(This was written in Moneylife, some time ago. Since the noise of the insurance salesman is never ending, I think you may like to form your views on annuity products.)
Annuity: Dead Investment?
05 April 2016 3
Last week, I bought a retirement policy. All I need to do is keep up the payments for 15 years and my agent can retire
There is a lot of noise about annuities. And I am sure, you will be bombarded with agents and media who try to tell you how this product is great for you. Please understand what the product does and how it works, before you plunge headlong. An annuity is a long-term investment that is issued by an insurance company designed to help protect you from the risk of outliving your income. Through annuitisation, your contributions (what you pay) are converted into periodic repayments to you that can last for life. You could invest a lump-sum or invest over a period of time and start receiving payments immediately or at some later date.
Why should it matter whether we choose an annuity from an insurer or whether we directly invest the money ourselves and keep withdrawing monthly amounts? Here, the insurance company plays on your fear—that if you do it yourself, at some point, the money will get over, if you live too long. Or what you can get as income is not guaranteed forever, something that an annuity does. For example, if we keep a fixed deposit (FD) of Rs1 lakh, we can permanently keep getting an interest of, say, Rs8,000 every year. However, the uncertainty is that bank deposits are for a certain period, say, five or even 10 years. At the end, we will have to renew it at the rate of interest prevailing then. It could be higher than 8% or lower than 8%. So, we have to take a view. Human beings hate uncertainties. How about 6% forever? Or 5%? Insurance companies give you a lower rate on annuities, playing on this uncertainty in your mind. Plus they guarantee that the contracted amount will be paid to you for life.
In an FD, you can keep withdrawing the annual or monthly accruals and protect the principal which can go to your nominee. In an annuity, you generally do not have anything residuary, unless you choose a product that has a return of capital to the nominee on your death. In such cases, the annual payouts are also lowered by nearly 20% compared to an annuity that does not return any money on your death. And annuities are taxed in the hands of the recipients as income.
When we compare the option of no return of capital, there is no reason why we should go and seek an insurance company to pay us a fixed amount as annuity. We can simply keep it in an FD or a liquid mutual fund (MF) scheme and get far better returns. And, after three years, the withdrawals can be tax-efficient too in case of a liquid scheme. So, there is no way I will go and buy an annuity today. I am willing to live with the risk of falling interest rates. In fact, if you are short of your retirement date, you should aggressively put at least half the corpus into a ‘balanced’ MF scheme and half into a liquid scheme. Once you need to withdraw, you could work out a systemic withdrawal plan (SWP). Depending on your corpus, you could plan to just take away a part of the growth. Of course, if your corpus is small, and you are the worrying type, you may not have the luxury of taking the risk and it may actually make sense to buy an insurance annuity with no return of capital. That will ensure that you have some amount coming your way.
The ideal way to build up for your annuity is to keep investing in equities up to a year or two before the actual retirement date. By retirement, I mean the time where you stop receiving income other than investment income. If you must buy an annuity product, buy it a year or two closer to your retirement. Do not start investing in annuity products early in life. That is because you can make your money work better than any insurance company can.
If you have to buy annuities, buy it in doses. Start with the first dose after your earning cycle is over. This is because the older you are, the higher are the annuity payouts, since the expectation is that you are closer to death with each passing year. Thus, the annuity is structured in a way where the older you are, the higher is the payout. Just check out this page:
Notice the annuity payouts given on this page. They keep increasing with age. In other words, the later you buy the product, the higher is the annual payout.
There is enough evidence to show why we must save and why we should start saving early. My simple advice is that, when you start early, put larger amounts into equities. Whether you use the mutual fund route, or the direct equity route, is dependent on your temperament. Of course, I am presuming that each of us would be in a position to plan everything precisely. But, in real life, many do not plan and each person’s situation is different from those of others. If you save and invest well, most probably, you will end up with enough cushion. At the other extreme will be those whose circumstances push them to selling whatever assets they own and be at the mercy of their children.
Do ‘No Return of Principal’ Annuities Make Sense?
In cases where there is NO return of your principal, the annual payouts are less than 8%. It is like keeping a FD in a bank and you forfeit the FD to the bank, when you die. However, let us look at it differently. If you opt to keep a corpus in a mutual fund product like liquid schemes that gives a 5% annual compounded return, you can do a SWP (equal withdrawals each year, to exhaust the principal and accumulated growth over a specific period) which will give returns as under:
20 years—7.92 %pa (per annum) of your invested amount withdrawn in EMI style;
15 years—9.49%pa of your invested amount withdrawn in EMI style;
25 years—6.02%pa of your invested amount withdrawn in EMI style.
The LIC table shows an annuity for life equivalent at 9.35% if you are aged 60, and over 12%pa, if you are aged 70. So, here is a situation where an annuity gives a better pre-tax return. As of now, annuities are fully taxable. Whereas, in SWP of MF schemes, we do pay a very low tax on withdrawals after the third year, if we plan well. Also, if your liquid schemes pay higher, their returns are better than annuities.
Thus, I would not totally write off annuity products. For instance, if I am 70, the annuity is a good product, on the assumption that I will live beyond 80 or so. Of course, if I die in a year, the principal is gone. There is a trade-off on the uncertainty of life. For example, with the same corpus, an MF scheme will not give you 12%; but there is comfort that your heirs will get back the principal that you did not live to enjoy. The deeper you get into financial planning, it gets beyond numbers. A lot has to do with your temperament and comfort. However, temperament and comfort must be taken into account after financial literacy, not before. Financial choices make sense only after you fully understand all the product choices before you.