What Is an Annuity? (And Do You Need One?)

Transcript

Mike:

Today, we’re going to talk about a financial tool that generates more questions and is less understood than probably every other financial tool combined. And of course, I’m talking about the word annuity. So let’s talk about what is an annuity. And when should you be thinking about using this tool and when should you not be thinking about using this tool? How about that? What really is an annuity? We’re gonna have to do a little, a history lesson here, and the word annuity goes back many, many years, but essentially annuity equals a stream of income. Now that stream of income could be for a certain period of time for five years, for 10 years, or it could also be for life. So this is the traditional definition. And if you think about it, this really means a pension. My father, he’s now 85 years old. He worked for state farm insurance, right?

Mike:

For pretty much most of his career. When he retired in 2000, actually retired in 1999. He received a pension for his lifetime. And the way it works is if he dies, then my mother, his wife gets the same amount for the rest of her life. That’s a pension, but guess what? That is also an annuity. So traditionally the idea behind an annuity was this, and here’s how traditional retirement planning went. It all went on this concept of a three legged stool. And here we go. You can tell I’m not the world’s greatest artist, but that’s our three legged stool. And the way it would work is like number one would be social security leg. Number two would be a pension or an annuity and leg number three savings, you know, like a 401k. So when my father retired, he had all of these. He has he and my mom has social security.

Mike:

They have a pension, they had a 401k, they got it all figured out. But here’s, what’s important about this model. Notice that these two right here both represent lifetime income. So the way it worked with my parents is they said, well, gosh, and this was true for a lot of people that pensions who retired right around, you know, 1999, 2000, right in there. And a lot of people who retired today, maybe they worked for the state or his teachers. They might have something similar, but notice for my parents’ social security pension, those two income streams are guaranteed for life. And guess what? They actually cover. Most of my parents’ regular income needs. It covers their base lifestyle for them. This equals their lifestyle and this equals their fun money right up here, their savings. That’s the fun stuff. And that’s how people used to retire all the time.

Mike:

It’s a very stable structure, because if you think about it, if the market had at the stock market has a good year or bad year, to what degree does that affect your lifestyle down here in this model? The answer not at all right. Does it affect you at all? Because your income is coming in no matter what. Now it might affect your fund money up here, right? But it’s not gonna affect, you know, your lifestyle. And when you’re retired, you don’t want the stock market to affect your lifestyle. You want to have, you want to enjoy stable, predictable, and consistent income. How does that compare to what’s happening today? So let’s look at this. What’s happening with people today. Well, first, how stable is social security today? Well, I can tell you what a lot of people that I talk to, they say, Hey, we’re worried that this is on a little Rocky ground.

Mike:

We’re not sure if that’s really going to be around for the rest of our lives. Now I want to share something with you. I think this is on very stable ground. If you are over the age of say 50, and do you know why I say that? Because this is as long as you’re over the age of 50. Here’s what I know about you. You do this thing called voting. You vote. And as long as people over the age of 50 vote, I can pretty much guarantee you the politicians they’re going to protect that leg. Because they don’t want to get voted out of office. If you lose your social security, I promise you you’re going to be voting to kick that person out of office. They know that they want to get reelected. That’s actually going to be pretty stable. I know the media wants you to think it’s not going to be stable.

Mike:

It’s stable for you. If you’re over 50. Now, what if you are 25 years old? Is it stable if you’re for you If you’re 25, eh, not as much. So we just be aware that there may be some changes for younger people, but if you’re over the age of 50, you don’t have to worry about that. One. How many of us are retiring with pensions these days? Well, guess what? That leg is pretty much gone. Unless again, if you work for the state, the government, you work in the, as a teacher, you might have a pension, but outside of that, most people don’t have pensions anymore to really maybe small ones, but not really much to speak of because what if company’s been doing, they’ve been saying, you know what? We don’t want to be responsible for this because they don’t want that responsibility. Instead.

Mike:

They, what they’re doing, they’re saying we’re going to instead, we’re going to just do some matching in your 401k. And we’re going to let you take the responsibility of your retirement. Now, this all started because by the way, in the eighties and nineties, this is when this transition really started happening in two things were going on. First, people are living longer. So the companies are like, we don’t want to deal with these pensions. Ah, we don’t want that responsibility. It’s not what we do anyway. And what was the stock market doing up, up, up, up, up, and people were all saying, gosh, why don’t you just give us the money? We can invest it and make way more than you guys are in the pension. So that’s what happened. And so now when people retire, what’s it look like they have social security leg over here, right?

Mike:

That’s still there, but their 401k leg looks like this. They’ve got tons of money in their 401k. And I see this all the time. People come to me and they’re saying, okay, Mike, I want to retire. Here’s the deal. I have my social security. And I’ve got this big, old pot of money in my 401k. How do I make this work? Right? How do I make this work? So we’re talking about annuities in this video and we’re talking about, when are they helpful? When are they, when are they not helpful? One area where annuities are helpful for people where if you’re not, if you’re in this situation I’m describing right here where you’ve got social security and savings and that’s about it, then I would argue as a true fiduciary, as a certified financial planning professional, I’d be saying, look, you absolutely are missing out.

Mike:

If you’re not considering adding a new cities to your planning. If you’re this person that we’re talking about right here, most research papers say that when you add a new cities to this picture, that it stabilizes your retirement in a positive way, it makes all retirement outcomes better. What you should be doing. Let’s see if I can take a different color is simply saying, let’s take some portion of this, of your savings. Not all of it, not all of it, not all of it. So in other words, let’s try to take some of this, this part of the leg right here. And let’s try to create that third leg. So you can go to insurance companies and you can say, you know, I want this much money for life and I want to come every month, just like the traditional pension. And the idea is between this dollar amount and whatever you’re getting for social security, ideally, that should cover your basic lifestyle expenses.

Mike:

All right. And so what you should be doing is saying, all right, how much the question is, how much of my savings would I need to put into some kind of an annuity that would be guaranteed to pay income for life? A lot of people say, oh, I don’t like that idea. Because if I don’t live for a long time, like, think about a pension. If you don’t live for a long time, all the money in that pension just goes away. It doesn’t go to anybody, but you don’t have to worry about that today because annuities today, not only do they give you lifetime income, but if you don’t live very long, then there are benefits to children, right? So you don’t lose out. You don’t lose out on the money you put in there. But the big question here is how much should we use?

Mike:

Like if you’re asking me, would an annuity be appropriate for me? If you’re in this situation. And I’m noticing that the more I write on this semester year, the screen gets right. But if you’re in this situation taking some portion and right here, we don’t know how much that we we’d have to find that out. But taking some portion to build up, to replace this leg right here in your planning, that can often make a lot of sense. That’s a very prudent and intelligent way to structure your retirement income, where you go back to be just like my dad, where you’ve got two legs right here. This one right here. And this one right here, those two legs cover basic lifestyle. And then you’ve got money over here. That’s for the fun, the extras, you know, all that good stuff. Right. Inflation too, by the way, don’t forget about that.

Mike:

That’s a really good use of annuities right there. Really good. Here’s another one. Here’s social security. Here’s my savings, Mike. I don’t the pension. Like I don’t have that at all. I’m I’m not going to have that. And maybe you’re like 50 years old. Right? And you said, I don’t have that pension leg. Well, guess what already, it might make sense to do what we just talked about. Take some of your savings and use it to build a pension leg for your future. Because guess what? Putting money in an annuity earlier on gives you some compounding. That could be a powerful thing to do. Sometimes that works. Sometimes it doesn’t. But notice what we’re talking about here, we’re talking about using a new cities. I’m going to put a red, red letter word income for life. In other words, using a new cities, taking some of your savings to buy annuities, to provide some amount of income.

Mike:

That’s guaranteed to last your lifetime. There is nothing. And I mean, nothing. There is no other financial tool. None that can do that. As well as an annuity. Some people I talked to, they hear this word. They like, oh, annuity. I don’t like that word. Why don’t you like that word? Oh, they, I hear that. They’re very complicated. I hear they’ve got a lot of fees. I hear they’re really expensive. And you know, all kinds of bad reasons. Guess what? Every time you hear that you’re hearing, they’re talking about deferred variable annuities. That’s a whole different thing. That is not what we’re talking about here. We’re not talking about that, but we’re talking about the kinds of annuities that are, that are principal protected, they’re insured, and they’re guaranteed to just pay out income for some period of time, whether it’s for your life. And sometimes people use this as, Hey, man, I don’t necessarily need it for life.

Mike:

If it pays out for 20 years, I’m good. Heck for some people, if it pays out 10 years, I’m good. Right? It’s just saying, let’s build up some pension like here to pay you income for some amount of time. How am I doing? I hope that makes sense. When should I use annuities? When I’m trying to create some type of guaranteed income, right? For some period of time and that period, it could be, as I said, typically, you’re looking for 10 years, 20 years or life. If you’re saying I need some income, like I need something to S to supplement my social security. I need some income that will last, that I can count on that never have to my go to bed at night. I don’t have to think about it. I just know it’s going to be there then. Yes, annuities are great for you in that scenario. When is it a no pretty much any other time.

Mike:

Ah, except there is one other reason you would want to use a certain type of annuity as a bond replacement in your portfolio. You know, as I’m writing this today, as I’m recording this 10 year, treasury bonds are paying about one and a half percent per year. And the reality is we’re going to interest a low interest rate environment. We’re in an environment where interest rates are likely going to start going up. And when interest rates go up the way it works, and I don’t have time to cover this in today’s video, when interest rates go up, bond values go down. Research tells us that fixed indexed annuities tends to work really, really well as a bond replacement. In other words, research tells us that, you know, if you have, I’m going to put here the word quality, fixed indexed annuities. If you’re using quality fixed index annuities that are really a quality annuity, that’s designed the right way, they actually are re they do a really good job in your portfolio to balance off the risk of the market.

Mike:

So the idea over here is when you put together a portfolio, we’ve got, you know, the bonds over here for safety, right? Then we’ve got the stock market over here, that’s for growth. And what are we trying to do? We’re trying to balance these off, have some percentage in each. So we’re balancing off risk, right? We’re saying I want some money over here to balance off the risk of what’s going on over here. And depending on where you are in life and, and you know, how much risk you like taking it’s that that equation is different for everyone. Research is telling us that, ah, replace these with the right FIA’s, fixed index annuities. And you actually end up doing better. You, you it’s an improvement over using bonds in your portfolio planning. That’s when you use annuities, you use them for either income or as a bond replacement.

Mike:

Anything else? Probably you’re not using the best tool for the job. And even when we’re talking about where they work, well, we’re not talking about all annuities, right? We’re talking about certain ones. Everybody’s situation is different. And so you need to talk to someone who really understands this world so that if annuities are right for you, you’re talking to someone who can help make sure that they’re getting you the right type of annuity, right? The quality annuities, that best fit what you’re trying to accomplish. All right. That’s our message. This week. Hope you found it. Helpful. Talk to you again soon.

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