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American Pension System: Tearing Down the Annuity Puzzle

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American Pension System: Tearing Down the Annuity Puzzle

The private industry in the United States offers several retirement plans from government or state plans to those sponsored by private sectors. One of the pension plans in the U.S is the defined-benefit plan. It is an employer-sponsored plan. It means that employers make contributions, which are affected by factors such as one’s salary. The employer guarantees a payout or benefit to the worker once they retire. The plan is calculated based on one of the three defined-benefit formulas.

1. Final Pay. An employee’s peak or highest-earning years are averaged when computing for this formula. The period where the average earnings took is towards the last employment years.

2. Career-Average. This formula does not pinpoint a particular year/s. Instead, a worker’s earnings throughout his career are averaged – whole employment duration.

3. Flat Dollar. The number of years in the labor force is multiplied by a fixed or flat dollar rate obtained for each employment year.

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Management and calculations of defined-benefit plans are the employer’s responsibility, but it may still run dry because of potential economic crises despite careful planning. Still, don’t worry because regardless of whether the company files for bankruptcy or not, a defined-benefit plan intact for it is insured by the Pension Benefit Guaranty Corporation (PBGC). PBGC is a U.S government agency that protects around 30 million Americans from losing their benefits when their private pension runs out of funding. So, the dilemma you might face isn’t with your plan but with choosing the distribution payment.

The Annuity Puzzle

Retirement plans, including the defined-benefit program, offer the distribution option for lump-sum and monthly payments – with annuities being the default option. Nevertheless, there is this enigma called the “annuity puzzle.” It is the term used for the phenomena where people in their golden years still prefer lump-sum payments despite the extensive research and studies about how annuities secure pension income for a lifetime.

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There has been a shrinking number of people taking the default pension distribution as years go by. Moreover, some are even pessimistic that their pension plans would not cover the United States' rising inflation. A considerable percentage of the American population is shifting from annuitized pension plans to lump-sum, which they convert to IRAs or Individual Retirement Accounts. One of the reasons for pensions being less common is probably because they used to be inaccessible. The American pension system was almost exclusive only for the white male population earning average to high income. Women, and other minorities, did not qualify for pension plans. Other factors impacting the move from the annuity to lump-sum are:

1. The pensioner or retiree holds other accounts providing monthly payments like Social Security or Medicare.

2. They share the risk of lump-sum payments running out, for they have spouses or partners that have annuitized plans.

3. They want to extend their benefits to their dependents by setting up trust funds or IRAs for them to access.

4. Lump-sum payments provide flexibility in terms of withdrawals. Having easily liquidated accounts may be used for emergencies like covering medical expenses.

5. People are drawn to complete control and ownership of personal assets.

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So, given both present and historical data, Americans think it’s better to have individual accounts. This explains the growing transition from annuities to lump-sum payments. Who would blame them, right? Having access to a considerable amount, which you can use to set up personal accounts or invest, sounds tempting. However, another main reason people veer away from annuities is that they do not fully comprehend its concept.

Demolishing the Conundrum

You probably are already aware of how annuities are paid – the basics. An annuity offers recurring payments to the pensioner over a lifetime. But before deciding on a distribution plan for your pension fund and being attracted by a large one-time payout, you might want to review first the features of annuities. By doing so, you will see a full and clear picture of the benefits of choosing annuitized payments. There are several types of monthly payments or annuities to pick from that may break down some of the misconceptions or factors mentioned above that contribute to the annuity puzzle.

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1. Single-Life-Only Annuity

• Received throughout a lifetime

• Maximum monthly payouts

• Benefits cease once the pensioner passes

• No beneficiaries may be appointed

Suitable for those who are:

• In shape and do not have any illnesses – or those assumed to live a long life

• Planning to avail of life insurance that will better help their family when premature death occurs

• Not married or do not have any other dependents – single

• Married to a spouse of old age – or those that are likely to pass away before the pensioner does

• Married to someone who has their retirement or pension plans – or those whose spouse can provide for themselves

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2. Joint-and-Survivor Annuity

• Spouse has the right to claim pension benefits when the pensioner dies

• Initial pension received while the participant is still alive is smaller than that of the single-life-only option

• The participant's monthly allowance is reduced to cover the spouse’s percentage or payout once they pass.

• The payout may be the pensioner’s entire monthly payout, 75% of it, or even half.

• Some survivor annuities allow the pensioners to name other beneficiaries like their children; however, this option is unusual.

Suitable for those who are:

• Married

• likely to die first before their spouse who does not have any existing pension or retirement plans to cover their expenses – spouse to outlive pensioner

3. Term Annuity

• Payments are given only for a certain period – within a term

• Beneficiaries don’t necessarily have to be the spouse – it may be the children or other dependents of the pensioner

• Benefits are handed down to appointed beneficiaries until the period ends when the pensioner passes while the term is still going

• Payout value is between the single-life-only options and joint-and-survivor annuity

Suitable for those who are:

• In need of income to cover only short-term needs

• Looking for fixed payouts or pay for a particular number of years

• Aiming for a guaranteed income without reduction in the initial pension

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4. Term Annuity

• Payments are given only for a certain period – within a term

• Beneficiaries don’t necessarily have to be the spouse – it may be the children or other dependents of the pensioner

• Benefits are handed down to appointed beneficiaries until the period ends when the pensioner passes while the term is still going

• Payout value is between the single-life-only options and joint-and-survivor annuity

Suitable for those who are:

• In need of income to cover only short-term needs

• Looking for fixed payouts or pay for a particular number of years

• Aiming for a guaranteed income without reduction in the initial pension

5. Accelerated Annuity

• Lifetime monthly payments

• Option for other types of annuities like joint-and-survivor

• Level income until the pension is eligible to claim their Social Security benefit at 62

Suitable for those who are:

• Eyeing an early retirement

• Expected to have higher needs before the Social Security kicks in

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Annuity distribution options have different variations that people fail to understand. This is why some would choose lump-sum payments, but this poses several risks. One of these is the possibility of a one-time fee to run out after a few years. If you think you are not financially literate enough to handle your full pension yourself, the safer option is an annuity payment. Ensure that whatever choice you make, you know the possible consequences and threats it may bring to you and your dependents.

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