As long as one is earning -whether salaried or self-employed - there is a regular income to fall back on. While life expectancy has risen, so has health and living costs. With inflation cutting into our income, the need for disposable cash and a regular income flow will continue to grow.

To maintain the current lifestyle post retirement with the added burden of increased health costs will require a steady income flow.

This is where pension can help. A pension is a fixed amount of money that a person receives periodically after retirement.

Insurance companies have several such pension plans. However, a workable pension needs to be built up when you are earning well. Hence, more than the annuity itself, it is important to set aside money for a pension plan and build a corpus large enough to give you a reasonable annuity.

It is never too late to begin savings under the national pension scheme and other annuity schemes popularly known as retirement/pension plans.

Understanding Pension Plans

Pension plans help customers accumulate a corpus over a period of time. At the time of retirement, the investor receives a maximum of a third of the corpus and the rest to buy an annuity on retirement.

An annuity provides an income to the person post retirement on a monthly/quarterly/ half yearly/annual basis for life. So, a pension policy works in two phases:

i) The accumulation phase through a pension policy

ii) Pension phase through annuities.

The accumulation phase is when you actually build up your corpus that will provide you the annuity. Here, you choose to invest money for a particular period of time. At the end of the tenure, the accumulated retirement corpus in your pension account will be available to you to invest in an annuity.

The accumulation phase is a crucial part of your pension plan as this is where you build your corpus. So you need to know how the underlying investments in funds are done by your insurer.

Choosing the right fund

If you consider pension plans from an insurer's perspective, it is like planning to pay you annuity after 20-30 years.

In order to plan for that, insurers have to take an interest risk of such a long duration when availability of instruments with high interest for long durations such as 30 years are limited.

This restricts returns and also the choices when it comes to investment.

Two broad types

Based on your risk appetite, you can choose from broadly two types of pension plans available: unit-linked pension plans (ULPP) and traditional plans.

Traditional policies invest in government's fixed income instruments (such as bonds and G-Secs). The resulting returns are low, typically in the range of 4-5 per cent per annum (after charges). On the other hand, unit-linked pension plans invest in a mix of debt and equity instruments. This provides you the equity exposure and helps you to gain higher returns from the equity market's long-term cycles, albeit with the associated market risks.

Most unit-linked pension plans also come with a capital protection assurance, which means that your capital is safe and the insurers will want to play safe and will not offer high equity exposure even in their equity-linked fund options.

Tax benefits

Apart from building up a corpus, there are also tax benefits to consider. Pension plans are eligible for a tax deduction under Section 80C of the income tax act. One-third of the accumulation can be withdrawn on maturity, which is tax-free.

Things to note

It is important to check about fund management charges, guaranteed addition charges, and any other administrative/policy handling/management charges before choosing a product.

In this case, the National Pension System (NPS) has the lowest deductible out of your premium as charges/fund management fee, and hence, should be one of your choices.

The minimum annual contribution for NPS is also lower. The pension plans also have a lock-in period of five years. If the plan is discontinued before five years, your value gets eroded on account of fixed charges and penalties.

You have a chance to revive the account not only during the five-year lock-in period but within two years of the date of discontinuance. These penalties are much lower in case of NPS at Rs 100.

While 60 seems far off and too long to lock up funds, it is a strategy that will pay in the end.

National Pension System, equity-linked savings scheme, gold bonds, public provident fund, employees provident fund and unit-linked pension plans with equity exposure will be a good choice for building a healthy retirement corpus.

If you are young, go ahead and choose a unit-linked pension plan and choose an equity fund to capitalise on the market movement.

Closer to retirement, switch from equity funds to debt funds to reduce the risk levels. A good retirement fund is a necessity. It is not something that can be left to chance. Plan well in advance to make the best of your retirement.

The writer is general counsel and head of compliance, BankBazaar.com