Great tools for retirement income using my IRA or 401K.
Hello and welcome back to my channel. I want to address a specific question that continues to be raised by our viewers: “Can I protect my principal, get continued growth, and make sure I can’t outlive my money?” Now, hang in there, this is a little bit longer than usual video, but packed with timely and great information for today’s market.
Dave Duley here with Georgia Advisor Group, with 40 years of experience in the financial industry, and a registered investment advisor working with hundreds of families, primarily here in the Atlanta area. I’m going to take longer than usual to answer this question, primarily because you’re not just asking a simple question, but one that deserves an in-depth look at how this can be done and the best dollars to use to accomplish this goal.
Let’s dive right in. When I ask people what they like about the stock market, they quickly reply to the opportunity to garner large returns. I then ask what they dislike about the stock market, and they quickly reply the risk of losses or losing their principal. When I ask what they like about certificates of deposit or a savings account at the bank, they say they like the protection of their principal. I then ask what they dislike about the banks or savings or CDs, they say low returns. I agree with all those prior statements.
I then ask, “What if you could have the best of both worlds, an opportunity for good market returns, and your principal always guaranteed?” I usually get their attention. Now, what I’m speaking about is fixed indexed annuities. Now, before you roll your eyes, let me make it clear that the ignorance level that abounds on this financial tool is astounding, primarily for two reasons: just sheer lack of understanding or a specific agenda to get you to invest your dollars somewhere else. To keep this as simple as possible, a fixed indexed annuity is a contract issued by an insurance company that guarantees principal protection and always allows you to participate in the upside of the market. Now, keep in mind that this is just a financial tool, no different than stocks, bonds, REITs, or private placements, and so on. Each has its place for getting you from point A to point B, but like any tool, each is created for specific use. There are no good or bad tools, just tools. All have pros and cons.
So when a client asks first and foremost for protection of their principal and a guaranteed income, as an advisor, we must eliminate the financial tools that are not applicable, such as stocks, bonds, REITs, ETFs, or private placements, because if none of these meet those requirements. Now, since the client also asked for growth with stock market-like returns, I can’t use fixed annuities, though they protect my principal also because they’re giving me a fixed return and not market returns. A variable annuity won’t work because it is in the name, variable – the principle is at risk, and in addition, fees are enormous.
That leaves me with an indexed annuity based on the client’s requirements, what they’re asking for. Let’s quickly talk about the pros and cons and dispel any ignorance or any agendas that are out there. As I mentioned, an indexed annuity is a contract with a life insurance company. The basics are this: First, your principal is guaranteed 100%, and it allows you to participate in the upside of the index, like the S&P 500. That is what we refer to as the growth aspect of the contract. In addition to the principal protection and growth, they also include guaranteed income as well.
The only other income annuity was either fixed or variable. We believe that these two options are too costly with fees and are clearly not as good. One limits you to the upside (the fixed annuity), and the latter doesn’t protect your principal. When I hear people say that annuities are bad or too confusing, they’re almost always referring to variable annuities. For our purposes, having been asked about wanting principal protection with unlimited growth possibilities and lifetime income, we have to focus on the indexed annuity. You want options and the indexed annuity can be used for safe growth only and also trigger lifetime income, or not. You don’t have to choose one or the other. So, unlike the recent past, the great news for you is that you have choices with innovations to use these financial tools. Some just want safe growth and when the contract expires, they walk away or leave it as an inheritance. Three out of four retirees want the lifetime income aspect to curtail the fear of ever running out of money.
The primary indexed annuities have four major components: participation rate, caps, fees, and reset. Let’s look at each individually. Let’s assume all these examples will use the S&P 500 Index. Now the great news is that you can choose several indexes and spread your dollars among all or a few. You get to choose each year or change your allocations, just like you would in a 401K.
The participation rate is based on what percentage of the index you will be credited each year if the index increases. So, if the participation rate was 50 percent, and the index increased by 12 percent, you get a 6 percent increase. If it increased 20 percent, you enjoy a 10 percent increase. Now, on the other hand, if the index, like we had in 2022, is down 20 percent, you take no loss. This is where the principal protection kicks in. You gain nothing from the previous year, but you took no reduction from where you started the previous year.
Let’s assume you placed a hundred thousand dollars in an indexed annuity using the S&P 500 and gained a 10% return in year one, resulting in a balance of a hundred and ten thousand dollars in your account. Then in the following year, or year two, the index dropped by 20%, like it did in 2022. Even with this drop, you still have your hundred and ten thousand, so participation is important to ensure that you have a contract with the highest rate you can get. Next, let’s discuss caps. In the beginning of the design of this product, most contracts had 100% participation but placed a cap on what you could earn each year. They may say that on this index, you’re capped at 5%, and if the index did a 20% return, you would only receive 5% of that return. We avoid capped rates and deal with companies that have no caps whatsoever.
Now, let’s talk about fees. Here’s where we prefer indexed annuities over variable annuities. Indexed annuities that offer principal protection and growth have no fees at all, zero fees. The only time you may incur fees is if you choose the lifetime income rider. This is for those of you needing lifetime income that you cannot outlive, for you and your spouse. Most companies will impose a 75 basis point to 1% annual fee for this benefit when you choose the income rider. The question then becomes, is it worth it? Let’s assume you invest $250,000 into the contract and choose the lifetime income rider at age 55. Now, let’s assume the worst-case scenario, and your index never gains a nickel over the next 10 years, highly unlikely but possible. At age 65, you begin lifetime withdrawals based on a 5% withdrawal rate. You begin taking out $12,500 annually and still have no gains whatsoever. By the time you reach 85, you may run out of money in your contract, but the insurance company continues to pay you and your spouse, even if she outlives you, for the remainder of her life. In other words, your contract never expires. If your index increases during retirement, then your paycheck will also increase during that same time. So you’re not stuck with a fixed retirement check. The key here is that the longer you wait to draw lifetime income, the higher your income will be. It’s no different than Social Security, where at 62, it will be lower than, say, 65.
Let’s assume you place a hundred thousand dollars in an indexed annuity using the S&P 500, and you gained a 10% return in year one, and now have a hundred and ten thousand dollars in your account. Then, in the next year (or year two), the index dropped by 20%, like it did in 2022. You still have your hundred and ten thousand, so participation is important to make sure you have a contract with the highest rate you can get.
Next is caps. In the beginning of the design of this product, most had 100% participation but placed a cap on what you could earn each year. So, they may say on this index you’re capped at 5%. If the index did a 20% return, you only receive 5% of that return. So, we stay away from capped rates. We want no caps whatsoever, so we deal with companies that avoid these.
Next, let’s talk about fees. Here’s where we like indexed annuities versus variable annuities. Indexed annuities, on their principal protection and growth, have no fees at all. That’s right, zero fees. The only time you can incur fees is if you choose the lifetime income rider. This is where, for those of you needing lifetime income that you cannot outlive, it’s for you and your spouse. Most companies, when you choose the income rider, will impose a 75 basis point or 0.75% to a 1% annual fee for that benefit. Now the question becomes, is that worth it? Let’s assume you put in $250,000 into the contract as an example, and you choose the lifetime income rider at age 55. Now, let’s assume the worst-case scenario, and your index never gains a nickel over the next 10 years, highly and probably unlikely, but it could happen. At 65, you begin lifetime withdrawals based on a 5% withdrawal rate. You begin taking out $12,500 annually and still have no gains whatsoever. By the time you reach 85, you’re out of money in your contract, but the insurance company continues to pay you and your spouse, even if she outlives you, for the remainder of her life. In other words, your contract never expires. If your index does increase during retirement, then your paycheck also will increase during that same time, so you’re not stuck with a fixed retirement check. The key here is the longer you wait to draw a lifetime income, the higher income will be. No different than Social Security; at 62, it will be lower than say 65.
The difference between the insurance contract and Social Security is that when you die, your check is gone if you choose to draw Social Security at age 65, let’s say, and it’s 70 when you pass away, that’s it. You collect nothing else. Your wife can get either her Social Security or half of yours, whichever is higher, but you don’t get both. With the indexed annuity, that payment continues for your wife or spouse as long as she continues to live, regardless if you run out of money or not. And, in addition, you can leave it or pass it on to your children. So, with Social Security gone, any dollars left are then passed to your children. Not so with Social Security. To me, that alone is worth the fee. In a managed account with an advisor, you will always pay an annual fee but are given no guarantees in principal or lifetime income. So here, I think the answer is clear that taking that lifetime income rider, if needed, is worth it.
Now, let’s talk about my two most favorable aspects of the inner workings of the indexed annuity: the reset factor and why using qualified money such as my IRA or 401K is the best. First, the reset. The thing to remember here is, I said, your principal is protected from losses and so are many gains you incurred. But here’s the critical part most people do not factor in when comparing indexed annuities to a regular managed portfolio or just stocks or bonds. If we compare apples to apples and we have two clients, each with five hundred thousand dollars in their IRA or 401k and both have the S&P 500 Index, one is in an indexed annuity, the other is in the brokerage account. The S&P index on January 1st is at 3000, as an example, and it drops over the next year by 25 percent to 2250. The client with the managed account now has a balance of $375,000 from his start of $500,000, a $125,000 loss. The indexed annuity balance is still at $500,000, but here’s the key: you have to be focused on the reset. Now, the index, remember, dropped from 3000 to 2250 from the start of the next year.
So let’s assume it increases back to the three thousand in year two. Because the index resets each year, you now have gone from 2250 to 3,000 on the index or 75 percent gain, whereas the brokerage account has just gotten back to even, or he’s just got his five hundred thousand dollars back he began two years earlier. You now have an account balance for six hundred and sixty thousand dollars, and this now becomes your new base that is completely protected. That’s your new principle. This assumes you had a fifty percent participation rate, so you can see the reset is critical, and it’s key. Each year you get to start over at the new index point, so I always say, “If we know you’re not going to gain any interest credits like we did in 2022, then I want the market to drop so I can take advantage of the reset.”
I’ve put up a chart so you can see the dynamic effect of the reset over the last 10 years. Now the final point I will make is why I like qualified money for this financial tool. With any contract, you have withdrawal penalties. A CD or a bond will penalize you for taking money out too early or too soon, so will an annuity. You do get to access up to 10 percent of the value of your contract each year with no penalty whatsoever. So, as the example of the 500,000, you can take fifty thousand dollars each year penalty-free, but if you exceed that amount, you will be hit with a descending penalty, such as seven percent the first year, then down to six if you take money in the second, five, four, three, two, one percent penalty.
So, I asked my clients, “How long will you have your IRA once you roll over your 401k to your IRA? How long when you have it?” The answer is the rest of your life until which time it runs out of money, meaning you will only withdraw what you need each year from your IRA for income purposes, or you will need to be forced to take your minimum required distributions at age 72, even if you don’t need income. So, if that’s the case, why would you not use those specific dollars, 401k or IRA money, to fund your own pension plan? The penalties won’t apply at all to you if you planned well, meaning set other money aside.
I’m not looking for additional tax deferral by having an indexed annuity than an IRA, but rather a guaranteed of my principal, unlimited growth, and if I need it, to pay me a lifetime income for me and my spouse. My IRA cannot provide any of those things, or my 401k. These are the best dollars to use. For those of you who say, “I want to protect these dollars. I want to make sure I can’t outlive my money.” As with any financial tool, you got to do your own homework, but don’t let ignorance or some other agenda get in the way of making a great decision for you and your family today.
These index annuities are fiduciary products, meaning that investment advisors are now paid a fee by the insurance company and not a commission, so it puts them on the same side of the table as you. They want to see it grow just like you do. As they are paid a fee, don’t listen to the commercials saying, “Because these are commissionable, you need to stay away from them.” That’s nonsense. Liberated reported last year over 42 billion million dollars poured into indexed annuities in 2022. Now, why is that? People are seeking principal protection with growth and lifetime income.
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