Annuity is a contract which provides payouts to the subscriber of a scheme such as a pension plan. In essence the most common type of annuity in India occur in case of pension plans, as in effect, they function as an agreement that entitles payouts to the purchaser at a future time such as after retirement. In India, purchase of annuities is among the most common methods of financing retirement expenditures and is considered by most experts to be a form of insurance rather than an investment option.
Types of Annuity
There are various types of annuity on offer to individuals desirous of seeking a steady source of income after their retirement. The following are some of the key types of annuities on offer in India.
Lump sum Annuity: Though the most common type of annuity plan features regular payouts after a specified period of time, some annuity plans do provide the option of providing a lump sum payout. Such a lump sum payout is usually optional and available only at certain period of time. However in most cases the entire retirement benefit cannot be obtained as a lump sum. For example, in case of NPS 40% of the total amount accrued needs to be mandatorily utilized for annuity purchase and cannot be withdrawn as a lump sum.
Periodic Annuity: Periodic annuity as the name suggests, is designed to provide the subscriber with payouts at regular intervals. Such intervals can be in a monthly manner similar to a system of pension. Alternately, it could be paid out in a phased manner at regular intervals such as at the end of the 5th year, 10th year, 15th year and so on irrespective of whether all premium payments have been completed or not.
Immediate Annuity: This style of annuity features the payment of lump sum as premium in order to subscribe to the scheme. Once this lump sum payment is made, annuity payouts to the subscriber start immediately as per the applicable payout criteria.
Deferred Annuity: Unlike in case of immediate annuity, deferred annuity payouts feature an interval between the time premium payments are initiated and the annuity payouts begin. The period during which the subscriber makes premium payments is termed as the accumulation phase of the scheme. On completion of the accumulation phase, the accrued amount is utilised for purchase of annuities which provides the future payouts to the subscribers.
Fixed Annuity: In case an individual signs up for a fixed annuity plan, the annuity payouts will remain constant over the entire period during which the payouts occur. In common practice, the fixed annuity plan is a relatively conservative option as they are mostly invested in fixed income instruments. Hence there is potentially little growth of the principal amount invested over the accumulation phase of the annuity plan. However in many ways, a fixed annuity is preferable as a pension payout because this system guarantees income to the individual during post retirement years.
Variable Annuity: The variable annuity also termed as participating plans feature variations in the annuity payouts between one payout and the next. This variation is in major part linked to market performance of the investments made by the pension fund or pension plan that the individual is invested in. In case good returns are received by the company managing the scheme, the annuity payouts will be higher otherwise the annuity payouts will be lower. As a result of being market linked, such plans cannot provide guaranteed results which makes them a comparatively risky proposition for a number of pensioners or prospective subscribers. At present, one of the best examples of a variable annuity investment is the NPS scheme, which being a market linked investment, does not provide assured returns or payouts unlike the earlier systems of central and state government pensions which are slowly being phased out.
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Taxation of Annuity
Annuities are designed to provide the benefit of pension payouts which from the perspective of income tax authorities is treated similar to a monthly salary. Thus, it is taxed according to the prevailing income tax rules. It is also noteworthy that the pension income is added to income from all other sources as part of the taxable income of the individual. As per recent changes in the slab rates, the current income tax slabs applicable to annuity payouts received by an individual investor (senior/super senior citizens) are as follows*:
|Income Tax Slab (Annual Taxable)||Tax Rate for Senior Citizens (60 years to 80 years of age)||Tax Rate for Super Senior Citizens (>80 years)|
|Up to Rs. 3 lakhs||Nil||Nil|
|Rs. 300,001 to Rs. 5 lakhs||10% on amount exceeding Rs. 3 lakhs||Nil|
|Rs. 500,001 to Rs. 10 lakhs||Rs. 20,000 + 20% on total taxable income exceeding Rs. 5 lakhs||20% on total taxable income exceeding Rs. 10 lakhs|
|Above Rs. 10 lakhs||Rs. 1.2 lakhs + 30% on total taxable income exceeding Rs. 10 lakhs.||Rs. 1 lakh + 30% on total income exceeding Rs. 10 lakhs.|
*(i) The above rate is exclusive of surcharge at 15% which is applicable to annual taxable income over Rs. 1 crores.
(ii) Additional 2% education cess and 1% secondary and higher education cess is applicable on income tax and the applicable surcharge.
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Annuities are purchased by the retirement fund or other relevant management body depending on prevailing market conditions. However, as future market conditions cannot be predicted with any degree of certainty, a specialized calculator is required to provide estimates. This calculator known as the annuity calculator is designed to help investors estimate how much they need to invest during the accumulation period of the pension plan in order to reach the desired corpus at the end of their investment tenure. As the pay out of annuity is almost exclusively used by pension plans and funds, some companies also term it as the retirement planning and pension calculator. The following are the key inputs required to calculate the savings that an investor needs to generate by the time they retire.
Demographic Information: This refers to the basic demographic info that the calculator requires to provide estimates. The key data points required in this specific case are – current age of the investor and the expected retirement age of the investor. These data points are utilized to determine the extent of the accrual phase of the annuity plan. The earlier in life an investor starts to invest, the longer the period during which he/she can stay invested. This will allow the investor to maximise the benefits of compounding, which would potentially increase the payout to the investor at the time of retirement.
Income Information: Savings target for the present and future need to be realistic, hence it is necessary for the calculator to receive key input data including current annual income of the investor. The current income would have a direct bearing on the investor’s ability to save and this is the key to ensuring accuracy of the retirement corpus calculation. An additional field to consider in this case is the expected rate of income growth. Historically, an individual’s income witnesses an increase as they have gathered more experience and grown in their chosen field. This info allows the investor to estimate how much annual income growth he/she can expect over the coming years.
Current Savings: As the power of compounding benefits investors starting early the most, the existence of savings currently available to the investor is an important consideration in calculating future value of an adequate retirement corpus capable of generating the desired annuity income. It is important that the investor should consider these savings as a separate category i.e. retirement savings and not consider it to be part of marriage, children’s education, etc. savings. It is additionally important to consider how these savings are held – FDs, mutual funds, stocks/bonds, etc. The key factor to consider here is their overall risk vs. return perception. FDs being low risk potentially offer low returns, mutual funds offer potentially higher returns than FDs with relatively higher risk whereas, stocks/bonds offer the highest rewards and feature the highest potential risk among the three.
Expenses: The ability to save is directly dependant on not just the earnings of the individual but also the current expenses that the individual makes. It is obvious that in case the expenses of an individual are low, the savings have a potential to be higher while if expenses are high, the potential to save will be lower for the individual. Additionally, the current expenses of an individual would go up in the future after factoring in the inflationary trend that is integral to the deficit financing model.
Rate of inflation: The rate of inflation has a two pronged effect on future savings. For one, expenses would tend to go up with the passage of time and at the same time, future returns would appear to be less valuable when adjusted for inflation. This adjustment for inflation is commonly applicable to debt mutual funds and is termed as the indexation benefit. In common practice, a higher rate of inflation would require the investor to save more in order to meet the future retirement savings target, while a lower rate would have the opposite impact.
Expected Rate of Returns: In common practice, investments are broadly classified into two key categories, fixed rate and variable rate. As the name suggests, fixed rate investments offer a constant rate of return whereas the ROI in case of variable rate investments tends to change depending on market conditions. In case a higher rate of return is obtained, savings would tend to grow faster, hence lesser amount of savings will be required during the accumulation phase in order to reach the retirement corpus.
Annuity Calculator Results: By providing the above data, a prospective investor can calculate the retirement results that will provide key data such as – total retirement corpus, future value of available savings and additional savings required. The total retirement corpus denotes the amount you would need to sustain your present expenses in the future after factoring in the rate of inflation. Current investments that grow at the expected ROI will yield the future value of investments. Lastly the difference between the total retirement corpus and the future value of current savings will yield the amount that the investor needs to accumulate to reach the target corpus. Finally the individual is also provided a monthly savings target over the tenure of the accumulation phase to reach the required retirement corpus.
How to Buy Annuities
As annuities are considered to be a form of insurance in India, it is obvious that these can be bought from major life insurance companies, both private and public-sector ones, currently operating in the country. However, apart from life insurance companies, annuities can also be bought from specific AMCs that are entrusted with managing the NPS (New Pension Scheme) which is currently open for subscription by all Indian citizens.
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FAQs on Annuity
Q. What is the difference between an Annuity and Mutual Fund?
A. Although the investment mandate and investment costs are nearly the same, Mutual Funds offer more diversification (as annuities invest mainly in fixed income securities) and have lower expenses. The taxation rules for both are different. Also, in Annuity the mode of payment is lump sum and not something periodic as SIP.
Read More: Know the difference between Annuity & MF
Q. Can you roll an Annuity into a Mutual Fund?
A. Yes, you can but it is suggested not to do as you will be charged for it. The charges depend on the amount of investment, the investment tenure and age and are a kind of surrender charges fined as a penalty. You must see the surrender charge percentage in your annuity contract and check if this roll over/switching to MF is worth the penalty deductions.
Q. Is Annuity and 401K the same?
A. No, they are not the same in spite of the fact that both are tax sheltered investments (income tax on these plans not incurred until you withdraw). Annuity is like a contract between an investor and an insurance company while 401K is an employee sponsored program. 401K is more of a relevant term in the USA. In India, Its equivalent plan is EPF (Employee Provident Fund). In an Annuity, you have to pay a lump sum amount and there is neither any limit nor it is tied to your workplace. In EPF (or even 401K), eligible employees invest a portion of their salaries in this scheme under a certain limit and the employer too needs to make a matching contribution.
Q. What are the disadvantages of investing in an Annuity?
A. The commission charges are usually higher than MF and early withdrawal or surrender charges are also high. Also, unlike Mutual Funds, the returns are not taxed as LTCG or STCG (Long or Short Term Capital Gains respectively) but as ordinary income once the withdrawals start.
Q. Is Annuity Income taxable?
A. Yes, it is. It is tax deferred as you have to pay tax not at the time of investment but at withdrawal. Also, the returns are not taxed as capital gains like MF but as ordinary income. If the Annuity is a Qualified one i.e. no taxes were paid earlier then it is taxable as income (as per income slabs) and if its a Non-Qualified one i.e. the Annuity was purchased after tax funds then it is taxed as per a calculation method called Exclusion ratio.
Q. Is Annuity Income a Capital Gain?
A. No, it is not. As mentioned above, Annuity Returns or Income do not qualify for capital gains but are taxed as ordinary income.
Q. What is a Variable Annuity?
A. Variable Annuity is unlike the conservative plan of Fixed Annuity (fixed Annuity payments). In Variable Annuity, the payouts depend on the market performance of the scheme the investor is invested in. It is slightly risky as annuity payouts may go higher or lower depending on the returns received in the scheme by the company from the market.