How Do Pension Plans Work in India?

With the ever-increasing expenses, inflation, elevated lifestyles and the growing inclination towards early retirement, pension planning has become more crucial than ever. It's a reliable means of securing financial stability during one's golden years.

Before aiming to build a secure future through these pension plans, it is highly imperative to understand how these plans function. Read on for details about pension plans and how they work to ensure a comfortable retirement.

A pension plan is a structured investment tool that enables individuals to save funds during their working years to secure income post-retirement. It serves as a financial safety net, ensuring a steady income stream during one's golden years.

The pension plans in India typically have two phases: 

1. Accumulation Phase

The accumulation phase is the growth phase. People contribute funds to their pension plan through regular deductions from their salary or voluntary contributions. These contributions are invested in various financial instruments with the aim of growing the pension fund over time. 

2. Vesting Phase

The vesting phase marks the transition from accumulating funds to accessing them on retirement. At this stage, people become entitled to receive payments from their pension plan. This phase ensures that people can enjoy the fruits of their employment labour and maintain financial stability during their retirement period. 

As discussed, pension plans have two phases: The Accumulation Phase and the Vesting Phase.

Here are the various steps involved in a pension plan: 

1. Enrolment in the Pension Plan

Investors enrol in a pension plan that aligns with their financial goals. It can be either an employer-offered plan or a plan of their choice. In the case of an employer-offered plan, enrolment typically occurs at the start of employment or during specified enrolment periods.

2. Contribution to the Pension

Investors can make regular contributions to their pension plan through payroll deductions in case of employer-offered plans or directly in case of plans outside employment. Employers also contribute to the plan on behalf of their employees, often matching a portion of the employee's contributions.

3. Accumulation of Pension Fund

The contributions to the pension plan are invested across various asset classes like stocks, bonds, mutual funds, equity funds, real estate, etc. The goal is to maximise returns and grow the value of the pension fund over time. Thus, contributions and investment returns accumulate within the pension fund during the accumulation phase, thus building a corpus for retirement. 

4. Vesting of Pension

After a certain age or period of employment, individuals become vested in their pension plan. This means they have ownership rights to the funds of their pension plan. In the case of pension plans, the vesting age is the retirement age when the individual starts receiving their pension. 

On vesting, you have two options: start receiving the pension or withdraw your maturity corpus and invest in an immediate annuity. 

5. Distribution of Pension Payments

Pension payments can be distributed in various forms, including lump-sum payments, annuities, or periodic withdrawals. The distribution method chosen depends on individual preferences and the pension plan features. For example, in the National Pension Scheme (NPS), you can withdraw up to 60% of the corpus on maturity, and the remaining 40% must be used to purchase an annuity. However, you can withdraw the entire amount if it is above 5 lakh. 

6. Tax-Deferred Growth

Annuity plans offer tax-deferred growth. Thus, the corpus grows tax-free until you start receiving the pension, which is taxable as per the income slab. 

7. Death Benefit in Pension Plans

Some insurance-based pension plans may offer death benefits. Thus, a death benefit is paid to the beneficiary in case of the policyholder's unfortunate demise.

This death benefit depends on the kind of pension plan. Some plans provide a certain percentage of premiums paid, while others offer pension continuity to the beneficiary in case of the demise of the pension holder. 

There are many types of investment plans that can be used to create a regular income source and thus, as pension plans. The most common ones are:  

1. National Pension Scheme (NPS)

National Pension Scheme (NPS) is a voluntary, long-term investment plan for retirement by the Indian government. The subscribers can make defined contributions, which are then invested in a mix of assets. At retirement, individuals can withdraw a portion of the corpus and use the remainder to purchase an annuity for regular income.

2. Employee Provident Fund (EPF)

Employee Provident Fund (EPF) is a popular retirement savings scheme for employees in India, where both the employee and employer contribute a fixed percentage of the salary. This fund primarily aims at promoting savings that can be used post-retirement. It earns tax free interest making it a lucrative option for long-term savings.

3. Annuity Plans

Annuity Plans are investment products or retirement plans that offer a means to generate steady income during retirement. By making a lump sum investment, the annuity plan provides regular payments for a specified term or for life, thus helping in managing living expenses post-retirement. These plans can be tailored with various options to suit different retirement needs and goals.

4. Atal Pension Yojna

Atal Pension Yojna (APY) is designed for the unorganized sector in India, offering them a chance to join the national pension system. This government-backed scheme encourages individuals to save for their retirement by promising a fixed pension of Rs. 1000 to Rs. 5000 per month, depending on their contribution, from the age of 60 years.

5. Whole Life ULIP Plans

Whole Life ULIP Plans are the insurance plans that offer both investment and insurance cover for the policyholder's entire life. These plans are flexible, allowing policyholders to switch between funds and adjust the premium amounts, making them suitable for long-term financial planning, including retirement.

Now that we have discussed how a pension plan works let's see the most important tips for buying a pension plan: 

1. Earlier the Better

As with all other investments, the power of compounding works best on long tenures since it gives the time to grow. Thus, retirement planning must begin as early as the day of your first salary. Set aside some of your earnings and utilise your employment tenure to save for your retirement. 

2. Vestige Age

Check the vestige age of the plan. Some plans offer a vesting age of 45 years, perfect for people planning for early retirement. Other plans offer a vesting age of 60, the average retirement age. Thus, select a plan with a vesting age aligned to your preferences. 

3. Annuity Option

Choose the annuity option that is most aligned with your needs. If you are nearing retirement, you can opt for an immediate annuity. However, you can choose a deferred annuity if there is still time for retirement. Other annuity options include fixed, variable, joint life, and last survivor annuity. Choose an option most suited to your needs.

Read More: Difference Between Immediate Annuity & Deferred Annuity

4. Death Benefit Payout

Check the death benefit your pension plan offering and its payout mode: lump sum, a percentage of premiums paid, or pension continuity. Depending on the terms and conditions of the pension plan, the accumulated corpus may be passed on to the beneficiary as a lump sum or through annuity payments. Choose a plan that is aligned with your requirements.  

The tax treatment varies depending on the type of pension plan and the manner of withdrawal (lump sum or annuity). It's essential to understand these nuances to plan for taxation efficiently.

Let's see how the different kinds of pension plans are taxed in India:

1. Commuted and Uncommuted Pension

In commuted pension, a portion of your accumulated pension fund is paid as a lumpsum on your retirement and the balance portion is paid as regular income. Here, the lumpsum payment is exempt from tax if you are a government employee and the regular income is taxed under the head ‘salaries.’

On the other hand, there is no lumpsum payment in uncommuted pension, and the complete corpus is paid as a regular income. These regular payouts are all taxable under the head ‘Income from Salaries.’

In the above case, if you are a non-government employee and are receiving gratuity along with pension, one third of the commuted pension will be tax free and the other two-third will be taxed as ‘salaries.’

However, if you are receiving only pension and no gratuity, half of your pension would be tax free and the other half will be taxable.  

2. Pension from Life Insurance Plans

Regular pension from annuity plans of life insurance companies is taxable under ‘income from other sources.’ The premiums paid towards pension/annuity plans are tax exempt upto  ₹1,50,000 under section 80CCC of income tax act. Pension paid as lumpsum on maturity is tax exempt under section 10(10A).  

3. Family Pension

Family pension is the regular pension paid to the beneficiary after the demise of the pension holder. It is taxable under ‘income from other sources’ after allowing a deduction of ₹1,50,000 or 1/3rd of the uncommuted pension received, whichever is less under section 57 (IIA) of income tax.  

4. TDS by Banks

Under section 194(P), banks deduct tax on senior citizens more than 75 years of age, who have only pension and interest income from the bank. They are also exempt from filing income tax returns.

We have discussed major heads of pension plans and how they are taxed. However, the taxation is as per the prevailing tax laws. These tax benefits are subject to change in tax laws. We therefore urge you to carefully analyse in consultation with your advisor the tax benefits/tax implications, if any that may arise on opting for this policy.

The pensioner utilises the pension funds as their regular source of income. However, on their death, the nominee can utilise the pension fund, which is paid as death benefit in the following ways:

1. Take the entire death benefit as lumpsum
2. Buy an immediate annuity plan with the death benefit payout
   
3. Withdraw the death benefit partially and use the remaining amount to buy an annuity plan.  

You can choose to surrender your pension plan anytime you wish to. However, in such cases, a discontinuation charge will be applied and deducted from your accumulated fund value.

The surrendered or discontinued fund will also earn an interest on 4% p.a. that you can withdraw after 5 years. If you surrender your pension fund within 5 years, the proceeds must be invested to buy an annuity plan.

Pension plans serve a crucial role for financial security in retirement, offering peace of mind through steady income streams. It is important to understand the types of pension plans and their features.

Hence, with timely investment in these plans, individuals can ensure a stable and comfortable retirement, safeguarding their future against economic uncertainties and enjoying their golden years worry free.