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What Are the Different Types of Pension Annuities?

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  • Written By: Dale Marshall
  • Edited By: Jessica Seminara
  • Last Modified Date: 01 November 2016
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Pension annuities in the US have typically been established for the purpose of providing retirement income for workers. Employers may create them for the benefit of their employees, or unions might offer them for the benefit of their members who work for different participating employers. Most are funded by a combination of employee and employer contributions, although a small percentage is funded entirely by employers. The benefit is usually paid on a monthly basis to retirees who meet minimum standards of age and years of service, and may periodically be adjusted to account for cost of living. Some pension plans pay their retirees directly; others purchase pension annuities for retirees from an insurance company.

The retirement benefits paid by pension annuities generally fall into one of two categories: the defined benefit and the defined contribution. A defined benefit plan pays a monthly amount usually based on the retiree’s earnings and years of service. In the US, a very common formula is 2.5% of the average earnings over the last two years of service for each full year of service, with a cap of 75% or 80% of the final earnings. Under such a plan, after 20 years of service, a worker who meets the minimum age requirements would receive 50% of his average earnings over the last two years before retirement.

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A defined contribution plan, on the other hand, accumulates all the contributions made on an employee’s behalf, plus earnings. The employee’s monthly benefit is based on actuarial assumptions of the retiree’s life expectancy. This approach is much like the more modern retirement savings plans like the IRA, the 401(k) and the 403(b). In many cases, both the defined benefit and the defined contribution plans may permit participants to withdraw their contributions plus interest as a lump sum upon retirement, in exchange for a reduced benefit based only on the employer’s contributions.

Pension annuities also can be classified according to the duration of their benefits. Whether defined benefit or defined contribution, the benefit is generally paid out over the retiree’s lifetime, although a few pay only for a specified amount of time and then stop. If the retiree is married, though, the spouse must be included in the calculations. In states which permit such an option, if the participant selects the plan which pays 100% of the unmarried benefit, then the spouse receives no benefit once the retiree dies. Four or five additional payment formulas, designed to provide income to the surviving spouse after the retiree's death, are generally offered by most pension plans.

Generally, plan participants select from among the different options when they first enroll in the plan, but may change their selections whenever they care to. Married participants generally must obtain their spouses' consent for any selections which reduce the surviving spouse's benefit. Once the monthly pension payments begin, however, the choice generally becomes irrevocable.

Participants are usually concerned that any pension plans to which they've contributed pay them or their spouses at least what they themselves have contributed, plus any earnings. The issue is that the funds they’ve been contributing to their pension plans over the years not revert back to the employer or the insurance carrier in the event that they die shortly after pension payments begin. To address this concern, pension annuities provide for payments over a "period certain." If the named beneficiaries — the retiree and spouse — die before the period certain ends, payment is made to a third named beneficiary until the period certain expires, or a lump sum representing the unpaid balance of the annuity is paid over to the retiree’s estate.

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