Do you find it difficult when you need to choose a retirement plan and investment option?
More often than not, when you seek guidance on the investment options available, there are many plans, schemes and financial terms that may lead what is commonly known as the ‘paradox of choice’.
What you would want to do is invest in a plan that is suitable for your current and future financial needs. As you look at retirement, you have to plan and factor in the following:
1. How to tone down your debts to reduce strain on your income,
2. Calculating your daily expenses that won’t go away simply because you are retiring,
3. Keeping aside money for your medical bills which will rise as you age,
4. Including costs of transportation which will also rise as you age, and
5. Other aspects such as estate planning.
As individuals, we want a secure future and a comfortable post-retirement life; annuities (pensions) help achieve this by protecting us from unpleasant situations. Annuities can be bought to generate income during retirement, and because by nature these are similar to pensions, they are called pension plans. Some Mutual Funds have started offering pension plans which have an investment in both debt and equity components.
Here is a brief note on pension plans and mutual funds to help you make an informed decision basis that suits you and your personal needs.
Retirement / Pension Plans and Mutual Funds - The basics you must be aware of
When life insurance companies mention retirement plans and pension plans, they are referring to bundled products that offer the combined benefits of insurance and investment.
1. Deferred pension plan - This type of pension plan has two phases – the accumulation phase and the distribution phase.
a. Accumulation Phase - In the first phase of the plan, you are required to pay premiums and the money accumulates through the tenure of the plan period – and a retirement corpus is built up. When the tenure of the pension plan ends, the accumulated money is used for buying an annuity. If at the accumulation stage you have invested in a pension plan from an insurance company, then it is compulsory to invest at least one-third of the amount received from this instrument in an annuity at the time of retirement.
b. Distribution Phase - Once this period is over, that is when your policy matures you can begin withdrawing money from the retirement corpus for monthly expenses. This is the distribution phase.
If you begin investing when you are 30 years old, with a plan to retire at 50, and assuming you live for another 30 years after retirement (till the age of 80), then the accumulation phase will last 20 years while the distribution phase will span 30.
Note that in most retirement plans, the age at which you will start receiving a pension (called the vesting age), is typically in the 40-70 years age bracket. As your targeted retirement age is 50, you are well covered in this respect. The period when a person gets a pension is also known as the annuity phase.
2. Immediate annuity plan – In this retirement plan, the investor can pay lump-sum, instead of contributing over the years and can start receiving income immediately. The frequency of payments received can be monthly, quarterly, half-yearly or annually.
There are many annuity plans on offer in the market, and their variants: e.g., the steady monthly income, the increasing monthly income, etc; choose one based on your preferences, financial requirements and premium payment capacity. However, remember that while an income source for life is guaranteed, it is a lump-sum one-time investment, whether one chooses immediate income or deferred income.
3. Mutual fund retirement plans –In a mutual fund retirement plan, you can opt for a systematic withdrawal system and you do not have to buy an annuity. This provides you with liquidity to meet your immediate cash flow requirements.
SIP, or the Systematic Investment Plan, is a scheme to invest a fixed amount regularly at a specific frequency, say quarterly or monthly. It ensures that you invest a fixed amount regularly and reward you with long-term financial gains, the potential for which is immense.
It is flexible in terms of termination or modifying amount, which ensures easy cash flow: the plan can be terminated when you want after submitting a written request. In a month’s time, the SIP will be discontinued. (Note: One can increase or decrease the sum being invested by ending the existing and starting a new one; this offers protection from market volatility.
The ‘Why’ and ‘Why Not’ of Pension Plans?
Advantages of Pension Plans
1. Ensures uninterrupted income after retirement - The biggest advantage with pension plans with a deferred annuity is that it ensures uninterrupted income after retirement; in other words, it provides you with the security that you will receive a pension every month for the rest of your life. You can also set the frequency of payouts – monthly, quarterly, yearly, as per your requirements.
2. You do not have to think of making an investment at the time of your retirement - This is a big plus because a fresh investment with X amount of money 20-30 years later may not fetch the same interest it would have earned now. In fact, you may have to invest more money to get the same amount of pension.
Short-term instruments such as the Post Office Monthly Income Scheme (POMIS) carry reinvestment risk (of lowered interest rates), but an annuity guarantees you the same rate of payout for life. And unlike the POMIS or Senior Citizens Savings Scheme (SCSS), there is no cap on annuities.
Disadvantages of Pension Plans
1. Money is locked in till maturity - You cannot make withdrawals during emergencies or if you want to switch to another investment avenue midway. The National Pension Scheme (NPS) allows a maximum withdrawal of up to 60% of the corpus at the age of retirement and the rest must be invested to buy the annuity.
Moreover, some amount of maturity amounts is taxable, which actually makes it less attractive for investment.
2. Payouts are given with simple interest calculations - while all the small savings schemes like PPF, EPF, etc. gives you the facility of compounding the money. Thus, the interest rate of any pension plan is very low – at about 6%-7% – too little to even beat the inflation rate. On the other hand, small savings schemes like PPF will give you a better return.
The ‘Why’ and ‘Why Not’ of Mutual Funds
Advantages of Mutual Funds
1. With this long-term investment, you can ride out short-term fluctuations - The advantage of equity funds is that as you are investing for the long term, you could ride out the short-term fluctuations and earn higher returns.
2. Helps save taxes - Opting for an ELSS (Equity Linked Savings Scheme) Mutual Fund will also help save tax under 80C and also enable growth. It is advisable to avoid MFs that invest only in large caps, as returns are low (about 10% annually); as the investments are for the long-term and for retirement goals. It is advisable to choose a mix of large caps as well as midcaps (where returns are better at 14%).
Since these schemes are expected to pool savings for retirement, you have the flexibility to lock-in the money till your retirement or redeem it before that.
Disadvantages of Mutual Funds
1. Do not offer death benefits and your nominee gets only the market value of the fund - Moreover, equity funds are volatile in the short term and sometimes the risk may not be worth the returns – especially as the investment goal is not profit but is part of your retirement planning.
2. Stiff exit loads for early redemptions - Mutual fund houses have lined up stiff exit loads for early redemptions to limit people from exiting before retirement. Make sure to check out the exit penalties if you do opt for mutual funds.
Given the ‘why’ and ‘why not’ of pension funds and mutual fund retirement products, a best-suited plan is one that meets your requirements, is appropriate based on your age, suits your budget, fulfills your financial goals, satiates your investment appetite and is aligned with your retirement plan. Choose wisely and make a timely investment to materialize your retirement plan. Here’s how