NPS is still not good enough, even with tax incentives

The Finance minister, in the latest general budget, has offered an additional and exclusive tax incentive of Rs 50,000 for investments in New Pension System/Scheme (NPS). Coupled with an additional tax incentive that is exclusively available to NPS investors, the scheme has created a lot of excitement, especially among the salaried employees. In this post, we discuss what NPS is all about, its salient features and various positives and negatives of the scheme. Finally, we weigh various pros and cons of the scheme and share our recommendation on the product. Let’s start with what NPS is all about.

What is New Pension Scheme (NPS)?

New Pension Scheme (NPS) is a voluntary, defined contribution retirement savings scheme designed to enable the subscribers/investors help save for their retirement through systematic savings during their working life. Earlier it was offered only to government employees. The scheme has extended to all, non-government employees or self employed. NPS is regulated by Pension Fund Regulatory and Development Authority (PFRDA).

Under the NPS, individual contributions/savings are pooled in to a pension fund which are invested by PFRDA regulated professional fund managers as per the approved investment guidelines in to the diversified portfolios comprising of government bonds, bills, corporate debentures and equities. These contributions would grow and accumulate over the years, depending on the returns earned on the investment made.

At the time of normal exit from NPS, the subscribers may use the accumulated pension wealth under the scheme to purchase an annuity from a PFRDA empanelled life insurance company apart from withdrawing a part of the accumulated pension wealth as lump-sum, if they choose so.

What is an Annuity?

An Annuity is a financial instrument which offers a monthly/quarterly/annual pension at a guaranteed rate for the period you choose for a given purchase price. There are different variants of annuities available in the market. For example, some variants provide guaranteed income for lifetime while others provide only for a fixed period. Some annuities provide income to the spouse of the annuity purchaser even after the purchaser’s death. An NPS subscriber may choose among the variety of annuities available to suit his/her requirements. Annuity market in India is still not well developed. However, you can expect greater innovation in the market by the time you retire, you can get much better and competitive annuity options (e.g. Annuities providing payouts that rise with inflation)

NPS is different from earlier pension system

Please note NPS is different from the earlier pension system where the amount received per month after retirement was fixed (based on your last salary) and increased periodically. The earlier system was a defined benefits scheme. In case of NPS, the size of corpus at the time of retirement depends on the return on your investments, which is not guaranteed. Additionally, the annuity income post retirement depends on the prevailing annuity rates at the time of purchase of annuity. Hence, monthly income is not guaranteed as in earlier pension plans.

Who can open an account?

Any resident or non-resident Indian aged 18 to 60 can open an NPS account.

How to open an NPS account?

To register for NPS, you need to submit registration form along with KYC (Know your customer) documents at any Point-of-presence (POP/POP-SP). Many banks/financial institutions provide this service. You can also enrol online through web-portals such as ICICI Direct. On opening the account, the investor/subscriber shall be allotted a unique Permanent Retirement Account Number (PRAN). This number remains with the subscriber throughout his/her lifetime.

Features of the Scheme:

1. NPS account is completely portable. You need not open a new NPS account while switching jobs or relocating to a new city. Any person can open only 1 NPS account. A NPS account cannot be held jointly.
2. NPS Account is structured into two tiers/ sub-accounts: Tier I and Tier II.
   1. A Tier I sub-account has limitations on withdrawal and is a retirement product in a true sense.
   2. A Tier II sub-account has no limitations on withdrawal. It is similar to a mutual fund. This type of account is allowed only if there is an active Tier I sub-account in name of the subscriber. Please note that the any tax incentives (applicable to NPS) are applicable only to investments in Tier I account.
   3. Any information shared henceforth in this post about an NPS account shall refer to a tier-I account, unless specifically mentioned.

3. A subscriber need not make contribution every month. Minimum contribution per year: Rs 6,000 (Rs 500 per transaction). No upper limit on contribution
4. A subscriber can make contributions to the NPS account till the age of 60
5. A subscriber can choose from six pension fund manager to manage funds and even shift from one to another.
6. Liquidity from the scheme: No partial withdrawals are allowed at the moment. A subscriber can only exit the scheme completely. The regulatory authority is considering allowing partial withdrawals subject to certain conditions.
7. Exit from the Scheme:
   1. Upon attainment of 60 years: At least 40% of the accumulated wealth in the account needs to be utilized for purchase of annuity. Remaining 60% can be withdrawn as lump sum. The subscriber has an option to defer the withdrawal of lump sum amount till the age of 70. At the age of 70, any balance in the account will be paid out to investor as lump sum. There is no compulsion to purchase annuity in case the total accumulated wealth is less than Rs 2 lacs.
   2. Before attainment of 60 years: At least 80% of the accumulated wealth in the account needs to be utilized for purchase of annuity. The balance can be withdrawn as lump sum.
   3. Death of the subscriber: Entire accumulated wealth to be paid to the nominee/legal heir. No option for the purchase of annuity.
   4. Deferment of Annuity: A subscriber has an option an defer mandatory annuity purchase (as mentioned in (a) and (b)) by up to 3 years

8. Applicable charges: The expense ratio is 0.01%, which makes NPS much cheaper than mutual funds. Additionally, there is a transaction charge of 0.25% or Rs 20, whichever is higher subject to a maximum of Rs 25,000, on every transaction/contribution.
9. Investment guidelines: NPS offers investments in three asset classes:   Equity (E Type), Government securities (G type) and investment grade credit-risk bearing debt or fixed income based instruments/corporate bonds (C type). For equity investments, the money is invested in index funds/exchange traded funds that replicate the portfolio of BSE Sensex or Nifty. Hence, one can expect the returns on the equity component to match returns on these aforementioned benchmark indices. There are two investment options available to the subscriber. However, under both the options, investment in equities (E type) is capped at 50%.
   1. Active choice investment: Investor can decide the allocation among the three classes as per his/her choice. Equity exposure is capped at 50%.
   2. Auto Choice investment/Life Cycle Fund: There is the default option and allocation among asset classes depends on the age of the investor. Under this option, investor does not decide the allocation. Till the age of 35, allocation of investment to equity (E type), corporate bonds (C type) and government securities (G type) is fixed at 50%, 30% and 20% respectively. After 35, allocation to equity will reduce by 2% and allocation to C type will reduce by 1% per year while the allocation to government securities will increase by 3% every year. This will continue till the investor age is 55. By the time, investor hits the age 55, allocation to E type, C type and G type would have become 10%, 10% and 80% respectively. The allocation to different asset classes is not modified subsequently.

How is the maturity amount taxed?

The NPS account matures when the subscriber turns 60. The contribution made by you or your employer, along with returns on your investments, gets accumulated in accumulated in your Tier I account. NPS is an EET (Exempt-Exempt-Taxable) product. At maturity (60 years), accumulated amount used to purchase annuity will not be taxed. However, the annuity income received (in the future years) is taxable in the hands on the investor as per investor’s income tax slab. Remaining corpus (left after purchase of annuity) is treated as income in the year of withdrawal and taxed at investor’s marginal tax rate.

In the event of death of the investor, the nominee can withdraw the entire accumulated corpus. The money, thus received, is tax-exempt in the hands of the nominee or legal heir.

Under the proposed direct taxes code, the income from the NPS is proposed to be made tax free i.e. NPS will become part of EEE regime. Such a move will make NPS very attractive. However, nothing is certain till such direct taxes code gets implemented. Basing your investment decision on expectation of such a move will be pure speculation.

There may be some tax relief on NPS withdrawal on maturity (for people subscribing to NPS offered by employer) on maturity under Section 10(10A) but that is subject to interpretation of the Act. Nothing can be said with certainty if the provisions of the said Section would be applicable to NPS.

Advantages:

1. It is a very low cost financial product. Expense ratio is the lower than any mutual fund.
2. Provides a balanced portfolio under auto choice option (life cycle fund). A subscribers’ portfolio is automatically adjusted towards debt as he/she nears retirement. A lot of us do not completely understand the risks involved in investing in equity markets. A small mistake towards retirement can jeopardise entire life’s savings. By automatically shifting the portfolio towards debt, NPS helps reduce such mistakes.
3. Tax incentives:
   1. Investment up to Rs 1,50,000 into NPS in a financial year is eligible for deduction under Section 80CCD. Please note this is subject to the overall ceiling of Rs 1,50,000 for deduction under Section 80C.
   2. The latest budget has provided an additional exemption limit of up to Rs 50,000 per financial year for any investments into NPS under Section 80CCD (1B). This deduction is over and above the ceiling limit of Rs 1,50,000 provided under Section 80C.
   3. Contribution from the employer up to 10% of Basic Salary + Dearness Allowance are also eligible for deduction under Section 80CCD(2). There is no upper cap (in terms of amount) on this tax deduction. This deduction is over and above the ceiling limit of Rs 1,50,000 provided under Section 80C.However, this benefit is available to employees. Self-employed cannot avail this deduction.
4. Annuity income in retirement can be extremely helpful. It is not easy to deploy assets to generate income. By the time people retire, they have groomed themselves to use monthly inflows (salary) to provide to provide for regular expenses. Post retirement, the monthly inflow will stop unless you have other regular sources of income such as house rent or interest income. This is where pension plans/annuity provides the maximum value.

Disadvantages:

1. Entire corpus taxed on withdrawal (EET)
2. Annuity payouts may not be able to protect you from inflation,
3. Low returns on annuity: Annuity rates in India are low. For the sake of simplicity, the lower the annuity rates, the more you need to spend to purchase annuity to achieve same level of income. For example, to earn an annual income of Rs 1,00,000 for lifetime, at 8% rate of interest (annuity rate), the amount required for such annuity purchase will be Rs 1,250,000. The amount required will rise to Rs 2,000,000 if the annuity rate falls to 5%. However, you can expect to evolve by the time you retire. Hence, you can expect better annuity products (for example, annuity payouts that are linked to inflation etc) by the time you retire.
4. Equity exposure, irrespective of the investment option chosen, is capped at 50%. Approach may not be optimal for young individuals.
5. Limited liquidity: At the moment, partial/premature withdrawals are not allowed. One has to completely exit the scheme to get the money out. You can expect some relaxation in the future.

Should you invest?

There are a few aspects of NPS, which makes it different from other investment avenues such as mutual funds, EPF, PPF, ELSS (tax saving mutual funds): Let discuss those aspects.

1. Annuities: That the NPS forces a subscriber to purchase an annuity for atleast 40% of the accumulated wealth is a good feature. For retirement planning, having a large corpus at the time of retirement is not sufficient. A retiree needs to have a good distribution strategy too i.e. how to use that corpus to generate regular income till the end of his/her life. Most of us do not acquire this skill during our professional life. We get used to getting salaries at the end of the month and using this to meet expenses. This is where an annuity fits well. A retiree gets a guaranteed monthly/ quarterly/annual cashflow after an annuity purchase. With a guaranteed income, he/she may be able to plan expenses better.

Some might argue that the annuity rates are low and annuities provide sub-optimal returns and are not tax friendly. Well, risk and reward go hand in hand. Since the returns are guaranteed, returns are bound to be lower. You can expect a lot of innovation and competition( in terms of rates and charges) in annuities market by the time you retire. Unless you have created an asset that can provide you regular income (stock/bond/mutual fund portfolio for dividend/interest, second house for regular rent), you can look at covering at least a part of retirement expenses through an annuity purchase at the time of retirement. However, no one stops you an annuity from your retirement corpus even if you don’t have an NPS account. Annuities are not exclusively available to NPS subscribers. You can simply liquidate a part of your assets at the time of retirement to purchase annuity.

2. Risk/Return/Discipline: With respect to return/risk, you cannot expect NPS to provide better risk adjusted returns. A portfolio mix offered by NPS can easily be built using a mix equity and debt funds. A lower expense ratio will certainly add to NPS returns. However, being an index fund (for equity), it also stands to lose out on higher returns from active fund management. Please note that active fund management does not always lead to better returns. With respect to discipline, since NPS has provides limited liquidity and has minimum contribution requirement, it enforces discipline while building a retirement corpus. However, you can maintain similar discipline yourself.
3. Tax Angle: One does enjoy tax benefits while investing into NPS. Some of the tax benefits are exclusive to NPS. However, since the entire corpus (considering annuity income is also taxed) is subject to tax at the maturity, the entire advantage of tax benefits is nullified. Some experts suggest that NPS will become part of EEE regime (maturity proceeds will also be tax free) eventually. An additional point to note; right now you might fall under a lower tax bracket. However, at maturity, since the corpus would have become much bigger, income that year might be taxed at the highest marginal rate. So, you may save 10% or 20% today but pay 30% later. For example, suppose you fall in 20% tax bracket, by investing Rs 100,000 in NPS, you save Rs 20,000 on tax this year. After 25 years (assuming 10% returns and 30% tax rate), your post-tax receipt will be Rs 7.58 lacs. However, on the other hand, if you had invested Rs 80,000 (after 20% tax) in a balanced fund, you would have received Rs 8.67 lacs (10%, zero long term capital gains tax). Please note that this tax equation may change completely if NPS maturity proceeds are indeed made tax free.

PersonalFinancePlan Take:

In spite of so many tax benefits being available to NPS, it is still not a good enough retirement product. Tax benefits shall not be sole criterion for choosing an investment product. There are products available which can provide better post tax returns than NPS. We recommend staying away from NPS till such time it becomes part of EEE regime.

Though we have recommended staying away, a lot of people might still get attracted to NPS because of tax benefits available exclusively to NPS. So if you still want to invest in NPS, invest to utilize tax benefits available exclusively to NPS i.e. fill your 80C exemption limit with 80C products other than NPS and invest in NPS If you still have money left to invest after this. Salaried employees can also invest through the employer to maximize tax benefits (under 80CCD(2)).

Additionally, since there is an equity component involved, we recommend you not to make lump sum investment in NPS. Rather, invest in NPS regularly (just like SIP in mutual funds). However, since there is a minimum charge of Rs 20 per transaction, you are advised not to make the size of each contribution too small otherwise transaction charges (minimum Rs 20) will eat up the benefit of lower expense ratio. Keep size of each contribution between Rs 5,000-10,000.

You can argue that, by not investing in NPS now and waiting for NPS to become an EEE product before investing, you would have forgone tax benefits (for multiple years) if NPS becomes an EEE product later. Well, that’s true. However, investing in a product (expecting a policy announcement) is tantamount to speculation and we do not recommend speculation to our readers.

Deepesh is Founder, PersonalFinancePlan