How a Pension Annuity Works and What It Pays You

A pension annuity converts your pension balance into monthly payments for life

A pension annuity is a contract between you and an insurance company where you hand over a lump sum of money — usually from a pension plan — and the company pays you a fixed amount every month for the rest of your life. You stop receiving payments when you die. The insurance company bets that you will not live as long as the average person; you bet that you will. One of you wins.

Most people encounter pension annuities when they leave a job with a traditional pension plan. Instead of taking a lump-sum payout, you can choose to have the plan buy an annuity on your behalf. The monthly payment is usually lower than the lump sum, but it comes in every month no matter what happens to the stock market or interest rates.

Pension annuities are different from the annuities you might buy on your own with retirement savings. A pension annuity is typically offered by your former employer's plan and is backed by insurance rules that protect the payments. You do not choose the insurance company — the pension plan does.

Key Takeaways

• A pension annuity pays you a fixed monthly amount for life in exchange for a lump sum, usually from your pension plan balance.
• The monthly payment depends on your age, gender, life expectancy tables, and current interest rates at the time you purchase.
• Once you start receiving payments, you cannot change your mind or access the remaining balance if you die early.
• You must choose between a pension annuity and a lump-sum payout when you leave a job with a traditional pension — you cannot have both.
• Pension annuities are insured and protected under federal law, so the payments continue even if the insurance company fails.

How the monthly payment amount is calculated

The insurance company uses three main pieces of information to set your monthly payment: your age when you start, your gender, and the interest rate environment at the time you buy the annuity. Younger people get smaller monthly payments because the company expects to pay them for longer. Men typically get slightly higher payments than women at the same age because life expectancy tables show men die earlier on average.

Interest rates matter because the insurance company invests your lump sum and uses the income to fund your payments. When interest rates are high, your monthly payment is higher. When rates are low, your payment is lower. This is why two people with identical pensions but buying annuities in different years may receive very different monthly amounts.

You will receive a written estimate before you decide. The estimate shows the exact monthly payment you would receive if you chose the annuity option. This number does not change once you lock it in — it is may provide for life.

Single-life versus joint-and-survivor annuities

When you choose a pension annuity, you also choose who receives payments after you die. A single-life annuity pays you a monthly amount for as long as you live. When you die, payments stop completely. Your beneficiary receives nothing. This option pays the most per month because the insurance company's obligation ends at your death.

A joint-and-survivor annuity continues to pay a surviving spouse or other beneficiary after you die, usually at 50 percent or 100 percent of your original payment. This option pays you less per month because the insurance company expects to make payments for longer. If you are married, your spouse may have a legal right to consent to or reject this choice.

Some plans offer a third option: a period-certain annuity that guarantees payments for a set number of years (such as 10 or 20 years) even if you die. If you die before the period ends, your beneficiary receives the remaining payments. This splits the difference in monthly payment between single-life and joint-and-survivor.

What happens if you die early

If you choose a single-life annuity and die one month after payments begin, the insurance company keeps the remaining balance. Your heirs receive nothing. This is the trade-off for the higher monthly payment. Many people find this unacceptable, which is why joint-and-survivor and period-certain options exist — they cost you money in the form of a lower monthly payment, but they protect your heirs.

If you choose a joint-and-survivor annuity and die, your surviving spouse continues to receive payments. The amount depends on the percentage you selected when you bought the annuity. A 100 percent survivor benefit means your spouse receives the same amount you did. A 50 percent benefit means they receive half. The higher the survivor percentage, the lower your initial monthly payment.

You cannot change your mind after payments begin. Once you have locked in a single-life annuity, you cannot switch to joint-and-survivor if your circumstances change. This is why the decision matters and why you should think carefully before choosing.

Pension annuity versus lump-sum payout

When you leave a job with a traditional pension, your plan usually offers two choices: take the pension annuity or take a lump sum. The lump sum is the present value of all your future pension payments, calculated using the plan's assumptions about interest rates and life expectancy. You can roll this lump sum into an IRA or another retirement account and manage it yourself.

The annuity guarantees you will not run out of money in retirement because payments continue for life. You do not have to worry about investment returns or market downturns. The trade-off is that you lose access to the money and cannot leave it to your heirs if you die early. The lump sum gives you control and flexibility, but it puts the burden on you to make the money last.

The choice depends on your health, your family history, your other sources of income, and your comfort with managing money. If you are in poor health or have a family history of early death, the lump sum may be better. If you are healthy, live a long time, and want may provide income, the annuity may be better. There is no universally correct answer.

Federal protections for pension annuities

Pension annuities are backed by the Pension Benefit Guaranty Corporation (PBGC), a federal agency that insures traditional pension plans. If the insurance company that issued your annuity fails, the PBGC steps in and continues your payments. This protection applies to annuities purchased through a pension plan, not to annuities you buy on your own.

The PBGC guarantees your monthly payment up to a maximum amount, which changes each year. For someone age 65 in 2024, the maximum may provide payment is roughly $6,800 per month, though this varies by age and other factors. If your annuity payment exceeds this limit, the amount above the limit is not protected. Your pension plan documents will tell you whether your payment falls within the may provide.

This protection is one reason pension annuities are considered safer than buying an annuity on your own with retirement savings. You are not relying solely on the insurance company's financial strength — the federal government backs the promise.

Taxes on pension annuity payments

Pension annuity payments are taxed as ordinary income in the year you receive them. If your pension came from a traditional (pre-tax) plan, the entire payment is taxable. If part of your pension came from after-tax contributions, a portion of each payment is tax-free — this is called the exclusion ratio.

Your pension plan will send you a Form 1099-R each January showing how much you received and how much is taxable. You report this on your tax return. The plan may also withhold federal income tax from your payment automatically, similar to how an employer withholds from a paycheck. You can adjust the withholding if you want to pay more or less tax during the year.

Pension annuity payments do not count as earned income, so they do not affect Social Security taxes or self-employment taxes. They may, however, affect whether your Social Security benefits are taxed, depending on your total income for the year.

Frequently Asked Questions

Can I take a lump sum instead of an annuity if my pension plan offers both?

Yes. Most traditional pension plans let you choose between an annuity and a lump-sum payout when you leave the job or reach retirement age. You cannot have both — you must pick one. The plan will give you written estimates of both options so you can compare.

What if I need access to the money after I choose an annuity?

You cannot access the remaining balance or change your mind once payments begin. This is why the decision is permanent and important. If you think you might need a large sum of money in the future, the lump-sum option may be better for you.

Do pension annuity payments increase with inflation?

Standard pension annuities pay a fixed amount every month for life, so the payment does not increase with inflation. Some pension plans offer a cost-of-living adjustment (COLA) that raises your payment by a set percentage each year, but this is less common and results in a lower starting payment. Check your plan documents to see if a COLA option is available.

What happens to my annuity if I move to another country?

Most pension plans continue to pay annuities to retirees living abroad, though some have restrictions or require additional paperwork. Contact your pension plan administrator before you move to confirm they will continue your payments and whether you need to update your address or banking information.

Is a pension annuity the same as an annuity I could buy with my IRA?

No. A pension annuity is offered by your employer's pension plan and is backed by the PBGC. An annuity you buy with IRA or other retirement savings is a contract between you and an insurance company, with no federal may provide. Pension annuities are typically safer because of the federal backing.