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Fake News On Investment (Again): Misleading Annuity Returns

Just a few weeks back, I had warned you about a fake news on investment.

As cautioned, you shouldn't let the 'absolute returns' fool you into making a bad investment. You must always focus on the 'annualized returns'.

Well, here is one more investment scheme, wherein quite a few articles on the internet and newspapers are reporting highly inflated and misleading return on investment.

First the scheme:

It is a Pension Plan offered by a leading insurance company in India. It is a fairly simple and straightforward plan. First, you have to make a large lump sum one-time investment in the said Plan. Thereafter, based on your choice, you will start receiving annuity pension either immediately or after 5/10 years.

Given below is the sample illustration of how much Annuity i.e. pension a person will receive if s/he invests Rs.1 crore (under the Return of Purchase Price option).


Note: In Pension / Annuity Plans, 'Return of Purchase Price' normally means that after death your nominee(s) will get back the amount invested e.g. Rs.1 crore in this case. This particular scheme, however, returns back around 10% additional amount i.e. Rs.1.10 crores. For simplicity sake, I will ignore this extra 10% for the present. Also excluded are the applicable taxes and other statutory levies.

Now comes the 'highly inflated and misleading return on investment' part of the story:

We will focus on the 'Deferred Annuity Option', because that's where the problem lies.

Take the case of a 50-year old person, who invests Rs.1 crore and opts for the 10-year Deferred Annuity Option.

As per the scheme, s/he will receive an Annual Annuity amount of Rs.12.78 lakhs every year as pension — after 10 years of making the investment. This pension amount will be payable until death, after which Rs.1.10 crores will be returned to her/his nominee (say the children).

Most people see this as Rs.12.78 lakhs being paid every year on an investment of Rs.1 crore. This simply means a return of 12.78% per annum. (Also, 10% additional amount to your children means that the effective returns are still higher.)

So far so good!

But, here's the catch.

You get nothing — absolutely nothing — for the first 10 years.

In other words, you have lost the opportunity to earn returns for the first 10 years. So logically, you have to account for this opportunity cost.

Since the insurance company doesn't have to pay you anything for the first 10 years, it takes your Rs.1 crore and invests it say @ 7% p.a. rate of interest. (Note: This rate is almost the same as Annual Annuity rate of 7.0758% payable under the Immediate Annuity Option. So, the insurance company is confident of earning at least 7% p.a. from its investments.)

Thus, after 10 years the insurance company would have almost Rs.2 crores in hand, when it has to start your annuity pension.

So, effectively speaking, the insurance company is paying you Rs.12.78 lakhs on Rs.2 crores and not Rs.1 crore. This works out to an effective cost of 6.39% to the insurance company. So logically, your returns are 6.39% and not 12.78% as many articles proclaim. (Of course, as the insurance company will return Rs.1.10 crores to your children, the effective returns will be slightly more than 6.39%, but definitely no where close to 12.78%. Meanwhile, the balance Rs.90 lakhs goes into the insurance company's pocket as profit.)

Let's look at it from another perspective.

Suppose you skip the pension scheme and instead keep this Rs.1 crore in a Bank FD at 7% rate of interest. After 10 years your corpus would be Rs.2 crores.

Now you invest this Rs.2 crores say in a 10-year FD and keep renewing it on maturity until death. At a reasonable 7% rate of interest, you will receive Rs.14 lakhs as interest income every year. This is Rs.1.22 lakhs more than Rs.12.78 lakhs you would have otherwise received from the Annuity Scheme. PLUS your children will get Rs.2 crores back as against only Rs.1.10 crores under the Annuity Scheme.

That apart, the Annuity Plans have multiple other problems. Read Many Disadvantages Of Buying Annuity Plans for the same.

Clearly, you are far better off skipping the Annuity Scheme and investing the money on your own.

As I have often advocated, for retirement a Do It Yourself (DIY) approach works far better than any Pension Plan including the Govt.'s National Pension Scheme. You can create a perfect Retirement Plan with a suitable mix of Senior Citizen Scheme, PPF, Debt MFs, 7.75% Savings (Taxable) Bonds and Tax Free Bonds etc. [Must Read
Tax-Free NPS Withdrawal Hiked To 60%. But Don't Say Wow. 
Invest In The National Pension System - Only At Gunpoint].

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