PFRDA

Concepts Important to Understand Annuity

Parties to an Annuity

Before understanding how an annuity works it is very important to understand and know the different parties to an Annuity.

Insurer/ Annuity Provider- The company paying the regular payments or annuity. Generally this would be an Insurance company.

Annuitant- The person who is the recipient of an annuity payment.

Nominee- The person who receives the funds after demise of the Annuitant. The nominee could be spouse, child/ children or parents. The Annuitant chooses or nominates his/her nominee at the time of buying the annuity policy. The insured person can nominate one or more person as his/her nominee.

Concepts related to Annuity

Purchasing an Annuity- Placing a lump sum amount with an Insurer/ Annuity provider in lieu of which the Insurer/ Annuity provider gives the periodic annuity.

Pension- the periodic annuity to be received by an Annuitant.

Purchase price- The lump sum amount used by an Annuitant to buy the Annuity.

Annuity rate- The rate that is used to calculate the amount of income that will be paid, following investment of a lump sum in an Annuity plan.

Longevity Risk- At the heart of the concept of Annuity lies Longevity risk. It is defined as ‘the risk that members of some population might live longer on average than anticipated. Longevity risk can have significant consequences for individuals with pension savings when they come to retire. In particular the risk may come in the form that people outlive will their retirement savings.

Purchase Price lost/ Loss of purchase Price- When upon the death of Annuitant, the Purchase Price of the annuity is lost i.e. the lump sum is forfeited in favour of the Insurer/ Annuity.

ROC- Return of Capital- When the Purchase Price i.e. the lump sum used for purchase of annuity is returned to nominee of the Annuitant.

Pension/ Annuity Formula

Pension = Annuity Rate X Purchase Price

Number crunching to understand the Pension/ Annuity Formula

For eg.

Annuity rate = 7.5% p.a.
Purchase price = Rs.60,00,000/-

Pension = 7.5% X 60,00,000 = Rs.4,50,000 p.a.

In other words, with an Annuity Rate of 7.5% and a Purchase Price (initial lump sum amount placed with an Insurer/ Annuity Provider), the Annuitant ( recipient of Pension) would receive a Pension of Rs.4.50 Lakh per annum.

How does an Annuity Work?

To understand how an Annuity works, it is important that we understand it from the side of the one who is making the regular payments i.e. the Insurer/ Annuity Provider.

First and foremost, the Insurer/ Annuity Provider is not providing the payments of free. As a customer, one places their lump sum with an Insurer/ Annuity Provider. The Insurer/ Annuity Provider invests the money is assets/ securities etc. and makes the regular payments through the returns earned through them. This is too simplistic but fundamentally that is how an Annuity works.

When a person purchases an Annuity from an Insurer/ Annuity Provider is getting into a long term contract for 5/10/15/20 years (depending upon the period of annuity chosen by Annuitant). By this contract, the Insurer/ Annuity Provider is bound by law to make the regular payments to the Annuitant for the chosen period. The Insurer/ Annuity Provider cannot default on the payments.

The lump sum with which the Annuity is purchased, acts as the fuel with which the whole engine of Annuity works.