While we put so much thought into planning how to spend our golden years, we tend to overlook financial security and independence. However, it is crucial to plan ahead so you have enough funds to enjoy your retirement life to the fullest and also take care of unexpected expenses.
Not quite sure how to do that? Well, a pension plan might be your best choice. It is nothing but a fund that can be used as post-retirement income, be it for day-to-day expenses, a business venture, or even travelling. So, if you wish to know more about what is a pension plan and how it works, keep reading!
What is a Pension Plan?
A pension plan, also known as a retirement plan, is an investment policy that acts as a savings fund and financial safety net for your retirement years. The primary objective of a pension plan is to enable people to have a steady income flow post-retirement. And the best part? You can utilize the amount for household expenses, investments, or even fulfilling your wants.
Additionally, pension plans can also come in handy to meet unexpected medical expenses, considering that old age comes with its fair share of health issues. Plus, you don’t have to worry about inflation, as already having a retirement fund in place will make financial management easier. But how does a pension plan work?
If you buy a pension plan, you will have to regularly contribute a fixed amount until your retirement. The accumulated sum is then given back to you as a pension (lump sum) or annuity (income replacement) once you are officially retired. Here’s an example:
Let’s say that you contribute Rs. 50,000 annually to your pension plan for 10 years. This means that by the time you retire, you will have collected Rs. 5 lakhs in your pension fund. Now, you can either choose to receive the entire amount in a lump sum (as a pension) or as a monthly income (annuity). Better yet, you also have the option to take part of the fund as a pension and receive the rest as monthly income. However, this varies from one insurance provider to another.
How do Pension Plans work?
Now that you are clear about the pension plan benefits let’s look at how they work. In India, pension plans are structured into two parts, i.e., accumulation and distribution. The premium you pay towards a pension plan is invested in a fund or asset of your choice for a pre-determined period.
Once the pension plan attains maturity, you will start receiving its benefits, also called vesting. During the time of vesting, you will have two options, i.e., you can either start receiving the benefits or withdraw the proceeds to purchase an immediate annuity plan from the same company.
Is Pension an Integral Part of Retirement?
Now that you know what is pension and how it works let’s discuss whether it is an integral part of retirement. Although we all know the answer to this question, here are a few reasons why:
- Financial Independence: Once you retire, you won’t have a steady income source, which can leave you to depend on your family for your expenses. However, investing in a pension plan will ensure that you remain financially independent and live your life on your terms.
- Financial Security: As we discussed, pension plans are an excellent way to financially secure your golden years. The accumulated amount can help you fulfil not only your needs but also your wants.
- Unforeseen Expenses: We all know that life is uncertain, especially when it comes to health. Plus, you are more prone to medical issues in your retirement years. Therefore, it is best to buy a pension plan so you can take care of unforeseen expenses, including medical expenses.
Estimate of How Much You Should Save for Retirement: Factors to Consider
Although it is easy to understand what is a pension plan, it can be tough to evaluate how much you need to save. While there is no sure way to predict the exact amount you will need during retirement, here are some aspects you should consider:
- Your Daily or Monthly Expenses: Before you invest in a pension plan, you should calculate your daily or monthly expenses. This should include your rent, electricity bill, food and groceries, internet or phone bills, transportation costs, etcetera. Doing so will ensure that you have enough funds to meet essential expenses.
- Post-Retirement Financial Responsibilities: When planning your pension fund, it is crucial to consider post-retirement financial responsibilities. This can be anything from paying off a home loan to paying for your child’s higher education.
- Unexpected Costs: While deciding how much you should invest in a pension plan, it is vital to consider unexpected costs. This means that you should put aside a considerable sum for financial emergencies or unforeseen medical expenses.
- Inflation: As per recent statistics, consumer food prices increased by 100% in India between March 2021 and 2022. While there is no way to avoid inflation, you can factor it in when calculating how much you should save for retirement.
- Your Dreams and Goals: Whether you wish to explore new countries during retirement or start a new business, it is essential to ensure that you have enough money to fulfil your dreams and goals.
In order to get an estimate of your plan, you can use a pension plan calculator online with help of a pension calculation formula. The pension plan calculator illustrates the tentative amount of pension, and the lump-sum money which an NPS subscriber may expect on maturity.
Types of Pension Plans
Now that we have covered what is pension and how a pension plan works, let’s understand the different variations available in India:
Deferred Annuity Pension Plan
By investing in a deferred annuity pension plan, you can build up a corpus by paying single or regular premiums. As a result, you will end up saving a large amount of money as a pension over the plan’s tenure. Furthermore, you might benefit from various tax benefits by buying this type of pension plan.
Immediate Annuity Pension Plan
As the name suggests, it’s a type of annuity that pays out immediately. You put down a large sum and instantly begin earning annuities as a pension. Additionally, you have a number of annuity options that you can choose from, as well as the amount you wish to invest in the plan.
Fixed Annuity Pension Plan
A fixed annuity promises to pay the buyer a specific guaranteed interest rate on their contributions to the account. A fixed interest rate will help you know how much your annuity will grow and how much income you will earn. This predictability feature helps make people feel comfortable about the stability of their retirement plans.
Variable Annuity Pension Plan
A variable annuity pension plan is a plan wherein the benefits change on the basis of the return of the plan’s assets. This pension plan has been around for quite a while but is not so common amongst the masses. This is because it does not guarantee that buyer’s monthly pension will not decrease.
Read More: What is Annuity Plan?
What is National Pension Scheme (NPS)?
The National Pension Scheme (NPS) was launched by the Indian government to ensure financial security for citizens during their retirement. Under this pension plan, your money is split between equity and debt funds based on your investment preferences. While 40% of the sum is utilized to buy the annuity, you can withdraw the remaining 60% upon retirement.
What Age Is Considered Early Retirement?
When a person retires at 65, he qualifies for all the social security benefits of retirement. Consequently, early retirement can be defined as a retirement that takes place before the age of 65. Currently, men retire at an average age of 64, whereas women’s average retirement age is 62.
Ready to Be a Pensioner? Understand the Tax Benefits of Annuity Plans
In India, pensions plans have several tax benefits as per Section 80CCC of the Income Tax Act, 1961. These provisions were introduced by the government to motivate people to invest in pension and retirement plans, which further help in achieving financial security.
So, what are the tax benefits of a pension plan? Firstly, you can avail a tax exemption of up to Rs. 1.5 lakhs for the premiums paid towards a pension plan. This also includes the renewal of an existing policy offering a lump sum pension or annuity. Secondly, the pension or annuity you receive is tax-free; however, this varies from one pension plan to another.
For instance, in deferred annuity pension plans, 2/3rd of the amount is taxable, whereas 1/3rd is exempt from taxes. On the other hand, the maturity sum received from the National Pension Scheme (NPS) is not tax-free. Therefore, when you buy a pension plan, it is essential to check if you are eligible for tax benefits beforehand.
So, now that you know what is pension, how it works, and its types, it might be time to explore the different plans available in the market. Also, it is best to invest in pension schemes regardless of your annual income, savings, and investments, as you can’t predict what the future (or your retirement period) holds!
The minimum age requirement for pension and retirement plans is usually 18 years, whereas the maximum age limit is 70 years. However, this may vary from one insurance company to another.
Yes, you can invest in more than one pension plan as there are no restrictions on this. However, there is a limitation of Rs. 1.5 lakh for the tax exemptions that can be claimed for pension plans.
If you wish to cancel your pension plan, you have to option to surrender. In this case, you will not receive the total sum assured but only the surrender value.
Yes, it is possible to change the nominee of your pension policy whenever you want to.
Yes, you can pay the premium for retirement and pension plans online through net banking, debit cards, credit cards, etcetera.
Both investment schemes have their own sets of pros and cons; however, PPF investment comes with lower risks if compared to a pension plan.
On the other hand, if you have less than 15 years left for your retirement, PPF would not be a viable option. In this case, a pension plan can help you create a retirement corpus for a secure future. Therefore, there is no one correct answer to this question.
The employee pension scheme or EPS is another pension scheme that the Indian Government offers. It springs from the employee provident fund, which means that not the entire contribution goes towards the EPF. 8.33% of this total amount goes to the EPS, and the rest becomes the EPF contribution.