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Podcast: Navigating Deferred Annuities

The following is the transcript from Episode 7 of Retire Happy with Roger Gainer, a financial and business audio podcast.

Roger: When we’re deciding about tools, emotion has to be part of the planning process because we’re people. But when it comes to making these kinds of decisions, what tools do I use to build my retirement house, we want to keep the emotion out of that.

Clark: You’re listening to “Retire Happy” with Roger Gainer, president of Gainer Financial and Insurance Services, Inc. This is episode seven, “Deferred Annuities.” Thanks for joining us. I’m your host Clark Butner. We’re continuing the conversation all about annuities and are about to take an even deeper look into this topic. You’re about to hear the full conversation, but for more content like this, be sure to visit gainerfinancial.com. Let’s begin.

Roger: Hi, Clark, welcome back.

Clark: I’m excited.

Roger: Yeah, so am I. We’re gonna dig a little deeper into the very meaty topic of annuities in this post. Today we’re gonna talk about deferred annuities. In our last podcast we discussed income annuity SPIAs, S-P-I-As, and deferred income annuities. But today this is an even bigger category called deferred annuities. And basically what a deferred annuity is, is an annuity, under tax code at least, where you’re gonna delay your income. See, in the IRS code, annuities are income-producing tools. And in a deferred annuity what we’re doing is we’re deferring the beginning of payments.

So, while we’re in deferral, you earn interest that is being earned tax deferred, much the same as in an IRA. Frankly it’s one of the reasons I fund my personal IRAs with annuities. I know there’s an awful lot of people out there that say, “Why would I pay for additional tax deferral?” thinking that there’s a cost associated with tax deferral. Tax deferral comes from the Internal Revenue Service, not from an insurance company or a mutual fund company. Tax deferral is based on the internal revenue code, and there is no cost to it. So that’s one of the reasons I personally like, in my own annuities, in my own IRAs, excuse me, to fund them with annuities. Because frankly I don’t have to spend the kind of time maintaining them that I would otherwise.

So these deferred annuities, deferring the first payment usually until you’re 90, 95, or 100 years of age. And then the way most of them work is you can have a single payment be your income stream. In other words, I can withdraw all of my money. Some of them require you to take a 5-installment payout, and there’s a few, very, very few these days that require at least a 10-year payout. And again those are pretty good tools in IRAs. I have that type in one of my IRAs. So, under this broad umbrella of deferred annuities, there are three main sub-types.

One is the variable annuity. A variable annuity, I’m gonna talk about in greater depth in just a minute. The other two are variations of fixed annuities. And the fixed annuity works a lot like a CD. You get a guarantee of your principal, you earn interest based on a declared rate. And then we have another variation called a fixed index annuity, which has the same guarantee of principle, but instead of a declared interest rate, you earn interest based on the movement of a market index. So you’re not directly participating in the market in a fixed index annuity, but you’re earning interest based on the movement of a market index.

We’ll get to that in much, much greater detail in a future podcast. But I want to circle back around to the variable annuity, because that’s the one that seems to engender the most passion and the most misunderstanding. Because variable annuities are, without a doubt, the most complex variation of an annuity you can buy. Variable annuities are sold by prospectus, much the same as a mutual fund would be, and that prospectus can be awfully thick. I ask people who I meet that own these things, and I say, “Do you get a prospectus every year?” Because I know that the insurance company’s required to send out a prospectus.

And then I ask, “Do you ever read it?” And the answer is, “No, I just throw it in the recycling.” At least I hope they’re recycling. They usually say trash. You know, it’s the same question from your mutual funds. If you own a mutual fund you’re gonna get a prospectus update beginning of every year, and I ask the same question and most people are recycling those as well.

So when we look at a variable annuity, much like with mutual funds, costs and options can vary widely. So, a variable annuity has inside it something called sub-accounts. And a sub-account is virtually a mutual fund, but because it’s in a variable annuity, it’s called a sub-account. In fact you can…most of these are managed by the same people that manage mutual funds of similar names. So if you’re in a fidelity growth and income fund, you’ll find a variable sub-account of a fidelity growth and income fund in many variable annuities.

So, you get to select from a menu of these sub-accounts. Some annuities have as few as 10 or 15 choices, and I’ve seen them with as many as 200 choices. I’ve even seen some variable annuities where you can pick your own money manager, or even use a hedge fund as your manager inside them. They have a wide variety of cost structures as well. And this is where a lot of people get messed up. There’s, with most of these, a menu of different options, and each option costs a certain amount of money. So the first charge that you should know about is called an M&E, or mortality and expense, charge. With most variable annuities that charge will run anywhere from a half a percent up to 1 and a half or one and three quarter percent, with most of them falling between 1 and 1 and half percent mortality and expense charge.

So that’s a pretty big hurdle. What that charge does is it guarantees your principal, not your earnings, but it guarantees that if you die your heirs will at least get what you put into the contract. You can decide what the value of that guarantee is in your particular situation. For some people it can be very valuable, and in some contracts if you do have a gain you can increase that guarantee. There’s a step-up feature. But it’s very important that you understand the options within that variable annuity.

Another feature that many of these have are what we call a living benefit. That would be something like an income for life. So what that is, is a…they’re referred to as either a guaranteed minimum withdrawal benefit or a guaranteed lifetime income benefit. And again, you pay a fee for those. That fee can be as little as 1%, or as much as 2 and a half percent. I reviewed one recently for a client that was at 2.55% on top of the 1.15% in the M&E charge that I mentioned before. So now we’re starting to see that it can get awfully pricey, because you add those two together and you’re at 3 and three quarter percent.

Given that you’ve got to earn more than that to have a positive gain in your contract, you’re stressing those investments trying to get there. Finally, the different sub-accounts, just like with a mutual fund, the money managers. Nobody does this work for free, Clark. And, and the money managers, whether they’re from Vanguard or American Funds or JP Morgan, those managers are also charging a fee. In the contract I mentioned that I was reviewing for a client who had bought this somewhere else, that average charge for their sub-accounts was another 1%.

So when you added all that up, they had earned 4 and three quarter percent a year just to stay even. Pretty expensive stuff. And so if you’re gonna pay those kinds of fees, which generally run, like I said before, from 1 and a half up to 5%, you better be getting some value for that money. So that’s why it’s really important today to study that prospectus and make whoever you’re working with, whether it’s directly with the company or with an adviser, make them explain the costs, fees, and the other options available with that contract. Make sure that you’re getting value for your money. It’s not to say that these are good or bad, but we sure hate spending that kind of money in fees if you’re not getting bang for your buck. Does that make sense?

Clark: Right. So you’re saying these accounts, they can have dozens, if not in the hundreds of these sub-categories. So is that actually [SP] right?

Roger: Exactly, you know.

Clark: So how do you navigate dozens and hundreds of options? Because it is dense stuff. How do you know what’s right for you?

Roger: Well, that’s really a great question. How do you know if it’s right for you? Well, this is one of the reasons it can be very, very valuable to work with a financial adviser who can help you analyze whether a tool like this is to your benefit. But what I really want to impress upon people, whether you’re working with an adviser or on your own, make sure you ask a lot of questions about the cost and about benefits. Because if you don’t like the answers you’re getting, then say, “Look, let me look at a different alternative.” It can be a different variable annuity, it can be a whole different type of asset class. And that’s what I want people to understand.

Now, these things come with some living benefits, like the…I mentioned the guaranteed lifetime income rider. A client was recently referred to me who bought one of these things about a year ago, and that was the appeal. That’s why they bought it. They were anticipating retiring, which they did early this year, and they went into their credit union and they said, you know, “I want to get the money out of my company’s retirement plan. I’m nervous about the market, and I need lifetime, to concentrate on creating income sources for the rest of my life.”

And the adviser there I don’t think fully explained to this particular client what they were buying. Because upon my analysis of this, when we were doing our initial review, this was actually the contract I was referring to with the 4 and three quarters percent cost annually, and they really did not understand that. But they are going to be able to create off of $250,000 deposit over $1,000 a month in lifetime income, which, again, will be guaranteed as long as they live. In this particular instance it’s 100% guaranteed for either one of them, so the surviving spouse will continue those payments.

So, in this particular case it’s arguable as to whether or not the cost was worth the benefit, but at least they are paying for something that they plan on using. So, this client plans on using the income feature, and even in years that the market goes down they’re getting a 5 and a half percent increase to their income value. So at least that’s growing each year they wait. But those income values can get a little confusing for the general public. That’s not real money, it’s just an account that’s used to calculate your lifetime income.

And, again, we’ll dig more into that in a future session when we’re dealing with fixed annuities. Because really, for most people that’s a better place to look if you want this type of income living benefit from your annuity and the flexibility that that creates. So, in short, a variable annuity is a wrapper that goes around mutual fund-like accounts. It gives the variable options to manage your investments based on what you feel the market conditions are currently and are anticipated to be. You can switch between those sub-accounts and not pay any taxes.

To many people that’s a tremendous advantage that if you want to do asset allocation. So, somebody that’s doing a lot of swaps and trades between different mutual funds might find that to be an attractive feature of a variable annuity. So, to summarize, the pro side of owning a variable annuity are these professionally managed sub-accounts. Same reason you buy mutual funds. The professional management, somebody concentrating on a specific management style or asset class. Certainly they can put in a lot more time and expertise than you or I that are, you know, doing other things with our time than analyzing the specific securities.

You get a guaranteed death benefit, equal to at least the original investment amount. So that’s another positive from this type of an account. You can get a wide variety of investment options. As I mentioned earlier, you can even have hedge funds. There’s a couple of companies that’ll let you pick your own hedge fund and put that in this wrapper. There’s an availability of guaranteed lifetime income. Besides those income riders, any of these accounts can be what’s called annuitized, which means turned into a SPIA at any point after a certain holding period. It’s usually from one to five years. After that you can annuitize.

And you can get tax deferral if it’s non-qualified. So in other words, if it’s not in an IRA, you don’t pay taxes when you swap, or the interest you earn or the capital gains that are distributed from these sub-accounts, no taxation. I think of it as taxed as spent. So in other words, when you take the money out to spend it, that’s when you’re gonna pay income tax on it. And then finally, unlike a CD where you have penalty for early withdrawal, and if you touch any part of it you’re gonna pay that penalty, here we have surrender charges. And we’re gonna talk about surrender charges more in our next episode.

But you can in most of these take 10% surrender charge-free access to your principal in the account. So there is an element of liquidity. Yes, you have a period of years, in variable annuities it’s anywhere from 5 to 10 years, with surrender charges if you cash the whole thing in, but here you can still access some of your money during that period of time.

What are the cons? What are the down sides of a variable annuity? You’re restricted as to which sub-accounts can be used based on the sponsor of that annuity, and what they’ve decided will be the investment options and opportunities within that account. So you don’t get to pick anything, unless, of course, the insurance company says, “Well, this is one that we’re gonna charge you a fee to pick whatever you want.” And there are a couple of those out there, but for the most part they’re selecting which sub-accounts can be used.

In fact, they might even restrict it further if you have one of those guaranteed income or guaranteed lifetime withdrawal benefits, the insurance company may restrict you to less volatile investments. And for good reason, because if the account’s down 30% but you can still pull lifetime income off the amount that was 30% higher, obviously that’s gonna cost the insurance company a little something. So they try to restrict the volatility if you’re gonna add one of those. The expenses can be relatively high. I just talked about a contract that’s paying 4 and three quarter percent. They’re not all that high. That’s why it’s very important to read the prospectus and to ask questions.

Clark: Don’t recycle it or don’t trash it. Keep it.

Roger: And you see, you might think, “Well , you know, I read it when I bought it. I don’t need to glance at this thing at all.” But they’re allowed to charge, to change the fees, and it’s important to know that. Now, some of these have bail-outs. If the fees go up a certain percent they’ll waive the surrender charges and you can leave. So, again, knowing what your options are, very important.

They can be very complex. Some of these options are hard to understand. They’re hard to understand for me. I keep referring back to this particular client, but it took me quite a while and several readings to understand the income rider on that variable annuity, and I do this every day. I can only imagine how hard it would be for somebody whose never read one of these things to figure out what exactly this particular company meant. And it’s one of the major companies and one of the major sponsors of variable annuities.

And then, of course, surrender charges. The fact is that you can’t just cash the whole thing in. Of course that’s true for a lot of mutual funds as well, but still it’s something always to keep in the back of your mind. So, I know that’s quite a bit to throw out there in a very short period of time, so I do want to make an offer that if you own one of these things or you have questions or you’re considering owning one of these things, feel free to give us a call here, 415-331-9030, and my staff will set up a time to get your questions answered.

You know, don’t throw the baby out with the bath water. These can be a powerful tool in the right hands. I think of it kind of like nitroglycerin. You’ve heard of that, right?

Clark: Right, right.

Roger: Well, you know, in the wrong hands nitroglycerin is very volatile and can explode and do a lot of damage. But in the right hands, it can be a very, very powerful tool that can have controlled explosions and help you with construction or moving things out of the way. So, like anything else, make sure you’re working with tools in a safe and proper manner. I’d say that’s the best way to put it.

Clark: Yes. Well, Roger, thank you so much again. I know someone can call you, you’re always available to help out. Something else that someone can do, of course, is the thought organizer. So that is just a quick thing they can fill out, help them understand where they’re at, what their goals are, and then it helps them best prepare to have a conversation with you, and so you can best understand where they’re at and where they’re going to go.

Roger: Exactly.

Clark: And that can be found on the website. Same place this podcast is and the blogs and all the other resources. So, Roger, thanks so much. I know this can be quite the lightning rod dialogue around deferred annuities, especially the variable annuities. So I really appreciate you cutting through some of the noise and some of the emotion that other people have. Because I know, for you, you remove emotion and you remove those types of feelings. It’s all factual based.

Roger: When we’re deciding about tools, yes. Emotion has to be part of the planning process because we’re people. But when it comes to making these kinds of decisions, what tools do I use to build my retirement house, yeah, we want to keep the emotion out of it.

Clark: Excellent. Well, thank you so much, I appreciate it.

Roger. All right, you take care.

Clark: Thanks so much for listening to this episode of “Retire Happy.” Be sure to head on over to gainerfinancial.com to download your thought organizer to get started. Roger L. Gainer, CHFC, California Insurance license number 0754849, is licensed to sell insurance and annuity products in California, Illinois, Arizona, Pennsylvania, and New York. Roger L. Gainer is an investment adviser representative, providing advisory services through HFIS, Inc., a registered investment adviser. Gainer Financial and Insurance Services, Inc. is not owned or affiliated with HFIS, Inc. and operates independently. Thanks again so much, and we’ll see you next time on “Retire Happy.”

roger-gainer

Roger holds the coveted and well-earned designations of Chartered Financial Consultant (ChFC®) and Retirement Income Certified Professional (RIPC®) from the American College. He is also a licensed insurance agent for life and health insurance, a Certified Paralegal for Estate Planning, and a current board member of SASM.

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Are Annuities Good Investments or Bad Investments?

Roger GainerRoger holds the coveted and well-earned designations of Chartered Financial Consultant (ChFC®) and Retirement Income Certified Professional (RIPC®) from the American College. He is also a licensed insurance agent for life and health insurance, a Certified Paralegal for Estate Planning, and a current board member of SASM.

roger-gainer

Roger holds the coveted and well-earned designations of Chartered Financial Consultant (ChFC®) and Retirement Income Certified Professional (RIPC®) from the American College. He is also a licensed insurance agent for life and health insurance, a Certified Paralegal for Estate Planning, and a current board member of SASM.

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What is a Deferred Annuity?

Roger GainerRoger holds the coveted and well-earned designations of Chartered Financial Consultant (ChFC®) and Retirement Income Certified Professional (RIPC®) from the American College. He is also a licensed insurance agent for life and health insurance, a Certified Paralegal for Estate Planning, and a current board member of SASM.

roger-gainer

Roger holds the coveted and well-earned designations of Chartered Financial Consultant (ChFC®) and Retirement Income Certified Professional (RIPC®) from the American College. He is also a licensed insurance agent for life and health insurance, a Certified Paralegal for Estate Planning, and a current board member of SASM.

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What Are Deferred Fixed Annuities?

Roger GainerRoger holds the coveted and well-earned designations of Chartered Financial Consultant (ChFC®) and Retirement Income Certified Professional (RIPC®) from the American College. He is also a licensed insurance agent for life and health insurance, a Certified Paralegal for Estate Planning, and a current board member of SASM.

roger-gainer

Roger holds the coveted and well-earned designations of Chartered Financial Consultant (ChFC®) and Retirement Income Certified Professional (RIPC®) from the American College. He is also a licensed insurance agent for life and health insurance, a Certified Paralegal for Estate Planning, and a current board member of SASM.

,

What is a Fixed Indexed Annuity?

Roger GainerRoger holds the coveted and well-earned designations of Chartered Financial Consultant (ChFC®) and Retirement Income Certified Professional (RIPC®) from the American College. He is also a licensed insurance agent for life and health insurance, a Certified Paralegal for Estate Planning, and a current board member of SASM.

roger-gainer

Roger holds the coveted and well-earned designations of Chartered Financial Consultant (ChFC®) and Retirement Income Certified Professional (RIPC®) from the American College. He is also a licensed insurance agent for life and health insurance, a Certified Paralegal for Estate Planning, and a current board member of SASM.