Charlie Gipple, CFP, CLU, ChFC

Buy annuities now! They are better than they have ever been, and they may not be here forever, at least in their current form. I don’t say that to be a “sales guy” trying to create urgency. I say that because there are memories that are tattooed into my brain that has been one of the most profound learning lessons of my career. I will share them with you below.

In my other article in this month’s edition entitled “GLWB Now, Or Accumulate then Choose a GLWB or SPIA?” I ended the article with the #1 reason I will usually choose purchasing a Guaranteed Lifetime Withdrawal Benefit (GLWB) Annuity now versus accumulating until retirement then choosing an income focused annuity (GLWB or SPIA). Although the math that I laid out in that article by itself should be enough, the “math” is not my #1 reason. What is that #1 reason? Because I am paranoid. Let me explain.

Once upon a time, I was a VP at one of the major variable annuity companies back when variable annuities were the dominant product line in the annuity space. At this time, fixed and indexed annuities industry wide production didn’t hold a candle to VA production. This was prior to the financial crisis that started in 2007. Those traditional variable annuities were largely sold with GLWB riders, and they were good! It was the variable annuity companies that pioneered these riders along with the earlier riders that were Guaranteed Minimum Death Benefit Riders (GMDBs) and Guaranteed Minimum Income Benefit Riders (GMIBs).

GLWBs were a great invention because they guaranteed a certain level of income, regardless of how the VA subaccounts performed. GLWBs were different than their predecessor—GMIBs—in that the GLWBs did not require annuitization. Hence, the difference between a GMIB and a GLWB was generally that the GMIB required annuitization and GLWBs were merely withdrawals that continued even after the account value went to $0. No annuitization required. GLWBs were such a great invention that the indexed annuity world copied the GLWB design around 2005 or 2006.

At the time (around 2006, 2007) our top Variable Annuity GLWB had seven percent compounded roll up rates and payout factors of five percent at age 65. These products sold like hotcakes. Variable Annuity wholesalers across the country were now driving around in Maserati’s, Bentleys, etc.

Then 2008 came and the market started to drop significantly from its previous highs in 2007. The quarterly results/losses of VA carriers started to generate horrible headlines that shed doubt about the future of major VA carriers. That is when the Brokerage firms that distributed these products started to invite carrier product actuaries to conference calls! Crazy thought huh? These actuaries’ jobs were to put these broker dealers and their reps at ease about if these VA companies can actually continue to afford to have such great withdrawal benefits. Afterall, if you have a variable annuity contract that has lost 30 to 50 percent of the “account value” but the carrier is guaranteeing income on a value that grows by seven percent, there will be strain on the carriers that guarantee that ultimate income. Furthermore, as interest rates dropped, the “present value” of the carriers’ future liability became huge! Hence, the capital drain from these VA products was a huge weight on the shoulders of these VA companies.

So, in 2008 and 2009 is when we all got to learn more about carrier hedging, dynamic hedging, futures contracts, put options, delta, theta, Vega, gamma, rho, etc. than we ever wanted to because actuaries were constantly doing calls with distributors. My carrier was saying something like they had hedged to the 99.999 percent, which meant that unless a .001 percent scenario happens in the stocks, futures, bond market, then they will be just fine. This was a consistent line from most VA carriers in the industry, not just mine. Well, .001 percent happened…

It was around early 2009, coming off the Lehman Bankruptcy, the market being down 57 percent, and interest rates plummeting, that the executives of these carriers started to come out and say, “Disregard everything we said previously. It is time to simplify and de risk our products.” The “de risk” buzzword basically meant that the lofty GLWB riders were going the way of the dinosaur. Well, by 2010 many of the products that were loved by distributors and reps were effectively extinct in the VA space.

The combination of the stock market losing over 50 percent in the financial crisis as well as interest rates dropping significantly sank many carriers. But then you had technical accounting issues that added salt to the wound, such as “deferred acquisition cost unlocking.” Billions of dollars of losses were reported by many carriers, quarter after quarter. Many VA companies were also downgraded by ratings agencies and many completely went out of the VA business. All because of this one product design.

For over a decade thereafter, I heard many advisors say, “That XYZ product that you guys sold at your old company, I should’ve sold more of that and should’ve bought more of that.” In hindsight they knew they had a good deal, but it was too late.

The irony was, around 2009, 2010, 2011, the executives of these carriers were now having their fixed/indexed annuity experts train many of the VA wholesalers on how indexed and fixed annuities work. What was once the black sheep of the carrier family of products was now the “last man standing” in many of these carriers, and the main strategic focus. The fixed/indexed annuities had better pricing dynamics and hence these products were more “derisked.”

Fast forward to today. Today, Indexed Annuities guarantee more robust GLWB payouts than the VA space ever did! The traditional VA space (not including RILAs) is about 54 percent of the indexed annuity space from an industrywide production standpoint. Accumulation focused indexed annuities are also better than they have ever been! In my 25 years I have not seen these indexed annuities as attractive as they are now. So, in my other article, I discuss how I am very much about taking advantage of these products that we have today. I will repeat, I don’t say that to be a “sales guy” trying to create urgency. I say that because there are memories tattooed into my brain that formed one of the most profound learning lessons of my career. Get them while we have them.

In closing, I want to be clear that I am not saying that carriers will eventually have to purge the wonderful indexed annuity benefits that we have today. Afterall, Indexed Annuity pricing as well as pricing on the GLWBs have completely different pricing dynamics than the VA space had. For instance, the difference between the “Accumulation Value” in an indexed annuity and the “GLWB Benefit Base Value” will not increase by say 50 percent in any one year because of a market crash. Why not? Because with indexed annuities the client cannot lose their account value. That means that the carriers “amount at risk” is not subject to as much volatility. That is right, the stability of the account value of an indexed annuity actually helps the carrier “hedge” the GWLB benefit on that same annuity.

What I am saying is, these products have never been better and that is largely because of where interest rates have been recently and where they are now. These higher rates may not last forever. Remember what I said earlier, if a carrier is guaranteeing a future income stream, lower interest rates means that their liability/capital requirements increase. If interest rates go lower, just don’t be in a position where you say, “I wish I sold more of that.” Some healthy “paranoia” is OK.

If you have not read last month’s article that is somewhat of a prequel to this one, please refer to “Social Security Prospecting Is Bait And Switch“ from April.

In that article I discussed how Social Security is about so much more than just Social Security and “crossover point analysis“ that many of us have seen. Crossover analysis is done by looking at the cumulative benefits of Social Security by filing at 62, 67, 70, etc., and which one comes out better at certain points in time in the future. This type of analysis is oversimplified for various reasons (taxes, time value of money, etc.). Let me explain by using my Monte Carlo Software.

As I go over this analysis, you will find that this conversation is about so much more than just projecting how long one will live then selecting the best timing based on our expectations. There is much more to it than that when you take into consideration taxes and RMDs. As I often tell my clients and agents, “Social Security optimization is about so much more than just Social Security. It is also about the other retirement income that can add to Social Security Taxation.”

Example client
Here is our example client. I’m simplifying it with one individual–Johnny–who was born in 1960 and has a full retirement age (Per Social Security) of 67 and his Social Security statement shows at full retirement age his benefit amount is $2,000 per month. That is his “primary insurance amount.” He also has a $1 million stock/bond portfolio (50/50) that is all Pre-Tax IRA money. Johnny wants to retire next year, 2025. Johnny is hoping that he can get at least $50,000 per year in today’s after-tax dollars in retirement income. That income he needs to adjust for inflation each year until he dies. What is his “retirement number” as I call it? That is what Monte Carlo simulations solve for.

In short, what Monte Carlo simulations do is it answers the question of: “When Johnny retires, how much is it in today’s dollars that he can take in retirement income among all of his sources of income so that he statistically does not run out of money?” The system will come back with a dollar amount that he “should” be able to take in order to last him his lifetime–which I put in as age 92. I wanted to be aggressive with the lifespan because I want to be conservative with his retirement income so he does not run out of money. Furthermore, the amount of income that the system comes back with is based off of a 95 percent confidence rate, which I won’t go into here. It’s irrelevant to this article.

Layering approach
The first scenario is what I call the “layering approach.” This is when consumers automatically file for Social Security once they retire, age 65 in Johnny’s case, and then just layer on top of it his portfolio income, which is 100 percent pretax in our simplified example. So the question is, what is the after-tax dollar amount that Johnny can take in his first year of retirement and then, adjusting for inflation, each year thereafter by taking this approach? The system came back with the following shown in Chart 1.

As you can see, $46,140, which is almost $4,000 short of our goal that Johny wanted of $50,000 in retirement income. Currently there is no difference between the box on the left and the box on the right. However, once we start to optimize his income by adjusting Social Security, you will see the box on the right, which is the plan, increase.

Now in chart 2 is what I mean by “layering.” What Johnny did was he took Social Security blindly at age 65 because he did not have a glorious agent like yourself to advise him on other strategies. But then on top of the Social Security he just blindly took from whatever portfolio he had, which was all qualified money. The lack of coordination among various income sources is quite common with the average consumer. Just blindly take what you need and layer it on top of your Social Security! When folks cook meals, they usually “coordinate” the various sides, main courses, etc. The below is equivalent to eating a Ribeye along with a glass of chocolate milk.

The gray bar is his Social Security, which is slightly penalized because he took it two years early, and the blue bar is his withdrawals from his $1 million portfolio. $22,794 is coming from Social Security and the difference of $24,730 comes from his portfolio. The total of those two numbers is $47,524. That is, $46,140 but with one year of Inflation adjustments, since he is retiring next year.

For you annuity folks, you are reading that correctly! The system is saying that on an inflation adjusted basis, only $24,730 can be taken from his $1 million portfolio to be sustainable until age 92 based on a 95 percent confidence! Yes, there is an annuity sale here, but not in this article…

The red line is how much the system projects he can take on an after-tax basis, and the green line represents the amount he needs to withdraw from his portfolio in order to get the red line after the taxes have been paid. In short, the “lines” are how much his expenditures are in retirement, and the “bars” are how he finances them. By the way, notice the yellow line. That is his required minimum distributions, which are approximately $35,000 when he turns age 75.

The bucketing approach
So now I asked the system, “What is the optimal Social Security filing age from an after-tax income standpoint based on our assumptions?” Check out our green box in Chart 3. This is where our green box starts to deviate from our original layering scenario and where we start to truly help our clients! How are we able to get him almost 10 percent additional income based off of the projections? The system says by filing for Social Security at age 70.

Now, filing at age 70 giving Johnny more income over his life may be no surprise to you, but what may be surprising is what all contributed to getting more after-tax income at age 70. It has to do with more than just “Delayed Retirement Credits” that the Social Security Administration gives us by delaying. In this case, it has to do with the “bucketing approach” that is represented by the new cash flow shown in Chart 4.

What I mean by “bucketing” is this. Relative to our first scenario, our dark blue bar is separated out from the gray bar, on a relative basis. By delaying Social Security until age 70, we are also becoming less reliant on portfolio income once that Social Security comes in. This is because the Social Security checks are so much larger via the Delayed Retirement Credits. And because we have less pre-tax income coming in at the same time we are taking our Social Security, it can decrease Johnny’s Provisional Income and thus his Social Security taxation. Don’t believe me? Check out Johnny’s projected Tax Returns (see Chart 5) in the year 2034 for each of the two scenarios.

The “Layering” Tax Return
Notice in line 5a on his tax return that he received $29,741 in Social Security income but yet $23,931 was taxable! That is over 80 percent of his Social Security that is taxed. Why? Well again, because he was very reliant on the pre-tax income represented in line 4a and 4b. Line 4b added to his provisional income, which also made his Social Security more taxable! The end result of all of this was, as shown in Chart 1, he falls $4,000 short of his $50,000 goal on an after-tax basis.

Compare that tax return to the one in Chart 6. This one is using our “Bucketing Approach.”

The “Bucketing” Tax Return
Now, less than half of his Social Security is taxed. This is because he is less reliant on our 4a and 4b!

Concluding thoughts:
The “Bucketing Approach” may not give the most income in every scenario, especially those scenarios where the consumer is on one extreme side of the retirement income spectrum. However, speaking with consumers about the bucketing approach does have additional advantages, such as:

1. During those “bridge years” between age 65 and 70 in our example, Johnny is spending down a significant amount of his pre-tax dollars. This oftentimes reduces his RMDs later on. Consumers hate RMDs if they don’t need the money!
2. The tax rates assumed above are today’s tax rates. The case for “bucketing” becomes even more pronounced if we assume significant tax increases due to our fiscal situation. The end effect of the bucketing approach can be that Johnny is paying taxes on his pre-tax dollars earlier, when tax rates are possibly “on-sale.”
3. The bucketing approach can also help in reducing “IRMAA,” which determines Medicare Premiums.

You can see how this analysis oftentimes leads you to a conversation about Roth IRA conversions. If Johnny had all Roth IRA money rather than Traditional IRA money, this calculus completely changes.

As many of you financial professionals can attest to, annuities have become more “mainstream” in the minds of consumers. So much so that we financial professionals are often prompted for more information about annuities from our clients without us ever even mentioning annuities. The industry-wide sales numbers speak to the increasing popularity of annuities, as last year (2023) was the best year in the history of the annuity business with $380 billion (more than 1/3 of a trillion!) written industry wide. That is more than a 25 percent increase from the year prior—which was also a record.

With that, if you get a phone call from a client and he/she says, “Can you teach me really quick about your fixed annuity offerings?” what would your response be? This conversation can be tricky because if you are like me, your natural tendency is to get in the weeds about all the options, bells, and whistles. However, you obviously have to be succinct and jargon free because clients are busy… As somebody once said, “The best presentations have a good beginning, a good ending, and both of those items as close together as possible.”

So, here is my “bucket approach” that I explain to consumers that gives plenty of information but is not a 30-minute dissertation. Furthermore, the below points are not something I just spout out uninterrupted, as there are always questions along the way that make this a dialogue rather than a monologue. From here, imagine I am speaking with one of my clients.

The three different types of fixed annuities that I offer I will call bucket number one, bucket number two, and bucket number three.

Bucket 1: Guaranteed Rate Annuities
The first bucket is what I call the guaranteed rate annuities. If you are familiar with certificates of deposit, with these annuities the interest is credited just like how it is credited with certificates of deposit. Guaranteed and for the number of years you choose. Also, like CDs, you choose how long you want to have your money in the annuity, which can be anywhere from two years to 10 years. Usually, the interest rate is higher the longer out that you go. Again, the main characteristic here is that the interest rate is guaranteed for the length of the term that you choose.

What If you want your money back by the end of the term? There are generally liquidity provisions, such as interest only withdrawals or 10 percent withdrawals, where you can take money out if the need arises, even during your term. However, if you cash it all out prior to the end of the term, a lot like how you will lose interest with a CD, you will be subject to surrender charges with the annuity. What happens if you die prior to the end of the term? Most of these annuities will pass on to a named beneficiary whatever you put in plus whatever it grew to. Today I can give you a guaranteed interest rate of anywhere from 4.5 up to six percent, depending on the annuity term you choose.

Also, this is very cool about any annuity. Whatever interest you earn over a year you don’t have to pay taxes on, at least until you take your money out! Annuities are tax deferred. So, if you are getting five percent over a year on $100,000, you may get a 1099 for $5,000 from the bank on that CD. Conversely, with an annuity, that 1099 does not come until you cash it out. (Note: this last point is irrelevant if you are discussing IRA money.)

Bucket 2: Accumulation Indexed Annuities
The second bucket is a bucket that gives you more upside potential than bucket #1, and it also does not have the downside risk of the stock market. Over “the long run” the stock market has done quite well relative to fixed interest alternatives. However, many consumers don’t have “the long run” to wait out any market downturns that can arise if they have their money in the stock market! You may have heard of “The Retirement Red Zone.” When folks get close to retirement (The Red Zone), losing money is obviously more dangerous than if you were otherwise only 25 years old. You don’t want to lose your money right before you retire!

So, with this product, you can actually harness some of the upside potential that the stock market is known for. But, you don’t participate in the downside. This is bucket #2, which is what I call “accumulation indexed annuities.”

Quite simply, the interest rate that you get in a given year is linked to a stock market index, such as the S&P 500 index in a product example I will use. However, if the market drops 20 percent in a given year, for example, how much money do you lose? You do not lose a penny of your money. You get a zero percent interest in that year. Now, what happens if that market index goes up? You get everything the index does to the upside, up to what is called a cap. For example, one product that exists will give you a cap of 11 percent on the S&P 500. So, in short, in a given year you have the ability to get between zero and 11 percent. No loss if the market drops, but higher potential than fixed rates when the market increases.

These products are not designed to beat the stock market, they are designed to beat the bank and also bucket number one that I talked about. The “surrender charge terms” of these annuities are generally five years to 10 years.

Bucket 3: Income Focused Indexed Annuities
Then you have bucket number three. Bucket #3 is what I call income focused index annuities. Many folks nearing retirement don’t necessarily care so much about accumulating money, but rather having their money turned into an income stream—like Social Security—once they hit retirement. In my experience, folks love their Social Security, they just want more of it! This is where this product really shines. Per dollar that you allocate to an annuity, you will find that the level of income it can generate over your lifetime can potentially be superior to many other products that you are used to. By the way, that income stream is guaranteed and, again, for lifetime!

So how does it work? Your money will grow a lot like how I just explained in bucket #2, the accumulation indexed annuity. You will get somewhere between zero percent and whatever the “cap” is on this product. Now, the cap is generally less on these types of products, for instance six percent instead of 11 percent. However, with these products, regardless of how your money grows or does not grow, today we can point at a guaranteed income amount that the carrier will guarantee you when you want to activate guaranteed lifetime withdrawals. So, for example, a 63-year-old today with $100,000, I can point to a guaranteed level of income of somewhere between $8,000 and $9,000 that he/she can activate at age 65 for example. And that income goes forever and ever and ever, even if you run out of your own money because you have lived too long. Just keep in mind that the guaranteed lifetime income component does have a “fee” of anywhere from .9 percent to 1.2 percent. (Note: Many consumers have no clue what “basis points” are, so don’t use that terminology!)

In Closing
Eight out of 10 times most of the questions that arise are in Bucket #3. Questions such as “What happens if I die? Does the balance go to my spouse or beneficiary?” The answer is yes! Notice that in my conversation about bucket #3, I did not mention roll up rates, the calculations, the payout factors, etc. I usually don’t have to…

GLWBs on an index annuity are quite simply a guaranteed level of income that you can point to today, just like a Social Security statement, and assure the client that when he/she retires this is the income that they are guaranteed for life regardless of how their “index” does. And unlike the myths thrown out there by the media talking heads that are living 30 years in the past, the client does not lose control of their money once they start taking income. There is a difference between annuitization and guaranteed lifetime withdrawals!