Immediate annuities: Multiple options available, weigh trade-offs carefully

Annuitise only essential expenses, retain liquidity and compare payout options and rates before purchase

DigitLife Insurance has launched the DigitLife Pension Plan, which offers a fully guaranteed lifelong annuity and a combination of guaranteed and variable annuities, with the latter linked to the Nifty 50 index. Three other insurers offer similar plans.

 

Secure regular cash flow

 

An immediate annuity starts generating cash flow as soon as the buyer purchases it. The insurer pays a fixed amount based on the option the buyer selects. This reduces uncertainty and makes budgeting easier for retirees.

 

A lifelong annuity addresses longevity risk, or the possibility that the retiree may outlive his or her savings. “It also protects against reinvestment risk because the retiree does not have to renew fixed-income investments periodically at possibly lower rates,” says Sameep Singh, head of investments, Policybazaar.

 

An annuity may, however, generate a lower return than a diversified portfolio. “A retiree in the 30 per cent tax bracket may earn a post-tax return below inflation,” says Arvind Rao, founder, Arvind Rao and Associates.

 

Most conventional annuities do not raise their payouts in line with inflation. The amount paid remains the same in nominal terms but loses purchasing power over time. After 10 or 15 years, the amount may no longer match prevailing living costs.

 

Immediate annuities offer limited liquidity. Buyers may find the decision to purchase an annuity difficult to reverse. “Surrender may return mainly the principal with only limited additional interest,” says Singh.

 

Retirees should not place their entire retirement corpus in an immediate annuity. They should use the product to create a safety net for essential expenses and keep the remaining corpus in more accessible investments.

 

Guaranteed return option 

 

The guarantee offers a high degree of safety. “It suits those who do not want their regular income to fluctuate with the market,” says Rao.

 

This safety, however, comes at a cost. “The insurer must invest in safe assets to honour the guarantee, which limits the return it can offer,” says Arnav Pandya, founder, Moneyeduschool.

 

The payout does not adjust for inflation. Over time, the retiree may face a low or negative post-tax real return.

 

“A fully guaranteed annuity is useful for someone without an organised pension, rental income or another fixed source of income, and who values certainty more than return potential,” says Rao.

 

Assess the market-linked alternative

 

A partly guaranteed and partly market-linked annuity combines two components. The guaranteed portion provides a minimum level of income, while the variable portion offers scope for additional returns.

 

“The buyer can decide the allocation between the two according to their budget and risk appetite,” says Rao.

 

The market-linked component usually invests in a largecap index such as the Nifty 50. “The guaranteed component may provide a lifelong fixed return of around 6–6.5 per cent,” says Singh.

 

“If the Nifty 50 delivers its historical average return of around 10–12 per cent, the variable component may outperform the guaranteed component,” adds Rao.

 

However, an investor may receive little from the variable portion during a bear phase. “This could affect financial planning, especially if the guaranteed component alone cannot meet total expenses,” says Pandya.

 

Rao says this option suits retirees who already receive a pension, rental income or have another source of passive income.

 

Joint life option for couples 

 

A joint-life annuity can protect both spouses. After the primary annuitant’s death, the insurer pays the income to the secondary annuitant, generally the spouse.

 

“This option is particularly important when the couple has no pension, rental income or another supplementary source of cash flow,” says Rao. The surviving spouse may outlive the primary annuitant by 15–20 years.

 

A joint-life option covers two lives rather than one. “Hence, the initial annuity payout may therefore be lower than under a single-life option,” says Pandya.

 

Buyers must choose the proportion of income that will continue to the surviving spouse. Ideally, the surviving spouse should receive at least 75 per cent, and preferably 100 per cent, of the original annuity so that inflation does not make household expenses difficult to manage.

 

A lower percentage may be adequate when the surviving spouse has substantial income from other sources.

 

Choose life or fixed-period payouts

 

A life-only annuity pays income for as long as the annuitant remains alive. The payments stop after death, and the family receives nothing under a pure life-only option.

 

“The insurer may offer a slightly higher rate because it benefits financially if the annuitant passes away earlier than expected,” says Rao. The risk for the family is that an early death ends the income stream without returning the invested principal.

 

“A return-of-purchase-price feature can mitigate this risk,” says Rao.

 

A guaranteed-period annuity pays income for a fixed term, such as 15 or 20 years, whether or not the annuitant remains alive. If the annuitant dies early, the family continues to receive income for the rest of the guaranteed period. The annuity rate under this option may be lower than under a life-only annuity.

 

“The downside of this option is that the annuitant may outlive the guaranteed period,” says Rao. The income then stops at an advanced age, when arranging another source of cash flow may be difficult.

 

A lifelong annuity generally suits buyers who want protection against the risk of outliving their savings.

 

Do you want return of purchase price?

 

Under this option, the insurer returns the original investment as a lump sum after the annuitant dies. “The amount can support the family and serve as an estate-planning tool,” says Rao.

 

This option suits someone who has no other wealth to leave to a spouse, children or other family members. “It also meets the common preference for receiving something back from an insurance product,” says Rao.

 

The option’s drawback is a lower annuity payout. The insurer must preserve the principal for eventual repayment, which reduces the income it can offer during the annuitant’s lifetime.

 

A buyer who has already made adequate arrangements to transfer wealth may not need this feature. Someone who has no dependants, whose dependants are financially secure, or who does not wish to leave a legacy may choose an annuity without return of purchase price. This option provides higher regular income and may suit a retiree whose sole objective is to maximise the payout.