Pension plans offered by insurance companies have gained tremendous popularity in recent years, though whether they really help the person retiring remains debatable. Also, this is that time of the year when investors are looking to save on income tax by making investments to that effect. Here are things you should keep in mind before you go around investing in a pension plan.
The Webster’s English dictionary defines the word pension as “a fixed sum paid regularly, especially to a person retired from work.” What insurance companies sell as pension plans aren’t strictly pension plans. Individuals have a choice of kinds of pension plans: immediate annuities and deferred annuities.
An individual putting money in an immediate annuity plan is assured of a regular payment from the insurance company. This payment can be monthly, quarterly, half-yearly or annually, depending upon the way the individual taking the policy wants it to be structured. Immediate annuity thus ensures that the policyholder gets a regular pension. But for a working individual buying a pension plan, it of course does not make sense to buy an immediate annuity. What the insurance company is interested in selling and the individual is interested in buying is the deferred annuity.
In case of deferred annuity, the individual taking the policy needs to pay a regular premium. This premium is invested for a certain number of years. This phase is known as the accumulation phase. The money is being accumulated so that at the time of retirement, enough money has accumulated to earn a regular income. Once the accumulation phase is over, the money accumulated has to be used to buy immediate annuities either from the same insurance company or another insurance company.
Hence, deferred annuities are like any other investment product, which let you invest and hence accumulate a certain corpus of money, depending on the returns they provide. Hence, the term ‘pension plan’ is a misnomer in this case.
You can’t choose the best pension plan
Almost all pension plans are structured like unit linked plans. After deducting various expenses such as premium allocation charge (used to pay high commissions to insurance agents) and policy administration charge, the amount remaining is invested in an asset class such as equity or debt or a combination of the two, based on the choice of the individual buying the pension plan.
Now, since deferred annuities (or pension plans, as they are popularly known) are investment products, an individual should ideally be investing in the best performing pension plan. But as regular readers of DNA Money would know by now, trying to pick the best performing pension plan (like trying to figure out the best performing unit linked insurance plan) is next to impossible.
The reason is simple. Different insurance companies have different expense structures and hence their returns are incomparable. So, why settle for a product category where you can’t even figure out the best deal available, the sales pitch of the agent or the company advertisement notwithstanding.
Tax inefficiency of pension plans
Earlier, investments into pension plans used to get a maximum deduction of Rs 10,000. Now, when an individual invests in a pension plan, he or she gets a tax deduction of a maximum of Rs 1 lakh, like they would do in the case of tax-saving mutual funds or even National Savings Certificates.
But the tax law works differently when compared with regular insurance plans or tax-saving mutual funds, if the individual decides to get out of the plan midway or holds on till maturity.
As stated earlier, pension plans are essentially investment products.
A few years down the line, you might realise that the pension plan has not been performing well in comparison with other plans in the market. The logical thing to do would be to get out of the plan. But, there is a price to be paid.
As is the case with most unit linked plans, the insurance company might charge a surrender fee. Also, given the current tax laws, the individual will have to pay tax on the entire amount the insurance company pays him. And after all this, when you enter a new pension plan, you will have to bear the high upfront charges, which is the bane of most unit-linked products.
Now what happens at maturity? As per the current tax laws, the individual is allowed to withdraw one-third of the corpus tax-free. The remaining money has to be used to buy immediate annuities. This means that the individual will have to buy immediate annuities even when other kinds of investment might give him a greater return.
What if he wants the entire corpus at maturity? The only way out is to surrender the policy. But again, the problem is that on surrendering the policy, the entire corpus will be taxed at the prevailing tax rates.
Returns of immediate annuities
As of now, the post-tax return on immediate annuities has been lesser compared with other sources of regular income, such as the Post Office Monthly Income Scheme, Senior Citizens Saving Scheme or even senior citizens fixed deposits. In addition, if on a later date, immediate annuities give a better return, an individual can always buy those rather than opt for other regular income generating options.
So how do you build a retirement corpus?
Pension plans aren’t the only way to build a healthy corpus for retirement, notwithstanding the fact that they contain the word ‘pension’. In fact, a combination of Public Provident Fund (PPF) and tax-saving mutual funds can work much better in this regard.
The maximum amount that can be invested in PPF every year is limited to Rs 70,000. The remaining can be invested in tax-saving mutual funds. Those who are comfortable with more risk can invest more in tax-saving mutual funds and less in PPF.
PPF account matures 15 years after the financial year in which the investment was started and can be extended thereafter. When you withdraw the accumulated corpus, it is totally tax-free.
Same is the case with tax-saving mutual funds, which come with a lock-in of three years. Also, if the investor sees that his tax-saving mutual fund is not doing well, he can easily switch to another scheme. That flexibility, as we have already seen, is not available in case of pension plans.
Individuals should not fall for the bogey used by insurance companies against mutual funds — that mutual funds are for the short term whereas insurance is long term. But, that is really not the case. Mutual funds are as long term as the investor wants them to be and come with the flexibility of the investor opting out of one scheme and moving on to another. Also, at the time of retirement, the individual has the option of buying an immediate annuity, if he wants to.