Annuity plans have gathered a lot of attention over the past few days after finance minister Arun Jaitley made an announcement in his Budget for 2016-17, stating that 60 per cent of the accumulated contribution to EPF (employees provident scheme) will be taxed w.e.f. April 1, 2016. This has led to a crisis-like situation nationwide among the salaried class who depend on these deposits as their lifeline with many even contributing more via voluntary provident funds so as to ensure a bigger corpus when they retire.
They use this pool to take care of their financial needs — be it buying a house, education fund for their children, marriage fund or their own retirement. And taxing the maturity proceeds (it was later clarified that only the interest on 60 per cent contribution to EPF will be taxed) will lead to their overall corpus come down by 18 per cent as that’s what the effective tax rate would be. (If 100 is the interest and 40 can be withdrawn and 60 is the taxable portion assuming an effective tax rate of 30 per cent without surcharge and cess the tax rate comes to 18 per cent).
The reason given for this is to bring the retirement schemes on par with other schemes like the National Pension Scheme. Further, there will be no tax payable on this 60 per cent withdrawal, if it is re-invested in annuity or pension products for earning a regular income.
The rationale is that the government wants employees to let the money remain invested in pension products even after retirement. And for any financial need they are already withdrawing 40 per cent of their retirement kitty which is tax-free.
So is this forced decision by the government to make a retired person buy an annuity plan a good one and more importantly what are annuity plans and are these smart products for an investor to invest in them?
An annuity is a lump sum investment and a type of pension product to ensure a steady cash flow during your retirement years so that you need not be dependent on others in your old age. It may not be necessarily your retirement years and could be used to start giving you a return from the very first month, where an income is paid at regular intervals. The income amount is guaranteed for life and can be availed in various combinations and options.
Just like Life Insurance insures against the risk of pre-mature death, an annuity insures against the risk of outliving your retirement corpus. It provides protection against financial consequences that may arise if an individual lives too long and thus outlives his/her financial resources. It takes care of investment risk and income replacement risk. You could also have an option of deferred annuity which starts paying after a certain period.
Right now, only insurance companies offer annuity plans in India. The pension for life sounds attractive along with it other benefits of countering investment risk, income replacement risk and more importantly risk of outliving corpus. But these benefits become its biggest challenge — which shows in its low performance. The returns offered by these plans actually go down to honour the above commitments. Also all investors are measured with the same yard stick and there is no way to differentiate among various kinds of investors as there are different kinds of risk appetites – some may be conservative but some may be willing to take risk. This could be a showstopper for the investors who want to take risk and have the required risk capacity.
Annuity plans offer returns which are a little higher than your bank savings account. On an average the return varies between 6-9 per cent. This also depends on the age of annuitant and the plan taken for annuity. So you have to live not only with low returns but also with inflation risk as the value of capital will erode over a period of time. Thereby making a fixed deposit a better product with the flexibility of funds available at call.
There are annuity plans now which offer you inflation protection but the protection is too small with the annual increase not more than 3-5 per cent. And wherever the equity participation is allowed the risk taken by the scheme would be limited due to assurance of capital being the core objective of the scheme. There are various annuity options and the annuitant needs to choose the one which suits him/her the most. Life-time income, life-time income with capital refund, life-time income with annual increase of 3-5 per cent, life-time income with certain income for 5-20 years, joint life combinations are some of the options available. And the annuity you receive is treated as income and is taxable at marginal rate of tax for the annuitant.
Liquidity is another drawback in annuity. The plan does not acquire any paid-up value and there is no surrender value. At the same time it does not offer any loan. So in case of any need for funds the investor is left to himself to fend his finances and manage with the monthly income.
So it is a product with low returns, tax disadvantage and lack of liquidity. The advantage of “guaranteed pension for life” is what used to lures investors. And now with it becoming mandatory it leaves investors with little choice but to pick the best of whatever options available.
So, has the decision been a little nasty in forcing an investor to invest in annuities when the options are limited? Well, maybe yes, as the options to invest should have been wider in giving access to various asset classes.