Nicholas Crown: How to Read an Annuity Contract | The Really Rich Podcast - Ep. 46

I wanted to show you how much return you could actually get in an annuity. It's probably going to blow your mind because 9% at the worst case scenario, if there was a negative return, you don't get the loss here. You're credited 0%. But look at this, because of the enhanced participation rate, you have years of 24%, years of 25%, fantastic returns with no downside risk.

In the highest scenario, we see a return of 14%. And in the most recent data, we see a net annual effective rate of 9%. Guess what? The most recent data was the worst case scenario.

You still would have been protected specifically in this policy. Today, I am going to do something that you'd have to call me up or call a smart financial advisor or a life insurance producer to ever have the opportunity to do. I'm going to walk you through a fixed indexed annuity contract. Now, in our world, we call these illustrations.

Basically, they are informal, even though there's a lot of pages, We are actually showing you what these numbers look like or would have looked like using historical data. It is a very interesting process. In fact, I bet you haven't seen this before. Unless, of course, you own an annuity and you just a real aficionado and want to brush up on your skills.

It's easy to see why you're here. An annuity provides 100% capital protection with a floor of zero. If the market goes down, you're credited zero. You don't lose any money.

Sometimes a really healthy cap on returns or in this case, a participation rate, meaning a percentage participation rate in an index of your choice. Turns compound tax deferred, that means the yield that you're getting here in annuity land actually is going to outpace anything that you're going to get in a taxable account. It's a great long-term product, and we're going to dig in. Now, before we get started, the really rich legal team really wants me to say that this is for illustrative purposes only.

It's going to vary by state, where you are in your life and your financial situation. So please do not take this video and assume you can get these rates by calling me up directly, or this exact policy by calling me up directly. These things are built to order, like a cheeseburger or hot dog. I love annuities because they compound tax deferred.

They are totally hands-free, set it and forget it. There's no active management. As you're gonna see from this example, they're an extremely low fee product and it provides a return schedule you can rely on. In annuity land, the worst thing that could happen is they hand you your money back.

Oh, and also, whenever you receive a stack of papers this big, it may seem complicated, but let me tell you, there are horror areas of this that really, really matter and there's some areas that are just, quite frankly, boilerplate language. I'm going to read this policy to you as if you are my beloved, dear client, and we have a fiduciary relationship together, so you can get the absolute most out of your annuity meeting should you choose to have one with us or with your friendly neighborhood advisor.

So let's get started. The first page you're going to see on any annuity policy is the cover page. This shows you the name of the product. I'm blurring out some stuff here because this is branded materials, and I just want you to focus on the numbers and the aspects of the policy.

The most important two numbers, or maybe one number sometimes, on the cover page is this. In this scenario, it is 10. That means the surrender period is 10 years. If you try to access your capital in this particular annuity within 10 years, you will be subject to fees.

That is why this thing is bold and on every page. The next most important lines in no particular order on the cover page are flexible, premium. What that means is you can put in as much or as little as you'd like into this annuity. You don't lose the annuity if you say you're gonna put in 1,000 a month and you put in zero.

The next two words are critical, deferred annuity. what this means is this is an accumulation vehicle. You're putting in money today, you're earning interest, you're deferring tax, and your ability to access that capital to a later date. In this case it gotta be at least 10 years or you gonna pay fees On each annuity there either gonna be a note for non meaning after bucks or qualified If you reaching into a savings account a money market account maybe you sold a piece of real estate you have a brokerage account, and you've got some proceeds in there, that would be a non-qualified annuity.

And if you're rolling over a 401k or another IRA into an annuity, where there's pre-tax bucks, that's money you haven't already paid tax on, this would say qualified annuity. Now, in this scenario, I've mocked up a non-qualified annuity, so let's just pretend I had a brokerage account and I just wanted to gift some cash, over into an annuity and de-risk that capital. Fantastic. You will see product terms.

This is a definition of what is on a policy, whether or not you've taken a insurance class or you're a professional investor. It doesn't matter. You can learn all about the policy right here. Every single policy, no matter what carrier you have, is going to have a definition of terms page.

This is going to show you all the critical terms that you need to know to read the policy. Now, I'm not going to go one by one and bore you. I am, however, going to highlight the most specific terms that you need to know. Absolutely.

The most important line on here, first and foremost, is the surrender charge schedule. Now, this shows you, if we can zoom in down here, the surrender charge schedule from year one to 10. All fees in annuity land, like life insurance land, are transparent in black and white. They have to show you everything.

There is nothing hidden here. So please zoom into this section. This shows you there is a steer step method of the fees that go down if you want to access your capital. 10%, 10%, 9%, 9%, 8%, 8%, 7%, 6%, 4%.

And finally, if you're going to pull your money out in year nine, you would pay a 2% fee. Okay, great. Now that we've got the surrender charges out of the way, this is if you try to grab your cash too early, you're going to pay a fee. The most important and greatest feature here is penalty free withdrawals.

Now, depending on the policy that you're looking at, there will be a certain percentage of the cash value in the policy that you can take out penalty free. In this case, it is 10%. There are no surrender charges. So this gives you a little bit of access to your capital while it is in something long-term like an annuity.

That being said, the accumulation value versus the surrender value. Now, the accumulation value is the sum of premiums paid in interest credited. Again, less any withdrawals or any fees. So this shows you what you can actually access right now at this period of time at this specific year.

And this is gonna be on the schedule. We're gonna get to that soon. All right, in this particular policy, I'm looking at a fixed index annuity. This means it's tied to an index, and we've got to tell you how we calculate that index.

In particular, from a very simple level, annual point to point, this takes the price of the index at the first day of the year and the last subtracts it, and we get a very, very simple interest rate. This is what is credited to your policy. However, we have opportunities to do what's called an enhanced participation rate. That means over-participate in a certain index, sometimes by two or three X, depending on how much money you put in the policy.

Now, in this specific illustration, I've chosen the Fidelity MFY. That means multi-factor yield 5%. This is an index that tries to generate really steady, easy, reliable returns at a low volatility. Stock market returns about 10% volatility.

This does about half. And as you can see, if you zoom in, this is a participation rate crediting strategy. That means you are going to get 220% of the annual rate. You say, Nick, that's 2.

2x. How am I getting such a good deal? Well, the insurance company is going to hedge itself by charging you a 1% annual fee. Now, this wouldn't be great if you were in your 60s, but in your 20s and 30s, this is a really excellent strategy.

And you'll see that this fee comes out in the wash when we get to the returns page. All right, this page could be my favorite in the entire policy. It takes 30 years of historical data and shows you what the worst case scenario was, what the best case scenario was, and what the most recent data was returning. So we see a low, a high, and a most recent.

And the best part is we get to see it net of fees. Of course, I have policies that don charge a strategy fee but I wanted to show you how much return you could actually get in an annuity It probably going to blow your mind because 9 at the worst case scenario if there was a negative return you don get the loss here You're credited 0%. But look at this. Because of the enhanced participation rate, you have years of 24%, years of 25%, fantastic returns with no downside risk.

In the highest scenario, we see a return of 14%. And in the most recent data, we see a net annual effective rate of 9%. Guess what? The most recent data was the worst case scenario.

you still would have been protected specifically in this policy. Now, once you have an idea of your risk tolerance, meaning, hey, what is the lowest rate that I'm going to achieve using a huge chunk of data? It gives you a lot of confidence. Of course, anything can happen tomorrow in the market, but this allows you to at least draw some boundaries of what you are willing to accept and what you're not in terms of the return.

Now, it's important to note, I happen to choose the Fidelity Multi-Factor Yield, but you could put practically any index you can imagine into an annuity. Every carrier has access to their own suite of indices. And oftentimes when I'm in a client meeting, I'm determining what index and what return profile we're looking for. And then I'm matching you up with the right product.

Now pulling up the full schedule page, this is the meat and potatoes of an annuity. I'm going to show you how this whole thing works. I'm going to show you what each column means. And this is something you want to study if you're ever in the market for an annuity.

The first column is pretty simple. It's the issue year, then year one, two, three, four, five, six, going down the line. The second column is pretty self-explanatory. This is showing, you know, we've put in your birthday into this policy.

So we know how old you are. And I use myself in this example. starting at 38 and you could see year one 38 39 year two 39 40 this gives you a feel for how old you are so that you can set some markers at say 59 59 and a half traditional retirement age or you could just forecast out to certain meaningful milestones in your life and see perhaps exactly how much cash would be in the policy at that point column number three is your premium in this case i have just allocated a hundred thousand bucks said and forget it i could opt to add additional premium contributions as i go through time in this example i just kept it simple column four is any plan withdrawals remember we could pull out 10 penalty free and of course more than that after the 10 year surrender period sometimes customers like to see this modeled maybe at the 10 year marker they are planning on taking out some of the policy and it's very easy to show it in this scenario the accumulation value and the death benefit is the actual cash in the policy the surrender value is what you can get right now so you'll see the surrender value is lower than the accumulation value from year one to ten and then those numbers are exactly the same from year 11 on.

Of course, that's because this policy has a 10-year surrender period. Now that we know the difference between surrender value and accumulation value and when they start to become the same after the surrender period, let's look at some key dates and see how much money is in my annuity. The 10-year marker is where I always look first because this is when the money is free and clear for you to do kind of whatever you want with it. In this example, set it and forget it.

10 years later, well, I'd be 47, a little bit older of an old man crown. I'd have $238,000 in the policy and I haven't even lifted a finger. Now, if you really want to get carried away, look at what happens when I'm even more of an old man crowd. At age 67, I'm looking at having well over a million dollars in this policy using recent data.

I've quite simply 10 times my money by putting it into this product and forgetting about it. Now, if you're wondering about taxes at this point, you don't pay any until you touch the cash inside the policy. And in a non-qualified annuity, you only pay tax on the gains. So that initial hundred grand that I put into the policy would be tax-free.

And keep in mind that the proceeds from an annuity is taxed as income, not as long-term capital gains. As much as it looks like an investment, it is still a life insurance product. Now, of course, your return schedule will vary and anything could happen in the market, but even buying a very small policy in your 20s and 30s is a almost surefire way to being a millionaire upon retirement. And you don't have to waste your time watching the investment news on TV And finally the credited interest rate This is the return on your policy You can see this pinging between 24 and zero and 13 You say to yourself what happening here Nick Well this is showing the participation rate at work and of course the floor of zero at work What important to note about this policy is while you're credited a zero percent rate because the market was down, you are still subject to that strategy fee.

Again, over a long enough investment horizon, a nine percent risk free tax deferred return is pretty unbelievable. Now, if you really want to understand, hey, how is my crediting method being calculated, there is always the actual market data that's used to calculate this stuff. Somewhere on your policy, you just got to find it. Here, we've got it on page 10, and we actually see the real return in the Fidelity multi-factor yield.

Year one, it was 10%. And of course, you're participating in 2.2x, so you get to 24%. Now, year two, you would have been down if you were just directly in the index.

However, of course, because you have an annuity, you get credited 0%, and so on and so forth. Now, finally, during that surrender period there is something called a market value adjustment. This is how the insurance company hedges themselves against any adverse move in the market. They've got to take your money and earn a return.

If they don't have a long enough time horizon they could actually be losing money on your policy and that is how the MVA comes into play. Again if you're using this as you should like a long-term product the MVA doesn't matter because it expires at year 10 or whenever the end of your surrender period is for your policy. Here's some big things to consider when you're scratching your head about an annuity, number one is where are you in your life? If you're later on in your career, you can handle a much, much shorter surrender period.

Basically, you might need access to the cash sooner. Number two, determine if the index that's being credited to your annuity makes sense for you. Is it hedging some other risk somewhere else? Is it uncorrelated with your brokerage account?

Is it providing the right return schedule for you? This is absolutely critical. It's the basis of your annuity. The good news is most carriers will let you adjust or swap out that index every anniversary year so you're not married to it for the life of the policy.

Now, this example has been great for a younger or middle-aged investor who wants to really focus on growth and accumulation. Of course, there are other annuity products that are especially built for those later on in their life and career who have a large lump sum of capital and really hear about income. I'm going to take you through one of those policies now. Okay, this is a policy that is tailored for investors that are at the end of their investment horizon.

They're at the end of their career, perhaps they're getting ready to retire. This is a single premium deferred annuity. Also, it has some riders and benefits that provide a guaranteed income for life. Now, you know your way through these policies, so this page is going to look very familiar to you.

You say to yourself, Nick, why are the returns lower in the income product? Well, in this policy, the insurance company needs to be compensated for the fact that, well, you could just keep on living forever when they're providing you a guaranteed income for life. They pay for this by offering a lower return schedule. This is how you get your guaranteed income.

Now, you might say yourself well where's the guaranteed income on the policy generally there are going to be a few separate columns here in this policy you can elect to have a guaranteed lifetime benefit that's level that stays the same that doesn't change that doesn't adjust remember you're paying for it with low returns in this scenario you'd be able to take out an income of 23 820 annually or if you waited a little bit longer perhaps till you were 70 you'd be able to take 34 000.