Tuesday 4 December 2012

[www.keralites.net] Why a Pension Plan may be a Bad Idea

 


Why a Pension Plan may be a Bad Idea
The focus on pensions plans stems from two reasons:
  1. People are more aware of the need to build a retirement corpus, considering lengthening life expectancies and rising inflation, so the customers want pension plans, as these plans give them a sense of future financial safety
  2. The focus is still off ULIPs after the bad press and subsequent changes in their structure over the past year.
But are pension plans a good idea? Let's take a look under the hood to see what this product really is.
  1. What is a Pension Plan?

    A Pension Plan as the name suggests is simply a plan, or a product, that promises you a pension i.e. a fixed regular income after you retire, for a certain period of time. These products are offered by life insurance companies to help individuals build up a retirement corpus.
  2. How do Pension Plans work?

    The premise is very simple.
    You invest in the pension plan by paying a regular premium. Your premium is invested (after deducting certain charges) into a safe fixed income product. When you retire, your invested premiums which have grown to a certain amount, are invested in an annuity scheme, from which you draw down certain income on a regular basis. You can choose to receive your annuity payment either monthly, quarterly, half yearly, or yearly - these options are offered by most insurance companies.

    Sounds easy and good, right?
  3. Are there disadvantages to pension plans?
    Yes. But let's list the advantages first.
    Pension Plans are easy.
    They are structured in a simple way: you invest your premium and can essentially forget about it until you retire.

  They also offer death benefit, so if the policyholder passes away before the plan matures, the beneficiaries receive a lump sum or annuity     payout, depending on the options offered by the company and chosen at the time of taking the policy. When taking the policy keep in mind how much life insurance you really need.
 Now for the disadvantages.

Insurance companies sometimes fudge the figures - not that they're lying to you, they're simply putting some facts in fine print that you may not read.

For example, most insurance companies will tell you that the premiums you pay will get invested into a safe product and will generate a rate of 8-12 % (typically somewhere in this range – this is only an illustration to show you the future performance of the plan) on an annual basis, growing slowly and steadily until your premium term finishes and you retire. But this is not entirely true.  But no one can predict how much the plan is going earn for you.   In normal cases, these pension plans are capable of earn maximum 6 – 7% net returns for your investments.

Premium are invested net of charges.
So for example if the company says you will earn 6% per annum, this is not on your premium but on your premium after the company deducts its charges, so your net return comes to around 5% per annum.

Is this enough per annum return for such a long term product? No.
  1. Why are returns so low?

    For good reason. Conventional pension plans will invest their monies i.e. your premiums into very safe instruments, such as bonds and government securities. The returns on these almost-zero-risk products is much lower (7.25% to 8% per annum) than the return on equity (12% plus over the long term).
  2. Is this return useful from a financial security point of view?

    Probably not, once you factor in inflation of 7% per annum. If you are earning 5% per annum net of charges, but cost of living is rising by 7% per annum, you are essentially losing money.
So if not a pension plan, then what?

If you are in your 30s or 40s, and you have more than 20 years to go for your retirement, invest your retirement investments into a mix of equity, debt and gold, in the ratio of 70-75% in equity, 10 - 15% in debt and the remaining in gold.(this is only an example, this ratio will change based on your personal financial situation and risk appetite  also please remember that equity and mutual fund investments are subject to market risk)

If you are nearing your retirement, i.e. you are already in your 50s and have less than 7-8 years to retire, invest up to 60% into debt such as debt mutual funds and high yielding but safe corporate bonds, keep 10-15% in gold, and the remaining small portion into equity to give your portfolio a boost. (please remember that equity and mutual fund investments are subject to market risk)
  1. What if I already have a pension plan?

    If you already have a pension plan, it might or might not make financial sense to keep it going. You will have to speak to a financial planner who will take into account how many premiums you have already paid, the current fund value of the premiums invested, the number of premiums remaining and other details.
Another advantage of pension plan is the insurance cover your dependents are going to receive on untimely death of the policy holder.  Now a days pure traditional term insurance policies are available at a throw away price.  Some insurance companies are offering Rs.  1 Core cover at even a premium of less than Rs. 8,000.00 to 10,000 per year (again the premium amount will be calculated based on your age and other health related criteria).  Instead of investing in Pension Plans, you can have a good  amount of life insurance cover by way of buying pure term insurance policy and the balance amount you can invest judicially to earn a good and reasonable more importantly inflation adjusted return.
Remember that planning for your retirement is very important, but you need to also invest in the right places to make the most of your hard earned money. A pension plan is not necessarily the right place, you could do better with simple mutual funds (equity and debt) and a gold ETF, over the long term. 
Please consult an expert Financial Planner to re-allocate your exisiting investment portoflio according to your financial goal and risk appetite 
Best Regards
Prakash Nair

www.keralites.net

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