Annuities Pros, Cons, Risks & Alternatives Explained

Video Transcript:

[Music] Hello investors and welcome to yet another edition of Smarter Money Matters with the Wealth Doctor, me, that’s Jeff Camarda, and our super CFPs Lou and Anna. Thank you so much for joining us today. And today’s scintillatingly interesting topic is annuities pros, cons, risks, and alternatives explained. Uh or or the truth about the truth about annuities and why we don’t sell them and you probably don’t want them. So annuities are wicked complicated vehicles and we’ll get into just a little bit of the complexity. talk about what is an annuity annuity and explain what annuities are the pros and cons of annuities and we have a real nice AI summary here that Lou’s prepared you know using annuities for retirement should you buy an annuity you know what’s the difference between fixed and variable annuities what’s the difference between indexed annuities and variable and fixed annuities and should you buy an indexed annuity you know what about guaranteed income annuities annuities fees and commissions which is a big one really uh that’s very difficult to spot. You know, what the annuity serenity charges are and which is really the flip side of the commission. Uh that’s why they exist for the most part. You know, some of the drawbacks, how the guarantees work, um tax treatment of annuities, which in my mind is the most horrible of all the investments in the investment pantheon. Annuities have the worst tax rate in a lot of ways. How fees affect annuity income and values. um some of the fine print that you’ll find in annuity contracts. Um some of the uh the concerns about um the alternatives to annuities and there are quite a few and in my view most of them are superior to annuities, some of the pitfalls to avoid and why we don’t sell them. And I I say this as a reformed top producing annuity salesperson from back in my past in the 1990s and I was very very active in this market. But as my education increased and toward the end of my my CFA, chart of financial analyst studies, I just got to the point where I I could not bring myself to to sell them anymore. Uh despite, you know, the high income that they produced because it just didn’t seem it was a good deal for me. I don’t think it was that good a deal for the clients. So why don’t we begin? Lou, you’ve got some pros and cons and we’ll we will turn through those. Before we do, it’s really important for everybody to know. An annuity is a life insurance contract. It is a life insurance contract. Burnout insurance. It’s a life insurance contract. It can only be issued by a life insurance country. It’s a life insurance contract. It’s kind of flipped by life insurance. It’s, you know, to how long will you live and how much money can we afford to pay you until you probably die? Um, so it’s the same kind of the same math, but but remember it’s got to be a life insurance contract. It’s not a bank product. It’s not a security traded on the exchange. Um, although sometimes they have securities in them, they’re life insurance contract. So that is, you know, as a preface, tell me what you know what some of the We’re going to play stump the chump. I’ll be the I’ll be the chump and you’re going to tell me what you think that the the the pros are and I’ll tell you if I agree with it or not. Right? So, a lot of people, you know, when they’re shopping for for annuities and and you know, advisers, the way you know advisors that sell annuities are going to, you know, list these items as as pros to to why annuities are a good product. So, number one, it provides guaranteed income. Yeah. And it is it the essence of an annuity, you know, and the way they were originally formed, it’s basically you’re buying a pension. I give the insurance company so much money and they guarantee me a payment for life. And it could be the life of me and my wife or there’s a lot of ways to slice and dice the payment. Um, but the the the simplest one is a pure life annuity that the payments go to me. So I get payments for life. Two of the things that there are pitfalls or three actually. Number one, in the vast majority of cases, these are not indexed for inflation. you know, so as costs go up, you know, your income will not go up. And if you’re getting $1,000 a month, the purchasing power may go to 900, 800 and so forth because it’s just like a mortgage, right? The lower the interest rate and interest rates are low now, the lower the payment except you’re on a bad end of the payment stream because it’s not going to go up. Second thing is if you die with a pure life annuity, what happens to the income? Goes away. It stops. So if I give the insurance company a million dollars and I’m getting what would that be? probably60 $65,000 a year, you know, and uh and then I get hit by a bus the next day and Ann is my wife. She gets nothing, right? The million say, “What did you do, you stupid son of a gun? That million dollars is gone. We only got $3,000 back.” That’s how they work. Yeah. And the other thing is the risk of the insurance company taking you out of business. You’re going to have a hard time chasing their money. All right. So the next one that you’ll hear a lot is is you know they provide you with tax deferred growth and uh well they kind of do but I think in the worst possible way. So if you put money you’re talking about annuities that are not in IAS right correct because if it’s in an IRA you already have tax deferred growth. So that’s kind of you know maybe a slick sales approach. Yeah. But the the thing that you can get tax deferred growth with growth stocks can’t you? Sure. Right. And or growth mutual funds. And is the tax rate better? Um, yes. When it becomes time to take funds out, you’re going to be taxed in a much more advantaged way with securities. Yeah. You’ll be paying capital gains rates or qualified dividends, right? You know, so it’s probably half. You know, annuities are taxed at your highest marginal rate, right? The highest ordinary income rate there is. And what happens if you take it out before 59 and a half? There’s additional penalty on it. 10% penalty. And also if I if you know if if Anna you know invests in a mutual fund and uh um and she’s got maybe $100,000 in it, it’s grown to be 150 and she wants to take out $50,000. Do you have to pay tax on the whole $50,000? No. And it would only be gains on the portion of gain that I take out. Exactly. What about an annuity? Yeah. You you have to pay 100% because it’s last in rather last in first out tax treatment. So you’re forced to pay tax on all the gains before you get back to your uh um your original investment tax rate. Yeah. Absolutely. Right. So with the tax rate a couple other things. Not only do you pay the highest marginal rate, it’s taxed on on a on a la lipo or last in first down basis. What about when I die Lou when poor old Dr. Jeff passes on? Do you get a and you’re my son before? You sure have grown. Do you get a step up in basis? Uh no you don’t. No. Unlike virtually every other investment that’s out there that entire the gain is not forgiven at death with annuities, it is with virtually other other investment. So it’s got it’s got and before we get back to the first point, sometimes I’m not saying annuities are evil, you know, but they they become so convoluted and the commissions are so, you know, outrageous in many cases that it really drives sales that I don’t think should occur. you know, that that that folks are, you know, being told to buy annuities for reasons that really aren’t a good fit for them. Uh, but it does provide lifetime income. If you need a pension, you know, that, you know, that’s what the base of pensions are. They have a place, but I but I I don’t think I think they’re frequently misplaced. What’s the third one? Well, third one is is uh downside protection or you know, protection from from market downturns. And it depends on the annuity, right? So if I buy a fixed annuity, what am I investing in? Anna, um essentially a bond, similar to a bond. Yeah. It’s kind of like you basically insurance company, remember it’s the insurance company’s promise. It’s not a bond. It’s not a bank product. The insurance company’s promise, but it’s basically to pay you fixed interest, but it’s kind of similar to a CD. It’s like you’ll get a fixed rate of interest at three, four, 5%. Right? So in a fixed annuity, the downside is guaranteed. at least substantively. But what about a variable annuity? You’re investing into a uh into a fund, right? So, you’re basing mutual funds, right? That you’re buying inside of a life insurance rapper, which increases the complexity, really screws up the tax treatment and increases the cost dramatically. But do I have downside protection there? Could lose all my money, right? Sure, I could. I mean, it’s probably death benefit, but it’s, you know, it’s a thin it’s a very thin veneer of what people will think about downside protection. And then equity index annuities, which we’ll talk about in a little bit, do have, you know, guarantee floors, but you got to read the the fine print. These are such complicated contracts. You know, I’ve seen them where the guarantee was 85% of your initial investment. It’s guaranteed. It’s guaranteed loss of 15%. But the agent’s not saying that. So, it’s guaranteed. Guaranteed to get your money back. Well, you better read the fine print. And it’s about that much fine print you got to go through by from very smart lawyers that put this together. What’s number six? So number four actually jumping ahead. I’m getting hungry. Yeah. But but the you know advisors that sell annuities are going to want to you they’re want they’re going to make you believe that it’s they’re customizable. So you can add different riders onto them. Yeah. But so basically when you say they’re customizable that means you can buy different insurance features at additional cost. Sometimes that makes sense, sometimes it doesn’t but it can ratchet the cost up. I’ve seen them as high as 5 6% in hidden fees, right? And and you know they but is this obvious to the client? Typically not. You got to dig down. You have to somebody that knows where to look. A lot of folks don’t, including those, you know, a lot of advisors. You got to know where to look to find out what the actual costs are. You have mortality charges. You have you have mutual fund charges. You have premium taxes. You have contract costs. You have writer expenses. I’ve seen them like 6% a year. Outrageous. Yeah, it’s a lot. Yeah. So, the next one, and you know, we see the these a lot. I’m sure Anna, you’ve seen these a lot, too. Um, you know, they’ll say there’s no contribution limits, just like, you know, on an IRA or 401ks, there’s contribution limits, but then we’ll see annuities in IRA and, you know, not so much 401ks, but definitely. Well, all I can say is AIMI. Okay. Is your contribution limit? If you open an account, it’s Charles Schwabs, you can put as much as you want, right? No. Yeah. The only difference is you probably get better tax treatment. True. Any other pros? That’s that’s all all the pros that AI spit out that any cons that you have? Yeah, I mean the the first one that we’ve already kind of touched on is the fees and the expenses of the annuity. Um high annual fees and then writer costs, different things that can that a lot of a lot of times are hidden um that can really impact the performance of the annuity. And these can be wicked expensive. But one of the nice things about variable annuities at nice, but one of the transparent more transparent things about variable annuities is you can look up the fees and expenses. You know, if you know where to look is the mortality cost, the life insurance charges, you really should pay life insurance often 1%. You invest $100,000 today and your death benefit is $100,000 and you have you pay $1,000 a year for that privilege of just getting your freaking money back. You know, crazy. But it really is. It’s just outrageous. But at least you can look them up. With fixed annuities, which include um indexed annuities, it’s really they don’t tell you. They just tell you what the what the interest rate is going to be. And with an equity index annuity where you have where the steps goes up, you get, you know, there’s participation. It looks like in the investment markets, but you don’t know what you’re paying for that. Yeah. The the next one was the fact that a lot of these annuities are not liquid and they have surrender charges. So let let’s talk about you know there’s really two aspects of that right. The first one is the liquidity problem. Most of them you can cash out and get something. The question is do you get you know a fair amount back? Um and frequently the surrender charge is the biggest factor on how much you get back. So, what is a surrender charge, Lou and Anna? I mean, essentially, it’s the commission that was paid to the salesperson spread over X amount of time that if you cash out that annuity early, you have to pay um that surrender charge out of your initial investment or the investment you receive back. Yeah. Naturally, that that’s that’s a pretty good, you know, distillation of what it is. though it’s kind of hard for the consumer to see that because there’s so much complexity and if you look at an annuity statement you’ll see account value, accumulation value, um surrender value. Sometimes you will, sometimes you won’t. So, it’s kind of hard to focus on and human beings will typically focus on a bigger number. Um so, if I put a million dollars in an annuity and the surrender value is $900,000, but I see an account value of 1.2 2 million. How much do I think I have? 1.2. Yeah, it’s pretty it’s pretty misleading, I think. You know, without really understanding what’s happened, but to your point about the commission, the surrender charge largely exists to protect the insurance company if they don’t have the money long enough to make up the sales commission they sold. So, a good way to look at that is uh an example that we used in a previous podcast, I think, is we have Sally that bought that annuity from the broker for a million dollar and when you look at the surrender value, it’s $900,000, right? So, what happened was the the broker in this case probably made a 10% commission. Million dollars goes in, they write a check the next week, back when I was selling them, uh is $100,000. pretty good pay for taking Sally to lunch. Yeah. Um and there’s $900,000 left. Um so if the insurance company paid me a hundred and um and Sally put on put in a million but 100 went to me and Sally wants her money back, how much money’s left? Not 100. It can be it cannot be otherwise, right? So, the surrender charge is designed to protect them until they’ve made enough money back by maybe earning 10% on Sally’s money to simplify this and giving her seven making 3% a year after their cost in order to actually have the annuity be profitable. Does that make sense? Yeah, makes sense. And and a lot of time these stretch out for years, you know, I’ve seen them as long as 15 or 20 years, you know, which is just outrageous. you know that the I think that they call it the federation of insurance commissions whatever there’s kind of a quasi regulator of insurance of life insurance companies and their best practices now you know for to protect the best interest of clients and this is just in the continuing education I did last week you know what the you know the preferred maximum surrendering charge and surrender period is bet you what you can’t guess try to guess 10 years and close yeah s of charge 10% 10% % the 1010 rule. You’re only losing 10% of your money. Only got to wait 10 years to get it back. Doesn’t that seem like it’s in the consumer’s best interest? I don’t think so. You got to be really really careful to figure this stuff out though because buried in pounds of disclosure that they it’s so burdensome. They hope you don’t read it and almost nobody does except for guys like us. What’s your next one? We’ve hit on this a lot, but complexity with the product structures, the writers, payout options. Again, we’ve hit on that, but it they’re extremely complex. Yeah. But it’s so hard for consumers to understand. I’m telling a lot of the agents don’t seem to understand it. They know what their commission is and when they get paid. But let’s take a a look from, you know, some of the parameters that you’re going to find in index annuities. And one is the participation rate. The participation rate is the percentage. So that if the um the the gross return is 10% and you participate to 70%, how much do you get? 7%. 7%. So they take a shaven off the top. So the participation rate is really important and it means you don’t get all the return. The insurance company keeps them. Therefore, you know, they’re not a charity after all. You know, another way to look at that and sometimes is in addition the participation rate is a spread. like they’ll take the first two percent. Um, another thing to be concerned are cap rates. Any you guys know what a cap rate is? Yeah. So, if if the market, let’s say, you know, the annuity is tracking a for for example, S&P 500 and and S&P does 10 10% this year, but your cap is only seven, you only get seven of that 10%. Yeah. So, and you can have a cap rate and a participation rate typically are both elements of a complicated equity index annuity contract. So you can participate at 7% and be capped out at you know 12. So if the market goes up 40% your participation rate is seven the most you could make is 28%. Gee was there making what 12% on top of that but you got a cap of 12%. So they keep all the difference. It’s really you know and most people don’t really appreciate this. Another thing I like to touch on do we have any we have some more disadvantages right? Yes. um is market value adjustments, which is another wicked sneaky way that that insurance companies and you see these in all sorts of annuities um are able to transfer more risk of this guaranteed product from the insurance company to the insured. So, so remember a lot all but variable all all um the fixed annuities of which index annuities are a subset basically take the money and they buy a bond or some other you know very safe product that they’re allowed to invest their reserves in by the various state insurance commissioners. Okay. Um so the uh so what happens to the value of bonds when interest rates go up guys? Goes down. the value of the bond goes down. Right? If there’s an MBA in that contract, a market value adjustment, who do you think eats the loss on the bond? The insurance company or the owner of the annuity? The owner. And that’s what that’s what an MBA is. And they’re all I tell you what, it’s usually on page 64, you know, with three pages of how the lawyers figured that the how it would be calculated. But market value adjustments are another, you know, really dangerous pitfall. All right. So, what else you got? I could go on obviously all day, but what else you got? Yeah. I we we hit on this a little bit, but the taxation, so in a taxable type, you know, annuity. Um the the gains are taxed as ordinary income and you’re taxed first and first uh um in rather last in first out and you don’t get any capital gains treatment as you mentioned and there’s no step up in basis of debt. Just really horrible tax treatment. The worst of any invest of any investment product I’m familiar with. What else you got? Um, last one is insurance company credit risk. Okay. And that that’s just is one of Lou’s favorite, you know, the concern about annuities. Tell us about that, Lou. Yeah. So, I mean that that basically means that if you give your money to an insurance company and they, you know, go go bankrupt or they go out of business, you’re basically left with nothing. Yeah. With a thin with a thin shot at getting it back from state, you know, um, guarantee funds. And that that’s a really really important consideration. We’ll finish on this because I know we’re getting kind of long in the uh the podcast tooth here is that you know insurance companies when they say it’s guaranteed it’s guaranteed by the insurance company. It’s not guaranteed by FDIC or securities investor protecting corporation or a lot of other government back stops. It’s the life insurance com life insurance company contract and it’s there how well they manage your book of business and their reserves and if they go belly up you know and it happens occasionally. I remember in the early 90s they were dropping like flies. Some people had to wait decades to get their money back on California I think. Um but you had it’s so important this is a long-term promise. As I was talking to my son and his soon-to-be wife earlier about buying life insurance, the insurance company’s ratings are so important because it’s important they be there when you need your money back or the death benefit to get annuity back. And there’s a lot of really shaky ones and and a lot of consumers and and agents unfortunately don’t they look at the numbers but they don’t do the underlying um the due diligence to make sure they’re investing in a safe product. you buy CD at a bank, as long as you give me the FBI limits, you’re getting your money back. Not so not not so fast with annuities. You guys have any including remarks? We could go on. There’s going to be a lot more upcoming um podcast episodes on this because it’s such a complicated um vehicle and it’s just so popular and there’s so much of that sold and so many of you have billions and billions of dollars that invest in annuities. I think you need to understand it better. But you have any concluding? Yeah, I mean for for me uh you know clients you’re going to come across um advisors and agents that sell these products and obviously to them you know as Jeff as we pointed out earlier it’s very lucr lucrative for them to to to be in this business but it may not be you know as beneficial for the client to to um to you know to buy these products. So, um, do your do your due diligence, do your research, talk to fiduciary, financial advisors, and, you know, really really see if this is something that you want to go into or, you know, something you want to buy before you actually put your money and you understand what it’s costing you because you don’t rely on the agent. There’s a whole bunch of required, you know, disclosures uh, that the new rules require. And I bet that there’s a lot of agents that aren’t going through that because you really understood you was Mr. investor. Just so you get it straight here, put a million dollars in this annuity. Great annuity, right? But if you want your money back next year because you can get a CD for a higher interest rate, you only get $880,000 back. Sounds good, doesn’t it? Who would buy that? But that’s the reality. But if I’m going to sell that to you, I really can’t be that quite that honest about it. Do you have any final remarks? I mean, I’ll just agree with Lou and and everything we’ve talked about. They’re very We always agree with Lou, of course. But like they’re saying, so she says, so she doesn’t. I mean, they’re complicated products. Work with experts that are that don’t have an interest in you purchasing the product, right? And just make sure it’s right for your situation. And it’s again, if if this is a legitimate product that makes sense for you, taking time to do due diligence shouldn’t make a difference. Understand the cost. And the commissions are man I you know, I hear a lot paying commissions. along is not making money yet. But remember, it comes out of your pocket. If you put in a million bucks and you shave down to 900 grand, you’re only starting with 900,000. You got a long way to break even, you know. And then I’ll finish with this. Now, we get a lot of new clients that have annuities, unfortunately, from past advisory relationships and develop what we call annuity rescue plans. And sometimes because of the tax characteristics, they need to stay in an annuity doing what’s called a 1035 turnover revenue code section 1035 exchange. Basically, it’s a tax deferred. It’s like an IRA rollover. All right? But there are a lot of cheap annuity and life insurance products that have developed so-called no-load products that are much cheaper and more consumer favorable. I still hate the tax treatment, but sometimes you’re stuck. But at least you’d have the opportunity with fairly priced products that aren’t loaded up on commissions to get a better return than you would, you know, with some of the things we’ve been discussing. So, thank you so much for watching yet another episode of Smarter Money Matters with Lou and Anna and your wealth doctor, Jeff Camarda. Till next time, thanks for watching. [Music]