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The NPS Plays a Limited Role

NPS is not the number one investment one should make. For all taxpayers, the first Rs 1.5 lakh of tax-paying investments must go to ELSS funds

In the April 2015 issue of Mutual Fund Insight, we discussed the National Pension System (NPS). We detailed all the nuances of using the NPS for retirement savings and how the NPS offers a unique opportunity to savers. Even otherwise, during the two-three months since the Budget, we have carried extensive coverage of the NPS.

This has led to some of our readers asking where exactly we stand on substituting mutual funds with the NPS. To some of them, perhaps especially those who are professionally involved with mutual funds, it seems that Value Research is saying that savers should shift focus from funds to NPS.

In reality, nothing could be further from the truth. I would like to re-emphasise what I'd written in that issue. I had said: Technically, the National Pension System (NPS) is not a part of the subject area of this magazine because it is not a mutual fund. However, for something like a decade now, we have always covered the NPS intensively. We have always enthusiastically recommended it as one of the best possible options for retirement savings. In effect, the NPS is a special purpose system of mutual funds that are regulated differently from normal mutual funds because the legalities surrounding them are different. However, from the 'mutuality' of the investments to professional management, they fit every other definition of mutual funds.

The NPS is a good fit for some of the utility that savers derive from mutual funds. A major reason for this good fit is the new ₹50,000 per year tax break that the finance minister announced in the Budget this year. This is a tax break which is not available for any other type of investment. In this way, this tax break is very different from that under the Section 80C, which can be used for any one of a large variety of investments like the PPF, ELSS funds, bank fixed deposits and many others.

The NPS is certainly not number one in the sequence of investments one should make. For all taxpayers, the first ₹1.5 lakh of tax-paying investments must go to ELSS funds. ELSS funds offer the shortest lock-in (three years) and generally the highest returns of all 80C-eligible investments. Unlike the NPS, the investment and the returns are completely tax-free. It is practically self-evident that an ELSS is the best deal around for tax-saving investments. It's only if you have further investible funds to spare (and scope for tax saving) that the ₹50,000 NPS investment comes into picture.

In any case, there are many investing needs that have nothing to do with retirement-oriented savings. Whether it's liquid funds for short-term investments or the wide variety of hybrid funds that help you tune your risk-return profile or any number of actively-managed equity funds, the NPS is not a substitute for them.

In fact, the passively managed (index-following) nature of the NPS is a major negative point. Another issue is the taxability of part of the NPS proceeds when they are withdrawn at the time of retirement. Even though this may get resolved eventually, nothing comes close to the tax efficiency of equity funds. The fact that equity fund returns are tax-free post one year is absolutely unmatched by any other investment.

The NPS has a role in the savers' portfolio. It's a role in which it excels, but it's still a limited role.