Analyzing Annuities Through the Prosperity Principles – Episode 039

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[00:01] Welcome to the Prosperity Podcast, fresh alternative personal finance talk for independent thinkers who prosper outside of Wall Street. Here’s your host, bestselling author, Kim D.H. Butler, and No BS Money Guy, Todd Strobel. Hey everybody, welcome to another edition of the Prosperity Podcast. This is No BS Money Guy, Todd Strobel. Once again, we’re fortunate enough to have bestselling financial author and my co-host Kim Butler with us. Welcome, Kim. Thank you, Todd. We’re happy to be here today and we get to cover a listener question, one of my favorite things to do. Super. Well, we’re going to be talking about annuities. And wow, what a controversial subject. A lot of people really feel that putting their money into annuities is safe.

[00:50] And there’s a tremendous amount of hype in the marketplace right now that I think in a lot of ways is misrepresenting the product into something that it’s not. And we really just want to kind of open your eyes to how they really work. They are probably right in some situations, but for most of the folks I’d say that’s getting them, they’re not getting what they think they’re getting. What do you think, Kim? That’s very well said. And it interests me that we have absolutely no annuities on our books because we just really struggle with trusting them. We just don’t like what they provide in terms of meeting our seven principles of prosperity. So we thought we would take the idea of an annuity through the seven principles

[01:37] of prosperity and use those principles as an opportunity filter to check them out. Now, of course, there’s two main types of annuities. We’re going to use the term fixed and variable when we do this. And variable could mean in the stock market like mutual funds, it could also be an indexed annuity and it could be some type of combination thereof. So we’ll jump in, which is the first principle we should hit. Well, I think just we’ll just back up just a little bit and explain what a fixed annuity is and what a variable annuity is just so that people have a complete understanding before we jump ahead. Oh, you want some detail, I see. OK, we can do that. So a fixed annuity is very much like a CD, but it’s offered at an insurance

[02:24] company. They’re probably paying around five, six percent these days. You’ll hear people talk about a death benefit, but that’s really just your principle and it might be growing a little bit, but it’s not life insurance. So an annuity is considered more of an investment. It’s money that’s locked up till you’re 59 and a half. It’s taxed with very specific tax law that goes to annuities only. I don’t know anything else that’s taxed that way. I’m sure there’s something out there, but fixed annuities are just exactly like what they sound. They have a fixed interest rate, usually for a period of time, and they don’t have taxation along the way, but they definitely have taxation when you take the money out as a source of income.

[03:13] I should also make it clear that we’re talking about deferred annuities, not immediate annuities, because immediate annuities create income right now today. These are deferred annuities and typically used as an investment. And most people use an annuity for what purpose? Investments. They put money in an annuity because they’re looking for a rate of return. They’re looking for safety and protection of their principle, and they want those dollars to grow. And a variable annuity is different from the fixed in what ways? It is invested in the stock market. It’s invested in what’s called a separate account. Could be mutual funds, could be what are known as indexed funds, could be a variety or a combination of those.

[04:01] But it is in the stock market and subject to all of the good and bad that the stock market brings. Now, many times you’ll hear about the people that sell annuities and how they talk about some of the downside protection and that kind of thing. But what we found in our practice is that annuities, though they may have some downside protection, the cost of that downside protection is prohibitive for any good gain that one could actually receive from it. So not only are you looking at still some risk, but you’re paying for something that’s a little elusive and very hard to understand. And I would question whether you ever actually get it. And that is some type of protection against loss of principle.

[04:46] The attractiveness, I guess, of these a lot of times are you mentioned the guarantees and also potentially upfront bonuses that people are offered to induce them into the contracts. But in my experience, I have never seen any of these that the guarantees or bonuses were in effect if you were to remove the principle. It is only covered if you later annuitize, which means taking the income over a lifetime, like 20 years or 25 years. So you’re not have you don’t have access to the principle. An example that I have here from the Internet shows an account that was 80,000 with the upfront guarantees and the guaranteed interest rates had accumulated to a hundred thousand dollars over a 10 year period of time.

[05:43] And if the person were to annuitize that the amount that they would receive monthly would be based on the hundred thousand. If they wanted to remove the principle, there was either an opportunity or there was a emergency that they needed to withdraw that money. The actual money available would only be the original 80,000. And again, this is an example off of off the Internet. So I think that fine print’s important. Absolutely. And such a tough thing for people to read and understand. And I believe that investments should be simple. They should be straightforward. We shouldn’t have to go through reams of documents to try to get at what is actually going on there. But nevertheless, again, annuities are out there in the marketplace,

[06:28] both fixed and variable, probably more commonly variable, because people don’t know what else to invest. And so they turn to this age old product. And quite frankly, I just don’t think it really should even be called an investment, because to me, what signifies an investment is double digit return without the potential for loss of principle. And most even the variable annuities that attempt to get a higher rate of return aren’t going to really be able to confidently back that up. Super. So if we take principle number one, which is think and apply it to the annuity, what do we get so when you want to be thinking from a prosperous mindset and that mindset matters, I think many times people run over this

[07:15] principle thinking it’s a little new agey or what have you, but it’s very important that you’re always able to think from a prosperous mindset. Well, annuity money is not available on any liquid basis. And so it’s tough to think prosperously when your money is tied up at an insurance company and you’re still worried about it because it is often invested inside the stock market, inside that insurance company. So we find it difficult to think from a prosperous mindset with annuity money. And then furthermore, you’re so concerned with all of the rules around the annuities. It’s tough to focus on what you’re really good at, which is what you should be thinking about. And then just as we mentioned before, you can sometimes see 10 to 20

[08:04] year surrender charges. So this is really a long-term commitment. Um, and from a thinking standpoint to think that you can say in the next 10 to 20 years, there won’t be an opportunity or an issue where you would need to have access to that cash, sort of that same, uh, 401k mentality where there’s a lot more things that I could probably do with that money than handing it over to someone else. Absolutely. And when we’re thinking prosperously, we want to be as flexible as possible. So great point on that. So number two is C, which is looking from a macro economic point of view. So inside this principle of C, we want to be viewing our entire asset base. And so often it’s very difficult because you get real narrowed in on a

[08:58] particular decision. In this case, annuities stand alone in that they’re very difficult to coordinate in any type of big picture strategy. So annuities are because of their nature, they have their own tax law. They sit off to the side, if you will, on the balance sheet, very difficult to see them in light of everything else, because you can’t really use them in light of everything else. So to me, we’re on a number two and the second principle here with still not having an annuity meet our requirements because we can’t coordinate them with everything else, which is what we need to do when we’re seeing things from a big picture. In order to increase the potential cash flow on an annuity, there’s often the

[09:45] person is encouraged to take a life only payout. I think it sees a good time to talk about what that is. Absolutely. So when you annuit ties your annuity, you take the asset and you create an income stream and that income stream typically exists over one life lifetime payout or over a joint life. You’ll hear it talked about joint and survivor. In other words, a payout that occurs over the annuity owner and a spouse or significant other, whoever the beneficiary might be. So here we’ve got again, an environment that’s very, very restricted. That does not enable you to see the big picture because it operates on its own, completely disconnected from all other assets and you cannot use it to do any of the other combining strategies that we’d like to do when we

[10:40] put one asset with another in order to make both of them do a better job. The annuity has to stand by itself in a very vacuum environment that only operates on its own, not coordinated with all the other assets. So if we were to take an example, you know, if you had a hundred thousand annuity and you were age 70 and you started an annuity income flow, the life insurance company would anticipate the average lifespan of a 70 year old and then create a monthly income or an annual income stream for you. If you were to pass away prior to that, then the insurance company would keep the extra money. If you were to live twice as long as what the average person or what you’re anticipated to, then I guess in a way you could look at it as you were making

[11:31] money on the life insurance company. But again, if we look at it from that C perspective, that almost feels like gambling. Yes. And we want to know that our insurance companies are winning and that we are winning every investment that we take a look at. If we can approach it from a win-win environment, we’ll be ahead. Now we need to remember that the insurance companies are designed to help us with longevity. That’s their job. And so you can still look at it as a win-win. You can get that win-win with other aspects of the insurance company’s capability without tying the money up into an annuity where the insurance company controls it instead of you. And we spend a lot of time talking about the variable side or the

[12:19] stock side of the annuities. But you know, if we look historically at fixed interest rates, I would be very scared right now at the lowest point in interest rate history to say, okay, this is the interest rate that I want to earn on a fixed annuity for the rest of my life at this point in time. What do you think? Absolutely. Locking something in for seven to 10 years right now would be limiting your capability. And so we don’t want to mix savings and investments. If you need liquid money, then put that in savings accounts or cash value of life insurance. If you need an investment, then go after something that’s going to get you double digits. Don’t try to run the middle of the road where you’re trying to get both

[13:05] savings and investment capability. It makes neither one do a good job. And that’s a little bit what fixed annuities are trying to do. Is they’re trying to get you that savings component where it’s fixed, but they’re also trying to get you the investment component, which is a little higher rate of return than a savings account. And of course tax efficient because it is in an annuity, but not so tax efficient when it comes out, because you’re not in control of that income stream, the insurance company is, and the government dictates how it’s taxed. Our third principle is measure. So here we’re talking about measuring opportunity costs. This is not measuring income or net worth. It’s measuring opportunity costs.

[13:47] And when you lock money up in an annuity, again, this is a deferred annuity, whether it’s fixed or variable, you now have that dollar unavailable for anything else. So you’re in a situation where you have an opportunity cost because those dollars cannot be used for anything else. No opportunity that comes along is going to be able to be taken advantage of if your money is locked up into an annuity. And so you have potentially huge opportunity costs because the dollars are locked up, which is one of the reasons that we don’t sell annuities. We don’t like to help our clients buy them. Again, there’s always exceptions and you may have times when it is appropriate, but as a general rule, if you need savings, go to savings.

[14:31] If you need investments, go to investments. Don’t try to use an annuity to run the middle of the road again, because you are going to have opportunity costs associated with that because of the money that’s locked up. And a good question just came in and it’s that is your objection to annuities because you don’t have confidence in the companies that are issuing in them or just the performance of the contracts themselves? Well, that’s a great question. The answer is no to both really. The companies that issue them are just fine. These are insurance companies. They’ve been around forever. They have good, good things that they provide us with. Primarily cash value of life insurance and death benefits.

[15:16] Now annuities are offered at all different types of insurance companies, but it’s not the insurance company that I’m concerned about, nor is it really the performance of the contract. I mean, you could argue that maybe it is on the variable or the index, but it’s the underlying law and rule that go with it. So the underlying tax law is not efficient because of the ways that annuities are taxed. And the rules that go with them. My gosh, I saw an annuity proposal the other day. It had 80 some pages of rules that the insurance company got to abide by. Because this is an example where they’re really supposedly taking on some of your risk, but they’re not, they’re shifting it right back to you in their contracts.

[15:59] So my concern around them is not about the company. It’s about the governmental rules about how it’s taxed and the contract rules about what they get to do and the various things that they get to change and control, and it’s all you giving up control and the insurance company taking that control. And we’re just not big fans of that. We are in a low rate environment. And again, you mentioned those administrative responsibilities, which cause annuities to be rather expensive. And those costs are built into the contract. So regardless of how pretty that it seems on the outside, I think most of them, if you boil it down, you still are looking at relatively low rates of return, aren’t you? Absolutely.

[16:53] And because of the way that the tax occurs, it’s called FIFO. It’s first in, first out. That means that you cannot withdraw any of the gain without getting tax. And annuities have a special inclusion ratio that causes taxation to occur on the gain that they do have. And so you’re going to get stuck paying taxes regardless. All right. Yes. It’d be a good time to move into number four, which is flow. So flow is a measure of cash flow. And this is something that annuities can do a good job of if you have a immediate annuity and there are definitely times that it’s appropriate for people to buy an immediate annuity. And I actually need to go back and correct statement. I am so stuck on how detrimental the tax law is that I use the wrong term.

[17:51] So annuities are actually taxed as LIFO. Last in, first out, not FIFO, first in, first out. So my apologies for a sentence about two seconds back, two minutes back, actually. When we’re looking at the principle of cash flow, we have to be, of course, very aware of the taxation of that cash flow. And so because annuities are taxed as LIFO and they do not allow for withdrawals to occur in anything other than a taxable way and the very special inclusion ratio that the IRS necessitates, it’s very difficult for us to get good taxation on our cash flow. However, again, immediate annuities can provide some very beneficial environments for cash flow. And as a matter of fact, one of the things that we’ll do on occasion is

[18:44] have somebody take their whole life cash value policy and convert it to an immediate annuity. If they’re much later in their years, 80s and 90s, and they truly just want the income, they don’t want the death benefit. So in that case, we’re big fans. An immediate annuity done in your 80s and 90s from either regular money or life insurance money can be a very effective strategy to get you the cash flow that you’re looking at. Now, if on the other hand, you’re in your 60s and 70s, we prefer other bridge loans and things that provide double digit cash flow in terms of a monthly income, whereas annuities typically are not going to provide that until you’re probably in your 90s or so. So again, like all things, you have to look at it very individually.

[19:34] It’s something that must be advised on very specifically for your situation, but I will say that principle number seven, we could check off as a yes, sorry, principle number four flow. We could check off as a yes for immediate annuities because of the cash flow that they provide. Super. And then number five is control. So we’ve talked about this a little bit, but clearly in an annuity, you’re giving up control. And this is one of the reasons that we don’t like it. So we check this off as a no, you are turning the control over to the insurance company, whether it’s a fixed or a variable annuity, you’re still giving up control. And that’s my biggest pet peeve with it. I do not like people giving up control of their assets.

[20:19] And I don’t find it a beneficial strategy to do so even if they got a decent interest rate. And of course they don’t again, whether you’re talking fixed or variable, there’s just nothing that would make it worth giving up control in my mind around this asset class. I don’t think there’s any more I can add to that. You’ve made that perfectly clear. I completely agree. Number six is move. All right. So if we’re talking about movement of money, we’re talking about the idea that your money should move through an asset and what that means is that you have the ability to put the dollars in and the ability to get those dollars back out while the asset is still growing. So good examples of this are cash value of life insurance, bridge

[21:10] loans, even life settlements to a certain degree, enable your money to move. You can move your assets through those products. It can go in and come back out the other side. However, in an annuity, this is not available at all unless you are going to annuitize it right away. And most people are looking at annuities as deferred annuities. And you simply cannot move the money through it. It just doesn’t work that way. You cannot take it back out the other side. Now an annuity salesperson would tell you, oh, you could take 10% every year. Granted that is in their rules. You can, but to me that is not done as a loan. It’s done as a literal withdrawal. So that’s not as effective. We would rather have your assets act like equity where you can borrow

[21:56] against them and annuities cannot in any way that I’m aware of be collateralized. So you can’t move your money through them because they can’t be put up as collateral for a loan. They can only be withdrawn from. And then of course, you don’t have the money working for you anymore. So we’re going to have to check no on the sixth principle of move. All right. And then finally, our last principle is multiply. So multiply means that we get $1 to do lots of different things. And we could argue that an annuity does a couple of different things. In theory helps the money grow and it definitely gives you some tax benefits while it grows. However, it does not give you any tax benefits when the money is coming out.

[22:41] And again, we’ve lost control. So we don’t have that job. If you will, we want $1 to do lots of things. We, we use the term jobs. We want it to do many different jobs and tax efficient income is one of those jobs and annuities are not tax efficient, they’re forced into this LIFO tax method where you’re going to pay income tax, not capital gains tax on the income out of an annuity. Again, typically a deferred annuity, but even an immediate annuity has that same tax law. So it does not qualify in our minds for the seventh principle of multiply. And so we, to summarize, have one yes and six nos. Sorry to say that clicks annuities off the list in my book. So if you are in a situation where you need immediate regular cash flow,

[23:35] which is our principle number four, the annuity stood up pretty well, but pretty much in all the other categories we had to wipe out. That’s correct. That is well said. Would encourage the listeners to contact partners for prosperity. Again, that’s partners, the number four prosperity.com. There’s more recess resources available on the website. And Kim, I believe you brought a gift with you as well, didn’t you? Absolutely. So this is our ebook we’ve been talking about. We want to make sure you get a chance to download it. It is going to get a price tag added to it very shortly here. So it is free to all of our podcast listeners, 60 pages of good three or four months of work on our part. And we’re happy to give it to you.

[24:23] It is the financial planning has failed ebook available at partners. Number four prosperity.com slash ebook, uh, 60 pages or so, and a couple hours on an audio version. Again, that’s partners. Number four prosperity.com slash ebook free to our podcast listeners. Super. Well, we just had another question, uh, emailed in, which is a good one. And that’s what, if you already have an annuity, what’s your recommendation? Yes, of course. I’m glad that came in. So please, please keep it in most cases. You should keep an annuity that you’ve started. Now, if you’ve owned it for longer than it’s surrender period, so seven to 15 years kind of depends on the company, then we could take a look at moving it and of course, it’s going to depend on whether that annuity is

[25:15] inside an IRA or not. And, uh, that’s something that we would have to have a personalized discussion on, but if you have an older annuity with no surrender, then we can look at moving it to another asset. And if you have a younger annuity, which still has a surrender charge nine times out of 10, it’s going to be too difficult to overcome that. And you’re much better just holding onto it until you get to the point where there is no surrender charge. And then we can help you get it into an environment that does what it’s supposed to do. So if your goal was savings, we can go the cash value method and get you cash value of life insurance. If your goal was investing, then we can do the bridge loans or the life

[25:56] settlements more effectively to actually get you the types of investments that we’re looking for again, double digit, no loss of principle. And yet if it’s a younger annuity, it best stay put, not worth paying that surrender charge in most cases. Although I have to admit we’ve had a couple of clients say, I went out of this so bad, I’m willing to pay. And sometimes as you get towards the end of your surrender period, the surrender charge is not that much. And it might be worth paying at that point, but we’re not big fans of paying surrender fees if they’re not necessary. And hopefully if you’re in this process of looking at an annuity right now would strongly encourage you to look at those surrender

[26:36] charges and the restrictions on what you have to do to get the guarantees and the bonuses. These are sold based upon guarantees and bonuses. And what you don’t see are caps, participation rates, and the penalties if you try to touch that principle. So as long as you fully understand what you’re buying, I don’t have a problem with somebody buying an annuity, but if you think you’re getting something that it’s not, then there’s a problem in our industry right now with that, that needs to be addressed. Very well said. I appreciate your additions on that. And again, we’ve offered a couple of times that this is an area that may need an individual conversation. So we welcome you to reach out to us, partnersforprosperity.com

[27:25] in the contact us section. We’re more than happy to help. Super. Well, this is No BS Money Guy Todd Strobel for the Prosperity Podcast. Again, today’s subject has been annuities. Thanks, Kim Butler and take care of everybody. Thank you for listening to the Prosperity Podcast to take control of your money and have it work for you. Visit us at partnersforprosperity.com. If you liked this episode, make sure you subscribe and leave a review.