Jason and Emilia discuss when annnuities make sense in a retirement plan.

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. And now here’s your host, Jason Parker.

Jason: America, welcome back to another round of Sound Retirement Radio. So glad to have you tuning in. It’s my good fortune to have Emilia Bernal back in the studio with me this morning. Emilia.

Emilia: Hi, Thanks Jason.

Jason: Good morning.

Emilia: Good morning.

Jason: So, we like to start the morning right. Two ways around here Emilia. The first is with a verse and this one is Ecclesiastes 7:9. “Do not be quickly provoked in your spirit for anger resides in the lap of fools.” You’ve got a joke for us. Tell us how this came to be.

Emilia: I thought I was doing a pretty good job. Well, I’ll get our listener’s opinion today. But, we had a client send us-

Jason: Not a client, but a listener.

Emilia: A listener, sorry. A listener, yeah, send us an email that said we might need a little help with the jokes. So, I got a call from them and so, I’m going to share one with you and you can just let me know or if anybody else has, our listeners would like to send some more jokes our way, they’re always helpful.

Jason: I think he said too that these are ones that his grandkids really appreciated.

Emilia: Yes, grandkids like these ones. So I don’t think I’ve done this one. Where do you find a cow with no legs?

Jason: I don’t know.

Emilia: Right where you left him.

Jason: That is pretty good.

Emilia: Yeah, I liked that one. Should I say the other one?

Jason: Yeah, let’s go.

Emilia: Okay. They must like cows though. What do you call a cow with no legs?

Jason: I don’t know.

Emilia: I think we’ve done this one. Ground beef.

Jason: Oh, of course.

Emilia: So there you go with the jokes.

Jason: Poor cows running around with no, I guess they’re not running around.

Emilia: Exactly. That’s why it’s right where you left it.

Jason: All right? So this is episode 176. When do annuities make sense? This is going to be a controversial topic because there’s some people that hate annuities, there’s some people that love annuities. As a financial advisor, our job is not to approach this with emotion, it is to approach it with logic and to ask questions, to find out what we’re trying to accomplish. So, this should be a good one though, I’m looking forward to … As we get into this, one of the reasons we wanted to do it because we get a lot of questions about annuities, we’re going to be doing a webinar on annuities. Do you remember the date on that one?

Emilia: Yes. It’s scheduled for Tuesday, August 7th at 5:30 PM Pacific daytime. That’s on our Sound Retirement website where you can go ahead and register for that webinar.

Jason: Okay, good. Just a way for people to get good information about the pros and the cons of annuities.

Emilia: So let’s just go ahead and start from the beginning for those of our listeners that don’t know, what are annuities?

Jason: It can be confusing because there are actually a lot of different types of annuities out there but in its most basic form, an annuity is a contract with an insurance company. So, insurance companies are who offer annuity contracts, but they come in a lot of different flavors. That’s really where I think we can add some value to people’s lives because sometimes what people will do is they’ll lump all annuities under just the one umbrella of what’s an annuity, and it’s really not doing annuities justice. You have to understand all of the different types of annuities, what they’re designed to do, how they work, what the fees are associated with them, why people are using them, why there are billions of dollars flowing into annuities in this new economy. Why some people that had once been opposed to annuities are now coming out and saying that they’re in favor of annuities.

 And this is something we see all the time. But the financial world is changing, the advice people are getting is changing. And it’s partly because demographics are changing. Annuities fill an important role or they can fill an important role in people’s financial lives. So we’re going to dive into this.

Emilia: Yeah. So, what are some of the pros and cons of annuities, Jason? Is it something that people are always afraid of? Is that why because there’s good and bad?

Jason: Well, part of the reason that we have to have this conversation is because there are people that use very strong language when talking about annuities. I think probably the strongest in particular is an ad that you see on the Internet a lot that says I hate annuities and you should to I think is the way it goes. I think part of the challenge is when you are working with an advisor who has a vested interest in only one area of the financial world. So if you’re working with an investment advisor that can only recommend stocks, bonds, mutual funds, ETFs, managed investments, of course they’re not going to want to recommend something like an immediate annuity for guaranteed income because that’s money that they’re not managing. They’re not collecting a fee on it.

 So I think there’s a, even though they try to, I think the argument is that there’s conflicted advice because an annuity pays a commission typically to the advisor that’s receiving them. Although, there are fee only annuities out there now too. I think that there’s, you know, there’s that old saying follow the money. So, oftentimes when people use language that’s so strong like hate or love, those are really emotional words. I don’t think that’s the appropriate thing for somebody that’s giving advice to be talking about hating or loving a financial tool. As hard as it is, the most important thing we can do is try to make none motional decisions about our money. That’s why I’m such a big believer in having a really good plan and using the plan to help us make these financial decisions in terms of financial products, things like annuities or stocks or bonds or mutual funds, which we have access at our firm to all of these different tools.

 My job, our job as advisors is to help people understand, to educate them that there’s no magic bullet, there’s no financial vehicle out there that’s perfect. Everything has pros and cons associated with it. We have to look at what are the fees, what’s the liquidity, what’s our growth potential, what’s it designed to do? When we understand all that, then we can start making some educated decisions. But we definitely don’t want to approach it with love or hate. That’s not the right way to approach a financial tool.

Emilia: That’s good advice. Good life advice in general.

Jason: So, I wanted to get back to the question, the primary question though, what are the pros and cons because it really depends on the contract. So annuities are contract driven, they’re issued by insurance companies. You have to understand the terms of the contract that you’re getting into. Big picture, I want to talk about some of the pros and cons of annuities and then we’ll start to dive into some of the specifics on these different types of contracts.

 Of course, let’s start with some of the cons, some of the things that are the problems with annuities. Number one is usually there’s a liquidity issue. Whether you’re buying an immediate annuity or deferred annuity, there’s an expectation that you’re giving up some time. This will make more sense as we get into the different types of annuities. There’s usually a time cost, there’s some kind of liquidity cost if you’re going to get into an annuity. You need to understand what that is.

 In the old days, one of the big concerns people had with immediate annuities, and you can still buy this type of annuity but I think it’s less than two percent of annuities being purchased today are issued like this. It used to be that if you would buy an immediate lifetime only annuity that was for income, let’s say I bought it today and then I died two weeks from now. Well the insurance company kept all of the premium. Now, that’s not an issue that we see many people running into because insurance companies have come up with other alternatives so that most people aren’t dealing with that risk. But that could be one of the cons with annuities.

 Fees are oftentimes something you hear about annuities. And usually when they’re talking about fees, that’s usually directed at variable annuities. I think in all of the annuity contracts that we’ve reviewed for clients over the years, variable annuities tend to be the ones that have the highest fee structure, at least in what I’ve seen. And so, you really need to understand what all of the fees are. So with fees, you’re looking at mortality and expense fees, you’re looking at surrender charge fees, you’re looking at sub account fees, you’re looking at annual fees and statement fees. The fees can really add up in these things.

 Yeah, so oftentimes when people come to us with these contracts, one of the things we’ll do is we’ll dive into it, we’ll really understand what’s the total cost involved in the annuities so that people again, can make an educated decision, do they feel like there’s value associated with what they’re paying for. And then in addition to just some of the contract fees, then you also have things like rider fees because you can add these additional riders to contracts that usually are based either on income or death benefit.

 Again, it can be complicated. They’re written, they’re contracts, they’re written by attorneys. It’s kind of like reading a prospectus from a mutual fund company. Most people don’t read the prospectus from cover to cover. Most people don’t read the annuity contracts from cover to cover. But you really need to understand what those contracts say, what they do and probably more important is understand if you’re thinking about using an annuity, it really needs to fit a specific purpose within the context of the overall plan. Again, start with the plan, something I’m just really, really passionate about.

Emilia: Well, it’s great that you do that for the people that come to see you, just kind of like you said, putting that flashlight in all those hidden places or understanding what you’re really doing. It’s all about the education of it.

Jason: Yeah, and the cons of annuities. Now, the pros of annuities, some of the reasons that annuities can be good are they can provide a guaranteed income for life. Retirement’s all about cash flow. One of the ways that people will look at producing income for themselves of course is social security or pensions. But some people will say, hey, I’ve saved a couple of million dollars. If I can set aside a few hundred thousand and know that all of my income needs are going to be guaranteed between my pension, my social security and this annuity that I bought, then what that allows them to do is not worry about market performance in order to achieve the income that they need. They don’t have to focus on trying to buy bonds or preferred stocks or these different REITs or limited partnerships or these different income producing vehicles because they know that their income’s coming from secure sources.

 And so what it actually allows people to do is take more risk with their investment portfolio, which should equate to a greater rate of return over time, which means that they may end up leaving even more money to the next generation or having a higher amount of wealth as a result of using an annuity contract. So, I would say income is definitely a big reason.

 The other reason that people would purchase an annuity contract is for safety or preservation. Maybe preservation’s a better word. The safety is always dependent on the financial strength of the insurance company that you’re working with. So you want to know what the financial strength of the company is. One of the reasons that we would see people use an annuity contract is because they tend to be more conservative. It really makes them uncomfortable and they see some of the wild swings in the market. So an annuity, and we’ll talk about all the academic research that’s backing all of this up. This isn’t just me with opinions about annuities. And really trying to be impartial. Trying to say, hey, we’re not in favor of annuities, we’re not opposed to annuities. We know what they are, we know why people are using them. There are pros and cons. Let’s evaluate all of those before you make any decision and see if it really should be a part of your plan or maybe it shouldn’t be.

 But we definitely don’t want to approach it with, I think the two financial tools that I hear the most negative response to are annuities and reverse mortgages. People, they come in with these, not because of any research that they’ve done but they just kind of come in with this preconceived idea that they should hate annuities or that they should hate reverse mortgages.

 Now, we’re not pro reverse mortgages, we’re not opposed to reverse mortgages. There’s definitely been a shift in the financial services industry because so much of people’s wealth is tied up in their home that the reverse mortgages is another tool that’s really gained in popularity over the last several years as the baby boomer generation is transitioning into retirement. But again, it’s just to make educated decisions. Understand that there’s no silver bullet. There’s no magic tool. We just have to understand what these things are, how they work, what they do, what they’re designed for and why we’re going to use them before we use them.

Emilia: Yes. So before we go into a little more detail like you were saying, I want to remind our listeners that you’re having a webinar on annuities so you get more information and really get more education on this. And it’s scheduled for Tuesday, August 7th at 5:30 PM Pacific daytime. You can go to soundretirementplanning.com to register today.

Jason: The great thing about a webinar is it’s a safe place to ask questions, to learn and not have somebody trying to sell you something. That is not the purpose of this webinar at least. The purpose of it is to say, hey, here are some things that you should know, that you want to know, that you want to arm yourself and equip yourself with as you venture out into this world where you’re going to have a lot of financial decisions to make.

 Some of the biggest decisions of your life financially are made when you decide that you’re going to retire. It’s maybe the single biggest transition financially that you’ll ever make. So, you’re going to be giving a lot of different options for people to approach that. One of the things they’re going to be confronted with are annuities. They’re also going to be confronted with stocks, bonds, mutual funds, ETFs, reverse mortgages, all these different financial decisions. But this Webinar specifically is just to help educate on annuities.

Emilia: Great. So let’s go ahead and get into more detail on what are the different types of annuities, Jason?

Jason: Yeah. Four primary types. Number one is what we call a SPIA, S-P-I-A. Stands for Single Premium Immediate Annuity. An immediate annuity is just guaranteed income. It’s a contract with an insurance company and you give them, you purchase a contract and then you say, I want this income to either start now or at some point in the future. So that would be a deferred income annuity if you’re going to have the income start at some point in the future. They can be fixed income, they can be inflation adjusted income. I think the easiest way for most people to think about an annuity like that is like a pension. It’s just guaranteed income. You can guarantee the income for a period certain, you can guarantee the income for a lifetime. You can guarantee the income for over two people’s lifetime for husband, wife, joint guaranteed income. So that’s a SPIA, Single Premium Immediate Annuity or a deferred income annuity.

 The next type of annuity is, and that’s what most people think of when they think of annuities are guaranteed income. The next type of an annuity is what we call a deferred fixed rate annuity. A deferred fixed rate annuity, the easiest way to think of this is kind of like the equivalent of a bank certificate of deposit. It’s the insurance company’s version of that financial tool. Basically, what a deferred fixed rate annuity is, it’s a way to earn interest and you have to typically commit to a certain period of time. So usually like maybe three years or five years for like a multiyear guaranteed interest rate.

 I had Larry Swedroe on the last program that we did and he brought up an interesting place that we’re at in the economy right now today, especially as it relates to yields. As we were talking about that, he said that 10 year treasuries were paying 2.7% and that you could go to the bank and buy a five year CD for 3.3%. Well, people that would buy CDs would also be interested in something like a fixed deferred annuity. Usually the interest rates are competitive with what bank CDs have. But for retirees, they can offer some advantages. Things like tax deferral. The contracts end on death meaning that typically if you die, the money just goes to your named beneficiaries or your heirs. They bypass probate because they’re insurance contracts so they don’t get caught up in the probate process. You can use them with a retirement account, so IRAs and Roth IRAs.

 But they’re just fixed rate accounts. They’re contracts that pay a fixed interest rate. The point that Larry was making is that individual investors have options that institutional investors don’t have access to. That would be something like buying a CD. If you’re a small investor and you can keep your money under the FDIC limits, you can buy a CD that’s paying a better interest rate than a 10 year treasury. So you can lock up your money for five years and get a better interest rate than locking up your money for 10 years. The reason that that’s interesting to me is because when you see these yield curves where you get a higher interest rate on short term money than on longer term money, that has historically been a sign that a recession is looming. So we have to be aware of that.

 But also, at the same time recognizing that if you can earn a higher interest rate with a shorter time period with less interest rate sensitivity, that’s where things like CDs and fixed deferred annuities come into play, and that’s one of the reasons I think people are considering them as alternatives. Not institutions. An institution is never going to do that because when you’re managing billions of dollars, you’re not going to go buy a fixed rate annuity or a bank CD. So, that’s a fixed rate annuity, a fixed deferred annuity.

 The next one, I’m going to skip over to the variable annuity. This is where, a variable annuities, I’ve never seen one that I’ve just felt like, boy, that’s a really good deal. But I have seen some of the riders on those variable annuities actually looked pretty attractive for, some of them, the ones that I’ve reviewed, they’re not offering them anymore because insurance companies realized they made too good of a deal at the time they offered this. But a variable annuity, the easiest way for people to think of these is they’re just mutual funds. In a variable annuity, it’s called a sub account. It’s kind of like mutual funds with an insurance contract around it and there’s usually some kind of guarantee that the insurance company’s offering.

 At one time, they were really sold aggressively because of their tax deferral. So for people that wanted to be able to defer their taxes, they would use a variable annuity. Then as more and more people have been heading into retirement, a lot of the variable annuities are including income riders. An income rider is usually a way to guarantee that you’re going to have a certain amount of income from that investment. So even if the account value goes to zero, there’s usually some kind of income promise. Again, their contract driven so you’ve got to understand what the contract says. Some variable annuities offer some kind of death benefit. They tend to have really high fees. And so that’s why I’m cautious on variable annuities. I would really encourage people to look at those strongly and really uncover them, work with somebody that has the ability to understand how they work and ask all the right questions before you get into them. So that’s a variable annuity.

 Then the more recent type of an annuity is what’s called a fixed indexed annuity. These came out in the mid-1990s. It’s kind of a mix between the fixed deferred rate annuity, the one that pays a guaranteed interest rate like a bank CD and it’s a mix between that and a variable annuity where you’re in the stock market and you can go up and down in value. A fixed indexed annuity is designed to say, hey, you can go up with the market, usually there’s some kind of participation rate or cap, but you’re never going to go down with the market. So it’s a way to try to earn a better interest rate than what you would typically earn in just a regular fixed rate account.

 An example of that Emilia would be for people that, let’s say they want to have some exposure to the S&P 500 index. They’re worried about bonds because interest rates are on the rise. They think that the equity markets could perform favorably given the tax cuts and money flowing out of bonds and into stocks. So, a contract on a fixed indexed annuity may say something like, hey, you can have 50% of what the index does. So if the S&P 500 index did 10% for example, you would get credited with 5% interest. But if the S&P 500 index did -10% that year, you would have a zero. So it says in the bad years you would have a zero but in the good years you could participate in the upside.

 Another way we’ve seen those contracts issued is where they say they’ll cap your gain. So instead of participation rate at maybe something like 50%, they say, hey, if the market goes up you can do as well as seven in the good years, but in the bad years you get zero. These are just hypothetical numbers I’m throwing out there to explain the concept. I’m not talking about contract specific, just big idea of how these things work.

 So, those are the four different types of annuities. You’ve got the immediate annuity or deferred income annuity for income at some future point. You’ve got a fixed rate annuity for just earning a fixed interest rate for a set period of time. You’ve got a variable annuity that’s kind of like a mutual fund and an annuity wrapper. Then you have fixed indexed annuities which are annuity contracts that help you try to earn a better interest rate than what you would get in just a regular fixed rate account. So those are the primary four different types.

Emilia: Okay, great. So four different types of annuities. So you mentioned fees a lot and I know that annuities also come with fees as you mentioned. So what are the fees associated with annuities? I think you’ve already kind of listed them out, but is there anything …

Jason: Yes. So the big ones are surrender charges. You want to understand how much access you have your money, liquidity. And then just all of these other fees that could come along for the ride. Now, some annuities are much more fee efficient than others. I would say a variable annuities are where we see the highest fees and immediate annuities are where we see the lowest fees, and fixed deferred rate annuities are usually pretty low fees as well. So, there is no such thing as a free lunch. Insurance companies are in business to make a living. They’re not doing this out of charity. So we just want to understand what those fees are before people allocate any of their resources to them.

Emilia: Absolutely. So, do annuities make sense in a retirement plan?

Jason: Yeah. They certainly can. It just really depends on the profile of the people and what the purpose of the money is and what it is they’re trying to accomplish and what the retirement plan says. Some people really like the idea of saying, hey, if we can take a portion of our life savings and annuitize it, turn it into a guaranteed income stream for the rest of our life and then we don’t have to worry about what the market does, some people sleep better at night knowing that rather than having to assume that the market’s going to perform at some set level, whether it’s four or five percent or whatever assumptions they want to make about rates of return to the market. Some people just like the idea of knowing that they have some guaranteed income.

 Now, in a rising market like we’re in today, I would say people, it’s kind of a risk on, people are seeing the market going up and they’ve got good returns on their investment portfolios. And so they feel better about that. They’re less inclined to want that safety element. When times turn bad, that’s usually when people say, oh man, this is really upsetting, I’m not sleeping well at night and so I’d like to have some element of safety.

 Emilia, there was so much else that I wanted to cover but I realize we’re already out of time. So, join us for the webinar and we’ll try to enlighten you and give you some more information. Thanks Emilia.

Emilia: You’re welcome.

Announcer: Information and 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. Parker 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 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.