I know this sounds like click-bait. And it is.
However, doesn’t it sound like a great investment?
You pay Rs 100,000 every year for 15 years. And then you get Rs 2 lacs annually for the next 15 years, effectively doubling your total investment.
If you are a salaried employee in your early to mid-forties, this may strike a chord. One of your biggest concerns (apart from retaining your job) is how you will manage your expenses once you retire. When you retire, the income stops but the expenses do not. That’s why such retirement focused products (as discussed above) appear so attractive.
However, should you invest in such products? There are pros and cons. In this post, let’s explore both sides. Let’s start with the positives.
What is good about such products?
Simple and easy to understand. No jargon.
You know what you will get.
No risk. Guaranteed returns. And seemingly adequate.
You do not know what bank fixed deposits will offer when you retire. Hence, locking in the rate of interest is a decent idea.
A little bit of life insurance too.
What else do you want?
An excellent part of these products is that you know exactly what you are getting into. You know everything about the plan.
- How much do you pay every year? (Annual Premium)
- How long do you pay? (The premium payment term)
- The deferment period
- How much do you get every year? (Annual payout)
- How long you get the payment? (The payout period)
Sometimes, in such plans too, the product structure can appear complicated because of additional benefits with fancy nomenclature such as guaranteed additions. However, despite everything, you can calculate what you will get and when. And this information is sufficient for your analysis.
Note: I have considered a hypothetical example. It could be any other combination of premium amount, payment frequency (monthly/quarterly/semi-annual/annual), deferral period, payout amount, payout frequency, and the payout period. Irrespective of the combination, you can calculate your final returns in case you survive the policy term. I understand Rs 2 lacs per annum during retirement may not be sufficient. However, as the input changes, the output can change too.
Where is the problem?
The belief that these products are better than these really are.
Sometimes, when we focus on just the top-level numbers (Pay Rs 1 lac and get Rs 2 lac), we may not try to figure out if we are getting adequate returns.
For a more objective assessment, you must also calculate the net return from such products. Armed with such information, you will be able to take an informed decision. This can be done easily on Microsoft excel or any other spreadsheet software.
As you can see from the above table, I have calculated IRR for various combinations.
Everything else being the same, the net return from the product goes down if the payment to me starts late. Hence, the longer your premium payment term and the deferment period, your net returns from the product fall. And that is the play. And you can also see that increasing the payout period does not change IRR much.
You must decide whether these are poor or adequate returns from a long-term investment.
You may still go for such a product (despite feeling the returns are low). Because it solves a use-case for you. Or that you will be able to sleep better if you know that you have covered a portion of your retirement expenses for a few years. However, if you do this exercise, you will know what you are getting into. And that’s important. This reduces the scope for disappointment or disillusionment with the product later.
Another problem with all traditional plans is that such plans are difficult to exit. These plans are long-term plans. You may assess after a few years that you no longer need such a plan. Or this plan is not the right fit with your needs. You can’t do much. If you exit prematurely, you must take a heavy penalty hit.
The Magic of the Deferment period
Deferment period is the gap between your last premium payment and the first payment from the insurance company.
You would often read something like this in brochures/illustrations of such plans.
You pay Rs. X per annum for 10 years. You will get Rs Y per annum for the next 10 years from the 12th year.
There is a catch here too. And this is deliberate by the insurance companies.
You pay premium at the start of the year.
The insurance company, while writing 12th year, means end of the year. Effectively, you get your first payment at the end of the 12th year. In other words, the start of the 13th year.
Hence, the gap between your last payment and the first receipt is 3 years (and not 2 years as the brochure or illustration seems to suggest). Again, quite deliberate by the insurers. This confusion can be easily avoided.
This deferral period makes life easy for the insurers. It is simple play on the time value of money.
Let’s see how deferment period affects returns in such an investment plan.
Annual Premium = Rs 1 lac, Premium payment term: 10 years
Annual Payout: Rs 2 lacs, payout period: 10 years.
The only change will be in the deferment period that will change the policy term too.
As you can see, an increase in deferment period quickly reduces your net returns from the product.
What should you do?
Currently, I do not own such products in my portfolio. And do not plan to add at least soon.
But that’s just me.
Moreover, over the years, I have learnt to accept that the financial planning decisions do not have to be perfect. It is OK to go with slightly sub-optimal solutions too if it gives you peace of mind. Products such as these may do exactly that for you. Hence, you can consider such products for your portfolio if such products are not your entire retirement plan. You may want comfort of these plans just for your basic and essential expenses during retirement. Do account in inflation in expenses. For other expenses, you may want to look beyond such guaranteed return products.
What do you think about such products?
And yes, if you must invest, first understand what you are buying. If you do not understand how it adds value to your overall financial plan, then we have a problem.
Hence, if you are keen on such products simply for peace of mind, then spend some time working out these numbers before investing and how such a product fits in overall scheme of things.
Quick note: How are such products different from annuity plans?
Both are non-participating life insurance plans.
Under an annuity plan, you pay a certain amount (as lumpsum or over many years) to the insurance company. And the insurance company guarantees you income for life, no matter how long you live. Hence, the insurance company assumes the longevity risk (the risk of you living for too long).
Under plans as I discussed above, the insurance company does not take the longevity risk. The insurer will pay you only for a certain number of years. As defined in the contract. In that sense, these plans are inferior to annuity plans.
But these plans offer one huge advantage over annuity plans.
Income from annuity plans is taxable. Taxed at your marginal income tax rate.
Income from such plans is exempt from tax subject to meeting certain conditions. The total cumulative annual premium for all traditional (non-linked) plans must not exceed Rs 5 lacs. And the life cover must be at least 10 times the annual premium.
Why do these plans get such benefits?
Because these are life insurance plans and the proceeds from life insurance plans are exempt from tax if the Sum Assured (death benefit) is at least 10 times the annual premium
Annuity plans do not meet the condition of Death Benefit 10X annual/single premium. In fact, in certain annuity variants (without return of purchase price), there is no death benefit. Hence, the income from annuity plans is taxable.
Regular readers would know that I like annuity plans and have highlighted many times how annuity plans can add value to retirement portfolios if the right annuity variant is bought at the right age.
Disclaimer: Registration granted by SEBI, membership of BASL, and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors. Investment in securities market is subject to market risks. Read all the related documents carefully before investing.
This post is for education purpose alone and is NOT investment advice. This is not a recommendation to invest or NOT invest in any product. The securities, instruments, or indices quoted are for illustration only and are not recommendatory. My views may be biased, and I may choose not to focus on aspects that you consider important. Your financial goals may be different. You may have a different risk profile. You may be in a different life stage than I am in. Hence, you must NOT base your investment decisions based on my writings. There is no one-size-fits-all solution in investments. What may be a good investment for certain investors may NOT be good for others. And vice versa. Therefore, read and understand the product terms and conditions and consider your risk profile, requirements, and suitability before investing in any investment product or following an investment approach.