The biggest financial risk during retirement is that you may outlive your retirement corpus.You may have planned really well and planned for the corpus to last till the age of 90 but you are fit for another 10 years by the time you turn 90.
What do you do then?
How will you provide for your basic expenses? Is there a way you can do away with this longevity risk?
There is. You can purchase an annuity plan from an insurance company.
What is an Annuity plan?
With an annuity plan, you purchase an income stream for life (or for a fixed period) from an insurance company i.e. you pay a lump sum amount to the insurance company and the insurance company pays you monthly, quarterly or annual income for life.
The monthly income you get depends on your age, type of annuity product chosen and the prevailing annuity rate.
Anything that increases the duration of payout from the insurance company will decrease your annuity payout.
Younger you are, lower the annuity income.
Higher the annuity rate, higher the annuity income.
For instance, if you invest Rs 10 lakhs in an annuity plan and the rate for the chosen variant is 6 percent p.a., you will get an annual income of Rs 60,000 (Rs 10 lakhs * 6%) or a monthly income of Rs 5,000. LIC launched a new annuity plan âLIC Jeevan Shantiâ in 2018. You can read more aboutÂ LIC Jeevan ShantiÂ here.
Here are the annuity options and the annuity rate sheet from the most popular Annuity plan in India (LIC Jeevan Akshay VI). LIC Jeevan Shanti provides a couple of additional deferred annuity variants.
Type of Annuity:
- Annuity payable for life at a uniform rate.
- Annuity payable for 5, 10, 15 or 20 years certain and thereafter as long asÂ the annuitant is alive.
- Annuity for life with return of purchase price on death of the annuitant.
- Annuity payable for life increasing at a simple rate of 3% p.a.
- Annuity for life with a provision of 50% of the annuity payable to spouse during his/her lifetime on death of the annuitant.
- Annuity for life with a provision of 100% of the annuity payable to spouse during his/her lifetime on death of the annuitant.
- Annuity for life with a provision of 100% of the annuity payable to spouse during his/ her lifetime on the death of theÂ annuitant. The purchase price will be returned on the death of theÂ last survivor.
Annuity payments can be monthly, quarterly, half-yearly or annual depending upon your choice.
Here is the list of annuity rates under various annuity options. The rates keep changing and you are advised to refer toÂ LIC websiteÂ for the latest rates.
You get better rates if you purchase Jeevan Akshay and Jeevan Shanti online.
These are the annual annuity pay-outs for Rs 1 lakh investment in LIC Jeevan Akshay.
You can see that the annuity payout increases with age under all the options.
Additionally, you can see (for the age of 60), that annuity payout for option 1 (with the return of purchase price) is Rs 8,930 and option 3 (with the return of purchase price) is Rs 6,600. Quite logical too.
What are the benefits of purchasing an annuity plan?
Once you purchase an annuity plan,Â the insurance company bears the longevity risk.
You may go on to live till the age of 100 or 120. The insurance company will continue to make payment till such time you are alive.
Annuity products are easy to understand.Â You pay a lump sum and you get a monthly income for life. Can it get any easier?
Many of us are used to receive salary credits at the start of the month and managing cash flows using that money.Â An annuity can keep us in our comfort zones.
Annuity plans come in multiple variants.Â Under one of the variants, your spouse can continue to receive the money when you are not around. Under another variant, your nominee can get the premium amount back after your demise.
Clearly, since the insurance companies take different levels of risk under these variants, the payout for the same premium amount will vary.What is the problem with Annuity plans?
What is the risk with Annuity plans?
- Annuity rates are quite low.Â With your retirement corpus in hand, you may be able to generate better tax-adjusted returns.
- You lose flexibility with your money. You cannot access your money once you have used it to purchase an annuity plan (barring a few variants).
- Annuity income is taxable at the marginal rate.
- Annuity payouts may not be inflation adjusted.
- If a person goes for an option (with no return of premium) and dies early, much of the money used to purchase the annuity plan goes waste.
- You pay GST on the purchase price.
- Well, the insurer can go bust. You get the income stream only so long as the insurance company is around.
- So, there will be no income if the insurance company is not around.
- I would rather go with LIC. Gives me peace of mind.
- By the way, I am not aware of any insurance company in India that has gone bust.
- You may happen to purchase annuity plan at a time when annuity rates are quite low.Â This is sheer luck. You may retire and need to purchase at a time when the annuity rates are low (yes, annuity rates keep fluctuating).
Annuities can be useful for the very old . This is the most important part.
As you get into late 70s, your physical and mental ability to manage investmentsÂ may notÂ be that high. You may not be able to manage your investments as well.
AnyÂ health ailmentsÂ may also compromise your ability to manage your investments. Unless you have a trusted friend or a family member who can devote time and help you, annuity purchase may be a good idea.
Moreover, as you grow older, basic tax exemption limit also goes up (Rs 5 lacs for 80 years and above). Annuity rates also improve with age.
You need to consider the quantum of annual annuity receipts and other income to see how tax efficient purchase of annuity plan will be.
Comparison with Bank Fixed Deposits and Government Bonds
One of the common reasons why many investors feel that the annuities are bad products is because of the lower interest rate. You compare the rate with the plain vanilla bank FD rate and find it is better than the annuity rate. You see no reason for investing in annuities.
For instance, variant 3 (with theÂ returnÂ of purchase price) offers an interest of 6.6 percent per annum for aÂ 60 year old. A bank FD today can easily fetch you 7.5 percent-8 percent p.a.
However, there are a few issues with such a comparison.
- With an annuity plan, you can lock in the rate of interest for life.Â With Bank FDs, you can do it for only up to 5-10 years. With FD, there is no guarantee that you will get a similar rate when you renew the FD after a few years. Special products for senior citizens such as SCSS and PMVVY also face the same issue. With SCSS and PMVVY, there is also an investment cap.
- With annuity products, the interest rate goes up with age.Â In the table shown above, the rate for 60-year-old is 6.6 percent p.a. It is 6.9 percent for an 80-year-old. Under bank FD, all senior citizens get the same rate. Given that the difference between annuity rates is small, you may feel it is not relevant.
What about Government Bonds?
These days, it is not very difficult toÂ directly purchase Government BondsÂ of very long maturity (say 30 years). Government Bonds will likely offer better rates than annuity products (with theÂ returnÂ of purchase price). At the same time, they will lock in the rate for a very long duration. As you can see, Govt. Bonds donât really face the same issue as FDs did.
However, there is still one aspect about annuities that we have not considered.Â Why do we always have to purchase an annuity plan with return of purchase price? Your financial situation may be such that youÂ wantÂ to maximize your income from your investment. In this case, you can simply purchase an annuity withoutÂ returnÂ of purchase price.
Under variant 1 (without the return of purchase price), the interest rate is 8.9 percent for aÂ 60 year old, 11.65 percent for aÂ 70 year oldÂ and 17.4 percent p.a. for anÂ 80 year old.Â I do not know of any fixed income product that can give you a guaranteed interest income of 11.65 percent or 17.4 percent p.a. for life.Â The caveat is that you wonât get your principal back. In fact, that is the reason the interest rate is so high.
Letâs think of a 70- year old investor. He has no plans to leave a legacy (or this part has also been taken care of through his other investments). He also maintains a separate emergency fund. He has some funds that he wants to use to generate maximum possible income. He is quite risk averse. As discussed above, he can generate guaranteed income of 11.65 percent p.a. by investing in an annuity plan (without return of purchase price).When to buy annuity plan and What type?
- Since the payout depends on the age, it is not wise to purchase an annuity before retirement. If you purchase too early, you will have to settle for lower annual income.
- Try to delay the purchase.
- If you are too anxious about retirement income, you can use an annuity plan to cover at least your basic level of expenses.Â Anything above can be invested for income or growth as per your risk appetite.
- You can also stagger your annuity purchasesÂ i.e. purchase multiple annuity plans over a period of time. Say one at the age of 60, then 65, then 70, then 75 and so on.
- Staggering annuity purchases can help you in many ways.Â Firstly, you should get better rates as you grow older. Secondly, you can use this strategy to increase your income with inflation. Thirdly, you will average your interest rate since even annuity rates keep fluctuating.
- If you have no financial dependents and do not plan to leave an estate for your family, purchase an annuity plan without the return of purchase price. You will get higher income.
- If you have a dependent spouse, purchase an annuity plan where you spouse also receivesÂ pensionafter you.Â Alternatively, you can purchaseÂ withÂ returnÂ of purchase price and your spouse can purchase another plan (after you)Â withoutÂ returnÂ of purchase price.
- If you want to leave this amount for your family, it is better to go for an option withÂ returnÂ of purchase price.
- In most cases (and not all), think about yourself first (and then think about leavingÂ estateÂ to your family). It makes no sense to go for a lower income (withÂ returnÂ of premium plan) when you know such income may not be enough.
Frankly, there is no one-size fits all solution. You have to think what works in your case.
It is not an either-or decision.
There is unlikely to be a case where you must utilize your entire retirement corpus to purchase an annuity plan.Â However, at the same time, it is also not wise to be completely closed to the idea of purchasing an annuity plan.Â Annuity plans, if used smartly, can deliver value to portfolios of many investors.
If you have a big enough retirement corpus (and you are sure of that), you can easily do without an annuity plan. A counter-argument can be: Why takeÂ riskÂ when you donât need to? You can simply purchase an annuity plan to lock-in a high level of income for life and invest the remaining aggressively. However, this is a problem of plenty. A good problem to have. You can do whatever you like except scoringÂ self-goals.
On the other hand, if you do not have adequate retirement corpus (and you know that), relying on annuities (at least to some extent) is not a bad idea.
In fact, if you know that your retirement corpus wonât last for too long, using a good portion to purchase an annuity plan is a good idea.Â Making aggressive investments to make up for the shortfall is a very risky proposition. Â Do noteÂ a retirement or a decumulation portfolioÂ (from which you are drawing income) can suffer despite returns, in general, being good.
During retirement, theÂ sequenceÂ of returnsÂ assumes great importance. If the luck is not your side, you run a very serious risk of depleting your corpus quite quickly and will have to bear financial agony for the rest of your life. With an annuity plan, you are at least guaranteed income for life. You may be able to carry on with some adjustments in lifestyle.
I am not in favour of purchasing an annuity plan too early in your retirement.Â But again, it is about you. You need to take a call.Â You will have to decide depending upon your lifestyle, the size of your retirement corpus and your circumstances.
Deepesh Raghaw is a SEBI registered investment advisor and founder ofÂ www.PersonalFinancePlan.in.Â You can read the original article here.