Ask Morningstar: Do I need an annuity?

Jan 17, 2023

Why do I need an annuity for retirement?  

Retirement Planning is complicated. Many aspects are the subject of hot debate, even among the experts.

Let me break down the answer to your query.

  • The first question is: How long will I live?

Sandra Tsing Loh  once said with a dose of humour, “In 1900, the average life expectancy of a U.S. citizen was 48, so most menopausal women were dead, which is not a great place to be.” Though spoken in jest, it pointed to an important blind spot and largest risk related to retiring: the longevity risk.

According to a World Economic Forum report, we better be prepared to blow out over 100 candles on our birthday cakes. Those born in 1947, have an average life expectancy of 85 years, it goes up to 103 for those born in 2007.

According to MacroTrends, the average life expectancy in India in 1950 was 35.21 years, it is now 69.96 years. But if you have not suffered from malnutrition and are in good health, the average is no indication.

This means that our investment corpus needs to be much fatter. Because with longevity risk comes shortfall risk: the possibility of outliving one’s savings. So don’t smirk if you are advised to develop a retirement plan based on the expectation of living to 100.

This is why advisors and researchers champion the idea of purchasing income annuities for retirement, arguing that doing so provides longevity risk protection. Please do read 4 ways longevity is going to change everything.

  • So, what is an annuity?

An annuity is a financial instrument issued that is backed by an insurance company. Its aim is to provide guaranteed periodic payments for the life of the contract, regardless of market conditions.

The National Pension Scheme, or NPS, is a voluntary retirement scheme through which you can create a retirement corpus or your old-age pension. It’s managed by the (Pension Fund Regulatory and Development Authority (PFRDA) and available to Indian citizens above the age of 18.

When you turn 60, 60% of your corpus is transferred to your bank account, while the remaining 40% you have to buy an annuity product.

Here is a list of List of Annuity Service Providers (ASPs) empanelled by the PFRDA.

  • Do you need it?

As is evident, annuities do provide peace of mind as they provide a regular inflow of cash. Having said that, annuities will be less useful for retirees who are deriving a healthy share of their income needs from pension, rental off real estate property, dividends from stocks - basically one who has multiple cash flow streams.

Also depends how large your investment corpus is and what the withdrawal rate is. The safe withdrawal rate (SWR) is how much a retiree can draw annually from their accumulated assets without running out of money prior to death.  It’s unknowable. You don’t know what the major asset classes will return or how high (or low) inflation will run during your retirement. Nor do you know how long you’ll live.

I know someone who resides in Goa and manages her house based on the income from renting a home in Mumbai. Her son gives her and her spouse a small sum to “just enjoy”. So basically, there is no one-size-fits-all solution. But an annuity does have strong pros.

More by Investment Specialist Larissa Fernand

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ninan joseph
Jan 26 2023 08:49 PM
Invest in NPS, 40% of the corpus moves to annuity. Until the corpus in NPS is high, the annuity you get will be miniscule. If your NPS is in crores, the 40% is sizable. Annuity is a disadvantage for NPS and Govt may may come out with SWP for NPS and remove the annuity in future.

The advantage of Annuity is that unlike FD which has a max tenor of 10 years, you get a fixed return for 20 or 30 odd years. Bajaj Allianz has many such products. I keep getting the whatsapp on these. Basically, you invest say 1 lack each year for 10 years and after 12 th years, you will get a fixed annual return. If you calculate, the IRR will be 6.5 to 6.9% right now.
If you think after 14 years from today, if interest rate will fall and FD interest rate will be in the range of 1 to 2%, then you should take this product. However, if you think, interest rate will be over 6.5% to 6.9 % even after 10 to 20 years, then this product is of no use. The biggest disadvantage is you cannot withdraw or prematurely close this. In case of an FD, in case of emergency, you can take it out. With annuity, you are marrying until you die. So keep this in mind.
The annuity amount again is taxable in your hands. So net returns will be lower from 6.5%. There are various options where the capital is returned back when the person dies etc. These are good features. The million dollar question for annuity is what is your perception of interest rate after 10 years.
If for some reason, Interest rate increase to 8% after 10 years, you will continue to be tied up with the same rate as you have agreed when you have entered into a contract. If you are thinking of annuity, this is the right time as interest rate is on the hike, keep a look out for this now. In case you have decided to take annuity, do it throught any Government owned Insurance company such as LIC. You never know what would happen to private insurance company whether they will survive for another 30 years.
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