NPS has attracted a lot of interest from investors due to favorable taxation announcements in the past few years. However, a number of investors have a few misconceptions about NPS structure.
Many investors think the NPS provides annuity. But that’s not completely true. You invest in NPS to accumulate corpus. You use the corpus (at least 40%) to purchase annuity at the time of retirement. However, these annuity plans are not sold by NPS Trust. The annuity plans are sold insurance companies empanelled with NPS. The annuity rates are not guaranteed. You get the rate prevailing at the time of your annuity purchase. If you exit NPS before retirement, you will have to purchase annuity for 80% of the accumulated corpus.
Hence, when you purchase annuity from an insurance company (annuity service provider) at the time of retirement, you enter into a contract with the insurance company. NPS has no role to play apart from transferring a part (or entire) of your accumulated corpus to the Annuity service provider (ASP).
Are you aware of the annuity options available to NPS subscribers? What are the annuity rates currently? Does mandatory purchase of annuity work in your favor? In this post, I will try to answer such questions. I will use keywords Annuity and Pension interchangeably in this post.
Read: Common Doubts about NPS
How do Annuity plans work?
When you purchase an annuity plan, you enter into a contract with an insurance company. In return for the purchase price, the insurance company makes you periodic payments (monthly, quarterly, semi-annual or annual) for life (or fixed period). The pension that the insurance company pays depends on your age and the type of annuity plan chosen.
Empanelled Insurance Companies for Providing Annuity under NPS
Currently, there are seven empanelled annuity service providers:
- Life Insurance Corporation of India
- SBI Life Insurance Co. Ltd.
- ICICI Prudential Life Insurance Co. Ltd.
- HDFC Standard Life Insurance Co Ltd
- Bajaj Allianz Life Insurance Co. Ltd.
- Reliance Life Insurance Co. Ltd.
- Star Union Dai-Ichi Life Insurance Co. Ltd.
You can see the updated list here.
Annuity Options available under NPS
- Annuity/ pension payable for life at a uniform rate.
- Annuity payable for 5, 10, 15 or 20 years certain and thereafter as long as the annuitant is alive. (I do not understand how this works)
- Annuity for life with return of purchase price on death of the annuitant.
- Annuity payable for life increasing at a simple rate of 3% p.a.
- Annuity for life with a provision of 50% of the annuity payable to spouse during his/her lifetime on death of the annuitant.
- Annuity for life with a provision of 100% of the annuity payable to spouse during his/her lifetime on death of the annuitant.
- Annuity for life with a provision of 100% of the annuity payable to spouse during his/ her life time on death of annuitant. The purchase price will be returned on the death of last survivor.
Option 6 is the default annuity option. Only monthly annuity is allowed under NPS.
For detailed information about these aforementioned annuity options, go through this post on LIC Jeevan Akshay.
You can also go through FAQs on CRA website for better clarity.
These plans differ on a few parameters namely
- Whether the annuity income stops or goes to your spouse after your demise
- Whether the purchase price is returned after the demise
- Whether annuity is increasing or constant
Expectedly, the return of purchase price will reduce annuity income (pension per month). If the annuity has to be paid to spouse too, the annuity income will be lower.
LIC Annuity Rates
I am copying NPS annuity rates from LIC website. You can check these rates here.
Please not there are annuity rates as on date. By the time you retire, these rates might be very different. Moreover, these are annuity rates from LIC. Other empanelled companies may have different annuity rates.
Points to Note
- The earlier you purchase annuity, the lesser pension you will get.
- The pension income is lower if the pension is to be paid to your spouse too (after your demise). Do note if the spouse dies earlier than you do, this option will go in vain. (Options 5, 6 and 7)
- The pension income is lower if you opt for return of purchase price (Options 3 and 7).
- If you opt for increasing pension (Option 4), the pension will be lower initially and increase over the years.
You can see pension income is lowest in Option 7 where annuity needs to be paid to the spouse along with the return of purchase price to your nominee (when both you and your wife have passed away)
Taxation of Annuity Income
This annuity income will be taxed in the year of receipt at your marginal income tax rate.
What is the problem with mandatory purchase of annuity in NPS?
This is best explained with the help of an example. Let’s consider Option (1) where annuity is paid as long as the annuitant is alive. There is no pension paid to spouse and there is no return of purchase price either.
If you purchased Option (1) for Rs 10lakhs at the age of 60, you will get Rs 7,450 per month for life. That is Rs 89,400 per annum. There will be return of purchase price (Rs 10 lacs) at the time of your demise. Hence, your spouse or any dependent do not get anything back.
So, if you die at the age of 65, you would have got only Rs 4.47 lacs from the insurance company in 5 years. The insurance company pays no further. You family does not get anything. You had paid Rs 10 lacs to purchase the plan and got only Rs 4.47 lacs back.
The IRR (internal rate of return) will depend on how long you survive. If you survive till the age of 75, IRR will 4.18% p.a. The IRR will be 6.69% (if you survive till 80), 7.86% (if you survive till 85) and 8.47% (if you survive till 90). So, you need to live longer to extract the most out of the insurance company.
Do note I have calculated these numbers with pre-tax numbers. If you have to pay tax on pension income, the return will go down further.
Now, let’s consider Option 3 where you get the annuity income as long as you are alive and your nominee gets the purchase price back after your demise.
If you purchase Option 3 for Rs 10 lacs (at the age of 60), you will get Rs 5,660 per month for life. After your demise, your nominee gets Rs 10 lacs. So, you get Rs 67,900 per year for life.
You could have got better returns on a fixed deposit. You can easily find FD with interest rate ranging from 7.5%-8% i.e. 75,000-80,000 per year. At maturity, you get the principal back too. With Senior Citizen Savings Scheme (SCSS), the interest rate is even higher at 9.3% p.a. at present. There is a cap of Rs 15 lacs on investment in SCSS though.
Interest on fixed deposit and SCSS is taxable. Pension income is also taxable. So, there is no difference on the taxation front either.
The only issue is that you won’t find fixed deposits for 20 or 30 years. SCSS maturity is 5 years with option to extend by further 8 years. So, you can’t lock in the interest rate for your life, which you can do with annuity product. However, you can invest in long term government securities or tax free bonds to lock in interest rates for long term.
You can see annuity is much ado about nothing. If you have discipline, you can easily replicate this performance yourself. You don’t need an insurance company to do this for you. The question is how many of us can exercise such discipline.
I am not strictly against the mandatory purchase of an annuity plan. Not many of us can invest with the discipline to generate regular income. Retirements can be long. If you indulge initially (initial years of retirement), you can face serious financial problems in the later years of your life. Annuity plans can enforce discipline. With annuity plans, you know how far you can stretch your expenses. You will get monthly income and you have to manage with it.
Moreover, managing an investment corpus may not be easy at an advanced age. So, essentially, you are paying an insurance company so that you can maintain financial discipline.
However, annuity rates need to be a bit more competitive.
A lot of people argue that it is your money and you should have the freedom to use it the way you want to. And they are right. Disciplined investors can always do better without annuities (at least with age on their side). No question about that. But what about the others? I think the Government is more concerned about the others.