The Misunderstood Pension Scheme
The National Pension System (NPS) is one of the most popular defined contribution plans for retirement in India. A defined contribution plan is one which allows an individual to put away a certain sum of money into an investment product every year throughout their careers and redeem a final lumpsum amount when they retire. Owing to a regulatory change in December 2018, the NPS now enjoys an Exempt, Exempt, Exempt (EEE) tax status. In other words, the amount invested in an NPS account, the interest earned thereon and the final corpus at maturity are all exempt from tax in the hands of investors. Also, NPS investments qualify for an additional deduction of Rs 50,000 per financial year under Section 80CCD of the Income Tax Act, 1961 over and above the limit of Rs 1,50,000 available under Section 80C. This naturally means that most individuals would be attracted towards opening and maintaining an NPS account. But, the NPS comes with its own set of shortcomings which mostly outweigh the benefits it offers. And we may sometimes invest in the NPS for all the wrong reasons. So it is important for us as investors to fully understand how the NPS works before deciding whether investing in the NPS would be an optimal fit for us. Therefore, in today’s post I will dissect and decode the NPS, giving an unbiased account of how the NPS works and thereby try to establish who among us should consider investing in the NPS and who should not.
First, we must understand how the NPS works when our invested corpus matures when we turn 60 years of age. At maturity, 60% of the corpus accumulated in our NPS account is paid out to us as a tax free lumpsum. The remaining 40% is locked into a pension annuity scheme offered by an insurance company, which would fetch us a fixed rate of interest every year.
This seems like a pretty good deal, but in many ways it is not. Firstly, the fact that we are required to lock 40% of our corpus in a pension annuity scheme means that we retain control full control over just 60% of our corpus. So a corpus of Rs 100 would actually allow us access to just Rs 60. And that makes a huge difference. Let us say I invest Rs 60 in a large cap index fund for the long term and the remaining Rs 40 in a pension annuity scheme that pays interest at 5%. Assuming long term returns of 10% from equity, my returns on this blend would be (60%*10%) + (40%*5%) = 8%. But, if not for the mandatory pension requirement, I could have simply invested the entire corpus in a large cap index fund and earned 10% (a full 2% extra) on a much larger investment. Also, the interest income from the pension scheme would be fully taxable in our hands at applicable slab rates. So in an indirect sense, there would still be a tax payment involved with a product that is advertised to be tax exempt. And finally, the interest rates offered by NPS pension schemes are no different than those offered by other insurance providers outside the NPS. Therefore, those simply looking for pension income post retirement are better off avoiding the NPS until and unless a special annuity pension scheme with a slightly higher rate of interest is offered at some point of time in the future.
A lot of us may invest in the NPS because it is offered by our employers as the default retirement contribution plan. But those of us who do this must be aware of the fact that the NPS is not widely offered by employers across the country. Therefore, in a situation where we may need to change our jobs for any reason whatsoever, there is a chance that our new employers may not offer us the NPS by default. Therefore, we may need to pause our NPS contributions post our job change. And resuming NPS contributions after having made zero contribution for a year or more would involve us having to pay the applicable penal charges before we can resume contributions. Also, redeeming from the NPS before the age of 60 would come with serious repercussions. If we were to redeem from our NPS account before the age of 60, 80% of the accumulated corpus would be locked in a pension annuity scheme and just 20% of the corpus would be paid out to us as a tax free lumpsum, among other conditions. Partial withdrawal before age 60 are allowed, but only in exceptional circumstances such as critical illness, children's education and so on. And even then we would be allowed to withdraw just 25% of our own contributions till date, among other conditions. For example, let us say I have contributed Rs 25 to my NPS till date, and this amount has now grown to Rs 100. But the maximum premature redemption I can make would be limited to Rs 25 * 25% = Rs 6.25.
And given that the normal retirement age, especially in the case of corporate employees is dropping from 60 to 55 or maybe even less, this feature of the NPS would prove to be quite unfavourable. This goes to show that those who wish to invest in the NPS through their employers, or retire before the age of 60 should think long and hard about these aspects before investing in the NPS.
The current version of the NPS allows us to invest in a variety of asset classes such as equity, government bonds, corporate bonds and other alternative assets. A list of recognised pension fund managers such as Birla, Reliance, UTI, SBI and so on manage these investments and the asset allocation as chosen by us on our behalf. Naturally, the majority of us would prefer to have equity exposure in our NPS account, sometimes going as high as the maximum limit of 75% equity that is allowed as per the rules governing the NPS. But as exciting as it may sound, the equity component offered by most fund managers have failed to beat the Nifty 50 index over 3 and 5 year periods. This is because equity exposure through the NPS would be locked in until the account matures. Hence periodic rebalancing of our equity portfolios would be become that much harder. Therefore, we must avoid equity exposure through NPS as far as possible. This is especially true for those investing in NPS solely tax benefits. A much better option would be to view the NPS as one component in our fixed income portfolios and hold government bonds and corporate bonds within the NPS. The same holds true for central government employees whose default asset allocation would be 85% debt and 15% equity, which is a fantastic strategy by itself that generates long term returns in the range of 8-10%.
The National Pension System has a clear set of benefits. But in many ways, its drawbacks significantly outweigh its benefits. Those of us who have not opened an NPS account so far, and/or are simply looking for a pension post retirement need not think about doing so. The same goes for most corporate employees and those who wish to retire before the age of 60. But even so, this does not make the NPS completely irrelevant. It is an excellent option for those who usually spend to much and save nothing, since the money in the NPS account would be locked in, thereby creating forced savings for such individuals. Those who have already invested in the NPS can continue to do so by matching their contributions to the exemption limit of Rs 50,000 under Section 80CCD. The amount can be parked in a mix of government and corporate debt with equity needs being met from elsewhere. Central government employees may also continue their contributions using the default asset allocation of 85% debt and 15% equity without changing it. All in all, it is vital for us to have the right understanding of how the NPS works, and invest in it for the right reasons. This would make our NPS investments relevant to our financial plans and ensure that they contribute towards the achievement of our financial goals.