What is a pension?
A pension is an employer-funded retirement plan, also known as a defined benefit plan.
It is characterized by regular monthly payments to the retiree after employment has ended.
Employees often work for years to earn credit toward these pension plans. They are more prevalent in the public sector, such as law enforcement and education. The employer determines investment decisions in a pension plan.
Pensions differ from other types of retirement plans, such as a 401(k), which are owned and controlled by the employee.
What are the advantages of a pension?
Guaranteed income: A pension provides a steady income in retirement, ensuring a stable retirement.
Not dependent on the market: Because a pension is defined by your years of service and not the market, there’s less of a worry that your retirement income will evaporate in unfavorable markets.
Higher investment amounts: Companies and governments that use pension plans contribute significantly to them. While you won’t have control over the investment, it is typically much more than companies that contribute to 401(k) accounts.
What are the disadvantages of a pension?
Limited: Not many employers offer pensions.
Years to become vested: If you have a pension, you must stay with your employer for a number of years
Company financials: You’re betting on the soundness of the company you worked for. It is possible they can default on pension payments.
Not portable: A pension plan doesn’t move from one employer to another as a 401(k) does.
Lack of control: You don’t have any control over the investments with a defined benefit contribution plan.
May not pass to your spouse: Some pension plans may have reduced benefits to surviving spouses.
What is an annuity?
An annuity is an insurance product that offers guaranteed monthly income, possibly for the rest of your life. The exact amount depends on your age and the annuity is structure. It can be funded up front or over time.
What are the advantages of an annuity?
Guaranteed income: An annuity is structured to give you guaranteed income and security in retirement.
Tax advantages: Some types of annuities offer tax-deferred growth.
Help manage market volatility: Annuities provide income regardless of market conditions.
Ensure you don’t outlive your savings: Annuities are an investment that offers returns to help your money grow with little risk.
What are the disadvantages of an annuity?
Liquidity: Once you invest in an annuity, your money is locked up for a set period before payouts begin. You can withdraw funds, but the money will be subject to insurance company fees and IRS penalties.
Cost: Annuities have high fees and commissions.
Complexity: Annuities can be confusing and may include various structures, exclusions, riders, and fees that can be overwhelming.
What are the similarities between annuities and pensions?
Here is a breakdown of some of the similarities between annuities and pensions:
| Annuities | Pensions | |
|---|---|---|
| Guaranteed income | Yes | Yes |
| Tax-deferred growth | Yes | Yes |
| Retirement focus | Yes | Yes |
Guaranteed income
The major similarity both annuities and pensions share is guaranteed monthly income. Annuities pay out monthly after they’re funded, while pensions pay out after the employee meets certain requirements (e.g., age, years of service, etc.).
Tax treatment
Both pensions and annuities grow tax-free and are typically taxed as ordinary income when distributions are taken in retirement. Taxes on annuities could vary depending on the annuity's structure and whether it was funded with pre-tax dollars.
See also: tax planning.
Retirement focus
Both annuities and pensions are designed for retirement income. They’re generally not accessible under a certain age (though there are exceptions).
What are the differences between annuities and pensions?
There are some differences between annuities and pensions, especially regarding funding source, flexibility, risk, cost, and control.
| Annuities | Pensions | |
|---|---|---|
| Funding source | Self | Employer |
| Flexibilty | Some | None |
| Risk and guarantees | Low | Low |
| Cost and fees | High | None |
| Control over investment | Some | None |
Funding source
With little exception, annuities are self-funded, while your employer funds pensions.
Flexibility
Annuities offer more flexibility than pension plans. Your employer defines pension plans with little variance, while annuities are insurance products chosen by you.
Risk and guarantees
Historically, pension plans have been administered by large companies and governments, which have lower risk. However, your employer can default on pension payments. You can also choose to leave an employer, and if you don’t have enough time vested with the employer, you may not have much to show for it.
An annuity shares the risk of default if the insurance company goes under, but there’s a higher likelihood you’ll see the money. The annuity stays with you, even if you change employers or don’t work for the same employer for a number of years.
Cost and fees
The employee bears the cost and fees of the annuity. The employer is responsible for the pension's administrative costs.
Control over investment
With a pension, there’s little control (if any) over the investments, allocations, distributions, and other requirements. You won’t see a statement or the results of investments made by the plan administrator. With an annuity, you can exercise a little more control in what you choose.
Is an annuity and a pension the same thing?
An annuity is not the same as a pension.
Both provide a consistent monthly income, but the funding source and underlying investment are vastly different.
The bottom line
To get the retirement you need, a financial plan is a must. To ensure you have the right investments in place, you’ll want professional financial advice.
Unbiased offers an easy way to get matched with a financial advisor who can advise on every aspect of your unique journey.