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How Pension Plan Works in India?

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How Pension Plan Works in India?
July 26, 2024

Table of Content

 

To be financially independent even after the employment years is the goal of everyone. But how to achieve this depends on how prudent your financial planning is. Investing in a good pension plan when you have a steady income is the right way of securing your post-retirement life. Several plans that offer a regular income stream are available in the market. Understand how pension plan works in India before investing. Read on for more about the various pension plans and an insight into which plan is right for you.

What is a Pension Plan?

A pension plan is a financial instrument that ensures a steady income post-retirement. Considering the inflation rate, investing in a pension plan is a prudent way of securing your retirement life and achieving financial independence retire early (FIRE). Retirement and pension are closely interrelated; whenever you think of planning for retirement, the first thing that comes to mind is a pension and how to remain financially independent through it. Government employees benefit from a regular income stream in the form of a monthly pension provided by the employer. For others without such benefits, buying a pension plan early in life can prove beneficial.

Generally, this is how pension plan works. There are two stages i.e., the accumulation phase and the distribution or vesting stage.  During the accumulation stage, the regular premiums paid accumulate to form a retirement corpus. On retirement, the pension plan provides you with a regular income source and this is the distribution phase.

How Do Pension Plans Work?

You have heard people around you discuss pension plans. However, there is no clarity about how pension plan works. Pension plans are nothing but savings and investment tools. The premiums you pay for a predecided term are invested in funds/assets of your choice which culminates into a consistent income stream after you retire. 

Knowing how pension scheme works is imperative to put your money into it. The pension plans in India have two stages i.e., the accumulation and the vesting stage. The premiums paid are invested in various funds and assets in the accumulation stage. The vesting stage starts after the plan has matured. During this stage, you start receiving the pension. You can opt for a pension or withdraw the accumulated funds in a lump sum and invest in an annuity plan from the same provider. The common vesting period is 3 to 5 years but the employers can choose other schedules too.

The pension plan or the pension policy provides guaranteed maturity benefits of guaranteed death benefits. The Assured  maturity benefit provides 101% of the premium paid or the fund value whichever is higher on maturity to the policyholder. This is the reason why the pension plan is considered a safe investment. 

Also, the plans provide financial security to the policyholder’s family by way of guaranteed death benefits.

What are Pension Funds?

Pension funds are tools for saving to ensure you get regular payouts once you retire. During your working years you will be required to make periodic payouts called premium payments. These are invested in funds/assets to provide returns. 

You can choose to either invest in government assets or equity/debts depending on your risk appetite. Here again, you can withdraw the funds and reinvest in annuity plans from the same life insurance company. 

Awareness about how do pension funds work is highly essential for an informed choice. For instance, if you are 40 years old and you retire at 60, then you will have to build funds over 20 years that would generate the extent of retirement income you require. You can use a pension calculator for this purpose.

How do Pension Funds Work?

Being equipped with an insight into how pension plans work is the first step to investing in lucrative plans. For getting the returns expected you should focus on the following aspects.

Investment Strategies

Investment strategies involve proper asset allocation and risk management for reaping better returns.

  • Asset Allocation

    • Given the market volatility and the inflation rate, the skill in asset allocation is the primary requirement to get the expected returns. It helps balance the risk involved in investments in various asset classes like debt, equity, stocks, and gold. The purpose of asset allocation is to ensure that your asset performs well under any market situation. Diversifying your portfolio helps achieve this as no asset performs well at all times.

  • Risk Management

    • Risk management is a crucial component in creating an investment portfolio. All investments carry a degree of risk. Analyzing the risk associated with your portfolio and whether it aligns with your financial objectives is important before investing. The risk tolerance is the extent of losses you are willing to face to achieve the desired level of returns.

    It depends on your investment goals, experience, time horizon, monthly expenses, financial commitments, etc. The fundamental rule of risk management is the diversification of the portfolio. Instead of putting all your money in one asset, spread it across multiple assets to balance the risk.

Performance Monitoring

Performance monitoring of the assets you have invested in is a fundamental requirement to make changes and adjustments to get the expected or more-than-expected returns.

  • Fund Managers

    • Fund managers have the acumen and strategic insight and play an important role in optimizing the returns on investments. They are entrusted with the responsibility of monitoring the investment portfolio. Fund managers make investment decisions that align with the fund’s objectives and generate returns for the investor. They track the performance of an asset and make adjustments as needed to meet the expectations of the investors.

  • Performance Metrics

    • Performance metrics help you understand how well an asset or portfolio is doing. They provide insight into the risks, returns, and other applicable factors. Benchmarking is an integral part of performance monitoring. It involves comparing the performance of an asset or portfolio with the standard benchmark. The common benchmarks are stock indices like the S&P 500 or specific sector indices.

    Performance metrics and benchmarking provide a vivid picture of the relationship between the amount of risk taken and the potential returns on the investment. For instance, the higher the risk the higher the returns.

A Nominee Can Utilize Pension Funds in Three Ways

A nominee has three choices to utilize the pension funds:-

  • Withdraw the entire death benefit
  • Buy an immediate annuity plan with the entire proceeds
  • Partially withdraw the proceeds and use the balance amount to buy an annuity plan.

Advantages and Disadvantages of Pension Plans

Being aware of the advantages and disadvantages of pension plans besides knowing how pension plans work is important for an informed decision. The following are the advantages and disadvantages of pension plans.

Advantages

  • The investors have the option to choose their portfolio. They can invest in government bonds, equity, or debts according to their risk tolerance level.
  • A long-term saving opinion that allows the accumulation of funds over an extended period.
  • Depending on your age or plan you can choose to invest a lump sum and get annuity payments immediately or opt for deferred annuity and allow the corpus to grow before the payouts start.
  • Tax benefits are available under Sections 80C, 80CCC, and 80CCD of the Income Tax Act 19611.
  • You have access to a lump sum during emergencies.
  • Some pension plans like the plans from HDFC Life provide life cover as well where a lumpsum amount is given to the family members on the death of the policyholder during the policy term.

Disadvantages

  • The annuity received after retirement is taxable.
  • It is more beneficial for early investors. If you invest late the returns are considerably low compared to investments made early in life.

Types of Pension Plans in India

Now that you know how pension plan works, you should also know the various plans available so that you can choose the one that suits your risk-taking ability, budget, and financial goals. The plans available are:

National Pension System (NPS)

NPS is a government-backed scheme. The regulatory authority for the scheme is the Pension Regulatory and Development Authority of India (PFRDA). The pension scheme applies to public, private, and unorganised sectors to enable their employees to save for their future. 

The scheme matures when the investors attain 60 years of age. They are allowed to withdraw 60% of the proceeds in lump sum and the rest have to be invested in annuity plans from PFRDA. 

Another advantage of NPS is the survival benefits. The surviving spouse gets the same pension as the subscriber for a lifetime. 

Employees' Provident Fund (EPF)

Employees’ Provident Fund is also a government-backed scheme offered by the Employees Provident Fund Organisation (EPFO). Both public and private sector employees can subscribe to the scheme. Both employee and employer make equal contributions to the fund which can be withdrawn after retirement. However, premature withdrawal options are available in some cases like children’s education, marriage, house construction, medical emergencies, etc.

Annuity Plans

Annuity plans are retirement plans that help you create a source of guaranteed income for your retirement years. The retirement benefits can be invested in a lump sum or the investment can be invested over years. The invested amount is utilised to generate returns which are paid out to the policyholder on retirement. 

This plan has both flexible investments as well as payout options. It is to ensure that you create a retirement corpus at your convenience and receive the proceeds to fulfill your long-term financial goals. Hare, you can opt for a deferred annuity or immediate annuity. In a deferred annuity you invest now and get the payouts after a pre-decided term and in an immediate annuity you invest the funds and start getting payout immediately.

Pension Funds

These plans provide a higher return on maturity and are in force for a longer period. 

Public Provident Fund (PPF)

PPF is a popular investment scheme and suitable for individuals with a low-risk appetite but who want to earn high and stable returns. The plan is government-backed and provides guaranteed returns. The maximum investment permitted in a financial year under the scheme is Rs.1.50 lakhs. The tenure of the scheme is 15 years with an option to extend it further for 5 years.

Atal Pension Yojana (APY)

Any citizen of India between 18 years to 40 years old can subscribe to the Atal Pension Yojana (APY). The government pays a guaranteed pension of Rs. 1000, 2000, 3000, 4000, or 5000/- depending on the contributions made.

Selecting the Right Pension Plan

When it comes to saving and investing for the future, there is no formula. You must pick a pension plan based on how much you can afford to save up or invest every month. Your risk appetite and retirement goals will also play a role here. You must come up with a sound plan based on how much money you will likely need in the future to cover your daily expenses, potential healthcare costs and all your retirement goals.

Features of Pension Plans

While choosing a pension plan, you should look for:

Guaranteed Benefits

Once you retire, you will need a steady income to help you take care of your monthly expenses. Your pension plan should provide you with financial independence even after you retire. Look for plans that offer guaranteed benefits.

Tax Benefits

The contributions you make to your pension plan will likely be exempt from taxes under Section 80C of the Income Tax Act, 19611. Depending on the kind of pension plan you opt for, the returns you receive might also be tax-free.

Can Be Customized

When you opt for a pension plan, you have the power to choose your accumulation years, your vesting age and the payment period. So if you get a pension plan when you are 30 and your accumulation period is 30 years, you will invest money until you turn 60. You can pick your vesting age to be 65, which is the age when you’d like to retire. If you want the payment period to be 15 years, you will receive a steady income until you are 80.

Flexible Payouts

Most pension funds allow you to pick how you’d like to receive the benefit. You can decide whether you want to receive monthly or annual payments.

Life Coverage

Possibly the most crucial benefit of a pension plan is that it also provides insurance coverage. The sum assured amount will allow your dependents, like your spouse and children, to remain financially independent.

Taxation of Pension Funds

Knowledge of how do pension funds work in terms of taxation is also essential to understand how much tax burden is reduced.

The premiums paid towards pension plans are eligible for tax deductions under 80C, 80CCC, and 80CCD up to Rs.1.50 lakhs. The deduction of Rs.1.50 lakhs is the total amount eligible under all three sections put together. 

One-third of the amount provided after retirement is tax-free. The payout received as an annuity from the rest of the amount is subject to tax as per your income tax slab.

Conclusion

Creating a retirement corpus is crucial for financial stability after retirement. Pension plans that provide for investment during your working years to create a retirement corpus are beneficial. For an informed decision, understand how pension plans work, what are the advantages and disadvantages of the plans, the various plans available and the benefits offered. Starting a pension plan early in life will provide better returns than starting a plan late in life. Invest in a pension plan today if you haven’t yet and secure your post-retirement life.

FAQs on how pension plan works

Q. How does a pension scheme work?

Pension plans comprise two stages. In the accumulation stage, the subscribers pay premiums till they attain retirement. The vesting stage or the distribution stage is where the subscriber receives a monthly pension based on the funds invested after retirement. This is how pension scheme works in India.

Q. How are pensions calculated?

The formula for pension calculation is average basic salary pensionable service/70 wherein average basic salary is the basic salary plus dearness allowance drawn for the last 12 months. Pensionable service is the number of years worked in the organized sector after 15th November 1995.

Q. Is the pension paid per month?

Yes. Pension is paid per month. You can also opt for annual payments.

Q. How to get an RS 50,000 pension per month?

To calculate the required pension uses a pension calculator. Enter the age, current income, monthly expenses, savings, saving goals, and the retirement age. You can on trial and error method arrive at the investment every month for Rs. 50000/- pension per month.

Q. How to get a 1 lakh pension per month?

You can calculate the approximate monthly investment for a 1 lakh pension per month using the pension calculator. Provide the age, current income, monthly expenses, saving goals, retirement age, and current savings. With several trials by varying the inputs, you can arrive at the monthly investment for a 1 lakh pension per month.

Related Article :

ARN – ED/07/24/13062

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Francis Rodrigues Francis Rodrigues

Francis Rodrigues has a decade long experience in the insurance sector, and as SVP, E-Commerce and Digital Marketing, HDFC Life, manages the online sales channel, as well as digital and performance marketing. He has had hands-on experience in setting up sales channels and functional teams from scratch over a career spanning 2 decades.

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Vishal Subharwal heads the Strategy, Marketing, E-Commerce, Digital Business & Sustainability initiatives at HDFC Life. He is responsible for crafting and ensuring successful implementation of the overall organisation strategy.

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1. Tax benefits are subject to conditions under Sections 80C, 80D, Section 10(10D) and other provisions of the Income Tax Act, 1961.

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