeners understand because there’s different types of deferred annuities. What are some of those different deferred annuities?

Bob: Basically, let’s start with the fact that an annuity that’s held outside of a retirement plan is tax deferred. In some ways, it’s like taking a CD. A CD, as you earn interest, you have to pay tax on the interest even though you haven’t received the money. A deferred annuity, that tax is deferred until the time that you pull the money out. You could make a difference in the growth rates of your funds over time. At a future point, you could annuitize it over a period of time and oftentimes the next benefit is more positive than it is, for example, holding a CD with the equal interest rate.

 Now, a deferred annuity, basically there’s two types. There’s a fixed annuity … Well there’s three, actually. There’s a fixed annuity, there are indexed annuities, and then there’s a variable annuity. The fixed annuity pays a fixed interest rate. It may be guaranteed for a year or two years and then it floats with the market. It may be guaranteed for the length of the contract. They could be for five years, they can be for three years, they can be for seven, they can be for ten, and basically they function as a tax deferred saving vehicle and often the interest rate that’s paid is a little better than what you can get at a bank or any other alternative fixed investment. [inaudible 00:16:05] used the term CDs or certificates of disappointment, you know? The CD rates right now are not very compelling.

 The indexed annuity is basically where you’re guaranteed never to lose money, but it goes up with one of the market indexes, the S&P 500 or the DOW, all other kinds of indexes, but it’s capped usually at 6 or 7%. It won’t go 20% up, but it’s a nice tool kind of in between where you’re not going to lose money, but you can have partial participation on the upswings of the market.

 Then there’s a variable annuity which is basically made up of what’s called sub accounts which are mutual funds, per se, that you choose and you can invest in the market. It goes up and down with the market. It can lose money or it can gain money. Over a long period of time, a variable annuity will probably do better than the fixed annuity, but there’s a lot of volatility and a lot of folks don’t want to participate in that.

Jason: Now the world just got more complicated.

Bob: Those are the three basic categories.

Jason: Yeah, but you took annuities and we started with the immediate annuity, the income annuity, the pension annuity, and then we transitioned into the fixed deferred annuity, which is kind of like a CD. Then we talked about the index annuity that allows you some upside potential, no downside risk. Then we talked about the variable annuity, which is basically mutual funds in an annuity wrapper that has more volatility and usually a lot of fees.

 Bob, I think part of the challenge when you have a discussion about annuities is that people will use the term annuity, lump all of those different types into one tool, and they’ll say, “I hate annuities.” You’re not really doing a service to anybody to take all of these different financial contracts and throw them under a bus.

 The other thing I want to say, a couple of things, number one, when it comes to the terms because you mentioned a 6 or 7% cap, I just want to remind people, it depends on the terms of the contract that you’re reviewing on those fixed index annuities. The terms are subject to change all the time. What the terms are today could be different than what they are tomorrow because they’re driven by the interest rate.

 Insurance companies, they have to have reserves which primarily are investment grade bonds. They’re buying treasuries, they’re buying high quality corporate bonds, and when the interest rate environment decreases, the attractiveness of some of these different tools may not be as good in a low interest rate environment as they are in a high interest rate environment, so you just have to really evaluate them.

 The other thing I wanted to talk on real quickly is taxes because you talk about deferred annuities being taxed deferred and that’s why they’re called deferred. They’re not generating income now, so they’re deferred, and they’re growing tax deferred. There’s two arguments that you can make on taxes here. One person, you especially hear this from the annuity salesman camp, the insurance guys, they say, “Hey, look, an annuity’s great because you get to earn interest on your … You get compounding on your interest and compounding on your tax savings because you don’t get a 1099 every year. You have control over the tax liability. If you want to take the interest out and the contract allows you to take the interest out every year, maybe you choose not to defer the interest and you just take it like you would a CD interest. You have control over the tax liability.

 The people that sell against annuities, the people that only work in the investment world, they will make the argument that tax rates are at all time lows, that when you pull money out of an annuity, you don’t benefit from long-term capital gains like you do a stock or an investment, and that you have to pay ordinary income tax on the annuity income. If you have a deferred annuity that’s in a non-qualified account that’s growing for a long time and then you die, your heirs have to pay ordinary income tax on the difference between what you put into the contract versus what it’s worth. You put $100,000 into a contract, you die, now it’s worth $120,000, your heirs inherit that non-qualified money, they’re responsible for paying taxes on the $20,000 of ordinary income. Some people make the argument that that’s not as tax efficient as buying real estate that gets stepped up basis or buying stocks that get stepped up basis. When it comes to taxes, you just have to understand, you can make an argument either way for the benefits or the disadvantages of that deferred status, it just depends on what you’re trying to accomplish, really.

Bob: It depends on what you look at what your potential tax rate could be in the future. You know, one of the fallacies people have is I’ll be in a lower tax rate when I retire. That’s changing. One, it’s changing because people are putting money away for retirement and they’re retiring a little better than they thought they would. The other thing is potential for higher income tax rates. The biggest one is that when you lose a spouse, your whole tax situation shifts. What would’ve been a great strategy for being married for a long time and growing old together may not be if you become a widow or a widower. Yeah, the future tax situation, we don’t know. That’s where it becomes a little bit of a challenge in terms of whether these are efficient or not.

Jason: The other thing I would say about annuities, deferred annuities, Bob, and correct me if you disagree with this, but I think they’ve been designed really primarily for people who are looking at retirement and especially for people over age 59 and a half because with an annuity, if you fund the annuity contract and you take a distribution from that contract, there’s potential tax penalties that you take for taking distributions before age 59 and a half, just like a retirement account. Is that correct?

Bob: Absolutely, 10% penalty. Not only do you pay tax on whatever the gain is, you pay a penalty. For example, you would not use it as a savings vehicle for a 30 year old. It’s a savings vehicle for somebody who’s not going to have to access the money until they’re 59 and a half. There’s some exceptions to that, but that’s the general rule of thumb, absolutely.

Jason: When you think about it, they’re designed because some of the things that they offer is they offer … Many of the contracts offer liquidity that says if you want to be able to access some of your money every year, you can access it without a penalty. Again, just getting to this idea because I remember once a gentleman called and I think he was in his 40s and he said, “Hey, I’m thinking about buying this deferred annuity, holding it for five years, and then taking my money out and doing something different with it,” I explained to him, I said, “Hey, that deferred annuity may not be the best tool for you in that scenario because not only are you going to have to pay taxes on the gains, on the ordinary income as you pull it out, but you’re also going to have to be hit with a penalty if you plan on exiting that contract or exiting annuities and using the money for some other purpose like paying for college or buying a house. You just want to be careful.

 Bob, I just can’t emphasize enough, like you said, there’s good, there’s bad, there’s ugly. I will say, in my experience, because we review a lot of these different contracts for people in immediate annuities, deferred annuities, index annuities, and variable annuities, the one annuity that I’ve never been personally a big fan of is the variable annuity. I want to just clarify why, for me, that has been the case. Variable annuities, my experience has been that oftentimes the fees within those contracts can range anywhere from two to I’ve seen them as high as 4% per year for the underlying guarantee of the insurance. I mean, those are all the fees. You’ve got the insurance fees, the mortality and expense fees, the mutual fund fees. When you wrap all those together, you end up at 4%, 2.5%, 3% per year and in a world that we live in today, if you’re paying 4% in fees, it’s going to be hard to see your money grow. I have never been a big fan of the variable annuity.

 Bob, I realize with that, we’re out of time. Thank you for being a guest and for folks online, visit us at Sound Retirement Planning. Thanks for being here.

Bob: Thank you. Bye-bye.

Announcer: Information and the opinions expressed here are believed to be accurate and complete for general information only and should not be construed as specific tax, legal, or financial advice for any individual and does not constitute a solicitation for any securities or insurance products. Please consult with your financial professional before taking action on anything discussed in this program. Barker Financial, its representatives, or its affiliates have no liability for investment decisions or other actions taken or made by you based on the information provided in this program. All insurance related discussions are subject to the claims paying ability of the company. Investing involves risk.

 Jason Barker is the president of Barker Financial, an independent, fee-based wealth management firm located at 9057 Washington Avenue NW Silverdale, Washington. For additional information, call 1-800-514-5046 or visit us online at SoundRetirementPlanning.com.