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  • Writer's pictureBridget Sullivan Mermel CFP(R) CPA

Understanding Fixed Annuities: How They Work and Making Informed Financial Decisions



In this episode of Friends Talk Financial Planning, John and Bridget dig into the world of fixed annuities. They discuss the components of a fixed annuity, how it works, and why it differs from a variable annuity. If you're curious about whether buying a fixed annuity is a good idea, this video will provide valuable insights.


John's firm website: https://www.trinfin.com

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TRANSCRIPT:


John: Bridget, recently we published an episode about three big annuity mistakes, and a viewer asked a question: “Is buying a fixed annuity a good idea?” And on this episode of Friends Talk Financial Planning, we're going to dig into: What are the components of a fixed annuity? How does it work? Why is it different than a variable annuity? And how you can make some good decisions around this idea. 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 any further, please subscribe. It helps our channel and helps us reach more people. So, John, I can't wait for this episode, because I got to admit that annuities are not my strong suit and every time that I encounter one, I scratch my head. So this is going to be me learning just as much as anybody else. So annuities, the rates look high now, so these are attractive. I'm sure they're getting a lot of attention. Are they a good deal?


John: Well, it's funny, I’m just surprised that you don't find annuities interesting. And the 200-page prospectus that you can read through and learn all about the legal language. I mean, golly, I can't imagine that it's not exciting, right? Fortunately, or unfortunately, I find them interesting, reading through and figuring out what's going on. And before we start, I just want to be really clear. There's a number of different styles of annuities and the two that we're talking about here, and some of the ones we talked about on that last episode, are variable annuities, in which case the structure and the pitch that comes from the agents is, hey, you get to invest in mutual funds, stock and bond mutual funds just like you would, except for it's in this annuity wrapper that has some tax and other advantages.


That's the variable annuity in real basic terms. A fixed annuity in real basic terms is really similar to a CD. I know that I can buy a CD that lasts for one or two or three years. I get a fixed rate throughout that. I know the rate, and there's a period of time, and in general that's how a fixed annuity works. There's a rate and there's a fixed period of time. And I don't know about you, but we see these in our newspaper here locally in Madison. It'll be a big ad that says, “5% interest guaranteed for three years,” or those sorts of things. And again, similar to how a CD works, there are some tax and some other advantages to the annuities, but in many cases, you see some higher interest rates than maybe what CDs are paying.


And so that's sort of the crux of what we're talking about today on the fixed side of things where, okay, I could go to the bank and buy a CD, or I could look at these annuities and how do we make sense of those things? And there's a couple of different components, and it's similar to what we talked about last time with annuities in general. The expense component is not really as important in this, because the rate that you get is the rate that you get, and that's an expressed rate, net of expenses. And I found an example, and we can pull it up here, and it happens to be from a large midwestern insurance company. Thrivent. You can see the name on there.


We're not endorsing Thrivent. They're a good company, but it was just available. So it's not a recommendation. It’s not that they're good or bad for you in general but take a look at the rates. And it looks very similar to what you might see when you go to a bank website. There're some different levels of investment and different interest rates that go along with that. And if you look over on the left-hand side, there's a three-year, five-year, seven-year, nine-year. And again, you can sort of think of those like CD rates. We can just pick one of those out. If we're going to invest $100,000 in a five-year, you get 4.65% for that time period. Does that make sense?


Bridget: Yeah, exactly. One thing I wanted to mention to you is that I think the interest rates are very interesting right now, because that's why you would be seeing so many more of these annuities right now. When the interest rates in general are very low, these are a harder sell. But now people know that interest rates are better than they've been in at least a decade, for the most part. And people know that there's a pretty concerted effort by people who know what they're doing to try to lower inflation and probably lower interest rates some more. So they want to lock in the current interest rates. As an advisor, I got to warn you that just because that's what everybody thinks now is not necessarily what's going to happen. This idea that interest rates can't go higher is flawed.


John: Right.


Bridget: They can. Nonetheless, you would still get this interest rate even if it does go higher.


John: I think that's a great example. Take a look at that $100,000 column. I picked out the five-year plan just because it caught my eye. But why wouldn't you want to lock in at 4.8% or 4.9% for nine years? Well, if interest rates go down, as a lot of people think they're going to recently, boy, that 4.9% looks like a pretty good deal. What if it turns around like you're just describing here? People think it can't happen. But what if rates go up and now we're in the 7%, 8%, 9% range? And suddenly that 4.9% that you're locked into for the next five years doesn't look so hot. That's the reason why it's not a slam dunk to lock in these long-term rates.


Bridget: Absolutely.


John: As you look at this from its base standpoint, it is those years you see on the left-hand side, on the top part, “Multi-year Guarantee.” Now, there's the market value adjustment MVA, or there's return of premium. That's beyond the scope of what we can dig into here, but there can be, depending on circumstances, some market value adjustment. And again, pull up that prospectus and read the 36-page analysis of that one component of things. You need to know what that means.

The return of premium is a little bit more straightforward. No matter what happens you're going to get your premiums back on things. Again, with a fixed rate, I'm not exactly sure where that comes from. And you can see this end notes. Whenever you see those ones, twos, and threes in the corners, you go, “Okay, wait a minute. That means there's some legal mumbo jumbo that we need to dig into here.


Bridget: Yeah, I just want to read this: “Guaranteed minimum interest rate: Multi-Year Guaranteed Annuity (MYGA) rate of 0.5%. MYGA issued in New York rate of 1%, security plus rate of 3%. Now, I’m a CPA, I’m a CFP, and I have been in the industry between the tax and financial planning for over 25 years. I don't know what that means.


John: Right.


Bridget: So what are other people going to know? What are the chances somebody else is going to know? And so, what you're saying is you got to look at the prospectus.


John: Right. You got to read that, and you got to look where it says minimum interest rate on there. We'll get to that in a little bit.


Bridget: Take some notes. And I would save this piece of paper, because, again, the next time you think about it, you might remember general things, but you want to actually remember what it is. And again, I'm in the industry, and I don't remember what it is from one time to the next.


John: Right. And I'll segue. That's a great topic, Bridget. And so how do you figure these things out? Well, one of the things that you can do is talk to somebody who's not selling this and not making a commission off it and doesn't care whether you buy it or not. We mentioned that there are fee-only actuaries, independent, who will look at this and read that 200-page prospectus and tell you what the upsides and downsides of things are.


You can also talk to people like us who don't sell any of these products and can help take a look at the stuff. As you said, you and I have to read into these things and dig into that stuff. I happen to know this particular company a little bit, and they don't play shenanigans and games. And generally speaking, what we're looking at here is accurate. So we'll assume that those are the rates that you get. It's not the case for every company, though.


Bridget: Not even with reading the footnotes.


John: Yeah. So you look at that, and you go, “Hey, it's not that simple.” One of the underlying concepts is to keep things simple, have understandable investments. If you don't understand something, and you look at these footnotes, and if it's not really clear, that's one indication that, hey, maybe I shouldn't be doing this, or I don't need to do this. And again, let me get to another key component. Like I said, I can tell you that this is a good company, and they're not playing games. Other companies do play games. So this seems okay to take it at face value. Let's use that five-year number, 4.6%.


I go, “Listen, I want to lock money up for five years. 4.6% is a good rate. Am I happy with this?” Well, there's one other key component to this fixed income annuity that you need to take a look at. And we'll flip over to the other page. That's over here. And this is, again, the same company, the same product, actually. And there's the surrender schedule on things. We can see down here, the five-year surrender schedule. Look what happens if you take money out within the first five years. Now with a CD, when you take out money early, you go, “I got a five-year CD. I can't get to it.”


Yes, you can. What you typically lose is about a quarter of interest, so you lose some interest, but you never lose principal. Look here. What we're talking about is you're losing 7% in the first three years that you own this. You can lose principal with this, so you got to be careful. But then you're locked in for five years. You might say, “Okay, good. I don't have to worry about that.” This is an example of a good annuity policy, because the five-year guarantee period matches up with the five-year surrender charge. After five years, the guarantee period is over, and you can take your money out with no surrender charge.


Now, think about what this means. What if the five-year guarantee period had a seven-year surrender charge. Take a look at the numbers on these surrender charges. And again, this is a good company with a good product. I've seen lots and lots of them where, hey, this is a great rate for three years, but you actually can't get your money out for five years. So what do you think happens in year four and five, Bridget, after three years of that great rate that's higher than anything else out there?


Bridget: Well, if you do nothing, you get a guaranteed minimum interest rate of 0.5%.


John: So where do you think the rate goes? Do you think it goes up over time after they've overpaid? And it's this sort of thing. You go, “Wait a minute. It's a five-year guarantee.” Yeah, but if you don't know what the surrender charge is, are you locking your money away for seven years? If the surrender charge and the guarantee period are the same, then you've got some more confidence and you go, “Okay, good, I can get out of this.” But who looks at those things, right? And that's one of the key things; that's low hanging fruit. You don't need to read all 200 pages to look at this and go, “Okay, at least I can get out when I need to,” or “can't get out.”


And that's bad news. So those are a couple of the key areas on how to think about this. You need to read the details on these things. But those are some things that, even as an untrained observer, you go, “Jeez, I don't know much about this. What can I look at?” Look at the surrender charge and look at how long the time is guaranteed for. Because once that guarantee period goes up, if it's a really high rate, CDs are paying 3% and this is paying 4.5%, you go, “Well, jeez, that's unusual. Why is that? Where are they making their money? On the other side? What am I getting locked into?” And that goes a long way in helping you make a good decision about whether this makes sense for you.


Bridget: Yeah, great. I love thumbnails. Yeah, with that, let's wrap it up. I'm Bridget Sullivan Mermel. I've got a fee-only financial planning practice in Chicago, Illinois.


John: And I'm John Scherer. I've got a fee-only financial planning practice in Middleton, Wisconsin. And both Bridget and I are taking on new clients. We'd love to hear from you, but if you like what we hear and are looking for an advisor in your local area, you can check out acplanners.org to find other people who think like we do.


Bridget: And John, we have a goal with our channel right now. Our short-term goal is to get over 1000 subscribers. We're right around 900ish. So if you subscribe, you'd be helping us out and you'd be helping more people find us. With that. We'll leave it there.

 


At Sullivan Mermel, Inc., we are fee-only financial planners located in Chicago, Illinois serving clients in Chicago and throughout the nation. We meet both in-person in our Chicago office and virtually through video conferencing and secure file transfer.

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