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Government's pet

Low costs, flexibility on investments and asset allocation, and transparency make the NPS quite an attractive retirement choice

Government's pet

Designed to offer market-linked returns on retirement savings, the National Pension System was first launched as the default retirement-savings option for government employees and later opened up to the self-employed and private-sector employees as well. It is regulated by the Pension Fund Regulatory and Development Authority (PFRDA), which selects private pension managers to manage the pooled funds.

The scheme
Any Indian citizen between 18 and 60 years of age can open an NPS account by applying to the banks/intermediaries authorised by the PFRDA. On applying, you will first be required to open a Tier I account, to which you need to contribute a minimum of ₹6,000 in a financial year, with no maximum limits (a Tier II account is also available, but it doesn't provide any tax benefits and is more investment-oriented rather than retirement-oriented). You can invest in monthly instalments or lump-sum amounts. The scheme is ultra-low cost, with about ₹360 levied initially for account opening and 0.25 per cent collected upfront on every subsequent contribution.

Government's pet

Once you enrol, you need to make two key decisions on how your money will be managed. You need to choose a manager for your money from the seven pension fund managers (HDFC, ICICI, Kotak Mahindra, LIC, SBI, Reliance and UTI). You also need to choose your preferred asset-allocation pattern for your funds to be divided between equities (E), corporate bonds (C) and government securities (G). Equity exposure in the scheme is capped at 50 per cent.

All fund managers disclose their portfolios and returns on a monthly basis, which you can use to track your account's performance. You can also switch between managers or asset classes anytime in the year, if unhappy.

At the age of 60, you will be able to withdraw your contributions plus the market-linked returns accumulated. Forty per cent of this withdrawal amount has to be compulsorily used to buy an annuity (monthly pension) from an insurer and the remaining 60 per cent can be used for other retirement needs. You can shop around for better deals by postponing your lump-sum withdrawals anytime up to the age 70. You can also delay the purchase of an annuity plan for three years from your retirement date.

Until recently, if you withdrew your contributions before 60, you were forced to buy annuities with 80 per cent of that corpus; this condition practically locked in your money till 60. But recent relaxations in rules allow NPS subscribers to withdraw upto 25 per cent of their contributions in three instalments, if they have completed ten years. This is subject to end-use criteria (child's education, marriage, critical illness, purchase of home, etc).

Returns
Your returns from the NPS will depend on two factors: one, the market performance of your assets classes and your allocations to them; two, the competence of the fund managers you choose to manage your money.

As of March 25, 2016, the equity options had earned five-year returns of 8.4 to 8.9 per cent CAGR. With equity markets down in the last one year, NPS equity funds had lost 7.3 to 8.8 per cent in value in one year. Among the managers, ICICI Pru Pension Fund has the best five-year track record across all three asset classes, E, C and G.

Had you opted for a 50 per cent equity allocation, with 25 per cent each in G-secs and corporate bonds five years ago, your returns on the NPS would have been at healthy annualised 9.3 to 9.5 per cent. This is despite a muted performance from the equity portfolio.

Taxation
While the NPS scores high on returns, it suffers from a significant disadvantage on taxation when compared to the EPF and the PPF. The NPS is subject to the EET regime. The initial contribution is exempt from tax to the extent of ₹2 lakh a year (₹1.5 lakh under Section 80CCE and another ₹50,000 under Section 80CCD), and returns aren't taxed every year.

But as returns are accumulated and not paid out every year, they do get added to your final withdrawals when taxed. As there is no provision for indexation benefits or capital-gains taxation on the NPS, your withdrawals (which include returns) will get added to your total income at the time of retirement and be taxed at your income-tax slab rate.

What's changed
The above taxation structure would have effectively made your entire NPS corpus taxable. But changes in the 2016 budget have now made the tax rules more investor-friendly. Forty per cent of the final withdrawals from the NPS are now exempt from tax and the FM has clarified that this can come from the non-annuity portion. If out of the remaining 60 per cent, you choose to buy annuities, this investment will again escape tax. The income you receive every month from annuities will however get taxed at your slab rate.

Our take
Low costs, flexibility on investments and asset allocation, and transparency make the NPS quite an attractive retirement choice. Yes, the lack of EEE status is a disadvantage, but then there is no guarantee that the EPF or the PPF will retain this privilege forever.

Investors should consider two factors while investing in the NPS. One, while making your contributions, decide on your annual investment based on your targeted corpus for retirement. Do not plan your investments around the tax break. Given that the NPS is clubbed along with a host of other investment options in Section 80C, using the NPS merely as a balancing figure in your annual tax savings may leave your short of a retirement kitty.

Two, your asset-allocation choices should depend on whether the NPS is your only retirement vehicle. If you do not own any equity at all in the rest of your portfolio, then you should maximise your NPS equity allocation to 50 per cent. But if you do own equity mutual funds or have direct stock holdings, maximise your corporate bond (C) and G-sec (G) portions in the NPS and opt for a lower equity allocation.

NPS equity funds have tended to underperform comparable actively managed diversified funds over the last five years, while its corporate debt and G-sec portions have outperformed the respective mutual-fund categories. While the five-year returns on multi-cap equity funds stood at 11 per cent (on March 25, 2016) and three-year returns at 17.4 per cent, NPS equity plans managed 8-9 per cent for five years and 12-14 per cent for three years, respectively. This differential could probably be due to the NPS' preference for index stocks.

The NPS' corporate bond (C) and G-sec (G) funds have, however, comfortably beaten comparable mutual-fund categories. NPS funds' corporate-bond returns of 10.6 to 11.4 per cent for five years are clearly superior to those of income funds, which managed 7.7 per cent. The NPS' G-sec returns of 8.85 to 9.6 per cent are likewise superior to long-term gilt-fund returns of 7.8 per cent for five years. The NPS' ultra-low expense ratio and its buy-and-hold approach may have aided this outperformance.

The big disadvantage of the NPS is the requirement that you need to compulsorily deploy 40 per cent of your final kitty towards the purchase of an annuity plan. Immediate annuity plans from insurers typically offer very low returns (current post-tax yields are at 5 per cent or so) and if you're a savvy retiree, you may resent the need to buy annuities.

Neither the EPF nor the PPF comes with strings attached that specify where you should invest the final proceeds after withdrawal.

Here you can read about the other articles in this series
No longer reliable - EPF
The incomplete solution - PPF
Time to look beyond the trinity - Conclusion