What is Annuity

An annuity is insurance in reverse. 

You can look at it this way - An insurance is protection against dieing too early while an annuity is protection against living too long. Let us learn more about Annuity in India..

What is an 'Annuity'

An annuity is a contractual financial product sold by financial institutions that is designed to accept and grow funds from an individual and then, upon annuitization, payout a stream of payments to the individual at a later point in time. The period of time when an annuity is being funded and before payouts begin is referred to as the accumulation phase. Once payments commence, the contract is in the annuitization phase.

What is a Life Annuity?
An annuity which provides for payments for the remainder of a person's lifetime is a life annuity. For ease of use, we would use the word 'Annuity' in place of 'Life Annuity'

Merits / Need for Annuity

• Annuities were designed to be a reliable means of securing a steady cash flow for an individual during their retirement years and to alleviate fears of longevity risk, or outliving one's assets.
• Annuities can also be created to turn a substantial lump sum into a steady cash flow, such as for winners of large cash settlements from a lawsuit or from winning the lottery.

Demerits of Annuity

• Annuities are highly illiquid. Now, you may argue how critical this factor of 'Liquidity' is. You can read a lot on the importance of Liquidity in the blogpost --> Liquidity is a Vital Aspect of Your Portfolio. Considering the lack of liquidity, an annuity is not a solution that should be forced upon everyone. A lot of people actually need a lump sum at retirement - for marriage of their children, opening up their own venture, travel around etc. 

• Since Annuity is an insurance product, it is designed in a way so as to mitigate your risk of living too long. Therefore, its returns cannot be practically compared with returns from other investment avenues like Equity Mutual Funds, Stocks or even Fixed Deposits for that matter. If you live for 30 years, then annuities available in India run to an effective rate of return ranging from 4% to 7%. That's just a pittance. Moreover, the same fixed sum every month every year for 30 years can hardly be called a retirement solution because the purchasing power will decline to a fraction of what it is in the beginning.

How Annuity Works?

Basically, you pay the insurance company a lump sum when you stop earning, and they pay you a certain sum every month, for as long as you live, or for a fixed period. There are many variations but that's the general idea.

How much do Annuities really pay ?
A typical annuity will pay you about Rs 6,000 a month for every Rs 10 lakh you pay as premium in the beginning, with some insurers paying a bit more or a bit less. 


Who Sells Annuities ?
Life insurance companies and investment companies are the two sorts of financial institutions offering annuity products. 

For life insurance companies, annuities are a natural hedge for their insurance products. Life insurance is bought to deal with mortality risk – that is, the risk of dying prematurely. Policyholders pay an annual premium to the insurance company who will pay out a lump sum upon their death. If policyholders die prematurely, the insurer will pay out the death benefit at a net loss to the company. Actuarial science and claims experience allows these insurance companies to price their policies so that on average insurance purchasers will live long enough so that the insurer earns a profit. 

Annuities, on the other hand, deal with longevity risk, or the risk of outliving one's assets. The risk to the issuer of the annuity is that annuity holders will outlive their initial investment. Annuity issuers may hedge longevity risk by selling annuities to customers with a higher risk of premature death.

Agents or brokers selling annuities need to hold a state-issued life insurance license, and also a securities license in the case of variable annuities. 

Types of Annuities
Annuities can be structured according to a wide array of details and factors, such as the duration of time that payments from the annuity can be guaranteed to continue.

Annuities can be created so that, upon annuitization, payments will continue so long as either the annuitant or their spouse (if survivorship benefit is elected) is alive. Alternatively, annuities can be structured to pay out funds for a fixed amount of time, such as 20 years, regardless of how long the annuitant lives. Furthermore, annuities can begin immediately upon deposit of a lump sum, or they can be structured as deferred benefits.

Annuities can be structured generally as either fixed or variable. Fixed annuities provide regular periodic payments to the annuitant. Variable annuities allow the owner to receive greater future cash flows if investments of the annuity fund do well and smaller payments if its investments do poorly. This provides for a less stable cash flow than a fixed annuity, but allows the annuitant to reap the benefits of strong returns from their fund's investments.

While variable annuities carry some market risk and the potential to lose principal, riders and features can be added to annuity contracts (usually for some extra cost) which allow them to function as hybrid fixed-variable annuities. Contract owners can benefit from upside portfolio potential while enjoying the protection of a guaranteed lifetime minimum withdrawal benefit if the portfolio drops in value. Other riders may be purchased to add a death benefit to the contract or accelerate payouts if the annuity holder is diagnosed with a terminal illness. Cost of living riders are common to adjust the annual base cash flows for inflation based on changes in the CPI.


Summary

Low returns and lack of liquidity are big drawbacks, and therefore Annuity should never be a forced option (like it is in the case of NPS). Freedom Seekers and financially savvy individuals who can manage their own funds can get much higher returns from traditional investment options. Only for those who are completely irresponsible in managing their retirement money, or those who get a windfall like a lottery should go on for options like Annuity.

IRDA and insurance companies are fine with the annuity options that are available in India. However, based on the ULIP experience, these are not organisations that will design customer-friendly products unless coerced into doing so. If annuities are to play a useful role for Indian retirees, then the annuity marketplace will have to be cleaned up first.

Nutshell, Annuities are a NO from our side in most cases in its current form in India, while in exceptional cases, we may take a call.

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The book "From the Rat Race to Financial Freedom" has many such investment concepts explained in a very simple and uncomplicated manner, especially in the Indian context.

Cheers

Manoj Arora

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