Annuity as a Retirement Saviour

Given the economically uncertain times that we now live in, most people prefer to embark on a sound investment plan at an early age to be able to generate a fixed income during their years of retirement. An annuity plan is one such option that locks your investment per month to be able to create a corpus which will pay back a regular amount each month on retirement. The article highlights the pros and cons of annuity plans while comparing them with other options 

Anil Kapoor is a retired man now. Nonetheless, he had planned for his retirement during his heydays and has invested judiciously in both equity and debt to take care of his second innings. However, the recent heightened volatility in the equity market has made him a worried man. Bellwether equity indices are swinging by a couple of percentage points quite effortlessly. Even the much stable debt market is witnessing a rise in volatility of its benchmark yield. For someone who has invested for the long term, these uncertainties may not impact much but for a retiree like Kapoor, who depends upon his investment in these securities to withdraw his regular income, any such uncertainty can be unsettling.

He would rather have regular and guaranteed income in his golden years and such volatility may push him into sleepless nights. As in the case of Kapoor, if you are one of those looking for regular and guaranteed income in your sunset years, allocating a part of your retirement corpus to a suitable annuity product may be the answer. These products are specifically designed to meet long-term retirement needs. However, before diving deep into the details of annuity, let us first try to understand the product itself.

Annuity Plans

An annuity plan is mostly offered by insurance companies. After you pay a lump sum to an insurance company, it invests this amount and pays back the returns generated from it in the form of regular payment. Hence, annuity is a plan that helps you to get regular payment for life after making a lump sum investment. However, though annuity plans are offered by insurance companies, they do not cover your life under annuity in most of the cases. But you can select a product that offers both annuity and life cover. Post retirement, the risk-taking ability of an investor declines significantly in the absence of regular income and in such a case annuities provide some relief.

Types of Annuities

Typically, any retirement strategy involves two stages. First is the accumulation phase and the second is the distribution phase. In the accumulation phase you save and invest for your retirement without withdrawing from it. Once you are retired, you start withdrawing from your corpus to meet your regular needs, which is known as the distribution phase. So, broadly speaking, annuities can be of two types depending upon when you buy them – deferred or immediate.

In the case of deferred annuity you first contribute towards your retirement corpus steadily when you are earning and once you retire, you can use the accumulated amount to buy an annuity plan. Most insurance companies enable you to build the corpus through a pension plan. When the tenure of the pension plan ends, you use the accumulated money to buy annuity. If at the accumulation stage you have invested in a pension plan from an insurance company, then it is compulsory to invest at least one-third of the amount that you get from this instrument in an annuity plan at the time of retirement. For example, consider the case of Arjun Sinha (35) who wants to retire at the age of 60. He has been investing Rs50,000 every year towards annuity i.e. about Rs4,133 per month. Assuming he earns 9 per cent every year on his investment, over the next 25 years his total investment would be around Rs12.5 lakhs. This investment would grow to Rs46.70 lakhs by the time he retires. If he buys annuity of this amount he will get monthly pension of Rs23,342 every month on retirement.

National Pension System (NPS)

I ndia moved on to a defined contribution-based pension system in 2004 based on the recommendations of two committees. The New Pension Scheme, now renamed as National Pension System (NPS), is a pension system administered and regulated by the Pension Fund Regulatory and Development Authority (PFRDA), which was initiated with all government employees joining from January 1, 2004. The scheme was initially made compulsory for government employees, and then in 2009, opened on voluntary basis to the general public.

The scheme is portable across jobs and locations, with tax benefits under Section 80 C and Section 80 CCD. You are compulsorily required to keep aside at least 40 per cent of the corpus to receive a regular pension from a PFRDA-registered insurance firm. The remaining 60 per cent is tax-free now. The two primary account types under the NPS are Tier I and II. The former is a default account while the latter is voluntary addition. The table below explains the two account types in detail.

Now take the case of immediate annuity. There may be a scenario where you have not planned earlier for such pension. However, once you reach close to the retirement age you realise its importance and want to add annuity in your retirement plan. You can allocate your provident fund, gratuity or any other fund to buy an immediate annuity plan where you pay a lump sum amount rather than a number of premiums over time as seen in the earlier case. This instrument then provides you with regular guaranteed payouts. Therefore, an immediate annuity is purchased by someone who is about to retire and would like to receive a monthly income right away.

Annuity Options

Once you have purchased an annuity plan there are many options that you can select depending upon your requirement. Essentially, they can be classified based on the timing of the benefit, variability of the benefit and coverage of the benefit. We will walk you through an example of how much you will get if you buy annuity of Rs1 crore at the age of 60 under different options. These rates of returns are not cast in stone and will change depending on the overall interest rate scenario in the economy.

1. Annuity Payable for Life: Under this plan, fixed annuity is payable to the annuitant (purchaser of annuity) throughout his life. This is most suitable for those who do not have much financial responsibility or obligation post their death. The highest amount of annuity is payable in such a case. For example, if you have bought an annuity of Rs1 crore, you can get around Rs8.07 lakhs every year till the time you are alive.
2. Annuity with Cash-Back: If you have a financial dependent and you want to leave an amount for your dependents, then go for this option. The annuitant will get pension till he dies and after his death the purchase price will be given to the nominee. Continuing with the above illustration of a corpus of Rs1 crore, you will get Rs6.09 lakhs every year.
3. Annuity Payable for Life with Guaranteed Period: With this option, annuity payout will be made at least for a guaranteed period of 5, 10, 15 or 20 years as chosen by the annuitant irrespective of the survival of the annuitant. In case the annuitant survives the chosen guaranteed term, the payout will continue throughout his lifetime and on death the annuity payout will cease. Upon death of the Now take the case of immediate annuity. annuitant during the guaranteed term, the annuity payout to the nominee will continue till the expiry of the guaranteed term. In the above case, if somebody has opted for 20 years of guaranteed income, he will get Rs7.57 lakhs every month. This is suitable for someone who has yet to fulfil his financial responsibility and has retired. He can buy such an annuity product for the next 5-10 years.
4. Joint Life and Last Survivor Annuity: In this case the annuitant will receive pension till he dies. If his spouse survives then he or she is also entitled to the pension. With this option, annuity payout will be made throughout the lifetime of the primary annuitant and upon his or her death 100 per cent of the initial annuity payout will be made throughout the lifetime of the secondary annuitant or the surviving spouse. If the secondary annuitant predeceases the primary annuitant, 100 per cent of the annuity payouts shall continue for the primary annuitant. For a single premium of Rs1 crore, you will get Rs6.94 lakhs every year.

In addition to the above there may be many other variants of annuities and it will depend upon the annuity provider. From the above illustration one thing that is clear is that you get the highest payout if you opt for lifetime without any cash-back. In that case you get around 8 per cent return while in case you want to get cash-back as well as have annuity during your lifetime, you might get return in the vicinity of 6 per cent.

Annuity among Other Options

Looking at the above illustration, does it make sense to go for annuity? The answer to this will depend upon other options that an investor has. Let us compare some of the other popular options and how annuity fares against them. For instance, compare this with the Senior Citizen Savings Scheme (SCSS) that currently gives an interest rate of 7.4 per cent per annum. This is higher than all the other pension options we have discussed above except for lifetime annuity without cash-back where the rate of interest works out to be a little more than 8 per cent. India’s biggest lender, State Bank of India, gives around 7 per cent rate of interest to senior citizens on their fixed deposits. This also compares well with many of the annuity options discussed earlier.

Pradhan Mantri Vaya VandanaYojana (PMVVY), which is offered by Life Insurance Corporation (LIC), also gives pension to senior citizen. The tenure of the PMVVY can be extended to 10 years and the annual interest rate that it offers is 7.4 per cent. On the death of the pensioner at any time during the term of 10 years, the purchase price will be refunded to the legal heirs or nominees. This beats even the best of annuity plans. The only limitation with PMVVY and SCSS is that they have overall investment permissible limit of Rs15 lakhs per scheme. However, since PMVVY’s upper limit of Rs15 lakhs is per elderly people, if both the husband and wife are senior citizens, the family can spend Rs30 lakhs towards PMVVY and get up to Rs22,000 per month.

The above analysis does not paint a rosy picture about the annuity plans that are being offered now. What further dents the returns is the fact that the payout you receive from the annuity plan will be taxed. The total amount will be added to the income of the annuitant and taxed at marginal rates. However, one of the best arguments that go in favour of annuities is that it locks the interest rate for life. This may look attractive when the interest rate as such is high compared to historical averages. Nonetheless, in the current situation when the interest rate looks low against its historical average, locking in at a lower rate may not make much sense. If interest rates happen to rise, the retiree will continue to get the lower rate he signed up for.

This does not mean that the interest rate is going to be high going forward. However, one cannot rule out the possibility and therefore locking in a huge corpus into it is likely to impact your retirement plan. Hence, annuity should not be your first option when you are planning for retirement. It should be considered only if you believe that the interest rate is high and want to lock in at the higher rates. Besides, there are other benefits of buying annuity plan, especially for those who are prone to take emotional decisions. Once a person buys an annuity plan, the money is locked away permanently. Under no circumstances can the investor touch this money.

This protects a retiree from taking any emotional decision and diverting his retirement funds towards other use. Lack of liquidity in an annuity product can be a blessing in such cases. Buying annuity also eliminates the risks of outliving his corpus for a retiree. Another case in which annuity can be used is when you are in the latter sixties or early seventies and your investment is not earning enough to meet your expenses. Remember that the payout increases as a person grows older. The rate of return for someone buying in this period would be in the lower double digits of the purchase price for a life annuity variant wherein the nominee doesn’t get any money.

Therefore, annuity should be used as only part of your total retirement plan. It should be used in a limited way. You should first exhaust other options before considering annuity. Besides, your tax slab plays an important role in deciding if annuity should be considered or not. Annuity is recommended only to those who do not have a taxable income or those who are in the lowest tax bracket. For such investors, the tax won’t eat into their returns like it would in case of those who are in the 20 per cent and 30 per cent tax slabs.

Selecting an Annuity Plan

Once you have decided on the amount and type of annuity you need, the next step is how to select the right annuity plan. Like every other financial product, while buying an annuity plan you should consider the following three factors: first is safety, second is return and third is liquidity. While buying a product with such a long horizon, safety should come first. A person buying deferred annuity would keep contributing in the form of premiums to the insurer for a long time before retirement. If someone starts contributing towards a pension fund at the age of 35, he will continue to make the payment till 60 years and for next 20-30 years he will get regular annuity payout.

This means he is associated with the annuity provider for more than almost 50 years. This is a very long period and hence the company you are entrusting your money with should have high solvency to navigate through changing economic conditions. On retirement he would expect the payback to continue till he is alive. In addition to safety, the other most important consideration is return. Most of the annuity products yield a return between 6-8 per cent currently. Depending upon the overall interest rate scenario, this may keep changing. So, the idea is to first check the best internal rate of return (IRR) being offered by different insurers and then lock your annuity at a higher rate. This IRR should be high enough to beat the current and future inflation levels. Besides safety and returns, liquidity is equally important.

An annuity product is very illiquid in nature which cannot be encashed whenever required like other financial products such as a bank fixed deposit, life insurance policy or mutual fund units. There could be financial contingencies that compel the customers to go for such options. In these critical circumstances, if your annuity provides you an option of partial withdrawal, it will help you to manage your cash flow in special circumstances. Therefore, the right way to select annuity is to look at the past track record of the insurer and not get carried away by product features or promotions. Industry track record, returns provided on past annuities and the current financial strength of the company are some of the key factors to be considered selecting an annuity product.

Conclusion

One of the greatest financial risks is if you die young and your family becomes penniless. In such circumstances, life insurance helps you to cover financial risk. On the other extreme, is if you live too long, chances are that you may outlive your savings. In this circumstance a well-selected annuity plan comes to the rescue. With better healthcare service we are witnessing rise in life expectancy and therefore the risk of outliving your savings is stronger. So what is the amount for which you need to take annuity? Diversification plays an important role here and therefore all your retirement funds should not be put in one product. Given that, only a part should go into annuity.

The amount you can lock in this product is something that can cover your basic needs, including medicine. For example if your monthly expense is Rs30,000 after you have retired, you can buy annuity of around Rs50-70 lakhs that will help you to get around Rs40,000 per month so that it also covers the inflation aspects going ahead. Those who are worried about whether the interest rate is going to rise may create a plan where they can buy part of their annuity every year and allocate maybe 20 per cent every year of the portfolio for annuities. This makes much sense than just waiting until a future point when you might feel better about the decision