All you wanted to know about NPS (National Pension System)


Most likely you have heard about NPS either through your employer who has started providing this as part of your compensation or when you were exploring different options to save taxes.

An employee’s contribution in NPS or any independent investment by an individual on his own in NPS is eligible for deduction in taxable income upto the limit of Rs. 1.5 lakhs under section 80C of IT Act. An additional deduction is also available upto Rs. 50,000 beyond Rs. 1.5 lakhs limit in a financial year under sec 80CCD.

When it comes to paying taxes, everyone wants to minimize it by all means! :)

But should you invest your hard earned money just to save taxes without actually understanding what are you investing in?

There are no free lunches and every benefit comes with its own set of drawbacks - either in terms of higher risk or lower returns or lower liquidity (lock-in, restrictions etc).

To make an informed decision regarding NPS, you need to know the pros and cons of NPS.

In this post we will explore and answer the following questions regarding NPS:

  • Is NPS a good tax saving investment under section 80C for the first 1.5 lakhs?
  • Is NPS a good tax saving investment under section 80CCD for the additional 50,000?
  • Finally, is NPS a good retirement solution?

What is NPS?

NPS stands for National Pension System, which is regulated by PFRDA (Pension Fund Regulatory and Development Authority). It is primarily a “retirement solution” made available by the Indian government to all the citizens of India. The money invested in NPS is managed by Pension Fund Managers (PFMs) like SBI, Kotak, HDFC.

NPS is a retirement solution

NPS is not a tax-saving solution with retirement benefits.
NPS is a retirement solution with tax-saving benefits.

Hence it has its own (not very flexible) rules about how you can use the money you put in it.

NPS is aimed at creating a source of retirement income when we stop earning. Read it again slowly - when we stop earning!

Any retirement solution has 2 phases - Accumulation (pre-retirement) and Distribution (post-retirement).

In the accumulation phase, an investor accumulates money by putting away a part of her savings every month to build a retirement corpus. In the distribution phase, living expenses (aka ‘pension’) are withdrawn from the retirement corpus to sustain our living after retirement.

From an investment perspective, both the phases are really important. We need to maximise the returns in the accumulation phase to reach the retirement corpus target well within time and thereafter manage it to (at least) beat inflation and without running out of money during our lifetime. In both the phases we need to stay within our risk profile and not take too much risk (after all, our life post retirement is dependent on this money!).

Mutual Funds are also used as a retirement solution as one can do a SIP (Systematic Investment Plan) for investing every month during the accumulation phase and SWP (Systematic Withdrawal Plan) for withdrawing a fixed sum of money every month during the distribution phase.

Liquidity

One of the most important criteria to evaluate any investment decision is liquidity.

Liquidity means how easily one can liquidate one’s investments and get the money. Since nobody can predict how the future is going to unfold, it is important to have minimum restrictions in accessing our investments at any point of time. Any kind of lock-in or withdrawal limit decreases liquidity. NPS scores very low in this aspect.

In a typical NPS lifecycle, you would start contributing when you start earning (minimum age for eligibility for NPS is 18 years though) and keep contributing till you are 60 (the default ‘retirement’ age for NPS, although you can extend it to 70). At 60, you would be eligible to withdraw 60% of your retirement corpus as a lumpsum (not all!) and the rest 40% has compulsorily to be used to buy an annuity from an insurance company where you would get a fixed sum (not inflation adjusted) every month till you are alive.

So right off the bat, you will never have access to all your money in NPS.
NPS also allows partial withdrawals totalling up to 25% of the invested amount (own contribution) before the age of 60 years for some specific purposes like your children’s higher education or their marriage, house construction, treatment of some specified diseases etc. Also note that you can withdraw only 3 times in the full tenure of NPS (including the lumpsum withdrawal at 60).

Furthermore, when 40% of your hard-earned retirement corpus has been spent in buying the annuity, it is gone to the insurance company forever! Once you (and your spouse) are dead, however soon after the annuity starts, the insurance company will not pay the balance amount back to your nominee or legal heir.

In comparison, Mutual Funds are much more liquid and don’t have such restrictions.

For the 1.5 lakh amount under 80C you can choose Tax Saver Mutual Funds (ELSS) which will give you the same tax benefits and have just a 3-year lock-in and for the extra 50,000 you can choose normal Mutual Funds which don’t have any lock-in (and no tax benefits).

Beyond the short period of lock-in for Tax Saver Mutual Funds, there are no restrictions on withdrawal of your hard earned money whatsoever. You can withdraw 10%, 50% or 100% whenever you want (after the 3-year lock-in). There is no mandatory annuity conversions or any such thing with Mutual Funds. Your money is yours and you get to do whatever you want to do with it.

Also, Mutual Fund investments are capital assets and will be passed on in full to your legal heirs in case of your death. Again, a major advantage over the annuity part of NPS.

Tax Saving

As mentioned earlier, any investment by an individual or own contribution by an employee in NPS is eligible for deduction in taxable income upto the limit of Rs. 1.5 lakhs under section 80C of IT Act. An additional deduction is also available if invested upto Rs. 50,000 beyond Rs. 1.5 lakhs limit in a financial year under sec 80CCD.

However, most of this tax saving is just an illusion. Let me explain.

Firstly, when you withdraw the 60% lumpsum at retirement age, only 40% is tax-free and the rest 20% is taxable.

Secondly, 40% gets converted into annuity and the monthly payout from the annuity is fully taxable as regular income.

So most of your taxes are only getting deferred (to a lower tax bracket probably in your retirement) and not actually saved.

In comparison, the 1.5 lakhs invested in Tax Saver Mutual Funds is more tax free since the entire principal is tax-free on withdrawal and there is only a 10% LTCG tax on the gains.

Normal Mutual Funds don’t provide any tax benefit on the principal but are very tax-efficient with respect to the gains. They have low long term capital gains tax applicable. You can read more about the taxation of Mutual Funds here.

Choice of Fund Managers and schemes

NPS currently offers 11 pension fund managers (PFMs) with mainly two asset classes - Equity and Debt. In comparison, there are 45 Mutual Fund companies giving 1000’s of schemes across multiple asset classes like Equity, Debt, Gold.

Flexibility of asset allocation in NPS is also low. You could either run it in an Do-It-Yourself mode where the maximum equity component can be only 50% or you could opt for an age-based asset allocation (called auto-cycle) in which it can go upto 75% for a young investor (less than 35 years old) with a high risk profile.

By using normal Mutual Funds you can construct your asset allocation as you please with a mix of the best Equity and Debt Mutual Funds. However, Tax Saver Mutual Funds are pure equity funds i.e. they invest 100% in equity.

Cost

NPS claims to have the lowest fund management cost in the world - about 0.01%!

But there is more to it than meets the eye. In addition to this charge, it also levies other types of charges like contribution processing charge (0.25% of amount), annual maintenance charge, custodian charge and tax, transaction processing charge, security deposit charge. So, the overall cost comes around 0.5% per year. And this is exclusive of the fees of any Mutual Funds or ETFs the NPS may be investing the money in. So for e.g. if the money gets invested in an ETF with a 0.5% management fees of its own, then the all-in costs of NPS becomes ~ 1%.

In comparison, Mutual Funds have a simple to understand cost structure with an all inclusive fund management charge known as expense ratio which varies between 0.5-2.5% per year depending on the type of fund viz Equity, Debt or Gold.

It is definitely higher than that of NPS funds but we must remember that what matters is not fees per se but the net returns after fees. For eg would you prefer earning 9% without fees or 12% after 1% fees? As long as the net returns are higher (for the same risk profile/asset allocation), higher fees should not be of much concern.

Investment Strategy

Given the low cost of NPS, the pension fund managers perhaps do not have much of an incentive to outperform the benchmark indices like Sensex and thus follow a passive investment strategy (e.g. investing in index funds tracking returns of indices like Sensex or Nifty). This is unlike the active management by the mutual funds where stock picking is actively done by professional fund managers to generate higher returns than the benchmark indices.

Further, PFMs are allowed to invest 100% of their NPS assets into Mutual Funds. For e.g. Kotak Mahindra Pension Fund invests 100% of its assets into multiple Mutual Funds [1].

It is quite surprising that if NPS pension fund managers ultimately invest into Mutual Funds then why one should not invest into Mutual Funds directly without creating an unnecessary layer of cost and complexity over it. Does this ring a bell for you?

Returns

All the Pension Fund Managers declare their past returns [2] as part of their public disclosure. This is quite useful as we can compare their returns with returns from mutual fund companies. On this aspect also NPS scores low in comparison to Mutual Funds.

For e.g. as on 30th November 2017, the last 5 years annualised returns of the equity portion of Kotak Pension Fund was 14.51% whereas a mutual fund scheme Kotak Select Focus Regular Growth from the same group company gave 20.61% annualized (net of all expenses).

So, if you had Rs. 10 lakh accumulated five years back in the equity part of NPS it would have become approx Rs. 19.20 lakhs (ignoring its charges deducted through reduction in units) whereas the same amount in the mutual fund would have become Rs. 25.5 lakhs (net of all expenses)!

Even during the distribution phase, you get a bad deal because of the compulsory conversion to annuity. Typically the insurance companies will give an interest rate, depending on your age at the time of buying annuity, in the range of 7-9% (pre-tax). You could have easily just shoved all of it in an FD and done better without any risk.

By investing the same amount in a combination of debt and equity mutual funds, you could have generated slightly higher returns (8-10%) with a benefit of handing over the balance amount as legacy to the next generation, which is not available when done through the annuity route.

Given the illiquidity, complexity and lower returns of NPS, I personally do not invest in NPS (except Rs. 2,000 per year to keep my NPS account active which was opened by my previous employer) either for tax-saving or for retirement.

I use Mutual Funds for both of my goals of tax saving and retirement and you can see my Goalwise portfolio here.

Hope this blog gives you a basic understanding of NPS so that you can make an informed decision whether NPS is good for your tax-saving or your retirement planning.

NPS is better than having nothing but today with platforms like Goalwise, good investment advice is accessible to everyone and can be implemented with a click of a button. There is no reason to settle for sub-optimal solutions like NPS.

Sources:

30th September 2017 report available at -
https://assetmanagement.kotak.com/pensionfund/portfolio_details.html
Pension Bulletin of November 2017 available at-
http://www.pfrda.org.in/index1.cshtml?lsid=410
Benefits of NPS: http://www.pfrda.org.in/index1.cshtml?lsid=92
Regulator: http://www.pfrda.org.in/
Investment Choices in NPS: http://www.pfrda.org.in/index1.cshtml?lsid=97