Seeking Stability with Annuities

Speaker 1 (00:08): Hi everyone, and thanks for joining us for Your Thriving Practice, a podcast from Global Atlantic. I'm your host Dan Corcoran as part of our ongoing series, focusing on the future of the 60 40 portfolio mix. This episode will explore how an investor may want to add an element of stability to their portfolio through annuities. We're joined today by Wade Pfau. He's the founder of Retirement Researcher and educational resource for individuals and financial professionals on topics related to retirement income planning. He also serves as a Principal and the Director of Retirement Research for McLean Asset Management. Wade, thanks so much for joining me today.

Speaker 2 (00:49): Thanks Dan. It's great to be here.

Speaker 1 (00:51): So for the sake of our discussion today and the limited time we have, let's focus on fixed index annuities. In a nutshell, how would you describe the features of an FIA and how it works?

Speaker 2 (01:03): Yeah, I mean that's a great starting point cuz there's a lot of different annuities out there. So it does help the focus on one at a time and, and a fixed index annuity. It credits interest and in particular, having that word fixed in the name, it provides principle protection so that the owner is not exposed to losses on the contract value. But what it does is it links to a market index. The most common would be something like the S&P 500, but there's generally a number of different options that could be international indices or just volatility focused type indices and so forth. But the S&P 500 is common linked to the price returns without dividends because it is based on financial derivatives. But then it gives some exposure to market growth through that index when it happens and it protects against losses when it doesn't happen.

Speaker 2 (01:49): It's kind of conceptually, the idea is the insurance company is able to purchase bonds to protect the principle and then with that doesn't take all the funds, all the premium because bonds pay interest. So with the leftover part of that goes to covering company expenses and so forth. But part of that is then used, it's called the options budget to purchase financial derivatives related to the index, such as a call option that will provide a payoff if the market provides gains. And so that's how you then get upside exposure and, and there's different terms. It could be a one-year term, it could be a multi-year term, but within each term it'll reset. Generally I, there's many different ways these can be structured, but generally you'd reset each term. If markets have a loss, your principle's protected. If markets have a gain, you'll get some portion of that gain.

Speaker 2 (02:40): If there's a cap, it could be, you'll get a hundred percent of the gains up to the cap on the index. So say if the cap was 10%, if the S&P 500 price return was up 5%, you'll get the full 5%. If the S&P 500 return was up 15%, you would get 10%. And in exchange for not getting the full upside, you would've been protected. If the market was down 20%, you would be credited with 0% for the year and then it would reset the following term. You would, you would get to start fresh for that term with a new opportunity to benefit from the market upside.

Speaker 1 (03:13): So you just discussed some of it right there, but talk more about some of the tax benefits for a fixed indexed annuity or FIA

Speaker 2 (03:21): On the tax side, it provides tax defer. You're not taxed until you take a distribution from the annuity. Now generally, even though these are linked to a stock market index, they're more an alternative to think about on the fixed income side where you have a taxation as ordinary income. Now the FIA as well, everything comes out as ordinary income, but you get the tax deferral. And so if you're comparing this, for example, against the taxable bond portfolio where you have to pay taxes every year as uninterest, as ordinary income, you don't have to pay that annual taxation. You wait until you take the distribution from the annuity and then as a deferred annuity, it's the gains come out first and then the return of principle after that. But by getting that tax deferral, it can be a particularly attractive option for how you wanna allocate to fixed income assets that do generally get tax as ordinary income.

Speaker 1 (05:06): So are annuities something that people gravitate toward when they're looking for portfolio stability?

Speaker 2 (05:12): They certainly can be, and that's particularly where the fixed index annuity can play a role. We were reminded in 2022 that the bond market can experience losses. When interest rates rise, people can experience losses on their bond funds and we usually think about bonds as providing a source of stability for the portfolio. That's not always the case, but that's where uniquely a fixed index annuity is an example of a structured annuity for stocks and bonds. The returns that are experienced have more of a bell curve distribution where it looks like a bell and it has these long tails where you could have really high gains, you could have really extreme losses. When you have a structured annuity such as the fixed index annuity, you're changing the shape of that distribution. And in particular with principle protection, those who are looking for stability, you don't experience the losses.

Speaker 2 (06:01): Even if the S&P 500 or whatever market index you're linked to is down, you have that principle protection in place and yet you have exposure to gains as well that aren't necessarily a replacement for the underlying stock index. But when you compare the potential outcomes against bonds, you can find quite attractive scenarios where you have a lot of potential to perform as well as bonds can do. But you also have the protection against losses and that's why, a fixed index annuity in particular can be a really attractive source of stability for a portfolio.

Speaker 1 (06:35): Okay. Wade, let me ask you this. Are there drawbacks to annuities? And if so, what are they?

Speaker 2 (06:40): Well, there there's many types of annuities and, and so when we start thinking about drawbacks, it's focusing specifically on the fixed index annuity. Some of the drawbacks that people might think of don't necessarily apply. They're not going to generally be a high fee product, which is sometimes what people think about with annuities. But that being said, though, so annuities are meant to be long-term contracts. They're not meant for funds that someone's thinking for the short-term. You can run into issues if you're trying to take the distributions before age 59 and a half, there can be that 10% early withdrawal penalty through our taxation system, not from the insurance company itself. There can be a surrender charge period, which for the long term owner is not an issue. And actually the idea of the idea of surrender charges, you want people to hold these for the long term because you wanna be able to buy long-term assets.

Speaker 2 (07:31): And if people are liquidating in the short run, that can harm the other owners of the contracts. So the surrender period, if I decide I need my money back out soon, within the surrender window, there can be an additional charge.

Speaker 1 (08:27): So we've talked about some of the positive aspects of annuities and also the drawbacks. Now I wanna talk about some of the misconceptions. What misconceptions do people have about annuities?

Speaker 2 (08:38): Well, when the media starts to talk about annuities, they generally, the biggest misconception is they create a Frankenstein product that doesn't actually exist in what they described. So they might say an annuity doesn't have liquidity, and that's not the case with a fixed index annuity or with any deferred annuity, really. But then they'll also say the annuity is a high cost financial product. Now , the immediate annuity that doesn't have liquidity is generally a very low-cost type of financial product. The claims about high costs are generally associated more in the variable annuity world. A fixed index annuity doesn't have that external fee associated with it unless you add optional living benefits to the contract.

Speaker 2 (09:35): So the claim about being high cost wouldn't really apply to a fixed index annuity either. And so you kind of, people are saying, well, no liquidity, high cost, neither of those attributes really applies to the fixed index annuity. The other one is just this idea that you're surrendering somehow if you use an annuity because you're giving up the potential for market growth. And that misconception is related to people really thinking about annuities as all or nothing decisions. And also framing that more in the context of the income annuity again, where yes, with the income annuity, you don't have the potential for market growth. You're turning over a premium to receive a guaranteed income for the, uh, rest of your life. But with other types of annuities, you still have that contract value. And rather than people framing annuities as alternatives for stock market investments or other growth type assets, it's really important to frame the annuity with a more effective way to invest in fixed income assets.

Speaker 2 (10:32): So it's a bond alternative more so than any sort of stock or growth-based alternative. And when you start to think about it in that context, you're not necessarily sacrificing legacy to have the protections that the annuity can provide. And in particular, if you are using it for lifetime income, so you add an optional guaranteed lifetime withdrawal benefit to the contract, that can provide so much more income for a long-lived retiree than an equivalent bond portfolio would be able to handle.

Speaker 1 (11:25): So how should financial professionals consider talking to their clients about annuities? I mean, it seems to come down to retirement income styles and messaging. Which solution is in the best interest for the client and most suitable for their individual goals, right?

Speaker 2 (11:42): Mm-hmm, yes, the, this idea of retirement income styles has been a major focus of mine over the past few years. It's ultimately the consumer media will default to what I call the total return style, which is pretty much what you do pre-retirement. So it's, you build a diversified investment portfolio focused on growth, saving, building, building the nest egg in that manner. And then in retirement, nothing in particular changes. You just switch 'em, you're no longer adding new savings, you're now taking distributions, but you continue to spend from that portfolio still focused on growth, market opportunities, flexibility and so forth. And so we call that style, that's the total return style. And I've been part of several national research studies at this point, the most easily available version of which would be a, a series of studies we did for the Alliance for Lifetime income, where we look at how these styles actually play out with a broad sample of Americans in, in this case, between ages 50 and 80.

Speaker 2 (12:43): And we find time and again about a third of the population seems to resonate with an investments only total return accumulation based mindset post-retirement. The other two-thirds of the population though is a starting point for thinking about retirement, are looking for either some form of contractual protection or a commitment to a strategy that a total return investing approach doesn't provide. And it's in those contexts and in that, with the two thirds of the population looking for something different that an annuity conversation can resonate more, uh, they're one of the styles we call time segmentation. It's also called bucketing, and it's, I want contractual protections, but I still want a lot of flexibility for my assets with that approach. They may not look for the annuity for lifetime income, but they might like to use different types of fixed annuities such as a fixed index annuity as part of their short-term buckets to cover their upcoming near-term expenses, uh, in that retirement phase with the free withdrawals from the annuity.

Speaker 2 (13:46): And then the other two styles, the income protection and risk wrap, those are traditionally the styles that would put much more emphasis on using annuity protections as part of a, a lifetime income plan to make sure you have enough reliable income assets to cover your core spending in retirement so that you can then feel more comfortable investing the remainder more aggressively or just not having to worry about even if the market is down, if I have my core spending protected, I don't have to be as worried about what's happening with the rest of my portfolio. And that's where a fixed index annuity with a guaranteed lifetime withdrawal benefit can be quite competitive in terms of providing the payout equivalent to what an income annuity might even be able to provide to get the most protected income for the least amount of assets. And it also has that potential for the contract value to still have some growth opportunities through that link to the market index, which with income protection, people are more focused on having the highest guarantee in the worst case type market environment with risk wrap, they're more comfortable relying on the idea of market growth, but they still want some sort of commitment.

Speaker 2 (14:55): They're generally more worried about outliving their money and so forth. And, and so a fixed index annuity in that context, they may value a bit more the opportunity for growth of the contract value in retirement as well. Though at the end of the day, what the annuity is doing is providing much more spending from that pot of assets so that if they're comfortable spending that pot of assets down, it, it's back to that point about the legacy outside of the annuity. There's a lot less pressure on the spending, and that's where the other assets are gonna provide much more growth opportunity because they don't have to cover as much spending because the spending is covered through the annuity.

Speaker 1 (16:18): So let's play this out just a little bit. Before recommending an annuity to a certain client, what factors should a financial professional consider when looking at the different annuity options?

Speaker 2 (16:29): So when they're specifically looking at a fixed index annuity, they'll wanna get a sense of just what are the index options available? What sort of parameters are there on the annuity? The simplest comparison would generally be look at the S&P 500 index, and if it's a one year term, what's the cap rate on that? And by comparing cap rates in the marketplace, you can get a sense of like, who's got a more competitive offering in that regard. That would be on the accumulation side for how the annuity would perform on an accumulation based focus, if you're interested in using it for lifetime income, you do wanna look at the annuitization options, although those are not typically used. So you may instead focus more on the guaranteed lifetime withdrawal benefit or the, the optional income writers that are available for that annuity, how they work in terms of is there a rollup rate, are there step up opportunities?

Speaker 2 (17:25): How does the payout work based on the age the contract is purchased versus the age the income is turned on, what are the fees for that writer? Just to get a sense though, generally the fee on the writer, it's not a profit center for the insurance company, it's more this is what it costs to provide the protections that the annuity contract is offering. Also, of course, wanna have a look at the surrender schedule though if the individual ends up needing the funds back before the end of the surrender period, what would those charges be though hopefully people are thinking of this as a, a long-term opportunity. You wanna look at the credit rating of the insurance company and make sure that they're a highly rated company and if the information is available. Just having a little bit of sense around the renewal history that, because every term it's important that the insurance company has the flexibility to update the parameters. It's if interest rates go down, that can put pressure on needing to reduce the cap rate, for instance, on the fixed index annuity. But you wanna make sure that the company's not taking advantage of these opportunities with inertia of reducing rates further than justified by changing market conditions.

Speaker 1 (21:03): Let's talk about recent market performance and if that's changed anything in terms of where annuities fall into someone's portfolio mix?

Speaker 2 (21:11): Well, with recent market performance, what we saw in 2022 interest rates increased and that led to potentially double digit losses on bonds depending on the duration of the bonds and so forth. Now, the, the 60 40 portfolio, it sometimes, even though stocks and bonds do not have a close correlation, it is possible that occasionally you see losses on both stocks and bonds. So it's not that the 60 40 portfolio is somehow disproven, but I, I think what we did see is people were reminded about volatility and stocks and bonds, and they can both experience losses. So I think that created a reminder that when you can experience losses with both stocks and bonds, you might wanna consider something with a more structured approach that can provide those protections. Plus, with the rising interest rates that triggered the losses on bonds, that's now allowing for much better terms on the annuities.

Speaker 1 (22:44): So we are just about out of time, Wade, but just your final thoughts. What do you want the listeners for hearing this discussion to walk away with today?

Speaker 2 (22:52): I do think it is important to dispel those misconceptions about annuities. Not every annuity is created equal, and you do have to do some due diligence to make sure that if you are considering a fixed index annuity, that it is competitive in that regard because annuities can get complicated. There's potential to obscure some of the a lack of transparency that can exist. But if you're comparing a, a simple fixed index annuity with a cap linked to the S&P 500, that's pretty transparent and you can get a good sense of the potential for that. And to the extent that that will continue in the future, really, you then have two options for how to think about a fixed index annuity, whether it is just a bond replacement in an accumulation portfolio or whether it's used for lifetime income. I think there's great opportunities to have conversations around what a fixed index annuity can do for a financial plan, particularly in retirement.

Speaker 1 (24:22): Well, we are so glad you joined us today to dispel some of those myths and misconceptions about annuities. Wade fau, thanks so much for being with us today.

Speaker 2 (24:29): My pleasure. Thank you.

Speaker 1 (24:31): To learn more about all of the annuities Global Atlantic offers, please visit global atlantic.com and then be sure to listen to our next episode of Your Thriving Practice. Take care of everybody.

Speaker 3 (24:49): The opinions, beliefs, and viewpoints expressed by the guests on this podcast do not necessarily reflect the opinions, beliefs, and viewpoints of Global Atlantic Financial Group. Global Atlantic Financial Group, global Atlantic is the marketing name for the Global Atlantic Financial Group, L L c and its subsidiaries, including Forethought Life Insurance Company and Accordia Life and Annuity Company. Each subsidiary is responsible for its own financial and contractual obligations. These subsidiaries are not authorized to do business in New York.