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Want to buy live longer, Buy an annuity !!

The government is doing its bit to increase the return on the annuities by promising to exempt approved annuities from tax in the revised discussion draft on the DTC. This will benefit the richer annuity buyers since they may be in the taxable bracket.

Harsh Roongta

28 Sep 2010

People who buy annuities, it turns out, live longer than people who don't Steven Levitt and Stephen Dubner in SuperFreakonomics


We have all seen television advertisements showing couples enjoying themselves in their golden years because they had the foresight to invest in that particular insurance company's pension plans. The whole focus is on accumulating enough money so that on retirement the kitty can be used to generate monies on a regular basis. The entire industry's focus has been on the savings phase (also called accumulation phase in industry speak) of the pension plan. There is very little interest or discussion on what happens when you actually retire and need the money to be paid out to you on a regular basis (called the annuity phase).


Now chances are that you may not know anybody who has used his accumulated savings to buy an annuity. The reasons are not very far to seek.


Look at the risk free returns that an individual can get from the various options for a person who is 60 years of age:



Scheme Name

Stated Return p.a.

Bonus on redemption

Effective interest rate compounded quarterly basis

No. of years for which the return is assured

Remarks

Post Office MIS Scheme

8%

5%

8.70%

6 years

Maximum Rs. 9 lacs in joint Names

Senior Citizen Savings scheme

9%

Nil

9%

5+3 years

Maximum Rs. 15 Lacs per senior citizen.

SBI Fixed Deposit (10 years)

7.50%

Nil

7.50%

10 years

No Maximum

LIC immediate annuity for life *

7.51%

Nil

7.31%

Till you live

No Maximum

Govt Bond (20 years)**

8.30%

Difference between purchase price and maturity value (could be negative)

8.21%

20 years

No Maximum but difficult to buy for amounts below Rs. 5 crores

* For sum assured of Rs. 50 lacs at the age of 60 years with return of purchase price to the heirs of the person buying the annuity.

** On yield to maturity basis


Clearly therefore people with accumulations below Rs. 25 lacs or so are able to get far better yields from government schemes than what they would get if they were to buy an immediate annuity. Even for amounts greater than Rs.25 lacs the return from ultra safe bank fixed deposits would beat the returns on an annuity plan. I am not even taking into account the government bonds mainly because of the difficulty for an individual to buy them from the market. Of course all these savings schemes run for a limited period (6 to 10 years) and interest rates will be reset at the then prevailing rates after they mature. The customer also has an option of investing in long-term income schemes of mutual funds which, though not providing a guaranteed return, have yielded around 8.50 % p.a to 10 % p.a. over the last 5 years or so. No wonder than that participants of corporate superannuation schemes (who have no choice) have been the only significant purchasers of these annuity schemes so far.


National Pension Scheme (NPS) now has about a million accounts and it is expected to gather pace from next year due to the proposed changes in the direct Tax code. The NPS account holder has to use most of the amounts in his fund to compulsorily buy annuities from insurance companies. Also IRDA has proposed to make it compulsory to buy annuities from insurance companies for at least 2/3rd of the fund value for pension plans issued after September 1, 2010. Therefore the relatively poor returns from these annuity schemes will soon cease being of peripheral interest and will need to be looked into.

One reason for the lower return is that the annuities (which is in the nature of interest paid on the sums invested in the annuity schemes if we consider only those scheme that provide life time annuity and return of purchase price after death) are guaranteed for the lifetime of the person buying the annuity. So irrespective of the interest rates that the scheme itself is able to get, the insurance company still pays a guaranteed return to the purchaser. Longer the period for which such guarantee operates, higher is the risk of mismatch between the actual returns of the scheme and the guaranteed returns. Obviously the insurance company needs to keep a cushion to absorb any drops in future interest rates when it works out the annuity payable to you over your life time.


That's where the mortality tables used by the insurance companies come into play.


In an analysis of schemes offered by LIC, ICICI Pru Life and Bajaj Allianz we found some interesting facts.


We compared the lifetime annuity schemes of these companies for both scenarios where the purchase price is returned on the death of the purchaser and where it is not (obviously the annuity is far higher for the second option). We assumed the person to be 60 years of age and the purchase price of the particular annuity at Rs. 50 lakhs. Here is what we found



Sr. No.

 Details

ICICI Pru

Bajaj Allianz

LIC

With return of purchase price

(1)

Annuity

3,22,113

3,76,750

3,75,500

(2)

Effective Interest rate

6.44%

7.54%

7.51%

Without return of purchase price

(3)

Purchase Price

50,00,000

50,00,000

50,00,000

(4)

Interest Rate as per (2) above

6.44%

7.54%

7.51%

(5)

Annuity without return of purchase price

4,30,018

4,69,900

4,87,500

(6)

Number of years ****

22

22

20

(7)

Rough life expectancy assumed (60 plus years at (6) above)

82

82

80



****Reverse calculation of period based on given purchase price, interest rate and the annuity amount at (5) above


The insurance companies clearly think that people who buy annuities live far longer than an average Indian. Only they have the data necessary to find out the life expectancy of the annuity buyer. It is a definite fact that the life expectancy of people who buy annuities will be longer than the average Indian. In fact Steven Levitt and Stephen Dubner in their book SuperFreakonomics (Page 82)  talk about this and I quote ".......People who buy annuities,it turns out, live longer than people who don't and not because the people who buy annuities are healthier to start with. The evidence suggests that an annuity's steady payout provides a little extra incentive to keep chugging along." Whilst this is written in the context of California pensioners , even in India the people who buy annuities belong to the population strata that has access to good medical and other facilities and will live longer than the general population.


Some major reforms are clearly needed in this space since a large number of people will soon be forced to purchase such annuity plans. Clearly the returns that they expect will need to be much closer to the returns that these senior citizens can get on their own from reasonably safe sources. The government is doing its bit to increase the return on the annuities by promising to exempt approved annuities from tax in the revised discussion draft on the DTC. This will benefit the richer annuity buyers since they may be in the taxable bracket.


We will definitely see a flurry of action both on the regulatory front as well as in the market as the dust settles down on the ULIP (including pension plans) controversy. Let's hope that it will lead to better returns for annuity purchasers in the future.