Buying a pension plan? Pick annuity first

Published in Mint on Aug 17 2015

 

The Insurance Regulatory and Development Authority of India (Irdai) has now made it mandatory for customers who buy pension plans from life insurance companies to select an annuity option at the time of purchase itself. An annuity is a pension product that provides periodic income. You buy a pension plan to accumulate a corpus, and on retirement or maturity, you use this nest egg to buy an annuity, which gives you pension for life.

The regulator felt that putting off the decision to buy an annuity till maturity leads to delays. “Due to non-receipt of annuity options from the concerned (sic) policyholders before the vesting date (maturity date), it’s leading to delay in the commencement of annuity on vesting date and consequent inconvenience, loss to annuitants,” said the Irdai circular of 4 August.

This will apply to all annuities falling due from 1 April 2016.

“Irdai is trying to achieve a seamless transition from accumulation phase to annuity phase. If there is a gap in exercising the option, the insurer may not credit further returns on the accumulated fund during the period of delay while annuity returns have not yet commenced because the option is still not exercised. The customer may get nothing during this period. This is the loss that Irdai is trying to avoid. But it’s possible to address this issue by making the insurers pay during the gap period too,” said P. Nandagopal, chief mentor, OpenWorld Money, a financial planning platform.

Here’s a look at how pension plans are designed and the types of annuities available.

Pension plans explained

The pension plans that help you accumulate a corpus are called deferred pension plans. These are deferred because the pension money or annuity doesn’t come to you immediately but in due course. You have to invest regularly for a defined period in the case of regular premium policies. On maturity or vesting, the accumulated retirement corpus becomes available and you can annuitise the corpus to get regular income for life.

Insurers offer two kinds of pension plans: traditional non-linked pension plans and unit-linked pension plan (ULPP).

Traditional plans are opaque investment products that don’t disclose investment portfolio or costs. They could either offer a minimum guaranteed return and peg additional returns to bonuses coming from the participating fund, or offer a guaranteed benefit at the very outset.

ULPPs, on the other hand, are market-linked products. The premium gets invested in funds of your choice. The costs as well as fund performance are made transparent to you.

According to rules prescribed by Irdai, pension plans are mandated to offer a non-zero positive return of premiums that will be given to the policyholder on maturity or to the beneficiary in case of death of the policyholder. Because of this rule, ULPPs don’t typically offer pure equity funds for investment.

In the case of ULPPs, there is a lock-in of five years. In traditional plans, heavy surrender penalties apply to discourage early surrenders. Moreover, you don’t get back all the surrender money; the rules now allow you to take only up to one-third as lump sum and two-thirds has to be annuitised or you can use the entire proceeds to buy a single-premium pension plan from the same insurer.

On maturity, you can keep only up to one-third of the corpus as lump sum and the rest needs to be either annuitised or used to buy a single-premium deferred pension plan.

Types of annuities

Annuity is a fixed sum that you get every year to provide for pension. They are of various types but all of them come at a fixed rate from the beginning. The rate depends on factors such as type of annuity you buy, your age and the current economic scenario. But once decided, the rate is guaranteed for life. Maximum you get is through life annuity without the return of purchase price or principal. In this, you will get periodic payments for as long as you live, but forego the principal amount. The return of purchase price, on the other hand, will mean that principal goes to your nominee after your death. So, for, say, a 60-year-old man with a corpus of Rs.1 crore, without return of purchase price annuity would give annuities at a rate of 8.72% per annum for annual payouts, whereas return of purchase price will give 7.07%.

There is a third type—joint life survivor annuity. In this you, and then after your death, your spouse, will get periodic income for life. You can choose to get back the principal.

There are also inflation-indexed annuities, in which periodic payout increases at a certain rate of interest a year. Then there are annuities that are guaranteed for a fixed number of years, usually 5, 10 or 15, which means that even if the policyholder dies during this period, the spouse gets paid till the guarantee period ends. Ask your insurer for a more exhaustive list. “Life annuity without return of purchase price offers the maximum payout. It makes sense for individuals who don’t have any dependants. With a joint life annuity, the spouse is protected and a return of purchase price can be opted for in case the customer wants to leave something for nominees,” said Suresh Sadagopan, a Mumbai-based financial planner. “In inflation indexed annuities, pay-out starts with a small amount at first and gradually inflates. Unless annuitant has a large corpus, annuity may not be adequate in the initial years,” he added.

Delay in paying annuity

Insurers have welcomed Irdai’s rule of making customers buy annuity at the time of buying the policy. This is because now that policyholders are allowed to buy annuity from the same insurer itself, the new rule will result in better understanding of the product and will develop the annuity market. “Earlier, many insurers offered deferred pension plans but didn’t have annuity plans, forcing customers to go to LIC (Life Insurance Corporation of India). To de-risk LIC (annuities contain long-term interest rate risk), the regulator mandated that annuities can be bought from the same insurer only. The next step was to smoothen the process and plug administrative delays so that the long-term savings objective is met,” said Vighnesh Shahane, whole-time director and chief executive office, IDBI Federal Life Insurance Co. Ltd.

However, your choice is not carved in stone. According to the circular, the insurer will have to send a communication to the policyholder six months before maturity intimating her of the annuity amount under various options available and the selected option. The circular said that the insurer will give the policyholder the chance to review her decision based on latest information and then select an annuity option that’s different from what she had chosen earlier. “(The) insurer shall clearly inform the policyholder in that communication that the last date for receipt of revised option, if any, is at least 90 days prior to the date of vesting, giving a specific date,” the circular stated. This means that if no revised option is received at least 90 days prior to date of vesting, the insurer can go ahead with the annuity chosen earlier.

The purpose of the new rule is to plug leakages, but pension plans are grappling with a larger problem—they have lost favour with insurers because they have to offer a minimum guaranteed return, even in ULPPs, and given the fact that customers have to buy annuity from the same insurer, choice gets restricted. “Instead of asking customers to pick an annuity at the outset, they should be allowed a free-look period of about 6 months after the annuity starts so that the buyer can change her mind. It’s also important to allow a buyer to not buy an annuity at all and exit the policy perhaps by paying tax or a penalty,” said Kapil Mehta, executive director, SecureNow Insurance Broker Pvt. Ltd. This is important as with a pension plan, you are committing to annuitise two-thirds of your corpus for a time that’s much later in the future.

The Irdai circular aims to plug delays and develop the annuity market, but you need to do your due diligence in terms of picking the right annuity product.

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