What is annuity? Younger people may not know sufficiently about it.
But ask financial advisors, and they will invariably suggest a retired person to buy an annuity.
Annuity is not a popular investment vehicle for people below 60.
But after retirement, it is hard to ignore annuity.
What makes annuity such a desirable investment option for retired people?
Generating a “steady source of income” is a first priority for retired people.
Annuity is that investment vehicle which generates a steady source of income.
In the market there are other investment options available, which also promises steady income generation.
So why annuity is so popular?
No, I am not going to say that its rate of interest is high.
It is popular because it is tailor made for retired people (like POMIS and SCSS).
When one buys an annuity, he/she must be assured that, “income generation” is the only objective for the fund manager.
Unlike other hybrid income generation plans, where conflict of interest may arise.
But in annuity, priority is only “income for aged”.
Moreover, annuity plans are very closely watched by IRDA, which is a Government body regulating the whole insurance sector.
#1. How assured is the income from Annuity?
Lets see a counter example first.
Suppose a retired person decided to put his money in bank’s fixed deposit (FD) for next 10 years.
As on today, a 10 year bank FD will pay an interest close to 6.9% per annum.
But this interest payment remains fixed for life?
Not really. With changes in MCLR, the offered rates on FD also varies.
If MCLR goes down, interest rate offered on a 10 year FD will also fall.
But this is not the case with Annuity.
Interest rate offered by an Annuity at the time of purchase remains fixed throughout its lifetime.
#2. Interest rate offered by annuity is low…
Do not worry about it. This will change with time.
Low interest rates offered by annuity today, will become attractive tomorrow. How?
Yes this is going to be the most likely case in India.
It is possible to buy a type of annuity which guarantees a fixed income for life.
This is only possible when the offered interest rate remains same for the lifetime.
Hence, it is not easy for insurance companies to offer such annuities (guaranteed income for life).
There were insurance companies in Europe which became bankrupt by offering such types of annuities at attractive interest rates.
Probably this is one reason why, private players in Indian insurance sector offers lower interest rates.
#2.1 Pradhan Mantri Vaya Vandana Yojana (PMVVY)
Life Insurance Corporation of India (LIC), offers best rates when it comes to Annuity.
One such example is “Pradhan Mantri Vaya Vandana Yojana (PMVVY)” of LIC. It is offering 8% interest.
The question is how?
On one side banks can offer only 6.9% interest rate on 10 year FD. But on other side, LIC is offering 8% interest for life time.
[Important: 8% for lifetime is equivalent to 8.3% for 10 years]
How is this possible?
This is possible, because of the following two reasons:
- LIC is compensated by Indian Government if they are not able to generate 8% p.a. return themselves.
- The maximum amount that one can invest in PMVVY is Rs.7,50,000.
- Maximum income that this annuity plan will generate is Rs.5,000 per month.
(There is a speculation that GOI is planning to increase the max investment amount from Rs.7.5 lakhs to Rs.15 lakhs)
For sure, income of Rs.5,000 per month is not enough for a retired person to maintain a decent standard of living.
But an assured income @8.0% per annum for life time cannot be ignored.
This is one reason why, I firmly believe that a plan like PMVVY must be included in the investment portfolio of a retired person.
[P.Note: PMVVY is only available between 4th May, 2017 to 3rd May, 2018.]
#2.2 Why @8% is a great return?
Why an assured income @8.0% per annum for life is so critical?
At present the repo rate of RBI is high (compared to other developed nations).
But such high repo rate will not remain forever.
In last 13 years (2005 to 2018), the average repo rate in India was as high as 6.88% per annum.
But in the next band of 13 years (from 2018 onwards), the average repo rate will be probably below 6% mark.
Over longer time horizons (20/25 years) looking into future, average repo rate will fall further.
This was the same case in Europe.
While the economy is developing, repo rates remain high. But as the country comes closer to becoming a developed economy, repo rate will fall further.
In Germany, the bank lending rate in 2018 is as low as 2.48%.
The point is, with passage of time, interest rate will fall.
Any investment option in India, which offers current interest rates to remain valid for rest of life must be grabbed with open arms.
#3. What is annuity?
Annuity is a product offered by insurance companies.
But it is not a life insurance policy.
In fact it resembles more a debt based investment option (like bank FD), than an insurance scheme.
Annuity assures the investor of a predefined regular payout (monthly, annually etc.), for life time or for a predefined period.
Generally people buy annuity to generate a fixed stream of income for life time.
But this is not the only type of annuity available in India.
There are many other types of annuity plans available in India.
#4. Different types of annuity plans in India
Not every body would like to buy an annuity to generate fixed income for lifetime.
Depending on ones priority and needs, the insurance sector offers different types of annuity plans.
Each annuity plan serves their own set of purpose.
Lets see few annuity plans and their purpose:
#4.1 Payout for lifetime (principal is protected):
This type of annuity plans are most commonly purchased by people.
They provide a fixed income for lifetime.
The payouts can be obtained on the following terms:
Depending on the term selected by the investor, the cost involved to buy the annuity will vary.
Example: Suppose a person wants a fixed income of Rs.5,000 per month from annuity like PMVVY.
What will be the cost of buying this annuity?
Will it be the same for all payout frequency (monthly, quarterly etc)?
It will not be the same.
Depending on ones payout terms, the cost will vary as shown below:
This type of annuity also comes with a death benefit.
The full purchase price (Invested amount) is paid back to the nominee upon death of the annuity holder.
#4.2 Payout for lifetime (principal is lost):
There is no death benefit in this type of annuity.
But in this type of annuity, the payout is maximum.
This type of annuity will cease to provide income after the death of the annuity holder (buyer).
This annuity is also like #4.1, but as here the principal invested amount is not recoverable, the payout will be higher.
#4.3 Payout only for a pre determined period:
In this type of annuity, payout is not for lifetime.
Here the payouts can be for the durations as below:
- 5 years time horizon.
- 10 years time horizon.
- 15 years time horizon.
In this type of annuity as well, the principal amount is lost after the expiry of the term.
Hence its payout is higher.
But what happens when the buyer dies before the term expires?
In this case the nominee with continue to receive the payout till the end of the term.
#4.4 Payout with annual increase:
This type of annuity is very interesting.
In the initial years, the payout will be lower. But with time it will grow.
Consider this, when a retired person needs money the most?
The higher will be the age, more will be the need for money.
This is exactly what this type of annuity offers.
Here the payout will grow at a predetermined rate of say 2% or 3% or 5% per annum. The growth rate will be offered as per the finalised and agreed Annuity terms and conditions.
It must be noted that, the rate of growth will not be linked to inflation.
But the best part is, this annual growth will continue to happen for the lifetime.
Such annuity has been offered by ICICI Pru in their website.
#4.5 Payout till spouse is alive (principal is lost):
In #4.1, we have seen a type of annuity where the principal invested amount is paid back to the nominee after the death of the annuity holder.
In this case a lump-sum amount will be received by the spouse (if spouse is the nominee).
But such lump-sum payments often get miss-utilised on the receivers end.
Hence a better decision will be to buy a annuity where, after the death of the annuity holder, the spouse will continue to received the same payout.
But there are few limitation here (as compared to #4.2):
- The payout will be smaller than #4.2.
- After demise of the spouse there will be no payout (principal is lost). But I am sure for a retired couple, this is not a main cause of worry.
#4.6 Payout till spouse is alive (principal is protected):
This annuity is similar to #4.5. But in this case the principal amount is not lost.
Here the principal is paid to the nominee after the death of the retired couple.
Lets sum up…
So now we know what is annuity?
It is that investment option which has been tailor made for retired people.
The main purpose of an annuity plan is to generate a fixed income stream for aged people.
But to maintain the utility of annuity, insurance companies provides several types of annuities.
If the priority is high income generation for lifetime, following annuities will be the best alternative:
- Payout for lifetime (principal is lost, #4.2).
- Payout till spouse is alive (principal is lost, #4.4).
Have a happy investing.