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The Lifetime Security
Weigh the pros and cons before you sign your life savings over to a life insurance company. Once you buy an annuity plan, you permanently lose access to your hard-earned capital – PMVVY is an exception
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If you have just retired with a lump sum of money, and are worrying about how best to generate a steady income stream from it for the rest of your life, you may be considering the purchase of an immediate annuity. However, you need to pause and take into account its pros and cons before you sign your life savings over to a life insurance company.
First the basics. An immediate annuity is a life insurance product designed to safeguard you against the risk of outliving your savings — a well-founded risk, where healthcare innovations are leading to an average increase of five years in our lifespans each decade. In a world of financial products, rife with confusing lingo, clauses, and fine print, annuities are relatively simple to understand. You hand a sum of money to a life insurance company, and they begin to provide you with an immediate monthly (or quarterly, or annual) income. This income continues for as long as you (or you or your spouse, depending upon the option selected) are alive. Depending upon the option chosen, a number of bells and whistles can be added to your annuity product —including a return of purchase price to the nominee upon your death, or an increase of 3 per cent per annum in the pay-out amount, to name a couple.
Annuities serve two obvious purposes for a retiree. One, the peace of mind that comes with knowing that you’ll be receiving an income stream as long as you’re alive. Two (for most annuity plans), you eliminate reinvestment risk — the risk of potentially having to reinvest your money at lower yields once your current investments mature. In other words, you lock in the current yield on offer, for life.
With annuities, there is a steep price to pay for the assurance of lifelong returns. Since an annuity is a long-term commitment, life insurers could exhibit conservatism while deciding rates — after all, annuity rates are determined based upon current interest rates, which could easily come down in the future — leading to a serious asset-liability mismatch for the insurance company. To make matters worse, annuity pay-outs received are fully taxable at your marginal tax bracket.
“With returns on annuities being in the range of 6-7 per cent pre-tax, it does not beat inflation even in the early years. It will struggle even more in the later years, given the fixed pay-outs and also because annuities are taxed at marginal rate. Hence, post-tax and post-inflation, you are left with dwindling purchasing power with each passing year,” cautions Priya Sunder, Director, PeakAlpha Investment Services.
No More Access To Capital
“Annuity markets in India are still at a nascent stage, and whatever is available is only in the form of insurance plans, with low liquidity,” says Surya Bhatia, CFP, Founder of Delhi-Based Asset Managers. This is another important reason to be doubly careful before purchasing an annuity plan — once you have bought one, you permanently lose access to your hard-earned capital (a notable exception is the PMVVY). In effect, this is the price you pay for eliminating re-investment risk. Once you annuitise your savings, there is no way to reverse the purchase once the IRDAI mandated free-look period has passed, or take a loan against it. Unlike other income generation products such as the Post Office MIS, SCSS or Mutual Funds, annuities do not come with maturity dates or redemption options. With the ‘return of purchase price’ option, your nominee does receive the purchase price paid upon your death, but choosing this option brings down your annualised returns commensurately. It is for this reason that Bhatia cautions retirees to evaluate annuity products thoroughly before signing above the dotted line. “Be sure about your annuity plan — as once bought, it gets your money locked in at a predetermined interest rate,” he says.
Better Options Available?
Given the poor returns, lack of inflation-proofing, and hard lock-ins that dampen most annuity products, are there better options available? Sunder believes so. “You can build a retirement fund that is tax efficient, which grows at a faster rate than annuities, is flexible enough to increase pay-outs each year with increasing inflation and which is also liquid,” she says.
Take, for instance, a portfolio comprising 90 per cent debt mutual funds and 10 per cent equity mutual funds. Over the long term, a portfolio built with such a construct will almost certainly deliver returns that beat annuity returns — while allowing you to continue having a high degree of access to your capital at all times. Sunder believes that SWP’s (Systematic Withdrawal Plans) from mutual funds make for the best way to generate a steady, inflation adjusted and relatively tax efficient post-retirement income stream. A qualified financial planner can help you structure your retirement savings in a manner that fulfils your specific objectives.
A Note On The PMVVY
As an annuity product, the LIC-led PMVVY (Pradhan Mantri Vaya Vandana Yojana) stands out as one that is worthy of consideration. With an annualised pay-out of Rs 60,000 on a lump sum deployment of Rs 7.22 lakh, it provides retirees an impressive pre-tax return of 8.3 per cent per annum for its 10-year duration — 98 per cent of the purchase price is redeemable, if required for the treatment of a critical illness for oneself or one’s spouse. It is a pity that at Rs 5,000, the maximum monthly income generated from the product is a pittance! Nevertheless,
if you have retired recently, it makes sense to lock-in some of your income generation corpus into this scheme before it closes for subscription on 3 May 2018.