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Pension vs. Annuity: What’s the Difference?


Pensions and annuities are two common sources of retirement income. However, they are quite different, and come with their own advantages and disadvantages. Determining 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 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. If you’re unsure how to allocate your assets, consider creating a full asset allocation plan with a financial advisor

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. Then 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 worked 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.

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

Advantages of Pensions

  • Automatic Savings: One of the major advantages 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.
  • Easy to Receive Benefits: 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.
  • Insured: 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 to 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

  • Less Transparency: 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.
  • Estate Planning: 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 the remaining payments after your death.

What Is an Annuity?

A couple researching the difference between a pension vs. an 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

  • Control: 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.
  • Tax advantages: 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

  • 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.
  • Additional fees and commissions: 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.
  • Not flexible: Once you put money into an annuity, you cannot get it back. Unlike other retirement accounts, such as a 401(k), you cannot withdraw funds.
  • No insurance: 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: Key Differences and Considerations

When comparing pensions vs. annuities, here are three key differences that investors should keep in mind:

  • Investment options: Pension plans typically offer a range of investment options, which can include mutual funds, stocks and bonds. But these are selected and managed by the plan administrator. Annuities, on the other hand, generally offer fewer investment options and can often depend on the performance of the investment portfolio that is picked by the insurance company. This is the case with fixed annuities, which can be invested in corporate and government bonds. By contrast, the owners of variable annuities can pick underlying investments but have to take on much of the investment risk.
  • Fees: Pension plans and annuities both charge fees, but the fees associated with annuities are generally higher than those associated with pension plans. Annuity fees can include administrative fees, investment management fees, mortality and expense fees, and surrender charges if you withdraw funds before a certain time period. Pension plan fees, comparatively, may include administrative fees, investment management fees and sometimes a fee for early withdrawals.
  • Performance: The investment performance of a pension plan and an annuity can vary depending on the investment options and fees associated with each retirement product. Pension plans may offer higher returns if the investment options are managed effectively, while annuities provide a guaranteed income stream regardless of market performance.

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 an 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 that 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.

Bottom Line

A couple choosing whether to set up a pension vs. an annuity.

Whether you opt to receive regular payments from a pension vs. annuity, the 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 more money than you would otherwise have.

Tips to Help You Save for Retirement

  • When you think about retirement savings, it can also be helpful to consider enlisting the aid of a financial advisor. An advisor can help you create a plan to pursue your savings goals for both the short term and the long term. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • 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.

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