Would You Buy This?
Annuities are not bought, they are sold. Please don’t ever forget that. Having said that, would you buy this?
And in this podcast episode (#458), Tim and Tom discuss the points mentioned to us by someone who called in. This was immediately after they were given a pitch for an annuity. Except they never mentioned the person would be buying an annuity. The “nice sales person” just referred to this as “an investment.”
There are lots of times where these very expensive products (the type of annuity you are sold may not even be a regulated security!) are mis-represented, or, in the excitement of the transaction, a person unfamiliar with these products may mis-hear, mis-remember or not even know enough to ask some questions.
After discussing the merits (and some non-merits), we wonder aloud, “Would You Buy this?”
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Here’s a link to Investor.gov regarding annuities
Here’s a link to Investopedia regarding annuities
Transcript for “Would You Buy This (Annuity)?
Tom: 0:29
Welcome back to the podcast. This is episode number 458. I am Tom Mullooly and joining me today is Tim Mullooly. Tim, hello, Hello. We’re going to delve into the world of annuities and ask the question After we kind of highlight some of the points would you buy this investment?
Tim: 0:50
I think annuities are a topic that we hear a lot about. We don’t do much work in the in the field of annuities. We don’t sell any annuities, so it’s not something that we’re, you know, often recommending to people. But we get a lot of people coming into the office with questions about either the annuity that they already have or kind of doing a rescue mission to get them out of it, or just educating them on what they can and can’t do with an annuity.
Tom: 1:20
It’s pretty surprising how much education or educating we need to do with folks that already bought an annuity, and I think that’s a combination of the salesperson who put them in the annuity may have glossed over some of the details, and it may also be a combination of the client not actually remembering or misremembering or not paying attention to some of the details.
They were just excited to get started with that. So, as Tim mentioned, we don’t sell annuities but, to be fair, for the first 16 years of my career, which is now approaching 40 years, I did sell annuities as part of being a stockbroker and working for some pretty large investment firms. We do have experience in them. We do know a lot of the pitfalls and also some of the potential opportunities that are out there.
We’re not saying all annuities are bad right, but there are some problems. We often get phone calls from clients or other folks that may not be working with us and they say, hey, I just got presented with this opportunity or I just got pitched this opportunity. Tim, do you kind of want to walk through the typical scenario that we hear?
Tim: 2:50
Sure. The pitch usually goes something along the lines of you know, if you invest, let’s say, $100,000 with us, you know over the next three years it could drop up to 25K in value, but you suffer no loss. The company would just eat that loss. Also, you’re entitled to the first $85,000 in gains, but anything over and beyond that you’re not entitled to.
But still, $85,000 worth of gains on a $100,000 investment, that’s all yours. Oh, and the last point, there’s no broker fee.
Ok, so it’s going back to what you said about either glossing over some details or people not remembering them or not understanding what was said and being too shy or timid to ask for clarification. You just shake your head and say, yeah, sounds good, sounds good. Yeah, on the surface that all sounds really great – those couple points that we just laid out for you.
Tom: 3:52
It does, and so let’s break these down point by point. The first point was that we should say is you may not have been told this, but this product that you’re being pitched is a tax deferred variable annuity?
Tim: 4:12
Sometimes people don’t even know that I didn’t say the word annuity anywhere in there.
Tom: 4:18
I don’t think it’s no, and many times people don’t even realize that they are putting money into an insurance product. The second point is and it’s the first thing that you had mentioned. We hear this a lot over the first three years it can drop by 25 percent and you suffer no loss.
Tim: 4:39
I don’t know yeah.
Tom: 4:40
What does that mean?
Tim: 4:41
The variable part of a variable annuity means that it’s invested or tied to an index of some sort other investments that are going to fluctuate and go up and down. It’s tied to the market, and how the market does, your variable annuity will do as well. So how could it possibly suffer no loss?
Tom: 5:02
So what it means is they’re not going to hand you back your 100 grand, even if it’s down 10 percent or 20 percent or the maximum 25 percent.
What it means is and people just don’t, it’s not explained to them or they don’t understand it. It means that suppose you put 100 grand into an annuity and it drops to 85,000. When they are calculating your value for either the time it comes to annuitize OR your death benefit, they’re not going to look at the loss. If it’s in a loss position, they’re going to calculate it based on the face amount.
So, you put 100 grand into an annuity, it drops to $75,000 and you die. Or you say okay, I’m retired, I wanna take my check. They’re not gonna send you a lump sum money back. They’re gonna calculate your monthly annuity OR your death benefit based on 100 grand, but they’re never going to give you your $100,000 back. I wanna make that crystal clear because people just – that’s never explained to them, you’re not getting your money back.
Tim: 6:23
Yeah, you’re not putting $100,000 into the investment. And then you see the market go down 25% and you’re like, eh, I want that back, like I want out. They’re not just gonna say, okay, you’re right here, you go, here’s your $100,000 back. It does not work that way.
They’re different… like you said, you either have to die or you have to annuitize the contract but we’re gonna touch on this a little later. But then there are things like surrender periods where you can’t or you could, surrender the contract, to annuitize it, but then you have to pay surrender fees and there are a lot of different strings attached. It’s not as simple as market goes down 25%, you want your money back, you got it, it’s not how it works.
Tom: 7:05
It just doesn’t work that way. And when you annuitize the contract, you’re actually giving up the asset. So you put 100 grand in, say the value has dropped to $80,000, $85,000, $75,000. And you say I want to annuitize the contract, so they’re going to base a monthly payout over a period of time, or perhaps over the rest of your life, based on $100,000. At no point going forward can you call up and say “hey, I changed my mind. I’d like my 100 grand back.”
Tim: 7:40
No, it’s a monthly income stream.
Tom: 7:43
That is the asset. Now is the monthly income stream. You don’t ever get your principal back.
Tim: 7:49
From a very high level. I feel like that was the initial. The origin story of an annuity was put money in, get a, and then at some point in the future, get a guaranteed income stream for the rest of your life. And then they added all these different bells and whistles to it and dressed it up real nice and sold it to people. But when you get down to it, that’s essentially what an annuity was made for. People just don’t tend to use it that way anymore.
Tom: 8:20
That’s right, so let’s move on to the next point.
Tim: 8:23
Yeah, so the next point that we had in the pitch was that the individual is entitled to the first $85,000 in gains. Anything above and beyond that you’re not entitled to get. So what exactly does that mean?
Tom: 8:39
When you do the math, it actually works out to in the first three years you’re entitled to a max of 22 and a half percent per year in each of the first three years. But if the underlying investment, the index, the market overall, whatever the underlying index is – if it exceeds that per year, you’re not gonna participate in anything over and above that.
So you’re getting capped out. That’s right. And so let’s say your annuity’s underlying investment is the NASDAQ and let’s say in the first year of your annuity contract the NASDAQ goes up 40%, You’re getting 22 and a half. Still really good, Right, Still really good, yeah. But you’re not really benefiting from the entire move. Yeah.
Tim: 9:33
Yeah, I think that’s part of the. You’re capping your upside for some of that. It’s the “upside with no downside” that you get pitched a lot Because, like the first point says, there’s no downside, wink, wink but you have to annuitize the contract, but then they’re capping the upside as well. I mean, you could just not put your money into the annuity and invest outside of it and get all of the upside as well.
Tom: 10:03
So the question that we were asked by someone who was thinking about this exact annuity product said he posed the question to us and said say I put 100 grand with these guys and in the first three years it grows to 150,000 or even you know the max, 185,000. Can I just take my 150 grand and walk away?
Tim: 10:30
No, you can’t, and it goes. The same thing that we were just talking about on the on the loss side, applies to the game side as well. You can’t just ask for your check of whatever the current value is, because a lot of times when you’re looking at your annuity there are two different values.
You can get that the higher number means that you have to annuitize the contract and you would get that $185,000, let’s say, over the span of whatever the payment period is your life, or 10 years or whatever it is. But if you wanted to just cash out the annuity right now, you’re going to get a significantly lower payout. You’re not getting that full amount.
Tom: 11:15
That’s so important. I think a lot of people are. This is not explained to them or it gets glossed over. I think what happens… I have not been in this position where I’m on the receiving end of a pitch, but I think when people hear that you’re entitled to the first 85% gain over the first three years, people in their minds – they shut down because they’re like. I’ve never had an investment that’s made 85% over the first three years. So, I’m not even going to listen anymore.
Tim: 11:49
Part of me thinks that they bring this up because once someone hears you’re entitled to the first 85% of gains, I feel like some people hear that, as your investment is going to go up 85%. You know what I mean, even though that’s not what they said at all. It goes back to what we said in the beginning about mis-hearing or mis-remembering or not paying attention to what was said. They didn’t lie to you. You just didn’t understand what they were saying.
Tom: 12:19
They could have also omitted a few things along the way. That’s always possible.
Tim: 12:26
The other way that you could get the 185,000 or the full current value is to die.
Tom: 12:34
Congratulations. Yeah, as they say in Oceans 11, “congratulations, you’re a dead man,” right.
Tim: 12:40
Exactly. One of the last points in the pitch that we mentioned in the beginning was that there’s no broker fee.
Tom: 12:48
Before we get to that, I just want to go back to this statement where this person said hey, in the first three years it grows to say 150 or even 185,000. Can I just take my money and walk away? The other part of that is it’s going to have a surrender fee. This may be the deal that the annuity or insurance company offers in the first three years, but you’re putting your money into an insurance product that is going to last for eight, nine, 10 years. This is gonna go on for a long time and this is only what the deal that they’re offering for the first three of them.
Tim: 13:33
So the answer I guess, if you ask for your money at that point, isn’t no, it’s “sure, but you have to pay 9%, 10% of the money to be able to get your money.” That’s the surrender. You have to surrender 10% of your money to get your money back.
Tom: 13:53
Yeah, so, not so hot, yeah, and there’s probably what they call a market value adjustment in there, and so it’s not actually what it says on the statement. It’ll be statement value less market value adjustment, less surrender fee. Right, you might wind up even …but with a tax bill.
Tim: 14:14
Right, exactly yeah.
Tom: 14:16
Let’s get back to your next point about the broker fee.
Tim: 14:23
There is no broker fee.
Tom: 14:25
What does that mean?
Tim: 14:26
Yeah, I mean, we know the answer, but I mean. Yeah, I mean. It essentially means that you’re not gonna pay anything above and beyond what you invest. But don’t confuse that meaning with meaning that the broker or the person selling you or pitching you this annuity is going to make no money off of it. In fact, it’s almost the exact opposite they’re gonna make a pretty good chunk of change off of it.
Tom: 14:51
Yeah, so you know, Charlie Munger and Warren Buffett always say “follow the incentives and you’ll find out who’s really winning this particular pitch.”
So the usual commissions on these products and I’m not begrudging anyone the commission. If they made a good sale, they earned it. I did that for a very long part of my career. Just know, “Mr Potential annuity buyer,” that the commission on this product is gonna range anywhere from 6 to 10%, with the actual range being somewhere like 8, 9, 10%. So 8, 9, 10% of every dollar invested goes to the broker.
And that is part of the reason why you have surrender periods that go out for 8, 9, 10 years.
If someone surrenders their contract, they want to get out of them — and, by the way, most annuity contracts are surrendered. They don’t go into annuitization, they don’t go out in death benefits.
I forget the number, don’t quote me, but it’s something like 80% of annuities get surrendered. So these products get sold and then they get surrendered.
I think when people find out, the take the lampshade off their head, so to speak. So to speak, but yeah, that’s part of the surrender cost is the insurance company is recouping the commission that they paid the broker upfront. So, that broker got paid 6, 8, 10% on day one – when you said yes.
They have to recoup that cost. So if you turn in your contract in the next 8 years, 10 years, they’re taking back a slice to basically break even on this thing.
Tim: 16:39
The brokers aren’t working for free, and you know I wouldn’t. I mean, I wouldn’t work for free either. So, again, not knocking them. That’s the incentive structure that they were given to work with. Yeah, but yeah, it’s not. It’s not like they’re giving you this beautiful, beautiful annuity out of the goodness of their heart.
Tom: 17:08
Or treating you, with a mailer, to come to a steak dinner at Ruth Chris’ Steakhouse to hear their pitch.
That is not free. So you’re just not paying for it by reaching into your pocket, yeah, and paying for it. So, yes, there is no broker fee, so you don’t pay on top of the money that you’re investing. However, you are paying a lot. In fact, we sit around the conference table with clients and we say it’s probably THE single most expensive way that you could invest money, bar none.
Tim: 17:34
Yeah or not, and especially considering the stat that you said, that people don’t annuitize or get the death benefit, like these contracts get surrendered, and people are essentially using them as invest investing tools.
So you’re, if you’re not, if you’re going to buy an annuity and you’re going to use it and you’re going to annuitize the contract and turn it into a guaranteed monthly stream of income, then that’s great.
That’s a way to use an annuity to your advantage. But if you’re just using it as a investment in an investing account or something to you know grow your money over the next 10, 15 years, then there are WAY cheaper ways to do it.
Tom: 18:15
Correct. And I would also say, in the first couple of years your broker made more money than you.
Tim: 18:20
Yeah, definitely In many cases.
Tom: 18:22
Not all, but in many cases. So yeah, let’s move on to another important point that almost always gets overlooked.
Tim: 18:30
I mean this factors into what I just said about there are more efficient ways to do things. You’re going to pay less money if you, if you do it differently, and that’s the tax ramifications of taking money out of an annuity. I feel like people typically don’t understand everything else that we just talked about.
So by the time you get to the tax ramifications of this, they you know it’s definitely something that gets lost on a lot of people. So kind of break down how getting money from an annuity works.
Tom: 19:03
And so a lot of this gets either, as Tim mentioned, gets glossed over during the presentation, or people just never asked, or a lot of the details get mis-remembered. It’s okay, but let’s just review them. Any distribution that you get from an annuity is taxed as ordinary income, just like a salary.
Tim: 19:25
The gains right, the gain right.
Tom: 19:29
So we’re talking about whatever the marginal tax bracket that you are in, is what each dollar that comes out of the annuity is going to be taxed at. Your accountant tells you, you’re in the 22 percent tax bracket. That means that which …and, by the way, 22 percent tax bracket is the most common tax bracket for pretty much everybody in the northeast part of the United States. The taxable portion which, by the way, comes out first out of an annuity (always), is taxed, is going to be taxed at 22 percent.
Tim: 20:05
Yeah.
Tom: 20:06
What’s the alternative?
Tim: 20:07
I mean if you were to invest that money in just a regular index fund and not have it be inside of an annuity, just in a regular like an e-triggerage account, yeah, in an ETF, and you sold it after a few years, then instead of paying ordinary income taxes on it, you’re paying long term capital gains rates, yeah, and that depending on your adjusted gross income for married folks, if you have an AGI under $83,000, you don’t pay any capital gains.
Tom: 20:30
Zero.
Tim: 20:33
And between $83,000 and $517,000 dollars of adjusted gross income, your capital gains rate is 15 percent. So for a lot of folks that – if you were to sell the same investment and take the money, those gains coming out of an annuity would be a taxed at 22 percent. Coming out of just your regular brokerage account would be taxed at 15 percent.
So there’s seven percent extra in taxes that you’re not getting Just because the money was in an annuity.
Tom: 21:18
As you said, probably the single most expensive way to invest that we know of. But a lot of times the tax discussion doesn’t even come up – or it may not even be relevant, because the person who’s buying the annuity is buying the annuity inside of an IRA.
Tim: 21:36
Buying a tax deferred investment inside of a tax deferred account.
Are there special double tax free tax deferred account rules or did those not exist?
Tom: 21:44
In my entire career, I have not heard a logical answer to “why would you put a tax deferred investment – like an annuity – inside of a tax deferred account?”
There is no logical answer for that. And so I don’t know how someone can act as a fiduciary and still put people into these expensive products inside of a retirement account. Plus, the person who asked us this question this week was participating in a section 457 deferred compensation plan that’s offered by a municipality.
So you can’t buy these kind of products – an annuity – inside of your Deferred comp plan. To actually do this, you actually have to take the money out of your deferred comp plan, roll it over into an IRA and then purchase this product.
What happens if you’re under 59 1/2 and you and you take money and move it from your deferred comp plan, into an IRA?
Tim: 22:54
Any sort of benefit… let’s say you’re, you’re not working for that 457 plan anymore. One of the benefits is being able to take money out – without having to pay the early withdrawal penalty. So, if this person is, 52 years old, and you roll it into an IRA, you essentially just locked that money into your IRA for another seven and a half years, or else you’re gonna have to pay 10% penalty to take any money out of it.
Tom: 23:25
Or you could just leave it in the plan and never have a 10% penalty before age 59 and a half. Really, it is unconscionable. And we’ve seen this happen. And it’s bad.
They lose that benefit forever. Again, not acting in a fiduciary capacity. Ever.
In fact, when you start to add all of these points together, it’s hard to see how recommending a product like this it’s even acting – ever – in a fiduciary capacity.
There may be situations where it makes sense. I have a hard time identifying those.
Tim: 24:03
Yeah, I think there are. There are more and, like we’ve said a couple times, not not all of these annuities are bad. I think some of the more basic ones can actually be used in a beneficial way for people if they actually truly want to annuitize the contract. But if they’re being used to just “invest money and no, no downside, with all the upside.”
You know, once you start attaching all the bells and whistles to it, it just gets complicated and expensive and unnecessary.
Tom: 24:34
There are, as Tim said, annuities out there that do provide some good options. We’re happy to talk about them with you. In fact, we’ve had conversations with folks here in the office where they were pitched this annuity product. They put a lot of money into it, a big chunk of their liquid – formerly liquid – net worth, and now they felt like they were kind of stuck.
We started showing them what happens… “hey, what if we annuitize the contract, you’re going to be getting thousands of dollars every month.” It’s not fatal. But it’s not optimum either.
I think that’s a good point to stop. Thanks again for listening to the Mullooly asset podcast. This has been episode 458. Tim, thank you for joining me!
Tim: 25:19
Yeah always a pleasure.
Speaker 3: 25:25
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 in securities discussed in this podcast.
