An integral part of retirement planning is a good pension plan –and with so many pension plan types in the market, it is easy to have a financial safeguard as one’s income sources become lower or get exhausted with progressing age. Pension plans are simple, easy to understand and implement and offer assured income in one’s retirement years.
There are many types of pension plan, each of which have their pros and cons. Here are some important things you need to know about these plans:
Working of Pension Plans
Accumulation phase: This is the period starting from when an individual buys a pension plan, until he/she retires. It involves regular payment of premiums, which remain invested suitably. Premiums paid enjoy tax benefits under Sections 80C/80CCC of the Income Tax Act.
Annuity phase: On retirement/maturity, investors can enjoy tax-free withdrawal of one-third of the accumulated corpus. The remaining amount cannot be withdrawn, it needs to be used to purchase an annuity plan. This is referred to as the annuity phase. The annuity plan investment becomes a steady source of regular pension, which varies as per prevailing interest rates and is fully taxable.
Boon or Bane?
If you are a compulsive spender, a pension plan could be a boon. These plans encourage discipline as you have to set aside a fixed amount towards premium payments - non-payment turns out to be expensive.
For others too, the enforced financial disciple pays handsomely in the long term. Pension plan types in the market today have become competitive and are almost at par with other investment products.
On maturity, pension plans permit investors to withdraw only one-third of the accumulated corpus tax-free, and the balance amount goes towards purchasing an annuity plan. Also, the pension earned is taxable. This often confuses investors if their funds could have been directed towards a more tax-efficient option.
Besides, after the deductions under Section 80CCC have been made a part of the overall 1.5 lakh limit under Section 80C, most individuals easily cross this limit after factoring in home loans, PFs, insurance premiums, etc.
In effect, the final tax benefit from paying the premium of different types of pension plans may be negligible to nil.
Mandatory Annuity Purchase
With all pension plan types, after one-third of the accumulated corpus is withdrawn, it is mandatory to purchase an annuity plan with the balance two-third corpus amount. This becomes a major constraint if urgent financial crises crop up where liquid funds are needed.
Since the core objective of a pension plan is to save for the long-term, premature exits are discouraged and may pose problems. Being tied down with one fund for what could possibly be decades, flexibility becomes a concern. Therefore, even if the fund is not doing well or more attractive investment options become available, the investor cannot exit the pension plan.
Diversification Takes a Hit
Most pension plan types are typically restricted to a limited investment portfolio, unlike mutual funds and shares that allow a large, balanced, and diversified portfolio. Since most people usually have only one pension plan, the portfolio becomes concentrated and diversification takes a hit.
Types of pension plans
Plans by Insurance Companies
Life insurance companies have started offering different types of pension plans, categorised as endowment plans and unit linked pension plans (ULPPs). Traditional endowment plans invest the corpus only in debt instruments including government bonds, government securities, etc. Since safety is a major concern here, returns are typically not too high.
ULPPs are market-linked pension plan types. Depending on his/her risk profile, the investor can decide the asset allocation of the fund – a mix of debt and equity, 100% debt, or 100% equity. In addition, ULPPs allow investors to switch their fund profile in accordance with their changing life circumstances. For instance, if you are a young investor, you can afford to take more risks, and hence could begin with 100% equity and then gradually switch to debt as you grow older. With transparency in cost structures and higher flexibility, ULPPs usually win over conventional endowment-type pension plans.
Plans from Mutual Funds
Only a few government-approved pension schemes from mutual funds are presently available, all of which offer 80CCC benefits. These schemes are the equivalent of normal balanced mutual funds, with a 40:60 equity-debt asset allocation. However, with these plans, you only get a single fund option and you have to pay an exit load for withdrawals made before retirement/maturity.
National Pension System (NPS)
National Pension Plan(NPS) functions like a regular pension plan. Its typical features are:
Three fund options - 100% government securities, 100% debt (other than government securities), maximum 50% equityMinimum fixed contribution of INR 500 per month/6,000 per annumFixed retirement age is 60 yearsAnnual fund management fees and other flat charges are lowTaxes like securities transaction tax, dividend distribution tax, etc. that normally apply while transacting in securities are not applicable for NPSOn retirement, you get back up to 60% (taxable) and the balance needs to go towards purchasing an annuity planYou need to withdraw 10% each year. When you turn 70, the entire balance is repaid in your account If you quit earlier, you get 20% and the balance gets you the annuity
NPS is akin to other regular pension plans and comes with the same drawbacks. Therefore, it is best to create your own portfolio of Mutual Funds, PPF, EPF etc. as this would offer greater diversification and higher flexibility.