The interest rates have been going down over the last year. If you are an investor who relies on interest income to meet expenses, this is not a happy scenario.
In this post, I will demonstrate how you can smartly use annuity plans to increase your income without risk even in this low-interest rate regime. This is more applicable to retirement portfolios.
Before we move to annuities, let’s quickly touch upon the other retirement income products.
What are your options?
I will compile the list of some of the popular options. This is not an exhaustive list.
- Bank Fixed Deposits (Little Risk. The interest rates are low)
- PPF (No risk. But you can’t just start investing in PPF to earn income. You must have planned.)
- EPF (you will likely not have EPF when are 70).
- RBI Floating Rate Savings Bonds (No risk. Fine product but you can’t lock-in the rate of interest)
- Senior Citizens Savings Scheme (No risk. Good return. But can’t invest more than Rs 15 lacs)
- Pradhan Mantri Vaya Vandana Yojana (No risk. Good return. But can’t invest more than Rs 15 lacs)
- Other Post-office schemes (No risk. Interest rates not very different from bank fixed deposits)
- Corporate Fixed Deposits and NCDs (Carry risk. Chance of capital loss)
- Tax-free bonds (Little risk but the yields are already low)
- Debt Mutual Funds (Many variants. Not difficult to pick a wrong one. No guarantee of high returns. Chance of capital loss)
An Additional Point: With none of the above products, you can lock-in the interest rate for life. Do not underestimate the impact. Around 8-9 years back, you could earn 10% on your bank fixed deposits. Now, it is difficult to earn even 6% on your FDs.
With fixed income products, the potential for extra return usually comes with higher risk. The higher risk can be in the form of higher credit risk or higher interest rate risk. The good part is this risk is not difficult to appreciate. You just need look at the credit quality of the portfolio (for credit risk) and portfolio duration (for interest rate risk).
For instance, a debt mutual fund that invests in lower credit quality paper carries higher credit risk. When the times are good, you will be rewarded with higher returns (than a fund that invests in good credit quality companies). The problem happens when things go wrong. Look no further than the winding up of Franklin schemes. Perhaps, Franklin’s was an extreme case of liquidity risk. But many credit risk debt funds have witnessed defaults over the last 2-3 years.
Coming to corporate FDs and NCDs, consider the pain of DHFL investors before investing. At the same time, it is unfair to paint all the NBFCs with the same brush. HDFC is just fine but it will offer a lower interest rate on FDs than other NBFCs.
More importantly, why are we taking so much risk? Perhaps, for a couple of percentage points of extra returns.
Can Annuities play a role?
Annuities are super products. You can lock in the interest rate and guarantee yourself an income stream for life. The only caveat is that you need to purchase the right variant at the right age.
I copy the annuity rates for LIC Jeevan Akshay VII. Variant A is “WITHOUT return of purchase price” variant. And that’s the variant I will focus on in this post.
Looking at the rates, if you are 60 years old, then perhaps it is too early to buy an annuity plan. Please understand my answer may change depending on case specifics. You might be better off investing in SCSS and PMVVY or even bank Fixed deposits (despite lower income). You also retain flexibility with your money.
Buying an annuity plan (WITHOUT return of purchase price) may make more sense when you are closer to 70 or above it. This is because, around that age, the difference between the annuity rate and interest rate from other retirement income products starts becoming too wide.
What if the interest rates go down by the time I decide to buy the annuity plan?
Yes, this is a risk. However, of all the annuity variants, the “WITHOUT return of purchase price” must be the least sensitive to interest rates, especially at advanced ages. This is because, under this variant, the insurance company does not have to return your principal. At an advanced entry age (say 70, 75 or 80), the insurance company knows that they may not have to make payments for too long and can hence offer a higher rate of interest (than prevailing in the economy)
Plus, there is concept of mortality risk pooling. Some investors will live for very long (and the insurers will lose money) while the others may die soon (where the insurers will make a lot of money).
Just to give an example, two friends Ram and Shyam, both 70 years old, purchase an annuity plan for Rs 1 crore. Both get 10.51 lacs per annum in income (not considering GST impact).
Ram goes on the live until the age of 100. Just to break even, the insurance company needs to generate a return of 9.89% p.a. Difficult in current times through fixed income investments. This is a losing proposition for the insurer.
However, let’s say Shyam passes away at the age of 73. Hence, the insurer took in Rs 1 crore and had to pay only Rs 30.45 lacs. A windfall.
Now, combine the two cases. To breakeven on these two cases, the insurer needs to generate a return of 4.54% p.a. Now that does not look so difficult. And leaves scope for earning decent profit margin.
Now, pool in the risk for thousands and lacs of customers and bring in actuarial science. We get an idea why the insurers can give interest rates (for the WITHOUT return of purchase price variant) that are much higher than prevailing in the economy.
Mr. Mehta is 70 years old. He has a portfolio of Rs 1 crore and needs to generate Rs 6 lacs in annual income to meet his expenses.
Of the Rs 1 crore, he has put Rs 15 lacs each in PMVVY and SCSS. The two products give him 7.4% per annum for now. The two products give him about Rs 2.22 lacs per annum. He still needs to generate Rs 3.78 lacs per annum.
His bank is offering him an interest rate of 6% on fixed deposits. If he were to deploy the money in FDs to generate the deficit income of 3.78 lacs, he will have to invest Rs 63 lacs in fixed deposits. To illustrate my point, I have not consider RBI Savings Bonds in this example.
He will still be left with Rs 7 lacs = Rs 1 crores – Rs 30 lacs (SCSS, PMVVY) – Rs 63 lacs (Bank FDs).
Looks comfortable but Mr. Mehta is not comfortable.
His worries are:
- He has not locked in interest rate for life. What if his FDs/SCSS/PMVVY are not renewed at the same or a higher rate of interest?
- His expenses may experience inflation. He does not have the bandwidth to generate additional income (as almost the entire corpus is deployed for income)
- If both (1) and 2) happen together, this can be serious problem. He may have to eat into his principal to meet expenses. Lower principal means lower income in the next year. He will have to withdraw even more principal next year. And this becomes a self-reinforcing cycle.
- His ability to meet emergencies is non-existent.
What can he do?
Instead of putting his money into bank fixed deposits, he can invest in say LIC Jeevan Akshay VII (WITHOUT return of purchase price variant).
At 10.75% p.a. he needs to invest Rs 35.9 lacs to generate an income of Rs 3.78 lacs per annum.
And he is still left with Rs 1 crore – Rs 30 lac – Rs 35.9 lacs = Rs 34.1 lacs
This Rs 34.1 lacs gives him potential to meet exigencies and also leave scope for countering future inflation. If he wishes, he can take some risk with some portion of this money.
And that’s not it.
He has invested with LIC. Therefore, there is almost zero risk. He has locked in this rate of interest for life. And annuities are perhaps one of the simplest products. At an advanced age, your ability to manage investments may decline. An annuity is a fine product for such investors too.
You don’t have to purchase annuity plans just once. In fact, you can stagger annuity purchases to counter inflation very smartly.
Continuing with the above example, let’s say Mr. Mehta experiences an expense inflation of 6% p.a. Let’s assume he somehow manages the inflation for the next 5 lacs through the surplus of Rs 34.1 lacs. I assume that Rs 34.1 lacs does not grow (you should generate a much higher return but let’s keep things simple)
After 5 years (he is 75), the annuity rate is 13.01%. With inflation, his annual expenses have grown to Rs 8 lacs.
He has already planned for Rs 6 lacs of income (Rs 30 lacs in PMVVY/SCSS and Rs 35.9 lacs in annuity plan). To generate an additional Rs 2 lacs, he can deploy additional Rs 15.3 lacs in annuity plans.
He will still be left with Rs 100 lacs – Rs 30 lacs – Rs 35.9 lacs – Rs 15.3 lacs = Rs 18.8 lacs.
Let’s optimize this further
When his SCSS and PMVVY deposits mature, he can route the maturity amounts (principal amounts) towards annuities. Remember, at the age of 70, the difference between PMVVY and SCSS rates (current: 7.4%) and annuity rates (10.5%) is ~3%.
For a 75-year-old, the difference is 5.5% (13.01% and 7.4% p.a.).
For an 80-year-old, the difference is almost 10% (17.1% and 7.4% p.a.)
For instance, let’s say his SCSS matures when he turns 75. Instead of rerouting the money into SCSS, he can invest in an annuity plan.
He needs Rs 8 lacs per annum.
At 13.01% p.a., an investment of Rs 15 lacs will generate Rs 1.96 lacs per annum.
PMVVY (Rs 15 lacs) gives Rs 1.11 lacs.
Annuity purchased (Rs 35.9 lacs when he was 70) gives him Rs 3.78 lacs.
Annuity purchased (from SCSS maturity amount at the age of 75) gives 1.96 lacs.
That’s 6.85 lacs.
He has Rs 34.1 lacs left (from 5 years back).
To generate this deficit income of Rs 1.15 lacs (8 – 6.85), he needs to invest only Rs 8.47 lacs in annuities.
He is still left with free cash of Rs 34.1 – 8.78 = 25.32 lacs.
At the age of 80, PMVVY deposit also matures.
His expenses have grown to Rs 10.7 lacs per annum. The annuity rate is 17.15%.
3 annuity purchases are giving him Rs 3.78 lacs + 1.96 lacs + 1.15 lacs= Rs 6.89 lacs.
He has cash of Rs 25.32+ 15 lacs from PMVVY maturity=Rs 40.32 lacs.
We need to generate income of Rs 10.7 lacs – Rs 6.89 lacs = Rs 3.81 lacs.
At 17.15% p.a., you need to invest Rs 22.02 lacs.
You are still left with cash of Rs 40.32 lacs – 22.02 lacs = Rs 18.3 lacs.
You can see how the purchase of annuities has reduced the capital required to generate requisite income.
An annuity plan is perhaps the only investment product from insurance companies that I like. If used smartly, it can add huge value to retirement portfolios. It is simple. It takes care of interest rate risk. It takes care of longevity risk. By providing high risk-free income, it releases money from your portfolio that can be used towards other goals. No other product can do that.
Unfortunately, many financial advisors deride annuity plans. Their reasons: Income is taxable. You lose control of money. What if the investor dies early? All valid points. At the same time, it is unwise to be blind to the value that annuity plans can add. Show me a product that can give me 10% or 13% or 17% p.a. guaranteed (with little risk) for the remainder of your life, even in this low-interest rate environment.
Of course, it is not the right product for everyone. It will also be unwise to put all your money into annuities. You must buy the right variant at the right age. Do reach out if you need professional investment advice.