Pension plans: Generating an income

A lot of individuals are concerned how retirement will treat them. They are uncertain whether they will be able to meet the rigours of old age when expenses are certain, but income isn't. Even greater is the uncertainty regarding how their dependents will cope in their absence. This is where pension plans come in.

Before we begin discussing how pension plans can light up your retirement, it is important to first understand what they are all about.

Put simply, life insurance covers the individual in two scenarios; first if he passes away prematurely, and second, if he survives for longer than expected. Under both scenarios, the individual runs the risk of either falling short of the expectations that his dependents have of him or running out of funds to meet his own needs. Life insurance can provide for both scenarios with the help of two distinct products.

To provide for the first scenario (passing away early), there are term plans and endowment plans. A term plan is a pure risk cover with no savings element and therefore relatively more affordable. An endowment plan is a savings-based insurance product that aims at supplementing life cover with savings; this combination comes at a price, which is reflected in the higher premiums.

Plans that provide for an early death, aim at securing the yet-to-be-fulfilled needs of the dependents (like child's education/marriage), outstanding liabilities (like home loans) and monthly household expenses. If you have been fairly honest and accurate in calculating your Human Life Value (HLV) these plans can provide for your family in your absence.

The second scenario of living longer than expected carries its own risks. Sure, we all want our loved ones to live for as long as possible, but living too long and not providing for it does not cut a very pretty picture. Long life brings with it its own challenges which are distinct from those of middle age. For one, you are not earning any more and unless you have a great deal of ancestral property/wealth or have amassed enormous wealth in your life time, leading the last few years of your life without an income source to fall back upon can be a frightening prospect. Secondly, while income in your twilight years dwindles, costs (particularly medical costs) can be quite high. This mismatch can have a depressing impact on your financial budget. Thirdly, borrowing money from friends/relatives to meet expenses can be an embarrassing prospect.

So fending for yourself and your family is the most acceptable option. At old age, that may not be the easiest thing to do, unless you were prudent enough to begin this process well in advance. It's better known as Retirement Planning and one of the acceptable ways to go about it is invest in Pension Plans.

Pension plans can be quite flexible. They can be tailored to provide lumpsum amounts, regular income (also known as annuity) or a combination of both lumpsum and regular income. Depending on your needs, you can select the most suitable option.

To give you an idea about how pension plans work, lets refer to Vivek's example. Vivek has planned for all his expenses related to child's education, marriage, loans and liabilities. With regards to household expenses, he wants to use the pension plan route to provide for a portion of his monthly expenditure. We have assumed this sum to be Rs 10,000.

Solution for Monthly Expenditure (Post-retirement)

Current Monthly Expenditure	Rs	10,000	10,000
Time to retirement	yrs	30	30
Expected inflation per year	%	5.0	5.0
Monthly Expenditure - at retirement age	Rs	43,219	43,219
Annual expenditure at retirement	Rs	518,633	518,633
Expected Annual Return - at retirement (post-tax)	%	5.0	5.0
Therefore, to cover exp., corpus reqd.	Rs	10,372,662	10,372,662
Solution
Corpus to be accumulated	Rs	10,372,662	10,372,662
Assumed Return (Pre Tax)	%	6.0	10.0
Assumed Return (Post Tax)	%	6.0	10.0
Tenure (Years)	yrs	30	30
Annual Saving Reqd	Rs	131,203	63,058
Or simply, Monthly investment of	Rs	10,644	5,028
Or a one-time investment of	Rs	1,805,985	594,442

 

After inflating Vivek's monthly expenses by 5.0 per cent (assumed expected inflation rate), his annual expenditure at retirement adds up to Rs 518,633. We have assumed the annuity he will opt for on retirement will earn a return of 5 per cent (post-tax). So the retirement corpus Vivek must accumulate to cover his monthly expenses is Rs 10,372,662.

In line with IRDA laws, we have assumed two scenarios -- an aggressive scenario wherein the corpus will grow at 10 per cent and a conservative scenario wherein it will appreciate at 6 per cent.

On retirement, Vivek can employ the corpus (Rs 10,372,662) to opt for an annuity. Insurance companies allow the individual to opt for an annuity option by which he can ensure that the annuity continues even in his absence. For this he must select the option wherein both he and his wife are beneficiaries so that the annuity continues even if one of them were to pass away. This way, the individual and his spouse will receive annuity till at least one of them survives

While we have taken the very basic cost (monthly expenses) to explain how one can employ pension plans to provide for retirement, an individual can include other expenses related to medical expenses for instance, to have a more elaborate retirement planning schedule. The idea is that at all times, individuals must be aware of their needs and the needs of their dependents post-retirement, so as to plan for them more effectively. And pension plans are a good way to achieve that.

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