A 2024 AARP survey found that 61% of Americans are worried they won’t have enough money to retire. As you weigh your options and start building a resilient retirement income strategy, you may find yourself wavering on where and how to save. To help clear the waters, here’s a look at the basics of an annuity vs. pension plan funding and payouts. 

What Is an Annuity?

Annuities are contracts with an insurance company that guarantee future income in exchange for a premium Annuities are most often used to plan for retirement. You can pay your premium in a lump sum or in smaller payments made over time.

There are both fixed and variable annuities.

• Fixed annuities earn interest at a fixed rate set by the insurance company. Depending on the contract, this rate can increase or decrease during the accumulation phase, before you begin taking withdrawals. Your money is not exposed to external investments, such as stocks, so your annuity will not lose value due to market performance.
• Indexed annuities are a type of fixed annuity that earn interest based on the performance of market indices like the S&P 500, but aren’t directly tied to the market, and usually provide a guaranteed minimum interest rate.
• Variable annuities offer a varying rate of return tied to market performance. The money you’ve paid into the annuity as a premium may grow or shrink depending on the performance of your sub-accounts. 

Immediate annuities begin paying out within a year of purchase. Deferred annuities accumulate tax-deferred earnings until you begin receiving income, though you're required to wait a minimum number of years before taking full withdrawals.

Note: All guarantees are subject to the claims-paying ability of the insurer.

What Is a Pension?

A pension fund is a savings fund employers sponsor to benefit their employees. Employees who are “vested” have met certain requirements, such as working for the company for a minimum amount of time, and can collect a percentage of that fund upon retirement.

There are two main types of pension plans:

• Defined-benefit pension plans offer employees a specific income stream for life. Pension payments begin after retirement and are typically determined by a formula based on your age, earnings, and years of service with the employer. Pension fund investment performance has little bearing on the amount retirees receive and employers are obligated to cover pension payments if the fund doesn't have enough to cover them. Today, defined-benefit pension plans are rare in the private sector and are mainly found in government jobs.
• Defined-contribution pension plans prioritize employee-led contributions, with optional matched contributions by the employer. Employee benefit amounts depend on investments’ performance. If the fund runs out of money, the employer has no responsibility to cover benefits or make additional contributions. Examples include 401(k), 403(b), and profit-sharing plans.

Pensions may pay out in a lump sum, recurring annuitized payments, or a combination of the two. Lump-sum payments are calculated using current interest rates and the estimated lifetime value of the pension. Pension annuitization offers steady income for the rest of your life (or until funding runs out, depending on the plan). When the retired employee passes away, pension income may be reduced for their surviving spouse, or the income payments may stop altogether.

Don’t confuse annuities offered by private insurance companies with a pension that can be annuitized. They’re governed by different rules, are funded differently, and base payouts on different factors.

Pension vs. Annuity: Key Similarities

Though pensions and annuities are different products, they share the same purpose: to give retirees access to guaranteed income. There are other overlaps, too.

Timing

For the most part, annuities and pensions are long-term financial planning tools. It can take decades with an employer and hundreds of contributions to become fully vested in your pension. Deferred annuities can keep most of your money tied up into the account for several years before you can make unlimited withdrawal amounts without a penalty.

Tax Benefits

Pensions and annuities both have potential tax advantages. Pre-tax money contributed to a defined-contribution pension fund may be tax deductible within limits set by the IRS. In 2024, the IRS raised 401(k) limits to $23,000. After-tax pension contributions aren’t tax deductible, but they still grow tax-deferred, with deductions taken from earned interest when the fund eventually pays out.

Qualified annuities use pre-tax dollars for premium payments, while nonqualified annuities use after-tax dollars. Both earn tax-deferred interest.

Note: Any reference to the taxation of annuities in this material is based on Annuitiy.com’s understanding of current tax laws. We do not provide tax or legal advice. Please consult a qualified tax professional regarding your personal situation.

How Pensions and Annuities Differ

As you consider your retirement plan, take a minute to learn the differences between annuity and pension plan payouts, funding options, and other important terms.

Funding

Defined-benefit pension plans are mostly funded by employers with some allowing employee contributions. Defined-contribution plans are mostly funded by employees with some offering employer matching funds. Contributions are made regularly, often coinciding with company pay periods.

Annuities are funded by an individual, the annuity owner, either with a single lump-sum payment or via a series of payments made over time.

Payout Amounts

The amount you’ll add to your bank account via pension payments depends on your accrual rate. The length of time you were with your employer, your average compensation, and your age all come into play. 

Annuity payouts are based on the account value of your annuity at the time you begin taking income, plus the length of time you wish to receive income. If you opt for lifetime income, the payout percentage will be based on your age.

Payout Timing

For defined-benefit plans, you can start drawing from your pension once you retire, which is typically once you reach the age of 65. Some plans allow individuals access once they turn 55. However, early withdrawals may be capped at a certain percentage and you may receive less money overall. Defined contribution plans allow you to withdraw money penalty-free as early as age 59 ½.

Annuity payout dates are based on an agreed-upon annuity maturity date. You can technically access annuity funds at any time, as allowed by your contract. But if you withdraw or receive payments from your annuity before the age of 59 ½, you may be assessed fees from your insurance company and a 10% penalty from the IRS.

Bottom line: If you retire earlier than expected, you can start taking your pension income immediately, but an annuity can’t be turned into a recurring income until it reaches that maturity date.

Savings Protection

The Employee Retirement Income Security Act of 1974 (ERISA) protects consumers enrolled in private, voluntarily established retirement and health plans. Covered pensions must maintain certain standards and transparency regarding everything from how plans are funded to what’s required to be fully vested. The Pension Benefit Guaranty Corporation (PBGC) is tasked with safeguarding retirement incomes in the U.S. in accordance with ERISA.

Annuities are issued by insurance companies and are regulated by state insurance departments. They do not have the same level of protection as pension funds. Before buying an annuity, you should assess the financial strength and stability of the annuity provider, and read all contract terms closely. 

Adjustments for Inflation

Pension payouts are not typically adjusted for inflation, which can leave retirees vulnerable to the rising costs of housing, utilities, and food. With an annuity, you can purchase a cost-of-living adjustment (COLA) rider. This annuity add-on minimizes the impact of inflation by increasing monthly payments to reflect changes in the Consumer Price Index (CPI).

Note: Riders may be subject to eligibility and underwriting requirements, additional premium requirements and/or minimum or maximum coverage amounts. Availability and rider provisions may vary by state.

Deciding Between an Annuity Vs. Pension Plan

You may want a pension if:

• It’s offered by your employer and the terms are favorable.
• You’re excited by the idea of hands-off funding and investment strategies.
• Your employer has an attractive contribution matching plan.
• You prefer lower-risk investing and the protections of ERISA and the PBGC.

You may want an annuity if:

• You’re self-employed or work for an employer who doesn’t offer a pension plan.
• You prefer more control over the funding, terms, and risk level of your retirement account.
• You’ve reached maximum contribution to other retirement plans but want to keep saving and growing money on a tax-deferred basis.

Can Pensions and Annuities Coexist?

Not only can pensions and annuities coexist, but having both annuity payments and pension payments can be quite advantageous.

A sound retirement strategy should include multiple income streams. You might combine a riskier product with higher potential returns, such as a variable annuity or mutual fund, with an option that offers more financial stability, like a pension or fixed annuity. Or you might choose an annuity for additional retirement income after you’ve maxed out your pension.

Take this concept even further and you can complement the benefits of annuities by funding retirement through a work pension, social security benefits, and a private IRA. 

Planning for Your Post-Retirement Era

One-third of Americans say they won’t have enough money to be financially secure in retirement, and another 31% aren’t sure they’ll have enough saved before they retire. Even those with access to workplace retirement plans may find their coverage leaves a gap that fails to provide for essential expenses. Instead of viewing the annuity vs. pension conversation as an either-or scenario, try seeing it as an opportunity for diversification.

Reach out to one of Annuity.com’s trusted insurance agents for more information on how you can lay the groundwork for a more secure financial future.