Why annuities are a poor investment choice

Narendra Nathan, ET Bureau May 26, 2014, 08.00AM IST
(One of the biggest challenges…)

Low returns, tax disadvantage and lack of liquidity make annuities a poor investment choice. Here's why you should avoid them.

Financial planners abhor them. Tax experts baulk at them. Yet, many investors pour their life savings into annuities from insurance companies. They fall for the 'guaranteed pension for life' sales pitch by insurers, without realising that this option offers very low returns, is tax-inefficient and hampers liquidity by locking up their money forever.

An annuity is a lump-sum investment, which gives a regular income to the investor for the rest of his life. It can be an immediate annuity, which starts giving returns from the very first month, or it could be a deferred annuity, which starts paying after a certain period. Right now, only insurance companies offer annuity plans in India.

One of the biggest challenges that retirees face is converting their nest eggs into regular income. There are many options before them, but an annuity is perhaps the worst. While the promise of pension for life sounds attractive, the returns offered by these plans are dismal, to say the least.

Exide Life Insurance, for instance, is offering less than 5% on the annuity option that returns the corpus after the investor's death. This is similar to the return offered by your savings bank on the balance in your account. If you opt for a sweep-in account, you could earn more by just keeping your money in the bank. "These are old rates. We have filed new rates with better yields and, hopefully, our new annuity products will be approved soon," says Kshitij Jain, CEO, Exide Life Insurance.

For many investors, buying an annuity is a compulsory evil. When they retire at 60, investors in the New Pension Scheme have to put at least 40% of their corpus in an annuity.

If you have taken a pension plan from an insurance company, you will have to buy an annuity with at least 66% of the maturity proceeds. The choice of annuity providers is also limited. "If you have invested in a plan with a particular insurer, you have to buy the annuity from that insurance company," says Jain.

Our cover story this week looks at why annuity rates in India are so low and other drawbacks of this investment vehicle. We also explain what investors can do to earn a better income from their nest eggs in their sunset years.

A major problem with annuities from insurance companies is the measly returns they offer. At a time when banks are offering 9.5-10% on fixed deposits to senior citizens, annuities offer less than 8% (see table).

The bad news doesn't end here. Unlike other financial products, in annuities investors have to consider the impact of the 3.09% service tax. So, if you were to invest Rs. 10 lakh in an annuity, Rs. 30,900 flows out as service tax. "This tax brings down the net yield from annuities further," says Jaya Nagarmat of Investor Shoppe. So, a yield of 7.5% will decline to 7.27%.

Since retirees are mostly senior citizens, they can earn much better returns if they put their money in fixed deposits instead of locking it up in an annuity. The glitch: banks are offering attractive rates on fixed deposits of relatively shorter tenures of 3-5 years.

For long-term deposits, the rates are lower at 8.5-9%, with the maximum duration of a bank fixed deposit being 10 years. So the investor is faced with the reinvestment risk.

If interest rates fall by the time his deposits mature, he will have no option but to reinvest the amount at the lower rate prevailing at that time, which would depress his returns.

On the other hand, an annuity is a contract for the long-term. "The biggest advantage of an annuity is that the rate is guaranteed for life irrespective of the interest rate movement," says G Murlidhar, managing director, Kotak Mahindra Old Mutual Life Insurance.

Other insurance companies join the chorus in favour of annuities. "In a world of uncertainties, the beauty of an annuity product is in its ability to not just offer guaranteed returns, but to do so for life to the customer," says Amitabh Chaudhry, managing director and CEO, HDFC Life.

Why annuity rates are low

There are several reasons for the low returns from annuities. First, short-term interest rates are currently higher than the long-term rates. Annuity products are linked to the long-term rates and are, therefore, unable to match the high, short-term rates. "The high short-term interest rates are an aberration. They should settle soon," says Jain. If that happens, annuity rates may go up.

The other problem is the unavailability of long-term corporate bonds, which can generate better yields than those offered by the ultra-safe, but low-yield, government bonds. Though government bonds have tenures of up to 30 years, getting enough long-term gilts is not easy. This explains, but does not justify, the yields that are significantly lower than those offered by the 30-year government bonds.