Using a Fixed Index Annuity as an Income Planning Strategy

 

Jessica Cannella: We’re going to talk today about how to use a fixed index annuity in your portfolio as an income planning strategy. Now, that is very different than what we just discussed in my previous video about using it for for guaranteed income stream or an income rider.

I’m Jessica Cannella, co-founder and president of Oak Harvest Financial Group. I’m looking forward to chatting with you about how to use this tool to diversify your portfolio and as an income planning strategy. I’m going to give you the example, for easy math, of somebody who has a $1 million portfolio. Let’s say in this portfolio we have a portfolio that’s traditionally comprised, especially where we’re working, of stocks, and mutual funds, some ETFs, and some bonds.

Bonds we hear a lot about as we get closer and closer to retirement. Traditionally, they have been used as a conservative play in your portfolio. If you’ve ever heard about target fund, that’s a tool or an investment that is generally available to you while you’re working inside of your 401K or 403B. It’s a fund that picks a target date for your retirement. Let’s say your target date for retirement is 2035. It’s the year 2022 and you’re 55 years old and hoping to retire around full retirement age, 67-ish, and you’re in a target fund. The target fund is set for the year 2035.

What does that mean? Well, maybe it means that in the year 2022, you are invested 80% in equities, which are your stocks, mutual funds, ETFs, your positions in your portfolio that you’re going to see the most volatility. They’re going to go up when the market goes up, down when the market goes down. Then 20% will be in bonds as a little bit of a hedge on your investments as a conservative play to your portfolio. Then the year ’23, let’s say that now it’s going to be 75% into equities, the more volatile investments, and 25% is going to start to shift more over to bonds and so on and so forth. In 2024, it’s 70/30. In 2025, it’s 65/35 all the way up to 2035.

Now, this was just purely for illustration purposes to give you conceptually how a target fund works and why I believe there are better alternatives to diversify your portfolio in retirement or approaching retirement. You can see that target fund shifting you out of equities, into more conservative investments within your investment portfolio as you approach closer and closer to retirement.

Now, living expenses in retirement. When clients and prospective clients come to visit with us at Oak Harvest Financial Group, a big topic of conversation is income in retirement. I believe that you cannot retire comfortably without replacing at least your baseline expenses, your living expenses in retirement with different streams of income.

Let’s take and example of somebody who has a million-dollar portfolio. This is how they’re currently invested in their 401K or what have you. They’ve got a million dollars, they’ve got stocks, mutual funds, ETFs, and some bonds. Let’s say that they have a traditional preparing-for-retirement 60/40 split. 60% of their portfolio is going to go up and down more often, and the 40% is just going to be more stable with little fluctuation here and there.
The challenge with that in the current bond market and why I say I believe that a fixed index annuity could be a stronger alternative than a bond in your portfolio is that we have inflation and we have rising interest rates. Bonds and interest rates have what’s called an inverse relationship. You could think of it as a giant see-saw, interest rates go up, bond values go down. Then when interest rates start to fall, bond values start to come back up. We are currently in a rising interest rate environment and we have been. Bonds are just not what they used to be back when your parents were enjoying the rewards of having bond funds.

Let’s say that I need $60,000 to survive in retirement to maintain my current lifestyle. To do a little bit of traveling, make sure all my bills are paid. The number for me is $60,000 in this example, and I’ve accumulated $1 million. My current portfolio is 60% equities, up and down, 40% bonds, and pretty stable, and we’re in a good market environment. I’m getting about, let’s say, 8% to 10% return on my portfolio, so I’m in the money. Let’s say I’ll also turn my Social Security check on, and that’s $1,500 a month or $18,000 a year.

Then I’m one of the lucky ones that has a pension, and that’s another $2,000 a year. I’m sorry, that would be a very small pension, $2,000 a month, or 24,000 a year. That’s bringing me up to $48,000, the $18,000 from my Social Security, the $24,000 for my pension, and I have now a gap of $18,000 because I need $60,000 and these to total up to about 48,000 a year. Let’s say I need $20,000 gap because I also, if I like the shoes, I tend to buy them in both colors. We’ll give me a little bit of padding and say I need about $20,000 extra in retirement.

My portfolio, as I mentioned, the markets doing what the market does, and it’s been going up the last 15 years, roughly, with some volatility that we’ve seen this year and couple years past, but overall, my portfolio is doing pretty well. My advisor keeps me in 60/40, and I’m in the money, I’m making an 8% return, I’m living off the interest that more than covers my $20,000 a year that I need for my living expenses and I’m feeling pretty good. Great.

What happens to somebody that struggled in a year like 2008, or multiple years in the great recession of 2008? The market doesn’t do this, it does what the market does, which is up and down, up and down. Now my $1 million looks more like, let’s say, $750,000 because the market went down, and I still need my $20,000. I imagine that most of you lived through 2008, and when you were working, if you held your job, your boss probably didn’t call you, or even during this recent volatility, or after 911, or COVID is another great example, we have temporary periods where the market goes down.

2008, not a temporary period, that was a recession that lasted two years. That said, did you get a call from your boss that said, “Hey, Jessica, I know you’ve been working really hard and that you need your $20,000 a year to live off of, but unfortunately, market’s down, we’re going to have to drop that to $10,000 a year, how’s that sound?” Horrible. You should quit your job and find someone that’s going to pay you even in down markets, and that’s retirement.

You don’t want to be faced with the choice of, “Oh, the markets down and I’m in stocks and mutual funds and my bonds aren’t really growing very much. Now these are down and I still need my 20,000, so do I just not buy any shoes that year or is there a better way?” That’s really what I want to show you how a fixed indexed annuity can be used as a part of a portfolio. Not a magic bullet, has some considerations, but as far as diversifying your portfolio and as a bond alternative, it can be used as an income planning strategy. I’m going to show you that now.

Remember this, we had $1 million. It looks like a mad scientist wrote it, now that I’m stepping back. We have $1 million portfolio, and that is comprised of stocks, bonds, mutual funds, ETFs, and it’s 60% equities, investments that go up and down, and 40% more stable investments that should stay even. We’re getting $18,000 a year from Social Security and $24,000 from our pension because we’re one of the lucky ones that have a pension.
Now we are meeting with a true financial planner who tells us about all of the tools that are available to us. We come in to sit with them and we say, “Hey, you’re not going to believe what happened, but my advisor at my old firm was telling me take out 4%. I was doing that, living the life, and then boom, we hit a recession and I was like, ‘Where’s my $20,000? I need that to live off of. My choices were trim the fat in retirement or reduce my expenses or sell at a loss of my investment portfolio. I’ve worked really hard for my money and I want to know if you financial planners have a better option for me to consider, would you please educate me?” Yes. Allow me.
If you have the same $1 million portfolio– Again, this is just easy math.

This is in no way suggesting that it is appropriate for you as an individual investor to put half of your life savings into an annuity. That is really a conversation that needs to happen between you and a professional, but for easy math and illustration purposes, I would like to show you with that example of putting now $500,000 towards your investment of stocks, mutual funds, ETFs, they’re only slightly different from each other, and bonds.
Now we’re going to say, “Hey, here’s this other option. Let’s send $500,000 into a fixed index annuity.” This is going to grow, if you remember from previous videos or your own education, about 4% to 6% conservatively year-over-year in a 10-year period. Again, there are real considerations with an annuity.

Liquidity is one of the biggest ones. It could be extremely appropriate for you to put $500,000 out of $1 million into a fixed index annuity. I just don’t know that without having gotten to know you personally. 4% to 6% on average over a 10-year period. You could have double-digit returns, you could have zero when you average them together over 10 years, conservatively 4% to 6%.

You cannot lose money in a fixed index annuity to market risk. You can only grow, and every year, every two years, or it could be up to six years that the reset period, which again, fine print, talk to your advisor, every year, let’s say, it annually resets, you are going to lock in your interest and it becomes your new principle protected value. This is a good way to think of a fixed index annuity, is that it’s the turtle in that old fable, the turtle in the hair. It’s slowly growing. It’s geared for safety.

How do we use it as an income planning tool? In my example of the first person who had $1 million and they had 60/40 split, that was on the total million dollars. Now that we know that we’ve protected $500,000 in this example and it cannot lose money in the market, we could probably be a little bit more risky in this account, or adventurous, as I like to say. What I mean by adventurous is your willingness or capacity to take on risks.
Before we were sending half of our portfolio to 100% safe strategy, no market risk. We said that our breakdown in here between equities and bonds was going to be 60/40. Now adventurous might look like 75/25. This is goals-based. This is also very personal and this is a conversation to have with your financial advisor and your spouse, if you’re married, how you want your portfolio to be allocated.

Let’s say that we go with 75/25, what does that accomplish? Now we have more market exposure on the $500,000 over here because we’ve protected $500,000 at the insurance company, and we have less funds going into the tragic bond market for 2% to 3%. What that allows for is more exciting growth over here with not exchanging that for peace of mind because our peace of mind is over here.

That said, let’s take the same instance where I need $60,000 to live my life in retirement. I’m getting $18,000 or $1,500 a month in Social Security. I have a pension and that’s $24,000 a year. I need an extra, roughly, $20,000 a year to get to $60,000 to live my best life. This year I want to take a $10,000 vacation with all of my girlfriends, so I need $30,000.

I’m telling this financial planner my experience before I even had the vacation plan, that I’m terrified to plan this vacation with my friends because what if the market goes down again? The financial advisor assures me that should I consider this tool, it works differently than my experience with just withdrawing 4% out or living off of the interest of my account when I was with the other firm. This is how that is accomplished.

In the same instance where the market goes up and the market goes down, let’s say that it’s another crap year in the market, it’s a recession, I was out $20,000, roughly, trying to pinch my pennies the year before. Now, I want $30,000 because I feel slighted and I want to be able to live my life, and I’m here with you, so help me, financial planner. I need $30,000 to bridge the gap between my living expenses and to take my vacation. The market goes down again, and now we’re two years and the market is down. Let’s say my $500,000 looks, again, like to $375,000.

I talk to my financial advisor and say, “Where are we getting the money from? Do I really have to tell my friends, ‘No, I can’t go, my life depends on what the stock market does these days”? Hopefully, he’ll have talked to me about this strategy, if it was appropriate in my instance. He will say, “Actually, Jessica, we have what’s called a 10% free withdrawal feature in this annuity that you started two years ago. You put $500,000 into it to start. Great news, we have a two-year reset, and when I looked at your current statement, your $500,000 in here is now $550,000 and we can take up to 10% out without any penalty or fee.”

Now we have $550,000 in the fixed index annuity. We can take out up to 10% in most contracts. Some of them it’s 7%, it could be as low as 5%, but most of the time, it’s about 10%. Again, your advisor will know the information around that. My point is you can take out $55,000 that you cannot lose money from. Of course, you take it out, that’s less money for your money to earn money on, so you need to be analyzed by a professional.
It’s a heck of a lot better, in my opinion, than taking out of your investment account when it’s down to the tune of you know 15%, 20% in a recession, because it gets you your $30,000 grand, you live life. Then most importantly, you stay in communication, you go to your reviews with your financial advisor, they’re proactive in an ideal situation, and you’re having this conversation annually or as income needs arise.

That is how we can use this tool to prolong the longevity of your investment account and to have your safe money growing at a slower rate. It’s the turtle, this is the hare, but it allows us the flexibility to pivot between the two accounts. What does that mean for you? Peace of mind in retirement, that you will enjoy your retirement paycheck regardless, and change that with your lifestyle, regardless of what the market does or does not do. One truth be told, I don’t care how good of an investment manager you’ve hired, They cannot predict the market. The market I believe to be efficient, but it is somewhat unpredictable and your retirement doesn’t have to be.