Running out of money is one of the biggest risks you can face in retirement, but you can take steps to help prevent it. Pensions and annuities are two tools you can use to secure a guaranteed source of income. While both can give you a steady stream of payments that last your entire lifetime, they do so in different ways.
Here’s a closer look at an annuity vs. pension to help you understand the similarities and key differences.
What Is a Pension?
A pension plan, also known as a defined benefit plan, is a retirement benefit an employer provides. Pensions can be structured differently, but all enable an employer to give workers a source of retirement savings.
Unlike a defined contribution plan such as a 401(k) or 403(b), most contributions to a pension plan typically come from the employer rather than the employee. This can be especially valuable if you don’t think you can afford to save much on your own.
Pros
- You can choose from a range of payout options.
- Some pensions include cost of living adjustments to help offset inflation.
Cons
- A pension is only available to you if your employer offers one.
- They are not portable and cannot be transferred to a different employer if you get a new job.
- Pension plans are not always flexible in regard to payments and withdrawal options.
- You may not be able to begin receiving payments until you retire.
- Pension benefits may be subject to vesting periods, which can reduce your benefit if you don’t stay with an employer for a minimum period of time.
- The employer’s financial health may impact its ability to make promised payments.
How Are Pension Payments Calculated?
The amount you receive in retirement is based on a formula described in the plan documents. It doesn’t depend on the investments’ performance in the account. Each employer has its own benefit formula, but most base the benefit on how long you’ve worked, your salary, and your age when you begin receiving benefits. The final benefit is often a percentage of your salary. For example, you may receive 75% of your final salary at retirement if you work 30 years but may get 50% if you work 20 years.
What Is an Annuity?
An annuity is an insurance product you purchase on your own. Like a pension, you can turn it into a guaranteed lifetime income stream.
You can pay for an annuity by making regular premium payments over several years or one lump-sum payment. Deferred annuities allow your annuity to grow before you receive payments, while immediate annuities allow you to collect payments immediately.
Pros
- You can pick any size you need.
- You can choose how to pay.
- You can choose from a range of payout options.
Cons
- You purchase an annuity with your own savings.
- Annuities don’t typically adjust for inflation (though you may be able to purchase an inflation rider).
How Are Annuity Payments Calculated?
The payment you receive from an annuity depends on a formula. It can also depend on the investments’ performance (based on the type of annuity you purchase). You can choose any size annuity to get the payout you’d like to receive. So, they’re especially attractive if you don’t have a pension or only have a small Social Security benefit and want additional guaranteed retirement income.
What Are the Available Payout Options?
Annuities and pensions offer several payout options. The best one for you depends on your income needs. Keep in mind that if you withdraw from an annuity or pension before you’re 59½, you’ll face an additional 10% early withdrawal penalty.
Lifetime Payouts
With a lifetime payment option, you receive a guaranteed benefit for life. This distinguishing feature of pensions and annuities makes them good retirement income tools.
Period Certain
You may be able to receive your payment for a fixed period, such as 10 years. Once the period ends, the payments stop. The trade-off is that your payments will be higher than if you chose the lifetime option. Period certain payments may be useful if you aren’t concerned about outliving your money or expect your expenses to be higher in the early years of retirement.
Lump-Sum Payments
Most pensions and annuities also allow you to receive your entire benefit in one lump sum rather than recurring payments.
Do Beneficiaries Receive Any Part of an Annuity or Pension?
With both annuities and pensions, you can choose a beneficiary combined with your payout option called a survivor option. It’s normally structured as a remainder percentage to your spouse. For example, you may choose a lifetime payout option with a 70% survivor payment. If the payout while you’re alive is $1,000 per month, your spouse would continue to receive $700 per month if you were to pass. Keep in mind that because the annuity or pension must pay out over two lives, choosing a larger survivor benefit results in a smaller initial payout.
Common survivor options include 50%, 70%, and 100%, but you may have other options too. For instance, guaranteed period payout options continue making payments to your estate or beneficiaries until the period ends. If you take your pension or annuity as a lump-sum payout, you don’t have an annuity or pension anymore—you have a sum of money. You’ll need to designate beneficiaries on the account you place that money in, such as an individual retirement account (IRA) or brokerage account.
Understanding Annuity vs. Pension Taxes
Annuities and pension benefits are subject to income taxes. That said, they may not be entirely taxable depending on who paid for it and where the money came from.
How Pensions Are Taxed
If your employer paid for your entire pension and you didn’t contribute anything, the benefit is included in your taxable income when you receive it. That’s also true if you paid into your pension and received a deduction for your contributions.
However, if you contributed after-tax dollars to your pension, you’ll receive those dollars back without additional taxes. Only a portion of each pension payment is taxable.
How Annuities Are Taxed
How your annuity is taxed depends on whether it’s qualified or nonqualified.
Qualified Annuities
You purchase qualified annuities with money inside a tax-deferred retirement account like an IRA or 401(k). Because money withdrawn from those accounts is fully taxable, your annuity payment is too.
Nonqualified Annuities
You purchase nonqualified annuities outside of a retirement plan. These are only partially taxable—you only owe taxes on the growth, not the premiums you paid into the annuity.
Related Considerations to Weigh
A few other factors can affect how annuities and pensions are taxed:
- If you choose a lump-sum payout, you may find that receiving such a large sum in a single tax year pushes you into a higher tax bracket. This could be inefficient from a tax perspective.
- Rolling a lump-sum payout into an IRA and taking the money out over several years could reduce the total taxes you pay.
- If you have a deferred annuity, it grows tax deferred. You don’t owe any taxes until you receive distributions.
Choosing the Option That’s Right for Your Retirement
Comparing the strengths and drawbacks of pensions and annuities can help you understand how each option may benefit you in retirement. For a deeper, more personalized look at your situation and needs, reach out to a financial professional. A Bankers Life representative can help you understand how pensions and annuities work and whether one might make sense for you.
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