Fixed Indexed Annuities are often promoted as ways for investors to participate in market-like returns with no risk of principal. That sounds good…but is it true? This week I take a deep look at these popular investment products, and how to evaluate whether it’s right for you, and what a great annuity looks like.
Make It Last with Victor Medina is hosted by Victor J. Medina, an estate planning and elder law attorney and Certified Financial Planner™. Through his law firm and independent registered investment advisory company, Victor provides 360º Wealth Protection Strategies for individuals in or nearing retirement.
For more information, visit Medina Law Group or Private Client Capital Group.
Click below to read the full transcript…
Announcer: Welcome to “Make It Last,” helping you keep your legal ducks in a row and your nest egg secure, with your host Victor Medina, an estate planning and elder law attorney and certified financial planner.
Victor J. Medina: Hi, everybody. Welcome back to Make It Last. I’m your host Victor Medina. I’m an elder law and estate planning attorney, as well a certified financial planner. I’ve got more hats than I have heads but it’s certainly fun to be helping people in this way.
So glad that you can join us on Saturday morning. I tell you, I am excited for this show. We’re going to talk about one of my favorite topics, which is annuities. No, no, no. Don’t tune out. [laughs] This is going to be a good one.
Before I get there, I want to share something with you real quick, which is that over the last week or so, I had the opportunity to meet with a great client of mine and it was one of these meetings where I had built it up in my head because I was, to be frank, very nervous about it.
I wanted to meet with this client because I wanted the opportunity to learn a little bit more about what they liked about what we do because I wanted to be able to copy that, serve them fantastically.
I wanted to give them everything that they think that they need, in that kind of relationship but I also wanted to know what makes them tick because if I can do that for them, then I can do it for other people and get more people like them.
Anyway, I built it up in my head and I was very nervous about it. I don’t get nervous about a lot of things but I was nervous about this meeting. I didn’t want to blow it because I knew this was my opportunity to learn about these people and learn what it is that they liked about us. I didn’t want to miss that chance.
What I ended up doing was preparing for it for the better part of the week before we had this Friday lunch. What came out off that meeting ‑‑ there’s a bunch of stuff that I learned, which was great but ‑‑ what came out of that meeting was their desire to know a little bit more about me, and see that in the communications.
See more of the personality that I have, and have that come out in the meetings. Challenge them, and work with them, and make sure that they’re doing the right thing. They wanted not more of me present, physically present, but more of who I am within the process of their relationship.
About a week before that, I was standing outside watching my middle son play soccer with another parent. Within that group of parents, I’d been charged with rounding up volunteers for this tournament that we were doing.
Over that time, I was sending out funny emails trying to cajole them into taking these volunteer jobs. They weren’t paid, and it wasn’t a requirement per se for you to do it. I figured, catch more flies with honey.
I was trying to be funny with the emails and get people signed up. People were having a lot of fun with it.
Anyway, he was talking about that. He said, “I’m trying to figure out in this new team. We’re just going to give you a free reign to send out these emails whenever you want. If you can make somebody laugh, go for it.”
They actually did that. It was funny to read. He says, “Victor Medina, he’s got unilateral authority to send out whatever email he wants.” When I was standing next to him, he mentioned that he had listened to the show.
It made me think that whatever it is that I think is funny, I’m not really showing that in the show. Those two things came together over the weekend. I was thinking about those two things, so I made a commitment.
That commitment is that I’m going to largely let my personality shine through this radio show going forward. Whatever that is, [laughs] it’ll either attract people or it will repel people, but it will be a little bit more of who I am.
The way that I started this ‑‑ we’re about 15, 16, 17 episodes in ‑‑ I was very stoic and wanted to be an educator, a teacher, a little bit of an entertainer. I just wanted to make sure that I was providing value in every one of these things that I was producing.
I’m still going to do that. Those of you who have been listening for a while, you recognize what the structure of this is. We go ahead and we take the first segment and we talk about something that I find interesting, that I think you might find interesting.
In the second segment, I try to teach you something more academically, educating you. Then the third segment, we talk about how you can practically use that information in your lives.
I’ve always committed to doing that, to be honest, the way you’re committed all the way through [laughs] the whole 30 minutes of the show. You learn then what’s important by the end of it. It was a good structure for me, and I can lay it on top of doing this 30‑minute show every time that we do it.
We’re going to continue with that, but I’m going to try to do a lot more sharing of what’s going between my ears when I’m thinking about something, especially in the first segment, so you know a little bit more about not what makes me tick.
You’re interested in me, but a little bit more about how I approach things so that you can see a little bit more of the personality and my philosophy and that stuff.
We’ve only got about two and a half to three more minutes on this segment, so I’m not going to have a full time to do it today. Tune in next week [laughs] is the best way of saying it.
Here’s what I want to talk to you about today. This one’s really about image. There was a “New York Times” article that talked about a financial advisement firm that was in New York City.
It talked to how they were in some cramped quarters and how they didn’t project the typical image of what a financial advisor looks like. They talked about how the place is down the street, the bigger wire houses.
They’ve got artwork in the lobby that they walk everybody through, and you’re looking at your own money in a box behind the painted [laughs] glass.
They basically went away from the concept that you should invest an image. It’s not about selling the sizzle so much it is about the steak.
That got me thinking about the way we’ve approached this over the years because for me, there are certain things that we decide to do in the office that are really about making sure that we are using the best tools, and we’re doing the things that work as opposed the things that look good.
I’ll give you an example. I’m a big proponent of using Apple computers. I love the Apple computer and I’ve been using that since the very beginning of my practice. In fact, one of the things I got known for, for a while was being a Mac lawyer, or being somebody that use…how to use Macs in the law office because for a while, it wasn’t very popular to do.
I even started a little conference for Mac using attorneys.
The reason why I got onto that kick was largely because I wanted to make sure I had a machine that worked when I needed it and I didn’t have to invest in an IT department.
I spend premium dollars when it comes to it on the machines that work, not because they look good, and not because they are sexy in terms of the gadgets and things like that but because they are the right tool for the job when we need a tool for the job.
I’ve been thinking about that a lot in terms of the difference between the image and being effective and it happens very frequently out in the community, especially community in terms of advisement. Lawyers need to look a certain way. I was told when I was coming up, that lawyers shouldn’t have beards. I don’t know why. [laughs]
I didn’t know if it makes me look like a hippie and back to the communist thing, but they shouldn’t have beards. I stayed largely clean‑shaven from that.
I’m not going to grow beard largely because my wife doesn’t like it but it did make me think that a lot of our preconceptions about what image needs to be for anything in particular, they can be challenged because at the end of the day, what you want is somebody that knows what they’re doing. You know that isn’t worried about the sizzle so much as making a great steak.
I just think that that’s super interesting to think about and talk about. That’s good for this segment. I know I blew a lot of time talking about my meeting with my client, but when we come back, I am going to teach you first about annuities, specifically fixed index annuities because they are the big talk of the town. Then, we are going to talk about how to determine whether one is right for you.
Take a look at them [inaudible 7:45] contracts to understand a little bit more about it. Stay tuned. We come back from the break, all about annuities. We’ll catch you on Make It Last. I’ll be right back.
Victor: Welcome back to Make It Last. This show, we are going to talk a little bit about annuities. In fact, we are going to talk a lot about annuities where I’m taking next two segments and discuss, if you think there is to know about a specific kind of annuity, which is a fixed index annuity.
Seems to be all the rage these days. Everybody wants to talk to you about them and the clearly question is, why?
Why is this being touted as the solution for everyone, and is it right for you? It doesn’t matter who I meet with. There are strong opinions on both ends of the spectrum.
People either love them or they hate them, and they do so with such a passion, you would think that they had a child who worked for an annuity company [laughs] or something like that their future was based on loving these things, like they invented them.
It’s important to understand a little bit more about these products because that’s really what they are, and then we can talk a little bit about how they’re right for you or not.
Let’s lay the groundwork first, which is that when we think about annuities, these are products that are created by insurance companies, and so largely speaking, they’re sold by insurance agents. When you get a discussion about them with somebody, they’re in some connection with an insurance agent, somebody’s making a commission.
Now, as you all know, I am a certified financial planner which is to say that I am a fiduciary, I am product agnostic. I really don’t care who is providing the product, because, at the end of the day, we make decisions that are in the best interest of what our clients need.
If we can go ahead and pick from anything out in the world, we’re going to go and pick the best thing that’s out there and not necessarily the thing that pays us the most money. That’s the way that other brokers work.
Since I’m a fiduciary, and since I can pick from anything in the world, and am only going to pick the best thing for my client, it gives me the opportunity to analyze these things from a different perspective.
I am not an insurance agent that has to sell anything, in particular, I don’t make any commissions off of the sale of any securities that we offer, and so, we’re able to look at these things a little bit more objectively, and try to figure out what makes them tick. Why are they good, and when should we use them?
To understand all of that, you have to understand the way that these products are created. These are insurance products that are put together to help people solve particular goals.
Way back when annuities were used to ensure against pension payments that had to last a certain lifetime. Insurance companies are really good about actuarials and understanding how to properly put together a contract in agreement so that they can get payments to last and take on the risk of longevity.
That’s the way insurance companies work. They do that for a life insurance policy and they do that for annuities.
The insurance company who got into the business of providing annuities for pensions. If you think about your pension, your pension is essentially an annuity. It is a structured payment for the rest of your life.
That seems to make sense. How are we going to use the product for other people’s retirement specifically for people that don’t have a pension? The insurance company ended up creating three kinds of annuities. I would tell you, I like two of them and I hate one of them.
The three different kinds of annuities. They can give you a fixed annuity, and that’s essentially a guaranteed interest rate for a period of time. That’s like a long‑term CD, that’s basically what it is.
You can get an annuity that is a fixed index annuity. That basically has a floor where you will never lose any money and a ceiling that is usually capped at some index that’s out there. You may not make everything the index performs, but you can make some of what the index performs. I’ll go into a lot of detail about that because that’s what the show is about. I’ll spend a lot of time on that one.
Then the last one’s the variable annuity. The variable annuity is essentially a way of wrapping traditional investments with an insurance contract. That one, you can lose all of your money, and you can gain unlimited amount. You have negative infinity, the positive infinity.
As some of you know, I wrote a book on retirement income and retirement assets in a financial planning and I have a chapter there where I talk about how much I hate variable annuities because I do.
Now, I’ve already spent some time in other shows talking about how I hate variable annuities, so we’re going to spend today talking about fixed indexed annuities, the way they work, and why they are amongst the products that we select for people, and why we think that they’re good alternatives and good ways of having it inside of their portfolio.
To understand the way that fixed indexed annuity works, you have to understand how insurance companies make money, largely.
They make money by taking premiums and investing those premiums in long‑term treasury bonds so that they pay off a steady amount of interest over time, and then their operating expenses go off of those interest payments. Essentially, they make more money than they spend, and they’re generating money based on the investments that they have.
Now, they can invest all your money. In fact, there are some regulations about how much cash they need to have on hand both to meet their operating expenses and to meet any claims that are out there.
One of the best companies is Nationwide by their ratings. The reason why they’re often thought of as so good is that their economics are so good. They might have 300 percent of all claims on cash on hand and 600 percent on operating income.
That’s just a way of signaling financial strengths. No guarantees, but you get an idea that they are a well‑run the company because they are prepared to meet whatever the claims are going forward. If you understand that they are investing in treasury bonds and they are throwing off interests, now that lays the groundwork for these fixed indexed annuities.
The fixed indexed annuities are often promoted to people as ways of getting market‑like performance with no risk. That’s a lot of sales talk but it’s not untrue. It has some measure of truth in it which figure out where it is in all that marketing talk.
The way that fixed indexed annuities work is that you put your money in a contract with the insurance company, and they’re going to invest it in these treasury bonds, and those bonds are going to throw off interest. With that interest, they are going to buy options to participate in an index. They are not investing in the index, per se, but what they’ll do is they’ll buy an option.
Now, if you don’t know anything about options, the way that it basically works, it’s the opportunity to buy something. The way that the options that they select work because they have the opportunity to buy the index back at the time you put the contract in.
You work backwards. I buy options to buy it today and I can have a year to exercise those options, or two years to exercise the options depending on the index.
A year from now, I’m going to look at the way that the index performed. If that index went up, I will exercise my option, buy the indexed value, and then sell it immediately to get all of the gain. You have a chance to participate in there. If the index goes down, I will let my options expire. I just won’t use them at all.
When we think about how it is that they can say that they have market‑like performance without risk, what they’re basically saying is that your principal is safe, and we’ve taken a portion of the interest, and we’ve invested it in the options.
If the options work out to our financial benefit, we’ll exercise them, we’ll let you make money on it. If they don’t, we’ll let it go, and your contract value hasn’t gone down.
That is a true statement. It’s one of the reasons why it’s a powerful investment tool because it gives you the opportunity to have principal protection, basically that your money doesn’t go down, and get some participation in the market.
Now, the insurance company is in the business of making money, too, so, what they are going to do is they’re largely going to cap…
Victor: …or somehow participate in the index along with you, so you don’t get a 100 percent of the participation. The amount that they allow you to participate or not is driven by the cost of the options at the time that they buy them.
Hopefully, that will give you a little idea about the way the fixed index works. When we come back from the break, I’m going to talk about how to examine the contracts, what to look for, and figure out whether that one is right for you. Stick with us. We’ll be right back on Make It Last.
Victor: Welcome back to Make It Last. We’ve been taking about annuities today and now I finally get to tell you what to look for [laughs] in your contracts. You can get something out of it. Annuities are sold and sold and sold and sold largely because they have such high commissions that are associated with some of these products.
Insurance agents look at them and they say, “Home run. Can’t wait to sell someone an annuity because I can make 7, 8, 9, 10 percent on their contracts depending on what I can convince them to buy.” If you’re working with somebody like that like A, I’m really sorry for you [laughs] and B, I have watch out because these things are so confusing.
There are so many insurance companies that are out there. Every one of them has a different flavor of whatever they’re offering. You have to understand the way the engine works underneath the hood of the car to know whether you’re having a good one or a bad one.
Let me tell you a little bit about the way that annuities are structured generally and then how they are oversold and what to look for, and then what we think are important factors of them. The insurance company does not want you to have the opportunity put your money with them and then take it away right away because they are long‑term investors like you.
They want to be long‑term investors. One of the basics tenets of annuity contract specifically fixed‑indexed annuity is that there is a schedule of surrender charges. Surrender charges are essentially your commitment to keep the money, the largest part of the money with the insurance company over a period of time.
Those surrender periods can range. You can get something short as five years, you can go some as long as 20 or more years depending on the contract. I tell you straight up, 20 years way too long. Way too long for any contract and those are the bad ones, the ones that are super long, but 7, 10 years are for the right investor I think it’s an OK trade.
With the idea being is that they don’t want you to give your money then take it right back. They need to have some opportunity to make money on it for them to stay in business. There is trade off in them for the way the contract is written where you going to keep your money there for a period of time. You don’t have to keep a 100 percent of your money there.
The surrender charges are above what’s called a free withdraw and so, on annual basis you’ll be able to take out a certain amount every year. Then it depends on the contracts. Some people take out seven percent per year.
Some will allow you to take 10 percent even have contracts that will allow you to take up to 20 percent on a two‑year basis so that you don’t lose that year that you choose not to take something out. It gives you a little bit more liquidity. When those surrender charges are presented to people often they are glossed over. Not in my office.
When we talk about them, we talk about them hard. I have people initials that they understand what they’re doing. They really get why they’re using this product in their portfolio as part of the solution. The surrender charges are big and we don’t want anybody to be unaware of the fact that they have to commit their money over there.
We go to from surrender charges to different contractual guarantees. At the end of the day, the more you ask the insurance companies to do with this, the more they’re going to ask from you back.
For instance if you going to want a very high indexing opportunity where you’re going to be on a three‑year cycle or something like that, they’re going to want to surrender period for maybe nine years.
If you want to participate a 100 percent in an index, more than a 100 percent, they might charge you for that. One of the biggest problems with annuities are the way that people load them up with the writer charges. Writer charges are basically what you pay for certain contractual guarantees.
If you’ve been promised an annuity in income benefits, many times that income benefits, income benefits being saying that you’re going to be able to get a certain percentage guaranteed over a period of time. That usually come to the writer charge.
That writer charge is there to make money for the insurance company and be able to stand behind their guarantees, but and here’s the trick [laughs] it’s also the way that they pay the insurance agent higher commission.
My experience is been that the more writers are associated with the contract, the higher the commissions are. If you’re meeting with somebody that’s telling you that this annuity does everything in the world. It slices, it juliennes, it’s a Swiss Army knife. It’s largely because it’s loaded up with writer fees. Those writer fees have increased the commission.
The insurance agent is selling it just because it’s paying 10, 11, 12 percent and tying up your money for a very long time. Of course that’s a disservice. We don’t want to see any of that in any situation for clients. You have to be looking out for that because again the more that you ask the insurance contract to do, the more the insurance company is going to ask from you.
There’s nothing secret about that. When we look at the way the contractual guarantees work for principal protection as well as for indexing, you need to understand that the indexing options are numerous. Everyone is familiar with the S&P 500. That’s one that attracts the 500 largest domestic companies in the US.
As a reflection of their performance the S&P goes up, the S&P goes down. The S&P is a pretty easy one for people to understand in terms of indexing because they see it reported fairly frequently. The S&P also happens to have an adjustment annually for inflation. It’s a good measure of where the performance of the economy is at any point in time.
S&P is a pretty good index or rather ‑‑ I don’t want to say that’s its good but ‑‑ it’s a frequently used index because it is something that people understand well. There are other indices there too.
Some of them are created to mitigate volatility. They would draw from multiple assets classes. The S&P is only the 500 largest US domestic companies, a representation of those companies and their performance.
You might have another index that draws from global companies that comes from commodities that blends those things together so that you have a smoother ride into that you’re going to expect a little bit better performance over time and they’ll give you the historicals on that.
We choose to use a lot of those indices in the products that we write. The more volatility‑controlled ones because first of all we’re able to explain them to clients I think in ways the other advisors can’t. They get what they are investing in. Also because the goal of the annuity is no home runs.
We’re not looking to hit anything out of the park. What we want is some steady‑controlled growth. We want to mitigate our risk. Our risk of longevity and our risk of market performance specifically in retirement. When we blend those things together, we say the index that works best for you over time is going to be this index that controls for volatility and that’s important.
It’s important to make sure that you understand what you’re investing in when you use a fixed‑index annuities.
Part of the reason why you are doing that is to participate in some of the growth going forward, that the contractual guarantees are working to your favor so you can have this thing grow over time in some, I don’t want to say guaranteed way, but some reliable way. A way that you understand that’s not going to be tied to a market performance.
It’s a counteracting investment so that it doesn’t matter what the market is doing on the right hand side. This over on the left hand side is providing some steady growth or steady value for you.
The fixed‑index annuity with their indexing options also often come with the opportunities to have income guarantees. If you think about your retirement income as being two buckets, on the left hand side, you have your required spending.
Your required spending are the things that you need to do to feel comfortable. Peace of mind that you’re not going to go broke and die penniless in a gutter someday. It’s going to be your housing cost, your food cost and your clothing cost and property taxes.
Those things that are mandatory spending. You want to meet mandatory with guaranteed income. For instance, if you have social security not pension and that only adds up to 80 percent of what you’re required spending is on that mandatory side, you might look at one of this products as being a way of to make up that 20 percent.
You carve out a portion of your portfolio so that it fills up the rest of that bucket on a mandatory spending. The other hand of the retirement stuff is the discretionary spending and that’s the fun stuff.
That’s the stuff that has to do with travel and the things that you might want to leave behind as a legacy. Those things that aren’t essential to your well‑being in the same way the mandatory ones are. That you can do with investments.
You can do that with things that you don’t need the contractual guarantees. If we look at the income benefits of a fixed‑index annuity, many times that income benefit is serving to fill up the rest of the mandatory spending bucket.
That extra 20 percent let’s say that we’re using to make sure that we won ever outlive our money. That’s a good use of it. I spend a lot of time describing the way these things are set up. Here’s three things that you can look for to evaluate your annuity. First look at the surrender period. My experience is been that anything longer than 10 or 12 years is too long for a contract.
Especially for somebody that’s nearing or in retirement. The second thing you want to take a look at is what your opportunity to participate in the index is. Many times it’s limited. You might have cap on it and you want to look at what that cap is.
There might be what’s called a collar or a spread. In that basically that the first portion of it is the insurance and then you get what’s over it. You want to evaluate what you’re indexing options are and how often you can redo them. Choose a new one or reallocate.
The last thing you want to look at is the writer charges. Many times there is investments embedded fees on the writers that are de‑cumulating your cash value making it lower. The insurance company they run two different books.
They have your income benefit and that’s one number. Then they have your cash value or surrender value and that’s another number. The one that you’re really worried about is your cash value because that’s really your money.
The income value is just a method of doing math for the insurance company. It’s not really your money. You want to look at those because if you have a lot of writer charges, if you are paying two, three percent annual and writer charges it’s probably too much.
If you have any questions about your annuities and you want to know how to get good one, you need to call us. You can reach out to us and you can have an evaluation with us. We’re going to be able to take a look at that. If you’re interested in them, we call tell you what the good ones are and help you get into them.
If you’re wondering if you have a good one and you want to figure out how you can get out of it, we can help you with that as well. We can take a look at those and help you. You just have to contact Private Client Capital Group or Medina Law Group.
Just find me, reach out to us, and we can help you with that because this is one of the biggest abuses out there. We really want to make sure that people are in the right setting when it comes to their annuities and making sure that it works with their portfolio.
That’s it for today look more of me coming up in the future. I promise, promise, promise as well as more education more fun in the radio show and everything that you need to be planning for retirement. I want to thank everybody for joining us today. I’m not going to get to ask you to go to iTunes and leave a review except I just did.
There, go to iTunes and leave a review. If you’re interested in any particular topic, you want to hear more about us, go ahead and send us an email at email@example.com or send us a personal email. Just let us know how we’re doing. We want to thank everybody for joining us.
We’re going to catch you next week on Make It Last Saturday where we help you keep your legal docs in a row and your financial nest egg secure. See you next time.
Announcer: The foregoing content reflects the opinions of Medina Law Group LLC and Private Client Capital LLC. It’s subject to change at any time without any notice. Content provided herein is for informational purposes only and should not be used or construed as investment or legal advice or a recommendation regarding the purchase or sale of any security or to follow any legal strategy.
There is no guarantee that the strategies, statement, opinions or podcasts provided herein will prove to be correct. Past performance is not a guarantee of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns.
All investing involves risks including the potential for loss of principal. There’s no guarantee that any investment plan or strategy will be successful. We recommend that you consult with a professional dedicated to your needs.
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