Troy Sharpe: $254.6 billion of annuities were purchased in 2021. Of those purchasers, how many do you think actually bought their annuity as part of a comprehensive retirement plan versus those who maybe just went to a dinner seminar, got a pitch, and bought an annuity that they know nothing about. We’re launching an educational series where we’re going to do a deep dive into annuities. If you’re considering purchasing an annuity for your retirement, you can be part of the group that’s educated and has it as part of an overall plan versus someone who buys one and has no idea how it works and no idea how it fits into a plan.
Hi. I’m Troy Sharpe, CEO of Oak Harvest Financial Group, certified financial planner professional, host of the Retirement Income Show, and also a certified tax specialist. For many years, annuity sales have been on the rise, but many of you may think that annuity is nothing more than a four-letter word. Annuities can be a very powerful retirement tool, but they’re not perfect. All financial tools, stocks, bonds, mutual funds, real estate, annuities, CDs. Every financial tool has a specific purpose that it’s designed to be used for. It has positives and all of them have downsides. There is no perfect financial tool out there. For my experience, those people who do add the right annuity as part of a broader comprehensive retirement plan, typically do find more peace of mind, more security. They don’t worry about the market’s volatility as much, but annuities aren’t right for everyone.
The purpose of this video series is to help you understand and become more educated about the annuity marketplace. Just like anything, there are some really good annuities out there, but there are some bad ones as well. We want to give you a deep dive into the products themselves throughout this series, but the insurance industry as well. We want to talk to you about things that you need to be aware of if you’re considering purchasing an annuity. They are a long-term investment, and they can provide peace of mind and income and safe growth, but there are some pullbacks. When you weigh all of those pros and cons together, only then can you decide if an annuity is right for your portfolio.
What exactly is an annuity? Well, first and foremost, annuities have been around for hundreds and hundreds, if not thousands of years, in some form or fashion. Today’s annuities, there’s simply a contract between you and a life insurance company that lays out certain terms and conditions. They can be used to protect your principal, provide reasonable growth opportunities, as well as a lifetime income, which is simply a paycheck that gets deposited into your account as long as you are alive or you and your spouse, depending if you choose a single lifetime income or a joint lifetime income.
This video series is going to give you two options. This video is about an introduction to annuities. We cover the high-level points, and then we’re going to have a basics for the different types of annuities, lifetime income writers, growth potential, index options, but then after that, we’re also going to go much deeper into subsets of these particular topics.
If you’re the type of person who says, Troy, I don’t care how the car functions. I don’t care how everything works. Does it have heated seats? Is it leather? Is it going to get me from point A to point B. These basic videos, the introduction ones may be enough for you to have a good understanding, but if you’re that engineer type who really wants to kind of get down and understand how all the gears work and how everything comes together, then we’re going to have those videos as we go throughout this series as well.
No matter which one of those two categories you fall into, after finishing this series and going through the appropriate videos for you, you’re going to be a much more informed consumer, and you’ll know if you want to add an annuity to your portfolio, you’re going to do so with all the knowledge that you need to make a good decision.
One of the key points that I want you to keep at the forefront of your mind as you go through this video series, is that an annuity must be used as part of a broader plan. Annuities are an asset class in and of themselves, just like stocks and bonds are an asset class but all of those, whether you’re using stocks, bonds, annuities, real estate, everything needs to be part of a plan. That is going to be the concept that we are going to stick to as we go through this series.
Do not look at annuities in a vacuum or an isolation as to their pros and cons. Look at them in the context of how does it reduce risk or increase income or help you sleep better at night. Look at it in the context of your lifestyle and also a plan.
There are primarily five types of annuities. You have immediate annuities. You have MYGAs, which is an acronym. It stands for Multi-Year Guaranteed Annuities. You have fixed index annuities, you have variable annuities, and pretty new to the scene is what they call structured annuities.
Now, for the purposes of this video series, we’re going to focus on the MYGAs and also the fixed index annuities. The reason we’re going to do that is because immediate annuities aren’t very attractive right now. Essentially, you give your money to an insurance company, and they start or immediately start giving you an income for life. For the purpose of this series, we’re going to focus on the types of annuities that are 100% safe, meaning your principal is guaranteed, never to lose if the market goes down, and also give you the opportunity for some reasonable growth. We’re not going to talk about the variable annuities or the structured annuities, because those come with market risk, and the guarantees that variable annuities, for example, provide when compared to fixed index annuities for guaranteed lifetime income, long-term care benefits, all the ancillary benefits that are available in the marketplace today. They simply aren’t competitive with fixed index annuities. I’m a firm believer.
If you want to put your money at risk in the market, you shouldn’t do so inside of an annuity. You should do so in the market itself. The fixed index annuity and the MYGA annuity give you 100% principal protection and the opportunity to have some pretty decent returns.
Why do you think the life insurance industry is allowed to use the word guarantee? No other industry within the financial services sector is allowed to use that word, but life insurance companies are. You can have a guaranteed death benefit. You can have a guaranteed lifetime income. You can have guarantees that your principal won’t go down if the market declines. The reason that the life insurance industry is allowed to use that word guaranteed, is something called the statutory accounting system. The life insurance industry is regulated on a state-by-state basis.
What the statutory accounting system mandates is that companies within the life insurance industry must have over 100% legal reserve of the dollars they owe you. If you invest a hundred thousand or a million dollars or whatever it is with a life insurance company, they must keep that amount of money plus a minimum guaranteed interest rate in reserve. They have solvency requirements. They have risk-based capital metrics they must adhere to.
Life insurance companies are the safest financial institutions in the world. If they reserve over a 100% and you compare that to a bank which may reserve only 5% to 10% of your deposits, you see why they have much more solvency.
Now, in addition to the dollar-for-dollar legal reserve system, there are stringent rules in place for what insurance companies can invest in. Also, insurance companies aren’t allowed to use leverage like banks or brokerage firms in order to invest their funds. Life insurance companies typically are going to be 90% to 95% invested in long-term government bonds. We’re talking 10, 20, 30 years, high-quality corporate bonds and real estate. That’s primarily what life insurance companies invested. They’re not allowed to use leverage, which is margin if you are familiar with that term. They can’t go borrow a bunch of money to then invest in risky securities. On the other hand, banks and brokerage firms do exactly that. Banks have trillions of dollars of derivatives oftentimes on their books. This is money they don’t have legal reserves for, but they’re allowed to do it. Life insurance companies aren’t allowed to do that.
When you’re comparing the safety of life insurance companies versus a bank, it’s not that banks aren’t safe. That’s not the point here. The point is the reason why life insurance companies are able to use that word guarantee is because primarily they have dollar-for-dollar legal reserve requirements, and they’re not allowed to borrow money, leverage up the investment portfolio, and invest in risky instruments. Life insurance companies are the bedrock of the financial industry.
Many people don’t know this, but the life insurance industry played a tremendous role in helping the country come out of the great depression. When people had money in the banks, and the banks collapsed, or they had money in Wall Street, and Wall Street collapsed, people who had money, typically it was in whole life cash value policies.
People who had money in their life insurance policies back then, they didn’t lose their principal. They didn’t lose their interest. When you look at the safety and the security, the great depression is a great example of how it’s withstood the test of time.
To go through a more recent example in a couple of minutes, I’m going to go through AIG and what happened during the 2008 financial crisis to show you the statutory accounting system and work in modern times.
It’s important to note here that life insurance companies, life insurance contracts, annuities, et cetera, they are not FDIC-insured. Banks do have FDIC insurance. Now the FDIC doesn’t have nearly enough money to insure all the deposits in this country. They do have an unlimited line of credit with the United States Treasury.
Life insurance companies and life insurance policies, annuity policies, et cetera, they are protected on a state-by-state basis by what’s known as the state guaranty association. Every state has different rules and regulations and limits. If you’re interested, I encourage you to check with your Department of Insurance for the state you live in, to find out the limits within your state.
Many of you remember back in 2008, AIG being all over the news networks. The CEO had people on his lawn, protesting, because they got a bailout from the federal government for $80 billion. The media didn’t necessarily characterize what was going on correctly. I want to show you the statutory accounting system at work in recent times with this example.
Back in 2008, AIG, and even today, they have a lot of insurance companies, and they have a lot of different banking entities, and investment banking entities underneath the AIG umbrella.
The insurance side of AIG, the insurance company was A+ rated back in 2008, and it had $1 trillion in liabilities. Pop quiz, if AIG, the insurance company, owed people over $1 trillion, how much did AIG, the insurance company, have in legal reserves? Well, according to the statutory accounting system, they must have had over a trillion dollars in reserve. Why did they have to get an $80 billion bailout then if they had over a trillion dollars in reserve? The simple answer is, it was the investment banking side of AIG that was in trouble. They were over leveraged with a tool called credit default swaps, which acted like insurance, even though they weren’t insurance. There were security that when all the mortgage bonds collapsed, those credit default swaps had to payout.
Now, that’s why they had to get an $80 billion bailout, but why didn’t they just come over here to the life insurance side and borrow the $80 billion, instead of having protestors on the front lawn and being all over the news? Well, there’s a firewall. Okay. This is the statutory accounting system. There’s a firewall here between the banking operations of AIG and the life insurance operations of AIG. That’s why they couldn’t go through and do that. The life insurance side of AIG has to go through audits in every single state that it does business in, so they can’t cover that up and get away with it through 50 different states. Someone would’ve found out that they had lent money over here to bail them out, et cetera, et cetera. This is the statutory accounting system at work.
Now, what does that mean for you? That simply means that when you put money with a life insurance company, because of the dollar-for-dollar legal reserve system, the oversight from the various state regulation, and the statutory accounting system, that’s why the life insurance industry is able to use that word guarantee where banks and brokerage firms cannot.
Last thing on this topic. There’s an old saying in the life insurance industry that a C-rated company is just as safe as an A-rated company, because of the statutory accounting system. That is partly true. C-rated companies still have to follow the dollar-for-dollar legal reserves. They go through all the audits. They invest in conservative investments. They can’t borrow funds and make excessively risky investments, but still you want to invest in highly rated companies.
Typically, a C-rated company, even though they have all those things in place, they are young company, or they don’t have many assets, and they haven’t proved themselves over many, many decades. Your A-rated companies, even your B++ is considered investment grade, but I personally wouldn’t want to go much below B++ and try to keep it as highly rated as you possibly can.
One of the myths I hear all the time about annuities is that, Troy, if I put money into an annuity, the life insurance keeps my money. Well, that could not be farther from the truth. You have 100% death benefit of your principal and all interest earned unless you choose otherwise. Now, why would someone choose otherwise? There’s a concept called annuitization, which is a choice that you can select and we’re going to dive deeper into that down the road. As we dive deeper into the series, we’re going to provide some examples, but for now, just know that an annuity operates just like any other account when it comes to death benefit in the sense that if you put money in and it earns interest, that is your death benefit. If you take money out, that will reduce the value of your death benefit, but know the insurance company does not keep your money.
Annuities are not short-term investments. They are long-term investments, and they come with something we call in the industry, surrender charges. I’ve heard before, I’m sure you have. If you put your money into an annuity, it’s locked away, and you can never get it back, and it’s a long-term investment. Well, it is a long-term investment, but yes, you can get your money back, but you don’t put more than an appropriate amount based on your plan into an annuity.
Now, possibly if you buy a one-year MYGA, or a two-year or a three-year MIGA, it could be a short-term tool, but for the most part, annuities are designed to be held for a longer period of time. They do come with what’s called surrender charges, and those surrender charges can be pretty big over the life of that contract. If it’s a 10-year annuity, the surrender charges are going to start out pretty big. Typically, they’ll start out around 9%, and reduce 8, 7, 6, 5, 4, 3, 2, 1, as the contract progresses.
Insurance companies are aware of that, and they don’t want to lock your money away, but they do need to know that you’re not going to be pulling all your money and pulling it all out and putting it back in because otherwise, they couldn’t make the guarantees that they make for lifetime income, safety of principle, interest potential. It’s a give and a take. If you want your money to be a 100% safe, and have the opportunity for a reasonable rate of return. There is a trade off and it comes with liquidity and timeframes. Annual liquidity is typically about 10% per year, so if you put in $200,000 and you need to go get 10 grand out, you can go do that because that’s about 5% of the account value. Every year, typically you can take out about 10% of the account value if you need the money.
Obviously if you need more than that, you would be hit with the surrender charge potentially. Let’s say you have a million dollars in your retirement portfolio. You wouldn’t want to put 900,000 of it into an annuity plan. If you put 200 or 300, maybe 400, depending on your risk tolerance, and how that plan came together, and how much income you needed, you definitely wouldn’t want to get up to 700,000 or 800,000. Even you need to keep your brokerage account intact for emergency purposes, for liquidity purposes, to invest in good companies that are in the stock market.
When you start to look at the surrender charge period that comes with annuities, you do have to keep it in context of, if you have a plan you put 20% to 30% of your assets dedicated to principal protection, reasonable growth opportunity, lifetime income, whatever your planning technique is. You still have 60%, 70%, 80% of your entire retirement nest egg, 100% liquid in available to you, but I also will point out this, if you take too much risk over here and the market is down 40%, many people will consider that a surrender charge if you need to go and take money out at that time.
Everything has ups and downs, pros and cons. It’s about having that plan and keeping the balance, so you don’t have too much money in any one particular tool, but more importantly, those tools are working in concert with one another to accomplish the larger objective.
Annuities pay commissions. That’s right. The person who you buy an annuity from is going to receive a commission. For the multiyear guaranteed rate annuities, those are often maybe 1% or 2% of the deposit that you make. When you start to talk about the index annuities, the fixed index annuities, those commissions can be 5% to 7%, and that goes directly to the company or the person who you bought the annuity from.
Now, it’s important to note that that commission that goes to the insurance salesman does not come out of your account value. Okay. That comes from the marketing budget of the life insurance company. It’s a cost of doing business essentially. Life insurance companies do not work directly with consumers. You have to go through the life insurance agent in order to purchase an annuity. You can’t go directly to the company. That commission structure is part of the reason why you have surrender charges in place as well.
If you surrender your contract in 12 months or within 12 months, for example, the insurance agent gets what’s called a chargeback, and essentially that commission has to be paid back either 100% of it, maybe 50% of it, whatever the terms and conditions are that the agent has with that insurance company, but part of the surrender charge schedule is in place because of those commissions.
You have a lot of financial advisors out there that say they’ll never sell anything with a commission with it. Well, it’s tough to actually then provide some of the very best products and services that are out there for your clients if you’re not going to look at life insurance products, if you’re not going to look at long-term care products, if you’re not going to look at fixed annuities or index annuities.
Just because a product pays a commission doesn’t necessarily mean that the product is bad, that’s just the compensation structure. Now, there are a lot of people out there who just sell annuities to make these larger commissions, and those are the people that you really, really need to be aware of. They’re typically just selling annuities without them being part of a plan. They’re like a hammer, and everything they see goes into an annuity. Typically, it’s the same annuity from the same insurance company, because they may have backend incentives based on total amount of production. You want to be very careful who you work with, but understand how agents get compensated and feel free to ask. Don’t be afraid to ask how much are you going to make if I purchase this annuity.
Another important note is that there is a difference in the life insurance industry between what we call independent firms or agents and captive firms or agents. Captive is exactly what it sounds. They’re held captive by a particular insurance company, and they must sell products from that insurance company. These are typically the bigger names that you hear often on television. You’ve known for 40, 50, 60 years, and they know they have a captive audience as well, so those agents sell those products only. Now because of that captive audience and the ability to only sell that one product line from that company, oftentimes those products are the least competitive in the marketplace.
Those are the ones typically you should avoid in my opinion, if you’re looking for the most growth potential, or the most lifetime income. I’ve seen a stark of a contrast over the years between what a captive company was offering versus an independent company, and you’re looking at 30%, 40% more annual income if you look at the lifetime income products, and if you’re looking at growth, oftentimes it’s 100% or 200% higher growth potential with something that you can find from an independent agency versus these captive ones. In my opinion, it makes a lot of sense to consider an independent firm that is not beholden to only selling one or maybe two companies within their product choices.
Consumers also do not deal directly with the insurance company. You have to go through an agent. This is the way the industry is set up. It helps the insurance companies keep costs down. If they had the public just calling with all of these questions, wanting to look at illustrations, wanting to look at brochures, they would have to employ so many people to answer the calls and handle the admin work. The costs would go up, and they wouldn’t be very profitable.
Life insurance companies aren’t tremendously profitable from a margin standpoint to begin with. Yes, they can make billions of dollars, but they’ll do that on trillions of dollars of assets. Typical margins on a lot of these products out there, the fixed annuities, maybe 1%, maybe half a percent, possibly one and a half to two. Insurance companies make money through value. That’s how they make their money.
One of the things that I think is really cool is that as the consumer has become more educated, as the internet has made more information available. Life insurance companies have made their products much more attractive today than they were 10 or 15 years ago, and it’s a highly competitive marketplace. A lot of people in retirement want safety of principle. They want the potential for good growth. They want lifetime income with more information, more accessible, and the consumer becoming more educated, all that has translated into life insurance companies offering better products that typically have lower fees, more growth potential, more income, and they’re competing for business.
As we go through this series, you’re going to learn a lot about not just annuities themselves. You’re going to learn about planning strategies, how to use them in the context of a plan. You’re going to learn about companies. You’re going to learn so many different things.
By the time you finish this series, you’re going to become a highly educated consumer, and I look forward to taking you on this journey with me.