What are Pension Funds in India: Meaning, Benefits and Working

source: cloudfront

After people retire from their daily office jobs, a new phase in their life opens. Some people pursue new hobbies and passions during this phase, while others go on trips worldwide. However, this lifestyle would be too expensive for anyone who has not saved enough.

This is where pension funds come into the picture. These funds help people pay for goods and services when they no longer have an active source of income.

A pension fund is a retirement scheme in which people invest to build a retirement corpus. These funds can be plans, schemes or other financial tools that let people accumulate wealth for retirement. Once an investor reaches retirement age, they start receiving fixed and regular income for the rest of their lives.

Individuals must invest a certain sum of money at least 10-20 years before retirement into pension funds. Nowadays, numerous schemes allow people to invest money systematically and regularly instead of saving a lump sum at a time.

Typically, there are two stages of a pension fund in India:

• Accumulation Stage: Individuals regularly invest a certain sum of money into the plan until retirement.
• Vesting Stage: After retirement, the individual will keep getting money from the fund every month.

The working of pension funds occurs in the following way:

• The investor pays an amount called a premium which they invest in the pension fund scheme. The insurer takes this premium towards a scheme that invests in different assets for a specific period (Vesting period).
• When this scheme reaches maturity, investors will start receiving money from that fund.
• During the vesting period, investors will receive two options. They can withdraw these proceeds and use them for post-retirement life. The second option is to purchase an annuity plan from the same company that provides regular income for the rest of their lives. This is how pension funds work.
• In India, most insurance companies operate pension funds. These companies mainly invest in debt assets to keep the risk levels low. However, ULIPs (Unit Linked Investment Plans are exceptional as they invest in equities and debts.
• Several government-sponsored funds exist, such as NPS (National Pension Scheme) and EPF (Employee Provident Fund).

Given below are certain benefits that individuals get from investing in pension funds:

• Variety of Investment Options: Investors who invest their money in pension funds will get an option to invest their money in different kinds of securities. They can choose to invest in government securities with lesser risks or in a mix of equities and debt securities. The investors will ultimately have the choice to gauge their risk appetite and choose a fund they wish to invest their money in.
• Choice of Payment: Every investor will have a different plan after retirement. As an investor, one can choose to invest a one-time amount or periodically make the investments via SIP. Furthermore, investors can choose whether to withdraw after maturity or opt for a deferred annuity plan where their corpus will keep on earning more interest payout.
• Long-term Savings: Investors looking for a long-term investment option often invest their savings in pension funds. Disciplined investment over a long period is an easy way to grow a considerable corpus. Pension funds allow people to invest a small or lump sum amount regularly.
• Does Not Get Affected by Inflation: Since pension funds are a long-term investment option, inflation does not affect the investors' returns. Pension plans pay the investor one-third of the collected wealth in a lump sum. Then, the fund uses the remaining two-thirds of the accumulated wealth to create a steady income for the investor.
• Life Insurance Cover: One of the most significant benefits of pension funds is that they offer life insurance coverage in many instances. Many pension fund plans in India offer investors a lump sum once they retire or, in unfortunate circumstances when the investor expires (whichever event occurs first).
• Access to a Lump sum in Case of Emergencies: Investors can choose to make specific changes in their pension policy and get a lump sum if they are going through a medical emergency and immediately need the funds for treatment.

Below are certain disadvantages of pension funds:

• Best for Early Investors: People who invest early will receive more returns than investors who start investing later. For example, Investor A began investing at the age of 30, whereas Investor B began investing at the age of 40. Investor A will get more returns during retirement compared to Investor B as they have been given more time to accumulate his/her wealth under the fund.
• Taxation on Annuity: In most cases, the annuity investors receive from pension funds is taxable. Annuities are considered to be salary income for taxation purposes and taxed accordingly.
• Limited Exemptions: Investors can apply for exemptions from paying taxes if they pay a portion of their income towards their premiums. However, the exemption amount is limited. The maximum exemption one can get up to ₹1.5 Lakh.
• Higher Risks Involved if Investors Want Higher Returns: Investors who want higher returns at maturity need to invest in securities with higher risks. Usually, it is seen through past performance of funds that carry higher risks tend to give higher returns.

In India, people usually use the employee pension scheme's formula to calculate the amount of pension they will be entitled to once they turn 60 or after retirement. The formula to calculate the pension amount is as follows:

Average Salary x Pensionable Service / 70

• The average salary of an individual will be their Basic Salary + Dearness Allowance in the last 12 months.
• Pensionable service is the number of years working in an organisation after 15th November 1995.

The following example will give a better understanding of how to calculate the pension amount:

A person has worked in a company for 14 years from 2003. During this period, his/her maximum average salary is ₹20,000 per month. The maximum pension they can earn monthly from a pension scheme is ₹4,000 (₹20,000 x 14 / 70).

Investing in pension funds is an effective way to safeguard your future. It will help you fulfil your dreams and passion after retirement. Furthermore, investing in such plans will enable you to be independent and live on your terms even after your income stops. The earlier you start investing in life, the more you will be able to accumulate wealth by the time you turn 60 years old.