While an old warhorse like PPF offers peace of mind at maturity, things are not so simple with pension Ulips
Let's take the case of pension plans sold by insurance companies. What if we were to tell you that there are other investments that can do what pension plans do, but they aren't really called pension plans? And since pension plans are called pension plans, you and me feel comfortable buying them, thinking that when we are old we can use the accumulated money to generate a regular income.
What Are Pension Plans?
The Webster English dictionary defines the world pension as "a fixed sum paid regularly, especially to a person retired from work."
Insurance companies basically offer two kinds of pension plans — immediate annuities and deferred annuities. An investment made into an immediate annuity ensures a regular payment from an insurance company, monthly, quarterly, bi-annually or yearly in nature, for that matter. Immediate annuities ensure that the policyholder gets a regular "pension".
In a deferred annuity, a policyholder needs to pay a regular premium for a certain number of years. This phase is referred to as the accumulation phase. The accumulation phase is essentially used to build a corpus. Once the phase is over, the money that has accumulated is used to buy immediate annuities which, in turn, generate a regular income.
So deferred annuities are like any other investment product that help you build a corpus by investing regularly. Hence, to that extent the name pension plan is clearly a misnomer. But given the name, pension plans used to be a top selling product for insurance companies. In 2009-10, pension plans mopped up around 58,000 crore. During April to June 2010, pension plans have garnered close to 7,000 crore.
Then things changed. Starting September 1, 2010, the Insurance Regulatory and Development Authority of India (IRDA), the insurance regulator made it mandatory for insurance companies to guarantee a return of 4.5% on unit-linked pension plans till March 2011.
Beyond that, the minimum returns will have to be linked to the average reverse repo rate (or the rate at which the Reserve Bank of India borrows from banks) with a minimum return in the range of 3-6%. Subject to this band, the guaranteed returns will be 50 basis points higher than the average of reverse repo rates during the four quarters of the preceding financial year. Further, unit-linked insurance plan (ULIP) commissions have been capped, which has ensured that the agents will not be too keen to sell these products. So far, only LIC and ICICI Prudential Life Insurance have launched pension Ulips, while SBI Life has reportedly sought Irda's permission to launch one. Notably, the two private life insurers are focusing on single-premium pension Ulips. The risk of offering a guarantee, assuming that premiums will flow in over such a long term, is apparently holding back insurance companies from designing regular premium pension Ulips. But it is highly likely as the tax-saving season (Jan '11 to March '11) approaches, several insurers may launch pension Ulips as they have been the best selling products in the past.
How's A Pension Plan Structured?
In unit-linked pension plans, the premium that you pay is first deducted for the premium allocation charge (through which the agent is paid commission). The remaining money is then invested in an investment fund of your choice. Also, typically the choice of fund may vary from a fund which invests 100% in equity to another which may put 100% in debt. That, of course, is not the case now, as insurers need to guarantee a certain return. So, no insurer is going to bet 100% of the investment on equity. For instance, LIC offers two fund options under Pension Plus – debt fund and mixed fund. The former invests the entire corpus into debt instruments, the latter invests up to 35% in equities.
Should You Invest In A Pension Plan?
Like all other Ulips, Irda has capped charges on ceilings pension Ulips too. Earlier, I never recommended pension Ulips because of the high charges that were built in. Now, I don't advise my clients to go for them because of the guaranteed return factor. Concurs Anil Rego, CEO of financial planning firm Right Horizons: The guarantee makes pension Ulips defensive. It may be useful for someone who is over 45 and is looking to invest for a shorter time-frame. But for those who are young, with perhaps a 20-30-year outlook, directing 100% of investment towards equity is better.
Since insurance companies have to guarantee returns, it doesn't make sense for them to offer an equity-heavy investment option to the investor. They have to ensure that the structure of their portfolio is such that it gives the investor a guaranteed return. This implies that a major part of the investment will have to be in debt securities. And given that, the corpus likely to be accumulated isn't going to be great.
Also, since no withdrawals are allowed during the premium-paying term, this could be a turn-off for those who may suddenly need some money in the interim.
What Happens At Maturity?
When the pension plan matures, the policyholder can withdraw one-third of the corpus tax-free, according to the current income-tax laws. The remaining portion has to be used to buy immediate annuities, which means that the policyholder has to compulsorily buy immediate annuities come what may, even when other investment options may help him earn more.
The Senior Citizens Saving Scheme (SCSS), allows investors to invest up to 15 lakh and guarantees a return of 9% p. a. with a payout every three months. Beyond that, the post office monthly income scheme (POMIS) pays an interest of 8% per year up to a maximum investment of 4.5 lakh. Even FDs give returns superior to immediate annuities currently.
The Alternatives:
Without doubt, your first stop for building a retirement corpus should be the time-tested public provident fund (PPF). The product is a must in your retirement planning portfolio. Any other avenues should be explored only after the yearly limit of 70,000 is exhausted. The product offers an attractive tax-free return of 8% per annum (compounded), and easily ranks as the best amongst its peers. Also, as far as guarantees go you would rather have a guarantee of 8% from the government of India, than a guarantee of anywhere between 3-6% from the insurance companies. A PPF account matures in 15-16 years and can then be extended for blocks of five years each indefinitely.
Moreover, in case of PPF, investor can withdraw once every year from the seventh year, which makes it a more liquid option compared to pension Ulips. Once the PPF option is exhausted, you can look at the new pension scheme. Since it is a long-term investment, you can choose the option to invest up to 50% of your contribution into equities. This apart, you can look at investing in tax-saving mutual funds (or even equity mutual funds) with a long-term horizon in mind.
The advantage of investing in mutual funds is that you can select the best mutual funds in the market. That is not so with Ulips, given their complicated structure. Also, if a mutual fund is not doing well, you can always switch, but doing that with unit-linked pension plans can be a complicated process.
The accumulated corpus can then be used to generate regular income first through SCSS, POMIS and FDs. Beyond that, you can look at immediate annuities. If they are giving better returns at that time, you can buy them using the corpus generated through a combination of investing in PPF and tax-saving MFs.
We guess Shakespeare was right. What's in a name? There are far superior ways of building a retirement corpus than a pension plan.
DEBT END
Pension Ulips may not offer the ideal support for your golden years
1 Most life insurers are reluctant to launch pension Ulips as the regulator has directed them to offer guaranteed returns to Ulip holders who pay premiums till maturity
2 The guarantee implies the premiums will be directed to debt products rather than into equities
3 Financial planners point out that pension Ulips should be heavy on equities, as this asset class tends to perform best over the long term
4 Investment in debt could cut down the product's ability to offer higher returns, making it unattractive for the investors
5 If you want assured returns, exhaust the PPF (public provident fund) limit (up to 70,000 a year) first. It offers a far superior taxfree return of 8%, compounded annually
6 If you are willing to take some risks, you can invest in diversified equity funds through the SIP route
