Menu burger Close thin Facebook Twitter Google plus Linked in Reddit Email arrow-right-sm arrow-right
Tap on the profile icon to edit
your financial details.

pension vs. annuity

Pensions and annuities are two common sources of retirement income. However, they are quite different with their own advantages and disadvantages. Which one is better for you will depend on your individual circumstances. For example, some people may choose a pension because they already have good retirement savings and just want the steady pay. Other people may prefer the flexibility that comes with annuities. In this guide to the pension vs. annuity decision, we discuss the difference between taking your pension payments and taking your pension as a lump-sum and using it to open an annuity.

What Is a Pension?

A pension is a type of retirement account that some companies offer their employees. Your employer will create and maintain a pension fund for you. When you retire, you are eligible to start receiving payouts from your pension. The exact amount of your pension depends on factors that include your age, salary and the length of time you work for the employer. Pensions have declined in overall popularity but are still common for government workers.

When cashing out your pension, you have two options. One is to receive monthly payments. This provides a regular source of retirement income that you can count on as you plan your retirement budget. You can also choose to receive your pension as a lump-sum payment. This gives you access to all your money immediately and allows you to handle it as you’d like.

It’s important either way to remember that pensions are funded with pretax income. This lowers your taxable income when you’re working but means you’ll pay income tax on all pension payments (unless you contributed to your pension).

Advantages of Pensions

A major advantage of a pension comes while you’re working. Because your employer makes the contributions and handles the payouts, it frees you from having to worry about the finer details of saving while you’re working.

Likewise, you don’t have to worry about creating any contracts or agreements with your employer. If you have a pension, your employer will pay it out once you retire. This is similar to Social Security benefits in that you automatically get regular payments. You don’t have to do significant research, choose plans or set up a relationship with a bank or insurer that you don’t already know.

An advantage of pensions after you start payments is insurance from the Pension Benefits Guaranty Corporation (PBGC). The PBGC is an agency the U.S. government specifically created to protect private-sector pensions. If you have a private-sector pension and the company handling your pension goes bankrupt, the PBGC will step in to try and get you as much of your pension as possible. There is no guarantee you get your full pension, but you will probably get most of it.

Disadvantages of Pensions

In the pension vs. annuity comparison, the fact that you don’t need to handle the day-to-day maintenance of your pension is a disadvantage for some. It could mean less transparency about how much you have.

One other thing to consider is what happens to your pension when you die. Even if you still have pension money left to pay, your plan may end if you’re not there to collect the payments. So before you start collecting, ask if your family or someone else can collect remaining payments after your death.

What Is an Annuity?

pension vs. annuity

An annuity is an insurance product you get by signing a contract with an insurance company. You purchase the contract for a certain amount of money, which you will fund through either one lump-sum or periodic payments. The insurer will invest your money in mutual funds, stocks or bonds. When you retire (or sooner, depending on your contract) you can start to receive regular payments from your annuity.

Exactly when you start receiving payments (immediately versus at a later date), how long the payments last (for a set number of years versus until your death) and how much you receive per payment will all depend on your specific agreement.

Advantages of Annuities

In the pension vs. annuity debate, a big advantage of annuities is that you are the one who opens an annuity. You decide how much money to put in and you choose the exact contract that you sign. You have the ability to dictate what your payments look like.

For example, people who are worried about outliving their retirement funds can open an annuity that lasts until their death. Keep in mind that an annuity only pays you the money that you put in plus reasonable growth that money experiences from investing. You can also use an annuity to help your family fund expenses incurred from your death.

If you fund your annuity with after-tax money, you will not have to pay income tax when you receive that money later as a monthly payment. This provides a similar benefit to Roth IRAs.

Disadvantages of Annuities

The biggest disadvantage with annuities is their complexity. There are multiple types of annuities and you can change the terms of an annuity contract to meet your specific needs. If you’re unfamiliar with annuities, the process of finding one and agreeing on a contract could become overwhelming. We suggest talking with a financial advisor. An advisor is a professional who can walk you through all your options.

Another potential disadvantage with annuities: the additional fees and commissions you incur. Because the insurer is investing your money in the stock market for you, it will likely charge you some fees for the maintenance of your money. Individual funds will also charge fees. Make sure you understand all fees before signing any contracts.

Once you put money into an annuity, you also cannot get it back. Unlike other retirement account, such as a 401(k), you cannot withdraw funds.

Unlike pensions, an annuity is not insured. Losing your annuity payments isn’t necessarily a big concern if you work with a well-established insurance company. Still, it’s worth remembering as you shop around.

Pension vs. Annuity: Other Considerations

pension vs. annuity

In general, an annuity will give you the most control over your money. If you take a lump-sum pension payment, you have the ability to use the money however you choose. For some people it could make the most sense to use a portion of your lump-sum to purchase an annuity and then invest the rest in an IRA or other tax-deferred retirement account. This is beneficial since you will still have the advantage of a regular income via the annuity, plus other money that’s growing while remaining accessible in case of emergency.

In the pension vs. annuity match-up, a pension requires the least thought and planning from you. If you have any concerns about the future of the company who is paying your pension, getting your money in a lump-sum could be a wise choice. However, as mentioned, your pension is likely to pay out at least most of its value because federal law protects pension payments.

Pension vs. Annuity: Which You Should Choose

Whether you opt to receive regular payments from a pension vs. annuity payments will depend on your specific financial situation. Start with a retirement budget. Figure out how much you will spend on essentials. Then consider all your sources of retirement income. Do you have enough to cover what you need? If you do, consider taking your pension payments. You may not want to go through the work and cost of finding the best annuity. If you don’t have enough retirement income to cover your costs, then putting money into an annuity may be a way for you to earn some more money that you would otherwise have.

Tips to Help You Save for Retirement

  • The best way to start saving for retirement is by taking stock of what you already have. Then, as part of the budgeting process, you will know how much more income you need in order to meet your spending. Do you have any savings in an employer’s 401(k)? If you do, use this 401(k) calculator so you can see how much you will have in your account when you retire. For those who don’t have access to a retirement account through an employer, have you considered a traditional IRA or Roth IRA?
  • As you get closer to retirement, you’ll be looking into your Social Security benefits. Social Security provides a regular source of income but first you need to make sure that you apply for Social Security.
  • When you think about retirement savings, you should also think about financial advisors. An advisor can help you to create a plan that allows you to meet all your savings goals for both the short-term and the long-term. A matching tool like SmartAsset’s can help you find an advisor to work with who meets your needs. First you’ll answer a series of questions about your situation and goals. Then the program will narrow down your options to up to three advisors who suit your needs. You can then read their profiles to learn more about them, interview them on the phone or in person and choose who to work with in the future. This allows you to find a good fit while the program does much of the hard work for you.

Photo credit: ©iStock/shapecharge, ©iStock/Peopleimages, ©iStock/DragonImages

Danielle Klimashousky Danielle Klimashousky is a freelance writer who covers a variety of personal finance topics for SmartAsset. She is an expert on topics including credit cards and home buying. Danielle has a BA in English from Wesleyan University.
Was this content helpful?
Thanks for your input!

About Our Retirement Expert

Have a question? Ask our Retirement expert.