Budget 2016 has made annuity plans popular thanks to proposed taxation on EPF and the NPS. In its clarification about Changes made in the Tax Treatment for Recognised Provident Fund & National Pension System, the government claims
It is expected that the employees of private companies will place the remaining 60% of the Corpus in Annuity, out of which they can get regular pension. When this 60% of the remaining Corpus is invested in Annuity, no tax is chargeable. So what it means is that the entire corpus will be tax free, if invested in annuity.
In a country where real inflation rates are at least 8-10%, it is astonishing that its government expects privately employed citizens to get ‘regular pension’ or pay tax!
Earlier this week, I had pointed out why one need not worry as the tax on EPF is quite small and the annuity can be avoided if not required.
In this post, I would like to discuss the basics of annuity plans or as insurers like to put it, immediate annuity plans. Immediate implies pension could start from the next month!
If you are inching close to retirement, you may need to ask, ‘Do I need an annuity?’. That can be answered with a calculator linked at the bottom of a post.
What is an annuity?
Annuity is nothing but a pension paid by the insurer in exchange for a lump sum.
The Lump sum is known as the purchase price.
The amount of pension is determined by the age at which we apply, the option we choose and also the purchase price. This is done with the annuity rate.
Pension = Purchase Price x annuity rate
A purchase price of one Lakh at annuity rate of 6% will provide a pension of 100000 x 6% = 6000 a year.
This pension will be payable for a fixed duration – typically until death with other options available for the spouse or nominee to receive either lump sum after death of the pensioner or continue receiving pensions.
The pension is typically fixed. LIC offers an indexed pension – one that increases at the 3% a year. Privates like SBI offer up to 6% increase a year.
Each annuity plan has multiple options. Before we consider these in some detail, here are two important thumb rules when it comes to immediate annuity plans.
(1) If the annuity rate or the interest rate ‘looks good’ for an option it is because the annuity provider (the insurer) benefits more from it! Not you – the annuity recipient or the annuitant
(2) The earlier you buy an annuity, the lower the annuity rate. Therefore, if possible, it is prudent to postpone the purchase of the annuity.
The annuity has to be added to income and will be taxed as per slab. This rule is not affected in any way by budget 2016. The government has unfortunately, perhaps inadvertantly, given the impression that buying the annuity is a way to escape all tax on EPF. This is incorrect. If an annuity is purchased, one need not pay tax on the purchase price. The annuity or the pension received is fully taxable.
Here is a list of annuity options available in LIC Jeevan Akshay VI plan. They should be reasonably self-explanatory.
i. Annuity for life simply means that the pension is paid out until we die and then the purchase price is lost. The spouse will get no pension. This is the best option for the annuity provider and the worst option for us! Therefore, the annuity rate is the highest! Why because it gambles on when we will die and when it can retain the purchase price! Imagine the gains the insurer makes if we die six months after buying the annuity! The best option for the insurer is independent of age.
So there should be a worst option for the annuity provider which should be the best option for us in terms of policy terms. However, since the annuity provider stands to lose a lot of money, the annuity rate will be the lowest. This is how annuity plans work!!
Think like an insurer (annuity provider)
The worst option for the insurer depends on when we buy the annuity (entry age).
Annuity rates for entry age 30,40, 50
Imagine a 30 or 40-year-old choosing a pension that will increase at 3% for life. Think about all the money that the insurer will lose! Therefore, the annuity rate for that option is the lowest!
Anyone less than 50 years of age should not buy an annuity unless absolutely essential. These rates are before tax. After tax, the rates will be quite low. With inflation around 8-10%, the purchasing power of the pension will only gradually decrease.
If the spouse is educated (financially that is!) then option iii. annuity for life with return of purchase price is a good idea. As pointed out by Mr Srinivasan at AIFW, the rates for this option do not depend much on age. Also the option will depend on the state of our finances – additional resources available etc.
Annuity rates for entry age 60
Notice that the worse option for the insurer has changed! The annuity provider hates either paying pension or increasing pension for long durations and/or parting with the purchase price!
Upon normal retirement, some fixed pension is always a good idea. However, if we go overboard it will be dangerous later in life.
Options iv or vi are reasonable choices ( like in life, neither too bad for the annuity provider nor too bad for us!)
Annuity rates for entry age 70
Notice how at age 70, the insurer does not mind paying an increasing pension! It is always gambling on when how soon we will die!
Annuity options are good at this age because health will start failing and active management of resources will be difficult. If the spouse is of comarable age, then even option ii is not a bad idea (we can gamble on our death too!). So is vi.
Notice how the insurer hates option iii.
Typically annuity rates at the mid of the curve are reasonable in term of pension amount and features.
I would like to conclude by asking When should senior citizens purchase an annuity?
Use this link to determine if your net worth is enough for you to take risk in retirement (invest in a spread of asset classes one of which is equity) or if you have no option but to buy an annuity with all you net worth and hope for the best, which -if you excuse me for being pragmatic – includes a swift death with no prolonged hospitalization.
Ramachandra Shenoi points out (see comments below) that the age difference between pensioner and spouse matter for options where the spouse receives pension. He has pointed out the case of ICICI immediate Annuity Plan where this is the case. For the above mentioned LIC plan, age of spouse does not matter.