030: Annuities Part 2: The Good, The Bad, and The Ugly
Sep 3, 2020
In last week’s episode, we started a deep dive into annuities: what they are, how they work, and why they might (or might not) make sense in your retirement portfolio. If you haven’t yet, we recommend you listen to that episode first, then come back to today’s.
More than anything else, you need to remember that whether you’re talking about stocks, bonds, mutual funds, exchange-traded funds, or, yes, annuities, there’s good and bad in everything. You need to make sure that you’re using the right tool for your situation and your family, because the wrong investment can get really, really ugly, no matter how “good” it might seem.
Today, we continue our deep dive into why annuities may – or may not – be right for you. You’ll find out what questions we ask in our discovery process as we determine whether a client should leverage annuities, why being able to track and monitor your assets’ performance is so important, and discover the biggest problems facing retirees when it comes to annuities.
Here are just a handful of the things that we'll discuss:
- The four different types of annuities, why a pension is a type of annuity, and why principal is not guaranteed.
- Why it’s so important that you do the math before purchasing any financial product – and how crunching numbers can save you from financial distress years down the road.
- Why you want to get any guarantee pertaining to your benefits in writing.
“As good as something is, if it doesn’t fit your overall situation, then it’s going to be bad for you.” – Ed Siddell
LeAnne Siddell: It's The Retirement Trainer with Ed Siddell, a podcast about finding ways to help you become financially fit for your future no matter what shape you're in now. Annuities, what are they? How do they work? Do they make sense? The Good, the Bad, and the Ugly of Annuities Part 2.
Ed Siddell: When one is not enough, right?
LeAnne Siddell: This is LeAnne Siddell and here to help us with all of our questions and give us some guidance to help us stay in the best financial shape possible, the retirement trainer, Ed Siddell. Hey, Ed.
Ed Siddell: Hey. Good morning, LeAnne.
LeAnne Siddell: Good morning.
Ed Siddell: Well, you know what, part two you're right.
LeAnne Siddell: Yeah.
Ed Siddell: You just can't get enough a Clint Eastwood. That's all I'm saying.
LeAnne Siddell: Well, that should make everybody feel a little bit better in the sense that this subject matter, this topic is a lot.
Ed Siddell: It is and we got some calls after the last one and it's really easy to get going down a rabbit hole and I think that's the hard thing. When you deal with it every day, you're just used to it. So, I think what we're going to do today is kind of clean it up a little bit. Pick up where we left off. We're going to kind of summarize the bad, the ugly, and the good because there is a lot of good even though there's a lot of bad and ugly as well. So, we'll just kind of break it down and make it a little bit more palatable and understandable for everyone out there.
LeAnne Siddell: Well, and I think the word should be complicated. We don't want to necessarily say good or bad but in essence, it's not a good fit for all.
Ed Siddell: Well, that's what I mean. Yeah. So, when I say good, bad, and ugly what I'm talking about is there's nothing that's perfect. And as good as something is, if it doesn't fit your overall situation, then the problem is, is that it's going to be bad for you. And if it is really, really bad, it could be really, really ugly no matter how good that investment is. So, it has to be part of your overall plan and that's really what I want to stress to everybody. There's good and bad of everything that we're talking about from stocks, bonds, mutual funds, exchange-traded funds, annuities, whatever it is. You just need to make sure that it's the best tool that you're using for you and your situation and your family.
LeAnne Siddell: Exactly. So, let's revisit where we've been and maybe offer some good tactical ways in which people can approach what's good for them and what's not good for them.
Ed Siddell: Alright. So, let's kind of summarize what we went through last week. So, remember, basically, there are four different types of annuities. You have an immediate annuity and when you think of annuity, it's the bad word but pensions are annuities. So, again, just like anything else, it's got to be a good fit. So, an immediate annuity is really like a pension. Okay. Then you have a fixed annuity. A fixed annuity is the insurance version of really what a CD is. Typically, the rates are the same or a little bit better and there's longer term. So, what I mean by that is you get a six-month and a one-year CD whereas, most fixed annuities are two, three, five, six, seven, ten years. Then you have a fixed indexed annuity. So, with fixed indexed annuity, your principal is guaranteed. Just like with a fixed annuity and like a CD so that you're not subject to market loss and it mirrors an index. So, it's not an investment. It is an insurance product, the principal’s guaranteed, and then you have a variable annuity. So, a variable annuity is you're investing in shares of annuity shares, that mirror stocks, bonds, mutual funds. It’s what that company actually purchased whatever the name of the insurance company is.
And so, based on whatever that account value is, it is subject to market risk. So, the gains could be higher but they can also be lower like that we saw a lot this year back in February and in March. And the principal is not guaranteed.
LeAnne Siddell: These are all the things to focus on.
Ed Siddell: Right. And we're going to come back. So, we're going to come back at the end and tell everybody what you should look for. So, I think last time we were kind of getting into the weeds as far as some of the expenses and what to look for what not to look for. So, these, again, are the key terms that we talked about last time, the cap. So, what a cap is that's the maximum amount. They're capping your earning potential, okay. Then you have participation rates. So, participation rates, that's the amount that you're able to participate in the growth. So, these are mainly for fixed indexed annuities. Okay. So, let's just say that you have 100% participation rate and you have something that's going to mirror the S&P 500 and it goes 10%. Well, you get to participate in all 10% but if it's only a 50% participation rate then you can only participate in 50% of that so you only get a 5% rate of return.
LeAnne Siddell: Got it.
Ed Siddell: Okay. And then you have spreads. So, a spread is what the insurance company is charging. This is aside from a fee, so let's just say the spread is 1% or 1.5% or 2%. That means if you're participating 100%, okay, in that rate of return and now all of the sudden you have a 1% spread or 2% spread, you're really only going to get 9% or 8%. So, it comes right off the top.
LeAnne Siddell: Easy to understand that, yep.
Ed Siddell: Now, a lot of these contracts, they don't charge a spread if there are no earnings. All right. So, it doesn't ever go negative.
LeAnne Siddell: That's right. Zero is as low as you can go.
Ed Siddell: A zero is low as you can go. And then every year or every two years, depending on which strategy, it's locked in. So, those gains are locked in and you can never lose them. So, once they're locked in, it becomes part of the principal. Unlike a variable annuity, where it's like a regular investment account and then you have those fees that are charged on top of it. So, you have the rider fees and there's also sometimes rider fees and indexed annuities, fixed indexed annuities. But with variable annuities, you have mortality, administrative fees, and expense fees and account fees. And so, they can range anywhere from two to significantly higher. So, those are the things we'll talk about a little bit later on. The big thing when we're talking about annuities and finding out what makes the most sense for you, for each individual family, is what is it that you're trying to achieve? So, when you talk about annuities, are you trying to put together your own personal pension and get that guaranteed income for you and your spouse?
And if so, you want to make sure that that income is lifetime income no matter what happens to the account value. So, even with a fixed indexed annuity even though the principal’s guaranteed as you draw money off for you, that income, eventually if you live long enough and hopefully we all do, that account is going to go to zero and you want to make sure that that income keeps paying, whether it's the fixed indexed annuity or a variable annuity. So, that's really, really important.
LeAnne Siddell: Again, this is about cash flow and that…
Ed Siddell: It's all about cash flow. Sometimes that income rider makes a whole lot of sense and the fees that they charge for those, I've seen as low as a little bit less than 1% and sometimes one-in-a-quarter to one-and-a-half, and you need to make sure that you're getting value for what you're paying for. What you don't want to have happened when you're getting all these fees is they become layered where you have a product that has a cap and a low participation rate, as well as a spread, and then all of a sudden, you're kind of stuck. You can't really do anything. You can't earn the money that you were hoping to make. And that's really important. So, when we're putting plans together and we're looking at the safety income growth, we probably look at it a little bit differently than most because we're looking at them as more of a bond replacement. And we ladder them just like bonds. So, you've got five years, seven years, 10 years. Some are nine years and just like intermediate and longer-term bonds, you do want to ladder those out.
So, you have the accessibility to the cash. You want to make sure and, again, just like anything else, the longer the term they're running your money for you, the higher the possibility is for a greater return on your money. So, the participation rate on a five-year is going to be a lot lower, usually 50%, 60% as compared to when you're going out seven years or nine years or even 10 years, and we've seen some out there that have 100% and even way more than that, as far as the participation rate which are being able to participate in, in the index that they're mirroring. So, in that example, if you're getting 125% participation rate and there's a 10% rate of return, you made 12.5%.
LeAnne Siddell: Okay. So, again, when people are looking to nail down what's a right fit for them, it's more about them coming in, obviously, they're going to have, I'm sure, a slew of questions that are placed in front of them but the main idea that they understand how it fits into their plan…
Ed Siddell: It's all about the math. It's all about the math and making sure that it's not just about the math but that you're getting value for what you're paying for. I mean, that's really what it is. Should you be paying for riders that you don't need? Right. So, those are add-ons to give you enhanced benefits but why would you pay for those if you don't need them? It doesn't make sense.
LeAnne Siddell: That's why the plan is so important.
Ed Siddell: It is so important because it'll define based on the math where you're at where you should be. Do you want anything with a cap on it? You know, a lot of times the way that we use them and as a bond replacement strategy, no, but sometimes they could make sense depending on what other benefits that they have, right? And again with the income rider, I keep going back to this because when people look at their account value and you're looking at income, the income and accumulated cash value are two completely separate numbers and this is where we got a lot of phone calls after the last one because it is confusing. And so, if you write it down and you put cash on one side, you draw a line down the center of the paper, and on the other side, you put income and they are separated. They're completely different.
So, you could have 200,000, 300,000, whatever it is in the income value but your cash or walk away is 150,000. So, even though it says 300,000 in your account value, if you say, “I want my money. I'm leaving,” after the surrender charges and everything are gone, you're only going to get that 150,000. But that income value is really, really important because if you're trying to put together your own pension and it's for you and your spouse forever, and especially if you have longevity, and you want to make sure that that money is there forever for as long as you live, having that account value as large as possible is important and making sure the withdrawal percentage, that's key too. So, sometimes you can only withdraw 3%. Well, okay, then how long is it going to take for you to get your money out? Statistically, what's the probability? Or is it 4%? Or is it 5%? Or is it 6%? Or is it 7%? So, those are the things it's being able to compare apples-to-apples and that's why having the plan is so important because it's all written down. And having that, for us, the retirement fitness plan, what it does is it makes sure that you're in the best shape possible.
And as corny and cliché as that sounds, it's key because it runs the numbers and it says based on the contract values that you currently have because a lot of folks that we started working with and helping, they already have these in place. And so, we're coming back trying to analyze what they already have to make sure that, okay, with what they have, how can we get everything to work? And the majority of the time, it's fine, but every once in awhile, we'll come across one where we need to do some tweaking and some adjusting so that that way, we can get those numbers to work correctly.
LeAnne Siddell: And sometimes it's just about fully understanding what it is that you do have. A lot of people have gone to previous advisors and some ways, their way of explaining something might not be completely understood. So, it's always good to get a second.
Ed Siddell: Yeah. It is. It's just that and that's why I take the quote from Remember the Titans, right? Denzel Washington as the coach said when they were trying to introduce all these fancy plays and smoke and mirrors, he's like, “Hey, my stuff is it's like Novocain. All right. Eventually, it'll start to work.” It may be boring but it works. And that's really being able to track and monitor, being able to make sure that what it is that you're putting your money into is going to benefit you and your family the most. Everyone has a different style and when you work with a fiduciary, no matter who it is, they're always going to make sure that you have your best interest at heart. It's just being able to understand it and making sure that it's written down. And that's why having that plan that you can track and monitor to make sure that your progress, right, that you're on task, that you're on goal, and that first meeting the first time that's going to be your benchmark so you can always go back and say, "Yeah, we're doing all right or we haven't moved or worse we're kind of going backwards a little bit.”
LeAnne Siddell: Good information. Good information. So, we're going to nail down those questions that they should be asking.
Ed Siddell: Yeah. So, these are the first things. What are the fees? And so, underneath those fees, remember what's the cap? What's the spread? All right. And what's the participation rate? I mean, that's really, really important. And then we're talking about fees are the rider charges for extra death benefit or enhanced death benefit or lifetime income. And it's so important if you're married because we had this happen before that we're working with somebody they came in, they thought that income was joint and it wasn't. It was only for the one and it wasn't even lifetime. So, understanding what you have, understanding that those riders and what you're paying for. Then the other thing is the mortality, expense charges, admin fees, and the surrender charges. So, the surrender charges they're just like CDs. When you pull your money out early, there's a penalty. It's a prepayment penalty is really what it is when you pull your money out.
Because these insurance companies, they made a promise to somebody else based on the promises that they made to you so they're investing longer-term and other bonds or options, however they're investing that those funds to make sure that they can live up to the obligation that they have to you. So, when they pull that money out or when an individual pulls their money out early, then they have a penalty too so they have to make up for that loss. And that's really what the key is.
LeAnne Siddell: Good. All right. And I think you are going to, as far as those questions are concerned, the relationship between am I going to run out of money if the account hit zero? Does it still for those variable annuities?
Ed Siddell: Oh, yeah. Right. So, if you have a lifetime income, I mean, that's the one thing that you want to double-check on. Because we've had it both ways, right? We've had other companies that guarantee that no matter what happens just like a fixed indexed annuity, that money will last forever for you and/or your spouse even if the account goes to zero. And that's what you want. You want that in writing? You want it on a recorded line. That's really key. We've also had situations where they were told that it was going to last forever. And then when we called and verified with them because that's what we do, we don't call the agent, we call the carrier and ask questions with the family that we're helping right there so that they can hear it on speakerphone. And we ask, is this money, if the account goes to zero, do they get the same amount? And in a couple of cases, they said, “No, it's reduced.” Alright. And so, that's really important, especially when you're on a fixed income.
LeAnne Siddell: Yeah. The last thing you want is to get to the point where you've nailed down your expenses. You think you've got everything buttoned up nice and tight and then you get a letter in the mail that says, “I'm sorry. Your benefit has now changed to such and such.” That is not something that you want.
Ed Siddell: It’s crushing.
LeAnne Siddell: Yes. And we've seen it before. So, again, this is all great information, our Part 2 of Annuities. Again, I wish that there wasn't so much complicated jargon.
Ed Siddell: Information and industry lingo but you know what, the lingo, that's important and that's what you have to know when you're asking the questions.
LeAnne Siddell: Well, if you want more information, I want to make sure that you know how to get ahold of Ed at email@example.com. You can also go to our website at www.EGSIFinancial.com or give our office a call at 614-526-4118. Please do not hesitate to give us a call with all of those questions that I'm certain are rolling through your mind. Again, thank you very much, Ed. Good information.
Ed Siddell: Thanks, LeAnne.