Annuity

Research By: Saizal Agarwal

An annuity is a financial product offered by insurance companies and financial institutions, which individuals can buy. It involves the issuer committing to pay a regular income stream to the buyer, starting either immediately or at a future date.

Individuals invest in annuities through either monthly premium payments or a single lump-sum payment. The issuing institution then provides a series of payments for a set duration or for the rest of the buyer’s life.

Annuities are primarily used to provide income during retirement, helping individuals mitigate the risk of depleting their savings too early.

Why do people buy annuities?

People usually buy annuities to help manage their money during retirement. Annuities offer three main benefits:

• Regular payments for a set period, which could be for your whole life or for the life of a loved one.
• Death benefits, where if you pass away before receiving payments, your chosen beneficiary will get a specific amount.
• Tax-deferred growth, meaning you doesn’t pay taxes on the money you earn from the annuity until you take it out.

How does Annuity work?

• An annuity works by having an individual make a lump sum or recurring investment into an annuity plan. In return, the annuity provides payments to the individual on a future date or over a series of dates. These payments can be made monthly, quarterly, annually, or even as a one-time lump sum.

• The amount of income received is influenced by several factors, including the length of the annuity term. The individual can choose to receive payments for their entire lifetime or for a specific period.

• The income amount also depends on whether they have selected a guaranteed payout (fixed annuity) or payments based on the performance of the annuity’s underlying investments (variable annuity).

Types of Annuity:

• Fixed Annuity: A fixed annuity offers a guaranteed income at a fixed rate of return for a specified period. The returns are predictable, making it a safe option for risk-averse investors.

Example: Mr. Sharma invests ₹10,00,000 in the LIC Jeevan Akshay VII, a fixed annuity plan, at age 60. LIC guarantees an annual interest rate of 6%.

Annual Income: ₹10,00,000 * 6% = ₹60,000.

Payout Frequency: If Mr. Sharma chooses monthly payouts, his monthly income will be ₹60,000 ÷ 12 = ₹5,000.

So, he will receive ₹5,000 every month for the rest of his life.

• Variable Annuity: A variable annuity offers returns that fluctuate based on the performance of the underlying investments, such as stocks or bonds. It carries more risk but offers higher growth potential compared to a fixed annuity.

Example: Mr. Shyam invests ₹10,00,000 in the HDFC Life Assured Pension Plan, a variable annuity. His investment is split into different market-linked funds. If the funds grow by 8% in a good year:

Annual Income in a Good Year: ₹10,00,000 * 8% = ₹80,000.

Monthly Income: ₹80,000 ÷ 12 = ₹6,666.

In a bad year with 4% growth:

Annual Income in a Bad Year: ₹10,00,000 * 4% = ₹40,000.

Monthly Income: ₹40,000 ÷ 12 = ₹3,333.

So, his income can vary based on market performance.

• Immediate Annuity: An immediate annuity starts paying out right after a lump-sum investment is made, usually within a year. It’s ideal for retirees who want a steady income stream right away.

Example: Mr. Sharma invests ₹10,00,000 in SBI Life Annuity Plus, an immediate annuity plan, where payments start right away.

Immediate Monthly Payout: Let’s assume SBI guarantees a monthly payout of ₹6,000 starting the month after his investment. 

So, Mr. Sharma will start receiving ₹6,000 per month immediately after investing ₹10,00,000.

• Deferred Annuity: In a deferred annuity, payments start at a future date, usually at the individual’s chosen retirement age. The investment grows tax-deferred until the payout period begins.

Example: Mr. Sharma invests ₹10,00,000 in ICICI Prudential’s deferred annuity plan at age 60, but he opts to start receiving payouts at age 65. Let’s assume the corpus grows at 7% per year.

Corpus at Age 65: ₹10,00,000 * (1 + 7%)^5 = ₹14,02,551.

Payout Starting at Age 65: Assuming an annual payout rate of 6%, Mr. Sharma will receive ₹14,02,551 * 6% = ₹84,153 annually.

His monthly income starting at age 65 will be ₹84,153 ÷ 12 = ₹7,012.

• Fixed Indexed Annuity (FIA): A Fixed Indexed Annuity (FIA) offers returns linked to a market index, such as the Nifty 50. The principal investment is protected, meaning even if the index performs poorly, the individual doesn’t lose their initial investment, but they might not earn as much interest. There is usually a cap on how much you can earn when the market performs well, but the principal is protected when the market dips.

Example: Mr. Sharma invests ₹10,00,000 in a Fixed Indexed Annuity plan, which is linked to the Nifty 50 index. The plan guarantees a minimum interest rate of 2%, regardless of market performance, and has a cap of 8% in case the market performs extremely well.

• Principal Amount: ₹10,00,000.
• Guaranteed Minimum Return: 2%.
• Market-Linked Cap: 8%.
• Index Used: Nifty 50.

Case 1:  Strong Market Performance (Nifty 50 increases by 10%)

If the Nifty 50 performs well, increasing by 10%, the interest Mr. Sharma would earn is capped at 8% as per the annuity terms.

• Annual Interest: ₹10,00,000 * 8% = ₹80,000.
• Total Investment Value at the end of the year: ₹10,00,000 + ₹80,000 = ₹10,80,000.
• Monthly Income (if taken monthly): ₹80,000 ÷ 12 = ₹6,666.

In this case, Mr. Sharma earns ₹6,666 monthly from the annuity for that year due to the cap on returns.

Case 2: Poor Market Performance (Nifty 50 decreases by 5%)

If the Nifty 50 performs poorly, dropping by 5%, Mr. Sharma’s principal remains protected, and he earns the guaranteed minimum return of 2%.

• Guaranteed Annual Interest: ₹10,00,000 * 2% = ₹20,000.
• Total Investment Value at the end of the year: ₹10,00,000 + ₹20,000 = ₹10,20,000.
• Monthly Income (if taken monthly): ₹20,000 ÷ 12 = ₹1,666.

In this scenario, Mr. Sharma still earns a monthly income of ₹1,666, despite the market’s poor performance, due to the minimum guarantee.

• Lifetime Annuity: A lifetime annuity guarantees income payments for the rest of the policyholder’s life, making it a popular choice for retirees who want financial security throughout their retirement.

Example: Mr. Sharma invests ₹10,00,000 in LIC Jeevan Shanti, opting for a lifetime annuity. LIC guarantees a monthly income of ₹5,500 for life.

• Monthly Income: ₹5,500.

Mr. Sharma will receive ₹5,500 every month for the rest of his life, regardless of how long he lives.

Which Annuity Plan is Right for Your Financial Goals?

• Different types of annuities suit various investor needs based on their financial goals, risk tolerance, and retirement plans. 
• Fixed annuities are best for conservative investors who prioritize guaranteed, stable income and want to avoid market risks. Variable annuities appeal to growth-oriented investors comfortable with market fluctuations, seeking higher returns through stocks or bonds. 
• Fixed indexed annuities are ideal for those looking for a balance between potential market gains and principal protection. 
• Immediate annuities suit retirees who need income right away, while deferred annuities work for younger investors aiming to grow their savings and delay income until retirement. 
• Lastly, lifetime annuities are perfect for risk-averse individuals seeking a guaranteed income for life, ensuring they won’t outlive their savings.

Tax implication on Annuities:

• Tax-Deferred Growth

One of the key advantages of annuities is their tax-deferred growth. This means that the investment earnings within the annuity accumulate without incurring immediate taxes. You only pay taxes on these earnings when you make withdrawals.

• Taxation on Withdrawals

When you withdraw funds from an annuity, the tax treatment depends on the nature of the funds:

• Earnings: The earnings portion of your withdrawal is subject to ordinary income tax. This means that the growth on your investment is taxed at your current income tax rate.
• Principal: The principal, or the original amount you invested, is not taxed again upon withdrawal, as it was already taxed before being invested in the annuity.
• Early Withdrawal Penalties

If you withdraw funds before reaching age 59½, you may face an additional 10% penalty on the earnings portion of your withdrawal, in addition to the ordinary income tax. There are some exceptions to this penalty, such as in cases of disability or certain medical expenses.

• Taxation of Annuity Payouts

Annuity payouts are treated as follows:

• Fixed Annuities: Payments are comprised of both principal and earnings. The earnings portion of each payment is taxed as ordinary income, while the principal portion is not taxed again.
• Variable Annuities: Similar to fixed annuities, the earnings portion of payments is taxed as ordinary income.
• Death Benefits

If the annuitant dies before the annuity begins making payments, the beneficiaries may receive a death benefit. This benefit is typically taxed as ordinary income.

Protecting against inflation risk in Annuities:

When people invest in an annuity, especially a fixed one, the payments received are usually set at a specific amount. While this provides stability, there is a significant risk of inflation. Over time, the cost of goods and services tends to rise, which reduces the purchasing power of money. For example, if Mr Shyam is receiving ₹10,000 per month from a fixed annuity today, it may cover his living expenses. However, 10 or 20 years down the line, due to inflation, that same ₹10,000 might not be enough to maintain his lifestyle.    

Why inflation risk matters in Annuity?

• Fixed Payments Are Vulnerable: Since fixed annuities provide the same payout every month, inflation gradually decreases the value of these payments in real terms.

• Cumulative Impact: Even a moderate inflation rate of 3% can significantly impact the value of your money. For instance, with 3% inflation, your annuity payments lose about half of their purchasing power in 24 years.  

Example: Imagine Mr. Verma, a 60-year-old retiree, has invested in a fixed annuity that pays him ₹50,000 per month for the rest of his life. While this fixed amount seems sufficient today, inflation over the years can significantly impact what ₹50,000 will be able to buy in the future.      

• Initial fixed annuity payout: ₹50,000 per month.
• Annual inflation rate: 5% (a moderate estimate for India).
• Duration: 20 years

Year 1:

• Monthly payout: ₹50,000
• Purchasing power (adjusted for inflation): ₹50,000

In Year 1, Mr. Verma’s ₹50,000 annuity covers his current monthly expenses. He is able to maintain his desired lifestyle without difficulty.

Year 5:

• Purchasing power loss due to inflation: After 5 years of inflation at 5% annually, prices have increased by around 27.6%.
• The formula for cumulative inflation over 5 years:

Cumulative Inflation= (1 + 0.05)^5 – 1 = 0.276

This means prices have increased by 27.6%, but Mr. Verma is still receiving ₹50,000 monthly.

• Adjusted purchasing power:
  After inflation, the value of ₹50,000 in today’s terms is:

Adjusted Value= ₹50,000(1+0.276)=₹39,185

By Year 5, the ₹50,000 that Mr. Verma receives is effectively worth only ₹39,185 in today’s money. This means he can only buy what ₹39,185 would have bought at the time he retired, a loss of over ₹10,800 in purchasing power.

Year 20:

• Purchasing power loss due to inflation: After 20 years of 5% inflation, the cumulative price increase is approximately 165.3%.
• The formula for cumulative inflation over 20 years:

Cumulative Inflation= (1+0.05)20−1=1. Prices have more than doubled in 20 years, but Mr. Verma’s monthly annuity payout remains fixed at ₹50,000.

• Adjusted purchasing power:
  After 20 years, the ₹50,000 in today’s terms is:

Adjusted Value= ₹50,000(1+1.653)=₹18,850 

While ₹50,000 per month seems like a stable income today, inflation gradually reduces its value. Over 20 years, Mr. Verma will see his purchasing power decrease to less than 40% of what it was at the start. Without adjusting for inflation, Mr. Verma’s fixed annuity will provide diminishing returns in terms of actual purchasing power, which could severely impact his financial security in later years.

Ways to mitigate inflation risks:

• Inflation-adjusted annuities: Where payouts increase in line with inflation. The payouts increase by a fixed percentage or in line with a specific inflation index (like the Consumer Price Index) to preserve purchasing power.

Example: Mr. Sharma purchases an inflation-adjusted annuity where payouts increase by 3% annually. He starts receiving ₹10,000 per month at age 65. By the time he reaches 75, his monthly payout has increased to ₹13,400, which helps him maintain his lifestyle as costs rise.

• Fixed indexed annuities: Which provide growth based on market performance. In this, principal is protected, but payouts grow based on market performance (subject to a cap). This can provide better returns during periods of inflation than a fixed annuity.

 Example: If the Nifty 50 grows by 7% in one year, the value of Mr. Sharma’s fixed indexed annuity grows by 7% as well, subject to any cap. This can potentially offset the effects of inflation, providing him with increased income.

• Diversification: Investments in stocks or real estate tend to grow at a rate that outpaces inflation, while bonds provide stability. By combining these with annuity income, you can hedge against inflation risk. 

Example: Mr. Sharma combines his fixed annuity with an equity mutual fund that provides growth over time. While the annuity covers his basic living expenses, the growth from the equity fund helps to counterbalance inflation.