Pension vs. Annuity: Top 5 Differences

Article Summary:

Pensions and annuities both guarantee financial stability and security after you retire, but they are important differences to consider. For starters, pensions are given to employees by their employers, while annuities are offered by private insurance companies. Understanding the key differences between pensions and annuities will help you decide which option is right for you and your financial health.

Chances are, if you are anywhere near retirement age, the words “pension” and “annuity” have been coming up in financial conversations more and more frequently. Both pensions and annuities are products that allow you to access reliable streams of income after you reach retirement age, but there are some key differences between the two that are important to understand.

The biggest distinction is that pensions are part of a retirement package for employees that employers pay into for the duration of their career, whereas annuities are usually private individual contracts with insurance companies. Let’s take a look at the ins and outs of pensions and annuities, the benefits they both offer, and the important differences you need to know while planning your retirement strategy.

Pension vs. annuity

Pensions and annuities are both retirement funds that are paid into for a set period before disbursing an agreed-upon structure of benefits. These can come in the form of monthly payments or a lump sum payout, and they often last for the remainder of the beneficiary’s life.

When an individual reaches retirement age — typically 59 1/2 — an annuity will automatically begin disbursing benefits. Pension funds, on the other hand, are often linked to employment and will be disbursed depending on the structure the employer has established.

A pension, therefore, is a specific kind of annuity. In other words, all pensions are annuities, but not all annuities are pensions.

Annuities

Annuities are insurance products that typically serve as protection for retirees against financial uncertainty and stock market fluctuations that may affect other, less reliable retirement income sources. An annuity contract has two phases: an accumulation phase and a distribution phase.

Accumulation phase

The accumulation phase for an annuity scheme begins when the annuity is set up and continues until the beneficiary reaches a certain age. Annuities can be very flexible in terms of structure, which is one of their major benefits. Most annuities require an initial contribution to open, and they may or may not require ongoing contributions.

During the accumulation phase, all the money deposited into the account is tax deferred. Growth is managed by a financial institution through a variety of products — such as stocks, bonds, money markets, and mutual funds — and is generally low risk. The downside of annuities is that beneficiaries usually are not able to withdraw funds before the maturation date without incurring a penalty.

Pro Tip

The penalty for early withdrawal from an annuity is usually 10%, so financial advisors do not usually recommend annuities to younger people who tend to need more liquidity.

Distribution phase

After the maturity date of the annuity passes, benefits are disbursed either as a lump sum or as periodic payments (often monthly or quarterly). Although an annuity will generally not replace a retiree’s income entirely, they do provide a steady income stream independent of market fluctuations that can have a negative effect on other income sources, such as dividends and stock values.

While an annuity in the distribution phase does not require contributions or additional fees to maintain, benefits are considered taxable income. By federal law, the income annuity beneficiaries receive is taxed at standard rates, and taxes are owed on the full amount.

Finally, annuity benefits may or may not last for the duration of a person’s post-retirement life. An annuity may be designed as a defined benefit plan that exhausts itself after a certain amount is paid out. Every annuity scheme is different, so it is important to carefully weigh your financial planning priorities before opening one.

Pro Tip

A life annuity is a defined benefit plan that pays out a fixed amount of money until the death of the beneficiary. However, as with any insurance product, this type of annuity comes with risks. If the beneficiary passes away shortly after the distribution phase begins, the company may disburse little or no money for all those contributions!Speak to your insurance agent or certified financial planner for more information about annuities, death benefits, and retirement accounts that are right for you.

Types of annuities

The accumulation phase of an annuity has two basic structures: an immediate annuity and a deferred annuity. Similarly, there are two broad categories of benefit structures for the distribution phase: variable annuities and fixed annuities.

Annuities can be structured using any combination of these types of phases, so during retirement planning, make sure to work with your financial planner to find a structure that works for you.

Immediate annuities

Immediate annuities are funded with a lump sum payment, and quarterly or monthly payments begin immediately. This is a popular option for people approaching retirement because it offers guaranteed income and regular payments that don’t require long-term contribution habits.

Deferred annuities

A deferred annuity is used for annuity pension schemes. Regular payments are made to the annuity for a fixed period. Periodic payments are then made unless a lump sum option is selected.

Variable annuities

A variable annuity may change its benefits and worth depending on interest rates and the market performance of the fund. Financial institutions often perform day-to-day maintenance to ensure their products are performing well for their clients. However, it is possible to lose principal on the annuity if markets are down or the fund performs poorly.

Fixed annuities

Fixed annuities are a popular choice for those looking for a stable income. With this structure, the only factor affecting a monthly payment is the claims-paying ability of the issuing insurance company or financial institution. However, if the fund performs well, the extra money will not be disbursed to the beneficiary.

Pro Tip

Not sure which annuity structure is best for you? Don’t be afraid to seek help from an insurance agent or professional financial advisor. After all, they do this for a living!

5 differences between pensions and annuities

As mentioned above, pensions are a specific type of annuity with a few interesting details that make them unique. Here are some of the important differences between pensions and annuities.

Pensions are funded by employers or the state

With most annuities, the beneficiary is the one making payments to the fund. With a pension, annuity payments are made by the employer (for private sector pensions) or the state (for government jobs or Social Security benefits).

Pension funds accumulate regularly

Another key difference is that pension funds accumulate through regular contributions. Employers or the state agree to make these payments on behalf of beneficiaries to ensure the pension fund remains solvent and pension payments can be disbursed regularly.

Pensions are not issued by insurance companies

Unlike pensions, annuity accounts are often offered by insurance companies as a form of generic retirement account. Traditional pension schemes, on the other hand, are set up by private companies or by the state to benefit large pools of employees.

Pensions are pools, while annuities are personal

One of the biggest differences between pensions and annuities is that a pension fund is a group product, whereas an annuity is tailored to an individual. When an employee retires, pension benefits are paid out as a lump sum payment or in periodic installments from the general fund. This is a major advantage of pension plans, provided they are well-managed.

Pension funds are protected by the government

The Pension Benefit Guaranty Corporation is a chartered corporation whose mission is to ensure pension fund solvency and secure pension benefits. Guaranty corporation guidelines provide support for struggling funds and restructure pensions as necessary, providing reduced pension payments and benefits to avoid fund collapse.

Because annuities are offered by private companies to individuals, they have no such protection from a government agency.

FAQ

Is a pension better than an annuity?

A pension plan may offer better benefits, and unlike annuities, pension funds are paid by employers to a general fund. However, an annuity can be structured very flexibly to meet individual retirement goals and needs. Because every retiree is different, it’s best to consult with a financial advisor about which option is better for you!

Can you have a pension and an annuity?

Yes. You will likely only get one pension from your employer, but an annuity is an insurance product that can be purchased privately by anyone.

Do I need an annuity if I already have a pension?

That depends on how comfortable you are with your current retirement savings and expected pension payments. An annuity is intended to serve as supplemental retirement income that provides you some income protection from more volatile investments. Talk to your financial advisor about what is right for you.

Is it better to get a lump sum payment or periodic payments from a pension?

Whether you should opt for a lump sum or periodic payouts from a pension depends on multiple factors. A lump sum will almost certainly be less than the total from long-term payouts, but you will have control of all your money sooner.

If the markets are performing well, you may be able to generate a lot more income by investing on your own. However, if you take monthly payments, the management of those funds is included in your plan without any additional fees or risks.

How much does a $100,000 annuity pay per month?

Every annuity is different, so it depends on when you want to begin receiving benefits and how long those benefits will last. On average, a $100,000 annuity that begins disbursing funds when you reach age 60 will probably pay around $500 a month.

Are pensions paid for life?

Unless you take a lump sum, pensions are required to pay you periodic benefits for life.

Key Takeaways

  • Both pensions and annuities offer a guaranteed income stream in retirement, which can be paid out as a lump sum or in regular payments.
  • Annuities are typically sold by private insurance companies or financial institutions, while pensions are a special type of annuity offered by employers to their employees.
  • A pension fund is a pool of funds for all of a company’s employees and is distributed based on a set structure. An annuity, on the other hand, is more flexible and can be tailored to fit an individual’s specific needs.
  • Pensions are paid for life and are protected by the government. An annuity, however, comes with risks and may not last for a retiree’s entire post-retirement life.
  • Whether a pension or an annuity is a better option for you depends on your individual goals and needs, so it’s best to consult with a financial advisor when putting together your retirement plan.
View Article Sources
  1. Topic No. 410 Pensions and Annuities – IRS.gov
  2. Retirement Plans Benefits and Savings – U.S. Department of Labor
  3. Annuities – Investor.gov
  4. Annuities – A Brief Description – IRS.gov
  5. Selecting Retirement Payout Methods – FINRA
  6. About PBGC – Pension Benefit Guaranty Corporation