National Pension Scheme (NPS): Do not invest even if you get tax benefits!

Published: April 21, 2014 at 8:34 am

Here is why I think one should not invest in the National Pension Scheme even if you get tax benefits. This is the updated version of an earlier post.

Earlier I had recommended subscribing to the NPS if you get tax benefits via the employer contributions. Tax benefits have actually increased since the govt. announced an additional 50,000 tax benefits over and above the 1.5 Lakh possible under section 80C.

Here the reasons why I think one should not invest in NPS despite the tax benefits:

  1. NPS is partially an EET instrument

That is, there is no actual tax deduction like in PPF. You are only deferring the tax benefits until withdrawal. Upon which you will need to pay tax not just on the gains but also on the investment. That is a bad deal.

Update 1: A Guide to investing in the National Pension System (NPS)

Update 2: Budget 2016: National Pension Scheme – 40% of withdrawal made tax free! Only 40% of corpus at the time of retirement is tax-free.

People argue that this will be changed and NPS will become EEE ‘soon’.

I think the government cannot afford to make NPS EEE. Even if it does one should not invest because:

2. 80% will be annuitized if you retire before 60 (after Budget 2016, 40% is tax free withdrawal, 80% of remaining corpus has to be annuitized official confirmation awaited). 

This is a terrible deal. How many of you want to work in a corporate job until 60?! If you are contemplating retiring before 60, stay away. Read more: Stay away from Corporate NPS, if You Wish to Retire ASAP!

Here are more reasons against NPS. This is part of the original post.

3.      Will you stay in a half-built house? As a product, NPS is a premature baby. It was rolled out in a hurry for government subscribers with no clarity on who will manage the fund, how it will be managed, and even when it will be managed.

For the general subscribers the case was much better but not perfect. The fund manager websites are extremely user-unfriendly and are still in their infancy. Information on investment strategy, where ones money will invested, etc. is hard to find if not available!

Hardly any personnel directly involved with the customer understands the rules and regulations as these are new! They have not been trained well enough. There seems to be no incentives offered to anybody to push NPS. Any product that has little or no commission associated with it is unlikely to be popular. The best example is the low AUM of the excellent fund Quantum Long Term Equity (see analysis here) because distributors do not get commissions to sell it

In my opinion, the product (NPS) is also half-baked. It is still evolving and only the framework is complete. Would you invest in such a product?

4.      Cheap and best is an oxymoron! Much has been said about the low fund management expenses. This means the NPS fund managers are unlikely to paid as much as typical mainstream fund managers. Therefore,

  • They are unlikely stay in the same job for long
  • I do not expect the same competence as mainstream fund managers

Want something cheap? Buy yourself an index fund If you want alpha, you are barking around the wrong tree!

5.      Poor Exit options/ liquidity If you exit before 60, you will need to annuitize 80% of the corpus. If you state only so much, as many articles do, I would say this is a good thing!

After all, most people cannot afford to retire before 60 because they simply are not investing enough for retirement. How much is enough? As much as you spend! So what is the problem with this? The idea is to discourage the misuse of a corpus meant for retirement. Given the number of nut jobs with fancy ideas around, this is actually a good thing. If you are considering retirement before 60, why consider the NPS in the first place?

The real issue is with respect to performance-related switches/exit. Assuming I can track a NPS fund managers performance and find it unsatisfactory,

  • I cannot exit the scheme without practically losing my corpus to an annuity
  • I will need to switch only among the fund mangers authorised to manage NPS. As of now, there is no easy way to gauge who is better.
  • Although switching is permitted, I will be extremely surprised if this is hassle-free!
  • To sum it up, NPS is a prison cell for the serious investor who would like to actively manage ones retirement corpus.

6.      Active management is mandatory for long term goals When it comes to investing for long-term goals, volatile instruments are inevitable, Be it debt products, equity or even PPF! So the key is to contain this volatility with making some tactical calls. They could range from rebalancing to simple profit booking to tactical asset allocation. If you are serious about retirement, you simply cannot afford to keep investing in a bunch of mutual funds without paying heed to market conditions and fund performance not to mention the fund portfolios!

The size of the corpus or nest egg is key to successful retirement planning. The larger it is, the most flexible will be your retirement plan. You simply cannot afford to follow a fill it, shut it, forget it (Hero Honda! as Ashal would put it) strategy.

7.     Why bother when we do so much better without NPS?  Using a combination of equity mutual funds + PPF combined with oodles of discipline one hope to do as well as NPS and perhaps even better. So why bother?

That is quite enough NPS bashing in one post!

Now let us ask,

  • What if my employer offers it? Should I take it then?
  • What if NPS is made the only 80C eligible instrument?
  • What if the 80C limit is enhanced?

Good questions!

A couple of points before answering. If the employer offers NPS and contributes to the NPS, the employers contribution will be eligible for exemption up to Rs. 1 lakhs over and above the 80C limit. Your contributions will be part of 80C.

So this is an opportunity to deduct an extra 1 Lakh from your taxable income. For someone in the 30% slab, this is a huge bonus. Each year I save an amount approximately equal to a months expenses as taxes because of this.

Under the above circumstances when there is an actual tax saving, it makes sense to opt for NPS, provided

  • NPS is only one component of your retirement portfolio.
  • you are disciplined enough to invest the saving wisely.

If I choose NPS for tax savings, how should I invest in it?

Choose NPS as a debt instrument. That is choose 100% of asset class C. Remember this is only part  of a portfolio with enough equity contributions from your side.

Here is an extract about asset class from the NPS Hand book

Asset class C (credit risk bearing fixed income instruments) – This asset class will be invested in the following instruments:

I. Liquid Funds of AMCs regulated by SEBI with the following filters:

  •  AMCs are SEBI regulated, with Average total assets under management (AUM) for the most recent six-month period of, at least, Rs.5000 crores.
  • All assets that are permitted for investment into liquid funds by SEBI.

II. Fixed Deposits of scheduled commercial banks with following filters:

  •  Net worth of at least Rs.500 crores and a track record of profitability in the last three
  •  Capital adequacy ratio of not less than 9% in the last three years. Net NPA of under 5% as a percentage of net advances in the last year

III. Debt securities with maturity of not less than three years tenure issued by bodies corporate including scheduled commercial banks and public financial institutions [as defined in Section 4 (A) of the Companies Act] provided that at least 75% of the investment in this category is made in instruments having an investment grade rating from at least one credit rating

IV. Credit Rated Public Financial Institutions/PSU Bonds

V. Credit Rated Municipal Bonds/Infrastructure Bonds

I think Asset Class C is a good option to ward off both interest rate risk and credit risk to a reasonable extent. My own NPS subscription has suffered due to overexposure to Asset Class G (govt bonds). I have only 15% equity exposure in NPS.
What do you think? Do you agree with my views?

Update 2:  NPS: Partial Withdrawal Rules 2016 are just awful! Beware.

Disclosure: I am a mandatory NPS subscriber with a pretty significant corpus. See my posts on NPS returns.

I would like to reiterate that this list is only for who understand the importance of retirement as a goal and are serious about planning for it

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