Radical Personal Finance Episode 251: Annuities: An Intoduction to the Types and Uses of AnnuitiesLet’s put our work boots on today and dig into some of the science of financial planning. We’ve been doing a lot of fluffy, motivational-type stuff on Radical Personal Finance recently. That stuff is really valuable but it needs to be tempered with some serious knowledge.

Today, let’s talk about annuities.

Annuities get a bad rap in the financial marketplace. And rightly so. They’ve been shamefully misrepresented, oversold, and abused by many insurance agents.

But do they have a place? Can they be an incredibly useful tool in the toolbelt of a good financial planner?

I believe so.

In today’s show I work to share with you some background and structure about annuities. This will help you to understand the words involved and the different product structures available.

We talk about:

  • The number of lives covered (single life vs joint life vs joint-and-survivor annuities)
  • When the payments start (immediate vs. deferred)
  • Methods of premium payment (lump sums vs. periodic payments)
  • Pure/straight life vs. refund annuities
  • Fixed vs. variable vs. indexed annuities
  • And tons more!

Enjoy the show!


View Transcription


[0:00:55] JS: If I say the word annuity to you, what are your general impressions? What image comes to your mind when I say the word annuity? Well, I know that for the majority of you, an image of excitement and just joy comes to mind where you immediately think to yourself, “Man, I can’t believe all the wonderful things that I could do with annuity, what a useful tool.” No, that’s not it?

What comes to mind for me because I deal in this space is the terrible reputation that annuities have. I think of popular commentator and consumer activate, Clark Howard, he always on his radio show which is a good radio show by the way if you enjoy it. If you can stand how slow he talks but if you listen to his radio show, anytime the word annuity comes up on his show, he talks about it as being a dirty word.

That’s his general opinion of annuities. Well today, I’m going to try to approach that topic and I’ll not argue with Clark. He does a good job and he’s probably right for many annuities but today, I want to give you an overview and a framework that you can apply to the concept of an annuity and my goal is that you would feel empowered and strengthened. That you would feel like you have a clue as to what is an annuity and how does it work.


[0:01:36] JS: Welcome to the Radical Personal Finance Podcast. My name is Joshua Sheats and I’m your host. Thank you so much for being with me today. I am excited to bring you this topic. We’re going to continue our technical financial planning discussions. It’s been a while since I’ve done a technical finance show and we’re going to get back into the swing of the show the way that I want it to be. I hope you enjoy it. Don’t be scared off by the word annuity. Relax, sit back and enjoy some learning and understanding.

My intent with today’s show is to empower you so that you’re not intimidated by the word of annuity, so that you understand what is this funny word and what does it actually mean and then more importantly, what’s available in the market place and then how can you apply what’s available in the market place to your own situation.

In today’s show, I’m going to be sharing with you a bunch of terms. We’re going to talk about a lot of vocabulary and the bulk of the content today will be me simply explaining and describing what these words actually mean. Because if you understand what the words actually mean, then you’d be able to look through the market place and understand what’s being talked about.

So if I use terms like fixed or variable or indexed or if I use terms like joint or joint in survivor or if I use terms like deferred or immediate or single premium or accumulation or annuitization, you need to know what those words mean and if you know what those words mean and you have a clear concept and understanding of what they mean, then you’ll be able to look at your situation or you will be able to look at situations of somebody that you’re working with and helping and be able to understand if an annuity product is an appropriate fit for them.

This is really where the big questions come on. I’m going to start with a quick definition of annuities and then we’re going to get into right up front here, the major controversies that surround annuities. Then I’m going to get into the vocabulary and on the controversies, I’m going to give you a brief overview and on future shows, we might talk more about the controversies in depth.

But remember with annuities that we are specifically talking about a type of life insurance. It’s important that you understand that. Often times, you’ll hear annuity is referred to as the 5th type of life insurance. The five basic types of life insurance contracts are term life insurance, whole life insurance, universal life insurance, endowment contracts or endowment life insurance and annuities. But in many ways, annuities are the exact opposite of life insurance. It’s almost a paradox. They are a type of life insurance but in many ways, they are the opposite of life insurance in this way.

The purpose of a life insurance contract, any type of life insurance contract is to pay out a sum of money at the death of the insured and so in order to fund that payout, generally most contracts will have a series of premiums that you pay into the contract. So you make payments into the contract until the death of the insured and then upon the death of the insured, there is a onetime lump sum payout to the beneficiary.

Well an annuity is the exact opposite of that. In general, the purpose of an annuity is to distribute a lump sum of money until the death of the insured and so, it is a type of life insurance and that it’s usually associated with the death of the insured in some manner but it’s more of a way to dispose of money and send money out. Now, there are exceptions to that rule. Not all annuity contracts are contingent upon the death of the insured but in general, they are.

One definition of an annuity from one of my financial planning textbooks is this and it will sound wordy but these words are important. “An annuity is a periodic payment beginning at a specific or contingent date and continuing for a fix period or for the duration of a designated life or lives.” Now, all those little caveats are important but in general, the way that I think about an annuity is, it’s a payment that comes in for life.

So the type of annuity program that most of us are aware of and comfortable discussing will be some sort of social program like social security. Your social security payments are a form of an annuity. You expect upon the distribution of your social security payments from the US government. You expect to receive payments that come in for life. If you turn 70 years old and you start taking your social security distributions, you don’t expect them to come in and then to run out. You expect them to come in for the rest of your life.

So in that context, the social security payments are a form of annuity. Now, we could actually get more specific with the terms. Social security is actually a type of deferred annuity. It’s an annuity that is deferred until a certain age, 62, your normal retirement age of say 67 or later time retirement age of say 70 and you make periodic premium payments into that contract with your employment taxes off of your wages based upon the social security wage base. So you make your contributions into that account. That account grows and is distributed to you at the time of your retirement.

The example of social security is an apt one to compare to annuities because there are some unique factors of annuities that don’t come into play with some other types of investment contracts. The first thing to point out is that annuities are always based upon the faith and credit of the issuing insurance company, in the same way that your social security payment is issued to you based exclusively on the faith and credit of the US Government. That’s it. There’s no actual money behind it and so you’re depending on the US Government to make your payments to you in the same way that you’re depending on an insurance company to make your payments to you.

So you need to be very careful when choosing who you buy annuities from to make sure that that company is going to be strong. Additionally, when looking at the distribution options, there are various distribution options. With social security, they’re relatively simple because they’re made for you in the sense that you’re basically choosing your age, that’s the biggest decision but the same with annuities.

You do have more options with annuities in the individual market place and annuities are classified along different lines. So in general, they’re going to be classified based upon the number of lives covered, the time when the payment starts, the method of the premium payment and what the type of obligation is from the insurance company.

We’re going to talk about the terms immediate, fixed, variable index, we’re going to talk about accumulation and annuitization, we’re going to talk about it all — we’re not going to get payout methods, that will probably be a separate show to talk about, payout methods, but I’m going to define these terms.

First, let’s address a couple of the controversies about annuities. Before I do that real quickly I want to talk about the sponsors and we’ve got two sponsors for today’s show. As I talk about these sponsors, you will notice in the last four shows, the sponsors have been the same. They will not always the same. I’m bringing out a total of 10 sponsors to the show.

I have almost all ten of them finalized, I’m just waiting on the final contracts. In some case, the final payments from the sponsors. Each one is a little bit different and I’ll be launching those systematically over the coming days but for now, we still have the same two sponsors today as we did yesterday so I will move through them quickly.

The sponsor for today number one is Paladin Registry, and Paladin Registry is a financial adviser referral service. Basically what Paladin does is they go through and they vet financial advisers. They have various criteria they go through and they try to do some of the due diligence that you need to do when hiring a financial adviser for you. They have a very stringent vetting process where they go through and look at the adviser’s history, their records, their compliance record and also they look at their business practices.

Then based upon that, they put together a group of recommended advisers who are in place to serve you. If you are interested on details of that, please listen to Episode 248 of Radical Personal Finance. There is an in depth interview with Jack Waymire, who is the founder of Paladin Registry and a former financial adviser himself and if you listen to that show, you will have an extensive understanding of why Paladin Registry exists and how they can serve you.

After you listen to that show, please go to Radicalpersonalfinance.com/paladin, put in your name and information. You’ll put in your name and your details and once you put in that information, they will put some advisers in contact with you. Usually, it comes out to be about three people that they’ll put in talk with you. These are the advisers that will be near you if they have advisers who are near you and who they are specifically selecting based upon the information you put in, about the amount of assets that you have under management things like that and they’ll try to match you with an adviser who’s appropriate to you.

You do not have to choose those advisers but hopefully, they’ll give you a good starting point. Interview them carefully, select carefully, make sure that they’re serving you but so far, the feedback from the audience has been fairly good. So you can put those details in at Radicalpersonalfinance.com/paladin and I will receive a commission when you use that link. So please go to Radicalpersonalfinance.com/paladin. I don’t receive a commission based upon your choosing to work with one of the advisers. I do receive a commission based upon your entering your information in there and getting in touch with the advisers. So thank you for using that link.

Sponsor of today number two is You Need A Budget, the YNAB budgeting software. YNAB, You Need A Budget. This software is awesome. It’s all about you need to know. If you don’t currently budget using YNAB, I think you should at least give it a try. If you don’t currently budget, you should and if you don’t currently budget using YNAB, I think you should give it a try. After I found it, I switched all of my personal accounting and budgeting to the system and also my business accounting and budgeting to their system.

It’s an inexpensive piece of software. It’s $60 or $70 bucks but you can have a free 30 day trial at Radicalpersonalfinance.com/ynab. So give it a shot, try it for free for 30 days. If it doesn’t work for you just cancel the subscription. I think it will make a profound difference for you. Again, find at Radicalpersonalfinance.com/ynab.

All right, controversy. Controversy, controversy, controversy. There are two major controversies I want to address right off the bat and they’re simply complexity and cost. Those are two things that you need to be aware of. Most consumer advocates who are generally against the use of annuities for investing. The major complaint that most consumer advocates have is not that annuities don’t work,can’t work or are ineffective for solving the financial planning problems but rather they’re complex and they are or can be complex.

They don’t always have to be but many of them are very complex. The basic function and design of an annuity is relatively simple. You give me an amount of money, I set it aside, I invest it — I being the insurance company. I invest it and then I pay you out a sum of money for your lifetime. It’s pretty simple. We have some simple terms in the contract. But what’s happened is that the annuity products that are on the market today have generally become very, very complicated.

All kinds of writers and benefits and phantom accounts and guaranteed minimum income benefits and withdrawal benefits and all kinds of funky things and so these can become very, very complicated. You get into the world of indexed annuities and your account earnings are based upon a certain index and you look at the index and there’s cap rates and there’s minimum rates and, and, and. And so they’re very complex.

Don’t get involved if you don’t understand those products. Major rule for success in investing, don’t invest in something you don’t understand. Never invest in anything that you don’t understand. Again, never invest in anything that you don’t understand. If you cannot explain an investment, an invest process, an investment product in a very simple terms to your young son or daughter, nephew or niece, a young person of normal intelligence and normal experience, you probably should not be doing it.

Good rule of thumb. Make sure that you understand it. So if you don’t understand the annuity product or the options or how it works, if you don’t understand the 267 page prospectus that you were given that you immediately toss in the trash can, don’t do it. Make sure that you understand what you’re doing. I believe you’ll have more understanding after today so in general, the complex annuity product, be very, very careful. I agree with the mainstream consumer advocates from that perspective.

What about the cost and performance? Here is Joshua’s number one rule. If you are comparing side by side an investment vehicle such as a mutual fund and an investment vehicle such as an annuity, in general the mutual fund will always be cheaper than the annuity. The reason for that is because all annuities involve some type of insurance and there’s a cost for that insurance. There is no insurance associated with most investment products such as mutual funds.

So you’ve got to make sure that you need and want the benefit of the insurance before you make that choice. You’ve got to make sure that it’s worth the money. Sometimes, it will be worth the money, sometimes it will not and after I go through the terms, you should start to be able to think about whether or not those benefits are worth it. But annuities will always cost more than other investment products such as mutual funds because of the component of insurance. I hope that makes sense.

Now, let’s talk about types and classifications and let me explain some lingo to you. We begin with an overview of the terms. The first way that we classify annuities is based upon the number of lives covered. So simplistically here, are we talking about a single life annuity or a joint annuity?

A single life annuity is an annuity payment that is calculated based upon one person’s life. I have a million dollars, I take a $1 million to the insurance company at the age of 60. I say, “Dear insurance company, please pay me out a payment for the rest of my life.” They will calculate that payment, it will come up to a certain monthly amount and they’ll promise me to pay me that monthly payment for the rest of my life. That is called a single life annuity.

If I have a joint life annuity or possibly also called a joint and survivor annuity and the distinction between those two is extremely subtle and not important for us to talk about, we’re just going to use the term joint annuity. If I have a joint annuity, then that payment is going to be calculated based upon two lives.

So I take that million dollars to the insurance company, I say “Dear insurance company, I want payments from this account for the rest of my life and for the rest of my wife’s life,” or it could be, “The rest of my business partner’s life.” Or it can be the lives of any two people who come together and make that request to the insurance company.

Well, what they would do is they’ll take my age, calculate that, take my wife’s age or my joint annuitance age, calculate their life expectancy and they’ll give me a different number. That different number will always be lower than it was if it was my life alone because they’ve got to stretch the payment over two life expectancies and it’s expected that we will have more years of payments over the two of us than just over one of us.

That’s the first way of classifying an annuity. It is based upon the number of lives covered. Single life annuity or joint annuity. Another way of classifying an annuity and these are not by the way exclusive. They’re not mutually exclusive. You could have various combinations of these classifications basically across the board. So just remember that these are just different words. Here are these words in the names of a type of annuity product.

So next way that we classify them is when do the payments start? Do they start immediately or do they start at some point in the future? If the payment is going to come in immediately, so I’m going to take my $1 million to the insurance company and I’m going to say, “Hey, here is a $1 million and I want payments immediately from this money,” so one month later, they’re going to send me my first payment. That is called an immediate annuity.

Or I can have some sort of deferred payment. I can take my $1 million to the insurance company, say, “Dear insurance company, here’s a $1 million. I want payments to begin 10 years from now because for the next 10 years, I have enough money coming in over here and I’m going to go and travel the world but 10 years from now, that’s when I want payments to come in.” That’s called a deferred annuity.

Immediate annuity, income right away. Deferred annuity, I’m deferring the income to some point in the future. That deferred annuity can be for a specific date. I can tell the insurance company, “10 years from today I want payments.” Or it can be for some date that I chose in the future. I can tell the insurance company, “At some point in the future, I will come to you and ask you for payments but I’m not establishing the date today.” That’s called a deferred annuity. Immediate annuity and deferred annuity.

Another way to classify an annuity is based upon how we pay the premiums and annuity can be purchased either with a single premium or with periodic premiums. A single premium is where I take my million dollars today and with one single premium payment to the insurance company, I purchase my annuity.

Periodic premiums is where instead of taking them $1 million, I instead send them $1,000 a month or $100,000 a year or whatever the number is. I send them my strict amount of money every month and that periodic payment could be the same periodic payment or it could change from month to month, year to year, depending on the type of contract.

Immediate annuities are always going to be single premium annuities because to take a payout immediately, by definition you’re going to give over a lump sum to the insurance company. So this is where the term “single premium immediate annuity” comes from. You’ll often hear this referenced in mainstream consumer finance literature.

A lot of consumer advocated will say, “This is the only type of annuities people should consider buying, a single premium immediate annuity — SPIA,” sometimes pronounced “spia” the acronym for single premium immediate annuity. So they’ll say single premium immediate annuity is the only type of annuity that somebody should purchase.

That’s a good starting point because what it does is it pulls out some of the more complex and trickier types of annuities but it’s not by definition true. If we were proposing analytical philosophical arguments, we could create the statement, “if this then that” and then we would prove that that is not by definition the only type of annuity or is it necessarily by definition the only safe type of annuity to buy. All it means is we’re going to bring $1 million of cash, a single premium and we’re going to get an immediate annuity payout.

Now, deferred annuities could be with single premiums or they could be with those periodic payments. Most of the time, they’re going to be periodic payments where you’re deferring the annuity contract, the annuity payment until some point in the future and you are making a series of payments.

The types of payments will vary again, depending on the annuity contract. Annuities have many different uses. Some uses are for the wealthy, some uses are not for the wealthy. The classical understanding of the annuity is that you sell a business, sell a piece of real estate and you want to turn that into an income. “Here’s my million dollars, send me income payments.”

But that’s not the only use of an annuity and this is where a lot of excellent planning comes in and also where a lot of abuse comes in because for example, by definition annuities are not taxed during their accumulation. So if you can put a sum of money into an annuity contract and that taxation on the growth of that contract is deferred until the future. Until some future date until the money comes out of the annuity contract.

Well, the other nice thing about annuities is there are no income limitations to participating in an annuity and there are no caps on how much money you can put into an annuity. So if you make a $100 million a year and you would like to invest $2 million per year into an annuity and if you can find the insurance company that will allow you to make that $2 million periodic payment every year going forward, you can put $2 million in, $2 million in, $2 million in, $2 million in.

As the account grows based upon whatever is written on the contract, you can defer the taxation on that contract until the money comes out and that’s as deep that I’m going to go with annuity taxation today. That is fundamentally true and annuities are a useful tool when doing tax planning. However, there are some limitations and down sides to annuities, some complexities to annuity tax planning that mean you have to be very careful.

We’ll cover those possibly in a future show if I dig in deep into annuity taxation but annuity taxation is very complex on the distribution. But the point is, there is useful abilities to it to make those periodic payments, put the money in and it will defer the tax on the growth. So we classify annuities based upon the method of premium payment, single premiums or periodic premiums.

Next, we can classify annuities based upon the nature of the insurance companies obligation. In here, the two technical lingo words would be a pure annuity or a refund annuity. Your social security payment is what’s called a pure annuity. The way it works is, you turn 70 years old, you take your distribution from social security, if you die at 72, your payments stop and for the purity of this example, assume that you are single, non-married, no spouse receiving spousal social security benefits.

You are 70 years old, you take social security at age 70, you die at 72, you received two years of payments and your payments stop. No beneficiary receives any excess money, you put hundreds of thousands of dollars into the account over the course of your working life time and your payments stop. That is called is a pure annuity.

Now a refund annuity would work like this. You start taking payments from your annuity not social security because social security is a pure annuity, you start taking payments at 70 but you stipulate that you’re account balance will be paid out in some way to a beneficiary. Let’s say that you’ve contributed a million dollars to the annuity and you take distributions at 70, you die at 72, you’ve only received, say $50,000 a year from your million dollar account.

So you’ve received $100,000 out of the account but you stipulate that at least the balance of the annuity will be paid out to your beneficiary. So your beneficiary continues to receive annuity payments until the full one million dollars has been paid out. I’ll cover some more options in a moment because this is where a lot of confusion happens but also where a lot of important planning can happen.

The key thing for you to recognize here at the outset is that the pure annuity will always be the highest payment. The highest month dollar amount will always be a pure annuity. That’s also the highest risk payment. With social security, if you die at 72 or worse, if you die at 62 before you even took payments at 70 which what happens to many people, if you die early, you get screwed because you put all these money into the contract or into the social security administration.

You put all those money in and you never see a dime of it and the people that you care about don’t see a dime of it. So you get screwed but if you live a really long life, you get a pretty good deal and the same thing exist with a pure annuity payment. You have the confidence of having a highest payment and if you die early, you might lose the money but if you live a really long time, you could make out like gang busters.

This is where a little bit of intelligent planning could come in. Some people, if they’re single, they don’t have any beneficiaries counting on them, you know the level of your health, most annuities are not underwritten based upon health. There are some annuities that can be underwritten based upon health and those are advantageous to you if you have an impaired health condition. Those are called impaired risk annuities.

Let’s say you have terminal cancer or you’re very, very sick for some reason. You can actually go to the insurance company and lobby them to do health underwriting for you and you can ask them to give you an annuity payment based upon your sickness and the idea is that they’ll give you a higher annuity payment than somebody who’s healthy because you have a lower life expectancy but most annuities are not underwritten based upon your specific personal health.

So if you are very healthy, you’re single, you have no heirs or beneficiaries that you’re worried about providing for, well, a pure life annuity might be a really great deal because you’re going to get the highest monthly payment. If you die, oh well, you die. You’ve funded somebody else’s payment but the idea is that if you live a 115, you’ve gotten a lot of money from the insurance company.

On the flip side, that could be an unacceptable risk to you. Let’s say that your total value of assets is $1 million and you either want to spend the money yourself or you want to pass that money along to your kids and it would make you sick to know that if you died two years in and you are at $100,000 the insurance company would keep $900,000, well then you can go ahead and take the refund annuity.

You can say that, “If I live then I’m going to receive this amount of monthly payment and if I die, I’m going to receive at least the million dollars, my kids are going to go ahead and get this value of my estate. This residual remainder value of my estate in the form of the refund annuity. The value of an annuity in that situation is that you can guarantee that your payments are going to continue for life.

That’s really, really valuable. By guaranteeing that your payments are going to continue for life, then you know that at least the million dollars is never going to run out and the flip side is, that you’re always going to get at least either you or someone you care about is always going to get the million dollar head of the contract.

Annuities can be very flexible tools in the tool belt of a good financial planner. They can fit specific needs because at the end of the day, we generally aren’t worried about optimizing the money or optimizing the lifestyle that can be bought with the money. While I’m on the topic of what the insurance company’s obligation is, pure versus refund, I should additionally note that not all annuity payments have to be made on the basis of a life payout.

So it doesn’t have to be a life annuity. You can purchase an annuity from an insurance company that pays out for a specific term or number of payments. An example here would be you can buy an annuity that pays out for 20 years and it’s not even connected to a life time payment. So that is an option or you can buy a, which we get to when we talk more in depth with some options about the type of payouts, you can also buy payment that pays out for life or at least 20 years but you can just buy a strict 20 year payout.

“Here’s a million dollars, I want payments from this account for at least 20 years,” and those payments are either going to come in for you for 20 years or to your beneficiary if you die before the end of that 20 years. So that is another subset.

One more very important type of classification is between a fixed annuity and between a variable annuity. This is a classification of basically how’s the payment of an annuity is going to be determined. A fixed annuity is a series of payments that is calculated based upon a fixed interest rate. This rate is known prior to the inception of the annuity or prior to the payout of the annuity.

It’s known, it’s calculated, it’s clear, it’s certain, it’s specific. The actual number will be based upon the prevailing economic conditions at the time and based upon the rate of the insurance company is offering when the contract is created. Mentally, you can compare this to something like a CD product. A CD product is issued by bank. It’s issued at a fixed rate of interest, that rate of interest is determined and is very highly subject to the prevailing economic conditions.

The prevailing interest rates, what the bank can earn on its excess deposits and where they can invest their money and then how much of that they’re willing to send back out to you in the form of a CD. There’s also competition so banks are forced to compete for one another for customers and that competition in some ways is going to be based upon interest rates. Well fixed annuities are no different.

The insurance company is going to offer a system of periodic payments based upon the prevailing interest rates and the insurance companies need to compete with one another. So when you’re purchasing a fixed annuity product, you need to make sure that you check the market carefully, that you do your due diligence and you try to find the best possible deal, the highest possible interest rate.

However, you also have to keep in mind that you’re going to balance the highest interest rate and what interest rate the insurance company is offering with the safety and security of the company. In the same way that a small struggling fledgling bank might need to offer a higher rate of interest to attract depositors to their accounts. A small fledgling struggling insurance company might be attracting depositors by offering a higher rate of fixed interest, a higher guarantee.

And the important thing about the fixed annuities is that fixed annuities are backed by what is called the general account or general portfolio of the insurance company. This is their large pool of money that specifically calculated planned and invest it to pay out for the general obligations of the company. So your contract is as strong as the company standing behind it.

That’s different than what’s called a variable annuity. In a variable annuity, the rate of interest that you earn on your account will vary, it is variable. It’s not fixed, it’s variable and its variable based upon what’s written on the contract or based upon some sort of scheme. Usually, it’s based upon what is the performance of a specific investment account.

Usually, in most variable annuities, this would be mainstream mutual funds which are repackaged in an annuity language that’s called “sub-accounts” so these are called variable sub-accounts. But what happens here is that the insurance company is basically managing the contract but the underlying investment results that you get from the contract are going to be based upon the performance of the investments contained within the contract.

Fixed annuities are insurance products only. Variable annuities are insurance products and investment products. Because of that, any insurance agent who is selling a variable annuity must be licensed both as an insurance agent and also as a securities dealer, a securities broker.

You can have very simple and straightforward variable annuities and you can have very complex variable annuities. Most fixed annuities are relatively simple and straightforward. And it’s hard for them to get very, very complex but variable annuities, in my mind, are tremendously useful products.

One of the simplest, I don’t want to get too deep into application but because variable annuities get a bad rap, one of the simplest types of retirement plans that I know of is just simply to take a sum of money, turn it into a variable income payment with a very simple investment portfolio backing it and you basically walk away from the risk of exhausting and depleting your assets.

The way those payout plans work is that the amount of the income that you receive every month will vary up and down based upon the performance of the underlying investments but you never exhaust the money. So when you’re trying to figure out back to, “Okay, I’ve got a lump sum of money, how do I retire on this?” one of the fears that you have if you’re going to take something like a three or four or five percent distribution is, “What’s the right distribution and how can I guarantee that I don’t outlive my money?”

Well, with an annuity, a life income annuity, it’s impossible to outlive your money. So they’re very, very useful, however they can also be very complex and have some pitfalls. Now, here I need to mention that there is an additional type of annuity that straddles the line between a fixed annuity and a variable annuity. These annuities are called indexed annuities, commonly called an equity indexed annuity, sometimes referred to as a fixed indexed annuity but the key word that you want to pay attention to is the word “indexed”.

Here, what happens is your rate is not fixed nor is it variable but it’s indexed to the performance of some other investment and these annuities have had a troublesome past. They’re especially the target of regulators trying to enact some regulation.

Fixed annuities were very popular back in the 1980’s and the early 1990’s during the very high interest rates of the Carter and Reagan administration. But since that time, interest rates continued to decline and stock market returns have increased massively over that period of time. During the 1990’s, you had a massive growth of stock prices, so the problem was fixed annuities weren’t really selling.

So the insurance companies are trying to figure out how can I offer a product that is going to retain, well in the advertising lingo you will hear it, the upside potential? In a search to develop products that will able to deliver higher returns than normal fixed interest rates than these products are developed and they’re not regulated and securities but in some ways, they work like securities.

And again, the advertising literature around this is infamous, you’re always going to find something around the lines of “all the upside potential without the downside risk”. You will find these heavily promoted and just turn on any run through your AM radio station dial on Saturday morning, you will find at least somebody in your local area who is doing a show on annuities and how they can protect your portfolio and your retirement from all the risks of the stock market and protect you in the next stock market meltdown.

These are extremely popular and they’re massive, massive sellers. Equity indexed annuities deserve an entire show. I really should go through and talk about them in detail but that show will probably be well done in some form of a debate format. If I could find somebody who’s a real proponent of equity index annuities and I could raise all of the objections, all of my objections to them and go through them.

I’m not going to cover them in today’s show. In short, my summary is this; I’ve never bought one, I’ve never sold one, I’m open to their being an appropriate financial planning place for them. I’ve had some people that I have respect that have made some arguments for them but I am intensely skeptical of any indexed annuity for various reasons. A lot of detailed reasons for that but personally, I would rather have either a fixed annuity or a pure variable annuity.

Basically it comes down the price of the insurance. Insurance companies can’t print money. The US Government can or more properly the Federal Reserve can and does but insurance companies can’t print money. So recognize that they’re investing in the same markets that are available to every other investor.

Now, if you look at economies of scale, it’s possible that an insurance company can build a real area of expertise because of the depth of their bank account. So an insurance company could go in and do $100 million deals that you and I as individuals can’t access. But what I don’t fundamentally conceptually like about index annuities is that usually, these annuities are indexed to a direct index that is widely and publicly available.

The most common one is the S&P 500. Well you can go buy an S&P 500 index fund and you’ll get the full return of the market with the full risk of the market as well. Well, the insurance company the way they work is they put in a series of rates. They put in a series of cap rates and participation ratios and things like that.

Since your returns are still driven off the S&P 500 but yeah, you’ve got the money there, hopefully, those of you who are in tuned with this area in the market, you can see the problems. I don’t like them. I’m open to being wrong, I’ve been wrong about lots of things before but I don’t like them. But I don’t want to go too deep into any particular application and I want to stay focused on this big picture overview.

This basic overview should help you to start to feel more comfortable with at least the meaning of the terms. So when you’re looking in the industry or reading a product name or you’re being presented something, you can have an idea of how it fits in. All financial planner should always have annuities as a component of their tool belt because they solve really unique problems in a really good way for you.

This is where you have to get down to the personal application of the problem. In general, most pundits on finance are going to be giving broad personal brush strokes but the boots hit the ground when it comes to, “What do I actually do with this sum of money? How do I take a distribution from it?” Then you get into somebody’s risk temperament, you get into their desires, their goals, what they’re willing to live with.

And you get into the fact that personal finance is very personal, it’s not all about finance. You can run studies and objective way and trying to figure out what’s the ideal way to optimize a portfolio for a large public pension fund but when you get down to the individual participant situation, money is all about funding life. That’s why we spend so much time on the show talking about life, life style and relating that to money.

So each of this different annuities, each of these different designs has an application and the actual classifications are relatively simple. You can purchase simple annuities and with all these different designs that may fit a place in your specific situation and in your financial planning needs.

I’m going to back through a couple of these frameworks and explain some of the products. Now that you’ve got the overview of these different ways of classifying, you should be able to remember these terms and I’m going to give you a little more depth on a couple of these classifications.

This deeper dive that I’m doing will be focused on the specific decisions that you will have to make if you’re buying an annuity. So the scenario here is you’ve gone through the process of a financial planning process with an adviser, you are sitting down and looking at your situation, you’ve sketched out what your goals and what your needs are and now, you have to make some specific decision.

So back to the number of lives covered. Annuities are powerful tools for you to be able to assure the income for your family under your marital obligations and annuities are one of the best ways to do that. I have many times done planning for clients and I’ve many times been in the situation of doing planning for clients where the major problem is not “do we have enough money” but the major problem is “how do we make sure that we have enough income for the rest of our lives”.

This is something in my situation for example in my marriage. I am involved and I lead almost all of the financial decisions in our household. I’m the nerd, I’m the leader, I am the provider, the protector of my household. My wife is an amazing woman and she’s very, very intelligent but she doesn’t love the details of finance. She’s extremely detail oriented.

When we sit down to sign a contract, she’ll sit there and she’ll read every single sentence of the contract from beginning to end and I love that about her. She never signs anything unless she’s read it carefully, she’s very, very careful and precise but she doesn’t love going through all the details.

So for me, in terms of sketching out our families financial planning and providing for the obligations of my marriage to make sure that my wife is cared for and to make sure that she’s able to maintain her lifestyle no matter what, if I were in a retirement planning situation, annuities would play heavily into my planning portfolio.

Because it allows me to eliminate some of the risk of her making a mistake from an investment perspective or eliminate some of the risk of her maybe being swindled or taken advantage of. It allows me to put in place some protective influences and so one of the most useful ways to do this is with a joint annuity where there’s going to be an income payment for the rest of my life and for the rest of my wife’s life.

The difficult thing about setting up annuity payments is that once you set them up, they’re done. You can’t really change them with very few exceptions but the wonderful thing about setting up annuity payments is once you set them up, they’re done and you can use annuity income on a joint annuity to provide for your spouse and make sure that for the rest of their life, they’re taken care of. That is powerful.

But you’ve got a lot of decisions to make, and you’ve got to be very, very careful here. When you’re choosing your annuity payouts, this is not during the accumulation period but during the distribution period. Using insurance lingo terms, this would be called when you’re annuitizing the contract or you’re moving from the accumulation period into the annuitization period where you’re receiving income from the contract.

You’re going to have to make a choice about single life annuity versus joint life annuity and you have to choose about having a refund option versus no refund option. So back to the priority. The highest payout is always going to be on the single life with no refund options. Highest payout, single life, no refund options. The older you are the higher the payout.

Joint life payout will be less of a monthly amount but it provides much more security for your joint annuitant. Refund options will be less still but it provides more security that the principle of your investment will be distributed to your beneficiaries. What should you choose? It depends on how much money that you have and it depends on priorities.

If you’re trying to eke out an income of, a high income as compared to your overall balance of investments, you’ll need to go in the direction of no refund option in order to get the maximum income and you might be walking away from the principle of the investment, the corpus of the account if you die early but at least you’ve assured the higher level of income.

But if you’ve got loads of money and you’re not too worried about eking out the highest income, then a refund option is certainly nice and most people will choose some kind of refund option. Now, when you’re choosing among distribution options, you’ll have options. So for example, do you want to have a joint annuity with a full income at the same amount for your life and the same amount for your spouse’s life?

Or do you want to have annuity that is a full income for your life and two thirds of your spouse’s life? Or 50% of your spouse’s life? Something like that. The answer to that question would be based upon the overall expenses. You’ll have a higher payout for your lifetime for both of your lifetime if you choose a lower payout for your spouse’s lifetime, but is your spouse actually going to be able to go through with those details?

So you need to get some good advice, chose carefully and you’re balancing between potential gain versus overall risk, you need to think very, very carefully. The lingo that will be used will be this: You’ll be offered a pure annuity, which is lifetime income for your life time only with no benefits and no refunds after the annuitant dies. You’ll be offered a refund annuity.

The refund annuity can guarantee either a life income or a certain number of payments, payments for 10 years, 15 years, 20 years after your death or it can offer a guaranteed refund of the whole amount of your account or 50% of your account. There’s not a right or wrong answer. It’s just a matter of looking through and seeing what you’re comfortable with.

The other comment I want to make on deep dive is between the questions of variable versus fixed. Basically, fixed annuities might form a portion of your decision but people don’t love buying them today because of the low interest rates that we’re living in currently and also, the fact that one of the major challenges that we face is overall inflation.

So anytime you need an amount of money that’s going to keep pace with inflation, you need to go in the direction of a variable annuity rather than the direction of a fixed annuity, that’s always going to be the use. So if your financial adviser says to you “variable annuity,” don’t all of a sudden assume that they’re out to swindle you.

Recognize that they’re trying to solve a problem and the problem is, “How does my income keep pace with my expenses?” Not just, “How do I have the same amount of money coming in every month?” Listen carefully and consider carefully. Always make sure when choosing annuities that you understand clearly all of the cost involved with the annuities.

In a fixed annuity, there will be no costs that are disclosed to you because you’re simply going to be given a specific rate of interest and you can calculate that overall rate of interest and rate of interest is coming in net of all of the expenses. So if you calculate the payments and you calculate what that represents as a rate of interest, you’re getting that income net of the expenses.

In a variable annuity, you’re always going to have a prospectus and that prospectus will list in it the specific costs of the insurance. It will list the mortality and expense charges, which is the cost of making sure that that income is there forever. There are some other little bonuses on annuities that you’ll usually see which I didn’t go into. Things like guarantees of high water marks. So for example, you have a million dollars in your account and then the markets decline to $800,000, in many annuities, you can buy an option where the million dollars will be paid out to your spouse rather than the $800,000. That has a benefit but it also has a cost.

You can go through the prospectus and you can see each of the costs and remember, you’ve got to deal with the annuity cost and also with the cost of the underlying sub accounts, the underlying investments and you need to shop carefully for costs.

Shop carefully for cost, make the companies compete. Make sure that you fully understand it. Just because the cost is higher doesn’t mean that the benefit might not be there but you’ve got to understand the cost carefully.

I hope this overview has been useful to you. I personally really love the power of annuities. In the right situations, annuities can really, really, really be cool and they can do some really cool things for you but you’ve got to understand the risk and the tradeoffs and hopefully this will help you to feel more confident and more competent with regard to you making your decisions.

I’ve put together, over the years, I’ve put together some very cool annuity transactions where my clients had some really neat and interesting benefits that were created by annuities. One of the more interesting ones that I did was actually with a client who was a retiring teacher and they were offered a pension from the school board but when we went through it, and this is the type of scenario that will be flagged by any compliance officer, by any commentator.

If you were to put forth this scenario in public and say, “well this was the scenario” and most people would say, “The client got screwed and the insurance agent was just trying to get a commission.” So let me explain to you the scenario and why it was such a cool scenario. Client was a retiring couple and one of the spouses was a retiring teacher and as a retiring teacher, this spouse had a traditional pension from the teaching system from the Central Retirement System of the state.

But as we went through and carefully examined that option and we looked at the details, there was some concerns about it. Number one, they were involved in a large pension system and although this pension system is well funded, it’s not as well funded as it should be. Most of the state back pension programs currently existing in the United States are not doing quite as well as they should be and some of them are downright dangerous. It depends, you need to research carefully.

This one was better funded than others but the trend is in the wrong direction. Population trends, investment return trends, participation trends, the trends are in the wrong direction. That was the least of the concern. That was an added bonus to escape the government run system and move over into the private market system where there was a much greater financial strength. That was the least of it.

So that was the extra bonus consideration. The bigger consideration was that they had either a lump sum payout or they had a series of payments and when we ran the numbers on the payments and look through them, they were good but they didn’t have any really good inflation options. They didn’t have any really great cost of living options. They were mediocre cost of living options.

Now this client was comfortable with investment risk. They were comfortable with fluctuations in the market at least with a well balanced portfolio. They had other assets that they can rely on. They weren’t scrapping the bottom of the barrel just living on every dollar of income and their overall goal was to have a higher total amount of income but to really have the same security that you get from the pension system.

[0:54:01]: This is where if you’re looking at the financial markets, one of the things that you’ll find is that financial planners generally argue in the abstract. So we’ll talk about what’s the highest total rate of return. Does it all come in from pure stocks or does it come in from stocks and bonds or does it come in with stocks and annuities?

Whereas individual people who aren’t financial planners would generally be looking at the situation and thinking, “What about my lifestyle?” And you’ll usually find that in that situation, most of us as individuals will go towards safety. If you just think conceptually the example that I always use is let’s say that you have retired firefighter, retired teacher both of them living on state pensions plus social security.

They got $10,000 a month between them, they’re not too worried about things. They’re not worried at that point about what’s the highest potential rate of return. The thing that we financial planners do is we’re debating and bickering back and forth about could we actually get them $11,000 a month with a little bit more risk of more fluctuation?

The client say, “No, I’ll take the 10 man. I’m not worried about every last dollar. I like the comfort and the safety of this government run pension.” So back to the specifics of the situation, this client, they were comfortable with the risk but they wanted the income and they needed the income right away.

So we ran the numbers on a variable payout plan for joint life payout plan and it’s just a simple variable annuity, no guaranteed withdrawal benefits, no other living benefits, it’s a simple variable annuity on a joint payout plan with a balanced portfolio behind it and we ran the number of putting the lump sum into that contract.

We stress tested it historically, we looked at the fluctuation, we went back and reviewed it, I reviewed all the expenses, all the numbers very carefully and these clients are very detailed oriented, very, very competent. We went through it all carefully and after doing the lump sum from the state run pension system directly into the annuity, after all of the commissions that were paid to me on the traction.

After all the cost and everything upfront, it was going to be a beautiful distribution. They are going to have a lower income payment for probably about first two or three years because of the expenses upfront and then I was basically the expenses. The commission that I was paid on the transaction but from then on, by having the accounts invested in a variable portfolio based return versus the state run fixed return. We expected a much, much higher with conservative estimates, we’d expect a much, much higher total lifetime income amount.

That was fundamentally due to being able to walk away from the minimums, the standards, the fixed promises in the fixed income space and move over into the free market where they can take advantage of the growth of the capital markets as prosperity and wealth grows overtime from the well-run companies of America and the world. That was fundamentally the basis.

So we reviewed the numbers carefully, we went ahead and pulled the trigger on the transaction, they could afford the short term loss of income over the first couple of years. We had a refund situation in there so no matter what, they had the refund and that was, incidentally, the other major benefit of the transaction in the state run pension, they didn’t have a refund option.

So even though we had the availability of the life income options and the joint life income, they didn’t have the refund option. So if they annuitized it over there, they wouldn’t have the income coming and then they both died prematurely, that whole payment system stopped. But if they took the lump sum, we could engineer what we predicted would likely be a higher total lifetime payout, likely be — possibly be a much, much higher lifetime payout and have the refund option for the kids and it came with a couple of years of lower expenses.

Well, it worked out. It was cool because we weren’t actually on wasn’t a timing move. But it was serendipitously timed with an increase in the values of the equity markets and really worked out well so it was even less than what we predicted by the time they had their full income and one of the sad things I had about closing my practice was I, from time to time would go and look at their payout options and assess the transaction just to see how it was doing.

Over the course of their 30 or 40 year retirement, I am very confident that it made it. At this point, now that I no longer have to worry about forward looking statements and things like that on an investment product, I feel really good that over the course of their retirement years, that my planning advice has made a difference of potentially an extra million bucks of money to spend. Time will tell. I don’t know if I’ll ever know but I am pretty proud of the transaction.

So it’s a cool scenario because it shows the power, it showed me the power of an annuity in the right place and that’s what a good financial planning can do. You can take it, you can look it through very, very carefully and just because an insurance agent is selling an annuity, it doesn’t mean that they’re just trying to scrape the biggest commission they can.

Yes, I got paid a very nice commission. It was a large transaction and I get paid a great commission. I’m very thankful for that. I deserved the money, I worked hard for it and I improved the client’s position immeasurably and they would never have known about that option if we hadn’t been working for a number of years on their financial planning.

So I hope that’s a useful illustration to you of the power of an annuity product where in theory, could they have had a higher total lifetime return if they were to invest the money purely into stocks. In theory, maybe? But the problem is that they weren’t willing to make that transaction because they needed the income and they wanted the security and the comfort of having the guaranteed income.

So we couldn’t sell out the pension, take the lump sum and put it all in stocks and spend off a percentage. They weren’t willing to make that transaction for their own comfort. I would have been willing to make that transaction myself but they were willing to make the transaction to move it into a variable income plan on a well-priced, low cost variable annuity. I hope you like the example.

Now, I want to answer a couple of comments and questions here that came out on the Patreon page. On the Patreon page, I put out the topic of the shows in advance for those who are pledging $3 a month or more and when I put out the topic of the show, I received a total of seven comments and I want to answer some of those seven comments here rapid fire.

So one comment came in from Julian and he talked about, he says:

[1:00:48] J: “At the bank, we use fixed annuities for very risk reverse clients who have a lot of cash but don’t want any additional market risk and then might already be taking within their investment profile. I still don’t quite understand how clients can compartmentalize this, but I digress.

The market place has changed in the past few years and there are now three and five year annuities which are shorter than the standard seven year surrender schedule of the annuities of yesteryear. What do you think about an annuity for someone with a short time horizon that demands the guarantee and does not want to play games dragging money from bank to bank?”

[1:01:17] JS: Julian, I think it’s a good idea for the right client who understands the limitations and the value and so in many ways, essentially what’s happening here is the insurance companies have created a product to compete with the banking products. So the products has similar attributes compared to a three or five year CD. In this situation, in many ways would be comparable to a CD product and so you could compare the rates.

And then you compare the credit worthiness of the issuing insurance company with the credit worthiness of the issuing bank behind the CD and you compare the returns. There are really going to be few in a simple short term fixed annuity product like that. There are going to be few downsides except for the lack of liquidity and as long as the client understands that and meets what they’re trying to do, I don’t have any problem with it.

[The next question here, Calvin says:

[1:02:08] C: “In regard to asset allocation diversification, how does one consider an annuity? I’ve been considering my military pension which is essentially an annuity as more bond like in regard to its stability and regard to the market. As such, I have most of my investments in stocks and stock funds. Please comment on this. Also suggestions for resources on pricing annuities would be valued, thanks.”

[1:02:26] JS: Calvin and by the way, if any of you don’t want me, I always read first names when I get e-mails or discussions on Patreon, feel free to use fake names anything you send me if you don’t want me to read your name on it or use a fake name on Patreon. Patreon will let you do that, no big deal.

But yes, how does one consider an annuity? One considers an annuity based upon the attributes of the underlying investments. So the use of the word annuity is not necessarily an asset class identifier. Just because I have an annuity doesn’t tell you anything about it. I could own a variable annuity with a 60-40 stocks and bonds asset allocation in my underlying sub accounts within my annuity contract.

If I owned that, then I would consider just 60-40 stocks bonds. I could also own a fixed annuity that is based upon a specific rate and in that situation, now that would be much more like a fixed income allocation or my bond allocation bonds or fixed income investments and so that underlying contract would be much more applicable to a fixed income portion.

With regard to a military pension, that would be much more bond like because it is stable. It’s performance is not tied to the underlying performance of the equity markets. It’s a government back fixed income investment with some inflation options associated with it and so the key there is I would look at the pension, and I’m not an expert on this. I haven’t reviewed it.

Look to see what your inflation adjustment options are and then based upon what that says, I would then compare it to other aspects of my investment market. Example, social security’s annuity payout is based upon the consumer price index. So in this situation, maybe you would compare that to other investments that are also connected to inflation metrics like TIPS — Treasury Inflation Protected Securities.

But if your military pension and I don’t think it does but for sake of illustration, if your pension guarantees which is going to go up at 3% or 4% or whatever every year, well now that’s different. That’s a little bit different. This is where some of the science of the pension research, which is what all the asset allocation stuff is based upon, has to be basically absorbed by you or by your planner and then regurgitate. It’s not going to be so, so scientific.

Resources on pricing annuities, I don’t have any website to mention to you. If anybody in the audience knows of a great website, come on by and do that. What I used to use is the internal systems of Northwestern Mutual when I was there and then I would check some of the online sites and talk to some brokers if I was pricing outside annuities. But as far as consumer level pricing, I don’t know of any good resources.

Steve says:

[1:05:12] S: “Besides thinking about annuities are a rip off. I don’t really have any questions.”

[1:05:16] JS: Well Steve, hopefully you have a little bit more of a discussion here.

Rick wants to ask about the role of annuities and retirement income planning and some of the work done by Dr. Wade Foul. He has done a great deal of work and annuities, the science is more and more demonstrating that for retirees, annuity should be playing a role in their portfolio and the planners are still going to argue about this but I don’t want to get too deep into that today.

Richard asked a question which is interesting question. He says:

[1:05:42] R: “What about Swiss Franc Annuities? Are they still available? This seems like a way to protect the fall of the US dollar and are annuities guarantees only as good as the insurance company which issues them?”

[1:05:53] JS: Richard, Swiss Franc annuities, I don’t know if they’re still available. My guess would be yes. There is no conceptual reason why they can’t work. You have to find the right provider. Annuities are interesting because once you understand the concept of it, you can actually structure them in different ways.

So there are private annuities out there if I were working a private family foundation or a family office or something like that and I were working with a wealthy billionaire family, then I would be out there looking for some of the private annuities that are available. And sometimes, people will write private annuities, sometimes people will purchase private annuities.

You can do this in the international market and yes, that can be a good way to protect against the fall of the US dollar and you can put different currencies within it. Also interesting with regard to annuities is you can create private annuity transactions and these would not be appropriate for not rich people but you can set — because there’s too much paperwork involved.

But you can set up annuity transactions with other assets, non-traditional assets behind them. You will use annuity calculations in different forms of estate planning, where you’re setting up a different kind of entity. You can use annuity calculations within that and so you use different rates depending on what you’re doing.

So the concept of an annuity is just a mathematical concept and it can be provided and issued by many, many people. Remember, that annuities are going to be tax deferred and if you can get big enough dollar amounts behind it and you get into the world of private placement life insurance and private placement variable annuities, if you have enough money behind it, what can happen is you can fund them with some interesting investments and you can enjoy some of the tax benefits of the annuity.

So it’s in theory and probably in practice although I’ve not gone out and searched at these products. I would if I were working for a family office but in theory, there’s no reason why you can’t take some of the investment vehicles which are usually more highly taxed and place them inside of an annuity contract. If you can pull enough money together to make it work.

So you can take something that would be maybe some sort of hedge fund, which is pursuing a trading strategy generating a lot of short term capital gains and move that into an annuity which allows you to defer the income over a period of time to the future and that can be very advantageous for you.

Additionally, annuities have some useful roles with their beneficiary designations and some of the control and some of the restrictions, some of the amount of money that can go into them. So they can be a little bit seductive at the higher levels. The key there is you’ve got to get enough money behind it. Those aren’t available on the retail market and it’s a very specialized market. I don’t know anything about it more than the concept.

You asked, “Are annuities guarantees only as good as the insurance company which issues them?” Yes, depending on the type of annuity. The fixed annuity, the payout is only going to be as good as the actual insurance company behind it. A variable annuity, in general, an insurance company is going to be covered by these SIPC — Security Investor Protection Corporation Insurance.

And because that’s a product, it’s based upon the performance of separate accounts, not the general account or the general portfolio but a separate portfolios, then the variable annuities in some ways are actually going to be safer because it’s the underlying mutual fund company that’s going to run, who’s money is going to fund the company.

So if you’re concerned about the insurance company, if the underlying investments are solid and well-constructed and if the company is covered by SIPC, then you’re going to have more consumer protection. So what SIPC does, it does not cover investment loss but it does cover loss in case of failure of the investment company so in that way, the guarantee there is going to be covered by the underlying investments. But still, there are enough great very strong insurance companies. I don’t see any reason not to choose a strong insurance company.

Next, Mike says:

[1:09:53] M: “One of the biggest frustrations that I have is that they’re basically two worlds in financial planning. Fee only planners versus salesman planners that receive commissions. They each talk smack about the other one. It seems like fee only planners will rarely discuss annuities, except maybe a SPIA.”

[1:10:07] JS: A Single Premium Immediate Annuity and hopefully, that means to you now.

[1:10:11] M: “The fee only planners will site all the negatives of the complex annuities to how much better their plan is but they are a little biased because they can’t sell them even if they wanted to. However the commission based adviser salesman have a huge conflict of interest. What are your thoughts? Have you ever heard of a fee only planner recommending an annuity? Was it SPIA or was it a more complex one?”

[1:10:30] JS: Mike, you’ve hit the nail on the head. There are all kinds of arguments in the financial industry and very few of them are academically pure. Most of them are based upon, what do I do and where does my income come from. We all have a biased, even a confirmation bias where our own approach, we have a difficult time absorbing information.

I have thought through over the last year, now that I have disentangled myself from any potential conflicts of interest, I’ve tried to think through most of my own perceptions and think, “Do I really believe what I used to believe or was I simply confirming my own bias because of my own compensation structure,” or something like that?

What’s the answer? I don’t know. Our fight against our own internal bias is a life long struggle. I think that much of the argument does indeed come down to two things. It does indeed come down to the compensation structure of the adviser and it also comes down to their clarity of message.

So if you are a fee only adviser and your client is thinking, you have $2 million under management. You are exclusively charging one percent, that $2 million account is $20,000 of gross revenue to your practice at a 1% rate. $20,000 of gross income. But if the client takes a $1 million out of the account and goes and purchases annuity, that’s a reduction of $10,000 of gross income to your practice. Thus, you have a conflict of interest or a potential conflict of interest. I should be accurate, a potential conflict of interest.

It’s hard to go around that and it’s hard to see the value of annuities when it’s clouded by the $10,000 walking out of your practice. On the flip side, if you only sell annuities. Let’s say that you don’t have a securities license, there are many people like this, so you sell equity index annuities, it’s going to be very hard for you to see the value of the overall performance and low fees that you can put in place in a stock portfolio.

And not see all the benefits of the equity indexed annuity and so, you’re going to lock onto all of the claims of the equity indexed annuity sales force, all the upside potential with no downside returns etcetera, etcetera, etcetera and you’re not going to be open to the other side. This debate is why actually I personally don’t love the concept of fee only.

I think that fee only can have a place but I would rather see both because if the adviser can household and custodian the million dollars of assets and have the $10,000 of gross revenue to their practice and also, they can sell the annuity and have the commission of the annuity, then in many ways, they’re going to be more comparable.

They’re going to be able to look at both of them with a more direct discussion. There’s all kinds of interesting ways that you can look at commission products and say they’re better than the fee only world. So I would like to see them both. I would rely, I also rely on some of the academic research and I’d say look at some of the academics.

There is a value of academics who are not connected to incentivized based upon the sale of products and look at the research that they put in place and what it seems to be demonstrating is the value of annuities but in general, the value of simple annuities. You don’t need a complex product. You can have a simple product.

I’ll also tell you from me personally, I am going to be launching the details of the coaching program going forward in the next few days. The part one component of that is general financial advice. Not side, I am not selling any products, no insurance, no investment products, I believe I would recommend both and I think also that if it were my personal planning, at the moment I still want annuities in my personal plan and my parents financial plan.

More can you say about that? I hope that helps. And then, “Have you ever heard of a fee only plan recommending annuity?” Yes. And, “Was it SPIA or is it a more complex one?” It’s usually going to be a SPIA because of the phase if somebody is working on the planner, “Okay, I got this lump sum of money, I’m going to put it over into a scenario.” But you can have a simple annuity that’s not a complex one.

Last question comes from James. He says:

[1:14:50] J: “If you purchase an annuity at the wrong time or the wrong kind for the wrong company, etcetera, is it possible to go back out and get some of the principle back waiting till perhaps a better time to start the annuitization process over?”

[1:15:03] JS: A good question. It depends on the phase of the annuity contract. In the early phase, annuities are an insurance product. So there’s always going to be a free look period associated with them. In that free look period, that will be associated with, based upon the laws of your state. It might be 10 days, it might be two weeks, it might be 30 days, check the laws of your individual state.

But you can do an annuity transaction and then if within the free look period, a very short period of time, you desire to undo the annuity transaction, then you can simply back out and you’ll get all of the principle back. If you are past the free look period, your annuity transaction, the amount of what you do will be based upon how you chose to pay your sales commissions.

In annuities, you can pay upfront sales commissions or you can pay back in sales commissions. If you were to pay upfront sales commissions, this would work similar to class A mutual funds where you pay an upfront sales commission, then you can back out and you’ll get all the principle back because the account value already reflects the payment of the commission to the insurance agent.

On a backend sales commission, which then you’ll have some sort of surrender charges associated with it and that surrender charge will be an amount of money that if you take it out, you will surrender the money. So this is where you will incur a cost.

Now, this is what angers me about the annuity market place. I don’t mind many of the things that companies do that really upset some other people because I say, “Hey, let the market decide. I’m generally a free market libertarian. Let the market decide, I’ll do my best job to go over things and hopefully the buyer can understand to do their due diligence.”

But I can’t stand the surrender charges that some of these companies impose and some of them are flat out nuts. 15 years of surrender charges for some contracts, in my mind that’s absurd and if there is a place for regulation in the financial markets, it ought to be in some of that stuff. Surrender charges should be limited and they should be a limited duration and a limited amount and that’s what I can’t stand.

Once you’re in it, you’ve got to look at it and there are some different ways and one quick way to look at, if you have an annuity contract that’s been established, maybe it was purchase at the wrong time, maybe it’s the wrong kind, maybe it’s for the wrong company and if you look at it and recognize that the surrender charges to get out of it are very expensive, then what you want to do is look at it and say, “Can I change this individual annuity contract to be a more appropriate type of contract?” And many times, that’s what you can do.

So can you change the investment allocation from one type of investment to another, from a stock portfolio to a bond portfolio? To a bond portfolio to a stock portfolio? Can you change the underlying investment accounts to lower cost sub accounts? Can you adjust the writers and drop some writers?

Sometimes you can drop a benefit that you purchased in the beginning which was some sort of minimum income benefit or a living benefit that was adding 1.5% to your annual expenses, you can just drop that and you’re not incurring the surrender charges in you dropping the annuity contract to a lower value and then also look to see can I do a 1035 exchange?

It is a light kind exchange from that annuity into another annuity and possibly with the same insurance company, and by doing that and keeping the money with the same insurance company, is there a way to wave the surrender charge? There are sometimes some ways out of those thorny situations.

So if you come across a situation that you believe is improper, think broadly about all of the escape routes out of the contract and those are some of the different ideas that I have and I hope that some of those might be useful to you.

So thank you all so much for asking those question. I enjoyed getting those questions on the Patreon page. I don’t always answer them for you guys but I do like to answer them when I can. And hopefully some of these answers were useful to you. An hour and 20 minutes today on annuities.

You, if you my friend have made it to this point in this discussion, you are a rare breed. It takes a special kind of person to make their way through an hour and 20 minute discussion on annuities. I hope you at least enjoyed it a little bit. I hope you found it interesting and I hope you feel a little bit more well equipped.

There are all kinds of different aspects of annuities we could go into. If you were an life insurance advice, you’ve got to be well versed in the taxation of annuities. There is some very thorny aspects of annuities with regards to estate planning. You need to be aware of those, if you are a life insurance or a financial adviser.

I don’t know if I’ll cover that on some point on the show. That’s not a very wide range and interesting topic. It’s an important topic but it’s not a very wide range and interesting topic but maybe at some point I will. I’m sure at some point, I don’t commit to when I will do an entire show in equity indexed annuities because they are such a popular part of the market place.

Some people are real proponents of them. I understand them. I understand why they are proponents of them. I’m not — but if any of you want to come on and talk about it with me, I’d be happy to have you on the show and we could debate it. It might be an interesting podcast for people to hear.

[1:20:13]: Thank you all so much for listening. Thank you for supporting the show. Hopefully you see some of the Patreon benefits even though I’m now having advertising on the show, I still am relying on you, the individual listener of the show to support the show directly and there are many benefits for doing so.

One of them is me answering your questions on things like this. So if you would like to support the show, please consider going to Radicalpersonalfinance.com/patreon. Also remember that over the coming days, I will be doing many more, six more phone calls with you who are supporting the show at $10 a month.

So Q&A, that’s a great opportunity for you if you would like to be involved in the Q&A. As I release this today on Tuesday, October 20, 2015. I did a Q&A yesterday and there were a total of four people on the call so I had an extensive amount of time to speak with individuals about their individual situation.

So if you’d like to get on next week’s call, go to Radicalpersonalfinance.com/patreon. Sign up for the show, check out You Need A Budget. If you haven’t tried it and you need a budgeting software at Radicalpersonalfinance.com/ynab and Radicalpersonalfinance.com/paladin for a financial adviser.

I’m out. Be back with you soon.

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