Retirement Answers

Jacob: 00:00

Hey, everybody, welcome back to another episode of Retirement Answers, a podcast built to answer your retirement questions for those who are already in retirement or if you're getting close to retirement and this is top of mind for you. So thank you so much for tuning into today's episode. This week, I wanted to continue our two part series on annuities. Remember, last week we did part one and we just really discussed what the ins and outs of annuities are, how they worked, the different types of annuities that are out there. And today, I wanted to talk with you about six reasons that I am not a fan of annuities.

Jacob: 00:33

Now, depending on who you talk to, different advisers, different people have different opinions on annuities in general. So today, I wanted to make sure I said upfront that annuities themselves are not good or bad. They're they just are. They're they're just a thing. They they accomplish a goal if that goal aligns with what you need from a financial standpoint.

Jacob: 00:54

So the reason I am not a fan of them is because they're often really incentivized to be sold. So advisors or insurance agents who can sell them, they have a really big incentive to sell those because of the commissions that they would receive up front, which are often very large. Also, these products are designed to be some sort of catch all kind of investment products, where they have fixed rate of return guarantees, you have tax efficiencies, you have investments, you have insurance. All these things are wrapped up into one particular product or wrapper. And and not in my opinion, it really dilutes the power and potential of each of those different things on an individual level.

Jacob: 01:33

So I don't think that annuities are bad nor good. They're just something that's often misused by advisors or sold to people in in situations that basically they're not needed. And a common quote here that is really interesting kind of across the industry or financial services in general is that annuities aren't bought, they're sold. Meaning that advisors or insurance agents, they sell these things and they make them sound so awesome, and they rarely are sought out by individuals, they're not trying to go buy them, they're often sold them by these advisors because remember, these advisors are typically incentivized very handsomely to sell those different annuity products. So that being said, let's go ahead and jump into the six reasons that I am not a fan of these different annuities.

Jacob: 02:18

Alright. Number one, they are complex. There are so many complexities within annuities. You have riders, you have guarantees, you have minimum withdrawal balances. You have so many things, so many conditions, so many terms that we have to be aware of.

Jacob: 02:32

And the reality is, is most of these products are so confusing that most people who buy them do not understand what's really going on inside of the annuity itself. Now, fixed annuities are probably the more basic of the bunch, but still there are some different things mixed in there that could be complex for me to understand. Now variable annuities, are on the opposite side of that spectrum. They are very complex. There's so many different things that are wrapped into one product there.

Jacob: 02:58

And then also fixed indexed or equity index type annuities, they are not as easily understood as most people think. And so the complexities in general are something that I typically like to run away from. I like to keep things simple. At the end of the day, this is your money. Like this is your life savings.

Jacob: 03:16

I would rather you not put it in something you don't fully understand. I'm a believer in investing in things that you understand. So for example, if you don't know real estate and you don't know the rental market in your area, you probably shouldn't just go buy a house randomly and try to rent it out. Right? You need to understand what's going on with your investment.

Jacob: 03:33

Same thing applies here. We need to understand what's going on with our money, make sure we're not investing in something that we shouldn't be based on our plan. And also following up to that, you should have a plan. And if your plan says, hey, I need to buy an annuity for x amount of income for this reason, then perfect. Maybe that's the best thing for you.

Jacob: 03:50

But in most situations, people are not buying annuities because it's a part of their plan. It's something that they try to buy because there's a guarantee attached to it, and they're scared of losing money in the market. But if they understand how these annuities work and the fact that they will underperform over time, it typically lends itself to saying, hey. I probably should not buy that annuity. So so number one, the complexities of annuities in general, all different terms, all the different things you need to know about them.

Jacob: 04:14

I just I'm not a fan of complexity. I wanna keep things simple. So that'll be the first reason that I'm not really a fan of annuities. Number two is that there is a lack of liquidity. So whenever I say that, it's not that you wouldn't have income from these annuities.

Jacob: 04:27

That's perhaps something that you could do in the future if you annuitized your investment and said, hey, you know, annuity company begin paying me a certain amount of money every month for the rest of my life for a certain period of time. What I mean by lack of liquidity is that you cannot access all of your money at one point, assuming that you're in that surrender period. Remember, talked about that last week. That's that period of time early on in the contract where you cannot access all of that money. Now you can access a portion of it.

Jacob: 04:53

But we'll get into that. You can go back and listen to last week's episode, episode 21 of the Retirement Answers Show and listen to how annuities work and some of the different rules there. But once you buy one of these annuities, think of that money as locked up. Like you can't access it unless you pay a penalty to do so, which was that surrender charge we talked about. You can get to 10% of it annually without paying that surrender charge.

Jacob: 05:16

But it's not something you wanna do. You don't wanna buy this product and then immediately start taking your money out. That's not the purpose of it. The purpose of it is some sort of long term growth and then guarantee on the back end. And liquidity is something that I personally place a premium on in retirement.

Jacob: 05:31

It's something that I think all retirees should value and should put a premium on because life is going to change. Things are gonna happen. Your circumstances will change. Your health will change. And if you can't access your money, you don't have options.

Jacob: 05:46

You don't have the ability to say, hey, I wanna pull income now from this account versus this account because of this tax reason, or maybe I need to pull extra money this month because of an expense that came up, and I'll just take less out next month. It's almost like viewing your primary residence as an asset for retirement income. Yes, it's an asset, but you can't really access the money in that because it's a fixed asset. Like it's a real estate, you can access it through different ways. Obviously, you can take out home equity line of credits and do reverse mortgages, which those in my opinion should be like last resort in terms of funding your retirement.

Jacob: 06:20

But annuities are very similar. Annuities are locked up. They're invested in something that is not liquid, meaning you can't access all of your money right away. And so for me as a retirement planner, I see the the issues with this all the time. I see people come to me and they're like, Jacob, I'd love to get out of this annuity, but I'm locked up for another four years, but I need the money to do x, y, and z.

Jacob: 06:41

Or I would just like to relocate to a different area and it does cost a little bit more, so I couldn't buy the new house with the proceeds from my current house. And so I'm kinda I've got a gap there and I don't wanna take on a mortgage. So a lack of liquidity eliminates your flexibility whenever you are in retirement, which kinda leads to number three, which is a lack of flexibility. Once you purchase an annuity, you're giving up your money to an insurance company with their promise to pay you back in some sort of way in the future. So think of it that way.

Jacob: 07:09

You you've worked your whole life, you've saved, you've done everything correctly, and now you're gonna give your money away to an insurance company who's going to lock it up. They're going say, hey, you can't access your money for x amount of time, and we're going to do some sort of guarantee where you we guarantee you a rate or or we make sure that you don't lose money or something like that. But for those guarantees, we'll talk more about in a minute, you're gonna pay really high cost to do that. And then you can't access all of your money. You can't really pick the investments.

Jacob: 07:35

It's limited. You can only have a certain lineup of investments to choose from. And the product is restrictive, and you can't change how you want your money structured as life changes. So for retirees, as I mentioned before, one of the most important things that I pay attention to and build into my retirement plans for my clients is flexibility. How can we have the most options available to us when life happens?

Jacob: 07:58

Because we know that life will happen, it's just a matter of when. Your circumstances will change, your health will change, your family circumstances will change. You will need to adjust as life goes on. And if we don't plan for that or build that into, your retirement plan, we will have some bumps along the way. So, that's something that I like to place a premium on is flexibility.

Jacob: 08:18

And with these products, you lose that flexibility. So if you have that annuity and you just collect your income every month, let's say you've annuitized it, you can't tell them to send you more money one month and less money in another month. Because maybe you have a one time expense that's larger, maybe you need to buy that new car, maybe you're buying a new house, and you need more money up front, and you're willing to take a lower payment in the future, you don't have the opportunity to do that. They're just gonna send you whatever your monthly check is every single month for the rest of your life, regardless of what your needs are. So this is the flexibility that I'm talking about.

Jacob: 08:50

You wanna be able to take more money from your accounts or less money from your portfolio, depending on your situation any given month. And this lack of flexibility can negatively affect you with your other retirement strategies. Let's say you wanted to do some Roth conversions to lower your taxes in retirement. Well, having a set monthly income limits your ability to convert money from Roth to from traditional to Roth from traditional to Roth because the income you're receiving from your annuity could be pushing you into higher tax brackets. Now, this depends on if your annuity is qualified or non qualified, but either way, some tax liabilities will likely be incurred if you are receiving annuity income.

Jacob: 09:31

And if you have Social Security coming in as well, you could be really limiting your Roth conversion potential because of how that could potentially be taxed on top of your annuity income. So all of this to say, being able to control your income in retirement is important to improving your tax burden and lowering your taxes overall. And the the lack of flexibility within these annuity products is something that I am not a fan of, and I typically discourage people from signing up for these products because of that lack of flexibility. Hey, Jacob here. Before we move on to number four, I wanted to just invite you really quickly.

Jacob: 10:03

If you're enjoying the show, please do subscribe that way you don't miss any future episodes. And then also, if you're enjoying it, feel free to give a review or rating that way that the algorithm knows that you are enjoying it and that other people might as well. So thank you so much, and let's get back to the episode. All right, the fourth reason I'm not a huge fan of annuities is the tax liabilities that potentially can come with them. Okay, so one of the reasons that I'm not a fan of annuities is because of how they're sold and why they're sold.

Jacob: 10:32

And part of the reason that I don't like them because of how they're sold is that they're often presented as this really tax efficient investment or account type. Now, there is a tax efficient piece to them, but they ultimately may not be as tax efficient as you had hoped. So yes, you do get tax deferred growth while the annuity is growing, but whenever you take income or distributions or anything out of the account in the future, those taxable portions of that income will be taxed as normal income taxes. Okay, so let me break this down. A qualified annuity, all income or distributions, they'll be taxed as normal income rates in the future no matter what.

Jacob: 11:10

It's almost like an IRA. If you have money into tax deferred IRA, whenever you take money from that in the future, both your contributions, were tax deferred, and then also the growth on those contributions, which is also tax deferred, all of that money will be taxed as normal income in the future when you take it out. Now, a non qualified annuity is slightly different. So you're taking after tax money like from a normal taxable investment account, and then you're purchasing the annuity with that money. And then the growth on that non qualified amount is growing tax deferred.

Jacob: 11:40

So you get some tax benefit while the annuity is growing. But what you do in the future, whenever you decide to take money out of that non qualified annuity or you turn on the income from it, what you're doing is is the distributions that are the growth part of that distribution, all of that is gonna be taxed as normal income. So I primarily wanna point this out that it's different from a normal investment account. The non qualified is different from the normal investment account. Investment accounts will benefit from long term capital gains rates instead of normal income tax rates.

Jacob: 12:10

So that's the disparity here. If you take non qualified money out of your normal investment account and go purchase a non qualified annuity, what you're doing is is you're now saying all the growth, I would rather that not be long term capital gains, and I'd rather that be normal income. Yes, I know I will not pay taxes on the growth or the dividends or any interest that happens along the way in the annuity, that's something that you will benefit from. But you can manage that investment account in such a way that your dividends and interests are minimized, and so you're paying minimal taxes each year, but you'll get the benefit whenever you sell those holdings in the future at a long term capital gains rate of having a more favorable tax rate. So that could end up being seven percent of or more of tax savings on the growth.

Jacob: 12:54

If you think about it from a 22% normal income bracket, which would mean you're in the 15% long term capital gains bracket. So that's a 7% difference just on the growth. And also in that investment account, it's possible to have a 0% long term capital gains rate depending on your income at the time. If you have very minimal income or your income is low, you could be in the 0% long term capital gains rate, just depending on your income. So that's something to pay attention to as well.

Jacob: 13:20

Any of that growth could be taxed at 0%, which is huge. And so that is not possible with the non qualified annuity. You will always pay normal income tax rates on the growth regardless of your income at the time. So in the end, keeping money invested in that normal taxable account will likely result in lower taxes on the growth overall. And the annuities are often sold as a super tax efficient investment, but understanding how those taxes work and the different types of annuities is very important.

Jacob: 13:49

And one final thought for you here, from a tax standpoint, it makes no sense to purchase a qualified annuity, meaning tax deferred annuity, with a tax deferred IRA account. So you would not want to have this qualified annuity wrapped up in this IRA or using IRA funds because the IRA is already tax sheltered. It would not benefit you to buy a qualified annuity that is also tax sheltered. So using IRA money to buy an annuity is pretty much a no no. I see it all the time though.

Jacob: 14:17

People have no idea what's going on with it. But in general, the tax deferred IRA should stay in the IRA. Don't buy a qualified annuity with that money because you're already receiving the tax benefits and you have the flexibility of the IRA and then how you want to invest that as opposed to within that annuity, you would be constrained to the investment options that are available through it, and you're gonna pay higher fees. So with that being said, we're gonna jump to number five, which is those higher fees. In general, annuities are costly.

Jacob: 14:44

Now there are some that are cheaper than others like immediate fixed annuities or SPIAs, which are single premium immediate annuities, meaning you just give them a lump sum of money. They begin paying you throughout the rest of your life a fixed monthly rate, and perhaps they have a little bit of an interest rate or adjustment on that over the years where it's kind of an increasing payment. And and there's also some middle of the road in terms of costs like fixed index annuities. And now when I say costs here, I mean, what they're the overt costs. They're the ones that are disclosed to you.

Jacob: 15:13

They're the ones that you know about. The way annuity company makes money on those fixed indexed annuities is on the spread of returns. Right? So remember, they're not giving you the full return on those index annuities. They're giving you only a portion.

Jacob: 15:26

So yes, you might not lose any money on the downside because you have that protection or that guarantee, but you're not getting the full potential on the upside. If the market goes down 5% this year, for example, and you don't lose any money because you have that downside protection, but then the market goes up 15% next year, you might only be getting 7% or 5%. Just really depends on the cap, or the participation rate that your annuity has. But that means that the annuity company is making 8% or 10% on your money in one year. So think of those spreads and the index annuities.

Jacob: 16:00

Think of those as the cost of the annuity. They're making money on your money. And so that's the cost that you're technically paying, whether it is a fee that's actually said, hey, this is the fee. It's not really said that way, but it really is the fee to have this guarantee of downside protection. They're just gonna make money on your money so they can guarantee that for you.

Jacob: 16:19

But variable annuities are the most costly out of all of them. They can be anywhere from one to 3% in annual expenses, but that just kind of depends on the different guarantees or riders or sub accounts that you are investing in within your variable annuity. The more riders you add, the more it costs and you're essentially buying more guarantees, you're paying a premium to get certain guarantees or benefits. And remember that in variable annuities, there's no guaranteed return or downside protection. You're paying those high fees to have something called a guaranteed minimum withdrawal value.

Jacob: 16:53

And so that's kind of what makes variable annuities really confusing. You have this, like, you have this cash value that you're trying to grow by investing it, but then you also have this guaranteed minimum withdrawal amount that you could potentially access one day. And what makes this really confusing is that the guarantee is not a guarantee on cash value, which is what you're investing. It's a guarantee on the minimum withdrawal balance. So on a $100,000 variable annuity, you could have in there a rider that says there's a 5% annual increase guarantee.

Jacob: 17:26

And that's not talking about your balance that you're investing. That's talking about your minimum withdrawal balance, which is ultimately what you can access one day in terms of if you annuitize your variable annuity and say, I want to begin taking income from it, that is a minimum balance that that annuity will be based on. And so a lot of people buy these different variable annuities thinking their account balance can only go up and it can never go down, but that's not based on the cash value that I mentioned, but that's not based on the cash value that I mentioned. The cash value fluctuates with the underlying investments that you chose. The minimum withdrawal balance is the guaranteed that's that's gonna be increasing, but you can't walk away with that money.

Jacob: 18:05

You can't just say, hey. I wanna walk away with that in four years or ten years. I want I don't I would just wanna get out of the annuity product in general and just walk away with my guaranteed amount. You can't do that. You have to annuitize it to in order to get that guaranteed amount.

Jacob: 18:18

So if your annuity value decreases from a 100,000 to 90,000 you wanna get out of the annuity, thinking that after one year, now you have a $105,000 of minimum withdrawal balance, you can't access the $1.00 5 because that's not for lump sum distributions, that is for your annuitization amount in the future. The 90,000 is all you can access and take to get out of the product. So because of all these different guarantees and confusing pieces of these products, they're very costly, whether that be in actual fees that you know you're paying or if it's because the annuity company is making so much money on your money. So that's one of the biggest issues with annuities in general, is they're so costly and they typically underperform, which leads me to the sixth and final reason that I am not a fan of annuities, and that is they have limited growth potential. With fixed annuities, you will underperform other markets.

Jacob: 19:09

There's no way around this. They can't guarantee a rate of return without somehow getting a higher rate of return or knowing that they can, then they pay you return and then they keep the difference. That's how they make money. They have to give you a lower rate of return than other investments that they can get out there. They won't sell you something that doesn't make them money.

Jacob: 19:29

Like it it does this doesn't make sense. They will not do that. You will not beat the annuity company. You will not outperform them. You will not get a deal here.

Jacob: 19:38

They always make their money and they always use your money to do it. With fixed index annuities, you get the downside protection, but you're limited on the upside. So you'll perform, so you'll always underperform the indexes because you're never participating in the full market return that the markets are providing. And with variable annuities, fees will eat into your returns over time and offset a lot of those different gains. So just limited growth potential in general.

Jacob: 20:03

And when we think about retirement, beating inflation and not running out of money are of the utmost importance. Like, that's the thing that we're trying to accomplish. And these different annuity products are limited in their growth potential. So from a long term growth perspective, they're not gonna match what we we could be doing otherwise. And because of that, we're not going to end up beating inflation over time, which is one of the most important things we can do.

Jacob: 20:26

And so if you is one of the most important things that we're trying to do. But, so hopefully this is helpful for you in terms of figuring out annuities, understanding them, why they're good, why they're bad, and just really understanding the product in general. Ultimately, I'll just leave you with this. Ultimately, companies, they use your money to make money and they make a lot of money doing it. So they offer you these really costly guarantees and then charge you something for that.

Jacob: 20:50

And they also use your money to go invest in different markets and give you a lower return than what they're making. So in my opinion, it makes way more sense to hold on to your money, invest it yourself, and then you can keep the full market returns that they're going to get, and you don't have to share those returns with the insurance company. You get to keep your money in hand. You don't lock it up. You don't have all the restrictions.

Jacob: 21:13

You don't have all the high fees, and you get to access that money whenever you like, and it's flexible, and you get to build the retirement plan that you actually need. So with that being said, remember, annuities are not bought, they're sold, and the more confusing the product, the easier it is for them to sell. If more people knew about how annuities worked, I I feel like annuity sales would be a lot lower. So that's all I have for you today. Thank you so much for tuning into Retirement Answers.

Jacob: 21:38

I look forward to talking with you again next week.