It is often presented that for creating an income stream, annuities are a great option. They are supposed to work well especially during the retirement years when ‘active’ income dries up. We find out if this is indeed the case, or if there are more efficient ways to get things done. We also compare annuity vs mutual funds to conclude which is best.
What is an Annuity?
An annuity is a fixed and guaranteed amount paid at fixed intervals. While there are many variants, one can imagine an annuity to be a Fixed Deposit for a long period of time.
However, Annuities are sold by Insurance companies. Hence, Annuity is an Insurance product. It is insurance against the risk of falling interest rates. Thus, Annuities are a combination of two inefficient financial products, Fixed Deposits, and Insurance.
We already discussed a few times on why insurance and investments should not be mixed. We also covered why FDs are not efficient investment vehicles. Here is why Annuities may not be your best friend.
1. Annuities are taxable
The annuity received by an investor is fully taxable, without any tax benefits. Even if the amount paid is termed as “pension”, it does not enjoy the various benefits of Income from salary, such as Standard Deduction, as there is no employee-employer relationship. Thus, if you earn Rs.1,20,000 as annuity or pension, the entire amount is taxable.
2. Low Rate of Return
The rate of return offered on an annuity is lower than the interest rate on a Fixed Deposit. This is because the Insurance company has to protect itself if the interest rates fall. Thus, what the investor receives is a very low rate of return, after accounting for taxes on the annuity.
Another reason why the return from annuities is low is due to commissions. Like every other Insurance product, the Insurance company pays commission to the friendly agent helping you invest your money in the annuity.
Since this is a cost to the Insurance company, it reduces the return being offered to the investor. As in the case of Other Insurance products and Regular mutual funds, the investor pays commission to the agent for the entire duration of investment, not just at the time of using the services of the agent.
4. No Insurance
The reason why your friendly agent recommends this product as “it does not require medical examination” is precisely for this reason. The Bank also does not ask for medical insurance when you do a fixed deposit as it is not taking a risk on your life. Same is the case with Annuity.
Most annuities, surprisingly, do not offer any Insurance. If you have made an investment of, say Rs.10 lakhs, in the event of death, the nominee gets exactly the same amount, as in case of a Fixed Deposit. Thus, an Insurance company is selling a product, without Insurance.
5. No Liquidity
An annuity is an investment for life. It is jokingly said that you will never see this money back! It is because the investor is not allowed to withdraw the money invested. It is given back on the death of the investor to the nominee of the investor.
One cannot surrender the policy or take a loan against the policy. Thus, in extreme conditions such as a medical emergency, this money is out of bounds for the investor.
6. Does not protect you against Inflation
A fixed amount of money for the rest of your life might sound like a good plan. However, with time, your expenses will increase. But if your income is fixed, you will fall short of the money required to meet your expenses.
Now there are a few plans that offer an annual increase in an annuity, but the increment is insufficient to tackle inflation. Moreover, the immediate amount payable is adjusted downwards.
I have explained annuities in this article in very simple terms. However, an annuity will offer you multiple options. A lay investor is likely to be highly confused with the various options. (Readers who did not clearly understand my previous point about inflation will immediately agree with this point about complexity).
The investor then relies on the advice of the agent as to which option to choose. Most of the options offered by the Insurance company make sense depending on the context and how is it positioned. Anyway, different options are suitable for different persons.
The insurance agent, who may not be professionally qualified, might not have the ability to decide the right option for the investor. They might make a mistake in terms of advising the same option to all investors (or the one that gets them most commission).
You must have often heard agents say, “Sir, just tick option 4”, without explaining what the options are. (I have an interesting case of an unmarried gentleman who was sold the option of annuity being paid to the spouse in the event of his death).
So, To Whom is an Annuity Really Suitable?
An annuity is suitable to persons who are looking to receive a fixed amount of money on a regular basis (monthly, quarterly, semi-annually or annually) for the rest of their lives. They do not have other sources of taxable income and value safety much more than liquidity and returns.
There are special situations during which Annuities can be used. For example, where illiquidity is a virtue, an annuity can be considered as an option. (A person wanted to ensure that one of his loyal employees who served him for a long period, continues to get some amount for the rest of his life. He was clear that no lump sum should be paid out as he was afraid that his children will take away the money.)
Conclusion – Where do we invest our money?
The simple and easy answer is to invest in direct plan mutual funds. One can structure the portfolio of funds so that all the financial needs are taken care of, as mutual funds offer a lot of flexibility, apart from earning higher returns, being liquid, tax efficient and convenient.
It may be wrongly presented by insurance agents that Long Term Capital Gains tax is a killer. But all the studies we have done show that LTCG is far less compared to the loss in commissions and other taxes involved in insurance products.
Features such as Mutual Fund Systematic Withdrawal Plans (SWP) take care of the need for regular payouts. You can also invest across family member accounts to minimize LTCG.
Choose a trusted fiduciary advisor who can help you the right mix of investments and invest through the zero commission platform to earn more.