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Wednesday, June 8, 2016

What is an Annuity?

 

What is an annuity?

 

An annuity can offer you guaranteed income for life when you retire but it may not always meet your expenses and inflation

 

 When you retire, you want a worry-free way of getting a regular income from investing the corpus you have accumulated over your working lifetime. In the absence of social security, or sufficient pension, you need a financial instrument that will give you the income you seek for the rest of your life. Annuities do precisely that. An annuity is a retirement product that gives you pension for life. In India they are sold by life insurance companies and you can choose from a range of options available currently.
 

What are your options?
Annuities are of two types: deferred and immediate. A deferred annuity requires you to first build a corpus, and then use it to buy an annuity. The National Pension System (NPS) and pension plans offered by insurance companies come in this category as they first help you build a retirement corpus and then mandate that you annuitise a part of that corpus.

 

NPS is a market-linked product that lets you invest regularly in funds of your choice. It currently allows three fund options: an equity fund (maximum investment allowed is 50%); a government securities fund; and a fixed income other than government securities fund. On retirement or at age 60, you can withdraw only up to 60% of the money. At least 40% needs to be annuitised.

 

Even under NPS, life insurance companies provide the annuities. According to the website of the NPS Trust website, there are seven insurers empanelled as annuity service providers for NPS.

 

Pension plans of life insurance companies, however, need you to annuitise at least two-thirds or 66.67% of the corpus on maturity. The remaining one-third can be taken as lump sum.

 

Coming to insurers, there are two kinds of pension plans that they offer: traditional plans and market linked plans (also called unit-linked pension plans or Ulips). Since the mandate is to annuitise a larger portion, some feel pension plans by insurers are at a disadvantage.

 

NPS mandates a minimum of 40% of the corpus to be annuitised, compared to a minimum of 67% in the case of insurance plans. This gives greater flexibility to customers of NPS as they get a larger disposable corpus in their hand. Also, there is no service tax levied on the amount used to purchase annuity in case of NPS, while a service tax of 1.4% applies to us. The rules should change to allow for greater flexibility in life insurance and parity between the two products.

 

Immediate annuity, on the other hand, doesn't need you to commit to accumulating a corpus. Just take your money and buy an annuity from any insurer that provides immediate annuity. "The downside of a deferred annuity plan is that you commit in the present to annuitise your money in the future. This is a huge risk because one doesn't know what the interest rates or inflation will be many years from now. Immediate annuity, in that sense, is better. But among deferred annuity plans, NPS is a superior option since it needs you to annuitise only 40% of your money. Even the tax treatment has improved on the product.

 

Moreover, in a life insurance pension plan, you need to buy an annuity from the same company, while in NPS, you can choose at the time of buying the annuity.

 

Types of annuities
An annuity guarantees regular payments to you for life after you invest a lump sum. You buy an annuity product at a prevailing rate, which gets locked. So, the payouts are fixed and guaranteed. But what rate you buy at will depend on factors such as your age, type of annuity chosen and the amount. For an insurer, annuity is managing the risk of living too long. So, younger the customer, lower will be the rate of annuity since the payout will be for longer. Annuity rates are mainly dependent on the long-term interest rates in the market. Also, there are fixed charges to manage an annuity. Hence, the rate will vary slightly and be lower for someone who buys the same annuity with lower corpus. The rates are also sensitive to the economic scenario and the insurer will alter the rate based on future projections. Therefore, the annuity rate may vary depending on when you are in the market to pick an annuity, but once bought, the rate is guaranteed for life.

In terms of choices, there are broadly two kinds of annuity products: one that returns the purchase amount or the principal to the nominee on death of the annuitant, and the second that doesn't. The one that doesn't return the principal amount will offer the highest rate of payout. For instance, a 60-year-old man with a corpus of Rs.1 crore would get an annual income of Rs.9.10 lakh under life annuity without return of purchase price option. The rate of interest in this case is 9.10%. If money has to be returned (return of purchase price option), the rate falls to 7.29% for the same parameters. Without return of purchase price annuity can be considered for someone who is single or doesn't have dependants.

 

One can also choose an annuity to provide benefits to the spouse. This can be done through joint life survivor annuity, which pays you an annuity, and on your death, to your spouse for life. Here, too, you could choose a return of purchase price for the beneficiaries or forgo the principal amount.

Then there are inflation-indexed annuities, in which periodic payout increases at a certain rate of interest a year. There are annuities that are guaranteed for a fixed number of years, usually 5, 10 or 15 years, which means that even if the policyholder dies during this period, the beneficiary gets paid till the guarantee period ends.

 

Some insurers offer other options as well by customising within the broad structures. But what seems to be popular with the market in India are annuities with return of purchase price. "The reasons may be due to skewed preference towards legacy planning and absence of inheritance tax in our country.

 

What should you do?
Annuities help you build a regular stream of income through the guarantee payout for life, and takes care of any reinvestment risk that products such as fixed deposits and Senior Citizens' Savings Scheme pose. Given the decline in interest rates over a period, locking a part of one's retirement corpus in a guaranteed instrument like annuity helps in protection from interest rate reduction and market volatility.

 

But there are some serious downsides as well. Once you annuitise, you can't liquidate it or access it. So, it's important that you commit only a small portion of your corpus to annuities to build a base of guaranteed income. Also, the annuity income or the pension money is taxable. For someone in the higher tax bracket, this is a serious concern.

 

One could also consider an alternative product mix. "For regular income generation, a mix of fixed income investments such as debt-based mutual funds along with tax-free bonds of longer duration such as 15-20 years, which give an annual income at 7-7.5% can be considered. In any case, annuities should not be more than 20% of your entire retirement corpus. To beat inflation over the long term, it is necessary to have equity mutual funds (with systematic withdrawal or dividend payout options) as part of the portfolio considering the risk profile of an individual.

 

Annuity market is underdeveloped in India currently, but if you need guaranteed income as a base, then an annuity is a worthy option; just don't commit all your money to it.

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