The annuity escape route

Last week, the Pension Fund Regulatory and Development Authority made a significant change to the National Pension System. For non-government subscribers, the mandatory annuity purchase at retirement has been reduced from 40 per cent of the corpus to just 20 per cent. You can now withdraw up to 80 per cent as a lump sum. If your corpus is under Rs 8 lakh, you needn't buy any annuity at all.

The financial press has covered this as ‘greater flexibility for subscribers’, which it certainly is. But there's a more interesting way to read this development. When a regulator reduces the mandatory purchase requirement for a product from 40 per cent to 20 per cent, it's essentially saying the product isn't working as intended. And annuities in India, to put it plainly, are not working.

Consider the basic economics of an annuity. You hand over a lump sum to an insurance company at retirement, and they promise to pay you a fixed monthly amount for life. Current annuity rates in India hover around 5-7 per cent annually. For every Rs 1 crore annuity purchase, you might receive about Rs 50,000 per month. That sounds reasonable until you realise two things. First, this income is fully taxable. Second, and more importantly, that Rs 50,000 will still be Rs 50,000, 20 years from now, when a cup of tea might cost what an entire meal does today.

Meanwhile, what does the insurance company do with your money? It invests the money, earns returns that keep pace with inflation (or better) and pays you a fixed amount from the earnings. The company's income grows; your payout doesn't. Over a 25-year retirement, this asymmetry can be devastating to your finances. The insurance company has inflation protection; you don't. In fact, you are paying for their insurance protection.

This is a problem the insurance regulator should fix, and I've often written about the insurance ecosystem's many shortcomings. But here's what the NPS changes tell us: if even the pension regulator, which presumably has more clout and focus on retirement outcomes than any individual saver, has essentially given up on fixing annuities and instead reduced how much you must buy, then you and I certainly cannot expect this situation to improve. The wise option was to reduce the requirement rather than reform the product.

However, credit where it's due. PFRDA hasn't just thrown up its hands. It has quietly built an excellent alternative for those willing to pay attention. The same set of amendments allows you to defer your exit from NPS until age 85. If you retire at 60, that's 25 years during which your corpus can remain invested and continue to grow. Unlike an annuity payout, this growth compounds, keeping pace with inflation.

Better still, there's now something called Systematic Unit Redemption, which allows you to withdraw from your NPS corpus periodically while the remainder stays invested. Think of it as an SWP from your mutual fund, except it's your pension corpus. Your money keeps working; you draw what you need.

And since October this year, PFRDA's Multiple Scheme Framework allows non-government subscribers to invest up to 100 per cent in equity, up from the earlier 75 per cent cap. For younger investors with decades until retirement, this is a significant enhancement. Combine full equity exposure during the accumulation phase with the option to stay invested until 85, and you have a retirement vehicle that can genuinely fight inflation.

The catch, of course, is that this requires you to take some responsibility for your retirement. You need to understand asset allocation, make conscious choices about when and how much to withdraw and accept market-linked uncertainty instead of a guaranteed monthly amount. Not everyone wants this, and not everyone should. For many retirees, the certainty of a fixed monthly payment, however inadequate, provides peace of mind that no market-linked product can match.

But for those willing to engage with their retirement finances, PFRDA has created an escape route from the annuity trap. The pension regulator couldn't fix insurance products, so it built a workaround instead. Sometimes, that's the most practical form of regulatory wisdom.

Also read: New NPS: More freedom, less annuity, bigger retirement role