How to calculate pension from NPS?

Published on / By M. Pattabiraman Twitter: @pattufreefincal

Published: November 6, 2021 at 5:58 am

Last Updated on June 3, 2022 at 11:16 pm

Swaroop asks, “I am 30 years old and have recently started investing in NPS. Can you please explain how to calculate the pension that we would receive from NPS?”.

The short answer is, it is not possible to accurately calculate NPS pension. Yes, we can make an estimate, but the result is likely to be disappointing once we use reasonable assumptions.

It may be called a National Pension Scheme (or new pension scheme), but it does not directly offer any pension! The NPS is a mutual fund scheme.  Like any other MF, you buy units from an NPS pension fund manager when you invest in the NPS.

You sell the units back to the pension fund manager when you wish to redeem or finally exit the scheme. As per your choice, a portion of the final corpus (min 40%) will be invested in an annuity (pension) scheme with a life insurer.

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At the time of writing, whether you buy this annuity with your NPS proceeds or any other investment, the pension you receive will be the same. The pension fund regulatory authority wants special annuity rates for NPS instituted, but that would not be easy. Even if it comes to force, the annuity rates will be not too different as insurers will also need to consider their profitability.

The NPS is a unique mutual fund, thanks to its large AUM. As of 30th Sep 3021, State govt NPS funds managed by SBI (UTI and LIC are the others) is Rs. 1,16,832 crores. Only the EPF (with not more than 15% equity exposure) can rival this – SBI ETF Nifty 50 has an AUM of Rs. 1,19,873 crores.

The Sep 2021 portfolio listing of the SBI NPS central govt scheme fills 40 pages! The state govt portfolio fills 44 pages! So even if there is a default (0.07% of state govt NPS AUM is NPA and 0.17% of central govt NPS AUM is NPA), we will barely notice it! So the pension fund managers are all set to negate concentration risk if the AUM swells in future (and it will).

Now coming back to the issue of computing NPS pension, we can sit and dream about 10% or 12% returns from NPS but what we will end up with is anybody’s guess. Sure, the NPS default central govt asset allocation has performed quite well in the past: After 11 years of investing in the NPS (15% equity + 85% bonds), my return is 10%, but this has little bearing on future returns.

Anyone can compute the NPS corpus we may accumulate with an assumed return number with this simple formula. This is also the standard SIP formula with a step-up feature (increment) included.

Corpus =(1+return)*sipamt*12*((1+return)^years-(1+increment)^years)/(return-increment)

  • Corpus is the amount that will accumulate
  • return = assumed annualized return from entire portfolio
  • sipamount = monthly investment.  If you don’t make monthly investments, replace sip amount*12 in the formula with the annual investment.
  • Years is the duration of the investment.
  • The increment is the percentage increase in annual investment. Do not give the same value for the increment and return. If you expect an 8% return and can increase investment by 8%, set the return as 8% and the increment as 7.9% (why?).
  • We recommend using a return of about 7-8% from a debt-heavy portfolio (e.g. default govt NPS allocation) and 8-10% from a portfolio with equity (lower return if the equity is set to reduce).

This is the easy part because you can fantasize about any return you want (and there is no guarantee that you get it). The next part is hard. Even today, the annuity rate is about 6%. Suppose you plan to retire at age 50 – that is 20 years away in the case of Swaroop. What do you think the annuity would be? We should be happy if we get 3% and overjoyed if it is anything above that!

So if you expect the NPS corpus to be Rs. 1 crore and you wish to annuitize 40% of that, the annual pension will be Rs. 40 lakhs x 3% = Rs. 1.2 lakhs or Rs, 10,000 a month.

In summary, NPS investors need to appreciate the nature of the product and the possibility of decreasing annuity rates in future and prepare accordingly for this. They should never be entirely dependent on NPS. We recommend that investors use NPS as a pure debt mutual fund and invest in equity elsewhere. Young investors like Swaroop should look to invest 60% of their entire investment amount in equity.