Annuity Plans – What, Why, and Why Bother

Summary

An ‘Annuity’ is a (financial) product that provides a steady, periodic income, over many years,  to the buyer. This part of annuity makes it similar to a pension. Probably due to this, annuity plans are popular in India. In this short article we consider the factors of annuity and look at who it is suitable for. We would see that, in India, unless you are forced to purchase it, you can ignore this product.

Who sells annuities?

An ‘investor’ buys an annuity plan by paying a large amount of money. The annuity provider then gives the buyer periodic, assured, and mostly fixed payments. The typical annuity plan provides the payments as long as the buyer is alive.  If you look at this closely, this is practically the reverse of term life insurance – the individual makes periodic premium payments and the insurance company provides a large sum in the case of death. Almost all, if not all, annuity products in India are offered by life insurance companies.

An important point to be noted that though it is offered by life insurance companies, an annuity plan has no insurance component to speak of.

Major terms in annuity

• Purchase Price – The upfront amount paid by the buyer to purchase the annuity plan
• Payout timing – Immediate – The annuity payments state immediately after the purchase
• Payout timing – Deferred – The annuity payments start after a specified number of years (usually on retirement)
• Payout frequency – Monthly, Quarterly or Yearly
• Annuity Coverage – Single (Buyer’s life) or Joint (Buyer, plus another person – typically the spouse) – Covered people are called annuitants
• Return of purchase price – Purchase price is paid to nominee after the death of the sole or last annuitant
• Annuity type – A large variety of options. Some guarantee payment for a certain number of years, and then for life
• Increasing annuity – Some plans in India provide yearly increase of 3% or 5%
• Annuity amount – This is the actual amount that is paid every period. This depends on a lot of factors – including the age of the buyer, the type of annuity, payout frequency, etc. Very roughly, the annual amount would be about 7% of the purchase price for an individual who is about 55 years old. Options like joint life, return of purchase price, etc would reduce the amount further

Example of annuity options

The recently launched Jeevan Shanti annuity plan from LIC has the following options for immediate annuity. This list is provided for illustration.

Option A: Immediate Annuity for life.
Option B: Immediate Annuity with guaranteed period of 5 years and life thereafter.
Option C: Immediate Annuity with guaranteed period of 10 years and life thereafter.
Option D: Immediate Annuity with guaranteed period of 15 years and life thereafter.
Option E: Immediate Annuity with guaranteed period of 20 years and life thereafter.
Option F: Immediate Annuity for life with return of Purchase Price.
Option G: Immediate Annuity for life increasing at a simple rate of 3% p.a.
Option H: Joint Life Immediate Annuity for life with a provision for 50% of the annuity to the Secondary Annuitant on death of the Primary Annuitant.
Option I: Joint Life Immediate Annuity for life with a provision for 100% of the annuity payable as long as one of the Annuitant survives.
Option J: Joint Life Immediate Annuity for life with a provision for 100% of the annuity payable as long as one of the Annuitant survives and return of Purchase Price on death of last survivor.

Comparison of returns with other options

The actual annuity would vary based on many factors. For a person who is 60 years old, these could be the approximate rates.

• Annuity plan, with return of purchase price – About 7%  (taxable)
• Senior Citizen Savings Scheme – About 8%  (max corpus limit of 15 lacs)
• Tax free bonds – About 7%

Who should buy an annuity

The right answer for India is – No one.

1. The biggest issue with annuity plans is that they pay a fixed amount.  If the inflation rate is 7%, your expenses roughly double in 10 years. So within a decade, the annuity would meet only half the initial expenses. 
   • In a low-inflation economy, annuity plans could be suitable. But India is far from that yet.
2. The other big issue is that Indian tax laws include annuity in taxable income. This removes the flexibility to make this tax efficient.  (On the other hand, if done right, withdrawals from debt mutual funds can be made with very little tax impact.)
3. The third issue is the lack of liquidity. While it can be omforting for some to get a regular, guaranteed income, your corpus is also held up completely. Most annuity plans don’t offer an easy exit once the annuity payments begin.

However, some people are forced to buy an annuity. Every pension plan in India (including NPS) and the superannuation schemes let you commute (that is immediately withdraw) a partial amount of the accumulated corpus; the rest of the corpus has to be used to buy an annuity.

Pension schemes and Annuity requirements

1. Unit linked pension plan – At least 2/3 of corpus should be used to buy an annuity
2. Superannuation schemes – At least 2/3 of corpus should be used to buy an annuity
3. National Pension Scheme (NPS) – At least 40% of corpus should be used for annuity

Conclusion

While annuity plans are sold by life insurance companies, they don’t have the protection benefits. While they offer the comfort of a guaranteed income, inflation would make the income ineffective soon enough. The tax laws continue to treat pension and annuity as taxable income. Considering these factors, one should stay away from annuity plans, unless there is a requirement to buy one.