Read the fine print on pension plans

Many of the variables that determine future savings are not in your control

There are three distinct risks we face when growing old — dying early, illness or dying late. Dying early or ill-health are risks well understood and can be insured through life and health insurance. The risk of living too long is less obvious, which is why elders so often bless you to live to be 100!

The main risk in a long life is that you will run out of savings. This is difficult to predict because the event is so far ahead in time and many of the variables that determine future savings are not in your control.

One such variable is inflation. Your effective return is what you earn on investments less inflation. Over the past 17 years, the increase in consumer price index, an indicator of inflation, has been between 2.5 and 12 per cent per annum. Over the past five years, the average has been closer to 7 per cent.

Another important determinant of future funds is the interest earned. For example, if you leave your money in a savings account, then your returns, on average, will be less than 3 per cent. If you invest in fixed deposits, then the rates would have varied between 4.75 and 9.25 per cent over the past 17 years, for deposits less than one year. The risk, then, when you live long is that one day your savings get wiped out.

Accumulation, annuity

Good retirement planning addresses this risk and factors in two stages — fund accumulation and annuity. Fund accumulation is the process of building up your savings whereas annuity is the process of drawing down. Fund accumulation can be done through many products such as the Public Provident Fund, National Pension Scheme, insurance savings plans and mutual funds. However, annuities are offered only by life insurers, a combination of fund accumulation and annuity.

The main decisions when buying pension plans offered by life insurers are the vesting age, premium payment term, investment preferences and type of annuity. The vesting age should be your expected retirement age. If you are salaried, then buy an annual premium payment policy. If you have surplus investable funds, then buy a single premium because those turn out more cost-effective.

The investment decision depends upon your financial situation. Government securities (safe but low returns) can be accessed through traditional, participating pension plans whereas equity (volatile but high returns in the long term) through unit link.

There are several annuity options. The most popular is where an annuity is paid throughout your life and the total premium returned to your nominee when you die. There are variants that do not pay capital back on death and offer higher living benefits. It is also possible to buy joint life, fixed-increase or limited pay annuities.

Be aware

There are some issues with pension plans that you must be aware of. First, at the end of the accumulation stage, pension plans allow you to withdraw only one-third of the accumulated amount tax free. The remaining two-thirds must be invested into an annuity. This is a limitation because you commit yourself to an annuity many years before you will actually make the purchase. This also means that there is little flexibility to withdraw money if you have a financial emergency.

The other issue is that annuities are taxed. This reduces the already modest returns. At age 60, the implicit interest rate in an annuity is less than 7 per cent per annum. If this is taxed at even 20 per cent, the returns are a relatively low 5.6 per cent, insufficient to create a real income after adjusting for inflation.

Watch out for a common mis-selling issue which is to push pension instead of life insurance. Pension is much easier to sell because there are no medical tests, policy issuance simple and in the initial fund accumulation stage both products look similar.

The benefit of pension plans is that they force you to save for retirement. These plans would be far more effective if insurers developed annuities that promise a real return after adjusting for inflation, the government were to make annuities tax-free and insurers allow withdrawal in emergencies.

The writer is Managing Director, www.securenow.in

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