A/B Conversations: CFP® Your Way Out Of It – Real Advice on Building Wealth & Retirement Planning

Ep #138 - Navigating Annuities: A Smart Buy or Not?

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Have you been pitched an annuity, or do you have one and wonder if it’s still the right fit for your financial plan? In this podcast, Adam and Ben introduce what annuities are, where they may and may NOT fit into one’s plan, and how important it is to understand the tradeoffs you’re making when buying this type of product. Listen in as they highlight their concerns around liquidity, taxes, and long-term contracts.


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Investment advice offered through Great Valley Advisor Group, a Registered Investment Advisor. Great Valley Advisor Group and Haas Financial Group are separate entities. This is not intended to be used as tax or legal advice. Please consult a tax or legal professional for specific information and advice.

[00:00:00] Adam Werner: Hi everyone, and welcome to AB Conversations, where we will help you CFP your way out of it. A podcast where you get into the minds of a couple certified financial planners on how we think and feel about everyday financial planning questions, and what should really matter most to you. A healthier financial life starts now.

[00:00:28] Ben Haas: Hola. Adam, how are you today?

[00:00:30] Adam Werner: Hey, doing great. Do you have your celebration?

[00:00:34] Ben Haas: Cinco de Mayo? Yeah. Although in my house it's just Lucas's birthday. Yeah.

[00:00:40] Adam Werner: I was gonna say. Yep. Lucas had a margarita for all of us.

[00:00:44] Ben Haas: Yeah.

[00:00:44] Adam Werner: That is a joke.

[00:00:46] Ben Haas: He had a good day though.

This is good. Yeah. Alright. Hard pivot to topic today. I think we usually start these podcasts by sharing just kinda like anecdotally what we're hearing from clients or you know, what the environment's presenting and how that kind of shapes certain discussions, especially in the world of financial planning.

And here we are again, interest rate environments kind of different. Markets have been a little wonky of course, if that's a fair way to put it. And I've gotten a call or two, and I know we've had some recently new clients that come to us and, I'm either getting pitched or I have this annuity.

Like, is this good? Is this bad? Like what say you Ben and Adam? And I'll be honest, like anytime I hear the word annuity, like the hair on the back of my neck picks up a little bit and I'm like, Ooh, yeah, let's talk about that. Yeah. So let's just bring it to podcast world. We've got opinions, we would got education we want to give.

Where do you wanna start?

[00:01:39] Adam Werner: Yeah. I think annuities are one of those products or just one of those financial instruments that are incredibly complex. And they are there, there are so many different kinds and all these different annuity companies, which by the way, are all insurance companies usually at their base, than the annuities are kind of an offshoot of that. They all treat these differently to some degree. Like there's so much variability in just the annuities that are out there. So that in and of itself can be a daunting thing for somebody on the other end to know, okay, it's an annuity, but what type of an annuity?

What does this mean for me? Are there bells and whistles that come along with that? Just all of the stuff and as long as we've been around, like you said, you're, the hair on the back of your neck starts to stand up. When somebody comes to us and says, I already have this, but I don't know exactly why I own it or what I purchased it for, you know, years and years ago.

Or the, I was at the bank. This is, I think, often where we see it, right? I was at the bank, have excess savings. They want me to do something with it. They're pitching me this type of an annuity. But again there's so many different types and so many different variables. It is needlessly complex and I think people just get overwhelmed.

And like you said, it is, there's a product that ends up being sold more often than not.

[00:03:05] Ben Haas: So, let's be fair in having this discussion. It's not as though you and I have never recommended one in our whole career. Sure. I think I've come to have a different understanding of where they fit and may not fit.

So if it's okay, I'm gonna start there. I think more often than not I associate annuities with more conservative investors, right? The fact that it is an insurance product usually means the conversation is around some sort of protection, right? That's why we talk. That's how we talk about life insurance.

We're protecting something your life, stability, your income, long-term care against care costs. Insurance is like, it's annuity's protecting your investment in a way, and I don't want to, yeah, put this a deep dive into the complexities, but it's either a promise of income or, you know, we will often hear you can't lose money in this and that all sounds wonderful, but there are trade-offs to that and that's what I think that's where I'd want to start the conversation.

What are those trade-offs?

[00:04:02] Adam Werner: Well, yeah, so just something as simple as the different, and you kind of alluded to it, the different types of annuities being on that more conservative side and where we typically see the most plain vanilla is like a CD at the bank. It's just a plain old fixed annuity, right?

This insurance company gonna give you a fixed rate of return for a period of time.

[00:04:26] Ben Haas: Usually extended period of time, like we're not talking 12 months.

[00:04:29] Adam Werner: That's fair. Yeah. I think what typical on that fixed annuity front, three years is usually like the shortest.

[00:04:37] Ben Haas: Yeah.

[00:04:37] Adam Werner: But they could be 3, 5, 7, 10, 15, but that period is very important especially with a fixed annuity because you're essentially, you're buying the interest rate, so like a CD, you're just, you're shopping for that flat rate of return.

That period of time that you're locked up that you really can't do much different without a penalty is important.

[00:04:59] Ben Haas: So here's the important trade off, right? I think I know where the interest rate environment is going right now. Yeah. But am I gonna make a huge bet on that three years from now, five years from now, it's going where I think it's gonna go.

Like,

[00:05:12] Adam Werner: yeah.

[00:05:12] Ben Haas: Think about everything that's happened in the world over the last two, three years, let alone going back to Covid five years and, there's just, I would caution that's why we are doing this podcast right now. You are making a trade off, you're trading your liquidity for a guarantee, and you better be comfortable with that guarantee.

And I'd encourage you to think about, would you still be comfortable with that guarantee under a completely different environment, not knowing what the future holds.

[00:05:38] Adam Werner: Yeah, and I think why the why that is so critical is unlike a CD where maybe you give back a few months worth of interest, right? In the annuity space it with whatever that term is, whatever that surrender period is, you make a decision to do or wanting to do something different.

We're not talking fractions of a percent, you know, on the margins. Those surrender charges could be as high as 10%. Again, depending on the length of time. So imagine you put a hundred thousand dollars into this thing, you're hoping for it to grow, and you change your mind six months later, a huge surrender charge could make your decision a little bit harder, right?

So that's where we just wouldn't want people to rush into something like this without really understanding that trade off, right? It is that lack of flexibility with these fixed annuities that ultimately drive a lot of the decision.

[00:06:34] Ben Haas: And I know I have a bias because we as planners, we just, we value flexibility knowing that it's not just here I am talking about economics and interest rates and like, what could change in the world, what could change in your world, like in your life, right?

What, right. What may necessitate some, a bigger need for liquidity. But let me get off that soapbox and like, pivot to, I think where we've maybe seen it and I'll say, work for people or people will come to us and say, Hey, I have this thing. Should I keep it? That's probably more on the variable side or the index side where I'm gonna lean on you here because I know Adam, you're gonna do a better job explaining this than me.

Like in the world of riders, that's going back to my comment of, you know, they're, it's complex, but they're kind of making you a promise in a way with that rider that makes it, I would say to a conservative investor, just feel better to consider.

[00:07:29] Adam Werner: Yeah. Yeah. And when we say the word rider, that's essentially like an add-on feature, right?

Beyond just the, whatever the investment component is. And typically when we're thinking about an income rider, like an income benefit, it is a promise to pay, like you said. And it's usually sometimes around, it's like a life, a lifetime, guaranteed lifetime income. Right? I'm the insurance company here.

You give me your money and I will promise to pay you by some formula that I'm gonna dictate how much I'm going to pay you for as long as you shall live.

And you can add your spouse to that if you wish, and I'll pay you a little bit less. But it'll essentially pay you income for the rest of your life.

Think of it like creating your own pension, but doing it through the insurance company on your own, which I think is often how those income riders are kind of positioned. Right? For people to get a guarantee. That's really the only way to get some sort of guarantee like that in the private world without, again a pension or some other promise to pay from an entity.

[00:08:29] Ben Haas: Yeah. And psychologically that might be comfortable. I feel like you told me very recently that you read a story about, go ahead.

[00:08:38] Adam Werner: Well, yeah. The study just being for, and this goes back to maybe a podcast we shared not that long ago, that what we've seen with a lot of retirees is they struggle to spend in retirement without having that, I'll say more of a regular paycheck. Right. Well, when people, if the study was basically saying people that had annuity income or pension income or social security income, right? Those guaranteed, quote unquote guaranteed sources of income, they were more apt to spend income versus if some of their income was just coming from investment withdrawals.

We would view that through the 4% withdrawal lens, but it's that psychological component of the monthly number, that monthly income being guaranteed. And I know it's gonna be there next month no matter what. The market does It no matter. Yeah. No matter what happens in the world, no matter what happens in the economy, I'm gonna get this payment.

Those people. In this study, spent more and did more with those funds than those that did not have that guaranteed level of income. So to your point, there are aspects where it can fit for people and even just that psychological component can fit. But all of that said there are caveats to these types of annuities because ultimately they are insurance.

Like you said, it is a layer of insurance that essentially you're purchasing on your investments, on your savings.

[00:10:04] Ben Haas: Yeah. And that's where, again, let's not go too deep into the weeds, but there, there are, again, other trade offs other than just the guaranteed income. You know, we've certainly run into people that realize after a little bit of time, Hey, maybe I didn't need the income.

Like the guaranteed income wasn't as important to me as I thought it was, and now the expenses associated with that investment are definitely a drag on that growth. So, yeah I just. Like many other things when you're making what feels like a more, I don't wanna say irrevocable decision, right? You were clear.

You can get outta these things, maybe you have to pay a penalty. But it certainly, without all that flexibility, we would just caution you to really make sure that you're okay with these trade-offs. And I just wouldn't want anybody getting into something without having these conversations on the longer term impacts, if it turns out that what you're valuing today.

That's my fear right now. Yeah. People cared about the market and in the middle of April they go, let's just put it into something guaranteed for me. Now, or two weeks later, we're back to where we were essentially when all this mayhem started, but now we've made a permanent decision and that was based on the emotions I had at that time of going.

Now I feel like I need a guarantee. Couple weeks later, oops. You know, maybe I didn't, these are big, long-term decisions and we didn't even talk about taxes yet on how, go ahead.

[00:11:27] Adam Werner: You teed me up for it because that's kind of where my mind was going. So, yeah. Not, only is that, and it is, I think a lot of the annuity kinda role is fit by avoiding something, right? I'm fearful of running out of money or I'm fearful of losses in the market, hence where this type of insurance on my investments can kind of play a role. But you said it, it's expensive. That annuity shell itself, compared to just a plain old investment account, there are additional fees, right?

The insurance company needs to spread out the risk among all their other annuity holders. Hence there needs to be some higher investment fees with that. But incredibly important for those people that have an annuity that's not also a retirement account. So non-qualified or a non-retirement annuity.

Again where we see those pitched a lot or where we see those fit in are people that have excess cash at the bank.

[00:12:26] Ben Haas: Yeah.

[00:12:26] Adam Werner: Which is usually non-retirement dollars. And the spiel can often be, hey, you're paying taxes on these dollars because it's earning interest. You put it in this annuity, you can defer those taxes, right?

I'm not gonna pay taxes as long as it's in that annuity shell, while you're maybe accumulating or the money is just sitting there. But in return for avoiding those taxes, maybe for a period of time, what would have been treated as capital gains. Within just a typical investment account is now treated as ordinary income from the annuity, which is not necessarily as favorable, depending on somebody's situation, that tax rate could be much higher than just investing, selling sometime in the future and paying capital gains on whatever that growth is once it's in the annuity, you can get your principal back out without paying taxes, but any of that growth is going to be taxable as ordinary income, which is just not as favorable.

And I think for most people that we talk to, that's not clear. They don't know that. Correct. Yeah. How it is taxed in the future when they want to go access those funds.

[00:13:32] Ben Haas: Right. And that's part of the job. If this is, Hey, I'll kick the can down the road on taxes and collect interest in the meantime.

It's not gonna be the same size can when you show up for that. Right. And wanna empty. Right. And we've, seen that go sideways too, right? You meet somebody that now liquidated this, their tax accountant goes, well, here you go. And they go, well, why is the tax bill like this? And we're asked to do some forensic accounting here.

And it's, that was an annuity. It was a non-qualified annuity. So they're def like, that's a bad surprise to get.

[00:14:05] Adam Werner: Well, and we've seen it a lot recently, unfortunately, for clients that are inheriting dollars, correct, from parents who had these types of non-qualified annuities or non-retirement annuities, that gain, again, that then becomes taxable to the beneficiary when they inherit it.

So if mom or dad bought an annuity for, you know, $50,000 and, hey, great news, it grew to $250,000, and now I inherit it and I liquidate it. I wanna get the cash, you're now going to pay that income tax on that growth as ordinary income. And again, that can lead to some unpleasant surprises from a tax aspect.

[00:14:43] Ben Haas: You got it. I don't know what else to share 'cause I feel.

[00:14:47] Adam Werner: We could go so many different directions from here.

[00:14:51] Ben Haas: Yeah, but back me up here. Here's what I heard were kind of like the main points. They're complicated. I think you started there, right? It's important that you know what you own if you already have it.

But if you are considering this, and I think hopefully we gave some situations where, hey, if this is you, it may fit. I'm not saying it's not for anybody. I'm just saying it's not for everybody. And yeah, we wouldn't want you to get into something that you either don't understand or hasn't been fully disclosed.

What is this going to mean for me? Not right now. But within my plan for later in life, right? Because when we choose to make certain decisions on products and services that aren't flexible, we are doing so looking out to some future point and we need to understand how that's gonna affect my financial plan at that time.

And that's why we're just, I don't know, we got to be a little cautious about that.

[00:15:42] Adam Werner: Yeah, for sure. So yeah, there can be potentially unintended consequences from a planning aspect. When, if you have something like this in your financial makeup, that is inflexible. Now other parts of your plan may need to adapt accordingly.

So to your point, it's not that they're not for anybody. I think there are times and there are places where it does fit. But, that's then kind of on us as the planners to make sure where does that fit. And by the way, if you already have something like this, what role should it play in your situation?

Is there something differently you could do without, you know, any major downside or penalty? It all depends on the situation.

[00:16:23] Ben Haas: Maybe that's just it. Just make sure you're talking to somebody who's willing to look at things holistically for you. Right? Our job as fiduciaries is to do that.

Certified financial planners are out there. Hopefully this is helpful. We're getting a lot of questions about it, so it had to be a podcast topic.

[00:16:39] Adam Werner: You got it.

[00:16:40] Ben Haas: Alright sir, appreciate you as always. Until next time.

[00:16:43] Adam Werner: Thank you. Alright, bye.

[00:16:45] Ben Haas: Bye.

[00:16:52] Adam Werner: Hey everyone, Adam and I really appreciate you tuning in. Please note that the opinions we voiced in the show are for general

information only, and are not intended to provide specific recommendations for any individual. To determine which strategies or investments may be most appropriate for you, consult with your attorney, your accountant, and financial advisor, or tax advisor prior to making any decisions or investing. Thanks for listening.

 

Investment Advice offered through Great Valley Advisor Group, a Registered Investment Advisor. Great Valley Advisor Group and Haas Financial Group are separate entities. This is not intended to be used as tax or legal advice. Please consult a tax or legal professional for specific information and advice.