Not financially savvy? Tackle reinvestment risk with deferred annuity plans

Invest only a part of your retirement corpus in them or else you will not be able to benefit from any rate increase

Returns on fixed deposits (FDs) have declined in the recent past. Many investors are fearful they may fall further and are hunting for instruments that will allow them to lock into current rates. One product they are turning to is deferred annuity plans from life insurance companies.

An investor who is, say, 50 years old, can put in a lump sum in a deferred annuity plan and allow his money to compound for 10 years. Once he retires at 60, the payouts begin. The option to pay a regular premium during the accumulation phase also exists.

Lock into current rates

The yield curve has been steep in India since the onset of the pandemic. “Interest rates over the longer term are higher than over the shorter term,” says Vivek Jain, head-investments, Policybazaar.com. By investing in longer-duration bonds, deferred annuities are, in many cases, able to offer better returns than fixed deposits (FDs).

Many investors fear that as India progresses, interest rates may decline to the levels prevailing in developed economies. It’s not possible to foretell if this will happen. But deferred annuities allow investors to lock into current interest rates. “These plans can be used to generate a fixed monthly income in retirement for the rest of your life,” says Naval Goel, chief executive officer (CEO), PolicyX.com. All other fixed-income products are subject to reinvestment risk: If the instrument matures when interest rates are lower, the retiree is forced to accept that rate.

Returns are low and taxable  

To be able to offer a guaranteed income for life, insurers invest the bulk of the premiums they collect in debt instruments (mostly longer-term government bonds), so returns are not high. Experts say their returns are unlikely to exceed 5-6.5 per cent.

It is hard for lay investors to figure out the exact rate of return they will get from these plans. Insurers are, however, not entirely to blame for this. “One knows the amount that will be paid, but not for how long the payouts will continue, since that depends on the investor’s longevity. That makes it hard to calculate the internal rate of return (IRR) of these plans,” says Deepesh Raghaw, founder, PersonalFinancePlan, a Securities and Exchange Board of India-registered investment advisor. The best you can do is get a financial advisor to estimate the IRR based on various longevity options, say, 70, 80, etc.

Locking in returns can work against the investor. “If inflation is high and stays so for a while, interest rates could rise. An investor who locks into current rates will not be able to benefit from this increase,” says Avinash Luthria, a Sebi-registered investment advisor and founder, Fiduciaries. A savvy investor, or one with an advisor, could also earn a higher rate of return during the accumulation phase by investing in mutual funds.

The entire income received from an annuity after retirement gets taxed at slab rate. “The return from a without return of purchase price (RoPP) annuity would be a mix of interest income and a part of your principal being returned to you. The taxman doesn’t distinguish between the two and taxes the entire amount,” says Luthria. Taxation at slab rate is problematic for investors in the higher tax brackets.

Who should invest?      

Investors who are not financially savvy, or don’t have an advisor, can use these plans. “They can guard against the risk that someone who is not savvy or disciplined could mess up his investments during the accumulation phase,” says Raghaw.

Even savvy investors may consider putting a part of their retirement corpus in these plans. “The rate of return on annuities 10-15 years later could be lower, so you may lock partially into current rates,” adds Raghaw. Since annuity rates are low currently, he suggests staggering one’s purchases.  

Some advice on purchase

For a better rate of return, it is advisable to purchase the without-RoPP option. Its only downside is if the person dies early in the withdrawal phase, his investment is lost.

Buy from a stable and bigger brand. “We are talking about payouts happening over 30-40 years,” says Goel. While it is difficult to calculate the IRR, you can compare the payout that different insurers will make, and go with the one that pays more.  

Purchasing these plans online will get you a slightly better rate of return.  

Finally, do the math backward. “Decide how much monthly payout you want from this plan to arrive at how much you should invest in it,” says Raghaw.