5 differences between an annuity and pension

A pension is an employer-sponsored retirement plan, while an annuity is a personal contract you purchase to guarantee income later in life.

Annuities and pension plans are two popular ways to gain steady income after you stop working. While both aim to provide you with money in retirement, an annuity isn’t the same as a pension. Read on to compare annuities versus pension plans and understand which suits your financial goals best.

What’s an annuity?

An annuity is a financial contract with an insurance company where you pay a lump sum upfront or via regular payments. In return, they provide you with regular income later on. 

Think of this savings strategy as creating your retirement paycheck. You're trading a large amount of money now for a steady stream of payments later, which can last for a set number of years or even for the rest of your life. It's a way to ensure you have income during retirement.

Here's a simple breakdown of how annuities work:

1. Purchase: You can buy an annuity with money you've already paid taxes on or from a retirement account like a 401(k). 
2. Growth: Your earnings depend on the type of annuity you choose. For instance, a fixed annuity offers a fixed rate of return, and a variable annuity lets you take advantage of stock market performance.
3. Payouts: The insurance company will send you money for years or the rest of your life.

Flexibility is key here. Many annuity types exist, from fixed (not tied to an index’s performance) to variable (tied to an index), tax-deferred and not tax-deferred. That’s what makes annuities great — you can customize your annuity to suit your long-term financial goals.

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What’s a pension?

A pension is a retirement plan your employer provides that helps you build your retirement income. Your employer manages the account and ensures you receive regular payments once you retire. This differs slightly from defined contribution (DC) plans like a 401(k). In a DC plan, you and your employer may contribute money, but you manage the account and use it as income when you retire. Pensions can make retirement easier by giving you steady, predictable income, while DC plans put you in control of managing your funds.

With a pension, you may have options for how you receive your payments. You could set up continued payments for your spouse after you pass away or take a lump sum to use as you see fit. If you choose a lump sum, you’ll need to manage the money yourself, which comes with the risk of running out.

Here's a simple breakdown of how pensions work:

• Earning your pension: While working, your employer funds your pension account. In some cases, a percentage of your paycheck is also set aside. The amount put into this account by either you or your employer depends on factors like how long you've worked for the company and your salary.
• Getting paid: The company sends you a monthly check once you retire. Some pension plans last for a set number of years, while others last for life.

Some points worth mentioning:

• The monthly payout typically stays the same
• Payments continue even if you live much longer than expected
• Some plans offer options for your spouse to continue receiving payments after you pass
• If your employer goes bankrupt, the Pension Benefits Guaranty Corporation (PBGC) ensures you still get paid

In the U.S., pension plans are becoming less common. Instead, most private companies have switched to 401(k) plans, where you invest whatever amount you like (without exceeding the maximum you’re allowed to invest) through payroll deductions and your employer may match your contribution. You then use these savings as you wish once you retire. 

Annuities vs. pensions: 5 key differences

You can get a steady income through pensions and annuities, but their funding, management, and level of control differ. Understanding these differences helps you make thoughtful choices for your financial future. 

1. Source of funding

Either your employer fully funds your pension, or you also add to it by contributing a percentage of your salary each paycheck. And your employer manages the account as part of your benefits package. In contrast, you fund an annuity, using your savings to secure future income. But both can offer guaranteed payments for life. 

2. Risk and reward

Pensions offer the benefit of a guaranteed income for life, with little risk to you because your employer manages the investment. The main risk is that your pension depends on your employer’s financial health. If the company faces financial trouble, your employer may reduce your benefits.

Annuities, by contrast, give you more control over your retirement income. You customize your annuity to fit your needs, and many annuity types offer the possibility of tax-deferred growth.

But with this flexibility comes more risk. Some annuities — like variable annuities — are tied to a market index like the S&P 500^®, and your earnings are based on how this index performs. This offers a higher earnings potential as long as the market performs well, but it could also reduce earnings during poor market conditions.

3. Tax considerations

You will pay taxes on your pension payments just like on regular income. Taxes on annuities depend on how you funded them and the type of annuity you choose. If you used pre-tax dollars — like money from a retirement account — your annuity payments are taxed as regular income. And if you used after-tax money, only the earnings or interest from the annuity is taxed, while your original contribution remains tax-free. 

4. Fees and costs

Typically, your employer fully funds your pension plan, although some involve you contributing money from every paycheck.

Traditional annuities can come with high maintenance, administration, and commission fees. That said, digital annuity platforms like Gainbridge^® remove the middleman to reduce costs and keep more money in your pocket. But no matter the annuity provider you choose, there might be fees related to early annuity withdrawal, although some insurers allow you to withdraw up to 10% each year penalty-free. 

5. Investment control

For pension plans, the employer handles the funds and makes any investment decisions. And for annuities, your insurance provider can help you select the right annuity type and retirement strategy. This approach gives you more control but requires more personal involvement.

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Can you combine a pension with an annuity?

Yes, you can have both a pension and an annuity. Many people use them together as part of their retirement income strategy.

A pension is typically a monthly payment from your employer, while an annuity is a financial product you can purchase to create an additional income stream. Some individuals even use a portion of their pension money to buy an annuity, giving them more flexibility and security in retirement.

If your pension provides a basic monthly payment, an annuity can help supplement that income, protect against unexpected costs, or provide a buffer against inflation.

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FAQs

Is an annuity better than a pension?

Neither is better for everyone. An annuity is funded by you and offers more control and flexibility, while a pension provides guaranteed income typically fully funded by your employer. 

What’s an annuity’s biggest drawback?

Traditional annuity providers often have high administration, maintenance, and commission fees.

Is a retirement annuity the same as a pension fund?

No, they’re different financial products. An employer manages a pension fund and provides a fixed payment once you retire, and an annuity is a personal financial product you purchase that can offer more customizable allocation and payment options.

Are pensions paid for life? 

Most traditional pension plans provide payments for the rest of your life after retirement, but the terms depend on your employer's pension plan.

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This communication is for informational purposes only. It is not intended to provide, and should not be interpreted as, individualized investment, legal, or tax advice.