Season 3, Episode 13: WTF is an annuity?

How something that sounds cool from a very brief description can sound a lot less cool after learning more about it

Hey - if you’re super risk-averse (despite listening to our very soothing risk-encouraging podcast), this episode is for you!

Caitlin learns that her big investment idea to get an annuity so she gets paid some amount of money every year actually has nothing to do with investing. It’s insurance??? Get the F out of here, Sara. Do you even know what you’re talking about??

Sara goes on to explain that annuities are contracts with insurance companies to protect us from losing money in the stock market and guarantee a yearly income in our senior years. But ON THE OTHER HAND, you don’t get any of the advantages of compounding interest.

The lows are higher and the highs are lower. That doesn’t sound like the way to make a million dollars. And it’s not. Sara says that they really only appeal to the moooooost risk adverse humans who are okay with giving up the chance to make more money in the stock market in exchange for a sure thing.

In fact, we go so far as to claim that getting an annuity is more like a psychological strategy than an investing one. Look at us go! A couple of Freuds over here!

We even (lightly) touch on actuarial sciences! (I know that has nothing to do with Freud, but it’s also very sophisticated.)

Ask us your dumb investing and finance questions for Season 3 on our Ask Us page!

We have the social medias!! Here’s our Instagram and Facebook and LinkedIn.

This episode was edited by our co-producer Kelly West. Music by Bad Bad Hats and Devmo.

Transcripts for Season 3, Episode 13: WTF is an annuity?

S3_Annuity.mp3

Caitlin [00:00:07] Welcome to women on the verge of a Financial Breakthrough, a podcast where we're figuring out finance. One dumb question at a time. I'm the dummy. Caitlin Meredith, a coach and mediator based in the Bay area.

Sara [00:00:20] And I'm Sara Glakas. I'm an investor, advisor and founder of Black Barn Financial and the Austin Women's Investing Group, which can be found on Meetup and Facebook.

Caitlin [00:00:30] Before we start, do you know a woman who might be on the verge of a financial breakthrough? Will you text her a link to our show and maybe two other friends while you're at it? Also, if you can, please leave us a review. This helps other women on the verge find us and we read all of them and they make us happy. Cry like this one from a listener who said A smart, panoramic, useful come let us Learn Together podcast that makes eating your broccoli about matters financial fun, encouraging, and potentially profitable too. Highly recommended. Oh, I love the broccoli part. Thank you to all of our listeners. Now let's get started.

Caitlin [00:01:16] The other day I was in a Facebook group, and I usually understand about 40% of what people are talking about, about like investing and all this stuff. Kind of funny since I have this podcast, but, I'm a lifelong hashtag, lifelong learner. But somebody was like, oh, you know, I heard it all this money, but I'm gonna retire into like some very complicated financial scenario that they were asking people and someone's like, oh, you should just do it, put it in an annuity, and then you'll get income every, you know, like perfect solution. And I was like, that sounds amazing. I want an annuity. And then I was like, oh yeah, what is an annuity like? It sounded too good to be true. Like, you just put your money and then it pays you every month. And that's amazing. So Sara, what the fuck is an annuity and can I have one? Should I have one? What is the deal?

Sara [00:02:06] Oh my gosh, that's awesome. So the super plain vanilla place to start from, which I think is the right place to start from, is an annuity, is a contract with an insurance company. And so you give the insurance company a lump sum of money. I give the insurance company $100,000. In exchange, they give me $4,500 a year for the rest of my life. That's it. That's what an annuity is.

Caitlin [00:02:40] Wait, what? I give them $100,000 cash. I first get $100,000 cash. Second, I pay them 100,000 to an insurance company. Allstate. Somebody like, not a stock market product, like an insurance company. And I say, hold this money safe. You're saying I will get $4,500? It's in the name annuity annual a year. For the rest of my life.

Sara [00:03:17] Something like that.

Caitlin [00:03:18] Yeah. And the idea is, whatever $100,000 divided by 4500 is like, I win or they win. Like, either I die before that money is out, and so I they get $20,000 in the bargain. But not accounting for inflation or surprise. I live for another 30 years. You suckers are going to be paying me, even though I've gone way beyond the $100,000 investment.

Sara [00:03:44] Yeah. That's it. That's exactly it. That's it. That's what it is.

Caitlin [00:03:49] Oh, okay. So, like, if you have really good genes, you should do it. Like, I could do it right now. They would accept I have very good genes. Yeah. So there's my point is I'm in my late 40s, so, like, could I do that now?

Sara [00:04:06] So you're looking at it's typically for can you buy an annuity right now. I think you can buy an immediate annuity an insurance company. You wouldn't get very good rates because the expectation would be you're going to live for a long time, right. So but the whole trade off is you you buy this contract for future cash flow payments. So you can do an immediate annuity, which is I give the insurance company $100,000 and they immediately start paying me.

Caitlin [00:04:41] Okay.

Sara [00:04:42] $4,500 a year. I'd probably divide that by 12 and take it monthly to recreate a paycheck. Or you can do something called a deferred annuity where I give the insurance company $100,000, but I'm not going to start taking payments for another five, ten years. Right. So that would be a different payout amount, and it would likely be a higher payout amount. I give you $100,000 today.

Caitlin [00:05:05] Because they're making all that compounding interest off of the money I just gave them.

Sara [00:05:09] Exactly. The insurance company, the reason it's an insurance company is insurance companies are really one of the only entities that can guarantee something. They can guarantee this contract. Right. Like stocks, like a brokerage account. Like you're taking risk. There's no guarantee that it's going to happen.

Caitlin [00:05:26] Is that because the government the fed dare I say, is like will pay if they can't.

Sara [00:05:32] That the insurance company is highly, highly, highly regulated. And like the whole premise of an insurance company is you buy a term life insurance policy and if you die, your beneficiaries get the money. So especially in the U.S., like insurance companies are very highly regulated. The almost the worst thing that can happen is for an insurance company to fail. I don't know if you remember, like during the financial crisis, AIG. Yeah. Remember? Yeah. AIG was an insurance company that was deemed too big to fail. Like, they didn't really have enough money to pay out the projected payout under the policies they'd written. And they got bailed out, like, okay, it's they're as important as mega banks, right? Because there's so many parts of the financial system that you're buying insurance for any number of risks. But yeah. Anyway, so that's why the annuity is connected to an insurance company.

Caitlin [00:06:27] Okay.

Sara [00:06:29] But it's all a numbers game. It's all. That's why actuaries make so much money, right? Actuaries and actuaries are statistics geniuses. That's what actuarial science is. It's like super complicated statistics. If 100 people buy this annuity and put in their $100,000, we know how like, how many of those hundred people are still going to be alive each year, right, based on statistics. So it's like throwing your money in a pool. You get your payout if you continue to live. Some people are going to die right away. Some people are going to live forever, and the insurance company has done the math to make sure that they make money in the process, so they get to keep more than they pay out.

Caitlin [00:07:13] To you advise. First of all, I just want to say the only actuarial actuary.

Sara [00:07:21] Yeah, an actuary.

Caitlin [00:07:22] I'm aware of is the Ben Stiller character in the movie Along Came Polly. He was an actuary, I remember that, and so he he was a very risk averse person because he run all the numbers on all this stuff. Okay. Which actually could go the other way because you'd see how rare or lightning strikes or whatever and actually be rational about it. Okay. That aside. So you're telling me I give this money to an insurance company has nothing to do with the stock market? It's a choice to do that instead of the stock market, because that feels safer.

Sara [00:07:57] Yeah, it's it's typically the best for very, very conservative investors who are also worried about outliving their money. Right. If you have an annuity, you will never not have income. You'll always get the check from the insurance company. So in this case, like no matter how long you live, if you had that annuity every year, you'll get your $4,500 check.

Caitlin [00:08:26] And $500 isn't selling it for me.

Sara [00:08:29] We probably should have made the numbers different.

Caitlin [00:08:31] Okay.

Sara [00:08:32] Let's make it $1 million.

Caitlin [00:08:35] Okay, but we know.

Sara [00:08:36] That 45,000.

Caitlin [00:08:37] Screwed up for another reason. I'm supposed to first make $1 million. I don't need it immediately. Save it, have it in cash, and give it to an insurance company. Okay, so that premise.

Sara [00:08:50] It's a pretty limited set of people, and almost no one does it with 100% of their money. Like, let's say the $100,000 is 20% of a $500,000 portfolio. So you have $500,000 and you are very conservative, right? Like you do not like taking risk at all.

Caitlin [00:09:14] Yeah.

Sara [00:09:15] What are your options? Your options are cash at whatever the cash rate is. Right. We've seen it at zero before. Yeah. An annuity. Treasury bonds, which again, like those rates can be very, very low. So if the choice like in especially like a if the, if the choice is between $100,000 in a savings account making zero or an immediate annuity that returns 3% per year, then the annuity is probably a good choice for at least some of the money. It's not a good choice. If you're like, well, I can either put $100,000 in an annuity or put $100,000 in the stock market. Like those are not they're not interchangeable right there. They're opposite sides of the spectrum. Like with the stock market. You could as you know, in the short term, you can lose 25%. You can make 30%. And over time you'll come. We're kind of somewhere in the middle, but there are plenty of people that just don't have any risk tolerance at all for that, those types of shenanigans. Right. So it's like, I want to know exactly how much I'm going to get and when I'm going to get it. That's cash annuities a pension is a type of annuity. You like a pension. You've paid into a system over a certain number of years. Like if you're a teacher, you pay and pay and pay in and then that money is managed. And then you know what your payment is for life, okay. Right. So an annuity a lot of times people think of it like recreating a pension. You take the money you've saved that you haven't put into a pension system, but you give it to an insurance company and you recreate a guaranteed stream of income for life.

Caitlin [00:10:58] Okay. Do you advise clients to do it? Or you're like, if you're that risk intolerant, I'm probably not your person.

Sara [00:11:05] That's exactly it. Like, if someone comes in with no risk tolerance, like I, that's just not what we do here. I'm not even licensed to sell insurance. It's just someone else's. Someone else's bag. I see a lot of annuities. I see a lot of annuities that instead of that, like, plain vanilla transaction that we talked about, insurance companies have invented lots of different types of annuities. I see a lot of variable annuities, which is like the life insurance companies attempt to recreate an investment of some type. So a variable annuity is something like you invest $50,000 in this variable annuity. Your $50,000 goes into an account and will invest it in our mutual funds, which always have a high expense ratio and will give you a guarantee that your account will never go well, never lose money. Right. So you put in your 50,000. It'll never fall below 50,000. But on the other hand we're also going to cap it. You'll never make more than 6% or whatever whatever the cap is. Yeah. So knowing what you know about the stock market you know that the upside is the thing, right? Yes. But an insurance company can create a product where they're giving you a range, a tighter range of outcomes. It'll always be less.

Caitlin [00:12:25] So those are higher and the highs are lower.

Sara [00:12:28] Yes. And again appropriate for some people. But most of the time when people come in with those they didn't know what they were buying. They're like, oh yeah, we invest in the stock market inside this variable annuity. It's like, well, did you know you're capped at 6% per year? Like you're never. So the year that like last year the stock market's up 25%. Like you got six. Congratulations. But in 2022 when the market fell by 25% you got zero which is way better right. So again it's like appropriate for some people. But a plain vanilla annuity is relatively easy to understand. The risk is that you give the insurance company your money and then you die and they keep it right. There's usually some sort of like, oh well, give your heirs some amount back, whatever it is. But the benefit is that, like, oh, I give you 100,000 and then I take out 500,000 over my lifetime, right? Because I live for a really long time. Variable annuities are very, very complex, and I almost never I think I've seen one variable annuity where my client was like, you know what? I'm really glad I have this right.

Caitlin [00:13:34] Well, sounds like they had a lot of money and other things, but it's like I mean.

Sara [00:13:39] But it's it's more like in the explanation of it and knowing what you are signing up for. Because with a contract, once you're in it, you can't undo it without cost. Right. It can be really tricky. And then like all of these, like annuities can end up, you have all different, more and more complex flavors. But, that immediate annuity again might be the right choice for someone who's like, listen, I just want someone to send me a check for the rest of my life, and then I'd be happy and like.

Caitlin [00:14:08] I don't, I'm not going to have. I don't want to travel the world like my financial needs are predictable to the extent that anybody's financial and are low and whatever. So this is just like the peace of mind that I'm going to get from this is going to be worth whatever I don't make by pursuing another path.

Sara [00:14:31] Exactly.

Caitlin [00:14:32] So that almost seems like a psychological evaluation rather than a financial strategy assessment. Yeah. Right.

Sara [00:14:40] Yeah, I would say it is mostly psychological in that, I mean, just like I kind of imagine how risk averse you have to be to make that okay.

Caitlin [00:14:50] Because with that same million dollars, let's say that if you had that and were retiring in ten years or had just retired, like what that could turn into, you need your price. You need to take care of your daily needs now, but you could still invest half of it in the stock market. And it will almost no matter what over the life cycle of it, increase a lot more than whatever you could get from an annuity, right?

Sara [00:15:19] So like if you're looking at annuity, an annuity and you're putting together your asset allocation, the annuity really should fall in the like cash bucket. Like I'm trying to do better than cash. But I'm giving up liquidity. Right. Like if you give the insurance company $100,000, that's $100,000. You don't have a bank.

Caitlin [00:15:40] Anymore access to. Yeah.

Sara [00:15:42] So it's but it's in that quadrant of the low, low risk, low, low return, super duper safe quadrant. Not a trade off for anything like having to do with stocks. Right. The stocks that the the characteristics are totally different like almost 180 from an annuity. So it's again it's like do you have an annuity in your mix like some people do? A lot of people do. Most people don't have only annuities. Right. Or don't take like a huge chunk of their money and put it in annuities.

Caitlin [00:16:15] Okay. They're like my grocery money for the rest of my life is taken care of. That is done. But also does it adjust for inflation? Like if I sign the contract today in 20 years, I'm still going to just get that amount of money.

Sara [00:16:31] Yeah, it might not like you would need a special inflation rider. So a rider is something you attach to an insurance contract that does something. So if you want it to inflation adjust, it almost certainly needs an inflation rider attached to it. That changes the contract in some way. And you'll almost certainly pay more for it. Right. So you're you're paying for inflation protection okay okay.

Caitlin [00:16:58] I'm kind of I'm out of the annuity game. I thought it sounded amazing.

Sara [00:17:02] Yeah it does. It does when you're like, oh you're just going to send me a check for the rest of my life. Like, where do I sign up me up?

Caitlin [00:17:08] Yeah, it's like, get out of all this other stuff. But the costs are considerable. Yeah. So I'm just going to go ahead and pipe in on my Facebook group, be like, you know what? After careful consideration of all of the details you've brought forth in this scenario, I think actually annuity, when it's hard to think of a situation where I would recommend it, except for somebody who like, I guess having lived through extreme poverty, like there's a lot of things that like the security aspect could just win out. Yeah. And then like, okay, all right.

Sara [00:17:45] It is hard though because it does require like that. You have in this case it sounds like this person. What inherited. Yeah a big bunch of money and they didn't know what to do with it. Right. Yeah. So that's I mean I think that's typically that like when this comes into.

Caitlin [00:18:01] Play because then you might have $100,000 all at once. Right. You're like, oh, I can do it right.

Sara [00:18:07] And you also might be like, oh my gosh, like, I have $100,000. I've never had $100,000 before. Yeah, right. If you never. Ever want that to go to zero. Then an annuity might be a good choice. Like it would never go to zero until you die. You would keep getting money every month, right? If you have no other like ability and you have no experience and you're like, I just this is my chance to lock in something forever. I can see, like in that type of situation where it might be, just it might be advisable, right. Again, like, it's hard to kind of imagine a scenario where it's like all of your money is annuities, right? Or put into an annuity.

Caitlin [00:18:50] Do you pay taxes on it when you start getting it?

Sara [00:18:52] There is I can never remember the different levels of taxation. It's like I think you're only taxed on the. So like if you if you put 100,000 in that's like your basis. Right. Like a cost basis so that the terms of the annuity, they're not just going to give you your $100,000 back, they're going to give you your $100,000 back, plus whatever. That relatively low rate of return on that investment is, so that the money that you get back from your original, yeah, the extra money would be taxable, but it would be a relatively low percentage. So if you started receiving $4,500 checks every year, I mean, most of it is return of your 100,000 and then the rest is earnings. And they keep track of that over time. That's because it would change. Right. Eventually you'll get your all your $100,000 back.

Caitlin [00:19:43] Right. And then it would all be taxed.

Sara [00:19:45] And I don't like this is where like the taxation of annuities is a little like okay.

Caitlin [00:19:49] Beyond in the weeds. Yeah. Okay. Well I think my takeaway is I can't afford to be that conservative. I dream of a 100 to 100,000 to $1 million to give to an insurance company. So it's sort of moot. And also that the more complicated they are, the like more important it is to really understand every single term and what it means in the long term, and to have someone run the numbers for like, okay, this sounds super safe and secure. What am I choosing not to do by putting my money in this?

Sara [00:20:26] Yeah, like with a variable annuity. Like I would if if I got a proposal from someone who is licensed to sell insurance, I would get a second opinion from someone, even if I had to pay for it. Nobody ever actually does that. But that's why they end up with things that they don't understand. Annuities are commission based products, so there is like it's your best interest can potentially not be taken into account. Yeah.

Caitlin [00:20:52] Insurance sales people are making money right. They're not fiduciary.

Sara [00:20:56] Right. And it's it's a it's a lot. It's like six seven, 8% of the value of the contract that they get paid upfront for selling it to you. So I would like if you're being pitched something there is has it 30 days. There's a certain period of time you have to cancel the contract. Oh. So I would either before signing it or before or within that 30 day window take it to some like fee only financial planner and pay. Yeah 250 or.

Caitlin [00:21:21] 200. But through the wording of it yesterday like what does this actually. Yeah. Yeah. And I would do it beforehand. That's so awkward.

Sara [00:21:29] It's so awkward.

Caitlin [00:21:30] Like the people part is really an awkward part of it. And people like insurance salespeople. We've had an episode like very well-meaning, well-intentioned, like, I totally think part of it can be smarmy sales, but also they're like, no, take care of yourself. That's a great. All those instincts are great.

Sara [00:21:47] Yeah.

Caitlin [00:21:48] Right. Also, they have an impact, like their family's livelihood depends on people buying that product.

Sara [00:21:55] Right? I mean, into your, you know, to your point, like most of the time it's like, why would you take the risk in the stock market if you don't have to? I have this thing where you'll never lose money and people say, yes, like, of course I don't want to lose money. Am I completely insane? But they don't know what it means to have your upside capped. They don't know that. Hey, you could potentially recreate your rate of return from this variable annuity by putting it in like a CD ladder or something else, right? Like if you're going to end up with a 3% rate of return anyway. But why not like keep it liquid and put it in something like a bond ladder or something? But anyways, that's it. But it is like.

Caitlin [00:22:38] A solid people. What is a freaking CD ladder? And then the one after that, what is a bond ladder? Getting some ideas. Okay, I feel like I'm up to speed on annuities and I can go back to not paying attention to that.

Sara [00:22:52] My work here is done here.

Music transition by Bad Bad Hats

Sara Did you have a question about finance or investing? Send it to us in an email or voice memo on our website womenontheverge.com.

Caitlin Hey, we want our listeners to know that economic abuse can be subtle, but it's a serious form of control. Watch out for partners who limit your access to money. Sabotage your job or rack up debt in your name. If this sounds familiar, know you're not alone and there's help available. Please learn more at the hotline.org or call 800 799 safe.

Sara This episode was edited by our co-producer Kelly West, with music by Bad Bad Hats and Devmo.

 Music outro by Devmo

Devmo I know the first thing you notice is that I'm covered in gold, the flick of the wrist it could turn a hot bitch cold, to get what you want in life girl you gotta be bold. Now Imma die rich, and I know...

Sara This podcast contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this podcast will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.