12 – The Good, The Bad, And The Ugly Of Annuities

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Episode 12 – The Good, The Bad, And The Ugly Of Annuities

Discover what an annuity is and how they work in order to help you determine if an annuity is the right option for you.

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This episode discusses the good, the bad, and the ugly of annuities. Bob and Mary Jo cover what an annuity is and how they work in order to help you determine if an annuity is the right option for you.

Annuities are designed to create a lifetime income stream, one that you can not outlive. However, that is not the only income option you have in most cases. The size of your income payments is based on a number of factors but mostly the length of time you will receive those payments and the type of annuity: fixed, variable, deferred, and/or immediate.

Mentioned In This Episode

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[INTRODUCTION]

Bob: Welcome to Christian Financial Perspectives, a podcast where we talk about ways to integrate your faith with your finances. This is Bob Barber.

Mary Jo: And I’m Mary Jo Lyons.

Bob: Are you ready to learn how to apply biblical wisdom to everyday financial decisions?

Mary Jo: Join us as we look at integrating your faith with your finances. If it’s your first time listening, welcome to our podcast, and if you’re a returning listener, welcome back.

[EPISODE]

Bob:
Mary Jo, today’s podcast is so important as we talk about annuities, the good, the bad, and the ugly. That’s the name of today’s podcast. Annuities: The Good, The Bad, and The Ugly.

Mary Jo:
Sounds like a movie.

Bob:
Yeah. An old Clint Eastwood movie. I loved Clint Eastwood growing up. My wife, she laughs at me. She goes, how many times are you going to watch these Clint Eastwood movies? And I said probably about a hundred more times. All those spaghetti westerns.

Mary Jo:
They never get old. He and John Wayne.

Bob:
There you go. Yeah, I love them. I remember this movie, The Good, The Bad, and The Ugly, and I wrote an article on annuities many years ago, and this is what I called it. I thought, what a great podcast this would be because this is good information that people can use. I know you have a great scripture that we’re going to start off today with that I’d like to hear.

Mary Jo:
Well, sure. I know how you love Proverbs and there are actually two of them that I think speak very closely to today’s topic. That’s Proverbs 26:23, “Smooth words may hide a wicked heart just as a pretty glaze covers a clay pot.” And then in Proverbs 27:12, “A prudent person foresees danger and takes precautions. The simpleton goes blindly on and suffers the consequences.” So, given today’s subject, I thought those were very appropriate.

Bob:
I will tell you, Mary Jo, when I saw that you picked those two scriptures from Proverbs, I thought this is the most perfect scripture you could choose when it comes to talking about annuities.

Mary Jo:
Everything might have a real shiny package, but when you dig deep inside, the luster wears off. Before we get too much into the specifics, there are some key things we want to focus on today. We want to first look at what an annuity is. They’re insurance products that’s a contract between you and the insurance company. In exchange from a payment from you, either you can do that with a lump sum or series of payments. There’s all kinds of ways you can pay money into an annuity contract. In turn, the insurance company is guaranteeing to you a stream of money. You can take that stream of money or income out. Most people think of it for a lifetime. That’s typically what they’re designed to do is create a lifetime stream of income, but there are other ways you can structure that income. So, there’s multiple options.

Bob:
I think an income stream guaranteed for life, Mary Jo, is a good idea, but when it comes to annuities, you really have to look at the fine print of these contracts and all these underlying expenses of what you’re paying for to get that guaranteed income stream because there’s really no free lunch.

Mary Jo:
No, there isn’t, and you’ve heard us say this before if you’ve been listening to the podcast, if it seems too good to be true, it probably is too good to be true. I think that’s an ongoing theme.

Bob:
Yes, I do. I agree with you there.

Mary Jo:
When you look at annuities, there really are four types of annuities. There’s a fixed annuity, a variable annuity, a deferred annuity, and an immediate annuity. Let’s touch on the fixed annuity first. How much you receive depends on whether you opt for a guaranteed payout. They’ll guarantee you a certain percentage. A variable annuity is one that the payout stream is determined by the performance of the underlying investments. That’s more of an investment vehicle. Then, a deferred annuity is when you invest money years ahead of when you plan to take it out in the way of income. It’s invested for a period of time and we would assume it would have a growth factor because you’re giving it up for that period of time. An immediate annuity is for your payment. Then, you can create an immediate stream of income. Typically, that’s a much larger sum of money. That’s kind of the landscape of annuities.

Bob:
In the last couple of years, because interest rates have been so low, the way that people have been trying to overcome that is by investing in these fixed indexed annuities that are tied to a certain index, like an S&P 500 index or a NASDAQ index or maybe an international index.

Mary Jo:
After 2008 when we saw that volatility, it really did scare a lot of people out of the market, but they still needed to create a retirement income. They were kind of at a loss, and a lot of them were very fearful and I think there were some unscrupulous people out there that kind of preyed on that and that mindset, if you will. A lot of people were looking for a flight to safety. The way they can describe it, the language they use when talking about these fixed annuities, attracted a lot of people. I’m working with a client right now that has everything for retirement in these annuities. He jumped out of the market and loved that idea of the guarantee, because he just couldn’t take it anymore after the volatility in the market. Now, he realizes the market has been rocking and rolling for the last five or six years, and he’s missed out. Now, he realizes that was probably the biggest mistake that he made and he’s looking at how he can unwind it, but he’s faced with these big fees. I’ll let you continue on about the fees.

Bob:
So many of these fixed index annuities, while he may have been invested in an index, they’re capped, and we’ll talk about that in a little bit. To your point, we’re going to have another market downturn. They always come, and it’s been a long time since we’ve had one, but I’ve noticed that from the last three market downturns and you and I have both been in this business long enough. I was there in the 87 downturn.

Mary Jo:
Yep.

Bob:
Then there was the major downturn from the internet bubble back in the 2000’s and then the 2008. After these downturns, you’ll notice that these annuities are very heavily marketed. Over the years and in increasing numbers, I’ve had many clients contact me about the opportunities for these types of annuities that they’ve heard either through a radio program, through the mail, or the free steak dinner.

Mary Jo:
We get those in the mail all the time. I’m like, do they know who they’re marketing to?

Bob:
That’s the big one and I mean these are steak dinners at some steak houses where it’s $40 or $50 per person, which tells me something. If the person who’s putting this on is paying $50 a person and you get 50 people there. Now, 50 x 50, that’s $2,500 plus the mailing costs. They’ll spend $4,000 – $5,000 in mailing costs because of the numbers, and direct mail doesn’t work very well today. That will push that cost up for them to put on one of these seminars, $7,000, $8,000, maybe $9,000. They’ve got to make their money back through selling annuities from the marketing costs. There’s a lot of important things to understand with these fixed indexed annuities before investing in them. I’m not against all these annuities. I’m not against all fixed index annuities. I’ve just seen a lot of abuse in marketing only the benefits. For years, we’ve looked at these. We’ve even placed a small portion of our client’s investible assets in them. We don’t really do that anymore because I think there’s some better ideas out there than investing in annuities, but for years we did a small portion to fit their investment objective. They still do have a roll for some people and in some cases.

Mary Jo:
Absolutely, Bob. I think you’re exactly right. Who doesn’t need a stream of income that they can’t outlive? As you mentioned earlier, it’s a good idea for some people some of the time.

Bob:
So now we’re going to share the good. You’re going to do that, then I’m going to share the bad, and then you’re going to come back in and share the ugly. So here we come to the good, the bad, and the ugly, right?

Mary Jo:
Exactly, and as I was just saying, many do offer a guaranteed minimum income, typically for life, and it’s based on the claims paying ability of the insurance company. If it’s got a high credit rating, that’s a good thing, but it might fit into your bad categories.

Bob:
That’s one thing you really want to look for. You want to look for a company that’s like A, AA, AAA rated.

Mary Jo:
I was looking at the statements from the client that I was referring to earlier and the companies that sold these annuities that he has. I had never heard of them, and I’ve been in this business a really long time. So what does that tell you? They may produce a better rate of return than today’s CDs, or savings rates, since interest rates are at historically low rates. That feels good on the surface, and they can create a predictable stream of income. That’s really important when you’re trying to come up with replacement income in retirement. There can be tax benefits. They grow in a tax deferred environment. We talked about the immediate annuity or the deferred annuity. You’re either giving a lump sum or paying in over time. That money continues to grow, and it’s in a tax deferred environment. So, you don’t have to pay taxes until you pull it out.

Bob:
And that’s one thing I like. I like the tax deferral part.

Mary Jo:
Absolutely. Now for the bad.

Bob:
So the bad. Well, the bad is many of these annuities, not all of them are like this, but many of them are very high commissions that are paid to the person selling them. Most of the annuities are sold by an insurance broker or salespeople who collect these commissions. Sometimes I’ve seen them as high as 10% of the amount invested. That means that somebody who’s investing $100,000 in an annuity, there’s a $10,000 commission paid up front to the person that put you in the annuity. Now, Mary Jo, you think of that right there compared to a fee based advisor who’s going to be making 1% a year. That would take 10 years to make 10% versus you’re making 10% in the first week that you put somebody’s money into the annuity. So, this can create a huge conflict of interest on the part of the person that’s recommending the annuity. I can see that you want to say something there too.

Mary Jo:
Bob, one of the things I think is really important is that “sales person” and you can’t see me but I’m quoting in the air. That salesperson, they’ve made their money, so where is their incentive to give you ongoing service? I bet you’re not being treated like you would if you had that trusted relationship with an advisor that was there along with you throughout the process.

Bob:
The fee based advisors, most of the time, they’re operating on 0.5% or 1% of assets invested. They’re participating in the growth, too, so they have a vested interest in seeing you do well over that 10 year period that it would take for them to make what the annuity salesman could make in the first day of putting you in that annuity. Also, the bad is the large surrender penalties that can apply to early withdrawals. And the reason the surrender penalties are there is, you think about it, if the insurance company is taking in $100,000, but they’re having to give $5,000 or $10,000 to the person sold the annuity, well you can’t turn right back around and just take a $100,000 out because the annuity company is not even keeping that $400,000. They’re giving 5% of that or 10% of that or 8% of whatever that commission may be, but they are typically between 5-10%. They’re giving that to the representative. The way that they make that back is over a period of time. And those surrender penalties sometimes can be as long as 10-15 years. I’ve even seen them last a lifetime.

Mary Jo:
It’s just amazing.

Bob:
Yeah, it is. And then the third of the bad is because of the low participation cap rates today and returns. Many of the times, these fixed index annuities do not even keep up with inflation, which can deteriorate your future purchasing power over the long term. So, even though you may be investing in the S&P 500 index, the cap rate, which might be 3%, if the S&P 500 index goes up by 10%, you’re only going to make 3%.

Mary Jo:
So you’re partially participating in it.

Bob:
Yeah, that’s right. Now, the good thing is if the S&P 500 lost 10 you’re not going to lose 10 but the majority of the time the markets are up and then you had that one or two years every 10 years or so where it’s down.

Mary Jo:
So you’re protected on the downside, but you’re really limited on the upside and that’s how they make their money.

Bob:
So we’ve shared the good, the bad. Now, you’re going to share the ugly.

Mary Jo:
One of the things is, and we’ve talked a little bit about this in the past, and that is the oversight that happens in our industry and the oversight for these, what we call sales people that sell the fixed indexed annuities, they are not securities licensed typically. In other words, they don’t have a securities license to be able to offer stocks, bonds, or mutual funds in addition to the index annuities. Typically, those people only have insurance licenses. They don’t have the level of supervision and compliance oversight that we would as investment advisors or registered investment advisors. So anyone who is securities licensed, they are under compliance disclosure guidelines that they must follow. I know Bob and I, we are always going through continuing education. We have to go through videos. We have to go through training from compliance on all the ins and outs, rules, and regulations regarding all of these annuities. And it’s something we constantly have to attest to. Another thing that we have to go through as advisors is if a client comes to us with an annuity, well we have to write, it seems like a book these days, to justify moving them into another product. Our regulators are looking for every rationale as to why we no longer think this is a suitable or an appropriate product for that client and why we’re going to recommend something else. There is a lot of hoops we have to jump through because we’re so highly regulated. I think you’ve heard us talk about the fiduciary standard. That means that all of our recommendations must always be in the client’s best interest and as registered investment advisors, Bob and I are always held to that higher standard of care. So, that’s one of the key things that I think fits into the ugly category on these annuities.

Bob:
Some other things that fit into the ugly category is be careful of the numbers that you see on a proposal if you can also not see what can be liquidated as cash on a year by year basis. There’s a lot of different ways that annuity companies structure surrender penalties that can be very confusing to people. You know, look at your rate of return based on what is actually convertible to cash, not just the account value you see on a statement because your actual rate of return is based on what you can liquidate for cash at any point in time. So, let me give you an example of this. A fixed annuity saying is paying a 6% simple interest rate. You put in a $100,000. At the end of 10 years based on just simple interest, not compounded, that $100,000 should be worth $160,000 because if you take 6% of a 100,000, it’s making 6,000 a year times 10, that’s 60. You add it to the 100. That’s 160, but after 10 years, if you could only surrender that contract for $120,000, this really computes to a 2% simple interest rate, not 6%. Now, if you want to make the 6% simple interest in this example, you can many times only withdraw a small percentage from the annuity each year of the contract value and you must keep the contract without surrendering it.

Mary Jo:
It’s typically 10% withdraw on an annual basis that you’re allowed to do without being impacted with the surrender charge. In conclusion, we’ve talked about the good, the bad, and the ugly, but one of the things we want to caution you against is if you encounter a salesperson who is only selling this one product, and that’s fixed index annuities, that should be a red flag. I think you’ve probably heard of the old saying, “If all you have is a hammer, everything looks like a nail.” So, they have in their repertoire, they’re going to tell you this is the best solution for you. Well, in reality, it’s the only solution they have. We want to make sure that you recognize that for what it is. This will enable you to build a diversified portfolio. If you look at other things that you can invest in, those people typically don’t have access to other fee-based accounts, other managed accounts, IRA’s and 401k rollovers. They might not have access to simple and SEP IRA’s, and those are for small business owners. There’s there in the solutions that they have available to you.

Bob:
This can also include stocks, bonds, mutual funds, and real estate or commodities, gold and silver, and fee-based managed accounts. They can only offer that one thing. So, if you can only offer that one product, usually that’s what they’re going to recommend. For more information on annuities with many different types of guarantees for lifetime income options as part of an overall strategy, feel free to give us a call to schedule a phone or office appointment. We’re required to disclose all the costs and surrender penalties and fees associated with the annuities so that you can make an educated choice if this should be part of your overall plan.

Mary Jo:
And we always offer a free, initial consultation. This is for informational purposes only, not intended to be a buy or sell recommendation for any specific investment type or product. Everyone’s situation is unique. Annuities may or may not be an appropriate solution. Please talk to your investment advisor for advice on your personal situation.

[CONCLUSION]

Mary Jo: You’ve been listening to Christian Financial Perspectives. Join us as we explore more about how to apply biblical wisdom to your financial situations.

Bob: To make sure you don’t miss any of our podcasts, you can subscribe to Christian Financial Perspectives on iTunes, Google Play, or Stitcher. To learn more about integrating your faith with your finances, visit out website at ciswealth.com or call 830-609-6986.

Mary Jo: That’s all for now.

[DISCLOSURES]

Comments from today’s show are for informational purposes only and not to be considered investment advice or recommendations to buy or sell any company that may have been mentioned or discussed. The opinions expressed are solely those of the hosts, Bob Barber and Mary Jo Lyons. Bob and Mary Jo do not provide tax advice and encourage you to seek guidance from a tax professional. Investment advisory services offered through Christian Investment Advisors Inc. DBA Christian Financial Advisors, a registered investment advisor.