What Is the Connection between Pensions and Annuities?

Annuities are life insurance contracts that provide the contract owner or annuitant with living benefits. Traditionally, pension plans took the form of annuities; this led many people to use the terms pension and annuity interchangeably. Toward the end of the 20th century many pension operators stopped using annuity based pension plans and moved funds to less expensive mutual fund or stock investment plans. Annuity pension plans provide participants with fixed monthly income payments whereas stock based plans have no benefit guarantees.

Both pensions and annuities are designed to generate income for retirees. Insurance companies sell the annuities that are often contained in pensions, and annuities that individuals can buy as stand-alone products. The insurance company funds the annuity buy charging an upfront premium. Purchasers or annuitants receive a return of premium as well as interest in a series of roughly equal payments that are structured to last for the annuitant's life.

Insurance providers use actuarial tables to predict the average life expectancy of annuity purchasers. Annuity issuers would go bankrupt if the payments that the annuitants received exceeded the premiums that annuity purchasers paid to buy the contracts. To reduce the chances of loss, insurance firms sell the same annuity products to large numbers of people and base monthly income payments upon the actuarial tables. The more annuities the firm sells, the less likely it is that a high percentage of contract purchasers will live longer than expected and put the insurance firm in financial peril. From an annuity issuer's perspective, annuity contracts are profitable if annuitants die earlier than expected because the issuer pays out less than anticipated in terms of living benefits.

Many insurance firms actively market annuity products to pension providers because pension plans have large numbers of participants and annuity providers need to sell annuities to large numbers of people in order to reduce the risk of loss. Employers and other pension plan providers are sometimes attracted by annuities because the potential income benefits are greater than the upfront cost. Additionally, some workers are more inclined to work for firms that offer lifetime income benefits in the form of pensions and annuities rather than firms that offer pension plans with no guarantees.

From the point of view of an employee or an insurer, pensions and annuities are an attractive combination. Conversely, from an employer's point of view, annuities are expensive to fund due to the large upfront premiums and the ongoing administrative costs. Many employers prefer to sponsor mutual fund based plans because the administrative costs are covered by the employee rather than the employer. While mutual fund plans include no guarantees, there are also no income caps so employees could potentially earn more than with traditional pensions and annuities.