Retirement Answers

Jacob: 00:00

Everybody, and welcome back to another episode of Retirement Answers, a podcast built for you if you are in retirement or thinking about retirement. My name is Jacob Duke. I'm a certified financial planner, and I help people just like you retire on a daily basis. So today, I wanted to talk about the topic of annuities, and this is something that I have a lot of questions around for a lot of people who are in retirement or who are thinking about it because they're like, man, I want that steady income stream, but I'm just not sure if they're the best thing for me. So I wanted to lay this out and do this over the course of two episodes.

Jacob: 00:31

I wanted today's episode to be really about just laying the groundwork and framework around what are annuities, what are the different types of them, how do they work, and everything that comes with that. And then next week, I wanted to talk about some of the reasons that I am not a fan of annuities. So there you go. You know that I'm not a fan of annuities, but, today, just wanted to talk objectively and give you the facts around how annuities work and what they are. So we've all heard of annuities, but what are they really?

Jacob: 00:57

How do they work and should you buy one? So that's what we're gonna be talking about. And I'm sure that some of you have even perhaps purchased an annuity throughout your past and maybe own one currently, but but if nothing else, you probably know someone who has. I wanted to tell a really quick story about a client of mine who, in the past, they purchased an annuity because it limited their downside, but it also gave them the opportunity to grow a little bit. And this was a variable annuity that had all these different protections in it and things like that.

Jacob: 01:24

And so they really were interested in the fact that there were different guarantees associated with it. The problem is, is whenever you have those guarantees within this type of product, what you're doing is you're giving up a lot to get those guarantees. And so they ended up not realizing the potential that they thought they were gonna realize through that annuity. And they found out at the end of that ten to twelve year period, they did not grow their account by nearly as much as they could have if they had not owned the annuity. Does that sound like a familiar story?

Jacob: 01:56

Well, maybe you know someone who has had a similar experience or maybe that has even been you. So I just wanted to take a little bit of time to explain what annuities are, the different types of annuities that are out there. And next week, I wanted to share some reasons why they might not be the best way to invest your money. So what is an annuity? Well, in the simplest terms that I can provide, it's a contract that you make with an insurance company where you give them your money, and they agree to pay you that money back over your lifetime with some sort of interest or credits along the way.

Jacob: 02:26

Now there are all kinds of different annuities, but that's the simplest way to understand them. They're a contract with an insurance company. You give your money away. They promise to pay it back over time, plus some sort of interest or gain. So the purpose of annuities is to provide some sort of steady income, either immediately or at some point in the future.

Jacob: 02:45

So how do you buy one? Well, you can do it in a couple of different ways. You can take a lump sum of money out of your investment account or out of your IRA and purchase an annuity contract with that money right away. Another way you could do it is you could over time continue to add, or what would be through premiums, you can continue to add to your contract. So you could almost buy more of the contract, almost like you were saving into your savings account over time.

Jacob: 03:10

So you could use the lump sum method almost as if you were entering retirement, you wanted to purchase an annuity, and then you could turn that income stream on, or you could do it over the course of your career while you're still accumulating and saving, and those premiums would be added into your contract over time. Okay. So now that we know that an annuity is simply an insurance contract with these different investment pieces added onto them, let's talk about the different types of annuities. Well, you have fixed annuities, you have variable annuities, You have qualified annuities, nonqualified annuities. You have immediate annuities and deferred annuities.

Jacob: 03:44

And so that's a lot of big scary words, and most of them don't make sense to us as normal people. So let's go ahead and break this down. A fixed annuity is one that is like it sounds. It has a fixed or guaranteed rate of return. So for example, let's say that you purchased a fixed annuity at retirement with a 3% return.

Jacob: 04:03

You would purchase that contract and the annuity company would begin paying you income payments out of that lump sum that you gave them plus the interest that they guaranteed. You could also purchase a fixed annuity while you are accumulating assets by paying, those different premiums over time, and then the fixed rate of return would apply to those increasing amounts that you've paid in over time. So you have an immediate or you have a deferred annuity. So you can start now or you can start it later. The annuity is simply the income stream.

Jacob: 04:32

Once you annuitize, meaning turn that income stream on, it is for most of the time, it's for the rest of your life. Obviously, you can't have a contract that is for a set period of time. Most of the time, it's throughout the rest of your life. And that's dependent on how much you on how much money was in the contract at the time of annuitization. A variable annuity is the opposite of a fixed annuity.

Jacob: 04:54

Your rate of return will fluctuate based on the underlying investments, which means you could have a higher upside, but you could lose money as well. You don't have as much downside protection because you're not getting a fixed rate of return. The underlying investments in that variable annuity are called subaccounts, and the best way to think of these different subaccounts is like they're almost like mutual funds. You get to pick those subaccounts. They would be invested almost if you were investing in mutual funds in your IRA, And so you could have, like, a a US stock account, a bond account, international stock account.

Jacob: 05:27

You get to pick. So all of those subaccounts, you get to choose how you want those to be allocated. And those different subaccounts, they have expenses associated with them. So they're not, they're not free nor are they cheap, but they are able to expose you to the market. That's the purpose of a variable annuity.

Jacob: 05:43

You are hoping to get a higher return because you're exposing yourself to some sort of risk. But the annuity part of a variable annuity is the insurance or protection that comes with the product itself. So a variable annuity has what's called an accumulation period. This is the time that you cannot touch the money. If you do, penalties will follow and you'll be assessed those different penalties based on the schedule that was in the contract.

Jacob: 06:07

And the purpose of these different accumulation periods is so that the subaccounts have time to grow. Once that accumulation phase is over, you would enter the payout phase, which allows you to either take that lump sum on the accumulation value, or you can begin taking those periodic payments out of your annuity or over a period of time. One of the biggest issues with variable annuities is typically the cost. There are so many costs that are associated with these different types of annuities, and I've seen with different clients, they're paying north of 3% a year just to have a variable annuity that is not performing the way that they would hoped. Those different charges can be like surrender charges, administrative fees, maintenance fees, different rider fees.

Jacob: 06:47

So you can add on different riders to your contract almost like a life insurance policy or disability policy has riders. You have those sub account fees that I mentioned and just so many other things. And these fees can range anywhere from 2% to to north of 3% like I mentioned, and that's really, really high. So for example, if you have a $100,000 variable annuity, you could be paying $3,000 or more a year just on those different fees as they all add up. So if you have a $500,000 annuity, you could be paying $15,000 or more just in fees to own that annuity.

Jacob: 07:19

And then on top of that, you might not be getting the performance that you were hoping for. Now I just mentioned that included in those different fees are what's called surrender charges. So before I talk about the next annuity type that I wanted to mention to you, I wanna make sure that I explain something really quickly that's very important to annuities as a whole. And it's the fact that all annuities, regardless of the type, have what's called a surrender period. And this is a period of time at the beginning of your contract that you cannot access the money without some sort of penalty being assessed.

Jacob: 07:52

The surrender period can be anywhere from three to all the way to fourteen years, but typically these periods are from seven to ten years. That's the most common, surrender period timeframe. And that means you cannot access the money or cancel that contract during that period of time without some sort of penalty, which is quite honestly, pretty insane. That means you gave your money away to an insurance company and you, now you cannot access it if you wanted to without some sort of penalty And the penalty for canceling that annuity contract or transferring out to a different annuity company, is is typically on some sort of declining schedule. So if you cancel in the first year of your contract, your penalty will be the highest that it would ever be.

Jacob: 08:35

If you cancel in the last year of your contract, it will be the lowest that it could ever be. But but what are the percentage penalties? Well, every contract is different, and it could be 7% to cancel year one. It could be 1% to cancel in year seven, or it could be 10% to cancel in year 13% to cancel in year seven. That's just an example.

Jacob: 08:53

But regardless, it's gonna be a percentage of the overall contract value that you initially started with, and it's gonna be declining about a percent a year throughout the surrender period. And I don't know about you, but I do not like how that sounds. I have to give my money away to an insurance company and I can't touch that money for seven to ten to twelve years without some sort of penalty, the way I understand that is that's not my money anymore. If I can't access it, if I can't use it, it's technically not mine. And I don't like the sound of that.

Jacob: 09:24

And as you can probably tell, I'm just really not a fan of annuities. I did wanna mention here that you can withdraw up to 10% of your initial contract value penalty free every year without paying any surrender charges. So this is a provision that is in most annuity contracts, but you can access 10% of the original investment amount year after year for that ten year period and withdraw that without paying those different surrender penalties. Okay. So now that we took a little sidebar and talked about surrender periods, let's talk about one final annuity type that I wanted to cover with you today, and it's called the fixed indexed annuity.

Jacob: 10:00

And this annuity lies kinda in the middle of a fixed annuity and then a variable annuity. Remember the fixed annuity, you get a set return year after year on that amount. And the variable annuity, it fluctuates. It's almost like a mutual fund account. You it goes up with the market or it could go down with the market.

Jacob: 10:15

Well, the fixed indexed annuity, that is a combination of the two because you get the potential upside, but you also have some downside protection. You can earn based on the performance of the index that you choose. So for example, you could use the S and P 500 index to be the thing that your fixed index annuity is being based on, and then you can also choose what guarantee you want in terms of downside protection. So you could say, hey, at any given point, my account, I never want to lose more than 10%, or I want my downside protection to be 0%, meaning I I never lose money. And these fixed index annuities have what's called a crediting system.

Jacob: 10:55

So you never actually own the index that you choose. So, like, if you said, hey. I want the S and P 500 index to be the index that my annuity is based on, you technically are not owning that index the way you might if you bought a mutual fund, but the indexes indicate how much interest will be credited to your contract. So there are all kinds of different crediting methods or calculations that determine how much interest will be credited to your account. And you get to pick which methods you like to use, and those can be changed every so often.

Jacob: 11:24

But the different ones might include something like annual point to point, monthly point to point, monthly average. You can have buffers and floors and all kinds of different things, which really gets confusing, but these different crediting methods determine what interest will be credited to your account. So for example, if you had annual point to point and that's the, that's the method that you chose, And that's just from the beginning of a twelve month period to the end of that period. So let's say that the index went up by 5% over that twelve month period, that means that you would get an interest credit of 5% to your contract. So your contract value would go up by 5%.

Jacob: 12:01

Let's say it went down 5% and you chose in your contract terms that you did not wanna ever lose money, but the index that your crediting system is being based on went down 5%. That means that a 0% interest credit would be applied to your contract because remember, your contract cannot go down in value. So you get the upside, but no downside. So you're probably thinking, Jacob, you're telling me that you get upside potential and then no downside risk at all? Well, not quite because most fixed index annuities have different things called cap limits or participation limits, on that upside.

Jacob: 12:38

So for example, you could have an annual point to point crediting method, but it comes with a 3% cap. That means that if the index went up by 5% over that annualized period, then you would be credited 3% because remember, 3% is the cap in terms of how much you can be credited. Or you could have something like a 50% participation rate. So if the market went up 14%, that means you would only get credited seven. Or you could do any combination of these different methods.

Jacob: 13:05

But the reality is the the different caps and participation limits and all these different terms of these contracts, that's how the insurance companies make money on these products. They're not giving you all of these guarantees for free. There's nothing free. They will make their money. And most of the time, the annuity contract holders, you and I, the ones who are purchasing these things, are the ones who are gonna be losing out because they know that the market will go up over time, but they aren't having to give out all of those gains back to the annuity holders, remember, because there's caps and participation limits.

Jacob: 13:36

They're never giving all those returns back to you as the contract holder. So they get to keep the spread on those gains, which is very lucrative. So I think you're probably picking up on the fact that I'm just not a fan of these annuities, but let's go ahead and continue by talking about how they are taxed. So annuities are tax sheltered accounts. What do I mean by that?

Jacob: 13:55

Basically, what I mean by tax sheltered is you do not have to pay taxes on those interest, dividends, or gains every single year. They're tax sheltered just like an IRA. You're deferring those gains or those taxes into the future, But there are different types of annuities from a tax standpoint. You can have qualified or non qualified. Well, what does that mean?

Jacob: 14:15

Well, a qualified annuity is just like an IRA. So you could use IRA funds to buy a qualified annuity, and this is one of the worst things that you could do because you're using tax deferred money to buy a tax deferred investment, which it doesn't help you in any way to do that. And your outcome is probably gonna be worse than if you just kept that money in that IRA. And you also have nonqualified, which basically means you would take cash from your checking account, which is after tax already. You'd purchase a nonqualified annuity, and then once that money is in the annuity, it is then tax sheltered because all gains would be deferred into the future upon withdrawal or distribution if you annuitize those funds.

Jacob: 14:57

So when you purchase a non qualified annuity, you're using that after tax money, but the difference is is whenever you take money out of that account, one of the drawbacks of it is that any of the gains that happen in that account, they are not gonna be taxed as a long term capital gain like they would if they had been in a taxable investment account. They're gonna be taxed as normal income just like you had earned that income from working a job or you took it out of an IRA or some tax deferred asset. This is one of the things that I don't like about annuities is they're tax efficient during the years in which you have them, but they're not very tax efficient whenever you begin to take money from them, either just by taking the money and running, or if you just start taking the annuitized payments. One of the things that is misunderstood often about these non qualified annuities, and they're different from a qualified annuity, because any money you take from a qualified annuity is going to be taxed normal income. All of it would be taxed because you put pre tax money in and that grew and now you have all pre tax money.

Jacob: 15:56

The difference with a non qualified annuity is that you put after tax money in and then it grew, and now you have after tax money and pre tax money in that same account. So how that money is distributed is actually important. Just know that on a non qualified annuity, anytime you take money out of that, the first dollars that will come out will always be the gains, meaning that it comes out and it's taxed as normal income. So for example, let's say you originally purchased a non qualified annuity with a $100,000, and then it went up by 20%, which means now you have $120,000 in your non qualified annuity, and now you wanna take 20,000 out of that annuity just so you can buy a new car, let's say. Well, whenever you take that 20,000 out, you're taking out the gains first.

Jacob: 16:44

You're not taking out the principal and you're not doing it pro rata, which are some of the rules on different account types. You're taking out the gains first, which means you're gonna pay income taxes on that 20,000, which means you're not gonna get a full 20,000 in your hand. You're gonna have to take more out of the contract than the 20,000 you had anticipated needing. So this is just one example of how, perhaps how non qualified annuities are maybe not the best tax benefits because a taxable investment account, while you still would be paying taxes on an annual basis on dividends or interest or any capital gains that would be created, you get the benefit of long term capital gains, which is always at a lower rate than normal income. Okay.

Jacob: 17:22

Are we exhausted yet? Because I'm getting pretty close. I'm just not a fan of annuities in general. The purpose of this episode was to simply give you a little bit of framework and understanding around them and perhaps how they work. But next week, I wanted to share some of the reasons I'm not a fan and really lay those out because what I've found just really quickly through my experience of working with many people is that they get to the end of their annuity contracts or their surrender periods, and they're like, man, this is not doing what I thought it was supposed to do.

Jacob: 17:49

Or even before their surrender periods are up, they're like, I just this is not what I need. It costs me $15,000 a year for something I really don't need. Can you help me get out of this, Jacob? And I can, but but the problem is is once you're locked in, you're locked in, and these insurance companies are not forgiving. So, if you're thinking about purchasing annuity, I would double check and and triple check what your options are and make sure it is the exact thing that you want because most of the time, they do not work out in the favor of you, the investor, the annuity holder.

Jacob: 18:20

It works out in a big favor for the insurance companies that are selling them. So, I guess that's what I'll leave you with today. I I don't like to be a Debbie Downer, but this is one of those episodes where I just have to kinda put my preaching hat on and say, hey, look, don't buy annuities. And, but, anyway, we'll talk next week about some of the major reasons I'm not a fan of them, and, hopefully, that'll be enlightening for you then. So thank you so much for tuning in to this week's episode of Retirement Answers.

Jacob: 18:45

I look forward to talking with you again next week.