Ryan Kilkenny 0:00
Hi everyone and welcome to The Atomic Retirement. I'm your host, Ryan Kilkenny, the founder of Atomic Planning, an independent, veteran-owned, fee-only financial planning firm, bringing tax and retirement planning to families over age 50. Atomic Planning is a virtual financial planning practice in Kansas City, serving families from coast to coast, from California to North Carolina. Thank you for joining me and welcome to episode seven of The Atomic Retirement.
Ryan Kilkenny 0:28
Today we're talking about annuities. And my goal is to help you answer the question, "Should I buy an annuity for retirement income?" Now, annuities can be incredibly complex financial products. I'm going to try to simplify them and break them down so that we can understand: what they are, how they work, pros and cons, how they're sold, when they are appropriate, and a few questions you can ask to learn more about an annuity contract you're considering, or that maybe you've even already purchased. My goal is not to make you an expert, but I wouldn't be surprised if you know a little bit more about annuities than a lot of financial professionals after you listen to this episode.
Ryan Kilkenny 1:09
Before we get started, it's worth mentioning that I do not sell annuities. And I'm kind of proud of that. I am a fee only financial planner. And that's just fancy industry jargon that means I do not sell any financial products or charge commissions. I only offer financial advice. And so before I launched Atomic Planning, I was licensed to sell annuities, life insurance, and other financial products. It was a requirement of my employment at that company. And so I didn't have to sell financial products, but I had to be licensed to sell them, and so I got to know a little bit about them in the process.
Ryan Kilkenny 1:47
Would you like to guess how many annuities I sold during my time at that firm? Zero, not a single one. Now, why was that? Well, in my experience, they just didn't make financial sense or add a lot of value to a family situation. In fact, whenever I input them into the financial planning software, they only lowered a family's probability of success. I couldn't find a single use case or situation in which the software showed that an annuity improved someone's probability of success. So, I never recommended or sold a single annuity contract to somebody that didn't already have one.
Ryan Kilkenny 2:28
I have recommended a 1035 exchange, and I'll talk more about that in a bit. And so when I launched Atomic Planning, I dropped my insurance and brokers licenses by choice, because I didn't believe that I should personally benefit or earn commissions as a result of my advice. And so I want to be clear, I have no problem recommending an annuity if it is appropriate. But in my experience, there is usually a better way to achieve the end goal without locking up your money with an insurance company. Okay, now that we have that out of the way, let's get started.
Ryan Kilkenny 3:05
What is an annuity? An annuity is an agreement with an insurance company. Simply said, you hand the insurance company a lump sum of money or a series of payments, and they agree to provide you with a guaranteed income stream for a specific amount of time, perhaps for as long as you and your spouse are alive. Now, insurance exists to transfer risk. And with an annuity you are essentially purchasing retirement paycheck insurance, and are transferring the risk of running out of money during retirement to an insurance company. Insurance companies are in business to make money, and so they're going to invest the money you give them and pay you a little bit less than what they think they can earn by investing it on their own.
Ryan Kilkenny 3:51
And annuities come in many different flavors and sometimes it helps to think of them like you would ice cream. There are fixed annuities, variable annuities and indexed annuities.
Ryan Kilkenny 4:03
Fixed annuities are the most straightforward. I sometimes just call these plain vanilla annuities. And with a fixed annuity, the insurance company guarantees your account will earn a certain amount of interest. And your payments are calculated based on your account balance and a few other factors. When you purchase a fixed annuity, you know what you're going to get. It's very predictable. It's just plain vanilla.
Ryan Kilkenny 4:27
Now, variable annuities are a little bit different as their value is based on the performance of a portfolio of sub accounts, essentially a bunch of mutual fund investments. And with variable annuities, you have the possibility to benefit from a rising stock market and earn higher returns than you would with a fixed annuity. But, if your sub accounts drop in value, remember those are those mutual funds, so does the value of your annuity and the payment that you receive. It's not fixed. Variable annuities can also have bells and whistles known as riders.
Ryan Kilkenny 5:00
Riders are optional add on features that you can throw on to an annuity for an additional cost. Think of these as the toppings that some people may add to their ice cream. A few of the most common riders include guaranteed withdrawal benefits, lifetime income benefits, a death benefit, long term care benefits, cost of living adjustments, and refunds or returns of premium. And so there are so many more riders out there. That's just a few of them. And as a reminder, riders are not free. You will pay an additional cost for each rider you add to an annuity contract. Okay, so we've talked about fixed annuities and variable annuities, that now brings us to indexed annuities.
Ryan Kilkenny 5:44
And so an indexed annuity pays an interest rate based on the performance of a market index like the S&P 500. And some people called indexed annuities equity indexed or fixed indexed annuities. They mean the same thing. And so, indexed annuities offer you an opportunity to earn higher yields than you would with a fixed annuity when the index is performing well. Even though these annuities are linked to the performance of an index, that doesn't mean that you should expect to get the full benefit of that index. Indexed annuities often limit your gain to a certain percentage, known as a participation rate. And so according to Investopedia, most indexed annuities offer a participation rate between 80 to 90%, during the first few years of the contract, and then it usually goes down after that. And so for example, if the stock index gained 15%, but the participation rate is 80%, you're only going to get credited with 80% of the 15%, which means 12%. So basically, you're giving up 3% of the indexes' return. But wait. Indexed annuities may also have yield or rate caps that reduce you even further. For example, indexed annuities may have a rate cap of hypothetically 7%, which means the yield that you're credited to is capped at 7%, regardless of how well the index does. So if the markets up 15%, but you have a rate cap of 7%, you're only going to get 7%, even in a year when the market is up 28%, like it was last year, and that's a lot to give up, in my opinion. But to be fair, when the markets down, you're typically credited with a minimum rate of return between 0% to 3%. As I've said before, annuities there's a trade off here because you are you're trading risk.
Ryan Kilkenny 7:42
Annuities can pay you income today or tomorrow. For example, an immediate annuity is designed to create a paycheck for you today. This is known as annuitization, and it's when your payments start. On the other hand, deferred annuities allow your money to grow tax deferred for a period of time before your payments start. This is known as accumulation.
Ryan Kilkenny 8:03
And so what about the costs? Annuities can be very expensive, and here are some of the fees that they may contain: commissions, annual administrative fees, investment expense ratios (remember those sub accounts, those mutual funds are not free), surrender charges, mortality and expense risk charges, premium taxes, redemption and transfer fees, underwriting fees, distribution fees, and of course, the bells and the whistles or those toppings known as annuity rider fees. So the list could go on and on. And as we can see, annuities can be very complex financial products to understand. They can be very confusing and come layered with many different riders and fees. And believe it or not so confusing that many financial professionals may not even fully understand the products and the features that they're recommending.
Ryan Kilkenny 8:58
So why do most people buy an annuity? Well, they buy annuities because a salesperson disguised as an advisor says that it will provide them with a guaranteed source of retirement income. But what salespeople often neglect to mention is that the vast majority of annuities do not protect you against inflation once you start taking income. No cost of living adjustments, Ryan? Nope. Not unless you are paying for an expensive cost of living adjustment rider. That means the guaranteed payment you receive loses value to inflation each year. For example, let's say you need an income of $5,000 a month, or $60,000 a year, and the inflation averages 3% a year for the next 25 years. Now I get it. I know inflation is higher at the moment, but historically it's around 3% a year. And so if you need $5,000 a month today, or $60,000 a year, and inflation averages 3% a year for 25 years, here's how much you'll need over time to keep up with inflation, and to have the same purchasing power. Now remember, we're starting with $60,000 a year. In five years, you'd need more than $69,000 a year. In 10 years, you'd need more than $80,000 a year. In 15 years, you'd need more than $93,000 a year. In 20 years, you'd need more than $108,000 a year, and in 25 years, you'd need more than $125,000 a year. Your money has to double over 25 years just to keep up with inflation.
Ryan Kilkenny 10:36
And so insurance companies have done this math. Their actuaries have calculated that they can profit by taking your money, investing it on their own, paying you a small monthly amount, and keeping whatever is leftover for themselves. They're hoping that you do not do the investment and inflation math for yourself. And in my experience, salespeople push annuities from a place of fear and through a series of half truths, using annuities as a product in search of a solution. And so remember, salespeople don't get paid unless they sell you a product and salespeople try to use annuities in situations where they are far from the best solution.
Ryan Kilkenny 11:16
And so when are annuities appropriate? Okay, I believe there are a few times when an annuity can be a good personal choice.
Ryan Kilkenny 11:26
Number one, if someone should not receive a large sum of money because they might spend through it quickly. Annuities can set up a predictable income stream to ensure that that doesn't happen.
Ryan Kilkenny 11:37
Number two is if you're scared of financial markets, and uncomfortable seeing your portfolio balance go up and down. I believe it's perfectly normal to fear things that we don't understand, and that a lot of that is just an education issue. But still, if investing in financial markets has you up at night and unable to sleep, perhaps an annuity can help give you peace of mind.
Ryan Kilkenny 12:00
Number three is if you don't already qualify for some form of guaranteed income stream like Social Security. I believe it's helpful when 100% of your retirement income is not reliant on financial markets. Annuities can be useful to cover your necessary expenses.
Ryan Kilkenny 12:17
Number four is if you've already maxed out all your other retirement accounts and you wish to save more. Annuities can offer you a tax deferred way to invest more for retirement, but remember, they're not very flexible.
Ryan Kilkenny 12:30
Number five, is if you already own an annuity. These products change all the time, and if you've owned an annuity for a few years, you may be able to do what's called a 1035 exchange. And a 1035 exchange allows you to exchange your current annuity contract for a new one that better meets your needs without having to pay taxes.
Ryan Kilkenny 12:53
I will say this though, if you're considering an annuity, it's generally not a smart idea to lock up more than a third of your retirement dollars into annuities because they limit your options and your flexibility.
Ryan Kilkenny 13:05
What are a few questions you might want to ask if you're looking at an annuity, or if you purchase one a while ago and want to learn more about the contract that you signed? Well, you can ask the salesperson.
Ryan Kilkenny 13:17
How are you compensated, or what is the commission paid to you if I purchased this annuity versus another annuity?
Ryan Kilkenny 13:25
Next, you could ask what is the insurance company's financial strength? And this is especially important because you're counting on them to make good on their promise to pay you. If they go under, so many your retirement income.
Ryan Kilkenny 13:38
And that leads us to, what happens to my annuity if the insurance company goes bankrupt.?
Ryan Kilkenny 13:45
What fees should I expect to pay on an annual basis?
Ryan Kilkenny 13:49
Is this annuity fixed, variable, or indexed?
Ryan Kilkenny 13:53
What is the current interest rate?
Ryan Kilkenny 13:54
Is the interest rate fixed for the entire term of the annuity?
Ryan Kilkenny 13:59
Can the interest rate decrease?
Ryan Kilkenny 14:01
What is the participation rate?
Ryan Kilkenny 14:03
Is there a rate cap?
Ryan Kilkenny 14:05
Is my principal and interest guaranteed?
Ryan Kilkenny 14:08
What is the surrender period and surrender charges?
Ryan Kilkenny 14:11
How much money can I withdraw per year without a penalty?
Ryan Kilkenny 14:15
What are my options at the end of the annuities term or when it matures?
Ryan Kilkenny 14:20
Will I be forced to take income from the annuity to realise the full value?
Ryan Kilkenny 14:25
How will my withdrawals be taxed?
Ryan Kilkenny 14:28
Can I be forced out of the annuity at a certain age?
Ryan Kilkenny 14:32
What happens to my money when I die?
Ryan Kilkenny 14:34
I'll be sure to include a list of the questions in the show notes for you.
Ryan Kilkenny 14:38
That's probably enough about annuities for today. Again, my goal was not to make you an expert on the topic. I do however, hope that you found the information helpful, and that it gives you some clarity around the question, "Should I buy an annuity for retirement income?"
Ryan Kilkenny 14:54
Next week, we're going to talk about Social Security, and why I believe it may be the best annuity that your money can buy.
Ryan Kilkenny 15:01
So that's it for today. If you have any questions, want to learn more, or see if we'd make a good team, you can find me at atomicplanning.com. There's a "Contact Us" button in the upper right hand corner of the website that makes it easy to schedule a Zoom meeting with me.
Ryan Kilkenny 15:15
Do you love the podcast and find it helpful? If so, I'd really appreciate it if you hit the subscribe button, leave a five star review, and a short comment. It really helps people find me. And spread the word. Please share it with someone you think may enjoy it too.
Ryan Kilkenny 15:31
This podcast is for informational and educational purposes only, and it is not investment, tax, or legal advice. Clients of Atomic Planning may maintain positions in the securities discussed in this communication. I try my best to bring you valuable information, but I may not know anything about you or your personal situation. So please talk with your fee-only financial planner, tax, and or legal professionals before taking any action or making any decisions about your own financial plan. Atomic Planning is a veteran-owned Kansas state registered investment advisor providing independent tax and retirement planning.