One of the reasons the new pension system (NPS) had got good previews before launch was due to the tiny costs the scheme carried. However, newspaper edits this week suggest that there is fine print to be looked at and that the product is not as cheap as touted.
The criticism also is that the product is elitist and does not work for a poor person who will invest the minimum Rs6,000 a year but will pay the same upfront cost as a person investing Rs1 lakh. Is there truth in this cost argument?
Any discussion on cost cannot be restricted to only one facet of the cost. A financial product carries at least three kinds of costs: You have to pay to get on the bus, that’s the entry load. You have to pay to ride the bus, that’s the annual recurring fund management and other annual administrative costs. And last, you pay to get off the bus, that’s the exit load.
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Sounds great on paper but things are messy in real life. The challenge for investors is to see the final impact of all three costs over the life cycle of the financial product and then see what the post-cost return sits at. This becomes difficult because different products build in costs in different ways—a mutual fund will have a different set of costs, a unit-linked insurance plan (Ulip) has an untidy cost structure that takes an actuary to unravel and, now, NPS brings its own set of costs.
One way to solve this problem is to ask the question: If the investment grew each year at 10%, what would be my post-cost return after all three types of costs are taken into account over the life of the product? Suppose the post-cost return is 8%, then 2% per year is the cost you have paid. Clearly, a product with an 8.5% post-cost return is superior to one which carries 7.5% post-cost return.
Let us cut the NPS story into two parts. The elitist bit first. Let’s compare a person investing Rs6,000 a year and another investing Rs1 lakh a year in an NPS scheme and see how costs pan out. Both invest for 25 years and earn 10% per year on their money. The post-cost return for the poor person is 9.19% and that for the rich person is 9.95%.
Clearly, the higher the contribution, the lower the cost incidence. The scheme is tilted towards those who can make higher contributions. But another way to look at this would be to say that this will actually encourage a higher contribution to the product.
Two, how does NPS compare with other long-term, market-linked, investment-oriented financial products in terms of costs? I looked at the post-cost return for a Rs6,000 annual investment, spread over 12 contributions in NPS, a Ulip and a diversified equity mutual fund, each year for 25 years. Each product earns 10% a year.
The results are unsurprising. The best Ulip will return a post-cost 8.07%, the average mutual fund does 7.74% and the NPS scheme throws back a post-cost 9.19% per year. This difference in costs translates into a very different corpus size at the end of 25 years. The Ulip earns Rs4.78 lakh, the mutual fund does Rs4.55 lakh and NPS gives Rs5.71 lakh.
Clearly, to restrict the discussion, even for the poor person, to just the front load and call the product expensive is an uneducated way to look at a financial product.
NPS is cheaper due to the shockingly low annual fund management and custodian fees. At 0.0084% or Rs8.40 for every Rs1 lakh corpus in the scheme, it is generations cheaper than a mutual fund that averages a cost of 2%, or Rs2,000 per year, and 1.5%, or Rs1,500 per year that a standard Ulip carries.
Remember, while upfront cost is a fraction of what you invest, the annual fund management fee is a fraction of the total corpus. The annual charge is levied on a growing number while the upfront is only on the contribution.
When all three costs are looked at over the life cycle of the product, NPS emerges ahead. In fact, there will now be pressure on the mutual fund and insurance industry to re-look their cost structures carefully. A friend’s father has already planned to open NPS accounts, one for each grandchild, through getting his children to open accounts since he is above 55 years of age. The financially literate ex-railway officer has understood the product and its benefits and worked out that this is possibly the cheapest way to pass on his assets to the third generation.
Don’t let the intellectual nit-picking keep you from riding in this low-cost bus.
Monika Halan is a certified financial planner and policy analyst in the area of financial literacy and intermediation. Your comments and personal finance queries are welcome at firstname.lastname@example.org