Unwrapping Annuities: Some Pros and Cons
In podcast episode #452, Tom breaks down some of the basics around annuities. Unfortunately, we have had experiences – where clients purchased annuities elsewhere – and came into our office to learn the gory details of what they signed up for.
Annuities are sold as a path to “not outlive their money in retirement.” As we are unwrapping annuities in this podcast, we wonder do annuities really need to be so expensive? It seems like these products are “over-sold” as income protection – but a little time with a financial planner may be time well spent – instead of purchasing the promise of a product like an annuity.
A “tale as old as time” – the problem WE have – along with others in our community – is that annuities are often marketed improperly. There is clearly a need for income, especially in retirement. But brokers often find annuity sales to be the magic elixir.
There’s an old saying we mention in the episode: “annuities are not bought, annuities are sold.” Folks do NOT sign up for these products voluntarily. But when they are sold these products, they either forget – or are not told of the details, the costs, how to exit, tax implications – including what happens to the annuity after they die. It’s a real problem.
In this episode, we cover the 60-40 portfolio, the four percent “rule” (it’s not a rule!) all as we are unwrapping annuities.
Links for Unwrapping Annuities: Some Pros and Cons
And this is the link to the ThinkAdvisor article referenced in the podcast.
Transcript for Unwrapping Annuities: Some Pros and Cons
Welcome back to the podcast. This is episode number 452. I am Tom Mullooly and and today we want to talk about annuities, the 60-40 portfolios and the 4% rule.
So we want to cover three different topics annuities, 60-40 portfolios and I’ll explain what that is and the 4% rule. But before I do that, I want to share with you a story that I read recently.
This goes back almost 100 years to a company called Standard Drugstores of Ohio and another company called the Bost Toothpaste Company. The Bost Toothpaste Company was trying to figure a way to sell more of their product.
The president of the company was Charles Lesser, and he would try all these different marketing ad campaigns:
Ads that said “we have a special sale on toothpaste today.” Didn’t work.
He tried “9 out of 10 dentists recommend this toothpaste.” That didn’t work.
Then he tried “this cleans so well that your teeth stay clean and your breath stays fresh all day.” That also didn’t work.
But he tried something else. What he did was he went into the drug stores – Standard Drugstores – and he placed his toothpaste on the tobacco counter in these drug stores. After someone would buy some tobacco – now remember, this is 1920s, going into the 1930s – the clerk would then ask “have you ever used the smoker’s toothpaste?”
It was pretty natural for a customer to say, “I never heard of it. What are you talking about? I’m not familiar with that.” The clerk would hold up Bost Toothpaste.
Long Story Short: Standard Drugstores sold a three month supply of this toothpaste in one week. So the power of the right words, spoken at the right time, can really make a difference. This has been one of the things that I have always believed.
When it comes to annuities, there’s an old saying in our industry that annuities are not bought, annuities are sold. And the right words at the right time, can really make a difference.
People in our line of work are very good at selling annuities. In fact, last year, in 2022, we had a record $312 billion in total US annuity sales. You know, when we talk about annuities, there are different types of annuities. You can’t just throw a blanket over all annuities and say “all annuities are bad.” They’re not. Some of them are very, very good.
But I want to break down there are four different areas of annuities that you should be familiar with. I’m going to walk through them very quickly here.
The first type of annuity is called an “immediate annuity.”
That is essentially where you deposit money with an insurance company and the insurance company immediately starts sending you a monthly check for a fixed period of time – or for the rest of your life. That is called an immediate annuity. You lose control of that asset. So you could send $100,000 to XYZ Insurance Company. You no longer have that asset. What you have – instead – is a promise to receive a monthly check from the insurance company.
That’s an immediate annuity.
We have no problem with investors putting some money into immediate annuities because it helps them plan for the future, because they’re going to know precisely what they’re going to be getting every month, like clockwork.
The second type of annuities are called “deferred annuities.” These are often sold as investment alternatives to mutual funds, stocks and bonds.
We have some issues with how these things are sold.
With deferred annuities, there are two different types of deferred annuities, so we’re digging in a little deeper with these. There are “fixed deferred annuities,” which means you’re going to get a fixed percentage rate on this money. It’s kind of like a CD. I’ll explain the semantics of that in a moment.
And then there are “variable annuities.” Deferred annuities that are variable deferred annuities with fixed deferred annuities. Oftentimes they’re marketed in this way, or at least they used to be marketed this way.
I say this from experience, because for the first 16 years of my career, which is now almost 40 years, the first 16 years I was a stockbroker and licensed to sell insurance products, including annuities. And so I speak from experience, knowing how these products are not only designed but also how they are sold.
So, with a fixed deferred annuity, they were often marketed as an alternative to a CD, and the pitch would go something like this:
“Hey, you have money in CDs, right? Why?”
“Well, because they’re safe and because I get a guaranteed rate of interest, or a fixed rate of interest for a certain period of time.”
The next question in the discussion would be something along the lines of “when that CD comes due, when it matures, do you take the interest out?”
Most people would not take the interest out. They often just let it accumulate and it would continue to defer.
And then the next line of questions would be: “But wait, this is a taxable investment. So you’re paying tax on money that you’re not even spending. You’re not even putting it in your pocket. Do you realize that?”
So if you were earning say, and this goes back 30 years, if you were earning 6% on a CD — after taxes, you might really only be earning four and you weren’t taking the money and putting it in your pocket, or spending it, or doing something else with the money. It was just continuing to compound.
The pitch would then continue along the same lines as “why don’t you just continue to do this but cut out the tax man?”
The concept behind this was to put the money into a deferred annuity with a fixed rate of interest. You were not taking the money out. With a CD – and an annuity would work the same way. You would not get the money, you would not get that earnings that you had, and the difference was you would not get a (form) 1099. And so you wouldn’t have to report and pay taxes on this money.
Currently, the problem is that all of this money continues to grow in a deferred vehicle. At some point, when you do take that money out, it will all come out… the earnings will all come out as ordinary income. You’re not even taxed at a capital gain. It’s all ordinary income as if you earned it in a salary.
There are some drawbacks to (fixed) deferred annuities. And for the better part of the last 20 years, this was not a competitive place to put money to work, because interest rates were so low. You just couldn’t earn any money.
Then we talk about variable deferred annuities.
These are marketed as alternatives to putting money into individual stocks or into mutual funds and growth vehicles. We are not crazy about these investment alternatives. This is because we have found – more than anything else – they are a very expensive way to invest your money. There are cheaper ways that you can accomplish the very same thing.
Yes, earnings continue to defer into the future, so you don’t have to worry about paying current taxes on your earnings. But along those lines, you’re going to have a future event where this money will be coming out of the annuity. And it will be taxed as ordinary income, even though it was compounded at variable rates over hopefully a long period of time.
You don’t enjoy the benefit of capital gains tax rates. You have to pay ordinary income on these.
These are points that usually get “glossed over” or sometimes not even mentioned at all – in the product presentation. These are some of the problems that we have – with the way these products are marketed. As I mentioned a few moments ago, we don’t have a problem with clients owning these investment vehicles, but most of the time they were not given all of the information.
So they didn’t go into these transactions with eyes wide. And it’s a little frightening to see that over $300 billion of YOUR dollars went into these annuities last year alone.
That’s a 23% increase from the year before.
People get worried about the volatility in the stock market. They get worried about all kinds of things – inflation, the future of social security. They worry about a lot of things. These annuities offer the promise of some type of security behind it.
We don’t always agree with that. I think our biggest issue is how these products get marketed.
But I wanted to talk about annuities, talk about 60-40 portfolios and talk about the 4% rule.
There was an article in ThinkAdvisor – that’s an industry website. I’ll link to this in the show notes. The headline is “retirement investors are losing faith in 60-40 portfolios and the 4% rule.” In order to talk about this, I wanted to walk you through the different types of annuities because really, after reading this, I felt like this entire article was a written marketing script for annuity salespeople.
They are trying to trash the 60-40 portfolio.
Now what is a 60-40 portfolio?
That’s how you measure how much money goes into stocks and how much money goes into bonds, or how much money is allocated for growth and how much is allocated for income. So the premise behind this is 60% of your dollars would be invested in long-term growth investments, 40% would be invested for current income. And the idea is that you would have a balance between growth and income.
Going back 30 and 40 years, this was marketed as kind of an all-weather portfolio. There were a couple of reasons for that. The most important one is that when the premise of the 60-40 portfolio came out in the mid-1980s, interest rates on fixed income investments were significantly higher than they have been in previous years.
So you could earn 4%, 5%, 6% on the fixed income the bond side of a 60-40 portfolio. And you could let the stock side run. That really has not changed all that much. 60-40 for really the better part of 40 years has worked pretty well for clients. The only time that I can think of where it – clearly did not work – in the last 40 years was last year. It was in 2022.
It does not mean that it can’t work in the future. It could work. It may not work, but it’s certainly worth exploring having money in some type of balanced portfolio where you’ve got 60% of your money set aside for long-term growth, 40% for income.
More than a third of respondents to this survey felt the 60-40 portfolio is no longer viable. And that the 4% rule is also something that’s no longer viable. So what’s the 4% rule? We’ve talked about annuities. We’ve talked about the 60-40 portfolio. What is the 4% rule?
In the same period of time, in the mid-1980s, there was a theory our industry came up with called the 4% rule. So let’s talk about what the 4% rule was initially designed to be.
Suppose in 1985, you retire with an investment portfolio of $1 million. Using a 4% rule, on the day of your retirement, you have $1 million. You can safely withdraw… the 4% rule says… you can safely withdraw 4%, or in this case, $40,000 per year, each year, without outliving your assets.
The 4% rule worked great, especially in the ’80s and into the early ’90s, because, as I mentioned, with the 60-40 portfolio, a lot of individual investors saw nice gains in the stock market. But, more importantly, they were earning 4%, 5%, 6%, sometimes 7% or 8% on their fixed income portfolios. Withdrawing 4% a year looked like a really safe way to go.
Move to the last 20 years, and we’ve seen interest rates below 4%.
So, we’ve taken a much more cautious approach. We would prefer to see clients drawing down something at 3% or less, maybe something closer to 2%. Because then we know this is going to be sustainable for very long periods of time 30 years, maybe even 40 years of retirement.
The 4% rule is a good idea. It’s a good concept. It’s a good way to get investors thinking about how much money they can safely pull from their investments when they’re in retirement.
But it’s not something we advocate as a “yardstick” only because we don’t know… we can’t predict accurately in the future what where interest rates are going to be, what returns we’re going to see from the stock market.
Again, I’ll link to this article in the show notes so you can read it for yourself.
It’s just dripping with lines like: “A growing number of Americans feel such rules of thumb should be replaced with other retirement income approaches, including those that incorporate various types of income guarantees.”
So sure, the market gets volatile from time to time and people say “I can’t stand the volatility, I want something that’s going to be guaranteed.” That’s a problem. There’s even a quote in there that “protected income is there to provide peace of mind” and it works as “a paycheck in retirement.”
We’ve seen this phrase in our industry used many times as a pitch, a hook, for an annuity sale.
The article also goes on to state that this survey they ran found “investors, on average, want 80% of their retirement savings to be invested in safer investments.” It really comes down to what your definition of “safe” is.
Do you feel safe investing in the S&P 500? Well, some people do, some people don’t.
I heard an interesting stat the other day that I’ll share with you.
In the decade — I’m sorry — in the century of the 20th century, from January 1st 1900 through December 31st 1999, the Dow Jones Industrial Average grew from 66 in the year 1900 to 11,400. Sounds great. What was the compound annual return?
Just doing the math – how do you grow 66 to 11,400 over the span of 100 years?
Well, the return is 5.3%. That’s just the nominal growth in the Dow Jones from 66 to 11,400.
That does not include dividends. The actual (returns) numbers are actually much better than that.
The problem is we can’t predict from year to year exactly what we’re going to earn. So, the pitch, so to speak, with an annuity is you know exactly what your rate of return is going to be with a fixed annuity.
With a deferred annuity, maybe you may not know what your returns will be this year, but you don’t have to worry about paying taxes on the gains. And you’re putting money away for the future you can enjoy in retirement. We understand the benefits. But a lot of times people hear only the benefits — they don’t hear any of the drawbacks.
I think it’s important that investors know all of the pros and cons before they get involved in any kind of investment.
Having sold these investment products for 16 years as a broker through the ’80s, ’90s up through 2002, I’ve seen a lot of negative outcomes — unhappy investors who weren’t told all of the details. And some of them are material details they need to know before they enter into a contract with an insurance company.
I will also say over the last 21 years, we have seen a lot of folks come into our office here at Mullooly Asset Management with annuity contracts. And WE have had to explain to them what the details are with these.
And we’ve seen a lot of regret at the conference table when people discover they have a very large surrender charge that they weren’t told about, or they have limited investment options that they weren’t told about, or that they’re going to be facing an enormous tax bill if they decide to dismantle this annuity contract – which they weren’t told about. It’s a problem.
We want to make sure folks know all of the ins-and-outs that they should be aware of – before they enter into these contracts. If you’ve got questions about potential investment, like an annuity, get in touch with us.
That’s going to wrap up our message for episode 452. Thanks again, as always, for tuning in.
Tom Mullooly is an investment advisor representative with Mullooly Asset Management. All opinions expressed by Tom and his podcast guests are solely their own opinions and do not necessarily reflect the opinions of Mullooly Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of Mullooly Asset Management may maintain positions and securities discussed in this podcast.