The Great Annuities Debate: What Price Would You Pay for Guaranteed Income?
It’s finally here… the income debate of the century! For the first time ever, Marc and Steve are facing off on annuities.
In the past, neither has been shy about his opinion. According to Marc, “They’re not wrong for everyone… just most people.”
On the flip side, Steve says, “Annuities may be costly, but you should at least consider the benefits before you dismiss the idea.”
Now the gloves are coming off. It doesn’t matter whose side you’re on – you won’t want to miss this no-holds-barred debate. Costs and fees… penalties… and tax benefits… not to mention the “death penalty”… Marc and Steve tackle every aspect of these controversial income products.
Who wins? That’s for YOU to decide. Watch them duke it out, then weigh in with your comments below the video.
Steve McDonald: Hi, everybody, I’m Steve McDonald. With me today is the “anti-annuity” man himself, Marc Lichtenfeld. And I am taking the “pro” side of the debate. We wanted to get together and go through the four major points most people have concerns about. We’re going to talk about annuities and what we think is appropriate.
The four topics we’re going to hit are cost, penalties, taxes and what we call the “death penalty.” I’m going to let Marc go first on cost or fees.
Marc Lichtenfeld: One of my big objections, and it’s a common objection to annuities, is how much they cost. The fees are exorbitant. A typical mutual fund might have an average expense ratio of 1%, meaning you’re paying 1% per year.
An annuity has triple that amount. It can be 3% or even higher. Then of course there’s the commissions that you pay right upfront. Those are typically 7% or 8%, but can go as high as 10%.
The other thing is that the industry isn’t very upfront about those fees, or any of the fees, which to me is a very big problem. As long as you’re aware of what those fees are and what you’re paying… fine. Then you can make an informed decision. But the fact that they try to hide it so much is a very big problem. In my opinion, you can do much better in other investments without paying such high costs.
Steve McDonald: Well, I agree with you as far as the transparency and the cost. In the 10 years I worked as a broker, I only put somebody into an annuity once. I was forced to. I didn’t want to do it for all of those reasons and other reasons. But now I’m a couple weeks away from . I’m only three years from full retirement age.
Marc Lichtenfeld: You only look 61.
Steve McDonald: I’m 61, 61 1/2 this week. And that’s why the idea of guaranteed income brought this whole thing up. I was talking about hedging our longevity because we’re living for so long.
When you look at my genes, everybody in my family from my parent’s generation lived into their late 80s, late 90s. And they were not health nuts. Nobody exercised. They smoked, they drank, they ate whatever they wanted. If you died before 85 in my family it was a tragedy, which is not a tragedy at all.
So it isn’t that I have become more open to the fees. The fees are expensive. It’s that the guarantee has become more important to me. When I sit down at night with Eileen and we talk about retirement, we look down the road 20 or 30 years, and we both feel a chill. That’s a long time.
So the point that I like to make is, yes, they’re expensive. There are fees associated with them, but there are fees tacked on to all four investments that you can legally label as “guaranteed”: annuities, savings, CDs and Treasurys. They all have some type of a fee. You don’t see it as a fee, but if you buy a 10-year Treasury, it pays you I can easily show you how to make 7%, but there’s risk.
The same is true for savings, for CDs and annuities. Are they expensive? Yes. Is there any other way to get guaranteed income for the rest of your life? Not that I know of.
Marc Lichtenfeld: Let’s move on to penalties. Steve will lead us off with that.
Steve McDonald: The penalties can be hefty. Normally the way they’re structured is you start at 8%. If you put your money into an annuity, you have to keep it there for a minimum of seven or eight years. It depends on the company that you’re using.
So the first year, if you take your money out, there’s usually a 30- to 90-day grace period, which most people won’t tell you about. I agree with you about that. But after that, they hit you for 8%. The second year it’s 7%, 6%, 5%, 4%, 3%, 2%, 1%. Then you can take your money out anytime you want.
But there are fees on lots of things. There are fees on 401(k) accounts if you take your money out before you’re 59 1/2. There are fees on IRAs. You pay a 10% fee if you take your money out of a CD early.
The only way the insurance industry can structure these things, especially in today’s low-yield environment, is to say, “Look, we’ve got to have your money a minimum of eight years. If you can’t give it to us for eight years, we’ve got to whack you.”
Marc Lichtenfeld: That’s my biggest problem is the idea that it’s so illiquid. As you mentioned, there are penalties with IRAs and 401(k)s, but that’s only up to a certain age. Usually annuities are bought by people who exceed that age. I don’t like the idea that you’re going to get hit so hard if you try to take your money out. Same with CDs, but usually CDs are much shorter term… six months, a year, two years.
I just hate the idea that someone doesn’t have access to their money for so long. And if they want to touch it, they have to sustain a very hefty fee or penalty, usually at a time when they can’t afford to pay that kind of a penalty.
Steve McDonald: Right. So let me just add one more thing there. When I recommend a bond, I always say to the people, “Always assume you have to hold this to retirement.”
And the same logic applies here. I got an email from a guy recently – was really angry with me because he had to sell six of his bonds to buy a house. I was thinking, “Well, why did you buy bonds?” So, if you’re going to put your money into an annuity or a bond, or even into the stock market for that matter, you better not plan on needing it within the first couple of years.
Marc Lichtenfeld: Absolutely, but with a bond or a stock you can sell if you have to. It might not be a perfect situation and you could lose money if it’s down, but you can sell. With an annuity, it’s a little more complicated.
Steve McDonald: Oh, it is definitely. An annuity is not an investment. An annuity is a contract between you and the insurance company. That’s it. That’s how it has to be seen.
Marc Lichtenfeld: Well let’s move on to taxes. One of my problems with annuities is that they’re often sold as a “tax-advantaged” investment. It is tax-advantaged in that the money can grow tax-deferred, but when you take the money out, you’re taxed at your ordinary income level. That’s higher than the tax rate on dividends or even capital gains. It could be significantly higher if you are in a higher tax bracket.
So this idea that it’s “tax-advantaged”… yeah, it grows tax-deferred, but you can get really whacked hard when you go to sell. I don’t think that is talked about enough.
Steve McDonald: Yes. I hope I don’t sound snippy when I say this, but you’re guaranteed to get the income.
Marc Lichtenfeld: You’re guaranteed to give Uncle Sam a third of it.
Steve McDonald: Absolutely, but one of the many reasons I left the brokerage business was people complained when you made money for them because they had to pay taxes. When you lost money, people complained because of the losses.
You’re going to pay a high price because it’s guaranteed income. There’s no way around it. But it is guaranteed income.
Again, is it expensive? Yes. Are there higher taxes? Yes. Is it a better feeling knowing that 30 years from now you will definitely be getting that check in the mail? Yeah, that’s a great feeling. Is it going to cost you a little bit more in taxes? Yeah, but again, most things that I think are appropriate in retirement are because Social Security is tax-free (unless you’re working). I like tax-free bonds very much. So, it’s really not going to bump up your adjusted gross income.
So is it going to make that much of a difference? Again, it varies on an individual basis. These are the things you have to talk about with your planner.
You made a good point in the beginning. There are a lot of people in the annuity business whom I would not let in my front door. A lot of people. But I think it’s changing.
There’s a bipartisan commission right now that is putting a lot of pressure on the annuity industry and reverse mortgages. They’re forcing changes that need to be made. I think we’re going to see more reasonable fees and more transparency. And I think it’ll be a better deal. Because frankly, I don’t see an alternative for some people.
Marc Lichtenfeld: Well I hope we certainly get more transparency. That’s key.
Steve McDonald: Yeah. I think it would be a good thing. Our last topic, this one is a killer: the “death penalty.”
Marc Lichtenfeld: It depends on the type of annuity you have, but you’re basically betting against the insurance company about how long you’re going to live. And let me tell you, they have a much better idea of how long you’re going to live than you do.
Steve McDonald: Yes, they do.
Marc Lichtenfeld: I don’t care if you go to the gym and eat kale salads three times a day. Their actuaries are brilliant, and they have a much better idea. You’re betting against the insurance company.
But the issue when you sign up for an annuity, depending on the type of contract, is what happens if you die before you’ve collected all the money.
Steve McDonald: Or any money.
Marc Lichtenfeld: Or any money. The answer is “sorry, you lose.” Your family gets nothing. The money’s gone. The insurance company keeps it all. You can set it up where your spouse what’s left with survivor benefits, but it’ll cost you. And it can cost you quite a lot.
Remember, you’re betting against an insurance company in exchange for that guarantee, and you could be betting a lot. You could be betting your whole net worth or whatever you’re willing to put into the contract. To me, it’s a bet I’m not willing to take, and I don’t want anybody in my family making that bet either.
Steve McDonald: Well, you’re right. That’s a big bite in annuities. So again you have to balance the need for the guarantee against what it’s really going to cost you long term.
So my first response is that you should never put all your money in an annuity. I had a very good friend, a judge in Baltimore. He lived across the street from me. One day he said, “I’ve been putting all my money in annuities now for years and years. I don’t even think about it.” I thought, “
You can set these things up so that you can start to receive the payments immediately or you can defer them for five, 10, 20 years. Or however long you want to defer. The longer you defer, the more you get. But there are options that allow you to set it up so your wife or children can inherit the annuity. But again, that does cost money. I expect that to change, too.
I don’t think these are perfect, but as I said when we started this conversation – this is a conversation, right? We didn’t touch gloves, did we?
Marc Lichtenfeld: No, not at all.
Steve McDonald: No gloves. As the conversation began, I said it’s all about the need for guaranteed income to hedge against our longevity. We have to realize how much longer we are all going to live.
I answer emails all day long from people who ask me for personal advice, which I can’t give, but I read these things and my heart goes out to them, Marc. If they could take a portion of their $250,000 and at least lock in income for a 10-, 20-, 25-year period, and I were them, I think it would help me sleep better at night.
And I was you 15, 20 years ago, before the reality of retirement in three years set in.
Marc Lichtenfeld: I do understand the need for guaranteed income, but like I say, annuities aren’t wrong for everybody… they’re just wrong for most people.
Steve McDonald: You say that because you’re still in your 40s! Once you cross that 60 to 65 line, it’s a whole different story, my friend. I want to be around when you reach that point.
Marc Lichtenfeld: We’ll do this again in a few years.
Steve McDonald: It’ll be a long time – 12 years for you. You’re a young guy. That’s it. For everybody here, I’m Steve McDonald.
Marc Lichtenfeld: I’m Marc Lichtenfeld.
Steve McDonald: Thanks so much for being a part of this. We really, really appreciate who you are and everything you do for us. See you next week.
By Marc Lichtenfeld, Chief Income Strategist & Steve McDonald, Bond Strategist
P.S. – Want to weigh in? Wonderful, because we’d love to hear your thoughts on annuities. Join the conversation by leaving a comment below.