IC-02 Practices of Life Insurance (PDF)

82 CHAPTER 4 ANNUITIES Chapter Introduction Retirement planning is an important tool for an individual, which helps them to be financially independent even after retirement. Government employees...

82 CHAPTER 4 ANNUITIES Chapter Introduction Retirement planning is an important tool for an individual, which helps them to be financially independent even after retirement. Government employees are more secure in this sense as they receive regular pension from their employers after retirement. But now-a-days, there is an increase in the workforce of people who are either self-employed or work in private companies that do not offer pensions to its employees. Hence the biggest worry for these individuals is to plan for their retirement. A proper retirement plan has therefore become necessary. Insurance companies now offer annuity products as a retirement solution to these self-employed individuals and salaried employees working in private companies. Annuity provides regular income or pension at the chosen retirement age. In this chapter, we will study the annuity products, their features and benefits. a) Understand the concept of annuity. b) Analyse the different types of annuity plans. c) Understand the advantages and disadvantages of annuity.  83 Look at this scenario Sharad Sharma is an executive engineer who works for a private electronics firm. He is 33 years old and wants to retire at the age of 60. Sharad and his wife are able to maintain quite a comfortable lifestyle in their present salaries. However, he wants to make sure that he invests the money prudently and earns a regular income after his retirement. He feels that regular income received throughout his lifetime will provide the necessary financial liquidity to meet his monthly expenses. He therefore wants to go for an investment plan that provides him with regular income in the form of pension after his retirement, and also lets him maintain his standard of living that he enjoyed prior to his retirement. 1. Understand the concept of annuity. [Learning Outcome a] Annuities are investments made by an individual with the aim of receiving regular income on a periodic basis after a specified period or immediately. Individuals invest in annuity to meet their post retirement or old age financial needs. The concept of annuity is similar to pension, which an employee receives from their employer after retirement. Pension is the regular payment that is received by an employee after their retirement. But some private sector employees or self-employed persons do not enjoy the benefits of pension from employers. Insurance companies offer annuity plans for such individuals. The annuity is purchased by an individual from the insurance company and in return, the insurance company provides regular income (pension) to the individual. Hence, annuity is also known as a pension plan. Annuities vs. Insurance plans Both annuities and insurance plans are sold by insurance companies, but the similarity between the two ends there. An insurance plan is a contract between an individual and the insurance company, in which the individual pays premiums for a specified period, against which the insurance company provides insurance cover to the individual. The insurance company makes a lump sum payment to the beneficiaries on the death of the individual, or to the individual on completion of the policy term. Annuity is a contract between an individual and the insurance company, in which the individual pays a lump-sum amount or regular payments to the insurance company and at the end of a specified period, the insurance company provides regular income to the individual.  84 Some important terms used in an annuity: ! Annuitant: an individual investing in annuity is known as an annuitant. ! Annuity income: the annuity (periodic amount) that is paid to the annuitant is annuity income. It can also be referred to as pension, allowance or income. ! Annuitise: to start the pension or annuity, an individual has to annuitise. Annuitising means instructing the insurance company to start the periodic payments. ! Deferment period: once the contract between the annuitant and the insurance company commences, the insurance company can start paying the annuity immediately, or after a specified period of time, or from a certain age. Such specified period, from the date the annuity contract begins till the actual annuity payments begin, is called deferment period. ! Vesting date: the date from which the annuitant starts receiving regular income is known as the vesting date. This date generally coincides with the retirement date of the annuitant. ! Commutation: on the vesting date, the annuitant has two choices. The annuitant can either start receiving the regular annuity payment from the insurance company or withdraw 1/3rd of the total accumulated amount as a lump sum payment (commuted value) from the remaining balance, and request the insurance company to pay out regular annuity payments. This process is known as commutation ! Commuted value: at the beginning of the annuity, the lump sum that the annuitant withdraws is known as the commuted value. Mihir has been investing in an annuity plan for the past 10 years. On completion of the deferred period of 10 years, his annuity contract with the insurance company will commence (i.e. on 12th September 2010). Hence 12th September 2010 is the vesting date for Mihir’s contract. If on this day he decides to withdraw a certain percent of his investments (commutation amount), then the remaining 75 percent will be used by the insurance company to provide regular payments (annuities) to Mihir. In the above scenario: ! Mihir is the annuitant. ! Deferment period is the 10 year period for which Mihir pays the premium. ! Vesting date is 12th September 2010, when the annuity contract commences. ! Commuted value: withdrawal of a certain percent of the accumulated amount. ! Commutation: the process of withdrawal of money. ! If Mihir decides to exercise commutation, then the income that he will receive from the insurance company will be lesser than what he had originally planned out of the whole corpus.  85 The main features of annuity can be summed up as below: ! Individuals purchase annuities to get a regular source of income (pension) after retirement or after certain age. ! The annuitant can pay premium to an insurance company either in lump sum or in instalments. ! No medical check-up is required for taking an annuity policy. ! The insurance company and the annuitant can mutually decide the annuity payment which can be either monthly, semi-annually or annually, as preferred by the annuitant. ! The annuity plans offered by insurance companies are very flexible. Annuity plans can either continue a) for the annuitant’s whole life or b) or a fixed number of years or c) fixed number of years / life or d) in the case of joint life policy; till the joint applicant survives The amount that the annuitant pays as premium for annuity to insurance companies depends upon several factors such as: ! the regular income that the annuitant expects at the time of retirement: the premium amount depends upon the current income of the individual and the amount that they can spare towards premium payment. ! the amount that they have invested in other schemes and the returns that they expect: this helps the annuitant in evaluating the income they expect to receive in future and the amount they require for retirement. ! Their future financial liabilities such as home loan, child education, medical expenses etc. Question 1 The individual has to instruct the insurance company to start the annuity income. This is process is known as ___________. A. Annuitising B. Commutation C. Vesting D. Deferment  86 2. Analyse the different types of annuity plans. Learning Outcome b] Types of Annuities Diagram: Classification of annuities  87 1. On the basis of premium payment: the annuitant has the option of making the premium payment either as a lump sum amount or in instalments. Based on the method of premium payment, an annuity could be categorised as follows: a. Single premium payment: in this type of annuity an annuitant pays a lump sum amount as a single premium. This is preferred by individuals who are nearing retirement and who have not made any prior investments for meeting post retirement obligations. On retirement, the individuals can invest their savings by purchasing an annuity plan. In return, the insurance company can start paying pension immediately after receiving the payment. Salaried employees receive provident fund money on retirement, which they can put in an annuity plan. Amol is retiring in February next year and is worried about his post retirement financial obligations. He has accumulated a substantial amount in his provident fund account, which he plans to use after his retirement. He is looking for some investment avenue where his money can be safe and that can provide regular payments to meet his post retirement expenses. Amol can select an annuity plan to invest his provident fund amount. The premium can be paid as a lump-sum. Once he pays the premium, he can immediately start receiving pension from the insurance company. b. Multiple premium payment: here, the annuitant makes a series of payments to the insurance company. This kind of premium payment method is preferred by young salaried individuals, who choose to make the payment of annuity premiums in instalments and do not expect the returns immediately. They continue to make regular periodic payments of premiums in instalments, till retirement or till a specific time. The insurance company starts paying the pension after the deferred period to the annuitant. Dr. Mukund Gupta is a reputed paediatrician who runs a private clinic. Over the years he has built quite a name for himself. Though he earns good regular income and has invested it prudently in various investments, he is concerned about his post retirement financial obligations. As he is in private practice he would not be able to enjoy pension after his retirement. Dr Mukund Gupta can choose to purchase an annuity plan, where he can pay monthly instalments for a specific period and after retirement, he can choose to receive regular pension.  88 2. On the basis of payment of annuity a. Life annuity: in life annuity the insurance company promises to pay a certain amount of annuity to the annuitant as long as he / she lives. The annuity payment stops on death of the annuitant, and the rest of the accumulated fund is returned to his beneficiary. Mehul Kumar works as an executive engineer with a leading construction firm. He has invested money in an annuity and has chosen the option of annuity for life. In this scheme, he will start receiving pension after retirement for as long as he lives. The insurance company will cease the payment on his death. In case at the time of the death there are some funds left with the company, that amount will be returned to Mehul’s beneficiaries. b. Annuity certain and life thereafter: in this option, the insurance company promises payment of fixed annuity for a fixed term. In case the annuitant dies during the specified term, the remaining amount will be paid to the nominees. In this option, the annuitant can choose to receive annuity payments for some specific period, say 5, 10, 15, 20 or 25 years irrespective of survival of annuitant and if the annuitant survives the chosen annuity certain period, the annuity will be paid for life thereafter. Rakesh Sharma is an executive working in a leading MNC. He has chosen to purchase an annuity guaranteed for a fixed period of 20 years. That means he will receive pension for 20 years. In case he dies after 12 years, the annuity will be paid to his beneficiaries for the remaining 8 years. In case he survives for more than 20 years, then in this case, the insurance company will pay annuity for the chosen term of 20years and stop the annuity payment after the completion of the specified tenure. c. Joint life last survivor annuity: in this option annuity is paid to the annuitant for their entire life. On the death of the annuitant, 50% of the pension will be paid to the spouse for as long as the spouse lives. A variation of joint life annuity allows annuity payment during the lifetime of the annuitant or their spouse, whoever lives longer. d. Annuity for life with return of premiums: in this option, annuity is paid to the annuitant as long as they live and on their death, premiums are returned to the nominee or legal heirs.  89 e. Increasing annuity: annuity is paid by the insurance company on any of the above terms but the annuity increases every year by a fixed rate or amount. 3. On the basis of purpose of annuity a. Immediate annuity: this type of annuity is taken when the individual wants to start receiving the annuity immediately. Here, the individual starts receiving annuity payments as soon as the annuity product is bought. The annuitant has to make a lump sum payment for receiving immediate annuity. b. Deferred annuity: when an individual wishes to receive annuity payment after certain specified period, they can choose deferred annuity. This specified period is referred to as deferment period. The annuitant can either make a lump sum payment at the time of commencement of contract, or make payment in instalments, during the deferment period. The insurance company returns the amount of premium paid to the beneficiaries of the annuitant, in case the annuitant dies during the deferment period. The annuity commences at the end of the deferment period, on a date which is known as the vesting date. 4. On the basis of type of investment a. Fixed Annuity: in fixed annuity the insurance company promises to pay a fixed amount of annuity for a certain period of time or life thereafter. Fixed annuity guarantees the amount of annuity. The investment is made in low risk securities like government bonds. In immediate annuity, the insurance company will begin regular annuity payments immediately after the lump sum payment is made by the annuitant, whereas in deferred annuity, the payment will be made after a period of time, say after the annuitant retires. b. Variable annuity: in a variable return annuity, the payment made by the insurance company depends upon the performance of the investment option that is chosen by the annuitant. In a variable annuity plan, the investments are generally made in mutual funds, money market instruments, stocks and bonds. The variable annuity helps the annuitant to participate in the growth of the investment avenue chosen. The premium that is paid by the annuitant is invested by the insurance company based on the investment option chosen by the annuitant.