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 “LIC Jeevan Shanti” in 2018. You can read more about LIC Jeevan Shanti 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 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 to LIC website 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, 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. 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. An annuity can keep us in our comfort zones.
Annuity plans come in multiple variants. 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?
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 investments may not be that high. You may not be able to manage your investments as well.
Any health ailments 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 the return of purchase price) offers an interest of 6.6 percent per annum for a 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.
What about Government Bonds?
These days, it is not very difficult to directly purchase Government Bonds of very long maturity (say 30 years). Government Bonds will likely offer better rates than annuity products (with the return of purchase price). At the same time, they will lock in the rate for a very long duration. As you can see, Govt. Bonds don’t really face the same issue as FDs did.
However, there is still one aspect about annuities that we have not considered. Why do we always have to purchase an annuity plan with return of purchase price? Your financial situation may be such that you want to maximize your income from your investment. In this case, you can simply purchase an annuity without return of purchase price.
Under variant 1 (without the return of purchase price), the interest rate is 8.9 percent for a 60 year old, 11.65 percent for a 70 year old and 17.4 percent p.a. for an 80 year old. 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. The caveat is that you won’t get your principal back. In fact, that is the reason the interest rate is so high.
Let’s 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?
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. However, at the same time, it is also not wise to be completely closed to the idea of purchasing an annuity plan. 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 take risk when you don’t 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 scoring 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 won’t last for too long, using a good portion to purchase an annuity plan is a good idea. Making aggressive investments to make up for the shortfall is a very risky proposition. Do note a retirement or a decumulation portfolio (from which you are drawing income) can suffer despite returns, in general, being good.
During retirement, the sequence of returns 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. But again, it is about you. You need to take a call. 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 of www.PersonalFinancePlan.in. You can read the original article here.
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First Published: IST