What Are Pension Plans And How They Work

What Is A Pension Plan?

The dictionary defines a pension as a fixed sum paid regularly to a person. A pension plan or pension scheme is an investment product that allows individuals to systematically save for their retirement while they are still working. Simply put, it is a scheme designed to help people build a retirement corpus, which is later used to provide regular payouts after they retire. In essence, it helps individuals remain financially independent even when their regular income stops.

How Do Pension Plans Work?

Pension plans usually follow a systematic process divided into three stages.

Stage 1: Accumulation Stage

Regular contributions are made by the employee, employer, or both, depending on the type of plan. The frequency and the amount of these contributions also vary across plans. The contributions are then invested in different asset classes such as equities, bonds, or government securities to generate growth. 

Stage 2: Growth Stage

During this stage, the invested money compounds and grows over time. Returns are earned not only on the principal investment but also on accumulated gains. The longer the tenure, the larger the potential retirement corpus.  

Stage 3: Payout Stage

Once you become eligible to receive a pension, which can be at retirement or on other specified trigger events, you start receiving payouts from your accumulated corpus. You may choose to withdraw a lump sum, opt for periodic payments, or a combination of both. 

Types Of Pension Plans

In India, there are different types of pension plans. Here are some of them: 

1. Defined Benefit Pension Plans: The pension amount is predetermined based on various factors such as the employee’s salary history or employment tenure. These plans are suitable for those who prefer a predictable income. 
2. Defined Contribution Pension Plans: Contributions to the fund are predetermined, either as a fixed percentage of salary (like the Employees’ Provident Fund (EPF)) or as chosen sums (like the National Pension System (NPS)). The pension payout, however, depends on the account balance. In some plans, such as NPS, returns are market-linked and vary with investment performance. In others, like EPF, returns are fixed at a government-declared rate. Thus, defined contribution pension plans involve varying levels of risk and potential returns.
3. Government Pension Funds: Offered by the government, these can be contributory or non-contributory. Examples include EPF, NPS, and Atal Pension Yojana. 
4. Annuity Insurance Plans: These guaranteed a fixed post-retirement income in exchange for a lump sum or periodic contributions before retirement. There are two types of annuities: immediate annuities, which start paying out immediately after purchase, and deferred annuities, which begin after a specified period, typically after retirement.
5. Insurance-Cum-Pension Plans: These combine pension benefits with life insurance, ensuring retirement income and financial security for dependents. 

Role Of Employers, Government, And Regulators

Many pension plans in India have been running successfully for years because multiple stakeholders play their part. 

1. Regulatory Bodies: Organisations such as the Pension Fund Regulatory and Development Authority (PFRDA) and the Employees’ Provident Fund Organisation (EPFO) oversee pension schemes in India. They ensure transparency and protect investors’ interests through fair policies. With these bodies in place, grievance redressal has also become streamlined and efficient. 
2. Government: Government-backed schemes not only offer safety but also extend tax benefits that further motivate people to invest in retirement schemes for their future. While some schemes enjoy the Exempt-Exempt-Exempt (EEE) status, others offer tax-deferred growth, where tax is levied only at the time of withdrawal. 
3. Employers: While the fund is built for the employee’s future, many employers also step in and contribute to it, accelerating its growth. Moreover, they manage the fund responsibly, reducing the employee’s burden. 

Pros and Cons Of Pension Plans

Pros

1. Retirement income: Pension plans are designed to provide a steady source of income when you are no longer employed or earning a regular salary. This helps you remain financially independent and maintain your lifestyle without major financial worries.
2. Predictable income: Defined benefit pension plans promise a fixed, predetermined payout. This predictability makes financial planning easier. 
3. Employer contributions: Many pension schemes involve contributions from employers. This further accelerates corpus creation. 
4. Tax benefits: Certain pension plans, such as PPF, fall under the EEE tax bracket, making your contributions, interest earned, and maturity proceeds all tax-free. 
5. Long-term financial discipline: Since pension plans require investing regularly, they help inculcate financial discipline over decades.   
6. Death benefit: Insurance-linked pension plans offer a death benefit. If the policyholder passes away during the policy term, the family receives financial support through payouts.  

Cons

1. Limited liquidity: Pension plans encourage long-term investing. Most plans allow partial premature withdrawal only under specific conditions.
2. Inflation risk: Pension plans with fixed, predetermined payouts may lose purchasing power in a highly inflationary environment.
3. Tax on annuity: Annuity payouts received are generally taxable. This may reduce the net post-retirement income. 

Choosing The Right Pension Plan

When choosing a pension plan to build a strong retirement corpus, consider the following factors:

1. Risk appetite: Your investments must be well aligned with your risk appetite. If you are a conservative investor, you can opt for pension plans that offer stable, predictable returns. On the other hand, if you don’t mind assuming high risks for high returns, you may opt for pension plans that invest in market-linked products.  
2. Investment horizon: Equities are better suited for long tenures as they take time to ride out market fluctuations and deliver growth. Hence, if you have a long investment horizon, you can consider plans that give equity exposure. 
3. Employment type: Some pension plans are exclusive to salaried individuals. If you are self-employed, you may need to explore private or government-backed schemes.
4. Tax benefits: If reducing your taxable income is a priority, opt for schemes with maximum tax benefits, such as the PPF.
5. Flexibility: Different plans have different terms. Review the conditions carefully, particularly those related to the choice of asset classes, contribution flexibility, withdrawal rules, and payout intervals.

Conclusion

Securing retirement is more than just enrolling in a pension plan. It is about making informed choices, selecting the right plan after careful evaluation, understanding how your money is allocated to earn returns, and even being aware of the vesting rules, as they ultimately affect the time when you start receiving the benefits. Portability is equally important because your pension benefits must be forwarded when you change jobs.  Moreover, regular reviews and timely adjustments are essential to ensure that your plan continues to align with your financial goals. 

Additional Read: 5 Investment Options in India for Retirement Planning