The words “pension” and “annuity” are both sometimes used to describe the same financial arrangement – a stream of money paid regularly to somebody who is no longer employed and lasting for the lifetime of the recipient. The words are also used to denote the contractual terms that govern the payments. It comes as no surprise, then, to discover that some annuities can perform the functions of a pension. Highlighting the many similarities and the few important differences between pensions and annuities enriches both of these financial tools.
Fundamental Pension Principles
A pension plan is a tax-deferred savings vehicle funded by regular contributions. The plan may be sponsored by an employer, a trade union or association, an insurance company or a level of government. Typically, the contributions are shared by the plan sponsor and the pension recipient. Pension plans are often referred to by this name in the U.K., as “retirement plans” in the U.S. and as “superannuations” in Australia. The most ubiquitous form of pension is the so-called social pension exemplified by Social Security distributions in the U.S. and National Insurance payments in the U.K.
In economic terms, a pension plan utilizes saving to redistribute consumption from earning years to retirement or non-earning years. Well-accepted theories of consumption, such as Milton Friedman’s “permanent income” hypothesis and Franco Modigliani’s “life-cycle” hypothesis predict that most people will engage in such behavior. In accounting terms, pensions are a “defined benefit” form of retirement saving in that the pension plan specifies a formula by which the pension payment will be calculated. In the U.S., the most popular such formula is “final average pay,” which fixes the pension payment at the recipient’s average level of monthly earnings in his or her last few years of employment. Other, more complicated formulas are in use, particularly in unionized sectors.
Although pensions can be either funded or unfunded, law and public policy in the U.S. and U.K. tend to require and encourage the funding of private pensions.
The “Pension Annuity”
A deferred fixed annuity bears a very close resemblance to a traditional pension. During the accumulation stage, the annuityholder makes regular payments to the issuer of the annuity, an insurance company. Those payments are invested and the gains grow tax-deferred. Just as with a pension, the accumulation phase eventually ends and the proceeds are distributed to the recipient. Although the dividing line between accumulation and distribution phases need not coincide with the point of retirement – as it does in a pension plan - this is the usual procedure. Once distribution payments begin, the general principle underlying an annuity mirrors that of the pension – to provide a level, lifelong income stream to the recipient.
Although the phrase “defined benefit” is seldom used in an annuity context, it is appropriate. The annuity contract spells out the income that can be expected in exchange for the regular contributions made during the accumulation phase. The annuity contract also normally allows for designation of a beneficiary who would receive a death benefit if the insured dies prematurely. Pension plans also can provide survivor or disability benefits.
The word “pension” can refer to the lifelong payments that conclude the pension contract rather than to the contractual arrangements. In this, it is analogous to the word “annuity.” Once again, there is an annuity that closely parallels that stream of pension payments. This is the single-premium immediate fixed annuity, in which the annuityholder makes one payment in order to assure the lifetime income stream that is achieved via gradual accumulation in a deferred annuity. The purchaser of a SPIA is essentially in the position of a pension holder who has just retired.
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The Pension Annuity: Substitute or Complement?
Up to this point, pensions and annuities have been portrayed as very similar financial vehicles used to defer consumption and taxes. They would appear to be economic substitutes. That is, a consumer would presumably choose one or the other but not purchase both. That is true in the sense that the simultaneous purchase of both is unusual. However, ketchup and mustard can be both substitutes and complements, not only for different consumers but also to the same consumer under different circumstances. Similarly, pensions and annuities can complement as well as compete with each other.
An employee may spend a lifetime working for one company, contributing to its pension plan. At retirement, he or she may choose between receiving the pension and withdrawing the lump-sum equivalent. (That equivalent sum would be calculated by an actuary engaged by the company.) One option often recommended by financial planners is to elect the lump-sum option, then purchase an immediate annuity with a payout sufficient to cover ordinary expenses.
The plan offers greater safety of principal and more flexibility than simply taking the pension. The safety of the pension depends of the security of the company’s payout ability, which in turn depends on its financial strength. The annuity payout is tied to the financial strength of the insurance company, which is not only more secure (due to the inherent diversification of its investment portfolio) but easier to assess (thanks to the various rating agencies that specialize in publicizing insurance-company financial ratings). This plan also creates the liquidity to allow the retiree to cope with emergencies, make a large purchase or take a long-cherished vacation.
The decision to use employee contributions to fund annuity purchases need not originate with the employee. Employers (or their financial representatives) may decide to fund a defined benefit retirement plan in just that manner. In effect, that is what certain governments – particularly Chile - have done by privatizing their sagging government-run social-insurance systems.
In the U.K., this complementary relationship is legally mandated. Employees taking a lump-sum payout at retirement are required by law to convert this to an annuity no later than age 75.
Differences Between Pensions and Annuities
Variable annuities, whether immediate or deferred, belong to a “defined contribution” model of retirement plan rather than the “defined benefit” model of pensions and fixed annuities. The benefit received by the retiree upon distribution depends not on previous contractual stipulation but rather on the investment performance of the contributions. In this case, the difference between pension and annuity is pronounced.
One seemingly obvious difference between a pension and an annuity is much less significant than it appears to be. Employers often contribute to employee pensions, sometimes by matching the employee contribution. Although employers do not contribute to annuity purchases in this way, this does not really constitute a serious difference between the two methods. Economists have long pointed out that employees do not really benefit from employer “contributions” to the Social Security payroll tax; employers are willing to hire for a certain level of total compensation and simply pay lower wages to counterbalance the Social Security contribution. The same is true of pension “contributions.”
There are, however, significant differences between pensions and annuities. One such difference points up a key use of annuities in retirement planning. The IRS imposes a 10% penalty on withdrawal of annuity income prior to age 59 ½. This allows an annuityholder to retire and take annuity income beginning at age 59 ½ and defer receipt of Social Security until age 65, rather than holding up retirement until age 65 or retiring at 62 but settling for a lower Social Security payout.
Another difference rebounds to the benefit of the annuity. Recent history has shown that pension benefits are an obligation that beleaguered companies strive to unload. They sometimes succeed. While insurance companies do (rarely) fail, this possibility can be anticipated with greater success than the failure of other businesses. (The emergency procedures for protecting policyholders are also more promising than the pension-guarantee mechanisms.)
Annuities often have high expenses and almost always have surrender charges. These obstacles to liquidity can either be overcome – by choosing a low-expense fund – or outlasted – by outwaiting the surrender period. Moreover, annuity contracts often offer limited scope for withdrawals (accrued annual interest in fixed annuities) and are now beginning to offer inflation-adjustment options. Pensions typically lack this degree of flexibility.
Pensions and annuities are very closely similar in concept. Fixed deferred annuities and single-premium immediate fixed annuities perform functions that are virtually identical to those performed by pension plans and pension payments, respectively. Although it is usual to regard pensions and annuities as economic substitutes, the two can complement each other in various ways – typically when annuities are used to fund lump-sum payouts of pension plans at separation of service. There are meaningful differences between annuities and pensions. Some of these are tied to the type of annuity contract – variable annuities are unlike pensions – while others are related to the additional flexibility provided by annuities.
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