Is An Annuity Like A Pension?

Ron Tetley | August 6, 2014 | Annuity Basics

The decline of traditional pensions and steady erosion of Social Security benefits has started to leave most retirees without a source of guaranteed lifetime income. Plugging that hole is emerging as the most important retirement issue of our day. According to a Black Rock retirement survey, 77% of retirees wish they had locked in a guaranteed income stream when they retired, and 86% say their employer should have helped them arrange one.

When the Employee Retirement Income Security Act of 1974 (ERISA) was enacted, it changed the way companies look at pension plans. Before this law, pensions used to be “defined benefit” plans. In other words, if you work for so many years of service and are a certain age, the employer will give you a defined portion of your salary as a pension (for example, $3,000 per month). After this law was enacted, we moved into “defined contribution” plans, where the employer contributes a certain amount into a retirement account (employees can also contribute part of their income), and at the time of retirement you have the balance of the account (401k) to take and use to supplement your retirement. Here, it is up to the employee to figure out how to turn this into income for the rest of his or her life. With the majority of 401ks invested in the stock market, this creates a huge problem. Employees typically do not know what to do with the investments, and even worse, they have no idea how to turn it into an income stream.

This is where annuities come in. Annuities have been used to solve the income problem for a long time. Every pension plan in America uses annuities to make the payments. Social Security uses a form of annuities, and if you win the lottery and choose the income stream, it pays out to you through an annuity. In fact, every country and company in the world uses annuities when they want to pay through a stream of income. To understand why annuities are so popular among governments and big businesses, we need to go back to the annuity’s roots. Where did they come from, and why were they started?

Annuities were first used over 2,000 years ago during the Roman Empire. The Roman government did not sell bonds to cover budget deficits or spending sprees like our government does. Instead, they went out to the Roman citizens and said, “Give us your money, and we will pay it back to you plus interest.” They named it “annuity” because the Latin word annua means annual payment. So, they paid the Roman citizens annual payments, including interest, for the borrowed use of their money.

Through the years, societies and nations have changed the way they use annuities (including the U.S.), but the general concept has remained the same: a structured periodic payment for a predetermined timeframe.

There are many different ways to take the income, but the two most popular are over your lifetime and for a certain period of time (10 years, 20 years, etc.). These payment options can get quite complex and can be mixed and matched – it’s enough to write another article, so I won’t go into more detail on payment options! You should consult with an advisor that understands ALL types of annuities and the different options for payouts before setting one up.

There are many different types of annuities, but they are all designed to be really good at one thing: INCOME. That is why you hear members of Congress, and even our President, touting the benefits of owning an annuity. Who does not want a guaranteed income stream?

So to answer the question in the title of this article: If all pensions use annuities to pay an income stream to eligible employees, then annuities are not just “like” pensions, they are pensions. Using annuities in your retirement planning can be an excellent answer for turning a portion of your retirement funds into an income stream you can count on.

 

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