In the absence of social security, ordinary annuity products help people earn an assured income in their retired life.
An annuity plan is a contract or a policy between a policyholder and an insurance company. Under the annuity plan, policyholders provide the insurance company with a lump-sum payment in exchange for a series of payments to be made in the future. An ordinary annuity comprises many payments made in series at the end of consecutive periods over a specific number of years. It is a well-known fact that increasing interest rates tend to decrease the present value of an ordinary annuity. When interest rates decline, their present value increases.
Usually, these payments are made on a monthly or quarterly basis, or they can also be made semi-annually or annually. For example, a monthly annuity plan would entail payments to the policyholder at the end of each month. To understand it better, the monthly payouts in an ordinary annuity scheme may be considered similar to a bank fixed deposit that pays interest at each month’s end. On the contrary, for an annuity due, the payments are usually made at the end of the month or the specified payment period. Every annuity contract is unique, so the specific features and benefits of the annuity depend on the plan, and the insurance company one buys from, and how one ultimately decides to use the annuity.
Benefits of Annuity Plans
Here is a rundown of the key benefits offered by ordinary annuity plans:
- Financial security: The most attractive feature of an ordinary annuity is its ability to provide an assured income for a fixed period. These payments offer a sense of financial security. The policyholder is able to plan one’s post-retirement life based on the certainty of the annuity payments. The financial security depends on the fiscal strength of the insurance company providing the payouts. Hence, it is essential to choose the insurance company before purchasing an annuity plan judiciously.
- Longevity and Reinvestment Risk Mitigation: Annuity plans mitigate the risk of longevity as they provide a fixed payout for as long as the policyholder lives. They also help mitigate the reinvestment risk. For example, a retired person faces the risk of outliving one’s retirement corpus or finds oneself reinvesting after interest rates drop.
- Insurance Protection: In addition to providing income post-retirement, some plans also provide an additional insurance cover. In the unfortunate event of the policyholder's death, this is meant to provide financial security to the dependents of the policyholder.
- Tax Benefits: Investing in an annuity plan with an insurance company generally provides tax benefits as an added attraction. The tax benefits range from deduction under Section 80C of the Income Tax Act to tax exemption in the event of insurance cover proceeds paid to the dependents of the policyholder upon death.
Limitations of Annuity Plans
Notwithstanding the advantages and benefits, ordinary annuity plans have some inherent drawbacks.
- Low returns: Annuity plans typically offer less interest rates than other fixed-income options available on a given day. In a situation of low inflation, abundant liquidity, lower current account deficit, stable currency, and comfortable government finances, interest rates are expected to continue to remain benign in India in the short to medium term.
- Lack of liquidity: Once a person buys an annuity plan, the money is locked away permanently. One may not be left with enough money for emergencies. Although some plans may offer a certain degree of flexibility in terms of partial withdrawal, they come at a considerable cost in the form of premature withdrawal charges.
- High Costs: Annuity plans have in-built costs. Although regulated, an insurance company will collect a fee at the time of purchase and on an ongoing basis during the tenor of the annuity. This depletes the corpus value, and as a result, annuity plans typically provide sub-par returns in comparison to a general fixed income product.
- Tax inefficiency: Annuity payouts are subjected to income tax. The payouts are added to the policy holder’s income and taxed at marginal rates. Senior citizens get tax benefits when they invest money in bank fixed deposits. In Budget 2018, Section 80 TTB was introduced in the Income Tax Act. This allows senior citizens to get an income-tax deduction of up to Rs.50 000/- on the interest earned from bank fixed deposits and savings bank accounts.
Varieties of Annuity plans
The different types of annuity plans are:
- Immediate Annuity: In such plans, the policyholder is entitled to periodic payments immediately after depositing the initial investment amount with the insurance company.
- Deferred Annuity: This policy may also come with a 'sum assured' cover in the event of the policyholder's death. For example, a person aged 50 years may purchase a deferred annuity policy by making periodic investments in the policy for ten years and then obtain ordinary annuity payments from the insurance company post-retirement at the age of 60 years.
- Guaranteed Period & Life Annuity: In a guaranteed period plan, the annuity is paid for a fixed period irrespective of the death of the policyholder. Whereas in the case of a life annuity, the payouts are made until the policyholder's life.
- With & Without Cover Pension Plan: Under a ‘With Cover’ plan, in addition to periodic payments, a lump sum amount is paid to the nominee of the policyholder in the event of death, similar to an insurance policy. Under a ‘Without Cover’ plan, there is no insurance cover available. However, the corpus amount accumulated until the date of death may be paid to the policyholder's nominee.
What is the right age to purchase an Annuity Plan?
While the Insurance Regulatory and Development Authority has not prescribed any age limit, private insurance companies offer ordinary annuity plans for those in the age bracket ranging from 20-90 years. The criteria of age bracket may differ amongst various insurance companies and plans.
The best age at which to buy an annuity plan is dependent on several factors, including, among other things, a person’s retirement goals, present net worth and investments, risk perception, and most importantly, expected income for a peaceful retired life. Considering these factors, the best age to buy an annuity plan is to optimize the benefits for one’s individual goals.
How to Select an Annuity Plan?
With a plethora of annuity plans available in the market, it is definitely a challenge to select a plan which best suits one’s financial needs. Prior to purchasing an ordinary annuity plan, it makes sense to evaluate the plans based on some basic parameters.
- Safety: The safety aspect is of prime importance in an annuity plan as it is an extremely long tenor financial product. For example, a person buying a deferred annuity would pay regular premium contributions to the insurance company for an extended period of years before retirement, viz. 20-25 years. One would expect the payouts to occur for another 20-30 years on an average on retirement.
- Liquidity: Although most pension plans stipulate a lock-in period, during which the policyholder cannot withdraw the corpus, some plans may offer a certain degree of flexibility in terms of partial withdrawal at a cost. One needs to be mindful of these costs prior to purchasing an annuity plan.
- Rate of return: The essential part of any investment is the rate of return it provides. Since most ordinary annuity plans will comprise guaranteed returns, the rate of returns is expected to below. In a low-interest-rate scenario, it may not make sense to lock one’s corpus in a low return, guaranteed annuity plan, given the risk of rising inflation. If one buys the annuity plan when interest rates are higher, one stands a chance to earn higher payouts for the same amount of corpus.
- Avoid over-reliance on an annuity plan: There are risks of putting all of one’s savings into a single annuity plan, in particular, or in annuity plans, in general, as a category of financial products. It’ll be difficult to withdraw money if one needs it for an emergency.
- Tax Benefits: Before one purchase an annuity plan, ensure doing some homework on the tax implications of buying the plan and earning regular payouts.
The optimum way to select an annuity plan is by analysing the past track record of the insurance company as an annuity provider.
Annuities are a valuable tool intended to help one build a secure retirement plan, but before one buys, one should make sure one understands how an annuity operates and be sure to use it as a tool to achieve one’s financial goals only when one needs it. A simple thing to remember about annuities is that the payouts increase as a person grows older.