Many of us dislike annuity plans. The rates are low and the income is taxable. You lose flexibility with the money. The income is not inflation-adjusted. So many problems. Still, annuities can add a lot of value of retirement portfolio if purchased at the right age. In this post, let’s try to understand this with the help of examples.
We will start with a brief introduction to annuities and its variants. Subsequently, we will jump to illustrations.
What are Annuities?
With annuity plans, you pay a lump sum to the insurance company and the insurance company guarantees you an income stream for life. Annuity plans come in multiple variants. Annuity plans can cover longevity though the income stream may not be able to keep up with inflation. In this post, I will use “Single Life: Annuity variant without return of purchase price” to show how annuity plans can add value to your retirement portfolio.
Annuity variants with or without return of purchase price
Immediate Annuity plan with return of purchase price: The insurance company pays you the pension for life. After you pass away, the pension stops and the purchase price (or your principal) is returned to your nominee. As you can see, this variant is not much different from a fixed deposit except that you lock-in the interest rate for life. At the same time, this annuity variant will likely offer an interest rate that is much lower than the prevailing interest rate of a fixed deposit. And the annuity rates do not increase much with age. Therefore, I do not find much merit in this variant (except lock-in interest rate for the long term).
Immediate Annuity plan without return of purchase price: The insurance company pays you the pension for life. After you pass away, the pension stops and no one gets anything. Since the insurance company does not have to return the principal, the monthly pension is much higher in the “Without the return of purchase price variant. And the annuity rates increase sharply with age.
For comparison, for an investment of Rs 10.18 lacs in these variants from LIC Jeevan Shanti, you will get these amounts on a monthly basis.
You can see how the annuity rate is going up sharply with age. For Rs 10 lacs of investment at the age of 80, you get Rs 13,125 per month or 1.7 lacs per annum. This is almost 16% p.a. Show me another investment that can give you such a high guaranteed income.
How Annuity plans can add value to your retirement portfolio?
Let’s say you are 70 years old and you need Rs 50,000 per month or Rs 6 lacs per annum.
You want to generate this entire income through interest from fixed deposits. Let’s say you can open a fixed deposit at 7.5% p.a. You will need Rs 80 lacs to generate this level of income every month. If you could open a fixed deposit at 7%, you would need about Rs. 85.71 lacs.
Instead, if you had purchased an annuity plan to generate the same level of income, you would need only Rs 61.01 lacs to generate the same level of income for life. I have considered LIC Jeevan Shanti as the annuity plan. Chose the variant “without return of purchase price”. GST of 1.8% is also considered in the calculations.
Assume 0% inflation
Unreal but please play along.
This means you would need Rs 50,000 per month for life. Let’s further assume that any contingency funds and other requirements have been planned for separately.
You need to invest Rs 80 lacs in fixed deposits to generate a monthly income of Rs 50,000 (interest rate of 7.5%).
In comparison, you need only Rs 61.01 lacs in the annuity to generate the same level of income. Remaining Rs 19 lacs can be invested in any manner you wish since your income requirements have been taken care of. You can give this money away to family or to charity or can invest this aggressively.
Picking the fixed deposit option leaves you susceptible to reinvestment risk. What if the FD can be renewed at only a lower rate? Your income can go down sharply. On the other hand, we must note that you have access to the principal in case of fixed deposits and can to eat into the principal if required. After all, Rs 80 lacs is over 13 years of inflation-adjusted expenses (at 0% inflation).
Dying too early? I believe this is the greatest deterrent to purchasing an annuity plan without the return of purchase price. Continuing with this example, a retiree puts Rs 61 lacs to guarantee an income of Rs 50,000 per annum. If he dies after a year, he would have got only Rs 6 lacs from the insurance. And for this, the investor paid Rs 61 lacs. This scares most investors away.
What are the drawbacks of the annuity without the return of purchase price approach?
I have chosen the age of the investor to suit my argument. The difference between FD returns and the Immediate annuity (without return of purchase price) is not this stark at younger ages, say at the age of 60. Frankly, at a younger age, products such as SCSS and PMVVY will be a better choice over annuity plans. These schemes will offer good returns and help you retain flexibility with your money. The only problem is that the investment amounts in SCSS and PMVVY are capped.
In addition, there are a few points that will trouble you.
- Lack of liquidity
- The pension won’t continue to the spouse
- Taxation (FDs face the same treatment). I have not accounted for taxes in the post.
- Income is not inflation-adjusted (FDs struggle too)
- GST of 1.8% is a minor hit.
I have discussed the pros and cons of annuity plans in detail in this post.
In this entire analysis, I have been indifferent to liquidity, which is not how many of us feel about money. We attach a premium to liquidity. With immediate annuity without return of purchase price, you lose access to your money. With Fixed deposits, you can break your FD and access money, if required. With immediate annuity plans (without return of purchase price), that is not an option. By the way, this is also a reason why you get such a high rate of interest. Since you do not get your principal back, the insurance company does not just pay you the interest/return it earns on the investment but also the principal.
What if you were a couple i.e. your spouse needs financial support after you? If you purchase an annuity plan without return of purchase price, your spouse gets nothing after you pass away. I conveniently ignored that aspect. You can split the amount on two lives i.e. purchase some of yourself and the remaining amount to purchase on your spouse’s life. However, I can see the complications there.
There are joint annuity variants available where the pension continues to your spouse too, but the rates won’t be as high (because the insurance company must pay till either of the members is alive). I copy the rates for assuming both the annuitants are the same age.
Please note the annuity amount depends on the age of both the members. If the spouse is younger, the age of the younger member will determine the annuity rate you get.
There is another variant where the spouse gets only 50% of the pension after your demise. The annuity rate will be higher compared to 100% annuity. However, you need to see the applicability.
Annuity income is taxed at your slab rate. Therefore, your tax bracket will play a big role in the decision process. This aspect does not make much of a difference if the comparison is between a fixed deposit and an annuity plan because the tax treatment is the same for both the products. However, there are many ways to generate income during retirement. Some of those ways may be slightly more tax efficient. How to use PPF as a pension tool? Systematic Withdrawal Plans (SWP) from debt mutual funds Why SWP from equity funds is a bad idea?
Is there a way we can get rid of these issues, especially with respect to Income to the spouse and liquidity?
Staggering annuity purchases takes care of many problems
It is not either-or. You can use several income avenues to generate retirement income.
Assuming we have only two product choices in FD and annuities, the best way in most cases would be to stagger annuity purchases.
For instance, let’s look at a variation of 0% inflation example. Rs 50,000 per month requirement. The current age is 70 years. You need to provide for the spouse too. I will consider annuity plans on a single life (and not joint life). For the joint-life variant, you can do a separate exercise.
You are not very comfortable with putting so much money into annuities. Therefore, you put most of the amount into fixed deposits.
Now, you can see even a small amount of annuity in the portfolio can be so useful.
In the above, I have considered annuity purchases of Rs 10 lacs, Rs 15 lacs and Rs 20 lacs at the age of 70, 75 and 80 respectively. The deficit income (Rs 50,000 – annuity income) is generated through fixed deposits. Any surplus amount can be put in cumulative FDs. Or now that your income requirement is taken care of, you can even put some portion into equities and potentially earn better returns.
At the age of 70, if you purchase an annuity for Rs 10 lacs, you have a surplus of 3.11 lacs. At the age of 75, you purchase an annuity plan for another Rs 15 lacs, the surplus goes up by another Rs 12.21 lacs, Rs 16.68 lacs (assuming 7.5% return). At the age of 80, you purchase another annuity plan for Rs 20 lacs. Just look at the return, you will be Rs 25,786 per month on an investment of Rs 20 lacs (including GST). That is a return of 15.5% per annum. The surplus goes up to Rs 57.43 lacs. And this will keep growing with returns.
By the way, with our assumptions, you can give away surplus funds to the family or charity at any time. Your retirement expenses are already provided for. Additionally, note that the surplus amount is liquid money. You can withdraw it without affecting your income. Therefore, the liquidity drawback of an annuity purchase has been taken care of.
Look at the legacy amount too. This is the amount that your family (or your spouse) will get if you were to pass away. This includes the surplus funds and FDs. If you were not around, your spouse could use a mix of annuities and FDs of her own to generate income. If this sounds complicated, you can use joint annuities.
Another advantage with this approach that you lock in your income in steps. Annuity rates are guaranteed for life. This is not the case with fixed deposits and FDs present reinvestment risk. If you can renew at a lower rate, your income will fall short. You will have to dip into the principal, which further reduces the interest income. Lower interest income increases shortfall and you need to take out an even higher principal amount. And the cycle goes on. Having surplus funds (through this mixed approach) will give you a cushion.
What should you do?
The intent of this post is not to show that an annuity plan is the best way to generate income during retirement. There are certain obvious flaws.
My only submission is that the annuity products if purchased at the right age, can add a lot of value to the retirement portfolio. Therefore, the annuity plans should be a part of your consideration set while structuring your retirement portfolio.
I have seen disdain for such products (especially annuity without return of purchase price) not just among the investors but also among the advisor community. Such dislike is unwarranted. By the way, I belonged to the same bracket until this fine piece from Mr. PV Subramanyam got me thinking a few years back.
After all, which investment product could give a guaranteed income of ~15-16% to an 80-year-old? There is none except the Annuity without return of purchase price. Therefore, we need to be open.
Food for thought.
Assume 8% inflation
I have assumed 0% inflation in the previous examples. Let’s increase expenses at 8% p.a. and see how we fare. We start with 20 times the annual requirement i.e. 20 X 6 lacs = Rs 1.2 crores. The FD interest rate remains the same at 7.5% p.a.
Let’s first see how FDs fare.
You run out of money in the 90th year.
With annuities, we will generate the entire income using annuity plans. When expenses increase due to inflation, we will purchase another annuity plan to bridge the shortfall. You can purchase LIC Jeevan Shanti only till the age of 85. Thereafter, we dip into the “Excess Portfolio” to fund the deficit.
You can see the portfolio gets over at the age of 91. However, do note you still get 19 lacs per annum for life. So, you generate inflation-adjusted income till the age of 91. Therefore, you still make money for life. Just that the income cannot meet inflation. With FDs, you simply ran out of money at the age of 90. Not just that, imagine the trauma when you know you will run out of money soon. You will perhaps cut your expenses to avoid that.
By the way, we could have used the entire portfolio to purchase the annuity plan at the age of 85. The portfolio would still get over by the age of 92. However, you will receive 24 lacs per annum with this adjustment.