Everyone has to think about their retirement and a pension plan would be your safest and best bet. Here are some tips to help you select the right pension plan for you.
1. How does a typical pension plan work?
A typical pension plan starts with the ‘accumulation phase’—the period from the time you buy a plan until you retire. During this period, you will be paying premiums, which will be suitably invested. The premiums that you pay will be eligible for tax benefit under Sections 80C/80CCC.
When you retire, you can withdraw 1/3rd
of the accumulated corpus. This withdrawal is tax-free. The balance amount cannot be withdrawn. It has to be utilized to buy an annuity plan. This annuity plan will be the source of regular pension until your death. This is called the ‘annuity phase’. The pension that you receive will depend on the interest rates then prevailing and is fully taxable.
2. What are its plus points?
It is a fairly simple plan; easy to understand and implement. You could just pay your premiums regularly and forget about it. Further, it enforces discipline. Since non-payment of premiums could prove expensive, you will try and not skip any payments. This is good for compulsive spenders.
Even otherwise, this discipline is good. For example, during the market crash, many of you would have skipped your mutual fund SIPs (systematic investment plans) or ULIP (unit linked insurance plan) premiums. Had you been forced to continue your investments, you would be sitting on handsome gains today after the recent recovery. Besides, the overall costs are also comparable with other investment products and quite competitive.
3. Buying annuity is compulsory
In pension plans, you have to compulsorily buy an annuity plan for 2/3rd
of the accumulated corpus. Pension plans are long-term products. Suppose in the interim you have moved abroad and decided to settle down there. Then you would probably prefer to take this money with you rather than get some nominal pension in India. Or suppose you need money for your daughter’s marriage. Or there is some medical emergency. These may not be possible for you with a pension plan.
On the contrary, if you had invested in other investment products, you could have possibly used the money in a more desirable manner. In fact you could have also bought an annuity plan with this money if need be. This constraint is a big problem with pension plans.
4. Taxation is an issue
Taxation is another problem with pension plans. One, on maturity you get to withdraw only 1/3rd
amount as tax-free, whereas in PPF (Public Provident Fund) or equity MFs you could withdraw the entire amount as tax-free. Two, the pension that you get is taxable. However, if you had the choice you could have opted for a more tax-efficient option available at that time.
That apart, even Section 80CCC is more on paper, especially after it was made part of the overall Rs. 1 lakh limit under Section 80C. Many of you would easily be exceeding this limit taking into account you’re PF, home loan principal, insurance premiums, tuition fees, etc. Therefore, you may not be getting any tax benefit from your pension plan premiums.
5. Flexibility suffers
Given that you are tied to one fund for possibly decades to come, the flexibility naturally suffers. As pension plans are long-term contracts, prematurely exiting from such schemes may not always be possible or easy. There could be many situations wherein you may want to quit the plan—the fund may not doing well, other investment products may be offering better deals, etc.
6. Low diversification
Unlike shares or MFs, where you would normally have a large portfolio, pension plans are typically restricted to only a few. In fact, because the main objective of buying a pension plan had been to save tax, most of you would be having just one pension plan. Thus, with only a few plans to depend on, the portfolio becomes highly concentrated and hence the diversification too suffers.
Instead, with the same premium money, you could build a well-diversified and balanced portfolio of about 8-12 mutual funds across different AMCs and types of funds.
7. Pension plan or own investment portfolio
Pension plans, as discussed earlier, suffer from some serious drawbacks. Instead, given that MFs, EPF/PPF and other such investment products have a lot more to offer, it may be prudent to create your own investment portfolio rather than buying pension plans.
Besides, in terms of returns, MFs/PPF/EPF and pension plans would usually be at par. On retirement, you can withdraw the entire amount, unlike the 25-33% in pension plans. In equity/EPF/PPF, the entire withdrawal is tax-free. In debt funds, there would be long-term capital gains tax. But, with the indexation benefits, this may be quite nominal/nil.
You can then invest this amount in suitable instruments, which will give you regular monthly income while your corpus remains intact. This is what happens in an annuity as well. Your annuity amount earns interest, which is paid out to you as pension, while the original corpus remains intact.
8. Pension plan from insurers
Presently, insurance companies offer pension plans. These broadly fall under two categories: Endowment plans and unit linked pension plans (ULPPs). Traditional endowment plans will invest the corpus only in debt instruments such as government securities, government bonds, etc. Safety is of paramount importance. The returns, therefore, will generally be in single digits only.
Of late, since the private companies have been permitted to enter the insurance sector, ULPPs have gained prominence. Here you have the choice about how you want your money to be invested—100% equity, 100% debt or some sort of a mix of the two—depending on your risk profile.
Switching is also permitted in ULPP from time to time. Thus, you can change your fund-profile with your changing circumstances. You may start with equity and later switch to debt as you near your retirement. Given the flexibility offered in the ULPPs and the transparency in cost structure, ULPPs usually score over the traditional endowment-type pensions plans.
9. Pension plan from mutual funds
Mutual funds have only a couple of government-approved pension schemes. You will get 80CCC benefits in these plans that you normally don’t get with other MF schemes. These are in the nature of a normal balanced mutual fund, with an equity-debt asset allocation of 40:60. However, these plans are somewhat restrictive. First, you only have one fund option i.e. 40:60 equity-debt allocation. Second, there is an exit load applicable for withdrawals before maturity/retirement.
Instead, as mentioned earlier, you could create your own portfolio out of the normal equity and debt funds. This will offer you much more flexibility and diversification. Therefore, under the present circumstance these plans may not serve any useful purpose.
10. National Pension System
In broad terms, National Pension System (NPS) works as a normal pension plan.
Salient features of NPS:
- Minimum contribution is fixed at Rs. 6,000 p.a. (or Rs. 500 p.m.)
- There are three fund options (max 50% equity; 100% government securities and 100% debt other than government securities)
- The flat charges and annual fund management fees are very low and hence extremely attractive
- The fund is exempt from dividend distribution tax, securities transaction tax, etc. normally applicable when buying/selling any securities
- The retirement age is fixed at 60
On retirement, you get back up to 60%—which unlike the normal pension scheme is taxable—and with the balance you have to buy an annuity. Further, you have to withdraw 10% every year and on reaching 70, you will be repaid the entire balance in your account.
If you want to quit earlier, you get only 20% in your hand while the balance gets you the annuity
NPS is similar to the normal pension plans. It suffers from the same drawbacks: higher tax, lower flexibility, poor diversification and compulsory annuity. That apart, the commuted amount is taxable. So your own portfolio of EPF/PPF/MFs etc. would still be a better option.
(Note: The provisions of new Direct Taxes Code have not been considered as they are still not the final law and could even see further changes.)
Excerpted from the book “10/10 Now Control Your Money… Perfectly” written by Sanjay Matai. The writer is the promoter of The Wealth Architects.