What Is a Pension? How It Works, Taxation, and Types of Plans
As a salaried employee, you get income in the form of a salary. This continues till you retire. You will receive retirement benefits like the employee provident fund (EPF) and your gratuity upon retirement. These payouts are a one-time occurrence. You may also get a pension, depending on the nature of your employment. However, you may need more for your regular expenditure during your retirement years.
This is where pension plans come in handy. If you are still working and have yet to do retirement planning, you should know what is pension, what pension plans and types of pensions are, and how they can help you during your retirement years.
What is a Pension Plan?
A pension plan is a type of fund in which you or your employer pool a part of your income, which you can use during your retirement years.
A pension plan is where you will be depositing a part of your present income in a specific type of retirement plan; during your active life, ensure you have a regular source of guaranteed income when you retire. If you are in a job, then you would typically retire at a certain age, which is usually close to the age of 60 years, when your regular earnings in the form of a salary may cease. If you're self-employed or run a business in India, the decision of when to retire is up to you. Make sure to secure a suitable life insurance or pension plan.
How do Pension Plans work for an Individual?
When you forgo a part of your present income, you save in schemes that earn you interest. Your savings grow based on the interest you earn, and the power of compound interest, that is, interest on interest, makes your savings grow much more than just simple interest.
As a thumb rule, the longer you save, the more compound interest accumulates for you. Similarly, the more you save, the more money you will accumulate. Further, the smaller the interval used to apply compound interest, the more you accumulate.
To explain this concept, let us understand what it means to compare simple interest vs. compound interest.
For instance, if you save Rs 5,000 today at 6% yearly interest, then 35 years later, this amount would earn you Rs 10,500 as simple interest. However, when you apply compound interest at the one-year interval, the same amount would earn you Rs 33,433.43.
When you apply compound interest at a monthly interval, the same amount will earn you Rs. 35,617.76. As you can see, compound interest has immense power, which works for you when you save, especially for the long term.
Another Example: For instance, if you are 25 years old and have just started a job and you start saving Rs 5,000 every month, which earns you 6% interest, then when you reach 60 years of age, you will have saved 35 years or 420 months. You would have saved from your own earnings 5000x12x35 = Rs 21,00,000.
However, the Rs 21,00,000 you save over the 420 months earns you Rs 50,94,787.01 interest because of compound interest applied monthly. Thus, at the end of 35 years, you will have in hand Rs 71,99,787.01 instead of just 21,00,000.
That is the power of compounding. This applies to pension plans as well. Thus, it makes sense that before choosing a pension plan, you should calculate the interest you will earn using a retirement planning calculator.

Types of Pension Plans in India
There are several types of pension plans in India that suit the requirements of various people based on several different factors, which are important to each individual.
These plans are as follows:
Deferred Annuity
This is a plan where you can save a fixed amount periodically for a certain period, accumulate a large sum at the end, and use that sum to give you periodic future income.
Deferred Annuity plans can also offer you a single investment, which stays with the company for a certain period, after which you can use the maturity amount to earn a steady future income.
It allows you to use the power of compounding to earn you handsome returns, and you can enjoy the fruits of that with a steady income.
It is an optimal plan for you if you are in a steady job and can save regular amounts periodically or if you have received a lump sum in the form of an inheritance, bonus, incentive, gratuity, or any other means.
Immediate Annuity
This is a plan where you can invest one lump sum and receive an immediate annuity per the scheme's terms.
This plan is suitable if you have just retired and have a lump sum to invest and get regular income in the future. Even if you are young, you can use this plan if you have received a windfall and want to earn additional income.
Annuity Certain of Fixed Annuity
This plan allows you to enjoy the annuity for a certain fixed period you have decided to opt for. You can select the payment duration most suitable to your requirements and choose an amount based on your available funds.
The National Pension Scheme (NPS)
The National Pension Scheme (NPS) is a market-linked scheme which is available to everyone and is said to be more beneficial to people who are self-employed and businesspersons.
All available NPS plans come with various features and benefits that may include tax savings and nomination; therefore, you can choose the plan that suits you best.
Life Annuity
This plan offers a predetermined amount to the policyholder throughout his or her life after retirement. For this, the individual must pay premiums as the chosen policy requires.
Pension Plans With Life Insurance
Guaranteed Period Annuity
This plan offers the option of a guaranteed period for a life annuity or a joint-life annuity. Should the annuitant, or both annuitants, pass away during the chosen period after the income has commenced, a death benefit will be paid.
Defined Contribution
This plan applies to you if you are employed, and in this plan, you and the employer will contribute equally a percentage of the salary towards the pension. Statutory requirements typically govern this plan.
The employee can also invest an additional sum under the voluntary contribution. However, conditions and benefits vary per the rules prevailing at the time. For example, this plan has a limit on the investment amount. One main feature of this plan is that it does not specify the amount you can receive at the end of your employment or retirement.
Benefits of Pension Plans
The benefits of pension plans are several, and the main benefit is the promise of a retirement income to ensure you can live reasonably comfortably in your later years. The government regulates pension plans through bodies like PFRDA and IRDAI to ensure safe investment and guaranteed retirement benefits.
The benefits under the pension plans are listed under certain technical terms as follows:
Guaranteed Vesting Benefit
Pension plans have two phases - the accumulating and vesting phase. When the policy matures, it enters the vesting stage. During this phase of the pension plan, the funds you've invested are accounted for. This would mean that sum assured plus any guaranteed additional benefits you have opted for. Some plans also give vesting additions on completion of the term of the plan.
Certain pension plans also allow you to withdraw a portion of the sum assured and allow you to purchase annuity plans with the remaining portion of the money.
If you have opted specifically for certain benefits, such as your spouse receiving the annuity in the event of your demise, he/she will get that benefit.
Death Benefit
Pension plans are available now that combine insurance coverage with retirement income. This enables your nominee or children to avail of death benefits during your untimely demise.
Flexible Premium Payment Terms
You can opt for the most convenient premium-paying term depending on your ability to pay the required premiums. You have several options: shorter premium paying terms, longer premium terms, or even a single premium option.
Rider Benefits with Customised Plan
You can tailor your plan to suit your specific requirements. For instance, you can attach a critical illness rider or an accidental death rider to your plan by paying an additional premium to provide enhanced protection.
Risk-free plans
You can opt for a risk-free plan and choose the protection and retirement income you need. Your investment is invested in instruments under strict regulation from statutory authorities, which would not allow your investment to be invested in risky instruments.
Unit Linked Insurance Plans
If you are willing to opt for some risk to receive additional returns from your pension plan, then you can opt for unit-linked insurance plans (ULIP). These plans invest in instruments whose performance is tied to market dynamics. This has the potential to get better returns than traditional plans but carries the risk of performing badly if the market hits a downturn.
Tax Benefits:
Tax benefits are available under various sections of the Income Tax Act. Several sections, such as 80C, 80CCC, and 80CCD, offer specific benefits. However, these keep changing, and you must monitor the budget yearly to see how tax affects your investment.
For instance, the premiums paid for most insurance plans are tax deductible from your income subject to conditions of section 80C of the Income Tax Act, 1961. The proceeds you receive on maturity are also considered tax-exempt, subject to conditions mentioned under section 10 (10D) of the same act.
Peace of Mind and Independence
Perhaps one of the most satisfactory benefits of all is the peace of mind you get from investing in pension plans and guaranteeing a retirement income all of your own accord. Your act would not trouble your children, who can safely plan for retirement.
You could also be independent for the rest of your life without troubling your children and spend your money how you want. You could continue to help your children and family and be satisfied with that, too.
Features of Pension Plans
Pension plans offer features that may appeal to all types of people. You could be in a salaried job, you could be retired, you could be just starting out, you could be a professional, you could be in business, or you could have received an inheritance.
The many features of pension plans are as follows:
Steady Flow of Income
The concept of pension plans is to secure a steady income when you retire. This is one of the key aspects and a compelling one at that.
If you are starting your first job, then you can use the deferred annuity plan, which will allow you to save during your productive years and, using compound interest, accumulate a sum that can provide a steady flow of income when you retire.
If you have just retired and collected a lump sum in the form of PF accumulation or gratuity, you could use this amount to invest in an immediate annuity so that there is continuity in your steady flow of income.
Surrender Value
Typically, every plan has a time element and an amount element built into the plan. Thus, there are milestones reached which offer the most benefit. However, if you face an emergency and you need funds to tackle it, then you can withdraw funds at a surrender value that will be much lower than what it would have been otherwise.
It is always advisable to resort to surrender value only under dire circumstances, as otherwise, you would lose all the benefits you had built into your original plan.
Further, surrender value is declared only after a minimum investment period and is also typically offered for plans with an insurance component. Also, you must be aware that you may lose any tax benefit you may have received.
Accumulation Period
The accumulation period is the one that allows you to build the corpus that can give you guaranteed income after a certain period. The sooner you start accumulating, the better you can build a sizeable corpus to give you more return.
For instance, if you start at age 25 and continue until age 60, you would accumulate for 35 years. However, if you start at age 40 and continue until age 60, you would accumulate for 20 years.
The plan also offers an immediate annuity without any waiting period. This plan is ideal if you retire with a lump sum amount and wish to secure a regular income from it.
Multiple options from your insurance company are available for the accumulation period.
Typically, the accumulation period is also known as the premium paying term.
Payment Period
The payment period refers to the phase when you start receiving your pension after retirement. If you seek payment from age 60 to 80, you will get the same for 20 years. You could also ask for payment until death.
Your service provider will offer multiple options, allowing you to select the one that aligns best with your needs.
Vesting Age
The vesting age denotes the age at which your pension disbursements begin. Typically, it is 60 years of age but flexible enough to start as low as 40 years and even go up to 90 years in some cases.
Your service provider would give you various options that you can choose from.
Liquidity
Pension Plans generally have long lock-in periods and, as such, are not very liquid. The very concept of these plans is to let your money earn returns, and the longer you let the money work for you, the better returns it gives you.
However, you can opt for getting out of the plan if you need some emergency funds, but this would come at a cost and is so designed that people usually avoid taking recourse to such a drastic detrimental measure.
You could get some plans that may build a partial withdrawal facility, such as a money-back policy linked to your pension plan.
Tax Benefits
The tax benefits from pension plans are tangible but are subject to change in the future.
Sections such as 80C, 80CCC, and 80CCD are offered on specific investments, but these can change over time. Even section 10 (10D) of the Income Tax Act, 1961, can come in here, which exempts insurance plan proceeds subject to meeting the conditions laid in it.
However, checking the available tax benefits as and when you start making investments is worthwhile.
Buying Pension Plans
Buying pension plans should be a well-thought-out strategy to secure your life after retirement. You also need to assess your strengths vis-à-vis your earnings, assets, future growth, and the future standard of life you have planned for yourself. Of course, these should take into account the various milestones you need to achieve, be it raising a family, building a home, providing for your family, providing for the standard of living you have chosen, taking care of your and your family’s health needs, and other aspirations you may have.
All these must feature in any pension plan you set out to explore.
One rule of thumb you must remember is that it is never too late to plan your retirement; plans are available for people of all ages. However, the cardinal rule is to start early. The sooner you start, the better it is because you get compounding benefits if you stay invested longer.
You must realise that the money you save in the first month will have the highest value at retirement, with subsequent months following in decreasing order. The last month you save will have the lowest value. But at the same time, Rs 10,000 you saved in the first month and the Rs 10,000 you saved in the last month will have different weights in your income. This means that if your first salary is Rs 100,000 per month and you are saving Rs 10,000 for your retirement plan, the saving percentage is 10% in the first month.
If you estimate your salary to be, say Rs 10,00,000 at the time of the last instalment, then, too, you would be saving Rs 10,000 as the last instalment, but now this saving will be only 1% of your salary.
Consider the impact of time on the value of money when planning for your future.
Keep Your Budget in Mind
You can perhaps start by estimating your income when you retire. This would give you a benchmark to plan. You can then estimate what is required to reach that goal. It's essential to account for inflation when making your financial calculations for future planning.
You should consider all factors and decide how much you can save. For instance, if your employer gives you a good deal regarding provident funds, you could factor that in. Likewise, you can obtain a comprehensive health insurance plan through your employer in India.
You should also look at your current outflow, including normal household expenditures, such as rent, school fees, health insurance, income tax, transport, and other expenses. If you have EMI payments, you must consider these as well.
Considering all these factors, you will arrive at a figure you think you can save.
Consider Your Debts
If you have a loan or a debt, you will need to consider if this will be cleared by the time you retire or if you will be carrying it forward. If the latter is the case, you will have to understand the impact of this on your pension and what it will take away from your pension income.
Plan Ahead of Retirement
Starting early in your retirement planning harnesses the power of compound interest. Your investments multiply as the interest on your principal earns its own interest over time. Additionally, an early start provides a cushion against market downturns. You'll have ample time to ride out market volatilities and rebound from losses. This extended timeframe also offers a greater window to set and achieve your financial milestones, making early planning not just beneficial, but vital for a relaxed post-retirement life.
Assess Your Risk Tolerance
This is a very important factor to consider. If you have a high-risk tolerance, then your thinking will be different from the other extreme of low-risk tolerance. Therefore, you must decide what your risk profile is. Based on this, you can proceed further.
The risk-taking ability will help you assess unit-linked insurance plans because they don’t guarantee you returns but leave it to the market to decide the amount you may secure at the end of the plan.
Consider Income Sources
When planning your retirement, understanding and diversifying your potential sources of income is crucial:
- Annuities: Contracts with insurance companies providing periodic payments during retirement.
- Dividends from Investments: Passive income from stocks or mutual funds, subject to market conditions.
- Rental Income: Earnings from renting out property, though management is necessary.
- Pension Funds: Employer-provided funds that offer a steady income post-retirement.
- Government Benefits: Depending on your region, you might receive government-sponsored retirement benefits.
- Part-time Work or Consultancy: Reduced roles or advisory positions that provide both income and engagement.
- Savings and Fixed Deposits: Safe but typically lower returns compared to other investment avenues.
- Business Profits: If you own a business, its profits can support your retirement, but planning is essential.
FAQ
How Long Does It Take to Get Vested Under a Pension Plan?
The vesting age signifies the age from which you'll begin receiving your pension. Typically, it is 60 years but flexible enough to start as low as 40 and even go up to 90 years in some cases.
Vesting has two components to it, one about age and one about the amount of pension.
Generally, the longer you take to accumulate, the higher the amount of accumulation and, therefore, the more would be the monthly pension.
How Does a Pension Work?
Pension plans are structured in two parts: accumulation and distribution of funds. Accumulation consists of paying the premium towards a plan, which is invested for a certain amount of time. Upon maturity of the plan, the benefits are distributed to you. Here, you have two choices, either you withdraw the entire amount at one go or invest a portion of the proceeds in an immediate annuity plan.
Who Gets a Pension?
An individual who wishes to have a consistent source of income during their retirement years can invest in a pension fund to receive a pension.
Plagiarism reduced from 7% to 4%