Topic: Current status of Equity Linked Pension schemes in India and Factors to be considered for choosing a equity linked

pension scheme Hypothesis: Retirement planning being a long-term exercise, individuals would do well to consider investing a portion of their retirement money in pension ULIPs (Unit Linked Insurance plans). Objective of study: To study the relationship between the level of return guarantee in an equity-linked pension scheme and the proportion of investors contribution needed to finance this guarantee. What a pension fund do?

It accumulates a corpus for you so that at time of maturity, you get upto one third(33%) of total corpus tax free & rest is used to buy annuity from any provider. Pension plans typically require regular premium contributions. Issues of pension plan: 1. Pension received is taxable & added to your income. 2. Annuity rate is low (not even 5%) so if your accumulation is 1.5 Crore, you will get 50 lakh tax free & a taxable pension of 5 Lakh per annum ( 1 crore will be returned to you or your nominee after some years as per the plan) 3. Insurance company charges too much initially so that your corpus do not grow for 4 years(time taken for break even). This is issue with all insurance companies. Pension plans are usually not linked to equity because of the inherent risks involved in equity investments. Equity schemes do not guarantee a specified return. That is not the case with pension plans. There is a guaranteed return for a specific period - usually a predetermined percentage of the Sum Assured.

Equity linked plans are called ULIPs - on maturity they can be converted into a pension plan.

Equity linked pension plans Equity linked pension plans are fund management products sold by the insurance firms. These schemes typically provide the investor with a choice of funds for investment in accordance with the policyholders' risk appetite. In FY11, of the Rs 125,458 crore total premium income, Ulips alone accounted for a significant Rs 52,944 crore.

Premiums An individual needs to pay the premium to be eligible to avail the benefits of a Unit linked pension plan. The premium is the amount that is paid regularly, throughout the term of the policy or a single premium in the initial period of the policy. In case of payment of a regular premium, the minimum amount is Rs.10,000 p.a. and in single premium it is Rs.25,000.

Investments The premiums are invested in the units of an investment fund. This is done according to an individual's will and is based on the prevailing unit prices. There are different kinds of Investment funds like, liquid funds, secure managed funds, defensive managed funds and balanced funds. The illustrations of these funds are briefly represented in the table below:

Funds

Area to be invested in Bank deposits and short term money market instruments Government Securities and bonds issued by companies

Level of risk

Liquid Fund

Very low level

Secure Managed Defensive Managed Balanced

Low level of risk, though unit price may vary

High quality Indian equities

Moderate level of risk.

High quality Indian equity and government

High Level of risk

Managed

securities and bonds

The investment in the aforementioned areas is portable, that is, an individual can switch his existing investments from one to another unit linked pension plan.

Benefits The benefits available to the members are pension benefits and cash lump sum benefit. The maximum limit for any cash lump sum is one third of the unitized fund value standing to the credit of a member. The rest of the amount is used to provide an annuity. These benefits are paid in cheque. In case of the death of the member, the beneficiary receives unitized fund value plus cash lump sum of Rs.1000.

Tax benefits The premiums offered under the plans are subject to tax benefit under Section 80ccc of the Income Tax Act, 1961. At the time of vesting, the lump sum (1/3rd of accumulation) is tax free, whereas the annuity is treated as income and taxed accordingly.

Charges For every premium that is paid, a percentage from that is invested in buying units. This is called Investment Content rate. There is also the charge for fund management which is included in the unit price each day. Changes can be made to these charges only after getting approval from the Insurance Regulatory and Development Authority. However, the maximum limit on the fund management charge is 2% per annum.

Annuities The annuity market in India is very small. Most insurance companies in India sell deferred annuities. The only company to sell an immediate annuity is the Life Insurance Corporation of India (LIC), the biggest public sector insurance company in India. Typically, the following options are available to the customers of annuity products:

Life annuity

Joint life annuity Annuity for certain (5/10/15) years Annuity with return of capital on death.

At the time of vesting, only 1/3 of the accumulated balance can be withdrawn as a lump sum, whereas 2/3rd of the balance has to be necessarily annuitized. All the insurance companies offer a free market option. As per this option, at the time of vesting, the customer can buy an immediate annuity from any service provider and is not bound to the insurance company from where he bought the deferred policy.

There are four main types of unit linked investment funds available to prospective policyholders.

Managed funds Unlike specialist funds, these popular unit linked funds invest in a mixture of UK and overseas shares, property, fixed interest securities and cash deposits. Specialist funds These are funds that cater for savers who wish to make their own investment decisions by investing in specialist funds that are focused purely on one type of asset. The majority of providers offer a range of such specialist funds. Tracker funds These are funds that can be characterized as passive as they aim to follow or track the performance of a specific stock market index. As expected the funds will fall and rise in tandem with the share prices of the indices that the funds track.

Lifestyle funds A hybrid form of funds, in the sense that they are usually subject to an arrangement, whereby savings are first placed in a tracker fund before being gradually shifted into a safer fixed interest fund over a period between 5 to 10 years. Why unit linked pension plans (ULPPs) are better? Earlier there were only participative pension plans where one's final retirement corpus from the plan depended on the various bonuses declared by the company. The company bore the investment risk. Most such plans had some form of guaranteed returns because of which companies were conservative in investing and the corpus had limited growth. Now, the guarantees are lesser and are available only for a part of the plan's tenure, say 3-5 years. Working of Equity linked pension plans: A part of the premium is used to pay for one's life cover (some plans do not carry life cover and, hence, mortality charges are not deducted) and the remaining amount, after deductions for charges such as fund management, policy administration and others, gets converted into units. The Insurers are obliged to send an annual report, covering the fund performance during previous financial year in relation to the economic scenario, market developments etc. which should include fund performance analysis, investment portfolio of the fund, investment strategies and risk control measures adopted. The net asset value (NAV) of the units grows with the company's investment performance, even as one keeps adding to the investment pool with premiums. On retirement, one gets a part of the amount as lump sum (up to 33 per cent) with the remaining amount as annuities for a certain period or for life. In Equity linked plans, the investor bears the investment risk, which depends on the debtequity mix of the plan. In return for the higher risk, the investor gets the benefit of higher investment growth in the long-term than what participative policies offer, especially from equity exposure.

With Equity linked plans one can adjust to other changing situations also. For instance, delaying retirement by forwarding the vesting age. Given the kind of growth possibilities and flexibility Equity linked plans provide, it is an ideal instrument for those in the 25-50 years age bracket. It is also important that investments in ULIPs are made after considering expenses like fund management charges since this will impact returns over the long-term. Also, don't lose sight of your overall equity allocation.

For example, if the individual has already invested a significant amount of his money in stocks and equity funds, then he might be better off investing in a conventional pension plan from a diversification perspective.

ULIPs other important benefits like liquidity. You can withdraw money from a ULIP to meet emergencies. Also, you can invest surplus money (i.e. top-ups) over and above the premium amount.

Some insurers have launched capital guarantee ULIPs. Such products aim to guarantee the premiums paid by the individuals (net of expenses) plus the bonus declared, on maturity. Individuals, who fear 'loss of capital' in a ULIP, will find such products attractive.

However, capital guarantee ULIPs has lower equity exposure which could dampen returns for the aggressive investor.

How to pick the right Equity linked pension plan Fix a retirement age. This will give you the vesting age or, in effect, the tenure of the ULPP. The policy you finally choose should ideally allow you to advance or delay this age. Go for a pure investment product. Try to choose a plan that doesn't have a life cover as this means that a greater portion of your premium will go towards growth investments. Choose high equity exposure. Investing in a high equity exposure plan, 80-100 per cent, is the best way of exploiting the growth opportunity that ULPPs offer. This will give your retirement funds the much needed growth kicker. As you approach retirement, you can switch to a lower-risk, higher-debt variant. Seek the lowest cost option. Costs relating to management and administration bite off a part of the growth of your money. Lower charges reduce the impact of costs on total returns.

Hedging vs diversification: Allocating assets between fixed-income securities and equities can help a portfolio strive for mean-variance efficiency. But retirement funds do not need such diversification benefits. The objective of such a fund is to hedge long-term liability. At the minimum, this means protecting a certain standard of living after retirement. Fixed-income securities and equities are unlikely to help investors meet these goals. Take fixed-income securities. A fund's bond portfolio will be exposed to interest rate risk. Our market does not offer many products to hedge such a risk. And even if OTC products such as exotic swaps are available, hedging costs will be high. Besides, fixed-income securities pay nominal coupons. So, the interest income may not beat inflation. Next consider equities: There is a notion that stocks are less risky in the long run. Besides, stocks have been empirically proved to outperform other asset classes in the long run. But this is not always true. It is important how stocks in the pension fund portfolio move during the investment horizon of each investor. That is, the likelihood of the pension fund generating the required retirement income for each investor is somewhat path-dependent. Suppose a pension fund investor chooses to allocate Rs 1 lakh every year for the next 20 years. What if the stock market passes through a bad phase in the initial five years? Or, what if the market tanks in the first year? Attempts will be made primarily to recoup the capital loss through the investment horizon. In that case, stocks may be unable to outperform other asset classes at the horizon. The point is that stock markets exhibit tail events that are severe in magnitude. They happen frequently for a long-term investor's comfort. It is very costly to hedge such tail risk, especially when pension funds have no finite maturity. Structuring retirement income: Pension investors essentially need a hedge against inflation to protect their consumption pattern. Besides, their investment should carry an upside potential to improve their standard of living and meet contingent liabilities. Yet, the downside risk should be protected. In effect, this means the investors should be able to buy a product that is inflation-protected and also replicates payoffs on a call option. Fortunately, the market can offer such products in the form of annuities.

At present, all life insurance companies offer annuity products as part of their pension product portfolio. Such annuities do not, however, protect against inflation risk. The unitlinked insurance plans have symmetrical payoffs. That is, the investor is exposed to both the ups and downs in asset prices.

Insurance companies should, hence, offer real equity-linked annuities. The payoff on such a product will be a combination of two factors. The base component will be a fixed-rate annuity, paying real income. This will protect the investor against inflation risk and provide a stable income. The variable component will be linked to an equity index. This payoff will be structured as a call option.

That is, the payoff will be non-linear in that the variable structure will participate in market rallies but will not decline below zero if the market tanks. Of course, the success of this product will depend on the ability to construct an inflation index that replicates the average consumption pattern of retired individuals.

Relationship between level of a return guarantee and Investors contribution: The relationship between the level of a return guarantee in an equity linked pension scheme and the proportion of an investor's contribution needed to finance this guarantee was studied using three types of schemes: investment guarantee (IG), contribution guarantee (CG) and participation surplus (PS). These are long term investment plans, in which the investor typically puts in periodic payments of cash over a long period. A proportion of this is invested in an investment fund, while the remainder serves to finance the return guarantee. Comparison of the pricing (and thus, implicitly, the hedging) of three types of pension schemes with guarantees is done. In investment guarantee (IG) the guaranteed rate of return g depends on the investment amount. In contribution guarantee (CG), g depends on the contribution amount. The contribution of the investor consists of the investment plus the premium for the guarantee. In participation surplus (PS), the construction of the payoff is equal to a fixed guaranteed amount plus a participation in the surplus of the investment payoff over the guaranteed

amount. The guaranteed amount is again given by the sum of the contributions compounded with a rate of return g.

The main findings are as follows. For each of the contracts, a negative relationship between the participation in the surplus return of the investment strategy and the guarantee level in terms of a minimum rate of return is found. This property is a consequence of the contract specification, namely the surplus participation and the type of guarantee.

Fig 1:Upper and lower bound for the investment fraction (g) as a function of the guaranteed rate of return g for an admissible pension scheme (IG;CG; SP); contract maturity T = 15 years, age x = 30 + (15) and bimonthly constant contribution.

Fig 2: Guaranteed benefit GB (t; g = 0%) at maturity as a function of the termination date t for an admissible pension scheme(IG;CG; SP); contract maturity T = 15 years, age x = 30 + (15) and bimonthly constant contribution K = 100

It is independent of the financial and non-financial risk involved. As financial risk we consider the price risk of the underlying investment fund and the interest rate risk. As the non-financial risk we explicitly allow for early termination of the contract. The magnitude of the financial risk dominates largely the impact of the non-financial risk.

Pension ULIPs: How they fare HDFC ICICI Prudential (Lifetime Pension II) Standard Life (Unit Linked Birla Sun Life (Flexi SecureLife LIC (Future Plus) Bajaj Allianz (UnitGain easy Pension)

Pension Plan) Market Product type Market linked plan linked plan

II)

Market

Market

Market

linked plan linked plan linked plan Equity index pension fund, Equity plus

Growth fund, Equity managed fund, Pension Maximiser II (Growth), Pension Balancer II ULIP fund options Balanced fund, Defensive Nourish, Growth, Enrich Bond fund, Income fund, Balanced fund,

pension fund, Equity MidCap plus pension fund, Debt plus pension fund, Balanced plus pension fund, Cash plus

(Balanced), Pension fund, Secure Protector II (Income), Preserver fund, Liquid fund 100% in growth fund; 60-100% in equity managed fund; 30-60% in balanced Up to 100% in pension maximiserII; up to 40% in pension balancer-II; Allocation equities to nil in Protector II & Preserver fund; 15-30% in defensive managed fund; nil in secure managed &

Growth fund pension fund Bond fund: Equity index NIL; Income fund: Not more than 20%; Balanced fund: Not pension fund: at least 85% in stocks primarily from NSE Nifty Index; Equity plus

Up to 35% in Enrich; up to 20% in Growth; up to 10% in Enrich

more than pension fund: 30%; Growth fund: Not at least 85%; Equity MidCap plus

more than pension fund:

liquid fund

60%

at least 50% in midcap stocks; Debt plus pension fund: NIL; Balanced plus pension fund: 30%-50% in equity index fund and 50%-70% in debt plus fund; Cash plus pension fund: NIL

Minimum premium (Rs) Life cover Yes Option 1: Zero sum assured. Pure accumulation. Optio Sum assured 10 times the How assured calculated Min/Max Age at entry (Yrs) Min-Max is Sum n 2: Sum assured = = Rs 1,000 regular premium amount. 5-20 times the Zero sum No Yes Yes No 10,000 10,000 5,000 5,000 10,000

option available

annual contribution plus the fund X tenure. Option 1: 1865.Option 2: 18-60 45-75 18-60 50-70 value.

annualised assured. Pure premium accumulation.

18-65 50-70

18-65 40-75

18-65 45-70

vesting age (Yrs) 8.50%-22% for years 1 17%-22% in first yr. and 2. (Exact 12%-15% for second percentage yr.(Exact percentage depends upon depends upon the Initial expenses years' annual premium amt). the annual premium amt). 21% for the first year. 8%-13% for years 1 and 2. (Exact percentage depends upon the premium amount). * 15% for the first year. Equity MidCap plus and Equity plus pension funds: 1.5%; Equity index pension fund: 1%; Debt plus pension fund Bond fund and Cash plus and Income pension fund: fund: 1%; 0.70%;

Balanced Balanced plus Maximiser II- 1.5%; Fund management charges Expenses balancer-1.0%; protector II & preserver-0.75% 0.80% 1% 2.2% second year onwards 2.50% fund: 1.25%; Growth fund: 1.50% pension fund: As applicable on component funds 2% second year onwards

after 1% for years 3 to 10. 1% third yr Nil thereafter. onwards.

initial years (%)

35 (Additional charge of Rs 2 levied in case life insurance Fixed monthly 20 15 2.5% for 1% of top-up value Charges on top- for first 10 yrs. Nil ups (%) thereafter. initial two yrs. 1% thereafter. Up to 5 free switches in a year. Up to 2% of the switched amt may be charged for 4 free switches in a year. Rs 100 per Switch charges switch thereafter additional switches thereafter. 2 free 4 free 3 free switches in a year. 1% of 1% 1.25% 2% cover opted for) 15 20

expenses (Rs)

switches in a switches in switched amt year. 0.50% of the amt transferred thereafter. a year. Rs 100 per switch thereafter or Rs 100, whichever is higher thereafter.

Apart from the expenses mentioned above, LIC's Future plus also charges for the following: (1) Life cover charge(as applicable) (2) Administration charge: Rs 1 per thousand of sum assured subject to a max. of Rs 1,000 in each of the first 2 years. (3) Policy charge: Rs 0.10 per thousand in each of the first 2 years (in case of life cover); Rs 0.10 per thousand of the total premiums payable in each of the first 2 years

The IRDA has come up with new guidelines regarding the ULIPs in India. The changes and its effects are as under:

Lock in for Five Years and Premium Payment Term: Minimum lock-in period has been revised from the current 3 years to 5 years and barring single premium policies, the minimum payment term has also been raised to 5 pay.

Increase in Minimum Sum Assured: The minimum sum assured multiple has been increased to 10 times for age at entry below 45 years and 7 times for age at entry above 45 years. At no time can the sum assured be less than 105 per cent of total premium paid including top ups. All top ups also must have life insurance cover built into them.

Net Reduction in Yield for Every Year from Year 5: This new guideline stipulates the maximum net reduction in yield every year from 5th year. It is primarily an extension of the earlier stipulation of maximum net reduction in yield of 3% for policy term up to 10 years and 2.25% for policy term above 10 years.

Cap on Discontinuance Charge: IRDA has introduced a cap on surrender charge, now termed as policy discontinuance charge, basis the year of discontinuance and annual premium. This allows life insurers to charge only a small penalty on early surrender of policy.

Modifications in Unit Linked Pension Products: Partial withdrawals in Unit Linked Pension products will not be allowed. On maturity, one third of the corpus could be taken as lump sum and rest must be used for buying annuities. This change will ensure a larger corpus is collected and used for retirement planning and not for other life stage needs. IRDA has also made it mandatory that all unit linked pension products must offer minimum guaranteed return which would be specified by IRDA from time to time. Even spread of charges during the lock-in period. The new guidelines stipulate that the overall charges in ULIPs should be spread evenly over the lock-in period of 5 years.

The new guidelines provide superior customer value proposition and ensure that life insurance is promoted as long-term protection and savings tool. It is always advisable to remain invested in life insurance policies for the full tenure to get optimal benefits of protection and long-term savings.

Unit Linked Plans offer unique opportunity to combine protection with investments. Their attractiveness to investors can be understood better when viewed through the prisms of their

relatively lower costs, better returns potential arising from their market linkage, greater flexibility compared with other savings products, transparency and unmatched proposition as a long-term savings tool. Some special features of Unit Linked Life Insurance Policies (ULIPs) are:

Provides flexibility in investments ULIPs offer a complete selection of high, medium and low risk investment options under the same policy. You can choose an appropriate policy according to your risk taking appetite, coupled with the opportunity to switch between fund options without any additional expense for specified number of switches. ULIPs provide the flexibility to choose the sum assured and investment ratio in the annual targeted premium. It also offers the flexibility of one time increase in investment portfolio, through top-ups to avail investment opportunity offered by external environment or own income flows.

Transparency The charge structure, value of investment and expected IRR based on 6% and 10% rate of returns, for the complete tenure of the policy are shared with you before you buy a product. Similarly, the annual account statement, quarterly investment portfolio and daily NAV reporting, ensures that you are aware of the status of your investment portfolio at all times. Most companies publish latest NAVs on their respective websites on a daily basis.

Liquidity To cope with unforeseen circumstances, ULIPs offer the benefit of partial withdrawal; wherein after 5 years you can withdraw funds from our Unit Linked account, retaining only the stipulated minimum amount.

Disciplined and regular savings ULIPs help you inculcate a regular saving habit. Also, the average unit costs tend to be lower than one time investment.

Multiple benefits bundled in one product ULIP is an outstanding solution for risk cover, long term investments with the benefit of various investment opportunities, coupled with tax benefits.

Spread of risk ULIPS are ideal for those investors who wish to avail the benefit of market linked growth without actually participating in the stock market, with the added benefit of risk-cover.

Findings and Conclusion: Ulips offer a choice of funds in the debt and equity space. The choice of either is usually a reflection of the investors risk appetite and investment objectives. Investors, who stay invested over the long term in either, stand to reap richer benefits from the power of compounding and rupee-cost averaging. Ulips afford professionally managed exposure to equity, along with insurance cover and tax benefits. The combination of higher return potential, life cover and tax benefit, which a Ulip affords, is unmatched. The investment returns are enhanced given the broadly even spread charges through the policy term and the higher initial allocation. As a long- term, market-linked investment tool, Ulips have no parallel, since, they are specifically designed and structured to benefit the investor in the long term. Given the kind of growth possibilities and flexibility Equity linked plans provide, it is an ideal instrument for those in the 25-50 years age bracket. The appetite for market-linked products has witnessed steady growth over the years and the trend is expected to continue. The new regulatory environment has made Ulips extremely customer-friendly and transparent. Customers benefit from the trine of life insurance, market-linked investment returns and tax benefits. The greatest appeal lies in its potential as an extremely effective tool for financial lifecycle planning, incorporating the best features of other competing platforms in the savings space.

References: 1. Equity-Linked Pension Schemes with Guarantees. J. Aase Nielsen (Department of Mathematical Sciences, University of Aarhus) Klaus Sandmann (Department of Finance, University of Bonn) 2. Pension Plans The Institute of Chartered Accountants of India , October, 2008 3. The Fair premium of an Equity- linked Life and Pension Insurance J. Aase Nielson University of Aarhus ,Klaus Sandmann Department of Finance, University of Bonn 4. Pricing of equity - linked life insurance contracts with exible guarantees Alexander Melnikov Department of Mathematical and Statistical Sciences University of Alberta, Edmonton, Canada , Victoria Skornyakova Russian Academy of Economics,Moscow, Russia. 5. Unit-Linked Insurance Policies in the Indian Market- A Consumer Perspective R. Rajagopalan Dean (Academic Affairs) T.A. Pai Management Institute Manipal 6. Franzen, D. (2010), Managing Investment Risk in Defined Benefit Pension Funds, OECD Working Papers on Insurance and Private Pensions, No. 38, OECD Publishing. 7. India Pension Research Foundation Working paper series, No: 10/04 Group superannuation schemes in India Surabhi Sinha September 16, 2004 8. Comparative analysis of insurance products . 9. Scope Of Unit Linked Insurance Plans In India. 10. Unit Linked Pension Products Challenges and Opportunities by P.Jagan Narayan 5th Global Conference of Acctuaries. 11. Unit-Linked Insurance Plans A Comparative Study of Selected Insurance Companies in Haryana and Punjab Neelam Saini (Assistant Professor in Commerce, Kanya Mahavidyalaya Kharkhoda Sonepat (HR)) 12. Insurance Regulatory and Development Authority (IRDA) Reports.