Pension vs Annuity: How Are They Different, and How Should You Take Your Pension?
An annuity is a contract you can buy from an insurance company that will pay you a fixed sum of money every year in retirement, for the rest of your life. If you have a pension, you’ll likely have the option to take your pension fund payout either by annuity or lump sum. This is an important decision, as it cannot be changed and will impact your retirement security.
But which do you choose? The right choice depends on many factors, like if you’re single or married, how much control you wish to have over the investments, and when you plan to start pulling from the accounts. In this article, we’ll compare pension plans and annuities focusing on how you might choose to take your pension fund payouts in retirement.
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Annuity vs. Pension Fund
An annuity and a pension fund are two different forms of retirement assets, but they are both sources of retirement income. You can also purchase an annuity with your pension funds. When you’re approaching retirement, you’ll likely have the choice to either take your pension fund payout as an annuity, or invest it in a defined benefit annuity fund. We’ll explain these below.
A pension fund is the account from which you receive your pension payments in retirement. Usually, pensions are funded by regular contributions from yourself, your employer, or both, while you worked.
Pension plans are defined benefit plans, meaning they provide a guaranteed monthly income benefit for your entire life after retirement. Your employer can implement different provisions to the plan, so it’s important to know the rules of your pension.
Unlike a retirement account that funds are contributed to over time, an annuity is a financial product you can purchase. Similar to the pension fund, an annuity provides regular monthly retirement income for the remainder of your life, and potentially the remainder of your spouse’s life.
Annuities aren’t usually funded by your employer, as a pension would be. But, since pensions are becoming rare unless you work in a government organization, annuities are more common. If your employer does provide a pension fund, you can purchase your own annuity to help supplement your retirement income by collecting annuity payments along with your pension payment.
Pension Plans: Lump Sum vs. Annuity
When it comes time to retire and start receiving your pension fund checks, you can choose to either receive your funds as a lump sum or annuity. We’ll explain the differences below.
Taking Your Pension as an Annuity
The major benefit of taking your pension fund payout as an annuity is that it still carries the benefit of guaranteed monthly income for life. You also might want to consider the annuity option if you’re not much of an investor.
Think about how you want to live your life in retirement. If you plan to live with minimal monthly expenses and don’t want the hassle managing your own investment decisions — the annuity option would be perfect for you. Keep in mind that with this option, your monthly payout won’t increase with inflation and you won’t have any control over how the money is managed.
Taking Your Pension as a Lump Sum
The lump sum option can be tricky. You might feel that your employer or fund managers are really pushing for this choice. But is this the right choice for you?
On one hand, the lump sum option can be attractive because it’s all of your retirement funds given to you at one time. This opens up your possibilities for reinvesting and growing your nest egg, but this also increases your risk of losing it all. Mismanaging your lump sum pension could mean you run out of your retirement savings early.
Taking your pension as a lump sum often means you forego any rights to guaranteed retirement income as well. The PBGC (Pension Benefit Guaranty Corporation) insures at least a portion of your pension funds so even if your employer mismanages the funds, you’ll still get your guaranteed payout, or at least most of it.
It’s essential to know the legal terms of your pension fund before deciding if you want to take your payout as a lump sum or annuity. Organizations like CFPB (Consumer Financial Protection Bureau) have published guides to help you better navigate your options.
Choosing between taking your pension payout as a lump sum or annuity is a tough decision, and a permanent one. Make sure you know the difference between your options, know the terms of your plan, and know the risks involved with each choice.
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Tylene is a freelancer in Boise, Idaho. She's a self-taught personal finance hacker with zero debt. She eats avocado toast for breakfast.
This post was updated February 28, 2019. It was originally published April 26, 2018.