You are still young and want to start saving for your retirement. You want to ensure that you get a regular income after retirement. For this reason, you want to invest in a pension plan.
Which pension plan do you pick up?
There is NPS (National Pension Scheme) and there are several pension plans from the insurance companies. Which one would you pick?
In a pension plan, you invest for a few years before retirement. Once you retire (or the plan matures), you can take out some money as lumpsum and use the remaining to purchase an annuity plan.
In this post, I will compare NPS with pension plans from insurance companies on various parameters and see what fares better.
NPS vs Pension Plans from Insurance Companies: Cost Structure
NPS must be a clear winner here. The fund management charge is 0.01% of the portfolio. There are other ancillary charges but those are unlikely to be substantial for a big corpus. You can check the charges on this link. For more on how these charges are adjusted, refer to this post.
- Traditional pension plans. The cost structure is opaque and the returns are poor.
- Unit Linked Pension Plans (an extension of ULIPs)
The cost structure of ULPP is quite transparent. The online variants have a fine cost structure. However, these plans can still come anywhere close to NPS.
I pick up the charges list from HDFC Click 2 Retire plan. Within the Unit linked pension plan space, this plan seems to have reasonable charges. Note that this is one of the plans that I picked up. I have not looked at the plan thoroughly.
You can check the Fund management charge. It is 1.35% p.a. (NPS is at 0.01%). Insurance companies can complicate charge structure by including additional costs. For instance, this one has an Investment Guarantee Charge. A few pension plans may also provide some life cover. In such cases, the mortality charges will eat into your returns.
Can’t beat NPS at costs. And costs matter for a long-term investment.
NPS vs Pension Plans: Flexibility
With NPS, you can contribute varying amounts. You do not have to contribute the same amount every year. The minimum annual contribution is Rs 1,000 in a financial year. There is no cap on the amount you can invest in NPS in a financial year. With pension plans from insurance companies, you must pay a fixed annual premium.
NPS account matures at the time of superannuation or when you turn 60. You have an option to extend the maturity of your account up to 70 years of age. An early exit before the age of 60 requires you to use at least 80% of the accumulated corpus to purchase an annuity. Now, this is a problem if you are planning to take early retirement.
With pension plans from insurance companies, you have this flexibility to choose the maturity age. If you are 30 years and plan to retire by the age of 45, you can pick up a policy term of 15 years.
NPS vs Pension Plans from Insurance Companies: Tax Benefit on Investment
Investment in a pension plan from an insurance company is eligible for deduction up to a maximum of Rs 1.5 lacs per financial year under Section 80 CCC of the Income Tax Act.
The tax benefit under Section 80CCC is NOT over and above Section 80C tax benefit of Rs 1.5 lacs per financial year.
Note: As per Section 80CCE of the Income Tax Act, the aggregate amount of tax benefit under Section 80C, Section 80CCC and Section 80CCD (1) is capped at Rs 1.5 lacs per financial year.
For more on tax benefits and tax treatment on maturity on pension plans, refer to this post.
With NPS, you can get tax benefit in 3 ways.
- For Own contribution to NPS Tier 1 account
- Rs 1.5 lacs under Section 80CCD (1): For your contribution to NPS, the tax benefits have absolute caps. You get tax benefit of up to Rs 1.5 lacs under Section 80CCD (1). This is no exclusive tax benefit and is shared with other Section 80C products such as PPF, EPF, life insurance premium, ELSS, etc. The tax benefit is further capped at 10% of basic salary for employees and 20% of gross income for self-employed.
- Rs 50,000 under Section 80CCD(1B): This is an exclusive tax benefit.
- For own contribution to NPS Tier 2 account
- Up to Rs 1.5 lacs under Section 80C: This benefit is available only to Central Government employees subject to an investment lock-in of 3 years. Poor choice. Don’t invest in NPS Tier 2 account.
- For Employer Contribution to NPS Tier 1 account
- Up to 10% of the Basic Salary (including Dearness Allowance): There is no absolute cap on the tax benefit. Higher your basic salary, the more tax benefit you can get. For the Central Government employees, the percentage is higher at 14%. Clearly, this benefit is available only to salaried employees. Self-employed cannot avail this deduction. For more on if you sign up for NPS through your employer, refer to this post.
NPS is a clear winner here.
Maturity Rules and Tax Treatment on Exit/Maturity
With NPS, you can withdraw up to 60% of the accumulated corpus at the time of maturity (at the time of superannuation or the age of 60 or thereafter). This lump sum withdrawal is exempt from income tax. The remaining amount (at least 40%) must be used to purchase an annuity plan. The amount used to purchase the annuity plan is not taxed. However, annuity receipts (income from the annuity plan) are taxable in the year of receipt at your marginal income tax rate.
If you exit before the age of 60 (or superannuation), you can withdraw only 20% as the lump sum. This lump sum withdrawal is exempt from tax. The remaining amount (atleast 80%) must be used to purchase an annuity plan. Income from the annuity plan is taxed at your marginal tax rate in the year of receipt. There is no concept of surrender in NPS.
For more on tax treatment of NPS funds at maturity, refer to this post.
With pension plans from insurance companies, you can withdraw up to 1/3rd of the accumulated corpus as lumpsum (commuted pension). In July 2019, IRDA increased this cap to 60% of the accumulated corpus, bringing this in line with NPS. Before you buy the plan, check the policy wordings to see how much can be commuted.
The entire lump sum withdrawal (commuted pension) is exempt from income tax as per Section 10(10A) of the Income Tax Act, whether it is 1/3rd or 60%.
The remaining amount shall be used to purchase an annuity plan. Income from the annuity plan is taxed in the year of receipt at your marginal rate.
The other issue is with the surrender of the plan.
In case you surrender the pension plan, the surrender value will be added to your income for the year and taxed at the marginal tax rate. This case is covered under Section 80 CCC of the Income Tax Act.
A minor twist here: The surrender value will be added to your income and taxed at a marginal rate only if you took the tax benefit under Section 80CCC of the Income Tax Act. So, no relief if you took the tax benefit under Section 80CCC. The entire surrender proceed is taxable.
If you invested in the plan but didn’t take the tax benefit under Section 80CCC for any of the years (and subsequently surrendered), you may get some relief. You can deduct the premiums paid from the surrender proceeds to arrive at the taxable portion.
For more on tax treatment of pension plans, refer to this post.
NPS vs Pension Plans: Investment Choices
Pension plans from insurance are likely to win here. However, the victory in this aspect does not matter much to me.
NPS offers you a choice of equity (E), Government Securities Fund (G) and Corporate Bond Fund (C). I am ignoring alternative assets (A) for now. You can choose the allocation between the 3 funds. Your portfolio will get auto-rebalanced on your birthday every year. In my opinion, that is good enough.
A pension plan from insurance company may give you a greater choice of funds but, in my opinion, NPS already offers enough.
NPS or Pension Plans from Insurance Companies: Which is a better option?
If the choice must be made between these two, my vote goes to NPS.
NPS has lower costs and provides better tax benefits. At the moment, it enjoys better tax treatment at maturity but the recent hike in commuted pension cap is likely to nullify that advantage. for the new buyers. Every pension plan will have its nuances. As a prospective buyer, you need to look at the nitty-gritty of the plans in your consideration set. And that makes the decision complicated. NPS is relatively simple.
By the way, it is not just either-or. There is a possible “neither” too.
You must think of pension plans (including) in this manner. You accumulate money and earn returns before retirement. Once the plan matures, you take out some money lump sum and use the remaining to purchase an annuity plan.
Now, you don’t have to purchase a pension plan to accumulate a corpus. You can do this in many other ways. You can invest in FDs, mutual funds, stocks, bonds, PPF, EPF, etc. At the time of retirement, you can use some portion of the corpus to purchase an annuity plan. This is as good and way more flexible. Tax treatment convolutes things a bit.
What you do pick? NPS or Pension Plan from Insurance Companies or neither?