The major difference that comes in someone’s life post retirement is the lack of continuous flow of income; which can adversely affect one’s standard of living. This means that planning to have a continuous flow of income post retirement is of utmost significance. Continuous flow of income can be generated through dividends, interest income, rent from real estate investment or through annuities.
What is an Annuity?
Annuity is an insurance product that is used to help increase and protect ones savings or generate a stream of income post retirement. The regular cash flow can be received either for whole life or for certain period of time post retirement depending on the kind of annuity selected. The annuity comes with a life insurance cover i.e. if the buyer of annuity dies before retirement then benefit will be given to the nominee or to the legal heir.
An annuity is a financial contract that is made between a financial institution and an annuitant. The financial institution that sells the annuity product is an insurance company also called an issuer. The annuitant is a person who buys the product is known as the buyer.
How Annuities Work?
Basically the entire term of an annuity plan is divided into two phases: the accumulation phase and distribution phase. In accumulation phase the buyer of an annuity will deposit money to the issuer either in lump sum or through regular fixed payment. In the distribution phase the issuer makes periodic payment to the buyer of the annuity.
Let’s take an example to explain about the working of annuity. Ravi is 35 years old and he plans to retire at the age of 55 and he wants to buy annuity for 20 years post retirement. He has estimated that he can live comfortably on a monthly income of Rs.40,000 post retirement. Henceforth twenty years is the accumulation phase for Ravi and 20 years afterwards the distribution phase will start.
Now let’s focus on the amount Ravi needs to have at the time of retirement in order to receive monthly income Rs.40,000 until 75 years of age. For that we will have to discount all the monthly payments that Ravi will receive after retirement to the time of retirement i.e. when Ravi will retire, which in this case is 55 years of age.
To calculate the discounting factor we will assume annual interest rate of 12% throughout the period of annuity.
Present Value (at 55 year of age) = Rs.36,32,777 ( Calculation can be seen in the attached Excel Workbook)
Ravi needs to have Rs.36,32,777 at the time of retirement for the annuity of Rs.40,000 per month. Ravi can either pay Rs.3,33,510 pay today in lump sum and let the amount to compound for 240 months (calculated amount is the present value of the amount required at the time of retirement) or he can opt for a monthly payment of Rs.3,636 (beginning of the month) for next twenty years.
Types of annuity
There are different types of annuity available and on the basis of the type the return on investment can vary.
Fixed Annuity: It offers a fixed rate of return on your money invested and pays out a guaranteed income post retirement irrespective of what’s going in the financial markets. These are the safest ones and hence offer low rate of return.
Variable Annuity: It offers variable rate of return on your money invested depending on the kind of investment option you have chosen. It has a minimum guaranteed but the rate of return can be increased if financial market does well. The risk is that financial markets do badly leading to lower returns.
Hybrid Annuity: It’s a combination of fixed and variable annuity. In this one can allocate certain amount of investment for fixed return and rest can be allocated to variable annuity which will give return depending on the performance of financial markets.
Immediate Annuity: It’s a kind of annuity which will provide immediate income at the time of retirement and he will immediately start receiving regular income. This annuity can be purchased by paying lump sum amount also known as the single premium.
Deferred Annuity: It’s a kind of annuity, if purchased at the present date, gives you income at a future date. During the accumulation phase you will have to either make one payment or multiple payments but the income will start only at the beginning of distribution phase.
The employee’s contribution, in the case of the Contributions scheme, qualifies for exemption under Section 80C of the Income-Tax Act.
In the first phase i.e. in the accumulation phase contribution (Self or employer) above Rs.150,000 (limit is subject to change) becomes taxable in the hand of employee if the contribution is made by the employer or in the hand of the buyer of the annuity if there is no contribution of the employer.
In the second phase i.e. in the distribution phase the benefit in the form of regular payment is taxable.
Authorised Annuity Service Provider (ASP)
A life insurance company registered and regulated by Insurance Regulatory and Development Authority (IRDA) and empanelled by Authority for providing annuity services to the subscribers.
- It helps annuitant to generate regular income post retirement.
- It comes with a benefit of life insurance cover.
- The contribution comes under section 80(c) and hence can be exempted from tax to a limit of Rs.100,000.
- Low interest rate compared to other investment avenues.
- It’s better to buy immediate annuity as in the accumulation phase the amount can be invested elsewhere which gives higher returns and investor can also take the benefit of 100% tax free status on long term capital gains.
- The income received post retirement is taxable.