Here is a guide to investing in the National Pension System (NPS) with suggestions for existing and potential individual, corporate and government subscribers.
Over the past few years, the government has tried hard to make the National Pension System popular. First, it used the magic phrase tax-saving by allowing an additional 50,000 invested in Tier 1 to be discounted from taxable income.
Next, it used the magic phrase tax-free by allowing 40% of the corpus accumulated at retirement to be withdrawn free of tax. As we all know, it tried and failed to implement the same rule with the EPF. Sooner or later the EPF is bound to become marked to market and taxable like the NPS.
Many invested in the NPS with the hope that it will be given EEE status. The budget drama should be an indication that such a ruling is simply not financially viable by the govt.
Now the question is, 'can I invest in the NPS now?' I had answered this earlier, but I thought a more detailed response is necessary. I have always been a vehement critic of the NPS and this post will not be any different. However, I would like to suggest a way to make the most out of NPS for current subscribers.
Before we talk about NPS, two aspects of investing need to be discussed.
1 Liquidity and National Pension System
Liquidity is the most important concept in investing. Not compounding. Not time. If I cannot redeem at will from the corpus I have invested in, then who purpose of investing is lost, in my opinion.
People argue that a lock-in forces a corpus to grow and is necessary for a retirement product. I disagree. There are so many positive and negative events that can make a person stop working well before retirement and require the money from the retirement kitty. At any point in time, the predominant corpus for any goal should have immediate liquidity at the fair market price.
I had discussed this point before: How Liquid is Your Net Worth? and so did Dr. Uma Shashikant: Nuggets from the workshop on "strategic personal finance"
The National Pension Scheme has pathetic liquidity (see below).
2 Asset Allocation
Asset allocation is the second most important investing concept. Without understanding what asset allocation is, one should invest in anything, let alone the NPS!
Asset allocation refers to the amount of exposure to different asset classes in a portfolio so that the portfolio has the potential to provide a return that would help achieve the financial goal it was intended for after taxes!
If I am investing in NPS, I must choose the asset allocation of the scheme such that the overall asset allocation of my retirement portfolio will get me the corpus that I have in mind. Preferably most of it liquid!
Here is how one can Decide on asset allocation for a financial goal. Asset allocation choices for existing NPS subscribers are discussed below.
Now let us consider each subscriber category.
Remember the actual tax benefits from NPS is only 40% of the amount saved! Tax on the remaining 60% is deferred until withdrawal!!
Existing and Potential Individual NPS subscribers
An individual subscriber is one who is either not employed or not offered any kind of pension plan by their employer.
Potential NPS Subscribers
I strongly believe that individual NPS subscribers, including NRIs who can now invest in the NPS should stay away from the NPS. The only exception being NPS Lite intended for "people who are economically disadvantaged and who are not financially well to do".
There are multiple reasons for this. I will list only two for this category.
1) Do not join the NPS or invest any further in it* before reading this post:
Those rigid rules alone should be motivation for individual subscribers to not choose NPS and for existing subscribers to go easy with their contributions (ignoring the tax breaks).
2) There are much better options in every possible way than the NPS
Existing NPS Subscribers:
Existing individual subscribers may reevaluate the need for an NPS account (if in the remote possibility they are convinced by this post!), keep it alive with the minimum investment and focus on more liquid and efficient investment avenues for retirement.
If they would like to continue with the NPS account, then I would recommend avoiding equity (option E) and choose a mix of corporate (option C) and govt bonds (option G).
The corporate bonds would typically be PSU bonds. See the portfolio from SBI pension funds: Scheme C
The average portfolio maturity and modified duration are quite high*. However, the bonds are from quite credit-worthy institutions (pl check before investing). So it should not be a problem.
* To understand these terms, see: How to Select Debt Mutual Funds Suitable For Your Financial Goals?
The government bonds are long-term gilt funds which can be quite volatile. So go easy on them. See the portfolio from SBI pension funds: Scheme G.
As an indication of their volatility, compare the average portfolio maturity and modified duration of class G with class C. I would recommend a 50-60% C with rest in G portfolio (let us refer to this as C-G portfolio for reference later).
The equity allocation (see last section below) for retirement can be via direct stocks and or mutual funds. Why? because they are much better!
Existing and Potential Corporate NPS subscribers
The govt has lured corporate employers to offer NPS, either in lieu or together with EPF. The reason, when an employer contributes to the NPS, they get tax benefits.
So do the employee! This is in addition to 80C and has no upper limit. However, those who wish to quit their job and freelance much before normal retirement (58/60) should either think real hard before choosing NPS or should have an alternative source of funding!
Both potential and existing corporate subscribers ought to think this through with care - the limitations of NPS and their own future plans.
Also, corporate NPS is not universally available, unlike EPF. So if you switch jobs then you would be left with both the EPF and NPS to nurse.
Yes, the tax benefits from the employer contribution are quite alluring, but do proceed with caution.
If you wish to use NPS, I would recommend the C-G portfolio with separate equity.
Existing and Potential Government NPS subscribers
Well, what can one say about this group! They have no choice in the matter! NPS is mandatory.
They have no choice in the asset allocation! They have 15% equity and rest in fixed income which is heavy on option G. So the NAV can swing quite a lot. For example, have a look at the three NPS mutual funds
The sharp fall in July 2013 corresponds to the bond market crash when the RBI tried to curb rupee depreciation.
It is only recently that govt employees can change their pension fund managers. I am told that they would soon be able to change their asset allocation too.
Once this is officially possible, I would again recommend the C-G portfolio with separate equity.
Overall asset allocation for all subscribers
Those who are far away from retirement can consider 50-70% equity from mutual funds or stocks and rest in the NPS C-G portfolio (they should be able to invest this much aside from the NPS contribution which may be mandatory).
NPS has an age-based variable asset allocation schedule where the equity allocation decreases with each passing year.
The PFDRA has sought feedback on two more such active cycles: Providing option of more Life Cycle Funds to the NPS subscribers
The active life cycle matters only if NPS is the only retirement product. This is the very last thing any NPS subscriber should do! While an active cycle will reduce volatility, it will also reduce returns.
Do let me know if I have missed out any aspect of investing in the National Pension System.