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Can the NPS Rescue your Retirement?

Union Budget 2015 makes the National Pension System much more attractive. Here's everything about using it to boost your retirement savings

Thanks to the big tax breaks it netted in the Budget, the National Pension System (NPS) has been the trending topic. The NPS is quite a large suite of products which requires the investor to make the right choices to reap the most benefits. The choices that the NPS presents the investor with are many. It offers both a Tier I and a Tier II account.

So if you have already decided to invest in the NPS, how do you make all these choices? Here's how.

Tier I or Tier II?
If you run through the menu of NPS schemes from different managers, you'll find them disclosing NAVs for both a Tier I account and a Tier II account. What's the difference between the two?

Well, the Tier I account is the primary pension account that everyone is referring to when they talk of the NPS.

This is the long-term pension scheme that earns you tax breaks under Sections 80CCD and 80CCE of the Income Tax Act. You open this account through any of the designated agencies, contribute a minimum of ₹500 a month, choose between asset classes and managers, and then sit tight until you are 60, to withdraw your retirement kitty.

The Tier II account, though it is managed similarly to Tier I, is an add-on savings account available to NPS subscribers. Investments in it do not earn any tax breaks. You can open it only if you already have a Tier I account. Minimum contributions are ₹1,000 at the start, and yearly contributions are flexible, provided you maintain a minimum balance of ₹2,000. Unlike Tier I, which restricts withdrawal before 60 and requires you to buy annuities with a certain portion of the proceeds, Tier II allows you to withdraw your accumulated investment at any time.

So, the choice you have as an NPS subscriber is whether you would like to open a Tier II account after going in for a Tier I account. Our recommendation would be that you don't, for the time being. Attractive tax breaks are one of the primary considerations to invest in the NPS over, say, a mutual fund. As the Tier II account offers no tax benefits, in place of parking your surplus savings in it, you may as well invest in an open-ended balanced fund, which may fetch you a higher return with greater flexibility.

Active choice or Auto?
One big reason why anyone would consider the NPS is that it allows you - the investor - to decide where your money will be deployed. By allowing you to allocate savings between equities, bonds and g-secs every year, the NPS allows you to have a say in how your retirement kitty is managed. This has a direct bearing on the returns you earn.

The Active choice under the NPS requires you to specify how you want to split your money between equities, bonds and g-secs. The Auto choice is meant for investors who aren't equipped to decide on their own allocations and want to put this on autopilot.

The Auto choice starts with a 50:30:20 mix between equities, bond and g-secs. It retains this mix until you are 35. From the time you turn 36, equities are progressively reduced by 2 per cent every year, bonds by 1 per cent and the resulting savings are ploughed into g-secs. By the time you are 55, your account will thus feature a 10:10:80 mix between equities, bonds and g-secs.

So, should you go in for the Active choice or the Auto choice? In our view, even if you have a modicum of knowledge about investing, you should opt for the Active choice. The reasons for this are twofold. One, the Auto choice assumes that investors rely only on the NPS for their retirement savings. But in practice, most investors may use a combination of instruments to see them through retirement.

But more importantly by trimming down your equity exposures from a young age, the Auto choice forces you to take an ultra-conservative stance on your retirement kitty. This can significantly reduce your returns.

Allocations - E, C or G?
Assuming you go in for the Active choice, how should you then decide on your allocations between equities, bonds and g-secs? The risk that you should take on in your portfolio hinges not just on your age, but on many other factors such as accumulated wealth, earning capacity, number of dependents and mindset. While equities may be risky over a three- or five-year time frame, they aren't if held for ten years, 15 years or more. Over such long time frames, stocks seldom fail to beat all other asset classes on sheer return potential.

Therefore, we would recommend a simple approach to allocations. Given that the NPS is meant to be a minimum ten-year vehicle housing your retirement savings, we suggest you use its equity limit to the hilt, parking 50 per cent of your savings in the E portion for much of your working years. When you reach 55 years of age with just five years left to retirement, you can switch the accumulated sum under the E portion entirely to the C portion so that your principal is then protected.

The fixed income portion can be divided equally between credit risk-bearing liquid funds/bonds (C) and g-secs (G) at all times.

Which fund manager?
While the NPS itself shortlists the six pension fund managers (PFM) based on the fees they bid for managing your money, we suggest you make your decision based on the manager's past track record. It is best to go in for the manager who has done well across all three asset classes.

Thus, we took stock of return data on the different PFMs under the NPS compiled by Value Research over the last four years to arrive at the best managers for your Tier I account.

Equities (E): ICICI Prudential and SBI have the best track records in equities over the last four years, managing annualised returns of 15.53 and 15.12 per cent, respectively, in this period. Other fund managers were not too far behind, with UTI, Kotak and Reliance managing 14.2 to 14.5 per cent.

HDFC and LIC have been relatively new entrants to the business of pension management and therefore boast only of a one-year record. Of the two, HDFC has managed to remain ahead of the pack in equities, with a 42.6 per cent return in the last one year, which compares well with the top performer - ICICI Prudential (42.7 per cent). While other managers delivered 40.8 to 42.4 per cent, LIC lagged behind the rest of the pack with a 39.9 per cent return.

Government securities (G): In the Central and State government securities segment of the portfolio, again SBI and ICICI Prudential turned out to be the best performers with double-digit annualised returns of 10.58 and 10.56 per cent, respectively, over the last four years. Other managers delivered between 9.58 per cent (UTI) and 10.32 per cent (Reliance). Returns from the g-sec portion have been impressive in the last one year, with returns ranging from 21.5 per cent to 23.3 per cent.

Credit-risk bearing bonds (C): Over a four-year period, ICICI Pru and Kotak have proven to be the best managers of these bonds, with annual returns of 11.9 per cent and 11.79 per cent, respectively. Others are clustered between 11.19 per cent (Reliance) and 11.67 per cent (SBI). In the last one year, these bonds too have managed some gains from falling rates. One-year returns from the C portfolio have ranged between 16.24 per cent (UTI) and 16.99 per cent (SBI). The new managers HDFC and LIC have delivered 16.25 per cent and 16.49 per cent, respectively.

ICICI Pru Pension Scheme and SBI Pension Scheme have proved to be the best bets so far as managers of your pension money.