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Pension Funds In India – Overview

A pension plan is an investment cum insurance product where you invest a specific amount throughout your working life. Here are some things you should know about the working of pension plans.

  • 2,873 Views | Updated on: Jun 13, 2024

Updated on: 14th July, 2023

With features like life cover, investment, and steady returns, a pension plan could be an ideal choice for every individual concerned about retirement planning.

Rising life expectancy and inflation have made it necessary for every working professional to start planning their retirement as early as possible. A pension plan is a product exclusively created to provide a regular stream of income after retirement. 

Key takeaways

  • A pension plan is an investment cum insurance product where you invest a specific amount throughout your working life.
  • Pension plans are divided into two essential components: accumulation and distribution.
  • Upon the death of the pension holder, the nominee may be eligible to receive the entire accumulated pension amount as a lump sum payment.
  • Many pension plans have a vesting period, which is the duration an employee must work for the employer before becoming entitled to the employer’s contributions.

Pension funds are very crucial for a secure tomorrow; when life becomes uncertain, pension funds are what come to the rescue. So, without further ado, let us now understand the need to know about pension plans and pension funds in India.

What is a Pension Plan?

As the name suggests, a pension plan is an investment cum insurance product where you invest a specific amount throughout your working life. Once you retire, the insurer will then start providing regular payouts as per the terms and conditions of the plan. 

These plans generally come with guaranteed maturity and death benefits. Some of the insurers also offer add-ons or riders, such as accidental death and permanent disability benefit. 

How Do Pension Plans Work?

In India, pension plans are divided into two essential components: accumulation and distribution. A pension plan entails a premium systematically invested in a chosen fund or asset over a predefined duration.

Upon vesting, individuals are presented with a pivotal decision to make, with two distinct options before them. The first option entails commencing the receipt of pension benefits, providing a steady stream of financial support. Alternatively, one may opt to withdraw the accrued funds and utilize them to secure an immediate annuity plan from the very same esteemed company.

Embracing these strategic choices, individuals can prudently tailor their financial future, enjoying the fruits of their pension planning endeavors.

What are the Accumulation and Distribution Phases of a Pension Plan?

Every type of pension plan has two stages- accumulation and distribution. The period you pay premiums to the insurer for the selected term is known as the accumulation phase. These funds are invested in the assets you choose.  

Once you retire, you have the option to ask the insurer to start paying you a regular pension or annuity. You can also withdraw 1/3rd of the accumulated amount on retirement and use the rest for purchasing an annuity from the same insurer. This phase is known as the distribution phase. 

A Nominee Can Utilize Pension Funds in Three Ways

What happens to your pension funds if you pass away before utilizing them fully? This is where the concept of a nominee comes into play. A nominee is a person designated to receive pension benefits in the event of the pension holder’s demise.

Lump Sum Payment

Upon the death of the pension holder, the nominee may be eligible to receive the entire accumulated pension amount as a lump sum payment. This option provides immediate access to the funds, allowing the nominee to utilize them for various financial needs. Whether it’s settling outstanding debts, investing in a business venture, or fulfilling personal aspirations, the lump sum payment provides significant flexibility and freedom to the nominee.

However, while this option may seem appealing due to its immediate availability, it requires careful financial planning. The nominee must consider factors such as tax implications, potential inflation, and long-term financial security. Furthermore, the temptation to spend the entire sum all at once can be detrimental to the nominee’s financial future, and thus, seeking professional advice is crucial.

Annuity Option

Another way a nominee can utilize pension funds is through the annuity option. An annuity is a financial product that provides a regular stream of income over a specified period or for the lifetime of the nominee. By selecting the annuity option, the nominee can ensure a steady and predictable income flow, replicating the security provided by the pension holder’s original pension plan.

The annuity option offers several advantages, including protection against market fluctuations, longevity risk, and the assurance of financial stability during the nominee’s retirement years. Furthermore, certain annuity plans may include provisions to ensure the remaining funds are passed on to the nominee’s beneficiaries after their demise, continuing the legacy of the pension funds for future generations.

Continuation of Pension Plan

In some pension schemes, the nominee may have the option to continue the original pension plan of the deceased. This continuation is especially common in government or employer-sponsored pension schemes. By choosing this option, the nominee can enjoy the same benefits and terms as the pension holder during their retirement.

Continuing the pension plan offers stability and familiarity, but the nominee must be well-informed about the plan’s rules, contribution requirements, and payout terms. It is essential to understand the implications of such a decision to ensure that the nominee can comfortably maintain the contributions and fulfill any obligations associated with the plan.

What is the Vesting Age in Pension Plans?

The vesting age is the age after which you’d like to start receiving an annuity. You can choose from monthly, quarterly, half-yearly, and yearly pension payouts. 

With most insurers, the vesting age is generally 45-50 years. But you do get the option to choose a vesting period of up to 70 years in most cases. It can be higher than 70 years with some insurers. 

How are Pension Plans Taxed in India?

With pension plans, you can choose between an immediate annuity and a deferred annuity. For instance, if you are already close to your retirement age, you can select an immediate annuity. In these plans, you invest a lump sum amount and start receiving a pension immediately after investing. Here the principal amount is tax-exempt, and the interest is taxed like any ordinary income. 

With a deferred annuity plan, you start making small contributions towards the plan through premium payments (accumulation phase). During this period, the investment grows without any tax deductions. 

Features of Pension Plans

We will delve into the essential features of pension plans and explore why they are a vital component of a well-rounded retirement strategy.

Tax Advantages

Pension plans offer significant tax benefits to encourage retirement savings. In many countries, contributions to pension plans are tax-deferred, meaning that individuals can deduct their pension contributions from their taxable income in the year they make them, potentially reducing their overall tax liability. Additionally, investment gains within the pension plan are usually tax-free until retirement, further enhancing the plan’s growth potential.

Lifetime Income

One of the most crucial features of pension plans is their ability to provide a lifetime income stream for retirees. With increased life expectancies and uncertainties in financial markets, retirees often worry about outliving their savings. Pension plans with defined benefit options offer a guaranteed income stream for life, relieving retirees of the stress of market fluctuations and ensuring they can maintain their standard of living throughout retirement.

Can You Surrender or Discontinue a Pension Plan?

Yes, you do have the option to surrender or discontinue a pension plan whenever you like. In the past, people were only allowed to terminate a pension plan after five years from the date of purchase. But this restriction has now been removed. 

Surrender Within Five Years

If you surrender a pension plan within five years, the fund’s value on the surrender date will be moved to a discontinuation plan after the deduction of some charges. 

Even this discontinued plan will earn interest at 4% p.a. You can withdraw the funds after five years. However, the proceeds from policy surrender can only be used for purchasing an immediate or deferred annuity plan.  

Surrender After Five Years

If you want to surrender the plan after five years, there will be no discontinuation charges, but the proceeds can only be used for purchasing an immediate or deferred annuity. 

Building a Stable Retirement Income with a Pension Plan

While your monthly salary will stop after retirement, expenses will continue to exist. Therefore, a pension plan is an excellent way to receive regular income and be financially independent even after retirement. In this policy, the investment risk in the investment portfolio is borne by the policyholder.

- A Consumer Education Initiative series by Kotak Life

Amit Raje
Written By :
Amit Raje

Amit Raje is an experienced marketer who has worked in various Fintechs and leading Financial companies in India. With focused experience in Digital, Amit has pioneered multiple digital commerce in India. Now, close to two decades later, he is the vice president and head of the D2C business department. He masters the skill of strategic management, also being certified in it from IIMA. He has challenged his challenges and contributed his efforts in this journey of digital transformation.

Amit Raje
Reviewed By :
Prasad Pimple

Prasad Pimple has a decade-long experience in the Life insurance sector and as EVP, Kotak Life heads Digital Business. He is responsible for developing user friendly product journeys, creating consumer awareness and helping consumers in identifying need for life insurance solutions. He has 20+ years of experience in creating and building business verticals across Insurance, Telecom and Banking sectors