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Why a Pension Plan May Be a Bad Idea - Outside View by PersonalFN
 
 
Why a Pension Plan May Be a Bad Idea

Just recently a prominent life insurance company launched 2 new pension plans. The focus on pensions plans stems from 2 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 theyre lying to you, theyre 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 6% or 7% (typically somewhere in this range) on an annual basis, growing slowly and steadily until your premium term finishes and you retire.
    But this is not entirely true.
    Premiums 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.

  4. 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).

  5. 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.

  6. 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. 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.

  7. 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. If you would like to opt for an insurance policy review you can contact PersonalFN, this is a paid service.
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.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

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