Ready For Retirement

Does It Ever Make Sense to Purchase an Annuity?

October 31, 2023 James Conole, CFP® Episode 187
Ready For Retirement
Does It Ever Make Sense to Purchase an Annuity?
Show Notes Transcript Chapter Markers

Have you ever wondered if purchasing an annuity makes sense for you?

There are two conflicting opinions from financial advisors: some advocate for annuities while others advise against them. James explores the concept of being a fiduciary and the challenges of understanding the financial advisory industry. He covers when annuities may be a suitable option, such as providing guarantees, protecting against longevity, guaranteeing core expenses, and the benefits of Qualified Longevity Annuity Contracts (QLACs) in reducing required minimum distributions.

There is no one-size-fits-all approach to financial planning. Your individual circumstances and goals will determine whether annuities are the right choice. It's always a good idea to seek professional advice and review all your options when making decisions about annuities.

Questions answered:
Is an annuity a suitable financial product for retirement planning?
What factors should you consider when deciding whether to purchase an annuity?

0:00 Intro
2:51 What is a fiduciary?
8:43 Explaining annuities
10:53 The wrong way to look at it
13:23 Another way to look at it
17:53 When is there a case for an annuity?
19:49 Another case
22:06 Qualified Longevity Annuity Contract
24:40 Outro

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Speaker 1:

Does it ever make sense to purchase an annuity? Well, if you speak to a financial advisor that works for an insurance company, they'll almost certainly tell you yes, but if you speak with a fee-only financial advisor, they'll almost certainly tell you no. So who should you believe? Well, in today's episode of Ready for Retirement, we'll walk through when it does and when it doesn't make sense to purchase an annuity. This is another episode of Ready for Retirement. I'm your host, james Cannell, and I'm here to teach you how to get the most out of life with your money. And now on to the episode. Today's episode comes from a listener question, and this listener is Adam. Hey, adam, adam says this. He says I've met with multiple financial advisors and all of them have two things in common. Number one, they all say they are fiduciary. Number two, they all try and pitch me on various types of annuities to supplement or augment my portfolio. Can you please address annuities on a show? Something I've read online says to stay away from annuities all types and I'm losing trust for the financial advisor industry. Are there cases where an annuity is a good move? Thank you Well, thank you, adam, for that question. I will add to it. I think this is a very valid complaint of the financial advisory industry as a whole, where you can have five different people line up and tell you they're financial advisors, but they all do completely different things. One might sell insurance, one might sell investments only, one might do hourly work, one might do investment management, one might do only fixed fee financial planning. Really, there's all different kinds of financial advisors which, as a consumer or as an individual looking for a financial advice, that becomes very confusing. If you look for a doctor, you know what a doctor does. If you look for an attorney, you know what an attorney does. Maybe they specialize in different things, but if you're looking for a financial advisor, a lot of people call themselves financial advisors, and there's no one tried and true definition of what that means. That makes it confusing to know. Number one, is this person a fiduciary? And number two, should I trust this person's advice when it comes to something as simple as isn't annuity right for my situation, or isn't it? So? In today's episode, we'll go over both of those things. Before I do so, though, I want to highlight the review of the week, as we've seen. Thank you to all of you who have taken the time to leave reviews. It means a lot to me. This review comes from username Bible 1128. It's a five-star review and says so much great information, provided in a concise, clear manner. After listening to several episodes, I feel more prepared to ask relevant questions about my retirement. These podcasts reassured me that I'm considering the correct, relevant factors for better planning in an earlier retirement. Well, thank you very much for that review and thank you to all of you who have left reviews, and just know that every time you do that, it helps me, it helps the show and, most importantly, it helps people who are looking for quality retirement information and guidance find that information. So thank you to all of you who have done that. So on to the show. For today. There's two things in this question that I want to address. The first is what does it actually mean to be a fiduciary? I could spend an entire episode on this, but I'm just going to briefly address this because it is important for those of you who are considering reaching out to an advisor. What does it mean to be a fiduciary? How do I actually know if someone is a fiduciary? But then, secondly and this will be the second focus, or the larger focus of the episode is are annuities good? There's so much conflicting information. Some say it's the absolute best thing to create a secure retirement. Other people say don't touch it with a 10 foot pole. Who on earth do we believe? Well, they are okay and they can be good in certain situations, but I want to explain to you when that might be, and we'll go through an example of that to show you. To start, though, let's touch upon the fiduciary piece, as Adam mentioned. He says, quote I've met with multiple financial advisors, and all of them have two things in common. Number one, they all say they are fiduciary. And number two, they all try and pitch me on various types of annuities, a supplement or augment my portfolio. End quote. So let's start with that right there, because, adam, I'm with you in this. Actually, I have talked to a huge amount of advisors over the course of my career, and I have and I'm not being exaggerated when I say this never met a single advisor that did not say they were fiduciary. It didn't matter how this advisor was registered, it didn't matter whether they were or were not technically a fiduciary. Everyone says they are, and so, as a consumer, how do you know what to do? How do you know if this person is actually being truthful or if they're not being truthful. Well, there's a different question that should be asked. That should shed some light on that, because here's a background of what it means to be an investment advisor. Back in 1940, an act was passed and it was very creatively titled the Investment Advisor Act of 1940. And in it the Investment Advisor Act of 1940 says that an advisor has a duty to provide advice that is in the best interest of the client. It goes on a little bit to explain what that means, but the bottom line is an investment advisor has a duty to provide advice that is in the best interest of the client. Now, that would seem self-explanatory. You would hope that all investment advisors would have that standard of care, much like a doctor or an attorney might. But there's a separation here where there's also something. There's a specific law for what are called broker dealers and I shouldn't say there's a specific law for it, but there's a carve out for it where the Investment Advisor Act. It excludes from the definition of an investment advisor quote any broker or dealer whose performance of such advisory services is solely incidental to the conduct of his business as a broker or a dealer, end quote. So essentially what they're saying if someone's business is just to sell a product, to sell a stock, to sell a bond, to sell a mutual fund, whatever it might be, the act excludes those people from the definition of an investment advisor and, as such, they are not held to the same standard of care. They are not required to put clients' interests ahead of their own. They have to be held to what's called a suitability standard. Is this recommendation suitable as opposed to being in the best interest of the client? Now, as I mentioned, I could do an entire episode on this, but really what comes down to is what should you know as an individual potentially looking for investment advice? Because here's the reality there are fiduciary advisors and there are non-fiduciary advisors. But here's the thing there are wonderful non-fiduciary advisors who I would trust in a heartbeat to manage my portfolio or my family's portfolio, and on the flip side, there are fiduciary advisors that I would never, ever trust with my money. So it's unfortunately not a universal thing that fiduciary equals good, but what it does is a fiduciary advisor in general is going to have fewer conflicts of interest to sell a particular product, and the reason that this ties in so closely with annuities is. This again is not universal, but it's widely true. I would say If someone's recommending a annuity, there's a very good chance this person's not a fiduciary advisor. They are likely getting paid a kickback. They're getting paid a commission, which is neither good nor bad, it's just what it is from the annuity company to sell that product and by the definition of the rule that they're in, they are serving as a broker to sell a particular product. They are not serving as an investment advisor. And while it may seem like aren't those the same things? No One. They are held to a higher standard of care as an investment advisor. They have to be a fiduciary in that capacity versus a broker. A broker does not have that same standard of care. So does one mean good and the other equal bad? No, it doesn't. As I mentioned, there's wonderful fiduciary advisors and there's wonderful non-fiduciary advisors. There's also really bad fiduciary advisors and really bad non-fiduciary advisors. So that alone is not something that should make or break your decision to work with an advisor. But I will say, in an attempt to eliminate as many conflicts of interest as possible, you're never going to fully eliminate them. Everyone has conflicts of interest. I would typically recommend that people steer clear of non-fiduciary advisors unless you really know what you're doing or asking the right questions, such as how are you paid? Do you work through a broker dealer? Do you work through a registered investment advisory firm? Questions like that that can help to give you some guidance or help to give you some understanding of where is this person coming from when they're making recommendations to me and to what standard of care are they being held to. Now I'm going to move on because I want to focus on the annuity piece of this podcast, but that's a good place to start with fiduciary versus non-fiduciary, and it does tie into annuities because, as I mentioned, people who are recommending annuities to everyone, they're typically not fiduciaries. Annuities do potentially have a place in people's plan, but not for everyone and for most people to actually say that's not the case in my opinion. But let's walk through an example of what that might look like. So here's what we should start with when we're looking at annuities. There is not one single type of an annuity. The definition of an annuity is a contract between you and an insurance company that requires the insurer to make payments to you, either immediately or in the future. What you are doing is you're buying some type of guarantee, but with that, there's not just one type of an annuity. You can have a fixed annuity, you can have a variable annuity, you can have an equity index annuity, you can have an immediate annuity, you can have a deferred annuity. There's all these different types of options that you have when it comes to the type of annuity that you may or may not want to pursue, depending upon your financial plan. For the sake of today's podcast, I'm going to use an immediate annuity as an example. It's relatively straightforward how it works. We can do a fairly easy comparison between that and alternatives, but I just want to make it clear that this is not the only type of an annuity. What I did, though I'm going to use an example I went to. This is not a recommendation or an endorsement of the site. It's just the first site that came up. When I googled it. I went to immediateannuitiescom, and on that site I ran a quote, an. I ran a quote for a fictitious couple, both who are age 65, and I said what would it look like if I put $1 million into this or I used a million dollars to purchase this single premium? Immediate annuity Single premium just means I put one single premium into this that million dollars as opposed to multiple premiums over the course of, maybe, my working career. An immediate annuity means I am purchasing this annuity in exchange for immediate payment or immediate income to come from of it, as opposed to defer annuity where I might put the million dollars in and say, five years from now or 10 years from now, begin taking income. That's what I ran the quote at and here's what that looks like. I would receive in this case a joint life payment of $5,346 per month. What that means is I'll put myself in the shoes of this fictitious couple. As long as I'm living or my spouse is living, we would receive $5,346 a month. If I predestines her, she would continue to receive that. If she predestines me, I would continue to receive it. But once both of us is passed, that money goes away. So that comes out to $64,152 per year. Now, there's a few different ways that you can look at this, and I'm going to start with the wrong way to look at it. A lot of people will say, okay, if you're receiving that much per month, or $64,152 per year, based on a $1 million investment, that represents a 6.4% withdrawal rate. If I just divide my annual income by how much I put into the annuity, that seems pretty good. Because, James, I've heard that there's this thing called the 4% rule. Or the alternative is, I could take my million dollars, invest it and be able to withdraw 4% per year, which in this case would be $40,000 per year, assuming I'm invested the correct way. So who wouldn't want to do that? The 4% rule would generate $40,000 per year for me, based on a million dollar starting point, versus this annuity would pay me $64,152 per year. What am I missing here, james? Who wouldn't want to do that, in that being, purchase the annuity to get a higher payment, as opposed to invest the standard away and accept maybe the 4% or $40,000 per year. Well, the people who wouldn't want to do that and just purchase the annuity with everything is number one people that want to keep up with inflation. I think one thing a lot of people miss when they're looking at annuities the initial withdrawal rate is pretty high. In this case, that's a really nice initial withdrawal rate, but it's not going to keep up with inflation. $64,152 per year is what you're going to receive this year and five years from now, and 10 years from now and 30 years from now it's still going to be the same exact payment. Meanwhile, your living expenses are going to have increased pretty significantly. Compare that to the 4% rule, where if you're basing the entirety of your portfolio withdrawals on that rule, well then your year one payment is $40,000, but that rule is based upon the assumption that you're increasing your withdrawals by inflation every year. So if we assume that inflation increases by 3% per year and if we assume that you live 30 years, well then by year 30, you're no longer taking $40,000 out per year. You're now taking out over $94,000 per year to maintain your same purchasing power. So, yes, you're starting at a lower withdrawal rate, but that withdrawal rate is increasing each year so that you can maintain your purchasing power, while the annuity starts at a higher withdrawal or a higher income amount in this example, but it's staying the same. It's not increasing with inflation. So that's one thing, one consideration to take into account. Hey everyone, it's me again for the Disclaimer. Please be smart about this. Before doing anything, please be sure to consult with your tax planner or financial planner. Nothing in this podcast should be construed as investment, tax, legal or other financial advice. It is for informational purposes only. Another is this there are plenty of studies that show if you are basing your portfolio with rules in the 4% rule, the overwhelming majority of the time, if you're only taking 4% per year out of your portfolio, you're going to end up with more money at the end of your retirement than you started with at the beginning of your retirement. In other words, when you're looking at this annuity, the annuity that you're receiving is an immediate annuity and that's going to pay you for as long as you live, whether you live for four years in retirement or 4D years in retirement. The nice thing about the annuity is that's a guaranteed income source that you can expect forever. However, once you have passed and if it's a joint life annuity, your spouse has also passed that goes away. If you pass one year in retirement and you don't have any period, certain options or return of principal options on the annuity, that money is just gone. You had it and it was like a pension, but as soon as you pass away, that money is gone, it's not going to your heirs. Well, compare that to the 4% rule and I'm just using the 4% rule as a proxy for a standard withdrawal rate on the retirement portfolio the overwhelming majority of the time. If that's how you're pulling money out of your portfolio, you're going to have more money at the end of your retirement when you pass than you started with in retirement. That has some pretty significant legacy considerations built in If you have children or heirs or charity or someone that you want to receive these funds once you've passed. That's not an option you're going to have with an annuity, unless there's a return of premium rider on it. But if you are accepting that or if you're taking that, it also means you're accepting less income every month or every year along the way versus a standard portfolio. There is still some balance. That's not guaranteed to be there, but will likely be there based on most market conditions. That's one thing to look out for when you're trying to compare an annuity versus a standard retirement portfolio, not saying either are good or bad, it's just understand the numbers and understand what you're looking at. Another thing to be aware of is just the misleading way you might receive an annuity proposal. I am not making this up Just in the last five minutes, as I've even been recording this episode, I got an email this annuity or this email, came from a director of sales at a large annuity organization. Essentially, what it's doing is it's saying hey, here's this spreadsheet that you can use to close more annuity business. Now, side note, I don't sell annuities. I don't sell anything that pays me a commission. So I don't know why I'm receiving this annuity, other than maybe it's a sign that this needed to be included on today's episode. But what it's showing is it's a spreadsheet saying hey, james, look at if this person invested a million dollars in the S&P 500 versus what if they invested it in this fixed index annuity that we're offering? And what if they're withdrawing 4% per year through these various market conditions? And I can tell that they are just cherry picking start dates and they're making all kinds of assumptions that the average person in reality wouldn't actually be doing with their retirement portfolio. All this to say, when you look at the numbers on the spreadsheet they sent over, it looks like this fixed index annuity is just a no-brainer. Why wouldn't I want this thing that protects against market downturns but also gives me some upside potential in the market's doing well, and look how it protected my money through various ups and downs in the market. Beware of this, because if you are receiving a proposal from an annuity company. I'm not going to go out there and say it's definitely something that's misleading, but at least get a second opinion, because, as I can see from this spreadsheet here, which it looks like is being used by a lot of people, there's just misleading information here. Yes, the information is correct, but if you don't have proper context around it of understanding this is, if you invested at the perfect wrong time and you didn't diversify your portfolio, you never adjusted your withdrawal rates, yes, then some of these things would happen and the fixed index annuity in this case might be best. However, if you just do a better job of diversifying your portfolio or adjusting your withdrawal rates or any number of things, there's no need for it. So this is just a side note that if you are receiving a proposal for an annuity, it might be not, it might be. It absolutely is best to get a second opinion from someone just to see is this what's actually best for you and is this annuity right for your situation, and it would probably be easier to actually see the spreadsheet that I'm referencing here. But this just came in. This wasn't part of the normal scripted podcast, so just wanted to include it as an FYI. Now let's talk about when there is a case for an annuity. I'm not going to say there never is. There are cases where it could make sense, and let's go through those. Number one the first case for an annuity is if you want guarantees. If you look at the stock market, over the last 50, 60, 70, 100 years, it has enriched long term patient investors. The market has done wonderful things in terms of allowing you to have a comfortable retirement, grow your wealth over time, build money for you and your family, but it never comes with a guarantee. It has a wonderful track record of success, but there's no guarantee that you're going to get a specific return over time and there's no guarantee that you're going to get a specific sequence of returns during your retirement. So that's what an annuity can do. An annuity can provide some guarantees, and those guarantees come in multiple different forms. But when you are purchasing an annuity, you are exchanging, you are buying security, you are exchanging your risk to the annuity company and in exchange, the annuity company is giving you some guarantee. Just keep in mind, though, there is a price for that guarantee. You are not going to do as well when the market's doing well with an annuity as you otherwise would have either because of the expenses with the annuity. It's not uncommon with variable annuities to see all in expenses in the 3 to 4% range. It doesn't take a mathematician to start to realize that 3 to 4% expenses per year really takes a toll and starts to drag on the performance of your portfolio. That's an explicit expense. Then there's other types of annuities, so immediate annuities, for example, where there's really not an explicit expense. You don't look on your statement in CO-CAM being charged 2% or 3% or 4%. It's really more of an opportunity cost and what I mean by that is you're likely to do a lot better outside of an annuity. Again, no guarantee. But if we use history in the track record, it shows us you're likely to perform better outside of an annuity. But the opportunity cost of owning an annuity is the real expense with that type of annuity where you're not paying an explicit expense but you're underperforming what you might have otherwise done. However, I'm going to come back to this. If you want a guarantee in your portfolio, you're not going to get that in the stock market. You're not going to get that in the bond market. An annuity is a way to provide guarantees. Another case where you could make a good compelling case for an annuity is if you have a lot of longevity in your family. So if you have longevity and that's part of your plan, that actually becomes a risk from a financial planning perspective because you might need your money to last for a very long time. Well, if you're just taking a standard withdrawal from your portfolio 4%, 5%, 6%, whatever it might be there's no guarantee that that's going to last forever. In fact, it's almost certainly not. So if longevity is one of your concerns, then an annuity could be a helpful way to protect against that. Now keep in mind the warning here is you also have to plan for inflation, because if you have an annuity that will pay you income for as long as you live and you live for another 50 years, that sounds great to have 50 more years of payments, but if that payment isn't increasing each year to go up with inflation, it's not necessarily going to allow you to provide for your basic living expenses for the next 50 years. The purchasing power is going to diminish over time. So, yes, annuities can help protect against longevity, but make sure that you do have a plan in place for inflation, because most of these annuities aren't going to have an inflation adjustment on them. Another reason or another case where annuities might make some sense is maybe you want to just guarantee your core expenses. For example, maybe you want to say, between social security and annuity payments, I want to make sure I have enough money for property taxes or for groceries or for utilities or just for the basic core living expenses, because once those are fully covered, then maybe I feel more comfortable investing in the stock market with my other funds, and my other funds kind of become like my travel funds or my discretionary funds. It's the things where, even if I run out of them because I spend that part of my portfolio down, I still feel peace of mind and knowing that I've got a social security payment and an annuity that cover my core expenses, so I'm not ever going to have to worry about living on the street or not having the ability to pay my basic bills. Now I will add to that this sounds very good in concept. Who wouldn't want to have the basics guaranteed, which frees you up to invest more aggressively or in a more growth oriented portfolio? For the rest, that sounds good in concept and sometimes in practice it's also good, but make sure you're running the numbers. Sometimes there are other ways of making this happen without necessarily needing to lock in an annuity contract to make it do so, but that is one area where people prefer to have annuities as part of their plan, even if it's just for the peace of mind that that provides. The final area that I'm going to go over today where an annuity might make a lot of sense is in something called a qualified longevity annuity contract. You might see this abbreviated Q, l, a, c Now qualified longevity annuity contract. It actually has a lot of tax benefits and what it does is it's a contract or it's annuity that allows you to put up to $200,000 from your retirement funds. You put that into the qualified longevity annuity contract and these funds then avoid typical required minimum distribution rules. So instead of having to start to withdraw that money at age 73 or 75, depending upon your birth date, that money can stay in the annuity, where it's not subject to RMD rules, until age 85. Then, once you turn age 85, there's a couple options, but typically once you turn 85, that annuity becomes a single life annuity where it turns on and becomes like a pension, so at $200,000, depending on what it's grown to based upon the terms of the annuity contract that then starts to pay you monthly income. So you've accomplished a couple of things with this Number one. You have deferred or you have reduced some of your required minimum distributions that up to 200,000 that you can put into the qualified longevity annuity contract. You're not having to pay required distributions on that, starting at 73 or 75. Instead, you start paying taxes on whatever money comes from that annuity Once you actually begin taking income. So if you start taking I'm just making up a number $20,000 a year, that 20,000 is fully taxable on top of whatever your required distributions are at that time, on top of your other income sources at that time. But you've avoided several years of RMDs between 73, 75 and whatever your start date is. The other thing you've potentially accomplished here is you've protected against longevity because this money has continued to grow for you unencumbered by required distributions. It can then turn into an annuity as late as age 85. And that might provide you another base of income to protect you if you live into your 90s, hundreds or beyond. So as you're looking at that, that actually could be a pretty compelling reason for more people to use an annuity. It's not perfect. There are downsides, there's other considerations with this, but that's another reason that I would add to this list of what my potential use case for an annuity be. Now, this isn't an exhaustive list. There's many reasons that you might want to consider, but these are for the bigger reasons that I would see and say, yes, that could potentially be an issue that is solved by an annuity. In this case, oftentimes there's alternatives and you absolutely want to look at different options, but these could be potential use cases. So that is it for today's episode. Adam, I appreciate the question both around how do I know? Some is actually fiduciary and number two is an annuity. Ever best for me. In case I wasn't clear with this, I typically like to avoid annuity because I think you can get better outcomes without them, but they are absolutely something that should be considered in certain situations, but it depends upon the person, it depends upon the plan and it depends upon what you're ultimately trying to accomplish. So thank you, as always, for tuning in to everyone who's still with us here. If you have not already done so, please go ahead and leave a review for the Ready for Retirement podcast. Helps me, helps a show, helps more people who are looking for good retirement guidance, and with that I will see you all. Next time. You should always consult a financial, legal or tax professional who's familiar with your unique circumstances before making any financial decisions.

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