Pension Plans or Wolf in Sheep’s clothing?

Who doesn’t want a safe monthly pension post retirement? And if there are promises and guarantees, nothing better than that. Insurance companies take advantage of just this desire in you to offer you Pension Plans. Or, as I call them – wolf in sheep’s clothing.

A reader (let’s call him Vivek) too has bought a couple of these wolf’s and shared his dilemma. 

I have 2 policies, namely HDFC Unit Linked Pension Plus & HDFC Unit Linked Pension II.

In the first plan I was to pay 2 instalments of Rs. 10 Lakhs each in first year. Thereafter Rs 10,000/- every six months. I have been paying the premium regularly. Present corpus in policy is about Rs. 50 lakhs.

In case of HDFC Pension II plan, I have paid premium @ Rs. 65000/- per month for 3 years. Now the accumulated fund is invested in Equity & Balanced funds in ratio of 75:25.

In both the cases, I was told by the agent that after 3 years I can withdraw the accumulated amount under the policies without any tax implications.

Last month I approached the office of HDFC Life to surrender my policies. I was told that entire surrender value of the policies will be taxable. I have not availed of any tax benefits while paying premiums.

I seek your advice how to move forward in the matter. Should I surrender both the policies, pay tax @30%+ & invest the balance amount in equity mutual funds?

OR wait till the date of maturity, receive 1/3 of the accumulated amount as tax free & buy annuity with the the balance 2/3 of the amount.

To me, Vivek’s situation is that of being stuck between the devil and the deep sea.

But why did this happen. Let’s take up some basics first.

What are pension plans and how do they work?

Pension Plans are a variant of the Unit Linked Insurance Plan or ULIP.  They ride on the idea of earning a pension post retirement, the life stage when there will be no other active sources of income.

You pay premium in a pension plan, typically, on a regular basis. The premium, after deduction of charges, gets invested into various options such as equity, debt or a mix of both.

Like ULIPs, a pension plan also gives you several choices of where you want your money to be invested. There are about 6 to 8 fund options – from an aggressive equity fund, which invest upto 80% or more in stocks to a conservative one, which invests 100% the money in government bonds.

The choice of the fund dictates the kind of returns that can be potentially generated from the investment.

When the policy matures, you can take 1/3rd of the maturity value of the funds in the policy immediately and that is completely tax-free. The other 2/3rd money has to be compulsorily converted into an annuity.

The annuity comes to you in the form of regular monthly payments, which you can use for any purpose such as to pay off your living expenses.

Why do you invest in Pension Plans?

There are 2 big reasons.

#1The premium you pay helps you get tax savings under section 80C of the Income Tax Act. You see, tax savings continues to be the biggest driver of our investment decisions. Further, words like safety and security are used indiscriminately to get your buy-in for the product.

#2 The promise of guaranteed returns. No one understands what and how much is the guarantee but that’s another debate. The fact that you would receive regular income post retirement is also an added reason. Though you never bother to ask, how much would that income be or what rate of interest would that earn you? It’s all hidden in a much twisted language and legalese.

What’s wrong with Pension Plans?

The most important issue is that of COSTS.

Like all ULIPs, there are a variety of costs associated with them – Premium Allocation charge, Policy Administration charge, Fund management charge, Switching charge, Discontinuation charge, Revival charge, GST and other miscellaneous charges.

Let’s take an example. I looked up LIC Pension Plus plan. This is how it describes the charges for Regular premium policies.

• Premium Allocation Charge (% of premium paid)
  • First Year – 6.75%
  • 2nd to 5th Year – 4.50%
  • Thereafter – 2.50%
• Policy Administration Charge– Rs. 30 per month increasing at 3% per year
• Fund Management Charge– This is the charge for the investment activity of the fund. For debt funds, it would be in the range of 0.70% to 1.20%; For funds that invest both in equity and debt, it would be in the range of 0.80% to 1.30%.
• Switching Charge– This is the charge levied on switching of monies from one fund to another. Within a given policy year 2 switches will be allowed free of charge. Subsequent switches in that year shall be subject to a switching charge of Rs. 100 per switch.

LIC Pension Plus is not offered by the company anymore.

After costs comes the ugly truth of Guaranteed Returns

You have to understand one thing first that the investment returns from a pension plan are going to be poor. What I mean is that the returns are going to be insufficient for you to beat the inflation and create a large enough corpus for your retirement. At least that is what the past experience has been.

So, to tap into the fear psyche of the individual, the words like guaranteed are used. In several cases, the way guaranteed returns are presented is like some alien code. So a guaranteed return would be something like 3% of Sum Assured of the policy.

One needs to question, what is the linkage between Sum Assured and Returns. Returns are and should be calculated in the terms of the premium paid, that is the actual investment.

Confusion is the hallmark of the marketing of such plans. Here’s a classic from the marketing material of the pension plan Vivek bought. The Premium Allocation Rates are guaranteed for the entire duration of the policy term. Can you really beat this? The costs are guaranteed? Wow!

The same LIC pension plus plan mentioned above does a little better by explaining it in the right terms. It guarantees a maximum of 6% per annum and a minimum of 3% per annum interest on the premiums paid.

The question that you still need to ask is – Is this even enough to cover for the rising prices, inflation?

Let’s now talk about the Surrender Rules for pension plans.

Now, unfortunately, the surrender rules for other insurance plans do not work for pension plans. If Vivek surrenders the pension plan before maturity, his entire surrender value will be added to his income and taxed as per current tax slab. Also, as stated before, 2/3rd of the surrender value will have to be converted into annuity. That is compulsory.

Then comes the trust factor.

You trust the person who recommends the pension plan to you. Vivek did too. He trusted the advice of the insurance agent / relationship manager at his bank who was acting out of pure self-interest with no consideration for Vivek.

The whole thing is crying only one word – WOLF, WOLF, WOLF!

What should Vivek do now?

Unfortunately, this is not a straightforward decision. Vivek’s current tax bracket, current age, his cash flow requirements over a period of time as also the status of his other investments are the key inputs to make a decision here. We also cannot ignore the availability of a decent annuity product.

Option 1: If these policies represent only a small portion of the overall investment portfolio, then Vivek can consider to surrender the policies, pay taxes now and invest it further.

Option 2: If the policies are substantial, then it could be fine to wait till maturity, take 1/3rd amount tax-free and reinvest it in efficient investments. The balance 2/3rds can be used to receive an annuity.

However, the case needs deeper scrutiny.

Hopefully, you now get an idea of what Pension Plans stand for. They are WOLF in SHEEP’s clothing meant to rob unsuspecting investors of their hard earned money.

If you are planning to invest for tax savings, you can go for several other efficient options than pension plans, ULIPs or any other investment based insurance products. 

However, the investment decisions are made easier when you have a financial plan to back them. Else, you will continue to execute random transactions add little value to your portfolio.