A lot of investors take pains to plan for their short-medium term needs like buying a car or providing for children's education. While this is a good thing, they must also show the same enthusiasm while planning for long-term needs, in particular retirement planning.
An inevitable outcome of the brisk pace at which our economy is growing is a decline in the purchasing power of currency, i.e. inflation.
Put simply, a product that costs Rs 100 at present, would cost Rs 105 a year from today, assuming that prices rise at 5%. This is the impact of rising prices over just 1-year, over a 30-year period, assuming that inflation continues to rise at 5%, the same Rs 100 product will be available at Rs 432.
It is apparent that if investors are not prepared to counter the looming prospect of rising prices, retirement (when income ceases, but expenses continue) can be a challenging phase. Another factor that needs to be considered is changing lifestyles.
Keeping this in mind, investors must plan for retirement in a manner so as to ensure that their finances are sound enough to provide for their expenses and to help them in maintaining their desired lifestyles. This is where pension plans can play a vital role.
What are pension plans?
When an individual opts for a pension plan, he has to pay a fixed amount, known as the premium, to the insurance company, over a pre-determined period of time, known as the term of the policy.
The premium (net of expenses) will be invested by the insurance company in various instruments to earn returns and build a corpus over the term of the policy. The amount paid as premium is eligible for deduction under Section 80C of the Income Tax Act, upto an upper limit of Rs 100,000.
How pension plans work
At the time of opting for the pension plan, the policy holder defines his retirement age (known as vesting age in industry parlance); at this age, typically, he will be provided with one-third of the accumulated corpus as a lump sum payment.
This lump sum payment (subject to a maximum of one-third of the corpus) is tax-free in the hands of the policy holder. The balance amount (accumulated corpus less lump sum payment) is converted into a monthly income, also known as annuity.
In other words, the policy holder can choose to invest the balance sum with any life insurer to obtain a monthly income for the rest of his life. The period over which he will receive the monthly income is known as the annuity period; the monthly income is taxable as per the policy holder's tax slab.
In a plan, wherein there is a lag between the policy holder making the lump sum payment to the insurance company, and he receiving annuities, is known as a deferred annuity plan.
Another form of annuity is the immediate annuity wherein the policy holder pays a lump sum amount upfront and the insurance company begins paying the annuity immediately.
In India most insurers offer deferred annuities, with only the Life Insurance Corporation of India (LIC) providing immediate annuities.
Like any other investment, if the pension plan is taken earlier on, the returns can be that much higher, as the benefits of compounding set in. Also, most insurers offer the option of increasing the premium over the policy term, which can be availed of by the policy holder as his income rises.
While LIC offers only traditional pension plans, most of the private insurance companies, offer ULIP (unit linked insurance plan) based pension plans, thus offering a wider choice to investors.
An example of a market-linked (ULIP) deferred annuity would help in understanding this better. Kumar is a 30-year old male, married with no kids. He opts for a pension ULIP.
How pension plans work
| ||||||||||||||||||||||||||||
| ||||||||||||||||||||||||||||
| ||||||||||||||||||||||||||||
Kumar pays an annual premium of Rs 20,000. At 6% rate of return his corpus will grow to Rs 1,384,404 after 30 years. If he invests the same in an annuity he will receive Rs 135,434 (@ 6% rate of return) every year till he survives.
In a ULIP, the policy holder can choose the proportion of his funds to be invested in equity and debt instruments. If the policy holder expires during the policy tenure, then the nominee/s, subject to certain conditions, are given the option to receive the fund value as a lump sum or to purchase an annuity.
An important feature of most pension plans available in the Indian market is the absence of an insurance benefit. For instance, Bajaj Allianz UnitGain Easy Pension Plus does not offer any life insurance cover. On the other hand, ICICI Prudential LifeTime Super Pension offers the policy holder the option to opt for a life insurance cover.
But it must be understood that the policy holder will have to bear the cost of insurance. The charges (i.e. premium for life cover) would be deducted from the pension plan premium paid by the individual and the same would impact his returns, as has been demonstrated in the illustration below.
For an investor who is not insured or inadequately insured, going in for the insurance cover would make sense. In case of death during the term, the higher of sum assured or fund value shall be paid to the insured.
Opting for life cover can eat into your pension returns
| |||||||||||||||||||||
| |||||||||||||||||||||
Continuing the above illustration; this time around Kumar opts for a life cover of Rs 600,000. The premium for the life cover (of Rs 600,000) is deducted from his pension plan premium. The net impact of this can be seen from lower returns on his pension plan.
At the end of 30 years his pension plan will return Rs 1,340,482 if he opts for a life cover, as compared to Rs 1,384,404 without a life cover. The difference can be attributed to the higher expenses in servicing the life cover of Rs 600,000.
On the same lines, his annual annuity without life cover amounts to Rs 131,137 (@6% rate of return), which is lower than Rs 135,434 (without life cover).
It is apparent that there are critical benefits in opting for a pension plan and it must form part of every individual's financial planning exercise.
At Personalfn, we have always maintained that a financial planner/advisor has a vital role to play in aiding individuals achieve their financial goals and objectives. Insurance plays a vital role in the financial planning exercise.
Individuals would do well to consult their insurance advisor to determine the suitability of any insurance plan and then make an investment decision.
Click here for a free download of the Retirement Planning Guide