Jason and Emilia talk about annuities and how they can be used as a tool in retirement planning.
Below is the full transcript:
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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: America, welcome back to another round of Sound Retirement Radio. So glad to have you tuning in this morning. It’s my good fortune I have Emilia Bernal back in the studio with me. Good morning, Emilia.
Emilia: Good morning.
Jason: How are you?
Emilia: I’m doing great today.
Jason: Good. We like to start the day two ways, first by renewing our mind, and then we’ve got a joke for you. And this verse that I wanted to share with you this morning comes from Hebrews 2, Verse 1. It reads: We must pay the most careful attention, therefore, to what we have heard, so that we do not drift away.
Gosh, I’ve been thinking a lot about this one. I know you and I, I think I shared this one a couple of weeks back, but, it’s just one I’ve been studying and researching and thinking about. It’s on my mind.
Emilia: Yeah, that’s great. So now here I go with my joke of the day.
Jason: Okay, let’s hear it. Here’s the joke!
Emilia: What do you call a sleeping bull?
Jason: I don’t know, what do you call a sleeping bull?
Emilia: A bulldozer. These are great.
Jason: I wish people could see the facial expression you give me when you give me the punch line there.
Emilia: I’m just wondering if you’re going to get it, but then I’m like, yeah, it’s not that hard.
Jason: Okay. This is episode 158, the title is: What are annuities?
Emilia: Uh-oh. Here we go! So Jason, what are the different types of annuities? Or what are annuities?
Jason: Yeah, well, annuities, first of all, in very simplistically, simply, if I could talk this morning I’d be doing a lot better. It always helps to be able to talk, when you’re hosting a radio show.
Emilia: There you go.
Jason: An annuity is a contract with an insurance company, and I like to think of annuities, there’s really four primary different types of annuities. The first type of an annuity is what we call an immediate annuity. And that, most people, when they think of an immediate annuity, that is an income stream. It’s a pension. Often times, when people retire from a job that offers a pension, they’re receiving an immediate annuity.
The second type of an annuity is what we call a deferred annuity. A deferred annuity is a contract that an insurance company offers that usually pays a fixed interest rate. It doesn’t currently pay any income, but it could be converted to an income stream in the future. I think the easiest way to think about a deferred annuity is to, it’s kind of like the insurance version, insurance company version of a bank CD. It just a contract that pays a fixed interest rate for a set period of time, is the way that most people, most fixed deferred annuities work.
Now, there are deferred income annuities. Let me back up. That first type of annuity, the pension annuity, most of the time we’re talking about single-premium immediate annuities, an annuity that starts right away. It could be a single-premium deferred income annuity, which is an income annuity that doesn’t start until some point in the future. You’ve got income annuities, and you’ve got these deferred, fixed-rate annuities, kind of like a CD. Just an instrument that pays a fixed interest rate. Those are the first two, Emilia. I’m going to keep going with this, but this whole conversation about annuities can get kind of confusing. Any questions so far, as I’ve discussed those first two? The first one’s for income, the second one is for just a fixed interest rate. Does that make sense?
Emilia: Yes. Well, I’m kind of familiar, but I can see what you’re saying. It’s going to get a little confusing, but yeah. Is there, maybe, an order that would be easier for you to go down, and, do they build on each other in any way?
Jason: Yeah, I think what I’m doing is, I’m starting with what most people think of in terms of an annuity, is the income piece. The deferred annuity is just a very secure place to put money to grow. The next type of an annuity, as you kind of increase your … Usually a time horizon and also the risk associated with it, would be, today they’re called fixed indexed annuities.
A fixed indexed annuity is built on a fixed deferred annuity chassis, so it pays, it usually guarantees a fixed interest rate. And then, but the way that it credits interest is that you are linked to an outside index, such as the S&P500 Index, or the Dow Jones Industrial Index, I mean, there’s a lot of these indexes that are being put together. Sometimes you’re linked to gold, or real estate, or Treasury bonds, I mean, you can be linked to a lot of different things. But the way that the contract credits interest to you is based on how those external indexes do.
What makes the fixed indexed annuity unique is that it gives you some of the upside potential of those outside indexes, but it takes away the risk of losing money if the index goes down. So you have some upside potential, no downside risk, in terms of the interest that you could earn.
And then, the final type of an annuity, we’ve covered three now. We’ve covered the deferred, or the income annuity, the deferred annuity, and then the fixed indexed annuity. The last one is what we call a variable annuity. And a variable annuity, the easiest way to think of those contracts, is to think of a mutual fund. It’s basically the insurance version, the insurance way of competing with a mutual fund. They call them sub-accounts, but essentially they’re mutual fund-type structures, inside of an annuity wrapper. You’ve got this annuity contract, and then with inside it, you have these investments. And a variable annuity is, again, it’s like a mutual fund. It’s going to go up and down in value, and sometimes, on the fixed indexed annuity, or the variable annuity, they also offer riders.
A rider is a portion of a contract, it’s a piece of a contract, and it’s usually some type of guarantee. And usually that guarantee has something to do with either future cash flow, future income, a future death benefit, a combination of those, or sometimes now they also have riders to help people pay for home care costs, or some type of long-term care costs. Like I say, it’s hard to talk about annuities, because they’re contract-driven, we’re trying to have a broad-based conversation about how, what these things are. But unless we’re looking at a specific contract, they’re kind of hard to understand. They can be, at least.
Emilia: Well, I think what our listeners may want to then focus on, in a general aspect, is, what are the pros and cons of annuities for retirement planning?
Jason: Again, this is very contract-specific. If you’re going to consider an annuity, one of the things I would highly recommend is that you work with somebody that has the ability, that’s independently licensed. So they don’t just work for one insurance company. They have the ability to go out into the entire universe of annuities to compare the different features and the benefits and the fees and the costs. But ultimately, the pros and cons, here again, we’ll start with the most basic.
When we talk about that immediate annuity, you give the insurance company, or you purchase, I shouldn’t say you give, you purchase an annuity from an insurance company. And if you’re buying an immediate annuity, essentially what they’re doing is that they’re guaranteeing that they’re going to pay you an income stream. That income stream, you get to decide how long you want it to last. So you can say, “I want the income stream to be guaranteed for the rest of my life.” “I want the income stream to be guaranteed for my life and my spouse’s life.” “I only want the income stream guaranteed for five years,” so you can do a period certain. Or you can say, “I want the income stream guaranteed for a period certain, five years and life.” They just give you all these different combinations for how you can take income.
Some of the disadvantages to those contracts, probably the biggest one, and the way that most people think of that type of an annuity, an immediate annuity, you give the insurance company, or you purchase an annuity from an insurance company, you get this income stream. If you choose the life-only option, and then you die two weeks after you started the income, you didn’t choose any kind of beneficiary election, you didn’t choose a period certain. Then that annuity income stops, and the insurance company gets to keep everything that you put into it. You’re playing this gamble, there’s this bet that you’re making with the insurance company. You’re betting that you’re going to live a really long time, and they’re betting that you’re going to live to life expectancy. And an insurance company has the ability to pool life expectancy risk, or mortality, they call them mortality credits. That’s why sometimes on those immediate annuities, they can give you these really attractive payouts, because they know that some people are going to die soon, and some people are going to live a long time, and that’s how they make their money on those.
That’s probably the biggest disadvantage. You give up some control of the principal–you can’t get your principal back, because you’ve converted it to an income stream. And if you die early, and you choose the life only option, you could be out a substantial amount of money.
That’s one of the negatives. Let’s talk about one of the pros associated with the immediate annuity. For people that are, remember, annuities really are designed for people who are thinking about retirement. Because it’s, an annuity is a contract with an insurance company, but originally they were designed for cash flow, for income that you couldn’t outlive.
The way that some people would use an immediate annuity in today’s environment is, let’s say they know that they’re going to have $3000 a month of combined Social Security. So maybe, the wife’s Social Security is going to be $2000 a month, the husband’s is going to be $1000 a month. Combined, they have $3000 per month. But their budget requires $5000 per month. So they’ve got a $2000 a month gap. The concept here is what we call the flooring concept for retirement income. And the flooring concept says you don’t want to gamble with your basic income needs. Some people would purchase an annuity from an insurance company to provide them with that $2000 a month difference between what their expenses are, versus what their Social Security is, just so that they know that their minimum expenses are going to be covered with that annuity contract.
They can be good tools. A lot of people in the academic community really like immediate annuities.
Emilia: Okay, so, they can be good tools, as you mentioned. But are annuities bad investments?
Jason: Yeah, well, so with something like an immediate annuity, it’s not an investment. It’s an insurance contract. I mean, you’re buying guaranteed cash flow from the insurance company. And so I think, sometimes people get annuity contracts confused with an investment. An investment is something like stocks, or bonds, or equities. There’s the ability to go up and down in value. With an insurance contract, it’s not an investment, it’s a contract with an insurance company, and so I would say if you think it’s an investment, then yes, it is a bad investment. Because that’s not what it’s designed to do. It’s designed to pay either a fixed interest rate, or you can have these variable annuity contracts that are based on these sub-accounts, that are based on what the stock market’s doing. So they’re, you know, you can have that. As we talk about the immediate annuity, that’s not an investment.
But let’s keep going down the list here. The deferred annuity, that’s the one that pays a fixed interest rate. The disadvantage to those contracts are that they typically have a surrender charge associated with them. Kind of like a bank CD, if you put money into a bank CD and then exit the CD before the maturity date you get a penalty. Same thing with a fixed deferred annuity. So there’s a liquidity cost there. And again, the annuities are contract-driven, so you really need to look at them on a one-on, one-off basis.
But as a kind of a big picture, now that we’re beyond the immediate annuities, if you think about fixed deferred annuities, fixed indexed annuities, and variable annuities, surrender charges are an issue on almost all annuity contracts. If you want to get back out of the contract, often times there’s a penalty. There are some annuities out there today that don’t have surrender charges, but those are just now becoming more of a new thing in the industry.
And then, surrender charges, fees, liquidity. Those are the types of questions people should be asking, if they’re thinking about including an annuity as part of their overall financial plan heading into retirement.
Emilia: And this is a question I have, just because I see the annuities coming through a lot, and I know it’s different from each state from what I understand. But, there’s a free withdrawal for most annuities, right? A percentage a year, if the funds are needed, is that right?
Jason: Potentially, yeah. Again, it’s contract-driven, so not all contracts offer this feature. But many of the contracts do provide for some liquidity, where they say, for example, let’s say you have a fixed deferred annuity that’s going to pay a fixed interest rate for a short period of time. Often times, the contracts that we see, they will say that you can take out ten percent per year without any penalty. So there is some liquidity, maybe a little bit more than people might find in a bank CD. But generally speaking, that’s considered a safe place to earn a fixed interest rate. And as most people know, interest rates are just, they’re finally starting to go up after about ten years. But you just don’t earn much interest these days, on a fixed account.
Emilia: Okay. So, a lot of people say, “I hate annuities.”
Jason: I’ve heard that, yeah.
Emilia: Do you hate annuities?
Jason: Well, some of them, I sure do. The issue that I have with the, you know, this is a marketing ploy, is what it is. There are people out there that say, “I hate annuities,” because they don’t work with annuities. All they work with are investments, stocks and bonds. And then, you’ve got the other guys, the insurance-only guys, and they say, they hate the stock market. They say that retirees shouldn’t be putting their money at risk, and they’re taking too much risk with their investments.
Here’s what I’ve found. When I went to, I was repairing and repainting my deck last year, and I decided not to nail in the new railings. I went out and bought these really fancy deck screws. Now, if I had taken my hammer and tried to hammer in those deck screws, that probably wouldn’t have turned out very good. Instead, I had a drill, and I had this very specific bit that was designed for those deck screws. And it made my life really easy. But it’s because I had the right tool for the right job, based on what I was trying to accomplish.
If you talk to somebody that’s only working with investments, then that’s, you know, they only have one tool that they can work with. If you talk with somebody that’s only working in the insurance world, then they only have one tool to work with. So you might need a drill and a special bit, but all they have is a hammer. Guess what they’re going to recommend? They’re going to recommend a hammer. So the people that say, I mean using a word like “hate” is so strong. But to hate something says that it’s never appropriate, that there’s no contracts that are out there that are reasonable or good, and I just don’t think that’s responsible financial advice-giving.
If you really want somebody that’s going to give you proper advice, I think the best thing that people can do is look for somebody that’s independently licensed. They work as an independent advisory firm, and they have the ability to look at investments and insurance contracts, give you an unbiased recommendation on those different contracts. I think that the conflict of interest you have to look out for there is who are you going to buy the contract from, because insurance annuities pay a commission to the person selling them.
So you don’t have to buy a contract from the same person that recommends, if they recommend it’s a part of your retirement plan. You don’t have to buy it from them, you can go buy it from anybody you like, to avoid the conflict of interest of the commission being paid. And I think that’s really the issue that people have in the financial services arena. The people that are truly fee-only, that can’t accept commissions, they say there’s a conflict of interest, because they don’t want to receive a commission on that product. But that doesn’t mean that there’s never a case, where those types of tools are appropriate for people, it just means that they shouldn’t get paid a commission. Or they need to disclose the conflict of interest, and make sure that if people are going to purchase it, that they understand that there’s a commission being paid. That’s the job of a fiduciary, is to disclose any conflicts of interest that exist.
Emilia: Yeah, that’s very important. So, when would be a time that you, that someone should consider purchasing an annuity?
Jason: Yeah, again, it really depends on what’s the purpose of the money. What are people trying to accomplish. Do they need income at some future point? A lot of times where an annuity, people are looking at them as if they need income today. They’re just getting ready to retire, and they’re trying to, they’re doing that flooring approach, where they want some guaranteed cash flow. They don’t want to depend 100% on the whims of the stock market. The, another place that people would use an annuity is if they don’t want all of their retirement money in an at-risk position. Maybe they want some money in a fixed account. An annuity contract can deliver that kind of, have some money set aside in more of a secure position.
And it really depends on, again, getting back to the main question, what’s the purpose? What are you trying to accomplish? If you are trying to put screws into your deck, you probably want to use a drill. If you’re trying to put nails into the deck, you probably want to use a hammer. Let’s just use the right tool, based on what you’re trying to accomplish.
An annuity’s just a financial tool, Emilia. I think that’s the most important thing. And, you know, here’s another very controversial financial tool. It’s reverse mortgages. That’s another one where you use that term, and there are people out there that say, “I hate reverse mortgages.” Well, I just don’t think that’s responsible. I mean, if a reverse mortgage is the financial tool that’s going to best serve somebody based on what their financial situation is, well, let’s review the pros and the cons. What are the advantages and disadvantages. What are the fees and the liquidity. What are the risks associated. And then make a good decision based on that information.
Emilia: Yeah. I think the best part of this is, you’re saying educate yourself on these things before you make a decision.
Jason: Yeah.
Emilia: That’s the best thing to do. And so, I want to take a moment. We have some learning opportunities for our listeners.
Jason: Yes, thank you.
Emilia: We have a webinar, you have a webinar scheduled for February 6th at 5:30 PM Pacific Standard Time. And if our listeners would like to register for that webinar, you can go to SoundRetirementPlanning.com and click on the link there.
Jason: Now, that webinar, that first one, the one on February 6th, is about the new tax law. And, so I wanted to make sure that, and again, the new tax law, but as it pertains to retirees. So, we’re not going to be talking about businesses and corporations. Well, maybe a little bit, just how we think that this could play out for corporations. But the emphasis of the tax law discussion is specific to retirees and things that retirees need to be thinking about.
Emilia: That’s important. And then, the second webinar is on retirement planning, and that one is for February 22nd, also at 5:30 PM Pacific Standard Time, and the link is also found on SoundRetirementPlanning.com, so you can register for both of those today. Do it now, if you’re interested. Yeah.
Jason: Yeah. One of the things I want to say about those webinars, too, is these webinars are not recorded. So we’re airing them at a time when most people are off of work, so they can set aside some time in the evening to watch it. If you’re out on the East Coast, you know, we’re 8:30, 9:30. 8:30 at night. Here, Pacific Standard Time it’s going to be 5:30. But they’re not recorded, so this is, there’s no replay available. If they want to sign up, I encourage them to sign up. There is limited seating, and I don’t know if we’re … I think we’re approaching capacity on the tax webinar. But yeah, for sure.
Emilia: Great. Do we have some time for a couple more questions?
Jason: Yes.
Emilia: Great. I wanted to ask, how can someone find the best annuity rates?
Jason: Well, again, that’s tricky. Here’s the problem. Annuities are insurance products. Insurance contracts are regulated on a state-by-state basis, not on a federal basis. So it depends on what state you’re in. And then, there’s not one centralized source that people can go to. You would think with the internet today, there would be one place you could go, but even a lot of the internet sources that are out there, they give you very broad, general advice, because they don’t know what state you’re in, and all these contracts are state-specific. Again, I think the best advice for people, if they’re trying to make a decision about an annuity contract, is to try to find somebody that’s insurance licensed in the state that they’re working, that can look at all of the different contracts that are available to help them find the best rate for them. Yeah, I wish there was one place you could go, where you could just find the best interest rates. There’s definitely an opportunity to create there, I think.
Emilia: That’s what I was just thinking.
Jason: You should get after that.
Emilia: Was it like Trivago, where they have all of those-
Jason: Maybe that will be the next website I build.
Emilia: Yeah. I have one more question. Can you give us an annuity example, when creating a retirement income plan?
Jason: Yes. Here’s an example of how people might think of using an annuity. Let’s say we’re creating a structure where, again, going back to this example, they have $3000 a month as a couple of Social Security income. Their budget requires $5000 a month. There’s $2000 a month gap. That would be an appropriate use of something like an immediate annuity. Because the immediate annuity is, they can purchase an annuity contract from the insurance company, they can put it on joint life, and guarantee that that income’s going to last for, as long as one of those people are alive. They’re going to continue to receive that guaranteed income every month. And so, if they’re really nervous about stock market volatility, or bond prices, or whatever the case may be, that might be a good tool to help give them a little bit more confidence.
Another way that people might use an annuity contract is, let’s say that they’re dissatisfied with the interest rates that banks are paying on certificates of deposit. And they’re looking at a tool like a fixed indexed annuity. And these annuities pay interest based on the upward movement of the stock market, so if the stock market’s doing well, you earn more interest, and if it does poorly, you don’t lose anything, you just have a zero. So that might be an area where people say, well, maybe that would be a tool for the short-term, five to seven years, where they want to have some money allocated to that position because they want to try to earn a little bit better interest rate than what they might get in a fixed deferred annuity or a bank CD or something like that.
Another scenario where an annuity could come into a retirement plan would be, let’s say they have, they don’t need income for maybe five or ten years down the road. And so they can purchase a contract that has a guaranteed income rider on it that guarantees that their income value’s compounding and growing at a certain percentage every year. That could be a solution. There’s just a lot of different ways.
I think the most important thing to understand is, there’s really no bad financial tool. They can be sold inappropriately, to people that don’t really need them. That happens all the time. But these tools have, they can have a purpose, and I think it’s just understanding what’s your purpose, what are you trying to accomplish.
Emilia, I just realized we’re out of time.
Emilia: All right.
Jason: Thank you for being here.
Emilia: You’re welcome.
Announcer: Information and opinions expressed here are believe 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. Parker Financial, its representatives, or 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 discussion are subject to the claims-paying ability of the company. Investing involves risk. Jason Parker is the president of Parker Financial, an independent, fee-based wealth management firm, located at 9057 Washington Avenue Northwest, Silverdale Washington. For additional information, call 1-800-514-5046, or visit us online at SoundRetirementPlanning.com.
