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Welcome to personal finance for
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long-term investors, where we believe
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Benjamin Franklin's advice that an
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investment in knowledge pays the best
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interest both in finances and in your
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life. Every episode teaches you personal
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finance and long-term investing in
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simple terms. Now, here's your host,
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Jesse Kramer. Welcome to Personal
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Finance for Long-Term Investors, episode
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131. My name is Jesse Kramer, and by
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day, I work at a fiduciary wealth
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management firm helping clients
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nationwide. You can learn more at
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bestinterest.blog. blog/work. The link
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is in the show notes. By night, I write
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the bestinest blog and I host this
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podcast. I also put out a weekly email
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newsletter. All those projects help busy
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professionals and help retirees avoid
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mistakes and grow their wealth by
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simplifying their investing taxes and
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their retirement planning. And I'm going
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to do a really quick review of the week
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and then dive right into the good stuff.
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The review is from LTI Wannabe Charlie.
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I think that's long-term investor. LTI.
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LTI Wannabe Charlie who says, "Truly the
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best. The world of finance, tax, and
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retirement planning can seem daunting,
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even intimidating. At least it did for
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me until I found Jesse. And I'm so
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grateful to have found him and this
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podcast. He's extremely knowledgeable,
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and his delivery of extremely difficult
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topics is superb. Jesse is able to make
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even the most complicated topics
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understandable and comprehensible to
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even those without the financial
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knowhow. I end each episode feeling
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empowered and ready to take on the
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world. Listen to his Q&A episodes.
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Listen to them all. You won't regret it.
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Thank you, Jesse. Well, thank you,
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Charlie. That was a very, very kind
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review. I'm very glad that you find this
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helpful and hopefully you leave today's
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episode a little more knowledgeable and
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empowered and ready to take on the
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world. Charlie, please email me jesseb
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bestinterest.blog and I'll get you
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hooked up with a super soft podcast
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t-shirt. Now, let's get to the good
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stuff. Whenever you start conversations
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about retirement and retirement
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planning, you can count on a few topics
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to come up. Investing, social security,
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RMDs and taxes, leaving money to your
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heirs. Now, income. Income is another
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pretty common topic. Where will my
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income come from? How will I replace my
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income? How will I build my paycheck?
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What if I don't have a pension? Should I
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own lots of bonds? They create income.
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Should I own dividend paying stocks?
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They create income, too. Should I
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purchase an annuity? That creates lots
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of income, too. Today, we're going to do
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a deep dive on that last one. We're
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going to do a deep dive on annuities.
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I've spent, you know, five or 10 minutes
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here or there to discuss why I don't
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like annuities. But because there are,
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you know, thousands of you listening and
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many of you have heard of annuities, are
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maybe intrigued by annuities. You might
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own an annuity or you're considering
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buying one. You've asked me about
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annuities before. And I wanted to devote
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some serious time to annuities today.
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And so that's what this episode is.
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Think of it as this hopefully evergreen
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long-standing episode that explains
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annuities in in pretty deep detail. But
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we're going to start with some of the
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the lighter details or some of the
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higher level stuff, right? An annuity is
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a contract with an insurance company
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where you pay them money. Usually, you
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pay them most of the money now, but
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sometimes you can pay them money over
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time. Either way, you're paying the
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insurance company a big lump sum of
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money. And in return, they promise to
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pay you a regular income stream, just
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like a paycheck, for a set amount of
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time or for in many cases for the rest
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of your life. So, a very common annuity
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might say you write the insurance
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company a million check today and then
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they start sending you $6,000 a month
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for the rest of your life. That is one
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example of how an annuity could work.
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Now, I'm going to start with a big
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picture statement with a little bit of
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backup about annuities. I do think there
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are more reasons to dislike annuities
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than to like them. And I think more
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retirees are worse off with annuities
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than they would be with the alternative
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options. Now, why do I say that? Well,
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let me give you what I believe to be a
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transparent but still a pretty simple
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pro versus con of annuities. Well, we'll
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start there. Just very high level pros
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and cons. The pros. Annuities provide
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longevity insurance. The longer you
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live, the better your annuity decision
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will have been in hindsight. Annuities
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create stable, predictable income, which
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is certainly a good thing inside of a
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financial plan. And it also really helps
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us, you know, behaviorally. It helps to
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have that steady income. Uh, it helps us
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make good decisions. Last, annuities
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provide simplicity. at least one type of
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simplicity. There's no rebalancing with
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an annuity. There's no withdrawal rate
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decision. There's no market timing
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anxiety. You simply collect the constant
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income stream just like collecting a
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paycheck. So in that way annuities can
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be thought of as simple and those are
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the pros. Those are you know in my
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opinion the main pros and so far that
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sounds pretty good right like with many
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things in the world we can't evaluate
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only the benefits. We need to consider
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what are the costs and in my view the
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actual costs and the opportunity costs
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of annuities are significant cons. The
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overwhelming majority of annuities are
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poorly designed and incredibly
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expensive. Variable annuities which we
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will explain the difference between
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variable annuities and fixed annuities
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in a minute but variable annuities can
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easily have fees exceeding 2% per year
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and that's on top of large commissions
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which are usually 5 to 10% of the
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upfront cost. Quickly a couple other
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major cons. Annuities are typically
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illquid and irreversible. It's a one-way
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decision, especially once the income
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stream is turned on. You basically never
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have access to your lumpsum ever again.
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Or if you do, you can buy something with
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a lot of annuity products called a
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writer or an add-on. If you happen to
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have an add-on that gives you access to
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your to your lumpsum after the fact,
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that's probably a very steep costing
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add-on. And that's really different from
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a traditional portfolio where you can
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live off of the income or growth of your
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traditional portfolio and then you still
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have access to all of the underlying
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investment. In annuity, you're giving up
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the investment itself. My last con of
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annuities is just the expected return.
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I've gone over that math many times here
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before, but I'm happy to do it again. In
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their best form, which I will talk about
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later, it's that whole variable versus
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fixed annuity conversation that I
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already mentioned once and we will we
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will get to it. In their best form,
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which I I will talk about later, at
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their very best, the long-term expected
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returns of an annuity are something like
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what I'm about to say. If if we look at
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say a healthy 60-year-old male, his uh
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payout rate in a very simple annuity
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product is probably going to be
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somewhere in the nature of 6 to 6 1/2%.
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So, you have to ask yourself, well, how
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many years of a payout at 6% do you need
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to have in order to get 100% of your
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money back? And you realize the answer
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is about 16 and 12 years. So in that
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case, his expected return for the first
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16 and 12 years is technically negative
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because if he dies after 14 years, he
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hasn't even gotten his original money
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back. For a typical annuity, you might
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say year 15 or so is about where the
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break even occurs. Before year 15, it's
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essentially been a negative return. Once
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you've collected 15 years worth of uh
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payments, okay, you finally have
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positive nominal returns. And these are
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nominal returns, right? doesn't even
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count inflation, which would make the
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situation appear worse. Once you get out
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to 20 years, the expected return is
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somewhere in the order of 3% per year.
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After 25 years, maybe 4 1/2% per year.
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After 30 years, it's up to about 5 1/2%
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per year. And then once you get out to
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40 or 50 years, that's when your return
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hits an asmtote at about 6 1/2% per
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year. So, if our 60-year-old male lives
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to be 100 years old, at that point,
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he'll see something like a 6 to 6 12%
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annualized return. But if he only lives
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to 75, he'll see a 0% return. If he
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lives to 85, he'll see something in the
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realm of a 4 to 5% return. And I just
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don't like those returns, right? If I'm
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investing for a 20, 25, 30-year
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timeline, I want something better than a
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nominal four or 5% return. So anyway,
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that's the big con for me or one of the
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big cons is just that the returns are
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not attractive enough. But before I go
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further, let's do some definitions. I
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used the terms variable annuities and
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fixed annuities before. Let's define
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those. Fixed annuities are the easy
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place to start. As the name might imply,
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fixed annuities have very few moving
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pieces. They're pretty simple. It's it's
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a straightforward trade-off between you
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sacrificing a lump sum of money upfront
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and an insurance company then taking
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that lump sum and providing you with a
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long-term income stream. The specifics
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of that trade-off are fixed. They won't
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be changing over time. It's it's
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predictable in that way. But with a
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variable annuity, those specifics, they
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actually can change over time. A
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variable annuity at its core mixes
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investing, you know, an investment
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account and mixes it with the idea of an
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annuity. So, a very common variable
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annuity might take your original
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lumpsum, invest that lumpsum in some
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way, and then create some sort of growth
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on your lumpsum and only then out in the
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future would you sensibly annuititize
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that larger investment grown lump sum
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into an income stream at a later date.
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And by the way, I just used the word
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annuitize. So to annuitize anything,
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including in this context, to
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annuititize something means to turn your
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lump sum into an income stream to to
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turn on the income spigot, so to speak.
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Again, you might think that this idea of
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a variable annuity sounds kind of good.
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You know, you get the guaranteed income
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still, okay, check, but your money
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actually has a chance to grow along the
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way. It's not bad. The problem is, how
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can an annuity protect you against the
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downsides? Remember, it it's guaranteed
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income. There's a downside protection
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there. How can it protect you against
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the downsides while also providing you
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with the upside from an investment like
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the stock market? The way they do this,
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the way they provide you both, it's
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really twofold. First, they cap your
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returns. For example, an indexed
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annuity, which is a a variable annuity
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tied to a specific stock market index.
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An index annuity might have a cap rate
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or a participation rate. A cap rate
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would say no matter how well the stock
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market does, your variable return is
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capped at X%. So, let's say X is 7%. The
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market's up 20%, well, your annuity got
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seven. The market's up 12%, you got
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seven. The market's up 4%, well, you
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only got four. The market's down 15%,
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well, okay, you're only down zero.
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There's no downside, but they cap your
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upside. The problem is, and and we'll
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get into this in a second, that's a bad
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trade-off. There's sometimes some uh
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variable annuities have something called
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a participation rate. It's kind of
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similar, but it's a ratio of the return
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that you receive. So, let's say your
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participation rate is 50%. The market's
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up 20, you only get 50% of that. You get
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10. The market's up 12, you get six. The
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market's up four, you get two. If the
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market's down 15, okay, you're down
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zero. You don't lose. There's no
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downside, but there is a limited upside.
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Again, the problem is it's a bad
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trade-off. And before I get into some of
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the math of why that's a bad trade-off,
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let me tell you of the second of the
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two-fold ways that uh insurance
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companies protect themselves when it
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comes to variable annuities. The second
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way they protect themselves. The first
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way being they they somehow cap your
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returns. The second way is by charging
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you 2% or more per year in most of these
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products. So if you combine those capped
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returns with the 2% plus annual fee,
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that is how an insurance company can
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provide you guarantees prevention of
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loss and also provide you quote unquote
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growth at the same time. that the true
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growth is either cut down by 50% in my
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example or it's limited at 7% per year
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and then every single year, rain or
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shine, the full monty is cut down by a
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2% annual fee. So, in case you're
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wondering, well, how stifling is that
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kind of setup? I grabbed uh S&P 500
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returns from 1950 through 2025, 75 years
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of data. I threw, you know, $1,000 on
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the top of my spreadsheet, put $1,000
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into the S&P 500 back in 1950. And if it
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just grows on its own in the S&P 500,
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the $1,000 would grow to 4.26 million by
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the end of 2025. Trust me, it's not a
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typo. That's not a mistake. $1,000 over
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75 years would grow to 4.26 million.
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That's what 75 years of compounding
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does. All right? Most of us only get 20,
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30, maybe 50 years of compounding if we
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start really young. 75 years of
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compounding at 11.6% 6% per year will
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turn $1,000 into 4.26 million. But now,
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what if we apply a typical index annuity
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rule to those same S&P 500 returns from
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1950 to 2025? In this case, I I chose
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the 50% participation rate and I also
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applied a 2% annual fee. So, you know,
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if the market was up, I don't know, 22%
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in 1961, well, this annuity product was
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only up 11%. And then also got charged a
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2% fee that year. But, you know, it's
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also worth noting the value of the
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annuity never goes down. So, Black
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Monday, the crash of 1987, the 1970
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stagflation, the.com bubble bursting,
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the great financial crisis, this annuity
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product did not go down during those
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times in in my little spreadsheet. Still
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the summary is if we get to the end of
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it, the annuity would have grown at 5.4%
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per year and the thousand would now be
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worth about 56,000. So 11.6% per year
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versus 5.4 $4.6 million versus $56,000.
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And that result, at least to me, it
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shouldn't be surprising. It shouldn't be
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surprising that the indexed annuity only
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generates a net 5.4% 4% return to the
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investor because when you look at
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long-term annuity payouts for typical
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lifespans, they typically end up in the
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4 to 5% range. So, it would make sense
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that one of these products is set up by
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the insurance company, the and we'll get
00:13:19
into this. It's it's the company, you
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know, they've got all the data about
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when people might die in the future.
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They've got all the data about what
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their expected payouts might be. And you
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better believe that they know that these
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products in their models are expected to
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pay out four to 5%. So, how do you give
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someone exposure to the stock market and
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then only pay out four or 5% at the end
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of the day and guarantee that it they
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never lose money? Well, you you cap
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their participation in stock market
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returns and then you charge them a high
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annual fee. And on that point, when it
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comes to defining annuities, I I do want
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you to think about these products from
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the point of view of where they are
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coming from. Annuities are sold by
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insurance companies. They are an
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insurance product. And how do insurance
00:13:58
companies think? Well, insurance
00:13:59
companies, they think about risks. They
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think about the average risks across
00:14:03
very large groups of people. They price
00:14:05
their products, meaning they price the
00:14:07
costs and the benefits of their products
00:14:09
to ensure that they yes address their
00:14:11
customers concerns about risks, but also
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so that the insurance company makes
00:14:16
money. If an insurance company doesn't
00:14:17
make money, it's going to go out of
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business and the products themselves
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will fail. We do need insurance
00:14:22
companies to make money in order to
00:14:23
continue providing us insurance. But it
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is worth understanding that for you, the
00:14:27
customer, to have your specific risk
00:14:30
addressed, it is going to cost you.
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That's just business. You know, you want
00:14:33
groceries, it'll cost you. You want to
00:14:34
fix the leaky roof, it'll cost you. And
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if you want guaranteed income for life
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risk-free, that is going to cost you.
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And that's why I don't want you or me or
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anybody to be necessarily surprised that
00:14:45
annuity payouts are what they are and
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certainly aren't as wonderful as maybe
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some people would tell us, especially
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those people happen to have a vested
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interest. Going back to the really high
00:14:56
really high commissions. Anyway, if
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you're the insurance company and you're
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selling annuities to uh 60-year-old
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males, let's say like my example from a
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couple minutes ago, as the insurance
00:15:05
company, you're thinking to yourself,
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well, some of these guys, they're going
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to die at 65 and 70. Most of them are
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going to die at 75, 80, 85. And yeah,
00:15:14
some outliers are going to live to 90 or
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95, maybe even beyond. On average, if we
00:15:19
average out all these 60-year-old males
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we're selling annuities to this year, on
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average, we might owe these people
00:15:24
something like a 3 to 4% annual return
00:15:27
over the next 20 to 25 years. I think
00:15:30
the insurance company can pretty
00:15:32
conservatively and reasonably invest
00:15:34
their pool of assets and achieve that
00:15:36
kind of outcome. Now, another quick
00:15:38
pivot. Whenever an insurance product is
00:15:40
is involved in one of our financial
00:15:42
plans, especially a long-term insurance
00:15:44
product, a good question to ask is,
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"What if the insurer themselves somehow
00:15:49
fails to uphold their promise, right?
00:15:50
What if they I don't go out of business?
00:15:52
They somehow become illquid. Does my
00:15:54
annuity just dissolve and and kind of do
00:15:56
I get screwed over?" So, a few notes on
00:15:59
that. An annuity is not backed by the
00:16:01
federal government in the way that a
00:16:03
Treasury or or that Social Security is.
00:16:05
An annuity is a general obligation. It's
00:16:07
kind of like a debt in a way of the
00:16:09
issuing insurance company. So the risk
00:16:11
is pretty simple in theory. If the
00:16:13
insurance company becomes insolvent
00:16:15
somehow, it may be able to unable to
00:16:17
fully meet its annuity payment
00:16:19
obligations to you. Unlike a mutual fund
00:16:21
or an ETF, you don't own kind of these
00:16:24
segregated assets inside of the
00:16:26
insurance company like maybe the
00:16:28
underlying stocks in a mutual fund. You
00:16:30
are a creditor of the insurer. They owe
00:16:32
a debt to you. This is credit risk. It's
00:16:35
not market risk. But how real is the
00:16:37
risk? And the short answer is yeah, it's
00:16:40
it's real, but it's very historically
00:16:41
rare. It's usually non-c catastrophic
00:16:44
for annuity holders. Insurance company
00:16:46
failures do happen. They have happened,
00:16:48
but they're far less common than, for
00:16:49
example, bank failures, and annuity
00:16:52
holders are typically protected or
00:16:53
largely made whole. There's never been a
00:16:56
widespread collapse where annuitants
00:16:58
broadly lost their income stream.
00:17:00
historical failures have been, you know,
00:17:02
kind of these regional, smaller
00:17:04
insurance carriers. Usually the failures
00:17:06
have been caught early on by regulators.
00:17:09
There's a good point. Yes, insurance is
00:17:11
regulated at the state level and those
00:17:13
state regulators are always kind of
00:17:14
sniffing around for signs of smoke and
00:17:16
insurers fail less often because they're
00:17:19
required to hold up statutory reserves
00:17:21
and and match their longduration
00:17:23
liabilities. Just like an annuity,
00:17:25
they're required to match those
00:17:26
liabilities with appropriate assets,
00:17:28
stress test what's going on, submit
00:17:30
themselves for actuarial review. It's a
00:17:33
pretty rigorous risk profile that they
00:17:35
have to go through. And you can think of
00:17:36
that state regulation as the first line
00:17:38
of defense for u an annuity customer. Uh
00:17:41
there are also the maybe the second line
00:17:42
of defense we can talk about now. There
00:17:44
are state guarantee associations. Every
00:17:46
state has a a life and health insurance
00:17:49
guarantee association funded by the
00:17:51
solvent in business insurance companies
00:17:54
providing coverage in case an insurer
00:17:56
fails. Now those coverage limits can
00:17:58
vary by state, but typically on the low
00:17:59
end it's something like $100,000. On the
00:18:02
high end it's $250,000
00:18:04
and that's per owner per insurer. So
00:18:07
again, you could have if something
00:18:09
really cataclysmic happened and multiple
00:18:11
insurance companies went out of business
00:18:12
and you happen to have a product with
00:18:14
those multiple insurance companies, your
00:18:16
state coverage would apply to each
00:18:18
company that goes out of business just
00:18:20
in case it matters. The third line of
00:18:21
defense and and really the third and
00:18:23
fourth are are pretty um minor corner
00:18:25
cases I would say. But the third one is
00:18:27
if an insurance company happens to go
00:18:29
out of business, their annuitants are
00:18:31
considered senior creditors, meaning
00:18:32
they get paid first, ranking above
00:18:34
unsecured creditors, ranking above
00:18:36
shareholders. So even without guarantee
00:18:38
coverage or even if the guarantee
00:18:40
coverage isn't enough, recoveries are
00:18:42
are often pretty substantial. An annuity
00:18:44
holder isn't totally screwed over. And
00:18:46
then the fourth line of defense should
00:18:48
it come to that. If you end up going
00:18:49
down a route where you want to purchase
00:18:51
an annuity or again any insurance
00:18:53
product, if you spread your purchases,
00:18:55
your products across multiple insurers,
00:18:58
you are effectively, you know,
00:19:00
mitigating and diversifying your risk in
00:19:02
that way. So that ends maybe my early
00:19:04
foundation, my beginner's foundation to
00:19:06
understand what annuities are, how they
00:19:08
work, the pros, the cons, the risks, the
00:19:10
rewards, all that stuff. Here's a quick
00:19:12
ad and then we'll get back to the show.
00:19:14
I love getting your questions and some
00:19:16
of you ask me questions about the wealth
00:19:17
management firm I work for in Rochester,
00:19:19
New York. Others ask about the Best
00:19:21
Interest blog and this podcast, Personal
00:19:23
Finance for Long-Term Investors, which
00:19:24
operate without advertising, without
00:19:26
pushy sales, and with no payw walls. How
00:19:28
can the blog and podcast stay afloat
00:19:29
without me dumping my own money into it?
00:19:32
Well, to answer both those questions, I
00:19:33
want to point you to episode 78 of
00:19:35
Personal Finance for Long-Term
00:19:36
Investors. I intentionally recorded
00:19:38
episode 78 to shine light on those
00:19:40
topics and inform you how you are
00:19:42
actually helping and can continue
00:19:43
helping these projects carry forward. So
00:19:45
if you've ever been curious about the
00:19:47
business of my blog and podcast or if
00:19:49
you're curious about my day job in
00:19:50
wealth management, please check out
00:19:52
episode 78 and let me know what you
00:19:54
think. Now, I want to dive into a
00:19:56
specific annuity, maybe red diving into
00:19:58
it because I've already kind of
00:19:59
mentioned how it works before, but this
00:20:01
is might be the only annuity, one of the
00:20:04
only annuities that's in my opinion
00:20:06
within sniffing distance of acceptable
00:20:08
use. It's one of the only annuities, for
00:20:10
example, where if I don't know, if my
00:20:11
uncle came to me and said, "Hey, Jesse,
00:20:14
just so you know, you know, I listen to
00:20:16
your podcast and I decided to buy this
00:20:17
thing." I'd say like, "Okay, I get it.
00:20:20
Might not do it myself, might not
00:20:21
recommend it myself, but I do, but I get
00:20:23
it. This annuity is called a single
00:20:25
premium immediate annuity or a SPIA
00:20:27
SPIA. Single premium, a one-time
00:20:30
lumpsum, a single premium. Immediate
00:20:32
annuity means the income stream starts
00:20:34
immediately. There's nothing variable
00:20:36
here. Everything's fixed. There's
00:20:38
nothing weird going on. From the
00:20:40
insurance company point of view, it's
00:20:41
very, very simple math. Well, also from
00:20:43
our point of view, it's very, very
00:20:44
simple math. But the insurance company
00:20:46
is just saying, okay, when are you
00:20:48
likely to die? Once we figure out when
00:20:50
you are likely to die, we will take the
00:20:52
lump sum you give us and we'll figure
00:20:54
out how do we make a income stream that
00:20:56
probabilistically means, yeah, you get
00:20:58
some decent income, but we're probably
00:21:00
going to make a little bit of money on
00:21:02
you. So, it it's simple no matter how
00:21:04
you look at it. At their core, SPIA,
00:21:06
like all annuities, should be, SPAS are
00:21:08
not investments. Again, they are
00:21:10
insurance products. And we should really
00:21:12
think of SPIA as insurance against
00:21:14
living too long or insurance against
00:21:17
some sequence of returns risk. We'll get
00:21:19
into that later, but it's a product that
00:21:20
guarantees a paycheck every month as
00:21:22
long as you live, regardless of market
00:21:24
returns, regardless of interest rate
00:21:26
environments or anything else going on.
00:21:28
SPIA can do this because they exploit
00:21:30
something called mortality pooling, and
00:21:32
we we'll talk about that. But SPIA don't
00:21:33
dabble in in market returns. And that's
00:21:35
intentional, right? That's a feature,
00:21:37
not a bug. Compared to other annuities,
00:21:39
SPIA have built-in fees. It's, you know,
00:21:42
an implicit fee, very low fees, minimal
00:21:45
moving parts, no sort of illusion of
00:21:48
liquidity, low complexity, low sales
00:21:51
incentives, no writers, no caps, no
00:21:54
participation rates, no annual resets,
00:21:56
no ongoing account value to
00:21:59
misunderstand. And I say this because
00:22:01
when you look at an annuity contract, I
00:22:03
was just looking at one last week, it
00:22:04
was about 90 pages long. There's like
00:22:06
four different ways that some of these
00:22:08
variable annuities measure their account
00:22:10
value. I don't know what's going on
00:22:11
there. But the point is that with a
00:22:13
SPIA, what you see is what you get.
00:22:14
Complexity in annuities almost always
00:22:17
benefits the insurer or the distributor,
00:22:19
not the customer. Complexity does not
00:22:22
benefit the customer. Anyway, ASPIA is
00:22:24
is the singular and immediate trade
00:22:26
where you sacrifice your lumpsum forever
00:22:29
in return for an income stream forever
00:22:31
until you die. Right now, as an example,
00:22:33
a 55year-old male in New York State
00:22:36
could receive a a 6.8% 8% income stream.
00:22:39
Meaning if that male sacrifices $1
00:22:42
million at age 55 into the SPIA, he
00:22:44
could get $68,000 in income every year
00:22:47
for life. And you might say that's not a
00:22:49
bad trade. Doing that, off the top of my
00:22:51
head, I think it would take you
00:22:52
somewhere between 14 and 15 years to
00:22:56
turn the $68,000 income stream back into
00:22:59
the 1 million. So again, for the first
00:23:01
14 or 15 years, the return is
00:23:02
technically negative. Now, criticisms of
00:23:05
SPO are definitely real. There's ill
00:23:07
liquidity. there's no real upside.
00:23:08
There's a a loss of principle at early
00:23:10
death. And we will come back to this
00:23:13
idea because at least those are not
00:23:15
hidden drawbacks. They might be
00:23:16
drawbacks, but they're clear and
00:23:18
obvious. They can certainly be analyzed.
00:23:20
They're explicit and knowable. And and
00:23:22
SPIA say that the point of a SPIA is
00:23:25
just clear. You're buying income. You're
00:23:27
not buying optionality. It solves one
00:23:29
problem about longevity and sequence
00:23:31
risk. And it solves that problem in case
00:23:33
you suffer those uh those risks. But
00:23:35
before I continue down the path of
00:23:37
annuities, let me just pause and talk
00:23:39
about term life insurance for just a
00:23:41
minute. Because if you if we think about
00:23:42
term life insurance, which almost
00:23:44
everybody understands, it will help you
00:23:46
understand annuities better. A term life
00:23:49
policy is to a large extent the exact
00:23:51
opposite side of the coin from a SPIA.
00:23:54
With a term life policy, you and a
00:23:57
million other people, you essentially
00:23:59
are pulling your money together to
00:24:01
protect against the risk of someone
00:24:03
dying early. With a SPIA, you and a
00:24:06
million other people are pulling your
00:24:07
money together to protect against the
00:24:09
risk of living a long time. With a term
00:24:11
life insurance policy, if you live past
00:24:13
the term, you have essentially lost your
00:24:16
money in the deal. But that money you
00:24:18
lost goes at least in part to the people
00:24:20
who did die early. So, you all shared
00:24:22
the risk together. Now, you didn't
00:24:24
happen to realize that particular risk
00:24:26
in your life and and you didn't get any
00:24:27
money back. With a SPIA, if you die
00:24:30
early, you have lost money on the deal,
00:24:32
but that money that you lost goes at
00:24:34
least in part to the people who do end
00:24:37
up living for a long time. You all
00:24:39
shared that longevity risk together, but
00:24:41
you didn't realize that particular risk
00:24:43
and you didn't get all your money back.
00:24:46
Term life policies, they they raise the
00:24:48
floor. A term life policy makes an early
00:24:50
death less painful, but it also lowers
00:24:52
the ceiling because money that you could
00:24:54
have otherwise used more productively to
00:24:56
grow over time. Instead, you had to use
00:24:58
to pay uh insurance premiums. SPAS do
00:25:01
the same thing. They raise the floor of
00:25:03
a retirement plan by ensuring this
00:25:05
guaranteed income floor no matter how
00:25:07
long you live. But SPAS also lower the
00:25:09
ceiling because money that you could
00:25:10
have otherwise invested for the long run
00:25:13
in typically more productive assets at a
00:25:16
higher rate of return. Instead, you use
00:25:18
that money to pay the annuity premium.
00:25:20
This type of sacrifice happens all the
00:25:22
time in life, right? We're given an
00:25:24
option to to raise the floor. In other
00:25:26
words, to take the worst case outcome,
00:25:28
the floor, and make it somehow better,
00:25:30
to make our worst case less worst, but
00:25:32
at the cost of lowering the ceiling or
00:25:35
making our best case scenario less good.
00:25:37
And sometimes that sacrifice is worth
00:25:39
it. Right? I own term life insurance,
00:25:41
but sometimes that sacrifice is not
00:25:43
worth it. And as a financial planner, I
00:25:45
don't usually think annuities are worth
00:25:47
it. Even speedas, I don't think speedas
00:25:49
are usually worth it. But I will say
00:25:51
there are some very, very smart people
00:25:52
who disagree with me on that. There are
00:25:54
plenty of good financial planners out
00:25:55
there who believe that the trade-off, at
00:25:57
least the trade-off for fixed annuities
00:25:59
like SPAS, certainly can be worth it to
00:26:01
certain clients, and I I respect their
00:26:03
opinions. But before continuing the
00:26:05
conversation about SPAS or getting any
00:26:06
further uh into the the numbers, the
00:26:08
math that way, I want to talk about a
00:26:10
quirky idea called erodicity. E R G O D
00:26:15
I C I T Y. Eggicity asks whether what's
00:26:19
true on average is actually true for you
00:26:22
over time. And that's a weird
00:26:24
definition. What is true on average is
00:26:26
actually true for you over time. And
00:26:28
often, especially in finance, that is
00:26:31
not the case. So, let's just explain
00:26:34
through example. That's always a good
00:26:35
way to go. Imagine that you all
00:26:37
listening flip a coin. Each one of you,
00:26:39
I'm going to say uh about 5,000 of you
00:26:41
are going to listen to this episode in
00:26:43
the first month. So, we have 5,000 coin
00:26:45
flips. And we know to expect roughly
00:26:48
2500 heads and 2500 tails. We know it
00:26:50
might not land exactly on that, but that
00:26:52
that's what the outcome is about is
00:26:54
going to be 2500 ads and 2500 tails.
00:26:56
That is the average of many outcomes.
00:26:59
And now imagine that just me, just one
00:27:01
person, that I flip a coin 5,000 times
00:27:04
in a row sequentially. Now, in this
00:27:06
case, I would also expect 2500 heads and
00:27:08
2500 tails. I would expect the same
00:27:10
outcome. In this case, the outcome of
00:27:13
many people doing one thing, that
00:27:15
average outcome is exactly the same as
00:27:18
the outcome of one person doing that
00:27:20
thing many times. So what's true on
00:27:22
average is also the same as what's true
00:27:26
over time. And this example, this coin
00:27:28
flipping example is what we would call
00:27:30
erotic. It is an erotic system. When the
00:27:33
average of many outcomes is also what
00:27:35
plays out over time, that is an erotic
00:27:37
system. But some systems very
00:27:39
importantly are not erotic. In some
00:27:42
cases the average over a large group is
00:27:45
much different than the average over
00:27:47
time. And that's why this idea of
00:27:49
erodicity and erotic systems and
00:27:51
non-erotic systems exists. It exists
00:27:54
because people kept on making the same
00:27:56
mistake. We would use the average across
00:27:58
many outcomes to make decisions about
00:28:00
something that plays out over time. And
00:28:02
I know that's kind of a weird statement.
00:28:04
I'll say it again. We would use the
00:28:05
averages across many outcomes to make a
00:28:08
decision about something that plays out
00:28:09
over time. And in some cases, we just
00:28:12
can't do that. There are scenarios in
00:28:13
this world where doing that is a path to
00:28:15
failure. You can't apply the the large
00:28:18
group average because the time series
00:28:20
average is different. I swear this this
00:28:23
has to do with retirement. It has to do
00:28:24
with annuities. Let's go back to the
00:28:26
coin flips for a second. Imagine we
00:28:28
place a bet on the coin flips. And even
00:28:30
imagine I gave you pretty good odds. If
00:28:32
you win, I'll triple your money. But if
00:28:34
you lose, I get everything. Let's just
00:28:36
think about one coin flip to start. You
00:28:38
bet $100. So if you win the coin flip,
00:28:41
you walk away with 300. I triple your
00:28:43
money. If you lose the coin flip, you
00:28:44
walk away with zero. The math's pretty
00:28:45
clear. Now, you should probably take
00:28:47
that coin flip every single time. The
00:28:49
expected outcome is that you start with
00:28:51
100 and that you walk away with 150 cuz
00:28:53
you have a 50% chance of winning 300
00:28:55
bucks. 50% of 300, that's 150. Your
00:28:58
expected outcome is profitable. So if we
00:29:00
think about the group of a hundred
00:29:01
people who all have that bet and if
00:29:03
those 100 people all take the bet, we
00:29:05
assume that about half of them win and
00:29:07
half of them lose. So the winners all
00:29:09
turn $100 into 300. The losers turn $100
00:29:13
into zero. But on net, those players,
00:29:15
again, it was 100 people 100 bucks each.
00:29:18
So they turned $10,000 into $15,000. 50
00:29:22
winners times 300 bucks. That's a net
00:29:24
win. Average outcome of this situation
00:29:26
is a win. this group of 100 people. In
00:29:28
fact, they probably could have teamed up
00:29:29
together beforehand and said, "Hey,
00:29:31
every for every winner, pair up with a
00:29:33
loser, split the proceeds, and it
00:29:35
guarantees that everyone walks away with
00:29:37
a profit. They could agree to share the
00:29:38
winnings. But now, what if just one
00:29:41
person had to take that same exact bet,
00:29:44
but had to take that bet a 100 times in
00:29:46
a row? Does the time sequence of a 100
00:29:48
times in a row match up with the average
00:29:50
outcome that we just described?" So,
00:29:52
let's think about it. You win your first
00:29:53
flip. You turn a 100 bucks into 300
00:29:55
bucks. You win your second flip. You
00:29:57
turn 300 into 900. Ah, but then you lose
00:30:00
your third flip and you go to zero. And
00:30:03
once you're at zero, in this particular
00:30:04
game I've invented, there's no coming
00:30:06
back. You can't triple zero. You've lost
00:30:08
your chance to win any further. You
00:30:10
could win 10 flips in a row and you
00:30:12
would actually turn a h 100 bucks into
00:30:14
about $5 million, but then if you lose
00:30:16
the next flip, it all goes to zero. So
00:30:18
the only way to avoid ruin in that
00:30:20
particular time sequence game is to win
00:30:22
a 100 coin flips in a row. And we know
00:30:24
that isn't feasible. So this game is no
00:30:27
longer erotic. It's not ergotic. The
00:30:29
average outcome of the 100 flippers does
00:30:32
not align with the time series outcome
00:30:34
of me flipping 100 times in a row. Now
00:30:36
when you as long-term investors think of
00:30:39
a time series of investments, where does
00:30:41
your mind jump to? I'll tell you mine
00:30:44
goes to sequence of returns risk. Now
00:30:46
you can assume that the the average
00:30:47
portfolio returns six or seven or eight
00:30:50
or 9% per year over the long run. I'll
00:30:52
give you that. But why does the 4% rule
00:30:55
exist if portfolios are returning 8 9%
00:30:58
per year? It's because retirement
00:31:00
planning is a non- urgotic activity. Two
00:31:03
retirees can live through the exact same
00:31:05
average investment returns but suffer
00:31:08
vastly different outcomes if the time
00:31:10
series of those two returns are
00:31:12
different. Here's a super simple math
00:31:14
example for you to follow. Imagine our
00:31:16
first retiree, a $1 million portfolio.
00:31:18
As they enter retirement, they follow
00:31:20
the 4% rule to a te. So they withdraw
00:31:23
$40,000 in year 1 and then they adjust
00:31:25
that withdrawal up each year by the rate
00:31:27
of inflation. And we layer the the
00:31:29
following investment returns onto their
00:31:31
retirement. We'll say they have uh
00:31:33
negative 5% returns per year in each of
00:31:36
their first three years and then 0% per
00:31:39
year returns in the next 3 years and
00:31:41
then 8% per year forever after that.
00:31:43
It's not really a nice sequence. So the
00:31:45
first six years are -5 -5 -5 0 0 0 but
00:31:50
then a nice consistent 8% per year
00:31:52
forever after that. And then I take a a
00:31:55
second retiree same exact circumstances
00:31:58
same exact average returns but all I do
00:32:01
is I adjust the timing that's all I do.
00:32:02
I change the timing. I use that same -5
00:32:05
-5 -5 0000 sequence but instead of
00:32:09
starting it in year 1 of retirement I
00:32:11
start it in year 10. every other year of
00:32:13
their retirement is the same 8% per
00:32:15
year. Our first retiree who suffered the
00:32:18
bad sequence up front. If they follow
00:32:20
the 4% rule to a te, they would run out
00:32:22
of money in year 28 of their retirement.
00:32:25
Of course, you know, the writing would
00:32:27
be on the wall for them much much
00:32:28
earlier and they might adjust their
00:32:30
withdrawals, assuming they had the the
00:32:31
wherewithal to notice, but still the
00:32:33
point is that if they follow the 4%
00:32:35
rule, keep adjusting up for inflation,
00:32:37
they run out of money after 28 years.
00:32:39
Now, what about our second retiree? the
00:32:41
one where all we did was uh we shifted
00:32:43
their the bad sequence out to year 10.
00:32:45
So they got 8% per year for the first
00:32:47
decade. Then they got -5 - 5 - 5 0000
00:32:51
and then back to 8% per year after that.
00:32:54
Well, in year 28 when our first retiree
00:32:56
is running out of money, our second
00:32:58
retiree would still have over $900,000
00:33:01
in their portfolio. Reminder, I mean,
00:33:03
they started with a million. They would
00:33:04
end up running out of money after 43
00:33:06
years. maybe look at a third retiree and
00:33:09
we shift the the bad sequence out to
00:33:11
year 20. That retiree by the time year
00:33:14
28 comes around where our first retiree
00:33:16
is failing. This third retiree would
00:33:18
have $1.6 million in their portfolio. As
00:33:21
a reminder, these three retirees,
00:33:23
they've all had the same exact
00:33:24
withdrawals each and every year. All
00:33:26
three of them withdrew $40,000 in year
00:33:28
one of retirement, then adjusted that
00:33:30
number up each year by inflation. They
00:33:32
also all had the same average investment
00:33:35
returns over their retirements. The only
00:33:37
difference was the sequence of those
00:33:39
returns as they came in. That is why
00:33:41
traditional investing for retirement,
00:33:43
typical withdrawal strategies for
00:33:45
retirement, the way that smart financial
00:33:47
planning, retirement planning typically
00:33:48
works. It's a non-erotic system.
00:33:51
Understanding the average is simply not
00:33:53
enough. The time series is too
00:33:55
important. You know, retirement itself
00:33:58
really is the ultimate non-erotic
00:34:00
activity because you only get one life
00:34:02
path, right? You only get one time
00:34:03
sequence. We know investment returns
00:34:05
compounded over time. That's non-erotic,
00:34:07
right? The average return of an asset
00:34:09
across time is not what a single retiree
00:34:12
experiences over time. As a result,
00:34:14
sequence and volatility matter more than
00:34:16
expected return. We already discussed
00:34:18
that withdrawal strategies are very much
00:34:21
non-erotic too. You know, withdrawals
00:34:23
convert investment volatility and can
00:34:25
convert that into permanent damage. You
00:34:28
can't average your way out of an early
00:34:30
depletion of your portfolio because zero
00:34:32
wealth just ends the game. And as you
00:34:35
approach zero wealth, you actually
00:34:37
accelerate toward zero. That the rate of
00:34:40
negative outcomes starts increasing.
00:34:42
Things get worse and worse. The the
00:34:44
retirement implication is that tail
00:34:46
risks dominate planning. Now, now what's
00:34:48
a tail risk? As an example, Ruben Miller
00:34:50
wrote a great article a few uh weeks
00:34:52
ago. I'll link it in the show notes
00:34:53
about the the tariff tantrum back in
00:34:55
April 2025. And it was it's funny. He
00:34:58
called it a one in a quadrillion event.
00:35:01
Or at least it would be a one in a
00:35:04
quadrillion event. If investment returns
00:35:06
followed a normal bell curve, but for
00:35:08
you stats nerds out there, investment
00:35:10
returns don't follow a normal bell
00:35:12
curve. The tails of an investment
00:35:14
distribution curve are very fat. And as
00:35:16
Ruben wrote, stock market returns are
00:35:19
not normally distributed. Daily outcomes
00:35:21
do not cluster around a daily average.
00:35:23
Instead, we observe and expect super
00:35:26
weird outsized fringe outliers. That's
00:35:29
his quote. And those weird outsized
00:35:32
fringe outliers, those are called tails.
00:35:34
Tail risks. These like, you know, kind
00:35:36
of rare but really impactful events.
00:35:39
Tail risks affect our financial plans in
00:35:41
really big ways and in non-erotic ways.
00:35:44
And if we get a bad sequence of tail
00:35:46
events in the wrong order in our
00:35:47
retirement, it's a it's a pretty big gut
00:35:49
punch. Longevity risk is very much non-
00:35:52
urgotic, too. Just like Jeremy Kyle said
00:35:54
back on episode 127, he thinks longevity
00:35:56
is the single most important number in
00:35:58
retirement planning. Life expectancy is
00:36:01
a is an average across a population. You
00:36:05
either die early or you live long. It's
00:36:08
pretty rare that you're going to be
00:36:09
average. In fact, there's only a 4%ish
00:36:12
chance that you die at your expected
00:36:14
age. In other words, you know, as I sit
00:36:16
here today at age 36, my current life
00:36:18
expectancy is 77, but of course, I might
00:36:21
die at 60 or 64 or 88 or 93. So, what
00:36:25
are the odds I die at precisely 77?
00:36:28
Those odds are about 4%. And, you know,
00:36:30
planning to age 84 works great unless
00:36:33
you live to age 97. Living longer can be
00:36:36
usually is financially dangerous without
00:36:38
some sort of protection. and planning to
00:36:41
averages might end up well it will end
00:36:43
up underfunding the people who live the
00:36:45
longest. That's why social security is
00:36:48
such a powerful tool and that's why good
00:36:50
annuities at least and we'll get into
00:36:52
this in a second that's one of the
00:36:54
corner cases in which good annuities
00:36:56
like SPAS can be useful. Inflation can
00:36:59
be non-erotic too. It it compounds
00:37:01
against you. You can't predict it. And
00:37:03
if big inflation comes at the at the
00:37:05
wrong times early in a retirement, it
00:37:07
can be hard to come back from or it can
00:37:08
be permanently damaging. Again, it's not
00:37:10
about average inflation. It's about the
00:37:12
inflation that you will suffer in your
00:37:14
specific time series of events. At the
00:37:17
end of the day, if your wealth hits
00:37:18
zero, the whole process stops. You know,
00:37:20
the the average across many people can
00:37:23
ignore those who failed. Uh Monte Carlo
00:37:25
analysis, for example, typically might
00:37:27
show average ending wealth. That's one
00:37:30
of the outputs from Monte Carlo
00:37:31
analysis. And that average is either
00:37:33
going to exclude paths that went broke
00:37:36
or or much more likely, it's going to
00:37:38
swamp them out. So here's what I mean.
00:37:40
Imagine I run a 100 Monte Carlo
00:37:42
simulations in my retirement plan and
00:37:44
I'm sitting here today about to enter
00:37:45
retirement. I've got $2.5 million and I
00:37:48
see something from the analysis that
00:37:50
they call average terminal wealth and
00:37:52
it's at $2 million. I said, "Wow, I
00:37:54
think I I have two$ 2.5 million today. I
00:37:58
can spend money throughout my entire
00:37:59
retirement and I'll still die with about
00:38:01
2 million bucks. That's great. I mean,
00:38:03
let's go. Under the hood, though, you're
00:38:06
going to want to dig into those 100
00:38:07
independent results that comprise the
00:38:09
the average of the Monte Carlo. And if
00:38:11
you did so, you might realize that some
00:38:13
of those outcomes actually turn your
00:38:15
$2.5 million into five or seven or 10
00:38:19
million or more, but that many other
00:38:21
outcomes might actually hit zero. They
00:38:23
might fail. In fact, what's the average,
00:38:26
for example, of of one outcome at 10
00:38:28
million plus four outcomes that all fail
00:38:30
to zero? Well, the average is 2 million
00:38:32
per outcome. Again, that's one
00:38:34
successful retirement out of five
00:38:36
attempts or a 20% pass rate. But because
00:38:39
that one retirement simulation happened
00:38:41
to have a a $10 million terminal value,
00:38:43
the average terminal wealth is 2 million
00:38:45
bucks. Statistics can be misleading. And
00:38:48
while I understand the desire to
00:38:50
compound your wealth and to maximize, I
00:38:52
think that good planning also needs to
00:38:54
focus on avoiding ruin. I really do.
00:38:56
It's like the Charlie Munger quote. Tell
00:38:58
me where I'm going to die so I can make
00:38:59
sure to never go there. Good financial
00:39:01
planning is tell me how my plan might
00:39:04
catastrophically fail so I can make sure
00:39:06
to avoid or mitigate that risk. Again,
00:39:08
we all have the desire to compound our
00:39:10
wealth in in some way and and maximize
00:39:12
what we have. But if you were to sit
00:39:13
here and say, "But Jesse, you know,
00:39:15
there's a risk. I might not achieve a
00:39:17
$15 million nest egg. I would tell you
00:39:20
that doesn't really sound like a risk to
00:39:22
me. Sure, maybe $15 million for you can
00:39:24
be a goal, but the lack of $15 million
00:39:27
isn't a risk. But if someone said,
00:39:29
"Jesse, there's a risk I've run out of
00:39:31
money by 75 and I'm forced to vastly
00:39:33
underlive my final decade here on
00:39:35
Earth." I just had someone the other day
00:39:37
say that her biggest fear in retirement
00:39:39
is becoming what she called a bag lady.
00:39:40
And if that's a risk that you feel and
00:39:43
that you fear, yeah, that sounds like a
00:39:45
legitimate risk to me and and something
00:39:47
worth considering. The risk of ruin is
00:39:49
non-orgotic. If you're one and only
00:39:51
timeline has factors that increase your
00:39:54
risk of ruin, then you don't care nor
00:39:56
should you care about the average that
00:39:58
other people are living. You only care
00:40:00
about the giant risk that happens to be
00:40:01
staring you in the face. Here's a quick
00:40:04
ad and then we'll get back to the show.
00:40:06
Serious question. Why do podcasters
00:40:09
constantly ask for ratings and reviews?
00:40:11
Yes, they do help highlight our shows to
00:40:14
new listeners. They help strangers find
00:40:15
us on Apple Podcast and Spotify. It's
00:40:18
totally true and a good reason to ask
00:40:19
for ratings and reviews. But I have
00:40:22
something more important, at least more
00:40:23
important to me. I want to know if you
00:40:26
like this stuff. I want to know if you
00:40:28
like my podcast episodes, my monologues,
00:40:30
my guests, the information I share with
00:40:32
you and the stories I tell. I want to
00:40:34
improve and make your listening more
00:40:36
enjoyable in the process. So yeah, I
00:40:38
would love to read your reviews. And
00:40:40
sure, if you throw a rating in there,
00:40:41
too, that's great. If you like what I'm
00:40:43
doing, please share it with me. It's
00:40:45
such a great feeling to read your
00:40:47
feedback. I'd love to read your review
00:40:50
or see a rating on Apple Podcast or
00:40:52
Spotify. Thank you. What, if anything,
00:40:55
can we do to turn the the non-erotic
00:40:58
risks of retirement into something that
00:41:00
maybe is a little more erotic? Or in
00:41:02
other words, how can we minimize our
00:41:04
exposure to unique bad luck time series
00:41:07
and somehow maximize or increase our
00:41:10
exposure to the long-term average or the
00:41:12
average of many people, which we know
00:41:15
when you look at kind of some of the
00:41:16
retirement numbers and you look at the
00:41:17
average of many people, things start to
00:41:20
look better than when you're looking at
00:41:21
the worst case time series. So, let's
00:41:23
think about that for a second and and
00:41:25
maybe we can follow this example.
00:41:26
Imagine you have 100 retirees and
00:41:28
they're all following the 5% rule in
00:41:30
retirement. Yes, I said the 5% rule
00:41:32
because depending on your preferred
00:41:34
asset allocation, the the 5% safe
00:41:36
withdrawal rate works in about 75% of
00:41:39
historical back tests. So, it means that
00:41:42
25% of the time our retirees suffer
00:41:44
either a lousy stretch of investment
00:41:46
returns and or they live so long that
00:41:49
they stress their portfolio and
00:41:50
ultimately run out of money. And that's
00:41:52
non-orgotic, right? We don't want that.
00:41:54
So, we approach this group of 100
00:41:57
retirees all following the 5% rule and
00:41:59
we have a little idea. We say, "Hey,
00:42:01
let's see if we can kind of meet in the
00:42:02
middle." We ask each of these retirees
00:42:04
to take a a small haircut from their
00:42:06
original portfolio, maybe 10% from each
00:42:08
retiree. And then we pull everybody's
00:42:11
10% haircut together into one big pot.
00:42:13
We invest it pretty, you know,
00:42:15
reasonably conservatively. And then we
00:42:18
actually start taking a small share of
00:42:20
the investment growth from that pool and
00:42:22
we give it back to all the retirees.
00:42:23
Now, not a ton of growth, but a little
00:42:25
bit. And on average, our retirees are
00:42:28
all going to have slightly less annual
00:42:30
growth from the pool because again,
00:42:32
we're being a little conservative with
00:42:33
our poolled investments. They're still
00:42:35
spending according to the 5% rule,
00:42:37
though, but their overall net worth does
00:42:39
look a little worse year-over-year
00:42:41
because they took the 10% haircut up
00:42:43
front. But now, why are we doing this?
00:42:45
Because here's the deal that we proposed
00:42:47
to our to the retirees about the 10%
00:42:50
haircut and the big pool of money. We
00:42:52
tell them, hey guys, if you die early or
00:42:54
basically no matter when you die, you
00:42:57
are not going to get your 10% back. You
00:42:59
put 10% in and you are starting to get
00:43:01
this this income from the pool and and
00:43:04
maybe by the time you die, you're only
00:43:06
going to have pulled a couple percent of
00:43:07
the of your original money back out. But
00:43:10
it doesn't matter. You're not going to
00:43:11
get your money back. Now, before you cry
00:43:14
uncle though, we need to ask if you are
00:43:16
one of these people who dies early and
00:43:18
doesn't get their money back, did you
00:43:20
run out of money? Did you live a bad
00:43:22
retirement? Did the haircut negatively
00:43:24
affect you in your retirement years? I
00:43:27
would say no. While they certainly did
00:43:29
suffer a net loss on their balance
00:43:31
sheet, on their net worth statement, it
00:43:33
didn't actually harm their retirement in
00:43:35
any way. You know, if we're just calling
00:43:37
successes and failures, period, their
00:43:39
retirement was still a success. And if
00:43:41
we do it right, maybe half, maybe even a
00:43:44
little over half of the 100 people might
00:43:46
fit this bill. They will get less than
00:43:48
their original 10% back or certainly
00:43:50
they would have been better off not
00:43:52
taking the 10% haircut in the first
00:43:54
place. But because they died relatively
00:43:57
earlier or earlier than average, that
00:43:59
10% haircut never actually comes back to
00:44:01
harm them in terms of their retirement
00:44:03
success at all. The only measurable harm
00:44:05
is that they have fewer assets at their
00:44:07
death. You know, their heirs get less of
00:44:09
an inheritance. That's the only harm.
00:44:11
But now let's ask about the other people
00:44:13
of the 100. Let's ask about the people
00:44:15
who die later than expected. Some of
00:44:17
those people might die just a couple
00:44:19
years later than average. And they'll
00:44:21
get most if not all of their original
00:44:23
10% haircut back in terms of the income
00:44:25
distributions, but it's doubtful they'll
00:44:27
ever get enough back to say that they
00:44:29
the pool concept was truly profitable or
00:44:32
helpful for them. Nevertheless, they
00:44:34
don't really live that long past their
00:44:36
average age of retirement and their
00:44:37
retirements will still be successful. I
00:44:39
would say for them the pool was very
00:44:41
much a a neutral a neutral uh addition
00:44:43
to their retirement. And then that
00:44:45
leaves us with a small share of people
00:44:47
who really live for a long time. They
00:44:49
live many many years past their expected
00:44:51
age of of death. And for those people
00:44:54
their 10% haircut, not only do they get
00:44:57
the 10% back in terms of the even uh
00:44:59
income distributions, they end up
00:45:01
getting a lot more. They end up getting
00:45:03
much more than their quote unquote fair
00:45:05
share. And because those people did die
00:45:07
late, they got more than their fair
00:45:08
share back. A few of them will fit the
00:45:10
following criteria. Without the proceeds
00:45:13
from the from the big pool, their
00:45:14
retirement plan and their withdrawal
00:45:16
plan might have failed due to their
00:45:18
longevity. But due to the proceeds of
00:45:21
the big pool, their retirement plan
00:45:23
withdrawal plan was actually successful
00:45:24
despite their longevity. So with all
00:45:27
that explanation, let's examine what the
00:45:29
big pool of money actually did. For most
00:45:31
of the 100 people, participating
00:45:34
contributing their 10% haircut into this
00:45:36
pulled asset was negative to their net
00:45:39
worth. But because they didn't live that
00:45:42
long, they certainly didn't live
00:45:43
forever. Even though it was negative to
00:45:45
their net worth, it really did nothing
00:45:47
to harm their retirement success. But
00:45:49
for a small minority of the 100 people,
00:45:52
not only was the pool possibly positive
00:45:54
for their net worth, at least it
00:45:56
outpaced inflation. It might not have
00:45:58
outpaced other assets, but it did
00:45:59
outpace inflation. But they also found
00:46:01
that the existence of the guaranteed
00:46:03
income pool actually increased their
00:46:06
odds of retirement success. So while the
00:46:08
the average net worth of the group goes
00:46:11
down due to the participation in the
00:46:13
pool, a few of the individuals a few of
00:46:15
the individual people out of the 100
00:46:17
actually saw their odds of retirement
00:46:19
success go up and none of them actually
00:46:21
saw their odds of retirement success go
00:46:23
down. So we have decreased the impact of
00:46:27
a specific time series of events. The
00:46:29
time series is that well some people
00:46:31
happen to live a long time and we've
00:46:32
lessened that impact and we've done that
00:46:34
by increasing a specific average
00:46:37
outcome. We provided that guaranteed
00:46:39
fixed income that all the retirees got
00:46:41
to benefit from. So really what we've
00:46:43
done is we've taken some of the the
00:46:45
non-erotic outcomes of many people's
00:46:48
retirement plans and we've just very
00:46:49
gently steered it toward a more erotic
00:46:52
outcome. And if you haven't caught on
00:46:53
yet, this pool that I just described,
00:46:56
that is an annuity. We're coming full
00:46:58
circle now. What I just described to you
00:47:00
is exactly how an annuity works. And
00:47:02
from an erodicity lens, why annuities
00:47:05
make sense to at least to some
00:47:06
retirement planners. We've decreased the
00:47:09
upside potential of everyone's
00:47:11
retirement, at least if measured by net
00:47:13
worth over time or spending over time.
00:47:15
We have decreased that, but in exchange,
00:47:18
we've reduced the probability that a few
00:47:20
people will run out of money. The hard
00:47:22
part for for any of you out there
00:47:23
thinking as an individual is to really
00:47:25
consider, am I going to be one of that
00:47:27
small minority who lives forever or
00:47:30
suffers a particularly bad sequence of
00:47:32
returns? Am I going to be someone who
00:47:34
suffers the the non-erotic downsides of
00:47:36
retirement and wishes I could somehow
00:47:38
achieve less of a bad luck time series
00:47:41
and achieve more of an average over the
00:47:44
large group? It really is a, you know,
00:47:45
an amazingly interesting question
00:47:47
because what it really comes down to is
00:47:48
this. Would you knowingly take a bet
00:47:50
that is, you know, highly likely to
00:47:52
reduce your net worth in exchange for
00:47:54
avoiding the small probability that your
00:47:57
safe withdrawal rate or that your
00:48:00
retirement plan or your lifespan ends up
00:48:02
being an outlier? Would you accept a 95%
00:48:05
chance that you might lose money in
00:48:07
exchange for a 5% chance that you'll
00:48:10
avoid a retirement failure? You know,
00:48:12
remember how annuities are the opposite
00:48:13
of term life insurance in many ways? I
00:48:16
bought life insurance when we bought our
00:48:17
house a few years ago and and when we
00:48:19
got pregnant with with our first child,
00:48:21
I was 33. I bought a 30-year term
00:48:23
policy. And looking at Social Security
00:48:26
actuarial tables for a 33y old male,
00:48:28
there is an 83% chance I live to age 63.
00:48:32
In other words, there's an 83% chance
00:48:34
that all my insurance premiums for the
00:48:36
next 30 years will not lead to any sort
00:48:38
of payout in the future. I'm accepting
00:48:41
an 83% chance that I lose money in
00:48:44
exchange for a 17% probability that I
00:48:46
might die and leave my family
00:48:49
financially okay. I'm accepting a high
00:48:52
probability of low-level failure in
00:48:54
order to derisk myself from a low
00:48:56
probability of highle failure. And that
00:48:58
is what term life insurance does, plain
00:49:00
and simple. And it's interesting. I
00:49:02
don't think anyone in their right mind
00:49:03
would say, well, you know that term life
00:49:05
is probably going to be a losing
00:49:06
financial proposition. So, why would you
00:49:08
ever buy it? I don't think anyone says
00:49:10
that. Back to our simple fixed annuity.
00:49:14
To buy an annuity is a high probability
00:49:16
of low-level failure in order to derisk
00:49:19
yourself from a low probability of a
00:49:22
highle failure. So again, it's a high
00:49:24
probability that you actually kind of
00:49:26
quote unquote lose money on the annuity
00:49:28
to derisk yourself from the small chance
00:49:31
that you hit a retirement failure. In a
00:49:33
perfect world, that is how annuities
00:49:35
would work and that's how people would
00:49:36
use them to their utmost. And if you put
00:49:38
an annuity or into a simple financial
00:49:40
model or you run a simple Monte Carlo
00:49:42
simulation and you ask yourself what is
00:49:44
this annuity actually doing under the
00:49:46
hood, most of the time an annuity will
00:49:49
take an already successful retirement
00:49:51
plan and will reduce the overall amount
00:49:53
of money in that plan. Either you die
00:49:55
with less money or you got to spend less
00:49:57
money along the way. in shorter
00:49:59
lifespans or in lifespans with a a
00:50:01
neutral to good sequence of returns,
00:50:03
that is certainly the case. But in a
00:50:06
small minority of a Monte Carlo's
00:50:07
individual simulations, particularly
00:50:10
when a a long lifespan combines with a
00:50:12
bad sequence of returns, we see that the
00:50:15
annuity certainly increases the
00:50:16
probability of retirement success. And
00:50:19
you can see that result in the numbers
00:50:20
themselves. The last caveat though on
00:50:22
that one, I will say the devil is in the
00:50:24
details. If I run a Monte Carlo
00:50:26
simulation with ultraconservative
00:50:28
investment rates of return and then I
00:50:30
compare that to a known constant payout
00:50:32
from an annuity, that particular
00:50:34
simulation is going to make the annuity
00:50:35
look really good. And hopefully that
00:50:37
makes sense. You know, if I'm choosing
00:50:39
to make my portfolio look ugly, the
00:50:41
annuity is going to look pretty by
00:50:43
comparison. Similarly, if I knowingly
00:50:45
use aggressive rates of return and then
00:50:47
I compare it to a known constant annuity
00:50:49
payout, again, if I make my portfolio
00:50:51
look gorgeous, well, then the annuity is
00:50:53
going to look extra ugly in comparison.
00:50:56
Anyway, that is my breakdown of
00:50:58
annuities. They are an interesting
00:51:00
product. They are an insurance product.
00:51:02
Most annuities are variable, which I
00:51:04
would avoid like the plague. Some
00:51:06
annuities are fixed, though, and and
00:51:07
they do have these corner case uses. In
00:51:10
most of those uses, you're knowingly
00:51:12
taking a bet that most likely will not
00:51:14
work out in your favor. But you know
00:51:16
that in a minority of cases, it actually
00:51:18
would work out in your favor. Why?
00:51:21
Because the nature of retirement, which
00:51:22
can be described using this idea from
00:51:24
the hard sciences, erodicity, retirement
00:51:26
planning cares much more about your
00:51:28
specific time series of events rather
00:51:31
than caring about what the average uh of
00:51:33
all people go through. Annuities are a
00:51:35
product that done correctly can diminish
00:51:37
your specific exposure to your one and
00:51:40
only time series of events that you'll
00:51:42
go through in the future and increase
00:51:43
your exposure to the average events of
00:51:45
all people. This has a tendency to to
00:51:48
dull both ends of your potential
00:51:50
outcomes. It dulls the end where your
00:51:52
portfolio grows and grows and you have
00:51:53
lots of retirement money to spend or
00:51:55
leave to heirs. But then it also dulls
00:51:57
the end where you might run out of money
00:51:59
and suffer a painful retirement failure.
00:52:01
Now, whether the potential payoff is
00:52:03
worth the high probability cost, I've
00:52:05
explained, you know, much of the general
00:52:07
math today. You have to understand your
00:52:10
specific math if you're interested. And
00:52:11
then the rest of the decision, it's a
00:52:13
personal choice up to you. As always,
00:52:16
thank you for listening to Personal
00:52:17
Finance for Long-Term Investors. Thanks
00:52:19
for tuning in to this episode of
00:52:21
Personal Finance for Long-Term
00:52:22
Investors. If you have a question for
00:52:24
Jesse to answer on a future episode,
00:52:26
send him an email over at his blog, The
00:52:29
Best Interest. His email address is
00:52:31
jessevestinterest.blog.
00:52:33
Again, that's jessevestinterest.blog.
00:52:37
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00:52:46
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00:52:48
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00:52:50
for Long-Term Investors. Personal
00:52:53
Finance for Long-Term Investors is a
00:52:54
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00:52:57
entertainment. It should not be taken as
00:52:59
financial advice and it's not
00:53:00
prescriptive of your financial
00:53:02
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