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The Pros and Cons of Annuities
They can provide income for life, though often at a high price
Reviewed by Charlene RhinehartFact checked by Amanda Jackson
Insurance agents and financial advisors have been investing their clients’ retirement money in annuities for decades. This practice has its detractors, with the criticism usually focusing on the high commissions paid to annuity salespeople and stiff fees charged to annuity owners year after year. In fact, when comparing the costs of an annuity versus a mutual fund, there can be a big difference, with a mutual fund being less expensive. It pays to know the details about annuities before you invest.
Here’s a rundown of the pros and cons of annuities, compared with other ways to invest for retirement.
Key Takeaways
- Annuities can provide a reliable income stream in retirement, but if you die too soon, you may not get your money’s worth.
- Annuities often have high fees compared to mutual funds and other investments.
- You can customize an annuity to fit your needs, but you might need to pay more or accept a lower monthly income.
How Annuities Work
An annuity is a contract between an individual and an insurance company. The investor contributes a sum of money—either all up-front or in payments over time—and the insurer promises to pay them a regular stream of income in return.
With an immediate annuity, that income begins almost right away. With a deferred annuity, it starts at some point in the future, typically during retirement. The dollar amount of the income payments are determined by such factors as the balance in the account and the age of the investor.
Annuities can be structured to pay income for a set number of years, such as 10 or 20, or for the life of the annuity owner. When the owner dies, any money remaining in the account typically belongs to the insurance company; however, if they live happily to, say, 120 years old, the insurance company still has to keep those regular payments coming.
Annuities can also be fixed or variable. In a fixed annuity, the insurance company pays a specified rate of return on the investor’s money. In a variable annuity, the insurer invests the money in a portfolio of mutual funds, or “subaccounts,” chosen by the investor, and the return will fluctuate based on their performance.
Pros
-
Guaranteed income
-
Customizable features
-
Money-management assistance
Cons
-
High commissions
-
High fees
-
Surrender charges
The Pros of Annuities
Despite the criticisms, annuities do offer some advantages for investors who are looking toward retirement.
Guaranteed Income
The insurance company is responsible for paying the income it has promised, regardless of how long the annuity owner lives; however, that promise is only as good as the insurance company behind it. This is one reason investors should only do business with insurers that receive high ratings for financial strength from the major independent ratings agencies.
Customizable Features
Annuity contracts can often be adapted to match the buyer’s needs. For example, a death benefit provision can ensure that the annuity owner’s heirs will receive at least something when the owner dies.
A guaranteed minimum income benefit rider promises a certain payout regardless of how well the mutual funds in a variable annuity perform. A joint and survivor annuity can provide continued income for a surviving spouse. All of these features come at an additional price, however.
Money-Management Assistance
Variable annuities may offer a number of professional money-management features, such as periodic portfolio rebalancing, for investors who’d rather leave that work to someone else.
The Cons of Annuities
High Commissions
When it comes to the commissions made for selling annuities versus mutual funds, the former is almost always higher than the latter. Say an investor rolls a $500,000 balance in a 401(k) into an individual retirement account (IRA). If the money is invested in mutual funds, the financial advisor might make a commission of about 2%. If it is invested in an annuity that holds the same or similar mutual funds, the advisor could make a commission of 6% to 8% or even higher.
Therefore, a $500,000 rollover into mutual funds would pay the advisor a $10,000 commission at most, while the same rollover into an annuity could easily pay the advisor $25,000 to $35,000 in commission. Not surprisingly, many advisors will direct their clients into the annuity.
High Fees
Most annuities do not assess sales charges upfront. That may make them look like no-load investments, but it doesn’t mean they don’t have plenty of fees and expenses.
Annuity contracts impose annual maintenance and operational charges that often cost considerably more than the expenses associated with comparable mutual funds. This has been changing somewhat in recent years, and some insurers are now offering annuities with comparatively low annual expense ratios. Still, as always, investors should scrutinize the fine print before they sign.
Surrender Charges
If an annuity owner needs to get money out of the annuity before a certain period of time has elapsed (typically six to eight years, but sometimes longer), they may be subject to hefty surrender fees charged by the insurer.
No Added Tax Benefits for IRAs
Annuities are tax-sheltered. The investment earnings grow tax-free until the owner begins to draw income. If the annuity is a qualified annuity, the owner is also eligible for a tax deduction for the money they contribute to it each year.
A traditional IRA or 401(k) has the same tax benefits—and if it’s invested in conventional mutual funds, it’s typically at a much lower cost. Placing an annuity in a 401(k), as investors may be urged to do by some salespeople, is redundant and needlessly expensive.
Important
If you’re planning to buy an annuity, make sure you’re dealing with a financially solid insurance company that’s likely to be around—and able to make good on its promises—when you start drawing income.
A Compromise Solution
One practical option for investors is to stick with mutual funds until retirement and then move some of their money into an annuity, especially one with a downside protection rider. That keeps the fees to a minimum during the investor’s working years but guarantees a steady income in retirement.
Can You Lose Money With Annuities?
You can’t lose money with annuities in the traditional sense that you can with other investments tied to the market. You can, however, lose money on annuities if the insurance company that issued the annuity goes out of business and defaults on its obligation. There is a degree of regulatory protection for investors in case this happens.
Why Are Annuities a Poor Investment Choice?
Annuities are considered poor investments for many reasons. Depending on the annuity, these include a variety of high fees, with little to no interest earned, an inability to keep up with inflation, and limited liquidity.
What Is Better Than an Annuity for Retirement?
There are a variety of options that are better than an annuity for retirement, depending on your financial situation and goals. These include deferred compensation plans, such as a 401(k), IRAs, dividend-paying stocks, variable life insurance, and retirement income funds.
The Bottom Line
Though annuities are one of the most established retirement savings options, they aren’t necessarily for everyone. Annuities work for people who are looking for simple, fixed payments—and who don’t mind the disadvantages, such as high fees.
When considering an annuity, make sure to pay attention to all of the details in the contract. Evaluate all of the pros and the cons.
Read the original article on Investopedia.
Don’t Make This Mistake if You’re Going to a Destination Wedding
Being invited to a destination wedding can be a celebratory affair for all involved, but how you choose to pay for it can rain on your parade.
A listener to the Clark Howard Podcast recently shared that she was invited to a friend’s wedding in Punta Cana. She was told the trip was being booked through a wedding/travel planner, so she paid up like the other guests.
Going To a Destination Wedding? Read This
When she arrived at the resort, she found out that not only did she not have a room, but the wedding planner and bride and groom were at odds as to what happened to the money.
This would-be wedding guest was stuck out of town, out of her room and out of her money.
Money expert Clark Howard says it’s super-important to make sure you’re never left holding the bag when it comes to group travel and events like destination weddings.
“The one advice that I’ve given repeatedly with destination weddings is to book your travel on your own. You’re in control then,” Clark says.
“When you go third-party on it, that’s where we hear the problems, whether the destination wedding is in the United States or outside the United States,” he adds.
Here are a few additional tips for your wallet when it comes to destination weddings and other forms of group travel:
Only Pay via Credit Card
Clark is a stickler for paying only with a credit card for travel (and anything else). Not only do you get more consumer protections, but you may be able to get perks, cash back and freebies if you use certain reward credit cards.
Let the Destination Choose You
If you’re in charge of travel plans, there’s no better way to save than to follow Clark’s #1 Travel Rule: Go where the sale is.
“My #1 rule of travel is buy the deal first and then figure out why you want to go there. By following that simple rule, I’ve been able to visit every continent except Antarctica and every state except North Dakota. And I’ve done it all on a dime.”
Consider Travel Insurance
One way to protect the money you spend on your travels is to insure it, but travel insurance is not something that you need for every type of trip.
Clark says the additoinal expense of travel insurance is worth only if you’re:
- Taking a cruise
- Booking special tours as part of your trip
- Traveling on an itinerary that requires prepayment of thousands of dollars
“So you don’t want to insure an airline ticket unless you look at it as a once-in-a-lifetime trip and you’d never have an opportunity to use the money again,” Clark says.
Read our guide on buying travel insurance.
Final Thought
Clark says when dealing with group travel, keep things simple for your wallet’s sake. “Book your travel on your own. Make sure you book with a credit card, not through any third party.”
Want more money-saving travel advice? Read up on how Clark plans a trip
The post Don’t Make This Mistake if You’re Going to a Destination Wedding appeared first on Clark Howard.
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Canada Pension Plan (CPP) vs. U.S. Social Security
Both offer benefits, but what individuals pay in—and get out—differs
Reviewed by Marguerita ChengFact checked by Suzanne Kvilhaug
The Canada Pension Plan (CPP) and the U.S. Social Security system are publicly provided pension systems. They both provide retirement, disability, and survivor benefits. However, the amount individuals pay and the benefits they receive differ.
Key Takeaways
- The Canada Pension Plan (CPP) and Social Security are government-sponsored retirement income programs.
- CPP tax rates and income thresholds are generally lower than Social Security.
- Taxed Canadian wages go into a trust fund managed by the CPP Investment Board, which invests the funds in stocks, bonds, and other assets.
- Taxed U.S. Social Security wages go into the Old-Age and Survivors Insurance Trust Fund and the Disability Insurance Trust Fund. The funds are invested in U.S. Treasury securities.
Canada Pension Plan
The Canada Pension Plan (CPP), established in 1966, is one of three Canadian retirement income systems that provides retirement, survivor, and disability benefits. Most Canadians contribute to the CPP. A Quebec Pension Plan (QPP) provides similar benefits to its residents.
Individuals contribute to the CPP if they are over 18 and earn more than CA$3,500.Based on earnings, the employee and employer contribution rate is 5.95% each, and the self-employed contribution rate is 11.9%. In 2024, Canada introduced an additional maximum pensionable earnings amount, adding CPP contributions of 4% for both employers and employees or 8% for the self-employed on earnings between CA$68,500 and CA$73,200.
The CPP Investment Board invests the assets “to maximize returns without undue risk of loss.” For 2024, the maximum monthly retirement benefit is CA$1,364.60. CPP benefits are based on how much and how long individuals have contributed.
Important
The Quebec Pension Plan is the equivalent of the CPP in the region. In 2024, its contribution rate is 10.8%, split equally between the employer and the employee.
CPP Benefits
- Retirement pension. Individuals can start full CPP retirement benefits at age 65 or get a permanently reduced amount as early as 60. For those who start benefits as late as age 70, benefits will have a permanent increase.
- Post-retirement benefit. Individuals under age 70 can keep working while receiving a CPP retirement pension, and contribute toward post-retirement benefits that increase retirement income.
- Disability benefits. Individuals get disability benefits and are below the age of 65 and can’t work due to a disability.
- Survivor’s pension. A surviving spouse or common-law partner can collect benefits based on the employee’s record.
- Children’s benefits. Severely disabled dependent children can receive benefits if individuals die or become severely disabled.
Social Security
Established in 1935, Social Security is a federal benefits program in the U.S. Employees and employers pay 6.2% each in taxes to contribute. Self-employed individuals pay the full 12.4%. Earnings are taxed up to $168,600 in 2024. The maximum contribution for individuals is $10,453.20 (.062 x $168,600). For the self-employed, it’s $20,906.40.
Most people must pay into Social Security, regardless of age. Individuals must have 40 work credits or 10 years of earnings to qualify for Social Security benefits. Benefits are based on the highest-earning 35 years of work.
Social Security taxes go into the Old Age and Survivors Insurance (OASI) Trust Fund and the Disability Insurance (DI) Trust Fund. Although legally distinct, they’re collectively known as “the Social Security Trust Funds”—or “Social Security.”All Social Security payroll taxes are allocated to the trust funds, and Social Security’s benefits and administrative costs are paid out. The trust funds are invested entirely in U.S. Treasury securities.
Note
Some groups are exempt from paying into Social Security and may include qualifying religious groups, nonresident aliens, and foreign government employees.
Social Security Benefits
- Retirement benefits. Full Social Security retirement benefits start between ages 66 and 67, depending on an individual’s birth year. Retirees can get a permanently reduced amount as early as age 62, or an increased amount if they wait until age 70 to collect. For 2024, the maximum monthly retirement benefit at age 62 is $2,710, and $4,873 for age 70.
- Disability benefits. You can get disability benefits if you can’t work due to a disability. Your family members may also be eligible for benefits.
- Survivor benefits. Your surviving spouse and minor children may be eligible to collect benefits based on your record.
Funding Shortfalls
In 2024, the Canada Pension Plan does not face a budget shortfall. However, according to the 2024 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds, Social Security benefits funded by the OASDI fund are projected to pay 100% of total scheduled benefits until 2035. Following the depletion of the fund’s reserves, continuing total fund income will pay 83% of benefits.
The OASDI fund combines the Old-Age and Survivors Insurance (OASI) Trust Fund and the Disability Insurance (DI) Trust Fund. Based on projections, The OASI Trust Fund alone will be able to pay 100% of scheduled benefits until 2033 with continuing program income sufficient to pay 79% of benefits. The DI Trust Fund can pay 100% of the total scheduled benefits through 2098.
Can Individuals Collect Both Social Security and Canada Pension?
Those with credits for both programs can benefit from one or both programs. Individuals who do not meet the basic requirements for one program may still be eligible for partial benefits.
What Is the Difference Between a Pension Plan and Social Security?
Pension plans are typically funded through employer and employee contributions. Social Security is funded through payroll taxes on workers. These taxes fund the benefits paid out to those not working or retired.
Can Retirees Collect a Pension and Social Security?
Yes, individuals can legally collect a pension and Social Security. Depending on the pension benefit, Social Security benefits may be reduced. Individuals should check with a tax advisor to determine the best setup for their situation.
The Bottom Line
The Canada Pension Plan and the U.S. Social Security program are pension programs for retirees in the respective countries. While the programs have their differences, both seek to provide income and a certain standard of living for retired individuals.
Read the original article on Investopedia.