Is deferred annuity a right fit?

Retirement portfolio is, perhaps, the most important investment portfolio that any individual will create during her working life. This portfolio changes its contours when the individual retires and creates the retirement income portfolio. We had discussed about the importance of buying immediate annuity as part of the retirement income portfolio. Several readers wanted to know if it would be optimal to buy deferred annuity. The question is: Can deferred annuity be part of the retirement portfolio?

This article discusses whether deferred annuity fits within the retirement portfolio's asset allocation policy. It then explains why it may not be optimal to consider such an investment during an individual's working life.

Retirement portfolio is typically initiated with large exposure to equity, as the individual is expected to have the ability to take risk during the early part of her career. The portfolio will be biased towards bonds at retirement, as an individual's willingness to take risk would then decrease. The question is: Can individuals consider deferred annuity as part of their retirement portfolio?

We consider all interest-earning assets including fixed-deposits and PPF as bonds. Classical annuity does not pay interest but does offer fixed cash flow. It is, therefore, logical to consider deferred annuity as part of retirement portfolio in lieu of other bond investments. There is one factor favouring such a strategy.

The premium paid on pension plans qualifies for tax exemption. Besides, the individual is not taxed on any accruals to the investment till she starts receiving the annuity. Annuity is, hence, a tax-deferred vehicle. This compares favourably with bond investments that an individual takes as part of her retirement portfolio; for such bond investments are usually taxed on accrual basis at the marginal tax rate every year.

However several factors need to be considered before buying a deferred annuity.

Immediate or deferred?

In classical annuity, where the individual is paid a fixed amount at periodic intervals till death, the payment that the insurance company promises is typically based on interest rate at the time the individual purchases the annuity; higher the interest rate, larger the periodic payment.

If an individual were to buy annuity only at retirement, such timing is not possible. A deferred annuity ought to offer individuals the ability to time the purchase of the annuity. Such annuities are offered by insurance companies through their pension plans. But buying pension plans does not serve the purpose. The reason is that these plans typically convert two-third of the total amount into annuity at the rate prevailing at the time of conversion.

Consider this. An individual aged 35 may buy a pension plan and prefer to vest it at age 60. The insurance company will typically allow the individual to take a lump-sum of one-third while the rest will be compulsorily converted into annuity at the rate prevailing when the individual turns 60, the time of conversion. This has the same effect as the individual purchasing an immediate annuity at age 60 using the assets in her retirement portfolio. This makes pension plans unattractive, if buying deferred annuity is the primary purpose of the investment.

The cost of buying an investment product from an insurance company is typically higher than buying comparable investments elsewhere. This acts as a deterrent in buying deferred annuity through a pension plan in lieu of bond investments. It would instead be optimal for an individual to take bond exposure through PPFs and bank fixed-deposits. The individual will no doubt face the risk of purchasing the annuity at unfavourable rates at retirement. But this problem can be moderated by annuity-splitting. This refers to splitting the money allocated for purchasing annuity into two — one portion can be used to buy immediate annuity at retirement while the other can be set aside to purchase an annuity at a later date when rates are more favourable.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investorlearning solutions. He can be reached at >enhancek@gmail.com )

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