Introduction
Pensions and annuities have long been cornerstones of retirement planning for many Americans. While both offer financial security for the golden years, they are distinct in their structure and function. This article seeks to answer a crucial question: Are pensions and annuities redundant, or are they both necessary for ensuring a comfortable retirement? This question holds significant importance as it impacts retirement planning, longevity considerations, and income security.
Understanding the Basics
Since there is sometimes confusion when discussing annuities and pensions, we’ll briefly define and discuss both products.
What Is a Pension?
A pension plan is a retirement plan that requires employers to contribute to a pool of funds for a worker’s future benefit. This typically provides a guaranteed income for life based on salary and years of service. Each company will have their own formula for calculating payouts. Pensions are known as “defined benefit plans.” Generally, the employer makes the contributions to this plan. At times the employee is also required to contribute but some companies make it voluntary. This contrasts with a “defined contribution plan” such as a 401k plan. In a similar manner to how personal banking accounts can be covered by the FDIC; pensions are also covered by the Pension Benefit Guaranty Corporation or PBGC. What this means is that in the unfortunate event that the company who owns your pension fails, the PBGC will insure your account up to a maximum amount.
What Is an Annuity?
An annuity provides set income at an agreed-upon rate at payout. Annuities are sold by insurance companies and typically convert a lump sum payment into a stream of income, usually for life. They come in various forms: immediate, deferred, fixed, variable, indexed, etc.
Comparing Pension and Annuity Income
Similarities
The primary benefit (and similarity) of a pension and annuity is the guarantee of lifetime income. Creating an income floor with a combination of annuities and/or pensions and social security can provide a solid foundation to any retirement plan.
With this benefit of lifetime income comes the reduced risk of outliving your savings. The higher income floor you have means the less money needed out of your other savings accounts during retirement.
Another similarity between annuities and pensions is that both can be structured to continue providing benefits to a surviving spouse after the primary beneficiary is deceased.
Differences
Funding for an annuity is typically provided by the annuitant. For a pension, an employer is most likely to provide the funds. Although sometimes the employee is also able to contribute.
Since annuities are offered by many different companies in many different forms and fashions, the flexibility and customization options available are typically much larger. An employer funded pension program may have some customization options but are generally rigid with pre-defined rules.
Depending on the type of annuity, you may also have some control over the investments made. However, with a pension whoever is managing the fund typically has full control of the investment strategy.
Situations Where an Annuity May Be Helpful (Even with a Pension)
Supplementing Pension Income
Both pensions and annuities tend to suffer from some of the same drawbacks. One of the biggest is inflation risk. Although both, over time, will decrease in spending power, having both an annuity and pension will mitigate the effect of inflation. As previously stated, the higher the income floor the better.
An annuity may also be able to help bridge any gaps that may exist due to retiring early. For example, if you were to retire at 62, an annuity may help pay for healthcare (premiums, co-pays, etc.) until you reach 65 and are eligible for Medicare.
Diversifying Income Sources
Whether it is poor planning or lack of access, not everyone will have had the opportunity to have funded an IRA or 401k for their retirement. There are certainly scenarios where a person can do just fine in retirement on a combination of Social Security and a pension. But having an annuity could reduce the reliance on only those two streams of income. This would also protect against the risk of pension plan cuts or underfunding (especially in private plans).
Managing Longevity Risk
Many pension plans offer spousal benefits, but often at a reduced income rate. An annuity may be able to supplement the income for a surviving spouse if the pension doesn’t fully cover them.
When an Annuity Might Be Unnecessary
Healthy Emergency and Investment Assets
Perhaps someone was able to invest in an after-tax brokerage account or saved a large cash reserve during their working years. These types of accounts can provide much faster access to liquidity and provide far more flexibility than an annuity.
High Fees or Complex Terms
Depending on what you’re looking for, some annuities can come with high fees, surrender charges and costly/complicated riders. These may not be as cost effective as other investment options.
Conclusion
An annuity can serve as a valuable supplement to pension plans by providing additional income, particularly in addressing longevity risks and covering healthcare costs before Medicare eligibility. It can also diversify income sources and reduce reliance on Social Security and pensions. However, individuals with substantial emergency and investment assets may not need an annuity due to the flexibility and liquidity these accounts offer. Additionally, the high fees and complex terms of some annuities may make other investment options more appealing.
Ultimately, the decision to include an annuity in retirement planning should take into account one’s personal goals, income needs, risk tolerance, and overall financial situation. Seeking advice from a financial advisor can ensure that retirement plans are tailored to individual circumstances.