What’s the best approach for ensuring a steady stream of retirement income? Discussions of this question inevitably come down to the two primary options: group plans and individual contracts. Fewer people talk about how to make your money work smarter before retirement.
Knowledge of all your options and what they entail is essential if you want an optimized retirement strategy (including a more purpose-filled life).
Table Of Contents
- Social Security, Employer Pensions, Individual Annuities
- Similarities, Differences & the Meaning of “Guaranteed”
- The Future of Social Security
- What About Pensions?
- The Security of an Income that You Cannot Outlive
Social Security, Employer Pensions, Individual Annuities
Typical financial advice is entirely retirement-focused. While it’s not the ONLY strategy you should pursue, it is important to extend the lifetime of your income. And in fact, most developed nations have some kind of tax-funded national retirement program. In the United States, this is Social Security. These programs give almost everyone coverage and have mandatory participation (through taxes). Income pays out over the retiree’s lifetime, and in some cases, for the spouse, as well.
Then, there is another type of large-group mechanism for retirement income. This is the employer-sponsored pension. With an employer-sponsored pension, the employer establishes a plan and funds it so that employees have income benefits in retirement. Level of income earned during employment and years of service are usually key factors in the formula determining how much retirement income an employee will have. Like Social Security, employer pension plan benefits pay out over the retiree’s lifetime. They usually also include survivorship benefits.
Then, there’s the individual strategy for lifetime retirement income, which is to purchase an annuity from an insurance company. The individual receives a guaranteed stream of payments in return for depositing a lump sum with the company. The payment terms selected and the individual’s age and gender are key factors in determining the payment. An individual with an annuity is called an annuitant.
Like government programs and employer pensions, you can structure annuity payments to be paid over the annuitant’s lifetime. This is called the life-only option. With life and joint-survivor options, payments are made as long as the individual and a designated beneficiary live. There are other design options available too, such as payments for a specific period or a combination of lifetime and periodic payments.
An annuity offers flexibility and freedom. And now, more than ever, it offers a degree of certainty that pensions and Social Security don’t have. On one hand, pensions are slowly going extinct, due in large part to the Social Security program. And on the other hand, there are growing concerns over the longevity of the Social Security program’s funding.
Similarities, Differences & the Meaning of “Guaranteed”
In several ways, the working parts of government plans, employer pensions and individual annuities are quite similar. In all three program designs, payouts are determined by actuarial calculations involving age, projected lifespan, and the lump sums available to provide ongoing benefits. Beyond these basics, however, the plans are dramatically different.
Social Security and employer pensions both involve large groups of retirees, whose numbers are always changing (as some people become eligible and others die). Ongoing deposits to the plan are necessary to meet the funding obligations of large groups of people. With Social Security, these deposits come from taxes. With employer pensions, the employer must make annual contributions.
Annuities differ from both these options. For example, a Single Premium Immediate Annuity (SPIA) is a one time financial transaction involving a single person. This is a significant difference. It is important to note that SPIA’s are best suited to those in their 80s, as the lump sum payment fund the lifetime income. The younger you are, the larger the lump sum will need to be to provide significant income.
Put in the simplest terms, Social Security and employer pension plans are promises to deliver a retirement income. An individual annuity, on the other hand, is a contract. Understanding this difference makes it clear how much more reliable an annuity tends to be.
When we hear the word “guaranteed” with respect to Social Security and employer pensions, “guaranteed” means that participants can expect a retirement income. However, both the eligibility requirements and the amounts received may be subject to change. By contrast, the word “guaranteed” regarding individual annuities means that the insurance company has a legal obligation to honor the specific terms of the agreement without change for the entire period of the agreement.
Social Security participants (essentially all American wage-earners) make tax payments today, not knowing what they will receive in the future. Employees that will one day get an employer-sponsored pension are forgoing current income in exchange for their employer setting aside funds for retirement income. Again, employees don’t know the exact amount they will receive.
When you have a fixed annuity contract, however, you will know exactly what you will receive for your one-time payment. All payments have been made, and the terms of the agreement are precise.
Given these differences, it’s easy to answer the question of which retirement income format is truly “guaranteed.”
The Future of Social Security
Everyone knows that Social Security, in its present format, is under-funded. In other words, going forward there won’t be enough money to provide the benefits “guaranteed” by the program. Any proposed strategies are to reduce (or delay) benefits, or increase taxes, options which face some strong opposition from the electorate given the current state of the economy.
What does this mean for retirees and their income? The AARP reports that in 2020, the Social Security Board of Trustee declared that the surplus in the specific trust funds that fund benefits are expected to be depleted by 2035.
If this happens, Social Security’s benefit to pay retirees may be reduced by at approximately 21 percent. That means that retirees would only receive approximately 79 percent of the benefits to which they may be entitled.
The AARP article explains that while at the end of 2019 the trust funds had $2.9 trillion in reserves, trends in demographic changes will mean that eventually the funds won’t be enough to cover everyone’s retirement benefits. Economic effects of Covid-19 are exacerbating the situation.
So even though Social Security is described as “guaranteed,” how seriously can you take that when we hear about significant financial losses and irregular paychecks?
What About Pensions?
Employer pensions have some “guarantee” issues, as well. Diminished returns on investments combined with an expanding number of eligible retirees are leaving many employer pensions under-funded. As we see with Social Security, one of the proposed strategies for dealing with the funding dilemma is to decrease retiree benefits. Another option is to terminate the plan. If this happened, the Pension Benefit Guaranty Corporation would take it over. This is a government-sponsored pension insurance entity, which will also result in diminishing benefits for many retirees.
The facts of one 2010 lawsuit are still relevant and help communicate the precarious nature of the employer-funded model. In the lawsuit that was brought by Minnesota state employees and retirees against the state’s pension board, the employees and retirees argued that the board acted illegally when cutting promised benefits. Unfortunately, there was no legally binding contract between the state and the employees. In contrast to employee-sponsored pensions (and Social Security), annuities are legally binding contracts. The annuitant has already fulfilled his part of the contract by making full payment to the insurance company, and so the company is legally obligated to deliver the benefits as stipulated in the annuity agreement. The insurance company may not ask for additional funding or decrease benefits because it failed to perform.
In contrast to employee-sponsored pensions (and Social Security), annuities are legally binding contracts. The annuitant has already fulfilled his part of the contract by making full payment to the insurance company, and so the company is legally obligated to deliver the benefits as stipulated in the annuity agreement. The insurance company may not ask for additional funding or decrease benefits because it failed to perform.
The Security of an Income that You Cannot Outlive
Fortunately, insurance companies have an excellent track record when it comes to keeping their commitments. Annuities and life insurance policies are famously dependable and have been so since the 19th century. Even through the Great Depression, there were no losses among annuity owners.
The security of having an income you cannot exhaust or outlive is the true value of an annuity. Both government programs and employer pensions attempt, with good intentions, to deliver this type of retirement security. Yet because these plans involve so many people, require ongoing funding, and include multiple variables that could affect the solvency of the plan, the promised benefits are subject to change.
Individual fixed annuities offer the same income security features—with a much greater degree of assurance that the promised benefits will actually be delivered.
The difference between large group plans and individual annuities illustrates one of the apparent paradoxes of a free-market economy. Both Social Security and employer pensions have default participation that may or may not deliver their promised benefits. The iron-clad guarantee that an insurance company offers through legally binding contracts is what makes it so attractive.
Insurance companies transact business individually with large numbers of people. This creates economies of scale that mean that every annuitant will receive a certain and secure retirement income.
You may never have thought about it before, yet it couldn’t be clearer: purchasing annuities through reputable insurance companies is one of the most dependable tools you can use to optimize your income later in life. Even if the income from your annuity is simply one of several income streams, an annuity could be the strategy you have been seeking to ensure you achieve your retirement dreams.
And while annuities are best suited to those in their 80s, whole life insurance is an asset you can acquire at nearly any age to optimize your savings. A properly structured whole life policy can also optimize most other financial transactions and decisions you make, which can provide you with more options later in life. To learn more, read our article on Why Whole Life Insurance is an Asset–Not a Cost!
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