Deferred annuity plans need caution in investment to avoid mis-selling

Before falling for the promised return, consider the principle of time value of money

Even high-quality investment products can be sold inappropriately. Consider a Nifty index fund, which is typically a low-cost and efficient equity product. If this fund, despite its merits, is marketed for a short-term financial goal, such as an investment horizon of just two months, it is mis-selling.

The writer encountered a similar problem with an annuity product offered by a well-known insurance company. Annuity plans can be an effective income source when purchased correctly and considering the appropriate variant and age. They lock an interest rate for life, a feature not available in other investment products. Additionally, by staggering the purchase of annuities, one can enhance income and mitigate risk during retirement.

An investor received the following message: “Good News!! You wanted it & we have revised our deferred annuity rates only for you. You can now get a guaranteed 12.3 per cent annuity with a one-time contribution. Invest Rs 1 cr once and get Rs 12,28,634 per annum for life + Return of investment in XYZ Guaranteed Pension Plan – Deferred Annuity."

These days, when senior citizen bank fixed deposits are yielding 7-8 per cent per annum, guaranteed 12.3 per cent per annum for life is an excellent return. But there is a catch: The promotion is for a deferred annuity plan.

There are two types of annuity plans: Immediate, starting pension income right away and deferred that start income after a few years.

The message the investor received clearly offered a deferred annuity plan. If you invest Rs 1 crore and start getting Rs 12 lakh from the first year until demise (and the family gets back the purchase amount in the event of demise), then you can say that the return is 12 per cent per annum.

However, if you invest Rs 1 crore but the pension income for life starts after 10 years (the family still gets back the purchase amount after investor’s demise), then the return is obviously not 12 per cent per annum.

This is how. Let’s say you have Rs 1 crore and you invest in a product that offers 6 per cent return post-tax. In the next 10 years, this corpus will grow to Rs 1.79 crore. For a corpus of Rs 1.79 crore to generate an income of Rs 12 lakh per annum, you need a return of just 6.7 per cent per annum. This 6.7 per cent is pre-tax (since annuity income is taxable).

So, we are talking about returns of about 6-7 per cent. You can earn a similar return in a bank fixed deposit too. Where is the 12.3 per cent that the promotion mentioned?

Note: With bank fixed deposits, you can’t lock in interest rates for life. 

Mentioning 12.3 per cent is a trick to attract investors. Yes, you get Rs 12.3 lakh per annum on an investment of Rs 1 crore but this income starts after 10 years. What about the time value of money?

*Annuity purchases are subject to GST of 1.8 per cent. Hence, while your pension income is calculated on Rs. 1 crore, you will have to pay Rs 1 crore + 1.8 per cent = Rs 1.018 crores

Where is the improper communication?

In no scenario does the plan return 12.3 per cent. The plan offers a deferral period of one to 10 years. The pension is not same for all deferral periods. Expectedly, lower the deferral period, lower the pension.

I checked the annuity amounts for various deferral periods for a 64-year-old investor. For a deferral period of one year, the pension amount was Rs 6.89 lakh. For deferral of five years, the pension amount was Rs 9.38 lakh. For 10 years, it was Rs 12.29 lakh (and this was mentioned in the promotion).

I calculated the internal rate of returns (IRRs) too (for a 64-year-old investor at entry). With annuity plans, everything is known upfront except the date of investor’s demise. I calculated the IRRs for demise at various ages.

Death at the age of 80 would result in an IRR of 5.33 per cent per annum; 4.82 per cent if the investor dies at the age of 85; 5.42 per cent if the investor passes away at the age of 90; and 6 per cent if the investor passes away at the age of 100. Nowhere close to the 12.3 per cent mentioned in the promotion.

What should you do?

Nothing wrong with a deferred annuity plan. If a deferred annuity plan fits into your financial plan, go for it.

I do not look at annuity products purely from the point of view of IRR. We must also appreciate these products for the peace of mind they can provide. For instance, a 50-year-old without a pensionable job is looking for a simple product to generate low-risk income after he/she retires at the of 60. He is not investment savvy and not really looking to optimise returns, just peace of mind that there will be a guaranteed income for life during retirement. Such investors can find deferred annuity plans attractive. Put Rs X per annum for 10 years and get Rs Y per month for life. Can there be a simpler product?

However, the key is not to fall for misleading communication. Understand the product properly before investing.

The problem is: Not everyone understands or can do the math. A 6 per cent return may be an acceptable return to an investor, but that investor should not buy a 6 per cent return product thinking it offers 12 per cent.

When an insurance company or an agent tries to sell a 6 per cent product while giving the impression that it offers 12 per cent, it is mis-selling.

Calculating internal rate of return (IRR)

There are two types of annuity plans: Immediate (where pension starts immediately) and deferred (starting after a set period).

When considering the return from a deferred annuity plan, you have to take into consideration that the amount invested grows for a few years and only then starts generating money for you

Insurers or their intermediaries sometimes claim that a deferred annuity plan offers a double-digit rate of return. But when you calculate the IRR (which factors in the time elapsed before payouts begin), you will find that the return is in mid to high single digit

Deferred annuity plans are suitable for those seeking a simple, low-risk income for retirement, but one should not be misled by false communications

Calculate the IRR yourself or get an expert financial advisor to do so for you before you invest in a plan

Calculating internal rate of return (IRR)

There are two types of annuity plans: Immediate (where pension starts immediately) and deferred (starting after a set period).

When considering the return from a deferred annuity plan, you have to take into consideration that the amount invested grows for a few years and only then starts generating money for you

Insurers or their intermediaries sometimes claim that a deferred annuity plan offers a double-digit rate of return. But when you calculate the IRR (which factors in the time elapsed before payouts begin), you will find that the return is in mid to high single digit

Deferred annuity plans are suitable for those seeking a simple, low-risk income for retirement, but one should not be misled by false communications

Calculate the IRR yourself or get an expert financial advisor to do so for you before you invest in a plan

The writer is a Sebi-registered investment advisor

The writer is a Sebi-registered investment advisor