IC33 English Chapter 7 Notes

Chapter 7 – Pension and Annuities

  • The basic objective of pension is to provide individuals with an income during old age when they are retired and no longer at work. These people have been working and earning an income during the productive years of their lifetime.
  • Pensions may be said to represent the flip side of life insurance. They provide protection against the financial consequences that may arise when the individual lives too long and thus outlives one’s financial resources.
  • The basic contingency associated with pensions is that of post-retirement income security.
  • Difference between Insurance plans and pension plans
  • Life Insurance products provide protection against the financial consequences of early and premature death. Pension products provide protection against financial consequences arising when an individual lives too long and outlives one’s financial resources.
  • In life insurance, the basic contingency covered is that of mortality. In case of pension, it is post-retirement income discontinuity.
  • In life insurance, premium payments result in creation of a capital sum known as sum assured. In case of pension, a capital sum which we call a corpus that gets liquidated in part of whole through its conversion into a stream of regular income payments.

Types of Pension Plans

  • Public pensions are provided by the State. It is the State’s responsibility to ensure that all citizens receive a minimum income during retirement. The schemes are publicly managed with mandatory membership. The schemes are typically funded on ‘Pay As You Go’ (PAYG) basis.
  • Occupational pensions have been set up by employers for the benefit of their employees.
  • Personal pensions are plans designed to provide an old age income. These are marketed by market

providers, like life insurers and other financial institutions.

  • A personal pension is typically offered and purchased in the form of an annuity contract. This contract is between the insurance company or other pension provider and an annuitant. The pension provider pools and invests these contributions, whose principal and investment earnings lead to the creation of a corpus.
  • An annuity is a series of regular payments from an annuity provider to an individual, referred to as the annuitant.
  • Annuities are often described as the ‘reverse’ of life insurance. Under a life insurance contract, the insurer starts paying on the death of the insured. However, under an annuity contract, the insurer usually stops paying on the death of the annuitant.
  • The period during which the insurer makes annuity payments, is referred to as liquidation period.
  • Amount of annuity payable depends on principal sum of money, investment period, rate of return and duration of annuity payments.
  • In an ordinary annuity payments are made or received at the end of each period.
  • Life Annuity: Provides periodic benefit payments during the lifetime of the annuitant.
  • Pure Life Annuity: The benefit payment would cease with the death of the annuitant.
  • Annuity Certain: Periodic payments are unrelated to lifetime of the annuitant. They are payable for a certain stated period of time regardless of whether the individual lives or dies meanwhile.
  • Fixed Benefit Annuity: The insurer guarantees a defined amount of monthly annuity benefit for each rupee applied to purchase an annuity.
  • Variable Benefit Annuity: The value of the amount accumulated in the annuitant’s name and the monthly benefit payable fluctuates with the performance of the account in which the fund is placed.

Annuities can be either immediate or deferred annuities.

  • Immediate annuities vest (become payable) immediately after they have been purchased with a lump sum. The annuity payments commence at the end of the month, quarter, half-year or year as per the features of the policy/option exercised by the policyholder
  • Deferred annuities are paid for in advance. The annuity purchase price may paid lump sum paid at the commencement before annuity is due to vest (be paid). Alternatively, deferred annuities may be bought by paying instalments over a series of years before vesting date
  • Every pension is an annuity in the sense that it involves a regular stream of income payments. However, not every annuity is a pension.
  • Let us understand the replacement income risk with the help of an example given here.
  • Santosh, aged 40 years earns a salary of Rs. 50,000 a month. Given that his income and expenditure are expected to rise @ 5% per year, he expects his final salary at the age 60 years to be around Rs. 1,32,665 (50000 x (1.05)20).
  • The replacement income he needs after retirement at the age 60 years would amount to more than two and half times what he earns at the age 40. Santosh is worried whether he would have savings that would be anywhere close to this amount.
  • If his company had provided him an occupational pension scheme, it could have solved his problem, at least in part.
  • Example: Consider a fixed deposit with a bank for Rs. Ten lakhs, which gives interest @ 12% per annum, payable monthly which yields a periodic payment of Rs. 10, 000 per month. In what respect does it differ from a pension, which also provides a periodic payment.