Should you invest in National Pension scheme?
I have been asked this question repeatedly over the last couple of months. Hence, I decided to pen down the pros and cons that you need to consider while deciding if the product is meant for you. Before we get started on the same, let’s summarize all that is known about NPS. These are facts that are available aplenty all over the web but for ease of understanding have summarized below.
What is NPS?
National Pension System (NPS) is a scheme initiated by Government of India to provide old age security and pension for all citizens of India. It is regulated by the Pension Fund Regulatory and Development Authority (PFRDA).
Why was NPS introduced?
This scheme was introduced by the government to shift from defined benefit to defined contribution scheme. It was initially introduced to all government employees and was mandatory for all employees joining service after 1st Jan 2004, it was opened to all citizen in 2009.
Who can Invest in NPS?
Any Indian Citizen (both resident and non- resident) between the age of 18 and 60 on the date of submission of application can join NPS.
How to apply for an NPS Account?
You can procure your PRAN application form from any of the Point of Presence – Service Providers (POP-SP) you wish to register with. One can also apply online.
Who manages the money?
You get to choose from the seven provident fund managers mentioned below andyou can change the fund manager once a year without any exit load.
- HDFC Pension Management Company Limited
- ICICI Prudential Pension Funds Management Company Limited
- Kotak Mahindra Pension Fund Limited
- Reliance Capital Pension Fund Limited
- SBI Pension Funds Private Limited
- UTI Retirement Solutions Limited
- LIC Pension Fund Ltd.
How does this work?
The scheme is based on unique Permanent Retirement Account Number (PRAN) which is allotted to each Subscriber upon joining. Subscriber can contribute directly or through the Employer. With PRAN, the disadvantage of shifting the NPS account due to change of employment is done away with, since PRAN is portable across geography and employer. An investor can open only one account during his/her life span.
There are two schemes available for subscription
Tier I NPS account
This is known as retirement account, withdrawals from this account is restricted. Tax benefit under section 80CCD is available only for investment in tier I account. On retirement or closure of the account, part of the corpus accumulated has to be compulsorily assigned towards annuity. Currently 60% of the corpus can be withdrawn and the rest will be retained to provide annuity. Minimum annual contribution for this account is INR 6000, however minimum contribution while opening this account is INR 1000.
Tier II NPS account
This is an investment account, withdrawal from this account can be done at any time as per need. No tax benefits are available for this account. In order to open Tier II account one must compulsorily open a Tier I account. Minimum annual contributions for this account is RS 250 subject to year-end holding of a minimum of INR 2000, however minimum contribution while opening this account is INR 1000.
What are the different fund options?
NPS offers 3 fund options
- Equity – investments in equity funds capped at a maximum of 50%
- Corporate bonds (C) – no maximum cap, it can be upto 100%
- Government securities (G) – no maximum cap, can be upto 100%
You have two options for deciding the percentage allocation towards the 3 funds. Under Active choice you get to choose your own asset allocation subject to a maximum of 50% in equity. The allocation can be changed once every financial year.
Under Auto choice the allocation is done automatically as per your age. You can shift from Auto to Active once in a Financial Year.
What about maturity and premature withdrawal?
On exit at retirement age, 60% of accumulated corpus can be withdrawn as lumpsum, of which only 40% tax free and 20% taxable. The remaining corpus (40%) will be utilized to purchase an annuity to provide monthly pension. However, the subscriber can choose to not withdraw as lumpsum and utilize the entire corpus for purpose of annuity.
On exit from NPS before retirement age, which is possible after 10 years of starting the scheme, only 20% of the corpus can be withdrawn and the remaining 80% needs to be compulsorily used for purchase of annuity
On death, the entire corpus can be withdrawn as lumpsum by the nominee/legal heir.
What are the most compelling reasons in favour of NPS?
Tax concessions
For NPS, tax deduction for contribution can be done under three sections
Employee contribution
- Contribution upto Rs.1,50,000 under section 80CC (this includes mandatory deduction for NPS)
- Additional Deduction for voluntary contribution upto Rs. 50,000 under section 80CCD
Employer Contribution
- Upto 10% of basic salary put into the NPS by the employer on behalf of the employee is deductible without any limit.
Cost structure
The expense ratio is very low and ranges from 0.1% to 0.21% when compared to 2.00% and higher in equity Mutual funds and insurances. This can boost returns over the long term substantially
Liquidity
Unlike many other products this is truly a long-term product meant to secure your retirement. It can be an advantage given that it forces the subscriber to stay invested over long periods of time.
Ability to tweak Asset Allocation
Allocation to equity and debt can be changed once a year under active choice.
What could be the disadvantages of NPS?
Compulsory Annuity
NPS investments mature when the subscriber attains age 60. If the corpus is in excess of Rs 2,00,000 at maturity then 40% of accumulated corpus has to be compulsorily used to buy annuity. Simply put, in this case you would pay a lumpsum (minimum 40% of accumulated corpus) to receive a series of payments which could last for a specific period or your life time.
The returns on annuity in India has been extremely poor. Assuming you get great returns during your accumulation phase, the investment can still be undone with very poor returns during your annuity phase. Further pension received from annuity is taxable.
Taxation at maturity
NPS maturity proceeds are taxable, as mentioned earlier only 60% can be withdrawn at maturity out of which 40% is tax free whereas tax is payable on the remaining 20%. Further pension received from annuity is taxable.
Liquidity
While the lock in period is huge, this apparent lack of liquidity can work to the advantage of investors who discontinue investments started with a long term horizon at the smallest of pretexts and do not stick to their retirement plans. For disciplined investors who earmark funds for retirement and persist with the plan, this can be a huge drawback..
Tax deductions
I am assuming that the 80C limit is taken care of by EPF contributions which is the case with most salaried investors in the 30% tax slab. For others where investments need to be made to avail of 80C exemptions, ELSS is a better bet (more on that in my next article).
Contributions to NPS are exempt from tax under section 80CCD to the extent of INR 50000 per annum. For a person in the 30% tax bracket this could lead to tax savings of approx. INR 15000 per year but for those in lower tax brackets, this amount is reduced to INR 10000 and INR 5000 respectively and does not provide a compelling argument in favour of investing in NPS.
Cap on Equity Exposure
The expense ratio being low is a huge plus and a very compelling reason to invest, but one needs to bear in mind that maximum asset allocation to equity under active choice is pegged at 50%. Given the long-term nature of NPS, this maximum cap of 50% limits the upside which aggressive investors could get by increasing their allocation to equity.
Given the overall arguments, I will not be investing my money in NPS in its current avatar and would rely on my discipline and knowhow to build a sizeable corpus. As an investor, the knowhow part can be outsourced to your financial planner. If you plan to give this a miss do ensure that you have discipline to set aside finances for your retirement and have the will power not to dip into your nest egg till you retire. If this seems unlikely you should consider investing despite knowing the pitfalls!