PODCAST EPISODE 284 – How Annuities Work…Or Don’t


0:12 – Start of the episode

1:43 – What is an annuity? A vehicle?

4:48 – What does an annuity do?

10:23 – What happens inside the annuity?

13:00 – The investments inside most annuities.

17:27 – No upfront sales charge.

19:12 – The different types of annuities.

21:46 – Qualified annuities.

26:08 – The downside of equity indexed annuities.

28:45 – Be your own fiduciary.

[Tweet “An annuity is a vehicle, a wrapper that gives you a deferred tax until you take the money out of the annuity. #YourBusinessYourWealth”]

[Tweet “The investments inside most annuities are almost always overpriced, even though they look a lot like mutual funds. #YourBusinessYourWealth”]

[Tweet “The one-way nature of going into an annuity means once you are in there, you can’t reverse course. Some annuities in some states have a 10-day free look, like life insurance. #YourBusinessYourWealth”]

[Tweet “An equity-indexed annuity could be a good option for those who are risk-averse. #YourBusinessYourWealth”]


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Full Episode Transcription



Hello, and welcome to sound financial group podcast. I am Paul Adams, founder of sound finance group, I’m joined by Corey shepherd who recently updated his camera settings, as you can see, created an error. His shirt is now not displaying on the camera as blue seems to be an error when he didn’t put on a red shirt, so yeah has to be the only outcome. Good morning gore.


Hello, hello. So name it evening, wherever you are,


wherever you are, we are going to talk about something quarry that just reminds me of South Park, we are not going to respect your authority, but we are going to respect your annuity.


We are


we are going to walk you guys through the basics of annuities how they work, you’ve heard about them, you’ve heard that they’re great, you’ve heard that they’re terrible. And we are going to show you both sides of that coin. Today, if


you if you heard that they’re exactly medium, then put that in the comments too. I’ve never actually heard but someone’s out too hot


or too cold, too big, too small, right? Or just right. And usually like most financial products, it could be just right, if they are fit in the appropriate way into your financial picture. So Corey, maybe just Would you just talk a little bit about what people are dealing with with annuities, how they get proposed a little bit about how they got a bad rap before we get into how they work.


So first of all, let’s just get clear on what an annuity is. An annuity isn’t a Roth IRA, or traditional IRA. Although those two kinds of accounts can be in an annuity. An annuity is just a vehicle a wrapper that you can set some different accounts and set some different kinds of money in and put some other different wrappers around it. I mean, let’s go with a vehicle metaphor for a second. And annuity is a new truck that you can buy for your money and put a whole bucket in the back. And then there’s lots of different kinds of trucks and kinds of options that you can put on the let the truck do a lot of different things. But it’s lots of different kinds of of money. So at its baseline, an annuity is going to do one thing is going to give you a wrapper around that money. So that tax is deferred until you take the money out of the the annuity. So if you have an IRA, and you put it into an annuity, that’s one thing that you’re not getting any additional benefit from, because your IRA already has a tax wrapper that you’re not paying until you take the money out. So it’s just like, double wrapping paper from that that standpoint.


Know? If, if I may, I didn’t mean to put you on the spot here, Cory? Yeah. But now Cory has been in the business since what year what year did you get in the industry


2007 2007.


And this is an almost 20 years. It’s an enormously deep and complex tool that comes in lots of different shades. And when asked to simply how does it work? What does it do? It pulls in all these different things. So we’re going to take one at a time. That’s a bit of a demonstration about how difficult these tools can be built to understand and to explain. And so we’ll take it away from Corey having to only use metaphors to explain it and we are going to wear to the whiteboard. So to Corys point I want you to think of something there is an annuity and the annuity is a vehicle I think that’s a great way to think about it. Let’s just grab our black pen here and we’ll put the annuity now the annuity has some tax ation that comes along with it. Now we’re going to be talking at first about something called a non qualified annuity. So if you guys hear anybody say non qualified, what that means is it’s not under any IRS program. Sorry for my slow speech there is listeners have tried to write while I was talking.


This is one of my favorite parts about the financial industry and my favorite you know, a kind of mean the opposite where they label a thing based on what it’s not. Oh, right. So that that means it’s not a retirement account retirement accounts like your IRA or Ross your 401k. All those different flavors are all set up in a way that they follow the specific rules has to be qualified as a retirement account. So everything else is a non qualified.


That’s right. That’s right. So a non qualified annuity, we’ll talk about just how it works. Now, there’s like three different levels. There’s the house, if you will. So if we call this our vehicle, like a car, look at my great little car drawing over here. It’s a car windshield, shaping up manche. I don’t think this thing’s going to do very well in this crash testing


around the new light because it was in the car,


oh, well, we’ll get there. I’m labeling him individually. Now the car could be parked inside of a building, which we weren’t not talking about yet. So we’ll leave that there. And then inside the annuity can be the contents payload, what’s its carrying? So that’s going to be what the investments are. So first, let’s just cover what the annuity does. So an annuity it is going to take our money. So if we’re under age 59, and a half, we put our money in Korea, do we pay any taxes while it grows? We do not. So our gains or interest are tax deferred. So we don’t pay taxes on that money while the interest grows. So put in $100,000, it’s worth $200,000. At retirement, we pay taxes on 100, the first 100,000 of our withdrawals, if we take it as a straight withdrawal, okay? That is going to get taxed when we take our withdrawals as regular income. So it doesn’t matter how those gains were created in the underlying counselor invest in it’s all regular income. And so that’s Let’s capture that that’s taxed at regular income tax. So it’s gonna get taxed that interest just like the money you pull out of a 401k, the earning part. Now, if you take it out prior to age 15 and a half, it’s a lot like IRS rules or IRA rules, that you will pay a 10% penalty, but only on the interest part if you take a premature distribution before 59 and a half. Now, what people will say, is the benefit of putting money in a non qualified annuity as you get to defer the taxes and isn’t that great. But here would be my cautionary tale on that part, we’re not going to get into math. Today, we’re just going to talk about an concept that if I was going to compare an investment, I’m just going to use this little territory up in the upper right hand corner for a second Corey that I could largely have my taxation at long term cap gains. And some deferral because I’m only rebalancing a certain amount of the portfolio, if I just bought a set of investments, an academically allocated globally diversified portfolio, for instance, I’m going to mainly pay long term capital gains, and I’m going to have some interest due, but that will be lower tax bill. So if that average is, say, 22% During my earning years, but me deferring all the taxes on the gain inside the annuity means I’m gonna retire in a high tax bracket, and I’m gonna be paying 32%. But all at the end, there might have been a lot of value to me just allowing that money to accumulate under my control, with my ability to access it anytime. Because if that was a non qualified investment account, I mean, those restrictions taking money before it’s 15 and a half and dang sure, no penalties.


Of course, you know, Roth, Roth type of taxation, full withdrawal, no tax is our favorite kind of taxation. But yes, long term capital gains is the nice is like the sweet, sweet, second cherry and mine, like it’s generally more favorable. So doing anything that would take you away from that into the federal income tax brackets is a thing to be done with great consideration and intention. There could be some reasons there could be, but don’t do it haphazardly.


Yeah, they need to be darn good ones because we’re going to give up access to our money from current age to age 59 and a half, we’re going to have irrevocably changed the taxation on any earnings that it earns inside of there. Though there are some benefits when it comes to distributions of annuities, which we’ll talk about in just a second. If the annuity was annuitized. And let’s use that same example where I have like 100k I put in and 100k of gains, so 100k of principal and 100k of gains, the 100k of gains has not been taxed yet. Then if I knew it times that over my lifetime, I will get something called an exclusion ratio. And it’s going to assume because I’m taking these payments over my entire lifetime, I don’t have to go through all my taxable amount first, to get to my tax free amount, they will give me a ratio across my lifetime, something like 25% of each of your distributions are going to be taxed. So


that’s, you know, Paul, I think we’re now we’re starting to talk about what happens inside the annuity once money is in there. And I should have said this at the very beginning, maybe we can, we’re not going to add it in, you’re just gonna hear it now.


But if you want to go back to the beginning, and pretend that you heard Cory say this, right?


If you are listening to this podcast to get a really quick and simple answer, like is an annuity for me? You will not get that because that is not a simple answer. Because there are so many different kinds of annuities, if they practically should have completely different names, frankly, like they shouldn’t just all be called an annuity because of how differently they act, different promises they deliver or don’t deliver, and fee structures. So that’s, you know, we’re not out to, we’re not going to just change the industry overnight. But that would be a good thing to lobby for is a three or four very distinct product name. So you’ve more quickly know what you’re even talking about when you hear the word.


I’m gonna take a slightly different shot at what you said, Gauri if you’re keen to this podcast to see if an annuity is right for you or not. It’s not. It’s not You’re not the right person for an annuity. You know why? Because you shouldn’t be listening to a podcast to come to that determination on


course, yeah. Gravity pulls you down. Of course. Yeah. Thank you. Oh, wait, oh, we’re doing it that way. Yeah. Okay.


Corys cores, little under the weather today. So he’s, he’s getting mean to me by like it. Okay. So now we have our annuity, we do have that benefit of maybe we get some exclusion ratio in the future, when we take distributions. But again, we have to give up control to get that because now we have to get lifetime payments. There’s high, high, highly valuable reasons to have lifetime payments, especially to secure part of your income, like a pension from say, if you’re a it’s like the one thing everybody, like most admires about firefighters isn’t their bravery. It isn’t the cool trucks they drive around or the equipment, they like that pension is awesome. Or the 24 on 48 off. Those are the two things people really look forward to firefighters. So very similar. People can use an annuity produce a lifetime income, but it restricts our money a lot. Because also, let’s say you don’t like the annuity you’re in, what’s your only thing you can do is roll it to another annuity.


If you wanted to tax free rollover, X ray, roll it right.


Yep. And you don’t want to pay those taxes and penalties. And there’s a few other things. We’re going to cover this as we get down to that investments part. And then we’ll finish off with the quote unquote garage you park that car into. But the investments inside most every annuity, if there are investments that look like mutual funds, they’re almost always over priced by a lot. I’m gonna give you an example. I reviewed an annuity this morning from a client of mine and it was called a variable annuity. Now a variable annuity has inside of it something looks a lot like mutual funds, but it’s technically called separate accounts. They work a lot like mutual funds.


Why are they looking like mutual funds but not called mutual funds? It’s though that folks don’t need a securities license to sell them to you.


Yes, not this same kind of


securities license to sell them. Yes, you do this. The other reason there’s several different types of annuities that have different licensing requirements like those should be called completely different things


agree. Agreed. Okay. Keep going ran. I love it. Okay. Variable annuities looks like mutual funds usually a limited set like eight to 12 choices of the mutual funds you could invest in some products allow automatic rebalancing others don’t. But just the underlying investments now to give some standard, the typical portfolio we use has total investment level costs, not the advisory fee that pays sound financial group, but investment level costs of like point two 7% Okay. When I looked at this client’s variable annuity today, the funds inside of it ranged from half a percent a year to 2.1% per year. Now that’s before some thing called the mortality and expense charge that is also in there. That is just the fund level costs, you’ll find things like international small cap, or some specific, even a US small cap like us heavily trading fund that they’re they think they’re doing a lot of research to get you better returns. We know that’s not likely, according the academic research. But those are the ones that are hot closer to 2%.


You know, I’ve, I’ve seen clients, I’ve met them, they have an annuity, very similar to that similar costs. And it was an IRA account, it was a 401k that they roll to an IRA that they put into an annuity. And it had no other bells whistles or what we’ll call safety features. Yeah. So yeah, we’ll get to that next. I had to tell them like this is, you’ve been sold just a little, just a more expensive investment account, more expensive version, which you had before, because you’re not getting tax deferral, you already had that with the IRA. It’s the same kinds of things you could invest in elsewhere. They’re just charging you more for it. So when you’re looking for an annuity, if you’re asking if it’s right for you, asking, what is it giving me that I don’t have now, and make sure that reason is something that’s really important to you. Otherwise, it may be just paying somebody somewhere more money and not actually giving you anything else.


That’s it. Yeah, it could be like the result of not shopping well, for something, you’re going to overpay. So that’s the next stage of something that can be valuable people add is something on a variable annuity, that will be like an income guarantee, they often call it a withdrawal benefit rider. Now, this can be highly useful. What it basically says is, over time, as the annuity grows, even if it drops in value, we’re going to let you take a lifetime income of four or 5% off of this higher number. Now, the benefit I’ve seen in it is that allows somebody to get into market based investing, with some of their money that they’re a little more worried about, like allows them to have part of their plan, be on a path to sufficiency, but it needs to be selected very carefully. We need to shop for the lowest fee of those types of programs and on the annuity itself. And last but not least, we talked about people make money on these the advisors. But if you look at it, one thing you’re gonna notice is there’s no sales charge when you go in. Cory, how do they get people into a product like this and not give them a sales charge upfront? No, it appears to be no fees. I put $100,000 in all 100 goes someone give me a bonus. I’ll put 107,000 in for me. How do they do that? Cory?


Well, there’s no upfront sales charge. But there’s something called a deferred contingent sales charge.


And I love the acronym CDSC. Tend to deferred sales,


or CV, right? So so basically, they say, we’re not going to charge anything extra now. But if you want your money, if you want more than 10% of your money in any given year, we’re going to charge you a lot. Like way more than they’d ever get away with charging an upfront sales charge, often in the first year can be 7% is pretty common. Yeah, I’ve seen as high as 10. I don’t even know if it’s legal to do 10 anymore.


They’re there. They used to be around 12 and 14 in the first year. So it’s very normal to surrender penalties on these are eight years long, seven years long. We’ve used


by a percent a year until the very end, and then they fall away. Yeah,


and they fall away it’s very in. The drawback is though, we just talked about how the fees are higher inside of it. And now you’re obligated to stay in to this tool, let’s say a tool is costing you a percent and a half more years than it ought to. And the only way to get out is to wait out that surrender charge and continue to pay that higher fee. That’s why you want to be really well thought out before any money goes into one of these. Now, the other things that can be put inside of one of these is it could just be fixed investments, you know, where there’s a big insurance company and they’re gonna say, hey, you know, we’re just going to give you the same rate of return that’s on our general account every year. And then there’s another one that’s called an index annuity, a fixed indexed annuity, they have a bunch of different that’s actually the problem Korea they have more names than they actually have products. Right, right. This is the reverse nucular split dollar fixed income return according to the you know, speed of the African swallow annuity.


And then every every company has as their own brand name for the annuity product that they release, like the aviator choice or any continental plus that yeah, it’s all like they just went through it this, Doris and just like, what’s word for really good? And then you know, yeah, and so thanks to annuity is kind of like a like a CD, except you’re getting from a bank, you’re getting it from the insurance company, you buy it, usually a certain amount of time, guaranteed interest.


And then the indexed is on the movement of an index. And you get some percentage of that index is movement. Your big, big, big deal. If you are considering an annuity, I’m going to go back to what Corey said at the very beginning. If somebody is selling you an annuity, you just need to come out and ask them. Are you licensed to manage my money for a fee? And then if they say no, and say, what other products can you sell me other than this fixed annuity? Because many of these advisors doesn’t mean that they’re unethical, they could be doing good work. At some point, it’s the beginning of our careers, Cory and I, for some limited period of time, we’re both insurance licensed only. Yep. Although it’s important for you to know if the reason you’re getting proposed a product is because they can’t propose any other ones. That’s just fair for you to be aware of. Right, right. Yeah. And now so that we have all these different kinds of investments that go inside of it, we’re either going to be getting whatever the fixed rate is that the company gives us, we’re going to be getting a fixed rate based upon the movement of an index, that’s the index option, or we’re going to be in these things called separate accounts that looked and act a lot like mutual funds, but more expensive. So if we have that annuity, we know the annuity can be non qualified. Now let’s look at if it’s qualified, which means it is under one of those IRS structures. Because the things that can hold an annuity contract are like a 401 k. Now, there are 401k annuity products out there. Out of all of our 401 K’s we took over as advisor of record on a couple of plans that are annuity based plans, the differences in those plans, the employers are huge. And as a result of the employers being huge, the cost on those plans are like next to nothing. Because there’s so much money, it’s very different your $100,000 annuity versus a $14 million investment in a company plan, they make it really, really, really skinny down and costs because they know they’ll lose the 401k If they don’t, in fact, they offer totally different kinds of separate accounts inside many of these 401 K’s then the same companies will offer inside their annuities. So it could be in a 401 K, you could rollover a Roth 401 K to a Roth IRA or rollover a Roth IRA, from not an annuity to an annuity. Same thing with a traditional IRA. Any of those Vietnam remember, it could be a non qualified annuity. It’s not inside any those we we parked outside, right, but if we park it in the 401k garage, now, we have all the expenses of an annuity. But now none of the accompanying tax benefits of deferral because that’s already contained inside the 401k. But now, we’ve added problems like the 401, Ks and IRAs come along with them things like required minimum distributions that we’re gonna have to follow. We’re going to have fully taxable distributions from the 401k, etc, or in the case of the Roth, we’re going to have tax free distributions, but because we just put it in an annuity, we’ve got eight years of potential surrender penalties if we try to take the money out. So our point here today is you might be proposed an annuity and there can be really really great reasons to get them guaranteed income, and amount of your money having guaranteed investment results. Those are all really good reasons to have an annuity. But what people neglect is the one way nature of going into an annuity means once you’re in there like you can’t reverse course some annuities in some states have a 10 day free look kind of like life insurance. So if you’ve got one last 10 days, and you need to know if you need to get out of it you need to know in the next day or two, reach out to us immediately. And we’ll do our best to try to help g


way.com. That’s info at SF g way.com. I think the and I agree and I’d like to give an example of one like that I helped a client with a great reason. But this is where the more different features that are added and they have crazy names for it and the bonus this and the guaranteed this and the Phantom account and you can feel like you talked about Southpark balls. It’s kind of like that episode where there’s what is it the garden gnomes steal our socks, and then something happens. And profit comes out, right? Yes, that’s what I feel like, we have to be really clear that there are some crazy things going on under the hood. But there’s benefits. And there’s always a cost offsetting that benefit in some way, that we’ve got to see if it’s really the right, the right fit for us. So I like I helped someone who was, you know, towards the end of their relative retirement journey, older and older and yours than average, and super risk averse, then all of their liquid cash and savings accounts and CDs. And there’s just several years ago when CDs, like the best CD that they can find was like, 2%, five years. Yeah. And they wanted something that was going to do some amount better than that, but really not have a lot of risk of, of loss. And so really well, there’s a thing called an equity indexed annuity that I think could work. Now, most of the time, when equity indexed annuities are presented to folks. And if you’re 35 to 45, or 50, and you’ve heard an equity indexed annuity, or you’re about to get one presented to you, they’re going to emphasize the upside potential, how you can have market like returns. Paul and I have studied this time and time again, and you know, we know what’s going on underneath the hood, in an equity index annuity. This is what’s kind of funny, you don’t own anything, you don’t own any stock or any separate accounts, the insurance company just lets you pick the index that you want to follow that they’re gonna give you interest on based on how that index does. So they don’t


even invest in the index. At best, they buy options to offset their promise to,


well, that’s how they do it, right, they have to buy some options to make sure that they’re not, they’re not getting in too much trouble if something goes crazy, but they’re just taking the money and doing whatever else they need to do with it and guaranteeing guaranteeing, but crediting and return. So when you take into account, all of those different, like they have caps and floors and returns, I do like that equity indexed annuities, if you don’t have all the extra riders for income or things like that is just growth, they generally don’t have a standalone expense charge in there, because it’s just whatever you’re getting credited. But if the market does 10, you’re probably only going to do for that year. So basically, I did all the calculations and showed this person that my estimate would be best case, they beat the, you know, 2% CD by a percent or two a year. But still like they can’t get a return lower than zero in any of those years. So some years, they might actually do worse than the CD. But on average, they probably should do a little bit better. Like that was really just kind of a reasonable kind of not getting overly exuberant, just a very sober, like, here’s probably what’s going to happen. And that was perfect for them. That’s exactly what they want in that situation. But someone who’s 40 I think is going to be disappointed by the net outcome of most of those index performances compared to what they could have in the in the stock market without all those constraints over a 20 or 30 year, year period.


Well, and we probably need to do a separate episode on the ills and evils and what can go wrong with equity index annuities, but but I want to share one with the team here that we just heard from our partner, Jeff Miller this morning. All right. Right. And that was, he was sent an annuity that was touted one of our clients, which we never mind our clients go talk to anybody else, just bring back and make sure we check the math before promises they’ve given you. Because in this case, it was touted the annuities great. We’re gonna give you stock market performance, whatever it does, we’re going to give you it’s returned up to 20. Never a year that’s less than 1% was kind of a promise. Well, Jeff being the enormously thorough man that he is, he goes back and checks the index that they’re proposing. And that program, that index hasn’t produced over 3% in like the last decade, as average. So think about that. They’re touting and selling him on luck, 20% cap, but the actual index they’re gonna put him in has no shot at getting anywhere near the cap. And when he pressed back on the company and kind of made like, a little bit of like, you know, we’re not contracted with this company like, Hey, I think you’re doing wrong. They just wrote back and said, Oh, that’s an all the disclosures. Like I don’t know why you have a problem that’s down in the disclosures, the very thing that you’re bringing up And it’s like, just look at their brochure design. They are intentionally distracting us from those disclosures.


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