7 Drawbacks Of Annuities

 annuities and we'll talk about this a little bit later. They're not checking accounts Caleb and they're not designed to be checking accounts. I've always described them as a medium to long-term vehicle for you're putting your money in for the medium to long-term. If you're putting your money into annuity and you need it all back next year, you've got problems because they're not designed. Now the annuities have liquidity and we'll talk about that. They have restrictions but they have limited liquidity. But look, you've got the wrong vehicle. Somebody put you in the wrong product. That shouldn't be that. Got it. Okay. Hey everyone. Welcome back to another Intentional Money Matters segment with the Better World Podcast. I'm here with Harry Stout and we're going to be talking about some of the drawbacks to fixed annuities. And so yes, you heard it. We're going to be talking about the downside to annuities and before you get all excited or something. We're we're we're pro doing the best thing for people and Harry, you've written a whole book on annuities and you know, I've seen annuities work in amazing ways for people and hopefully you can explain why people use annuities. But also if you're in the market of looking for this and maybe incorporating this into your retirement plan, like you got to understand some of the downfalls because unfortunately we live in a world where some people cut corners. They don't know what they don't know and we've all met someone that's maybe has an annuity or something like that in their portfolio or in their life that is a hindrance in drawing them back. So with that, without further ado, why don't you take us away and I'm going to be taking notes as well. All right. So let's let's talk about annuities and actually for the audience, I've been the CEO of two of the nation's largest annuity companies. I probably have sold an excess of 30 billion of annuities in my life. So I haven't wanted to say I'm the 30 billion dollar man or something like that. But again, annuities are a tool, Caleb. And I think what that's what people have to understand. They're not for everyone and they don't solve everything. But there are drawbacks. Now, I just think as you described, I think people need to understand what those are. Now, one thing that's happening this year that's different maybe for a lot of people in your audience is when they get their 401k statements, they're going to begin to get income disclosures about how much income that how much income your 401k balance would generate. And there's some requirements for what that disclosure looks like. They take it to age 67. They're have some assumptions of the type of annuity they buy and so on. I think that's going to shock a lot of people Caleb because someone will say, I've got $100,000 in my 401k. The world's wonderful. But in reality, it doesn't generate a lot of income. So I think annuities are going to be more on people's lips this year. They're going to be asking more about them and they need to have a comprehensive knowledge. And so there are drawbacks. Now, give me an example, fixed annuities for one. How do you earn interest on them? Typically, the insurance company declares the rate of interest on that annuity product. But it's usually for one year. But the annuity itself, the fixed annuity may have surrender charges or a deferred sales charge that's five or seven years. So you're relying on that insurance company to pay you a competitive rate for the other years for which the product has a surrender charge. And so that is a drawback. Now, there are some annuities where the interest rate is the same for all years in the surrender charge period. They're called multiple year guarantee annuities. So that you're safe if you totally safe if you buy that. But this has been the way in which annuity products fixed annuities have been designed and marketed for years. Appreciate that overview. And yeah, I know that let's get into this list. All right. So that's that's number one is the interest crediting restrictions. They can change every year. So the the care the life insurance company sets that rate of interest every year. Is there a question that we can ask or making sure that we avoid when when Ezra relates to that that potential number one downfall? Well, I think that's I think that that's a really good. That's great question Caleb. And I think you can. Most insurance companies, really good annuity companies, we'll publish what's called their their renewal rate list their renewal rate report. And it will show how they've renewed their annuities over a number of years. The really quality companies stand behind that. That's a selling point for them. But in the course of the sales process, the consumer should ask, how will this product renew? Can I get a copy of the renewal history? And they can do legwork on various the company that they're looking to buy from to see if there have been any major complaints. So I think you know, you can you can do that. So number one is interest crediting can change. So that's a drawback. Number two, now this is shocked to some people because they really haven't been presented with it. But annuities, the income that you earn on an annuity is not subject to capital gains taxes. So say you buy you buy an annuity for $25,000. And in seven years later, you've decided to cash it in and it's worth $50,000. That 25,000 of appreciation is ordinary income. So there's no capital gains. And one of the reasons for that is when the Congress and the internal revenue service put together all the rules relating to annuities and they grant annuities tax deferral. annuities for one of the only vehicles that have tax deferral. They said, look, you can have tax deferral. I'll let you defer it up until you know, up until the time you retire and so on. It's forever rather it is still a tax deferral. But we're going to give you some restrictions. And one of the restrictions we're going to give you is no capital gains tax, no capital gains tax benefit. So you're stuck with that. And that is that's the reality of the way the products work. Yeah. No, Harry, is it fair to say that if people are cashing out, there may be not, you know, staying like it that tells you that they had a bad annuity to begin with? Or are there some annuities that the whole goal is to cash out? What is your thoughts on that? There are products that are accumulation based so you would cash out. And there's some we could describe many seniors use multiple year guarantees annuities as alternatives to certificates of deposit. And they either live off the interest or decide to cash it in because they need that flexibility. So some use for accumulation. Others, you know, they maybe they have a life event that they hadn't planned on annuities. And we'll talk about this a little bit later. They're not checking accounts Caleb. And they're not designed to be checking accounts. I've always described them as a medium to long term vehicle for you're putting your money into the medium to long term. If if you're putting your money into annuity and you need it all back next year, you got problems. Because they're not designed. Now the annuities have liquidity and we'll talk about that. They have restrictions, but they have limited liquidity. But look, you, you've got the wrong vehicle. Somebody put you in the wrong product. That shouldn't be that. Okay. All right. The third, the third thing that you see in the marketplace is many of the companies will sell a fixed annuity. And they'll offer a bonus interest rate. They'll say, look, you know, our normal interest rate is 3%, but we'll pay you a 3% first year bonus if you come over to and buy our product. So you look at that and say, I'm going to get 6% for the first year on fixed money. That's wonderful. I'm going to do that. Well, you know, drawback, you need to make sure how you qualify for that 3%. Sometimes they'll say, we'll give you that 3%, but you, you have to stay with us for five years. So you vest on that 3% over five years or in some cases, you'll only get that 3% if you, if you take an annuity stream from us versus a lump sum. So there are restrictions. So please be careful when you buy an annuity that offers a bonus to understand how you qualify for it, how it vests and how you'll be able to use it. But just a little, it's interesting how the marketing and the draw, so because some, some financial professionals, I know will not sell bonus products. They just won't because they don't want to get involved in that because they're concerned that that's an improper approach. Other sell them, but they fully disclose exactly how they work. And I'll tell you, I bought a bonus, I bought a bonus, I want one of the annuties I own, I bought a bonus. And one of the reasons was I knew exactly that money was going to sit there for that was a 10 year pro. I wasn't going to touch anything for a decade until I was going to convert it into income. So that was a great thing for me. So, so I bought that and I've used it that way. So that's what the key issue there. That's number three. Now, number four gets back to the issue that you and I were hitting on as limited access to cash. annuities are again medium to longer term vehicles. They have something called a surrender charge. So if you say it's a seven year surrender charge annuity, there'll be a surrender charge. Typically goes seven, six, five, it'll step down over the over the seven year period. And that's just the way annuities are designed. The carriers need that in order to make the economics of the product work and also to pay what are normally higher rates than other fixed income options in the marketplace. So if you buy an annuity and you something happens and you need the cash, maybe you didn't expect you were going to need it. But your roof goes bad or a health issue comes in. Well, there are ways you can get cash out of the and most annuities will allow you to take 10% a year. What's called a 10% free withdrawal. Others you can do a partial surrender, a full surrender, or they have other income options that are allowed you to to to draw money from the annuity contract. The key is there are restrictions. You need to understand what those restrictions are and be able to live with them. Yeah, one when I was working at the bank, there was a company that had did a fixed annuity. We kind of used it as a CDL alternative and they had a 20% free withdrawal and a five year in a five year time period with pretty low surrender charges. And so while the interest rate wasn't the highest, like there was other annuities that were higher when it came to flexibility, when it came to the reason why someone would opt for that versus others is is the more liquidity because you and I have both experienced people that have might be locked into a quote unquote good annuity, but life changed and they need access to money. And now they're paying some type of penalty on top of other things just to access their money. And so that can be a very negative thing depending on where you are and if it's suitable for you. Right. And I think one of the things and you bring up a really great point Caleb, what percentage of someone's liquid net worth should go into an annuity? And that's been a it's an age old question. I think what we find in practice is the answers anywhere between 25 and 50% of a person's liquid net worth typically related to age older people might have a higher percentage because they need that income to last the rest of their life so that you'll see that. So I mean that's one of that one of the issues that are there that you have to kind of work through, but different annuities, different flexibility, different approaches to access cash. And that's what if you're buying an annuity or if you're selling an annuity, your consumer that you're working with need to need to understand those withdrawal features. And if you're buying you definitely do so that you can look at them. And by the way, a lot of the carriers of that had really nice new features. If you over the last decade, 15 years, they've added if you're terminal yield, you can get the money out without a surrender charge. If you are mandated to go into a nursing home, you can get the money out with any sort of surrender charge. Some have other provisions if you're just if you have a long term care event and you're not unable to perform three of six ADLs, you can get out without a surrender charge. So carriers have been creative. The key for the consumer is to understand what you're buying and the provisions that are there. The other thing in just playing devil's advocate. Playing devil's advocate is we surrender charges are good for an annuity company because it creates stability. And when they tap into mortality credits and other other assumptions like rate of return on capital and so they can fulfill their promises on other of the people that have those products like those surrender charges create that insurance for the company. And so we sometimes look at it from a consumer standpoint, but it's not a so cut and dry where you want to go with the company that has all the quote unquote xyz best surrender charges because that also potentially creates some laws on the back end. It's just just my nature of playing both sides. But no, it's a balance and that's true. That's exactly true. You surrender charge are needed by the insurance companies. There's no doubt about that, but they do enable them to pay higher rates potentially. And because they're going to invest the money in longer term bonds. And if you're going to have a low surrender charge and take the money out, they could be left holding significant losses on the bonds should interest rates change dramatically. So it's a given take. But again, I think the key is anyone buying an annuity should have a pot of liquid cash somewhere that they can draw on for those those emergencies in life. I mean, you shouldn't be looking for the annuity to be your emergency pot. Hopefully, it's there to create that supplemental income flow for you later. Yeah. Now another drawback and this is one we we want to thank our folks in Congress for adding is that if you take out any money from an annuity prior to age 59 and a half, they have this wonderful additional 10% penalty tax that you have to pay. Now, there are some ways to get around that 10% tax that I won't go into a tax professional can provide you guidance. But if you take the money out prior to age 59 and a half, you're going to get a 10% additional tax penalty. And why is that? Congress said, look, we're creating annuities and a great giving them tax deferral in order to create a supplemental retirement vehicle. That's what we're trying to do. That's what we're trying to get we want people to use them as such. So we don't want people putting in the money into an annuity and taking it out right away. We don't want that doing that. So that's the approach there, but that 59 and a half situation is something that you really have to understand and it's a drawback. And Harry, that is on the interest, correct? The penalty would be on the interest, yes. So if you if you had a qualified plan, it would obviously be on the whole whole amount. If you did a non-qualified plan, meaning you've already paid taxes on your money going into the annuity, it would just be on the interest. Now it's my understanding that annuity, you pay all the interest taxes first before you tap into principle. That's one thing that is set up. And I'm sure Congress had something to say about that as well. And so, well, it's changed over the years. It used to be last in first out, but now it's going to be, it was first in first out versus you took the throws out these to be tax free. Now you're correct, they're last in first out. So any interesting come as tax first before you then to get tax free return of your principle if you're using non-qualified money. Yes. So we could do a whole program on the taxation of annuities and we could board the entire audience to death unless they're really, really interested. All right. Next up, and this is a key point too, is that an annuity has tax deferral. So if you elect to put qualified money into an annuity, you're not going to get a new source, you already have tax deferral. So maybe you have a four, maybe you've got an IRA that you funded. The money in your IRA is obviously tax deferred up until the time you withdraw from it, covering the rules that relate to IRAs. So if you put that money into a qualified annuity, you're not picking up any benefit at all. Some people don't understand that and I think it's important. What's happened, I think, Caleb over the years, is the reason people have taken money from an IRA and into an annuity is the annuity had payout options and maybe protection of principle, other benefits that they didn't have in their 401k plan. Yeah. Or didn't have in their scheme, either IRA and they could get it on an annuity product and they would use it. So yeah. So there's no additional tax benefit for qualified funds. And our last drawback is why we're having this whole conversation today. Unfortunately, the way annunities have been designed and disclosed over the years. The mandatory regulatory disclosures is that they're complex. Now, they're understandable, but they are complex. And in the sales process, the buyer has to, the buyer has to sign off on a significant number of disclosures. There has to be an interview about their basic financial health, their financial wellbeing. I think there's by the way, those are all reasonable actions that someone should make sure they go through prior to buying any, any, if you're going to, the average annuity today, $166,000 for a lot of the fixed annuities, $150,000. If you're going to part with your harder money, you want to make sure you understand those disclosures, you go through them, but it is complex. But the product itself has a lot of applicability, especially today. Yeah. And maybe we should have a podcast where we break down the benefits. And I think it's very, very important to lead with the, here's the reasons you shouldn't do it. These are the things to watch out because we don't want someone to take a sound bite and then go and get an annuity lock up majority of their money and something that they don't know what they're doing and it being a problem. And so I appreciate you taking time to break this down. And I will say the complexity part is ironically how we got connected and further dart conversation. Because as a company, we, we want to be able to offer solutions to people. And I've always kind of been a little bit negative towards annuities because I've always known that stereotypical financial advisor that maybe used them a little aggressively. But I always knew that there was a place, especially in income planning, cashflow planning, retirement planning. And I just knew that there was a place as a potential bond alternative as a potential to your portfolio. And so when we connected, I was just obviously really admired your background, your experience. You articulated, you have an amazing book on this that I really, really want to plug. If you are in the market to selling annuities or looking to buying annuities, I would highly, highly recommend you take time to read Harry's book on that. We'll make sure to have a link there because I, again, I think it's one of the best books out there on annuities. But I just want to highlight that there are pros, but some of the things that we went through, the complexity, the additional taxes, the interest rates, being unknown, you really want to work with a company that's important or has that history background. I think all those things are important. Is there anything else that you wanted to say as it relates to this whole conversation and kind of what a next step should be if someone's kind of watching this and wanting to maybe know more information before they make a decision? I think they should spend some time. My book today's annuity, a tool for creating protected lifetime income. As K-level put it in the show notes, I've written it to be objective. It describes the tool. It shows you the positives, the negatives. I go through each of the six product types and give people the positives and negatives of what those are. So if you're a financial professional, I think if you read it, it will give you a more comprehensive knowledge of what you're selling. And if you're a consumer, I think what it will do is give you the confidence to talk to a financial professional about an annuity and how it might be a tool that you can use to meet the financial challenges you have. And the key thing here is education, improving knowledge so that people can use this a valuable tool. And by the way, you can't and Caleb, you know what we sell collectively life insurance annuities, other products that guarantees and guarantees are powerful. And but consumers understand what they're buying, why the guarantee is important before they do. So those would be my concluding comments. 100% agree. Harry, I appreciate your time. I appreciate you putting a comprehensive list together. If this was helpful and you're watching on YouTube, if you could take time to like the video, maybe give your biggest takeaway from this talk. And if you're listening to this on the podcast, think about anyone that might need to hear this, maybe a financial advisor that you know, maybe someone that's one of your clients who's in the process of looking this show is going to give a good comprehensive outlook on what to look out for and how to be better prepared for what you should do in the future. And so without further ado, thank you. And we'll make sure to get your book on annuities in the show notes for people to go and buy. Great. Thank you, Caleb.