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Evaluating NPS as an Investment option

In this post, we will evaluate whether the National Pension Scheme (NPS) is a good investment option and if it can help us meet our various investment goals.

What is the National Pension Scheme (NPS)?

NPS stands for National Pension Scheme. Thus, at the core, it is a pension scheme. In other words, it attempts to provide the investor with a periodic income post retirement. There is no option to “commute” or make this pension “lump sum”, which is to take a lump sum instead of a regular pension. A maximum of only 40% of the total amount can be converted into a pension.

The Good and Bad of a “Compulsory” pension

India doesn’t have a meaningful social security mechanism. So most employees prefer to take away all retirement benefits such as a pension, gratuity, PF, etc in the form of a lump sum, which they are free to invest or spend anywhere.

In fact, they may simply choose to distribute the entire amongst family members. However, in such circumstances, there is a possibility that they may become financially dependent on family members. Even if the money is not given away but invested, say in a house, there could be problems of liquidity. There may not be enough regular income, leading to financial difficulties. In such circumstances, having a regular pension, howsoever small the amount may seem, surely gives a lot of comfort.

However, the problem is that we have no idea about the amount of pension we would get. We do not have a choice to reject it even if it looks unattractive. We are stuck with the scheme and we do not wish to be in such a situation in our retirement years.

Do we have similar Annuity Schemes now?

Yes, we do. Most Insurance companies offer “Annuity” plans. These annuity plans have different variants, but at its core, an annuity plan offers a fixed amount of pension every month/ quarter/ annually against a lump sum amount deposited with the Insurance company. Since the amount is committed by the Insurance company, it is exposing itself to some risk and hence protects itself by offering a lower return than what any other organization offering a fixed return offers. Investors are assured of a fixed return for life and do not have to worry about fall in interest rates in the future.

Are Annuity Schemes popular?

Annuity plans offer safety of capital but fare poorly on liquidity and the returns are lower than comparable schemes ( for reasons explained earlier). Hence, Annuity plans are not very popular amongst investors, particularly retirees, who are the target segment for Annuity schemes.

So, is National Pension Scheme an inefficient scheme?

The biggest attraction of National Pension Scheme is the additional tax benefit that it offers. All tax saving investment schemes such as PPF, LIC, ELSS, NSC, Tuition Fee, repayment of home loan, etc are bundled under the limit of Rs.150,000. The only investment that offers an extra Rs.50,000 of deduction in taxable income is a contribution to NPS. If you are a person in the highest tax bracket, that is a straight Rs.15,600 back in the pocket. However, on withdrawal, 20% of the accumulated amount is taxed, and the rest converted to an annuity.

What are the returns?

Operationally, NPS works exactly like a Mutual Fund. A professional fund manager is managing your money across various asset classes – Equity, Government Debt, and Corporate debt. The investor has the option of choosing from alternatives with pre-defined allocation across the 3 asset classes. As in the case of Mutual Funds, there is no assurance of the return that one would earn.

The Pros and Cons of National Pension Scheme

One clear advantage of NPS is the additional tax benefit. Similarly, the disadvantage is the compulsion to purchase an annuity, although only 40% of the accumulated corpus needs to be converted into an annuity. The investor is free to take back the balance 60% and use it whichever way he or she chooses to.

Another advantage of NPS is that it has a very low expense ratio. This is also because the investment is passive in nature. There is no active fund management, which implies lower returns, at least in the current context. However, as we see markets becoming more efficient, passive funds are likely to be better bets than active funds with high TERs.

NPS scores poorly on Liquidity. There is no provision to withdraw the money before you turn 60. Only 20% of accumulated surplus can be withdrawn before the age of 60, with the balance 80% compulsorily getting converted into an annuity. Even at the age of 60, you can withdraw only 60% of the money. Thus, you will never see 40% of your money in your hand. It will be enjoyed by your nominees.

Conclusion: To Invest or not to Invest?

Consider the National Pension Scheme as a balanced Fund with a tax saving sop. Let us say, you are in the highest tax bracket of 31.2%. Assuming the NPS earns a return of 10% p.a. and current tax laws prevail, it will get you an effective post-tax return of around 11.08%, about 1.08% more, which is significant over a period of 30 years. Let us say, 40% of the accumulated corpus is invested in an annuity which earns 2% lower than what a comparable instrument would earn. The effective return over 60 years would still be 10.71% p.a. post tax. This is a decent return, higher than the 10% return assumed from the balanced fund. However, the returns are not very attractive if you are in the lower tax brackets. Hence, NPS is a recommended option for investors in the highest tax bracket.

PS: NPS Tier II

All along, we have discussed investments in Tier I of the National Pension Scheme. However, investors have the option of investing in Tier II of NPS, which is like investing in any other Mutual Fund. There are no tax exemptions and there are no restrictions on withdrawals or any compulsion to purchase an annuity plan. Hence, the above article only discusses National Pension Scheme Tier I.  Compared to NPS Tier II, Mutual Funds offer much more flexibility and liquidity.

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