An annuity and a pension are different instruments used for retirement planning purposes. They are similar in their goal, but the source of the money is different for each as annuities are commonly funded by individuals while pension funds are funded by companies acting as employers.
The following article intends to explain the most important details, similarities, and differences between an annuity and a pension to help the reader in understanding how they work.
What is an Annuity?
Contents
An annuity is a financial instrument commonly offered by an insurance company as a retirement planning tool. This instrument is funded by individuals who periodically pay a certain amount during the accumulation stage of the annuity. This amount is invested by the insurance company and the resulting earnings are reinvested into the annuity to continue building the annuity’s capital.
Once the holder meets certain criteria, the annuity enters a distribution stage. At this point, the holder starts receiving a set of periodical and consecutive payments to cover for his living expenses during retirement.
Additionally, there are two types of annuities: fixed-rate annuities and variable rate annuities. Fixed-rate annuities offer the holder a minimum rate of return for the funds invested into the annuity while a variable-rate annuity offer the holder a rate that fluctuates according to the performance of a certain index or benchmark.
What is a Pension?
A pension is a retirement account set by an employer and commonly managed by an investment fund. This pension is funded by the employer, who makes regular contributions to it on behalf of its workers and also from deductions made to the worker’s paycheck and the funds are progressively invested to increase the Balance Sheet of the pension fund in order to cover current ongoing pension payments.
Once the employee retires, the pension fund issues a set of periodical payments to cover for his living expenses. The amount of these payments will depend on the amount earned by the worker during his years of service to the company.
Additionally, in some cases, the holder may choose to receive a lump sum payment instead of a set of installments.
Key Takeaways
Source of Income: Annuities are financial products purchased through insurance companies to provide a steady income stream, often used as part of individual retirement planning, whereas pensions are employer-sponsored retirement plans that offer employees a predetermined monthly income based on their salary and years of service.
Investment Control and Risk: Pension funds are typically managed by employers or appointed fund managers, with the employee bearing little to no investment risk. In contrast, some annuities allow for individual investment choice and management, with the annuity holder assuming varying levels of investment risk depending on the annuity type.
Tax Treatment: Pensions and annuities are both subject to income tax on distributions, but the tax treatment of contributions and investment growth can vary significantly. Pension benefits are usually funded with pre-tax dollars, offering tax-deferred growth, whereas annuities can be funded with either pre-tax (qualified) or after-tax (non-qualified) dollars, affecting their tax advantages.
Differences between Annuities and Pensions
Purpose of each
The purpose of a pension is to serve as a benefit for employees who can rely on their pension payments once they retire to cover for their living expenses. These pension funds are set by employers with this intention and they are fairly popular among government institutions and non-profits.
Annuities, on the other hand, are set by individuals either as a complementary fund to their employer-extended retirement accounts or by a self-employed individual as a retirement planning tool.
How are they purchased or setup?
Pension accounts are usually opened by the employer once the employee is considered a permanent employee as part of their contractual benefits. The employee doesn’t have to contribute anything to open the account as the contributions are directly deducted from his monthly paycheck and the employer also contributes a portion of the funds that go into the pension account.
In contrast, annuities are set up by individuals and they are commonly offered by insurances companies. They are similar to an insurance policy as there are several conditions that apply to various aspects of the annuity including payments, distributions, contingencies, and rates of return.
Calculation
Pension payments are usually calculated by analyzing the amount earned by the individual during his years of service and also by considering the number of years he served at the company.
The amount of each payment received through an annuity is estimated based on the outstanding balance of the annuity once the accumulation phase ends.
Advantages
The main advantage of a pension is the degree of certainty that it provides to the employee, as he can rest assured that he will receive a certain compensation for his years of service once he reaches his retirement age. Additionally, pension contributions are tax deductible, and also, the individual is free from the burden of managing the funds invested.
The most relevant advantages of an annuity are that the holder has more control over his retirement funds as the can choose between various annuities to pick the one that fits his particular situation the best. Additionally, most annuities give the holder the right to withdraw funds from it after a few years has passed without incurring any penalties.
Disadvantages
Pensions have their disadvantages. For example, pension funds don’t necessarily have to disclose how the invest the funds deducted from employees and they are less transparent when it comes to calculating the lump sum payment of a pension once the employee reaches his retirement age.
Annuities, on the other hand, also have a few negative aspects including the fact that individuals have to choose among various alternatives, which could be a difficult task for someone who is not well instructed in financial matters. Additionally, annuity contributions are not tax deductible.
- Guarantees to Recipients
- Stability
- Types
Annuity and Pension Examples
Irma is a 56-year old Executive Assistant to the VP of an important marketing agency in New York. This company is a multinational advertising powerhouse that has a pension plan for its workers. Irma currently earns a salary of $67,000 per year and according to the pension plan she will be entitled to receive ¾ of the average salary she earned during her last 3 years working for the company.
This means that if Irma retires with that salary she will receive nearly $50,000 every year until she dies.
Additionally, Irma decided to purchase an annuity from an insurance company that offers her an additional payment of $20,000 per year for 25 years if she agrees to contribute $8,000 every year for the next 15 years. Even though it is a big sacrifice, Irma thinks this additional income will give her the chance to enjoy a comfortable life style once she retires.
Botton Line
Annuities and pensions are retirement planning tools that have the same goal: support an individual once he reaches his retirement age. On the other hand, even though they share this goal, they work differently as one of them is setup by an employer directly while the other is purchased from an insurance company.
Frequently Asked Questions
What distinguishes an annuity from a pension in retirement planning?
An annuity is a financial product purchased from an insurance company that guarantees income for a specified period or for life, while a pension is an employer-provided plan that offers employees a fixed payout upon retirement, based on salary and years of service.
How do payouts from annuities compare to those from pension plans?
Annuity payouts depend on the terms of the contract, including the initial investment amount and the chosen payout option, whereas pension payouts are typically determined by the employee’s earnings history, tenure with the company, and the pension plan’s formula.
Can individuals control the investment decisions within annuities and pensions?
Individuals cannot control investment choices within a pension plan, as it is managed by the employer or a pension fund manager; however, with certain types of annuities, individuals may have options regarding how their contributions are invested.
What are the tax implications of receiving income from an annuity versus a pension?
Income from both annuities and pensions is generally subject to income tax; however, the specifics can vary based on whether the annuity was purchased with pre-tax or after-tax dollars and the nature of the pension plan contributions.
