If you are working in a small or medium-sized private-sector firm, chances are your employer may not offer you pension benefits in the form of fixed income for life. So, how can you create synthetic pension using products available in the market?

In this article, we show how you can use annuities to synthetically create pension income. We also provide some guidelines that you can apply to evaluate whether annuity should be a part of your portfolio.

A retired government employee typically receives a fixed sum of money every month from her former employer. You can synthetically create such cash flow even if your former employer does not provide such income.

To do so, you have to buy an annuity from an insurance company. This requires you to pay lump-sum amount (purchase price) to the insurance company. In return, the company promises to pay you a fixed sum of money till you live, and in some cases, to your spouse as well after your lifetime.

You cannot replicate such fixed cash flows with fixed deposits. Why? For one, you need to renew your deposits each time they mature. Even if you invest in a 10-year deposit, you have to make three renewals, assuming you live for 30 years after you retire.

Now, the problem is you overestimate your cognitive capabilities as you age. Are you confident today that you will be able to take sound investment decisions when you are 80 or 85? Annuity does not pose such kind of problems- it is in fact called dementia insurance.

If you buy an annuity today, you can expect to receive income for life, unless you suspect that the insurance company will be unable to pay for that long! For another, if interest rates decline, you will receive less income on your deposit after each renewal How do you meet the shortfall in income?

synthetic pension

Not all is good with annuity, though. In the classical version, the insurance company will not return the purchase price to your family after your lifetime. This feature makes annuity less attractive. So, why should you buy annuity? Here is a set of guidelines for you to consider. First, if you are healthy today and nearing retirement or just retired, you are likely to live at least till your life expectancy. Are you confident of generating stable income for life to meet your lifestyle needs?

Two, if you have low to moderate risk tolerance level, are you are willing to invest in equity or bond funds and assume market risk to fund your lifestyle needs? Or invest in fixed deposits and expose yourself to the risk that interest rate may decline at renewals? And three, are you willing to keep a portfolio that requires continual monitoring just to sustain your basic needs post-retirement?

If your answer is no to any of the above questions, you should buy an annuity.

We recommend that you buy annuity just to cover your basic standard of living — transportation, clothing, food and normal supplies of medicines, if any. For the rest of your requirement such as long-term health care, you should invest in equity.

Such an annuity-equity portfolio provides you pension-like stable income and yet offers you growth potential. You can buy annuity at retirement or after you turn 40 (refer this column dated August 12, 2012).

spending power

Equity can offer you higher expected return. But what if your equity investments decline in value? Annuity offers you better spending power. After you retire, you are not looking to earning higher return.

You want to spend money to sustain your lifestyle needs. Annuity can offer you such cash flows. Invest in equity to meet discretionary spending. Annuity provides you synthetic pension to meet basic needs.

Related Topics
comment COMMENT NOW