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Episode #588 - Retirement Basics - Fixed Annuities (aka MYGAs)
“Things turn out best for those who make the best of how things turn out.”
-John Wooden M.
Roger: Welcome to the show dedicated to helping you not just survive retirement, but to have the confidence to lean in and rock retirement because you're focusing your planning on things you can control.
Today on the show, we're going to continue our month long theme on, the basics today are the basics of fixed annuities. We are also going to talk about the basics of treasuries, bills, bonds and notes. It's like a two for one special. How about that? Once we finish this theme on the basics this month, it's going to be a reoccurring segment that comes on so we can expose ourselves to things that maybe we haven't heard of or reexamine our understanding of something we think we know so we can identify those pesky blind spots. Love to find those blind spots.
Before we get to the main segment, I want to continue this discussion on navigating retirement planning during uncertain times. Back on episode #584, we talked about your retirement safe. How to navigate financial security. So, let's continue that conversation right now. The uncertainty is like a loud thunderstorm in the middle of the night. Bam. Social Security, bam. Markets are going down. Bam. Tariffs, the economy, politics, et cetera. It's loud in our faces and it can be a little scary. The reality is we're not in any worse of a situation than we always are. It's just loud in our faces. So, we have to be extra careful in navigating this thoughtfully so we don't make unforced errors related to this. By the way, I'll put a link to that in our weekly email. If you like the show, you'll love our email recap with links to resources. You'll get that at thenoodle.me. That's where you can sign up for it.
But one of our listeners, Christina, had some comments related to some things I asked you to do.
She says,
“This week you said we should test our plan for resiliency by planning without Social Security. Given that Social Security would be about 50 to 75% of our income and given that I only have 10 to 15 years to retirement, this is simply impossible. The idea of setting aside five years of income without Social Security is laughable. I think you've worked too long with wealthy clients. How about doing some episodes for the rest of us and how we could possibly survive without Social Security?”
I understand the sentiment, Christina. Social Security is a critical benefit for virtually all of us. It's guaranteed income. If we're married, there's a spousal benefit and its joint life when one party dies and it's adjusted for inflation. If we take that away, virtually all of our plans are no longer feasible. It's a critical benefit. I think the point of doing the stress testing, Christina, is to pull the curtain back, to see the good and the bad and the ugly of some of the risks that we think about and that are real in retirement. Social Security is one that is scary to think about going away because it's so critical. It's important to acknowledge that and see that the other ones that I suggested, which I think are actually a little bit more interesting, which are, what happens if I'm married and one of us dies prematurely? How does that impact the life of the other? What happens if we have a big market downturn and we lose a bunch of money today? What happens if there's a big head healthcare event like a long term care event? All of these risks are present, some more likely than others.
To be honest with you, Christina, the risk of Social Security going away is the least interesting in terms of stress testing for two reasons.
Number one, it's the risk that we have the least amount of control over managing or mitigating. Not much we can do to stop that other than vote and express our opinion in the political circles.
Number two, it's by far the least likely to occur relative to the other ones by a mile. But it's still good information to have. It is better to have that when you're 10 to 15 years from retirement than being in retirement and finding it out because you can maybe identify some ways to improve your Social Security benefit by work and salary and all those other things. We need to assess the severity of the risks, let's use these four. Social Security, premature death, market downturn, major health care event. The next thing we need to assess is, well, what is the likelihood that these are going to happen? If you put those on a scale, by far Social Security going away or being eliminated is the least likely by a mile. But these other risks are important too and this can help us identify what we can do to manage them.
Now I didn't say eliminate them because it's almost impossible to eliminate any of these risks. The best we can do is manage them. So, let's take one of them as an example. Let's take a long term care event. Well, if we assess what happens if one of us or if I have a long term care event and it will show how vulnerable our plan could be to such an added expense. Depending on the severity, we could say, oh, I need to, I can't get rid of that because I can't control it. But maybe I can purchase some long term care insurance to transfer some of that risk, or maybe I can improve my health to try to fight against the impacts of aging in a negative way. You just have to brainstorm them. It's not meant to scare us. Instead, it's meant to bring it back to what can I do now to manage this risk or mitigate it?
Now, when it comes to Social Security, two things. I'm not going to do any episodes on how we could possibly survive if it's gone? I'm not because I think the odds of that happening are so small that it's not worth your time or mine. We have more important risks to manage. But Christina, I am going to do an episode at the beginning of May where we're going to work at separating fact from fiction and talk about the state of Social Security and how worried we should be about it either being eliminated or cut. If it's cut, what are the likely scenarios that it would be cut so we can wrap our hand around managing this risk. We're going to do that in May. But I want to make sure that we understand that we have to pull the curtain back and see the good and bad and ugly so we can figure out where we have control to improve our plan. That's the critical part of the exercise.
But that said, let's get on to fixed annuities.
PRACTICAL PLANNING SEGMENT
Now let's look at the basics of fixed annuities, also known as multiyear guaranteed annuities or MYGAs. These terms are used interchangeably and essentially, we're talking about the same thing, what they are, how they work, and how they fit potentially into a retirement planning process. So, at its core, a fixed annuity is an insurance contract between the purchaser and the insurance company. It's an insurance contract and that has some benefits, but it also has some drawbacks that we'll try to call out.
Now, how do they work? In some ways they're very similar to a CD or certificate of deposit, but they are different in some important ways as well that we'll point out. In the ways that they're similar in that when you purchase a fixed annuity, you're committing a sum of money. Usually it's a lump sum, just like a CD. Let's assume it's $100,000 just to make this simple. So, you're committing a lump sum, let's say of $100,000. The insurance company is going to guarantee a rate for a specific period of time, sort of like an interest rate you would get on a CD. Let's make an assumption that that's 5% a year. Okay, so far so good. That interest rate or guaranteed rate is for a specific term, usually a number of years between three or ten years. So, let's assume it's for five years and we'll look at an example to really bring this home. Now we have committed $100,000 to this insurance contract. They're going to pay us 5% per year and they're going to guarantee that rate for five years, very much like a five year CD. This is where the similarities start to go away. First difference is, unlike a CD, it's not guaranteed by the FDIC or government sponsored agency. It's guaranteed by the credit worthiness of the insurance company. It's their promise to pay you back your principal and interest. So now we have to worry about their ability to pay back that money, which is their credit rating. We have to take that into account. That's one way that they're different.
Another way that they're different in a positive way is that the interest that you earn in a fixed annuity is going to be tax deferred. This is one of the benefits of that insurance wrapper. So, in year one, if I put in $100,000 at the end of the year, they credit me with my $5,000 in interest. If I'm in a fixed annuity and I'm using after tax money, that's not going to be taxable, that's going to accrue tax deferred, so there's some benefit there. Now that may not make any difference if you're using IRA money, but if you're using after tax money, that can make a difference.
Now what's one of the negatives of this fixed annuity wrapper? Well, one is liquidity. Liquidity can be very limited during the term of the contract. Usually there's limited liquidity where you can get out to 10% of the value without any penalty. But if you try to surrender the annuity prior to the end of the term, they have what are called back end sales charges. These can be pretty significant. Each contract is going to be different in terms of what these charges are. As an example, let's stick with my example, let's assume we put in $100,000 into a five year annuity that's going to pay 5% interest a year. Well, if I try to sell that contract, let's say in the first year because something happened and I needed the money, I would have to go to the contract and see, well, what's their surrender charge. These can start off at about 8% in the first year. If I tried to surrender my $100,000 in the first year, they could charge me $8,000 just to get my money back. This surrender charge usually goes down as you get closer to the end of the term. So, it's important to realize that and go into something like this with the intent that you're going to hold it until the end of the term so you don't have these back end sales charges. So that's a significant difference.
Now, what about withdrawals from a fixed annuity when they mature? If they're non-qualified, you're going to have a decision to make of one. If I surrender the annuity, you're going to pay ordinary income tax on all of the interest that you receive. If you are under age 59 and a half, you will have a 10% penalty on the earnings. You have to be careful using fixed annuities with after tax assets, especially if you're under 59 and a half and you're thinking that you're going to surrender these and use the money. Now you do have the option to roll these to another insurance product and that all gets deferred until you come out of the annuity wrapper. But that's one of the key things that we need to be aware of. Now if you're using IRA money, this is a moot point because it's all sheltered by the tax deferral of the IRA. Those withdrawals can be a little bit problematic if you're pulling from non-qualified or after tax assets.
Now, how are the rates of annuities determined? It's going to be off of a couple of things.
Number one, it's going to be on the length of the term. So similar to a bond or a cd, the longer the term, usually the higher the rate. They're always going to ask you your age, but they're also going to ask you what state you live in because every contract is different even within the same state. Even more so, there are big differences when you look from one state to another. Let's look at an example here, and I'm just going on immediateannuities.com. I don't have any affiliation with them, I'm just using it as an example. I'm going to say I'm 60 years old and I'm looking for a 5 year annuity, and I live in New York State. They're going to give me a big list of all these different insurance companies. They're going to tell me their credit rating, what the minimum investment is and what the annual rate is. If I'm looking at a five year surrender, the best rate that they quote is 4.75%. So that's for New York State, 4.75%. Now if I'm the same individual, but I live, let's say in Texas, where I'm at right now, the best rate is going to be, let's see, 5.6%. So that's a significant difference in rate with the only difference being the name of the insurance company and the state that I live in. You're going to have to do some research, just like you might search for CDs across the country. That's essentially how the rates are determined. Length of term, the rating of the insurance company and the state that you live in.
What are the primary uses of these fixed annuities? Why do people buy these? Well, they buy them generally for principal protection. You get that guarantee from the insurance company, secure income, that you know what the interest rate is going to be for and you know how long you're going to receive it, that secure income part of it. Then lastly, a lot of people buy these for tax deferral, the fact that the interest isn't taxed year by year. You do see a lot of people using these in IRAs, which already have the tax deferred wrapper. So why might that be? Well, within a retirement plan, these types of products are used in one or two ways, either in resiliency or funding the income floor, remember we buy a security that has a specific maturity and a specific rate. We have that guarantee of principal return and we know when we're going to get our money back. It's used for those purposes to help improve the resiliency, to build out that income floor. It's also used in terms of optimization in looking to get the best yield for the dollars that you're investing. This is more of an optimization question.
Let's go through an example of what I mean by that. We identified a five year fixed annuity in Texas that is paying 5.6%. Again, all of this is different. It moves day by day. When I look at the current yield curve for US Treasuries, which is generally what I would say we use as a default to fund our income floor. Let's say I need to fund $100,000, and I know I need that money in five years. Well, as of the day that I pulled this up, a five year U.S. treasury is yielding 3.7%. I'm rounding here, and these are just for example. If I need my $100,000 in five years, I can buy my US treasury, which is the simple thing to buy, and it's going to pay me 3.7%. But if I want to try to optimize this a little bit and eke out a little bit more income but still keep the guaranteed interest rate and the maturity date or the date, I know I can get my money back without any cost of five years. Well, maybe I look at a fixed annuity as another option for this. We can see with the quote that I just pulled up, a fixed annuity at five years is currently paying 5.6%, which is almost 2% more, about 1.9%. Right. Each year I could earn $1,900 more in the fixed annuity than I would earn in the treasury bond. In this example, $1,900 more per year.
Okay, there's no free lunch, so what am I giving up? Well, one, I'm giving up security at some level because a U.S. treasury is guaranteed by the government. It's the only thing you can say is guaranteed. Whereas the interest rate paid by the fixed annuity company is a promise of the insurance company. Which means I'm counting on them to be financially viable to pay me back my money and my interest in five years. So, I'm taking more risks there. I'm also taking on more friction because a fixed annuity is much less liquid than a Treasury bond which is issued by the government. We're going to talk about those in a minute. They're the most liquid investments in the world. You can buy and trade them in billions of dollars all day long. That's what people do. A U.S. treasury is really liquid and it's a very clear market. So, if I had to get out of it early I could do it very quickly without a lot of friction. Whereas with a fixed annuity I have that back end surrender charge that could be up to 8 or 9% or more if I tried to sell it early. So, it's a lot stickier and so it's harder to get out of and I got to be comfortable with that. Then lastly, we're dealing with increased friction because it's an insurance contract. There's a little bit more paperwork involved to get it in place. It doesn't show up on my account statement the way it normally would. I have to deal with the withdrawal rules if, especially if I'm using non-qualified assets. There's more friction involved so they're paying you a higher rate to compensate for all of these downsides to a fixed annuity versus a Treasury. But this is a place where you could optimize if you chose to try to get a higher yield, understanding the baggage that comes with a fixed annuity.
Now, is it worth it for you? It's going to be a case by case decision based on the entirety of your plan. We default in our process to use US Treasuries unless there's enough juice in the squeeze for a particular client profile to go look at doing these in place of a U.S. treasury. But that's the basics of fixed annuities. And we'll put some links on the basics in our Noodle email. Now let's move on to the basics of treasury bills.
LISTENER QUESTIONS
So, let's look at the basics of Treasuries, bills, notes and bonds. This came from a listener.
Barbara says.
“I'm an avid listener of your show for a few years now and I just love it and your clear and concise way of explaining some of the most complex subjects. Can you educate us and me on what you meant by investing in, quote, unquote, Treasuries? This category of investment sounds like it's safe while providing some growth. I also hear sometimes that the very wealthy invest in this. So, what is meant by Treasuries?”
Barbara, this is a great question. I'm going to answer it here for the show, but I'm also going to do a short video explainer that we're going to share in the Noodle email that I send out every Saturday because sometimes it's good to have some visuals and I'm going to go look at a couple different Treasuries in detail and show you how to read them if you're looking at them on, you know, wherever you have Your assets at Schwab Vitality or Vanguard or wherever. But we'll go through it here. You can get that video if that helps you a little bit.
What do I mean by U.S. treasuries? So, U.S. treasuries are securities that the U.S. government issues to finance the government. They're the only investment that is backed by the full faith and credit of the U.S. Government, the only one we can really say legally is guaranteed by the government. There are three categories of treasury bonds. The first ones are called treasury bills, which are sometimes referred to as T-bills. These are going to be short term. They're short term securities with maturities in 4, 8, 13, 17, 26 or 52 weeks. So very short term. These are like cash equivalents. The way a Treasury bill works is that you don't get an interest rate like you get a coupon where they pay you money. What happens is if the value starts at say $1,000, you'll buy it at a discount. So, say you buy it at $950 and then at maturity it matures at 1,000. That difference from when you buy it to when it matures is how you get your return. So, they’re sold at a discount to face value, which is the amount that's worth of the bond. You can actually buy these, a minimum purchase of $100 at treasurydirect.gov so those are the short term financing. I mean less than a year or less in maturity. These things are rolling all the time.
The second category of a treasury is what are called treasury notes. Now these are more like a traditional bond. They're a medium term bond of 2, 3, 5, 7 or 10 year maturities. These are more like a traditional bond where they're going to pay you a fixed interest rate every six months and you'll receive your face value at maturity. So, you put in $1,000. If it's a 5% interest rate, you're going to get half of that every six months, every single year. Then at the maturity date you get the money that you invested or the face value back. So that's a Treasury note T-note. And the last category is what are called treasury bonds or T bonds. These are longer term securities, 20, 30 year maturities and they act very much like a Treasury note. This is what we mean by Treasuries, Barbara. And these can all be purchased at Treasury Direct, which is going directly to the U.S. treasury and purchasing them at auction when the Treasury Department is issuing them. Now I have a treasury direct account, and I've used that to buy I bonds and Treasuries before. I've also used my brokerage account, let's say Charles Schwab, where you can purchase these bonds on the aftermarket. The advantage of purchasing them at an investment firm like a Charles Schwab or Fidelity or someplace is that it's just a much easier transaction. You don't have to have a separate account. You can have it embedded with all of your other assets. Like the fixed annuities, these are used mainly for resiliency when we're building out our income floor and we want to make sure we have money that we have mature for us. We're just trying to get a certain amount of interest or improve the interest, but we have got to have our money back because it's creating our paycheck. This is the default of what we would use for that category unless we wanted to optimize to go to some more esoteric things. So that is the basics of Treasuries. You can buy them and I'll share in my explainer video. I'll show you how to look at them on a particular website or brokerage firm as an example. But that's what we mean by your Treasuries.
With that said, let's go set a smart sprint.
TODAY’S SMART SPRINT SEGMENT
On your marks, get set, and we're off to set a little baby step you can take in the next seven days to not just rock retirement, but rock life.
All right, in the next seven days, I want you to reframe how you do your retirement planning in that you're a scientist and you're trying to discover information.
When we're doing these stress tests or feasibility tests, we're trying to understand where there might be risks and where there might be opportunities. Knowing that this information may in the moment be uncomfortable and we may not know what to do with it, but it's the beginning of a process to continually focus on finding little baby steps that we can control and take action on.
BONUS
Now we're off to share another installment from my grandfather's log of his missions. He flew in a B-17 in World War II.
Before we get to that, John has a suggestion.
He says,
“If you haven't read any Stephen Ambrose, I would highly recommend adding it to your list. The Wild Blue, about World War II B-24 bombers or Citizen Soldier, both amazing books chronicling the sacrifices made by the greatest generation.”
Well, thanks, John. We'll add those to the list. We are on missions number 40 and 41. He's getting close to 50 now.
“August 29th ship number 337 sortie 26. Went to Czechoslovakia today. Rid flew right waist and I was flying tail gunner from now on. Hit a rail yard in industrial part of the city with fair results. Flak low and inaccurate due to heavy overcast. Enemy fighters paid us a visit again. 51 were escorts. Carried 16,250 pound bombs. Mission was 9 hours and 10 minutes. Altitude 28,500ft.
P.S. lieutenant Wolf, pilot of our crew, finished up his 50th mission today. Here's hoping. Three down, seven to go.”
The opinions voice in this podcast are for general information only and not intended to provide specific advice or recommendations for any individual. All performance references are historical and do not guarantee future results. All indices are unmanaged and cannot be invested in directly. Make sure you consult your legal, tax or financial advisor before making any decisions.