Pension Plans from Insurance companies, understand it before investing..

By Karim Lakhani - CFP CM
Chief Financial Planner & Managing Partner 3rd EYE Financial Planners LLP
Academic Head 3rd EYE Academy for Financial Studies

Pension plans! Very popular amongst people who are not having privileges of pension from Employer if they are Employees of Private Sector or Self Employed people. And when time comes when employees have to plan for their taxes and declare investments under section 80C (80CCC), Pension plans are one of the favourite instruments where people think that they can save on taxes at the same time secure their retirement income, and they end up buying such pension policies/plans from Insurance Companies.

The understanding about the objective of such products is very right but they are designed in such a way that the objective is generally never fulfilled and they do not prove to be the best in class, reasons are many starting from designing to operational to regulatory to statutory.

Below are few of the drawbacks of pension plans that one has to understand before investing in it....

Liquidity: In pension policies you have 2 phases, 1^st is accumulation phase i.e. pre retirement period when you are earning and paying premiums and 2^nd is withdrawal phase i.e. post retirement period wherein you expect regular income in the form of pension also known as annuity. The policies are designed in such a way that they allow withdrawal only after retirement i.e. withdrawal phase. But if you try to withdraw money or surrender policy before maturity date or vesting age (retirement age), this will attract hefty penalty or surrender charges resulting in you receiving very less amount back, at times it is so low that you don’t even get what you have paid through premiums.  Before annuity starts i.e. pre retirement period you do have an option to withdraw or surrender the policy though with charges but once annuity starts it takes away even the little possibility of liquidity or withdrawal for life i.e. after retirement once annuity starts there is no option to surrender policy and withdraw the funds.

Flexibility: Another problem with such plans is you do not get flexibility to invest your money in alternate instrument if the former is not performing well, once you have started a policy, you have to stick to the same company & fund for the whole term, then whether you are happy with the performance or no, you have to continue without much of options. Flexibility is very important as pre retirement period is very long period and many opportunities will knock the door in between, there might be many better funds or options which can be introduced in between and having funds available at such time will help you take benefit, locking money in one instrument is like losing opportunities.

Charges: These policies charges are at a higher side spread across multiple heads, i.e. Allocation Charges, Admin Charges, Fund Management Charges & above that Service Tax. All these charges generally eat away all the returns generated by the fund and leave very less for you. Other than the above charges, such policies also attract surrender charges as discussed in the previous points.

Returns pre retirement: There are 2 variants of pension plans, 1^st is Traditional & 2^nd is Unconventional plan. Traditional policies invest in Government Securities and other secured Debt Securities and as a fact that everyone knows the yield is too low and after charges they end up giving returns between 5-7% which is even lower than inflation. The second one being unconventional i.e. ULIP’s, over here the investor though have an option to park their funds in Equities but due to high charges the net returns to the investor/policy holder is too low compared to what an Equity fund should generate.  

Returns Post Retirement: Once a person retires and opts for Pension/Annuity, all the accumulated funds are then transferred in to an annuity fund which is a pure Debt fund, again resulting much lower yields i.e. around (7-7.5% aprox) then other debt securities in the markets. And more over they are fixed in nature depriving you from interest rate benefits in future if the rates happens to go up.

Annuity options: Once a person retires and wants to start Annuity, has to select options out selected few available with Insurance Companies, some of them which is more popular and opted by many are

1)   Life Annuity: Under this option you get annuity for the whole life as long as you live and after death no money comes back to family. This is not a good option if death occurs in a very short duration after annuity starts.

2)   Joint Life Annuity: Under this option annuity continues throughout the life of couple, it continues even after the main annuitant (policy holder) expires. In this option Annuity reduces after the death of the main Annuitant which at times may not be sufficient for the surviving Annuitant and over here same as Life annuity, no money is received by the family members after the death of both the partners.

3)   Annuity with return of purchase price: In this option all the investments made i.e. purchase price to buy the annuity at the time of retirement will be returned to the family after the death of the Annuitant, but in such case the annuity received is so less that it proves to be insufficient at times to take care of even basic expenses.

There are many other annuity options but none of them prove to be better.   

Taxability: Insurance plans generally comes under EEE category i.e. Exempt at Entry, Exempt on Earning & Exempt at Exit but pensions plans are exception to this as it falls under EET i.e. Exempt-Exempt-Taxed. Pension plans get Tax benefit under section 80CCC at the time of Entry i.e. Premiums get exempt from Tax to the extent of 1L pa, all the gains, interest or profits earned out of Funds invested is also Exempt from Tax but the bitter part is Exit which is all Taxable, tax benefits at the time of exit is equally important or say more important at times when you have no other source of income other than Annuity. At the time of retirement you get 2 options, 1^st is convert all the funds into annuity & the monthly annuity will all be taxed as Income from Other Source as per your individual Tax Slab. 2^nd option being little beneficial than the 1^st which allows you to withdraw 1/3^rd of the Fund value as Lump Sum one time which is all tax free and the remaining 2/3^rd can be used to purchase annuity and the reduced Annuity will be taxed. But in this case also if the 1/3^rd part is reinvested in such instrument which is taxable on returns part then this option will add no value. If you try to withdraw all fund or surrender the policy before retirement or say Vesting age then all withdrawal will become Taxable in the year of withdrawal and will be added to that years income possibly at times pushing you in a higher tax bracket for that particular year. This is more dangerous and calls for double taxation for those people who had not taken 80CCC benefit at the time of investing/paying premiums as with their other investments 1L limit might have got exhausted, this purely being a retirement plan in such case the premiums paid were also taxed as 80C/80CCC limits were already exhausted resulting in tax on such investment in the year of payment of premium and again taxed at the time of withdrawal as in such case all amount withdrawn is Taxed without discriminating or considering Capital Gains (returns) & Principal (premiums paid).       

Overall I can say there are much better options available than pension plans which prove to be better in terms of returns, liquidity, flexibility, charge-ability & tax benefits.