Pensions Vs. Equity-Indexed Annuities

Pensions and equity-indexed annuities are two methods of saving for retirement.

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Employees now have a wide range of retirement account options from which to choose. Two options that have been available for decades are company pensions and annuities. Many larger companies still offer traditional pension plans, although this option is not as common as it was in the past. Annuities are instruments sold by banks and other financial institutions that are designed to grow funds deposited by an individual investor. The investor then receives payments from the annuity upon retirement.

Functions of a Pension

A pension plan is a form of savings account in which an employer contributes to a pool of funds reserved for an employee's retirement benefits. These funds, which are typically exempt from taxes, are then invested on the employee's behalf. The investment of these funds provides the employee with additional benefits when she retires. A pension plan functions as a partial transfer from the employee's current income flow toward future retirement income.

Examples of a Pension

The two primary examples of pension plans are those with defined benefit amounts and those with defined contributions. A defined-benefit plan states that the employer assures the employee will get a certain sum of money upon retirement, regardless of how the funds in the investment pool perform. A defined-contribution plan states that the employer will contribute specific amounts toward the pool of retirement funds, but the final amount of money the employee will receive upon retirement depends upon how well the fund's investments perform.

Functions of Equity-Indexed Annuities

An equity-indexed annuity is an annuity purchased from an insurance company that pays a return rate based on a designated equity-based index. The equity-indexed annuity offers a guaranteed minimum interest rate to protect investors from severe downturns in the equity markets. However, investors can also see higher returns from an equity-indexed annuity when the equity markets are on the rise. In these respects, they capture the best features of both fixed-rate and variable-rate annuities.

Examples of Equity-Indexed Annuities

Many equity-indexed annuities use the Standard & Poor's 500 Composite Stock Price Index, also called the S&P 500, as the index for their funds. If the S&P 500 earns 10 percent per year, the annuity holder would expect to earn a 10 percent annual return on the annuity. However, many equity-indexed annuities have management fees and caps on their return rates. For instance, an S&P 500-indexed annuity may have a cap of 9.5 percent and fees of 2.5 percent, for a total maximum return of 7 percent.