Guard against longevity risk with an annuity

Falling interest rates on fixed-income products have left senior citizens anxious about their finances. The fear of rates tumbling even further is nudging many aged between 50 and 70 years to buy large annuity plans.

Once the salary stops, investors need to invest their corpus in instruments that help generate a regular income. Says Naval Goel, chief executive officer and founder, Policyx.com: “The purpose of an annuity is to give you a steady income stream throughout your retirement or once your income stops. It’s like a reverse equated monthly instalment.”

Adds Melvin Joseph, a Securities and Exchange

Board of India-registered investment advisor and founder of Finvin Financial Planners: “You give a lump sum amount and the insurer guarantees you an income stream for life.”

Annuities are of two types: Deferred and immediate. Deferred annuities are for people who are still earning. They put in money for several years, it compounds, and then payouts begin at retirement. People who need an income stream right away should invest in an immediate annuity.

Make the right trade-offs when buying an immediate annuity. Some variants, like return of purchase price, pay the initial amount back to the nominee after the annuitant’s death. It is for people who want to pass on wealth to their children. “The regular payout will be less if you choose the return of purchase price option,” says Joseph.

An annuity plan can cover one life or two. In the latter option, after the death of one person, the spouse continues to receive payments for his/her lifetime. An annuity that covers the lifetimes of both partners is advisable, though the payout tends to be lower in that option (than in the single-life option).

Annuities safeguard the investor against longevity risk. The annuitant receives a fixed sum irrespective of whether he lives for 20 or 40 years after retirement. They also guard him against the risk of a secular decline in interest rates. However, they have a few disadvantages. They don’t safeguard him against inflation. Their rate of return tends to be on the lower side. Annuity income is taxable and it is an illiquid instrument.

To tackle inflation risk, investors need to diversify. Says Joseph: “Not more than 20 per cent of your retirement corpus should be parked in an annuity.” Some part of it (depending on age and risk appetite) should be invested in equity mutual funds where it can earn a good return and hedge against inflation. The rest may be invested in fixed-income instruments that also generate an income but have a short- to medium-tenure. And they should be invested in a laddered manner (should mature at regular intervals) to beat reinvestment risk.

Avoid buying an annuity in this low interest-rate environment. Says Joseph: “Buy an annuity now only if you are retiring or are over 60. Those in their 50s should invest later to avoid getting stuck at the current rates.”

Buying at a later age also improves the rate of return from an annuity.

Finally, select a reputable brand. Says Goel: “Choose a company that will still be around 30-40 years later.”