How Pension Plans Work in India?

What is a Pension Plan?

A pension plan is a savings-oriented plan designed to create a retirement corpus and can also secure annuity income, depending on the plan selected. The structure of pension plans can be divided into two phases:

• Accumulation phase – This is the phase when you contribute towards the pension plan. These contributions grow over time to create a retirement fund.
• Distribution phase – In this phase, the accumulated corpus is used to provide annuity payouts, ensuring consistent income.

Pension plans help individuals to cover essential expenses, fulfil lifestyle needs and meet the rising healthcare costs, without depending on others.

 

How Does a Pension Plan Work?

A pension plan is a long-term financial planning tool designed to ensure a steady income after retirement. There are different types of plans, and their working depends on the type selected.

In most pension plans, the main aim is to create a retirement corpus. You buy the pension plan, choose the tenure (if applicable) and start contributing to it. Over time, this contribution grows with the added returns that pension plans provide.

Once the retirement corpus is created, depending on the type of pension plan selected, you can start receiving regular, lifelong annuity payments. For instance, if you buy an immediate annuity plan, you can pay a single premium and start receiving regular pension payments lifelong. These payments help in creating a source of income in your golden years so that you can meet your financial needs.

 

Types of Pension Plans in India

There are several types of pension plans in India designed to cater to diverse retirement needs based on individual risk-taking capacity, financial goals and budget. Popular pension schemes in India include the following:

 

1. National Pension System (NPS)

The NPS is a government-backed, market-linked retirement scheme offering equity, debt, and other asset classes. Pension Regulatory and Development Authority of India (PFRDA) is the regulatory authority of NPS in India. It provides flexibility to choose fund allocation, portability across jobs, and attractive tax benefits. Upon retirement, a part of the corpus can be withdrawn, while the remaining funds are invested in an annuity.

 

2. Employees’ Provident Fund (EPF)

The EPF is a compulsory retirement savings scheme offered by the Employees Provident Fund Organisation (EPFO) for salaried corporate employees, where both the employers and the employees need to contribute a fixed percentage of the employee’s salary to the fund. The accumulated corpus earns annual guaranteed interest. Upon retirement, employees receive lump-sum benefits along with tax exemptions.

 

3. Atal Pension Yojana (APY)

APY is a social security scheme for all the citizens of India between 18 years and 40 years, backed by the government of India. Subscribers to APJ can get fixed pensions (₹1,000–₹5,000)¹ after retirement, depending on entry age and contribution made. It also provides death benefits to nominees, making it an affordable and secure pension option.

 

4. Public Provident Fund (PPF)

The PPF is a long-term savings scheme suitable for individuals with a low-risk appetite. PPF offers fixed and stable returns, tax exemptions under Section 80C, and tax-free maturity proceeds. It provides guaranteed returns as it is backed by the government of India. PPF encourages disciplined savings while ensuring a secure retirement corpus.

 

How Do Pension Funds Work?

Understanding how do pension funds work is essential for informed decision-making and retirement planning. Pension funds pool contributions from investors and invest them to generate long-term returns. In a pension fund investment in India, the process consists of three key aspects: asset allocation, fund management, and performance monitoring.

 

1. Asset Allocation

Given the inflation rate and market volatility, proper asset allocation is crucial for good returns and wealth creation. Pension funds distribute funds across different types of assets depending on the type of plans you have selected.

 

2. Fund management

In market-linked pension plans, there are fund managers who are professionals with expertise and insights into fund diversification and risk management. Fund managers play an important role in optimising returns on investments by actively monitoring investments, rebalancing the investment portfolios, and ensuring compliance with regulatory guidelines.

 

3. Performance & Risk Handling

Performance metrics enable you to understand how the selected market-linked pension funds are performing. The fund performance is reviewed periodically against benchmarks. It provides a vivid picture of the risk involved and potential returns on investment. However, past performance does not depict how the fund would perform in the future.

 

Benefits and Limitations of Pension Plans

Pension plans offer several benefits, but also possess certain basic limitations. Hence, to make a well-informed retirement decision, it is necessary to not only understand how pension plans work but also be aware of their benefits and limitations. Here we take a look at some of the benefits and limitations of Pension Funds:

Benefits of Pension Plans

 

1. Regular Post-Retirement Income

The primary aim and benefit of a pension plan is to provide a regular income in your post-retirement years for meeting your day-to-day expenses. It ensures that you don’t have to depend on your family support or drain your savings.

 

2. Flexibility

Pension plans allow you to choose your portfolio (equity, debt or government securities) and payout options as per your requirements. 

 

3. Tax Savings

Pension plans can allow tax benefits on the contributions made and the returns earned depending on the type of pension plan you choose. 

4. Financial Security for Family

If you choose deferred life insurance annuity plans, you can enjoy life insurance cover, which provides financial security to the family in case of the untimely demise of the life assured. It pays a death benefit to the nominee as financial support.

 

Limitations of Pension Plans

 

1. Withdrawal restrictions

Pension funds usually have restrictions on how and when the funds can be withdrawn, which may not be suitable for individuals who want easy access to their funds.

 

2. Moderate returns

Pension plans offer moderate growth in comparison to pure equity investments or market-linked products. Pension funds are designed for stability rather than high returns.

 

3. Taxability

Though the premiums for the pension plans are exempt from tax, the annuity received is taxable in the hands of the policyholder

 

How is Pension Income Taxed in India?

The taxation of pension income in India depends on how the payout of the pension plan is received- as a lump sum or as a regular annuity. Both residents and NRIs are eligible for tax deductions for the pension plans². However, HUF cannot claim deductions under Section 80CCC². Let us understand the tax benefits of pension plans in India during the investment phase, as well as the tax treatment at withdrawal.

 

During the Investment Phase:

Your premiums or contributions payments for the pension plans can enjoy deductions up to Rs. 1.5 lakhs per annum under Section 80C, 80CCD, 80CCC². The tax benefit depends on the type of pension plan selected.

 

At Withdrawal Stage:

You can commute a part of the corpus, and the commuted corpus would be allowed as a tax-free income

The entire annuity is taxable in the year of receipt as salary income in the hands of the policyholder.

 

How to Choose the Right Pension Plan?

When selecting pension plan in India, the choice depends on your risk appetite, financial goals, and retirement lifestyle. The right pension plan balances return, security, and flexibility, while aligning with tax benefits. A pension calculator can help you estimate how much you should invest today to accumulate a desired post-retirement income. Here are some key pointers you can consider while choosing the right pension plan:

Assess your financial goal and determine the funds you would need post-retirement based on your healthcare needs, inflation and lifestyle habits.

• Ensure to start early, as it benefits from compounding returns and helps you to create a large corpus.
• Compare different plans available and check their features, benefits and limitations.
• Consider your risk profile, check tax benefits and liquidity options enabling partial withdrawals when in need of funds.
• Ensure the pension plan provides income and is aligned with your post-retirement financial needs.

 

Key Takeaway

• Pension plans ensure financial stability and a regular income post-retirement.
• Contributions to pension plans qualify for tax exemptions depending on the type of plan chosen. However, annuity income is taxable in the hands of the policyholder.
• Choosing the right pension plan requires evaluating retirement goals, flexibility offered and risk profile.
• Starting early maximises the corpus growth through the power of compounding.

 

Conclusion

Pension plans are a reliable way to secure financial independence post-retirement. For informed decision making, it is necessary to understand how pension plans work, the types of pension plans in India, their benefits and limitations, and how it is taxed. Investing in a pension plan early can be beneficial than starting late. Invest in a pension plan in India today if you have not invested in one, and secure your life after retirement. Using a pension calculator can help you to estimate your future income, making the right pension plan choice easier and more effective.

 

Frequently Asked Questions (FAQs)

 

1. Can NRIs invest in Indian pension plans?

Yes, NRIs can invest in Indian pension plans, primarily in the National Pension System (NPS), subject to FEMA/RBI rules. a.

 

2. What happens to pension funds if the policyholder dies before retirement?

The death benefit depends on the type of pension plan selected. In the case of deferred annuity plans, if the life insured dies during the policy term, the death benefit is paid. However, under other types pension plans, the death benefit would depend on the type of pension plan you had selected.

 

3. Can I switch between pension funds during the accumulation phase?

Yes, market-linked pension plans,like ULIPs and NPS, allow you to switch between pension funds during the accumulation phase, allowing you to rebalance your portfolio, manage risk and optimise returns based on personal risk tolerance and market conditions.

 

4. What is the difference between pension plans and annuity plans?

Pension plans is a broad concept and annuity plans are a part of pension plans. While the former includes different types of plans, annuity plans are those that are offered by life insurance companies.

 

5. How early should I start investing in a pension plan?

The earlier you start, the greater will be the benefits of compounding, enabling you to generate a larger retirement corpus.

 

6. Are pension plan payouts fixed, or do they vary with market performance?

Pension plan payouts can be either fixed, ensuring guaranteed income, or market-linked, where returns fluctuate with the performance of the fund, depending on the plan type.

Source –

1. https://www.npscra.proteantech.in/nsdl/faq/Final_APY_FAQs_English_18.10.2023.pdf
2. https://cleartax.in/s/section-80ccc