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Do you need a pension plan during retirement?


01 Jul 2021 - Contact Sayan Sircar
5 mins read

This is the impact of adding a pension plan to your retirement plan.

Bucket theory for retirement with pension

Table of Contents

Introduction

We build on the retirement with bucket post to handle retirement calculation with the addition of a pension plan (also called annuity). A pension plan is a financial product that gives you a fixed amount of money called a pension throughout your life. This allows you to have assured minimum income throughout your retirement.

There are many types of pension plans. Most of them do not give any money back and the money that you get is also taxable. There are two main types of pension plans that we are going to mention here. The first type gives the money immediately every year while the other, called deferred plan, starts five or ten years later. If you are purchasing it a few years before retirement then you need the deferred type else if you are retiring now then get the immediate type.

When you buy a pension plan you may get tax benefits under section 80C. Pension plans can be taken singly or jointly with the spouse. In a joint pension plan, the remaining spouse will get 50 or a hundred per cent of the pension upon the death of the original purchaser.

What should you do before buying a pension plan

The most important factor that you need to consider when buying a pension plan is that how much money that you have for retirement purposes and how much income do you need every year. It might be possible that you do not need a pension plan at all especially if your corpus is very high compared to the amount you need every year. However, for those with a small amount of corpus relative to the amount they need, it will be good to have a pension plan for them.

Considerations for purchasing pension plan

You need to keep in mind that a pension plan cannot be exited. This means that after some time if you change your mind, you cannot get your money back. Some pension plans have the return of premium option which can be used to leave an inheritance for the nominee. These plans give lower returns than the plans that do not give the premium amount back.

Pension plans have an option to pay out money monthly, quarterly or yearly. However, the monthly options have the least return compared to the yearly one. In some pension plans, the amount paid out every year increases by a small amount, like 3%, which does not beat inflation but is still better than the other pension plans where the payment does not increase at all and will have a very low return compared to inflation.

There is also the concept of vesting age which is the time at which you start receiving the pension. You need to make sure that the vesting of the policy matches the time that you need the money from. You need to provide yearly proof of life to continue receiving pension.

Pension plans can be purchased from insurers like LIC and private insurers. It is worthwhile to mention that there is a specific LIC provided annuity scheme offering around 7% (7.4% as of July 2021) called Pradhan Mantri Vaya Vandana Yojana (PMVVY) that offers pension for 10 years (and not life).

It is possible, for knowledgeable investors, to replicate a pension plan somewhat by buying RBI bonds where the bond coupon gives the pension and the maturity amount of the bond returns money to the nominee. We will discuss this in a future post.

Investors have an option of buying additional annuity plans in case there is an excess corpus accumlated due to a market rally or reduction in projected expenses (maybe due to death of a spouse) in order to lock in a guaranteed income stream at different points of the retirement journey.


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Is a pension plan adequate for retirement?

Due to the inability to beat inflation, you need equity in the retirement portfolio to beat inflation. Current (July 2021) pension plans are offering around 5% pre-tax returns which are lower than the 8%+ inflation in the country. There is a trade-off between having the best of having the longest time the corpus can last vs. the mental peace of knowing that you will have some amount of income till death even when the main portfolio is gone.

Walk-through of the example

Buckets example

We buy a lifetime annuity (joint, 100% for spouse post death of purchaser) of 50 lakhs while keeping more or less the same asset allocation with the rest of the 1 crore of the assets. The chart below shows a zoomed version of how the portfolio behaves post retirement:

Pension during retirement

Compared to the example without the pension plan, the corpus lasts 3 years less (due to the returns from the annuity from the rest of the portfolio) but it does provide 2.8 lakhs of income (pre-tax) for the rest of the life. This makes a pension plan invaluable from a psychological point of view.

We give a walk-through of the worked-out example in this Excel workbook.

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