Last Updated on October 2, 2023 at 9:27 am
A reader wants to know, “Sir, I am about to retire (at age 55) and am looking for a pension. I essentially see two choices: Either buy an annuity plan from an insurer or buy a bond from the RBI portal (thanks to your article) – How I used RBI Retail Direct to buy govt. bonds and create an income source“.
“However, I am confused by the multiple annuity choices (for life, return of purchase price etc) and do not know which to choose. Can you write an article explaining how to buy a pension and which option offers the best return?”
We will split the answer to this question into two parts. First, we shall consider annuities vs bonds and then discuss which offers the better rate of return. These articles are part of our “retirement planning with income laddering” series. The first two parts are linked below.
Buying an annuity vs buying a govt bond for a pension
Like in life each option has its pros and cons and it is a matter of considering which product is more suitable.
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For example, bonds pay interest twice a year and not monthly. Such a cash flow pattern may not be suitable for some. Annuities require proof of life each (life certification), while bonds do not need it.
Bonds always return the principal to self or nominee while annuities provide a choice. The pension from the return of purchase price option is considerably lower! So you will have to pay the insurer more to get the same pension as a bond or a simple annuity for life if you want the principal back. Which option offers the higher return depends on when we die as we shall see below!
At a young age (how young depends on prevailing yields and rates), bonds may offer a higher income than annuities. Older retirees may get a better deal with annuities. See: What are the annuity rates of LIC Jeevan Akshay VII from Feb 2022?
That is, annuity rates depend on age and is favourable for older retirees (and the insurer who are betting they will die sooner!).
Let us consider an example. If we log in to the RBI retail direct portal, we see that a bond maturing in Dec 2061 has an indicative yield of 7.73%. See: RBI Retail Direct: A look inside – how to register and what you can buy/sell
If we consult the above article to get the rates for the “annuity for life option (without return of principal)”, we see that retirees who are 55 and below get a better rate with govt bonds and those who are older (at least 60+) will get a better rate* with LIC Jeevan Akshay. Private insurers will offer a better rate but it all depends on who you trust more!
* Annuities are subject to 18% GST, while bonds are not and the above does not factor GST.
However, bonds are subject to reinvestment risk while annuities can offer income until the lifetime of the younger spouse. That is if you buy a bond and die after say, 15 years, the money will come back to your spouse. He/she will have to buy another bond or annuity at that time with a revised (typically lower) interest rate. See: How LIC annuity rates have changed over the last 20 years.
So if our spouse is not financially savvy or uneducated or uninterested or indifferent to matters of personal finance, a “Joint Life Immediate Annuity for life with a provision for 100% of the annuity payable as long as one of the Annuitant survives” with or without return of purchase price to an heir is suitable.
Ashal Jauhari points out that there is a joint ownership option for bonds in RBI direct. This will take care of the reinvestment risk.
The govt can recall a bond (that is pay back the principal and stop interest payments) under exceptional circumstances. This can happen with an insurer in principle but is probably less likley.
Higher the age, the better the annuity. This can be used for income laddering to fight inflation. Bond coupon rates are the same for all ages. Bonds are not as well suited as annuities for income laddering due to the reinvestment risks mentioned above.
Both options are illiquid. That is, you cannot get your money back after you have purchased a bond or an annuity (certain choices). At the time of writing, RBI Retail Direct purchases will not show up in your demat account for sale in the secondary market. Even if it does in the future, the retail bond market is immature and getting a buyer at the price we want would be tough.
In LIC’s Jeevan Akshay, only options with a return of purchase price can be surrendered mid-policy for a fraction of the purchase price (see link page 11 in the link for computation). So unless you are sure you need an income, do not buy either option!
Please keep in mind that bond yields keep changing while annuity rates are reasonably stable. So the yield of new bonds can be higher after we purchase one leading to regret of missing out (ROMO!).
In summary, the decision to choose bonds or annuities for income depends on personal circumstances and a single choice will not be suitable for everyone. We recommend buying a bond if the pension income is only one component of a retirement portfolio. See: How to build the ideal retirement portfolio.
If the pension is going to be the primary source of income then an annuity guarantees a pension for our life and that of our spouse (which may be longer than a bond’s tenure) is perhaps a simpler choice with a better cash flow (monthly).
Older retirees (60+) may consider an annuity if it offers a better rate (after accounting for GST). Those with a younger spouse who may have difficulty reinvesting the corpus may consider an annuity option until their lifetime. It would be prudent to pay a SEBI registered fee-only advisor a fraction of the corpus as a fee and get professional advice.
Combining bonds and annuities: A retiree can consider buying a bond for the first annuity if it offers a higher yield and then buy single/joint annuities (simple choices as mentioned above) after a decade or so when the rates would be higher.
In the next article, we shall compute the return (IRR) for various annuity options for comparison and then follow up with a discussion on buying multiple annuities (income laddering).
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