Variable Annuitites: The Truth About Guaranteed Rates of Return

In this episode we continue our discussion on annuities, this time focusing on the variable annuity.

TRANSCRIPT: 

    John: Variable annuities generally invest in mutual funds and things like the stock market, but can they get a guaranteed rate of return? That's our topic on today's episode of Friends Talk Financial Planning. Hi, I'm John Scherer, and I run a fee-only financial planning practice in Middleton, Wisconsin.

    Bridget: And I'm Bridget Sullivan Mermel. I've got a fee-only financial planning practice in Chicago, Illinois. Before we go further, we've got a goal of getting 1000 subscribers, so please help us out and subscribe. Okay, John, so happy to be talking about variable annuities. You're the guru. You've taught me most of what I know about these things. 

    And the topic for today is the variable annuity. So that's the other thing. This is a variable annuity, not the other type, which is a fixed annuity. So with a variable annuity, they'll say, “Oh, it's guaranteed at 6%,” which makes it sound like you can't lose any money. Doesn't that sound good? I think that sounds good.

    John: That one's good. I like that idea.

    Bridget: So why am I losing money?

    John: Let's dig into that. And I love you saying that. There’re different kinds of annuities. We can put a link in the show notes to our recent episode on fixed annuities. There are actually several other kinds of index annuities and maybe we'll dig into those if it's useful for viewers. But we're talking about variable annuities here. And at its core, it's just like investing in a mutual fund, but it's got this insurance wrapper that's got some other things that go with it.

    People buy it because it's like buying a mutual fund, but I've got some other benefits that the insurance company provides. And as part of that, there're no guarantees. When you buy a mutual fund, it goes up and it goes down. That's how that stuff works. And that's how these annuities work, but with some exceptions. And I can pull up an example. Actually, this came from a cousin of mine who's getting ready to retire, and he wanted to talk through this situation.

    He put an old 401K into an annuity inside of his IRA and said, “Hey, here's how I'm going to work this.” And I said, “Well, golly, you should ask some questions.” He said, “Well, would you mind looking at it for me?” I said, “Great, I'll take a look at it for you.” And here's a snippet of what a statement looked like. And you can see kind of right here in the middle, it says, “LIFEGUARD FREEDOM FLEX 6% A INCOME STREAM.”  

    Bridget: All words that I like.

    John: Right. But 6%. And, of course, read the 180-page prospectus; it describes exactly what that means. But in his mind, it was, “It's got a guaranteed 6%. Plus, I got some upside to it.” And here's what it looks like. And these are pretty common, so I think it's worthwhile to look at this so that folks can understand what's going on. I looked at that, and I'm always questioning myself. I know what I think I know, but what am I missing? And just take a look at what the statement says right up on the top. He started this in 2016. And this was last year that he came to me, so about seven years.

    And it says, what's the beginning value? Since the issue date, a little over $500,000. So he put in around $500,000. It says he's taken some money out of this. He's taken out a little bit, $40,000. But he's put in $500,000. And look at the ending value that's over here on the middle left. It’s just $530,000. So just think about those numbers for a second. There's other complicated math, but just basically, I put in $510,000. I took out $40,000, so that's $470,000. I've had it for seven years, and now it's worth $530,000. That math doesn't add up.

    Bridget: It would be making 30 grand a year.

   John: Right. At 5%.

    Bridget: And in seven years, that's $210,000. Even if I took out $40,000, it wouldn't be a big hit.

    John: 6% of $500,000, is just $30,000, not even including compound interest. Seven years at $30,000, I'd expect it to be something like, $700,000. I don't have to be exact. I'm thinking, “Okay, if it's around $700,000, I kind of feel good about it.” And it's at $530,000. What is going on here? And take a look down at where it says that 6% income stream. What's the guaranteed withdrawal balance?

    That number is $680,000. So it's close to $700,000. You go, “Yes.” And when you dig into these things it says that we started with $500,000. It's sort of this artificial pot of. He doesn't actually have $680,000, but here's the withdrawal balance, and then below that, the amount available to withdraw is 5%. So what he can take out is 5% of the $680,000 number, which is where that 6% guarantee comes in each year. Are we confused yet?

    Bridget: I’m totally confused.

    John: He gets 6% on a shadow account that's not actually money, that the insurance company then says, “You can take out 5% of that.” And you start going, “Well, wait a minute.” And then there're some caveats and some restrictions and other things. And so, it's not like saying, “I get 6% a year, and then I can take my money and do what I want with it.” It's this moving part. And, yes, I get that. But then I give that I've got this restriction, then I got to take it out in a certain way. And one of the tenets that we both believe is that if an investment should be something that you understand.

    If you don't understand it, you don't need it. And you start going through this stuff. And, of course, I've read these things enough. Okay. I know it. But you go, “Wait a minute. If I don't understand this thing…” And we said in one of the recent episodes, as we're talking about this stuff, right. You're a CPA, a CFP, have a master's degree, and you kind of go, “Okay, right.” How is a regular person supposed to figure this out? So that 6%. I mean, there's a factor, so it’s not like they're completely lying, but it's not like you're getting 6%. The actual balance that a person has is much less than that.

    Bridget: What you're saying is they say, “Okay, here's your beginning balance. We'll keep a thing over here and say, okay, we are going to pretend that's earning 6%, and of that 6%, you can take out 5% a year of that big balance?”

    John: Right. And I will say here that there's probably more to it.

    Bridget: Right. But in concept.

    John: What I recommend to my cousin is hiring an independent actuary who for an hourly fee will break this down exactly what those things are. But this is conceptually right.

    Bridget: It's not like you're getting 6% a year.

    John: Yeah, you can't walk away with 6% a year.

    Bridget: But there's some sort of withdrawal. If you take out 5% a year, for a while. How long does that take?

    John: That's where you get into some of the details. I didn't look at that in depth, but it's that sort of thing. You go, “Hey, here's this question,” and that brings up another question. Well, what does that mean? And then does that change once you take money out? How does that all work? What if you need to take out more than that 5% for some year? Can you take that out because you've got a balance? And does that affect the guarantees and all those factors that come in? And again, part of the point is that you say, “Well, wait a minute.” When things start getting that complicated, is that really where you want to have a big chunk of your retirement money set up? And what are the advantages?

    And I'll tell you some of the advantages. I know we covered it when we talked about three annuity mistakes. If you're worried about longevity because everybody in your family has lived into their nineties, and you never want to outlive your money, there is a place for things like what we're looking at there. It does make sense. In my cousin's situation, both of his parents were gone well before they were 80 years old. And so, you take a look at some of the history, and you go, “Okay, that's not the reason for it.” So in the proper setting it can make sense. It's not like, “Oh, annuity means bad.” No, that's not the deal. But what is it used for? And what are you trying to accomplish with this?

    And we talk with a number of people, and I'm sure you do, too, who are like my cousin, saying, “I'm getting a guaranteed 6%, so I like that.” Well, wait a minute. Not exactly. Not like we talked about on the fixed annuity episode where, yes, you are literally getting that 6% interest, if that's what it says, like in a CD, you're literally getting that 6% interest. That's a different story. And that's the real frustration that I have with things like this. You get into a spot where the person buying this thinks one thing, but that doesn't really have anything to do with how it actually works. And that's not right.

    Bridget: Yeah. Honestly, one of my tips is if you're buying an annuity contract, take notes. And it would even be helpful to have the person who's selling check your notes. I bet it could have been explained to this person who bought it when they bought it.

    John: Yeah.

    Bridget: But that's not what sticks. It's 6%.

    John: Right. And that's part of what the sales pitch relies on. What's the sizzle factor?

    Bridget: What sticks? Flex. Lifetime. Words like that.

    John: Right. Like guaranteed. I've got another thing I'll bring up here really quick. We have talked in previous episodes about knowing what your expenses are, so I'll just highlight one of the expenses from this particular product. It’s that guaranteed income factor inside of annuities. If you've watched the other episodes, you'll know that there's a mortality and expense charge. There's an insurance charge that's on top of the mutual fund charge and an administrative charge. But in this particular one, that ability to have that 6% flex guarantee, 5% withdrawal rate thing that cost at least 0.8% and as much as 1.5%.

    Bridget: Oh, wow, that seems like a lot.

    John: And that's on top of the annuity charges.  

    Bridget: Especially in the current interest rate environment. Currently, you can get 4% without any extra things. In this case, the insurance charge is 0.95%, so almost 1%. And then there’s an administration charge, and you're looking at total insurance costs of around 2%, that is 1.9% to 2.6% before you get to the investment charges. So you're talking 2.5%, maybe 3% on this for the right to have that income. And again, it's not wrong necessarily, but for somebody like my cousin who looked at this and says, “Well, jeez, guaranteed 6%.”

    And you're paying each year inside the annuity 2.5% or 3% for the right to have this thing that maybe you don't even want. And you go, “Wait a minute.” That's where these problems come in. And again, I appreciate having you to discuss this with. You do this for a living and it's complicated. How does a regular person understand? Hopefully this gives folks some idea of things to look at, some of the questions to ask and not just take it at face value.

    John: So with that, I think it's a great place to wrap things up here. And again, I'm John Scherer. I've got a fee-only financial planning practice in Middleton, Wisconsin.

    Bridget: And I'm Bridget Sullivan Mermel. I've got a fee-only financial planning practice in Chicago, Illinois. We're both proud members of ACP, the Alliance of Comprehensive Planners. We do tax-focused, comprehensive, fee-only financial planning. And there're advisors all throughout the country. John and I are both taking clients, but if you're interested, you can check out acplanners.org.

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