What are pension annuities?

There are numerous ways to save for retirement. One option is a pension annuity, which provides guaranteed income throughout your retirement.

But the phrase “pension annuity” can mean different things, depending on who you ask. In this article, we dive into the different meanings of pension annuities, explaining how they work and the factors to consider when deciding if it’s right for you.

What is a pension annuity?

The term pension annuity is more of a generic phrase than a specific financial product, so it can mean a couple of different things, depending on the context.

When your job offers a defined benefit plan, better known as a pension, you generally have two ways to receive that money in retirement: As a single lump-sum payout or as a stream of monthly payments that lasts the rest of your life. The latter option is referred to as a pension annuity.

Pension annuities provide a reliable source of income, often at competitive rates. However, they can be restrictive. You may have limited flexibility regarding when payments begin and the type of payout (such as single life vs. joint and survivor for couples). In some cases, your plan might require you to take the entire amount as an annuity, eliminating the option for a lump sum payout.

But the term pension annuity can refer to something else, too. You might be able to use part or all of your lump-sum pension payout to purchase a retail annuity, a similar product sold by private insurance companies.

Retail annuities are more customizable and may offer the potential for greater flexibility. You have more control over when payments start and how often you receive them. For example, you can wait until you’re older to purchase a retail annuity or buy an annuity with only part of the lump sum amount.

“Private annuities often come with features that pensions usually don’t offer, such as inflation protection and long-term care coverage,” says James Ustby, a fiduciary and fixed annuity specialist at LPL Financial. However, it’s important to note that these private annuity features often come at an added cost.

Additionally, opting for a private annuity gives you the opportunity to shop around for the best rates from different insurance companies.

“It’s possible the payout rates could be higher [with a retail annuity],” says Scott Witt, a fee-only insurance advisor at Witt Actuarial Services. “I also suppose it’s possible that someone is less worried about the solvency of the insurance company than the pension plan.”

Trading in pension funds for a private annuity comes at a cost, though. Retail annuities might require a larger initial investment from your lump sum to achieve the same income level as a pension annuity. This can be especially true for women due to their longer average life expectancy. There are also fees and tax implications to consider.

Online annuity calculators can help you compare the monthly income you’d receive from your pension plan versus a retail annuity purchased with your lump sum.

How a pension annuity works

The process of purchasing an annuity with pension funds is pretty straightforward. You contribute a lump sum of money to the insurance company. This amount, along with the chosen annuity type and other factors, determines the size and frequency of your future payouts. The insurance company then invests your contribution and utilizes a portion of the investment returns to make your regular payments.

You can typically choose to receive payments immediately or defer them to a later date.

Types of pension annuities

When you purchase a retail annuity with pension funds, you’ll need to make a lot of decisions. One of the most important decisions is the type of annuity product you want to buy.

Here are some of the most common options:

Pension annuity pros and cons

You worked hard for your pension, so understanding the pros and cons of receiving regular payouts as an annuity is essential.

How much do pension annuities pay out?

The payout amount of a retail annuity purchased with pension funds depends on multiple factors, including:

• Your purchase amount: The larger your initial contribution, the higher your monthly payments will be.
• Your age: Younger people typically receive lower payouts due to their longer life expectancy.
• Type of annuity: Different annuity types have different payout structures. Fixed annuities, for example, offer guaranteed rates, while variable annuities fluctuate based on market performance.
• Interest rate environment: Higher interest rates generally translate to higher payouts for fixed annuities.

Pension annuities and taxes

Both pensions and withdrawals from tax-deferred annuities are taxed as income in the year you receive the money. These taxes eat into your available funds, reducing the amount you have left to spend.

Regular pension payments generally have federal income tax withheld at your regular rate as you receive the money. This helps ensure you’ve prepaid at least some of the taxes owed. However, if you opt for a lump-sum payout from your pension, the total tax bill comes due when you file your tax return for the year you receive the money.

If you’re offered the full lump sum but are still interested in an annuity, you could roll the entire amount into an IRA first. Then you can use a portion of those IRA funds to purchase an annuity in the open market. This approach allows you to potentially defer taxes while still enjoying the benefits of an annuity. Once your money is in an IRA, future withdrawals will follow standard IRA distribution and tax rules.

Remember, the tax landscape is complex and your personal tax situation is unique. To make the most of your pension, speak with a qualified tax professional. They can assess your entire financial picture and evaluate the potential tax bite of either a pension annuity, lump-sum payment or a retail annuity purchased with a lump-sum pension payout.

How to buy a pension annuity

Purchasing an annuity with pension funds involves careful consideration and planning.

Start by evaluating your needs. How much retirement income do you need? Are you comfortable with some risk, or do you want predictability? Consider your existing sources of income, such as Social Security and IRAs, to determine your overall financial picture.

Next, research and explore annuity providers. Compare rates, fees and the features offered by multiple insurance companies. Prioritize reputable companies with strong financials to ensure your investment is secure.

After you find a reputable company and an annuity product that meets your needs, make sure to thoroughly read the annuity contract. Pay close attention to fees, surrender charges and payout options. Make sure you fully understand all terms and conditions before signing.

Finally, consider speaking with a qualified financial advisor who isn’t associated with the annuity company. They can assess your situation and recommend suitable options that align with your financial goals.

Should you buy a pension annuity?

Opting to receive either a full or partial payout from your pension in order to purchase a retail annuity can be complicated.

If you’re interested in regular, steady payments in retirement, you can always opt for regular payments from your pension provider. You don’t need to take that money to an insurance company, which will provide a very similar service, but with added fees and tax implications.

If receiving guaranteed benefits is a priority, sticking with the pension plan might be the best option. However, if you choose a lump sum distribution and purchase a retail annuity with those funds, make sure to research your state’s guaranty fund, which offers some protection for owners of private-sector annuities in case the insurance company that issued the annuity goes bankrupt.

Alternatives to pension annuities

Pension annuities are just one way to receive income in retirement. Pensions are also increasingly rare in the private sector, and might not be an option for a majority of people.

Here are more common alternatives to pension annuities:

• Social Security: This government program provides monthly benefits based on your lifetime earnings with an annual cost-of-living adjustment.
• Traditional IRA or 401(k): These retirement accounts allow tax-deferred growth on your contributions, with withdrawals taxed as income in retirement.
• Roth IRA or 401(k): Contributions are made with after-tax dollars, but qualified withdrawals in retirement are generally tax-free.
• Investing in dividend-paying stocks: Investing in companies with a history of paying dividends can provide a steady stream of income in retirement.

Bottom line

Pension annuities offer a guaranteed income stream for your retirement, providing peace of mind and reducing the risk of outliving your savings. However, they come with limitations in terms of access to the principal amount. Speaking with a financial advisor can help you determine if a pension annuity is right for you.