Annuity – When is it a good investment choice?

What is an annuity?

An annuity is a solution for post-retirement income. How it works is simple. You invest a fixed initial amount and in return you get a lifetime of assured income.

When you buy an annuity, you get

• an assured income
• lifelong income (pension)
• no risk income
• no hassle income
• no bother about investment options, advisors, rebalancing, etc.

Take an example.

You are 60 and you need an assured Rs. 50,000 per month to meet your post retirement expenses. If you want an assured income of Rs. 6 lakhs a year, then you simply buy an annuity for approx. Rs. 75 lakhs, as a one-time payment. (Estimates based on an immediate annuity plan of a private insurer)

You don’t have to bother at all. No money management hassles, no investment selection, no dealing with bankers or advisors and collecting cheques from various investments.

The annuity provider will transfer the amount to you every month/year as per the frequency you choose.

An annuity ensures that you earn an income for the rest of your life.

But is it all that good? Not really. 

Let’s look at the downsides of annuity

When you buy an annuity, it means

• zero liquidity during your lifetime – if you have a medical emergency, you can’t access it.
• no or low protection against inflation
• low returns
• income is taxable
• no return of investment amount (unless you opt for it, in which case the income reduces)

Continuing with our previous annuity example, by any chance, if your soul were to depart this planet at age 70, that is within 10 years of buying the annuity, you would have got back only 60 lakhs. The annuity provider makes a neat profit of Rs. 15 lakhs plus any returns thereon.

Of course, you need to appreciate the fact that annuity provider took over your risk and assured you a lifetime of income. What if you had lived till 100? You get the point.

Now, you could counter the early demise theory and say, that one can go for the return of investment / premium option when buying the annuity.

Absolutely!

What does Return of Premium (ROP) mean?

With this option, you receive the income via annuity as along as you are alive. However, post your demise, the original investment (in this case, Rs. 75 lakhs) is returned to your nominee(s).

Does it make sense? Back of the envelope calculations (based on the same immediate annuity plan of a private insurance company as used before) suggest that you are better off leaving the money in your savings account then buying an annuity with ROP option. Yes, that bad!

Honestly, you can do much better yourself, that is, if you can.

Can you manage your money better?

Let’s evaluate that.

Suppose, you manage to earn an average 7% return (pre tax) against an average inflation of 6%, your retirement corpus of Rs. 75 lakhs at age 60 will still struggle to last till age 75.

Yes, you can do some deft money management, use an allocation of equity & fixed income and make your corpus last longer. Remember though that you will also take on the volatility and risk in your portfolio too.

Not just that, there are intangible risks too.

What someone told me about intangible risks

When you have a large sum of money, you may go berserk and spend it faster than you should.

Worse, someone in the family can emotional blackmail you and take the money, leaving you with very little or nothing for your own needs.

Bottomline, you may not make your precious retirement corpus last long enough. Managing the mind is tougher than managing the money.

Instead, if you buy an annuity with the Rs. 75 lakhs, at least you are assured of a lifetime income of Rs. 50,000 a month, hassle free.

On the positive side, we all know that while inflation has an impact on our expenses, our needs also go down as we age. In the 70s and 80s age bracket, you may not be spending as much as in the 60s age.

You can learn to spend only as much as you earn.

Does that make a case of buying an annuity?

Not entirely. Considering the downsides, go for a pragmatic solution. While it still depends on case to case, a better working alternative is

• Use a part of your money to buy an annuity thus ensuring a base level income at all times.
• Use the other part and manage it yourself. This can also be used as a fallback for lump sum requirements such as a medical emergency.

There are several government and post office schemes (Senior Citizen Savings, etc) that may deliver a good return.
Bank FDs typically offer a 0.5% higher return for senior citizens.

Coupled with the safeguard of an annuity income, you can enjoy a relatively smooth ride into your post retirement journey.

What do you think?

Read more on Unovest: How much money is enough to retire?

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Disclaimer: The view in this post about annuity should not be considered an investment advice. The numbers and estimates used here can vary for different products and companies. Please consult your investment adviser to know what investment options suit you best.