BackDoes NPS make investment sense now?
High returns, low cost and tax benefits make NPS attractive. But there’s more to analyse
Premium(Sneha Srivastava/Mint)
The budget announcement for financial year (FY) 2016 has made the National Pension System (NPS) more attractive. Investors will get an additional tax deduction of ₹ 50,000 if they invest in NPS. Also, doors have been opened for the scheme to compete with the Employees’ Provident Fund (EPF) by allowing an employee the option to choose between the two retirement vehicles.
“After the budget, queries about NPS have shot up. It is likely to get a lot of traction due to the tax advantage. We will again consider opening an online platform to invest in NPS by applying for distributor licence," said Srikanth Meenakshi, co-founder and director, FundsIndia.com. This mutual fund website used to facilitate online subscriptions to the product through a tie-up with IL&FS Securities Services Ltd, an NPS distributor, but stopped because the new rules needed it to become a sub-distributor, and also due to tepid response.
Given the recent buzz around NPS, you may be thinking about using this route to pension planning. It’s important, therefore, to understand the product, how it has performed and its tax advantages. Read on to find out.
It is a pure defined contribution product, wherein you invest till the age of 60 years. You can begin with a minimum annual contribution of ₹ 6,000 and your money gets locked in till you turn 60. Early withdrawals are discouraged by mandating you to annuitize at least 80% of that money. At 60, you need to buy an annuity—a pension product that gives you periodical payouts—with at least 40% of the proceeds. The remaining can be taken as lump sum.
Currently, NPS offers two types of accounts. The tier I account is basic, and works strictly like a pension product. The tier II account, which retirement account holders can open, works more like a savings account as it gives you the flexibility to withdraw any time.
Pension Fund Regulatory and Development Authority (PFRDA), however, is framing rules to allow liquidity even in the retirement account so that an investor can use the money to meet financial emergencies. These guidelines are expected to be announced in a month’s time.
The choice extends to the fund, the fund manager as well as an suitable investment strategy. There are three funds to select from. One is scheme E (equity), in which you can put up to 50% of your investment in equity. In scheme C, you can invest in fixed income instruments other than government securities. Scheme G lets you invest in government securities.
While the active choice lets you invest freely in any of these funds, the auto-choice option does an automatic lifecycle-based investing with maximum exposure to equity in the younger days, which tapers as you reach the retirement age.
There are now eight pension fund managers (PFMs) in the private sector—HDFC Pension Management Co. Ltd, ICICI Prudential Pension Fund Management Co. Ltd, Kotak Mahindra Pension Fund Ltd, LIC Pension Fund Ltd, Reliance Capital Pension Fund Ltd, SBI Pension Funds Pvt. Ltd and UTI Retirement Solutions Ltd. Birla Sun Life Insurance Co. Ltd is yet to start its pension fund management business. The fund management charge is currently fixed at 0.01%, making NPS one of the cheapest investment products available. But this charge structure, which PFMs say is unsustainable, is under review.
“NPS allows the flexibility to choose funds and fund manager. It’s transparent and low-cost, making it an attractive product to save for retirement. In comparison, EPF lacks this flexibility," said Hemant Contractor, chairman, PFRDA. EPF holds a debt portfolio and invests largely in government securities. It declares the interest rate every year (8.75% for FY15).
If its architecture makes NPS an elegant and cost-effective pension product, the returns give it a further push. The equity funds of all PFMs can invest in index funds that replicate either the Bombay Stock Exchange’s Sensex or the National Stock Exchange’s Nifty 50 index. These have performed better in the short term compared with returns since inception when benchmarked against Nifty. “That’s because in 2009, these funds started with passive management and were subsequently allowed active management. Last April, the rules were reversed to allow only passive management. Hence, short-term returns will mirror the benchmark returns more accurately," said Sumit Shukla, chief executive officer, HDFC Pension Fund.
The debt funds have also done well. For these, we used Crisil Composite Bond Fund Index for the corporate bond fund and Crisil 10-year Gilt Index for government securities fund. These indices are widely used to track NPS performance as there isn’t a determined yardstick for the product’s debt funds.
PFRDA reviews these funds quarterly, and according to a company executive, takes the help of rating agency Crisil Ltd in benchmarking the performances. However, PFRDA has not made any benchmark available to the public yet.
When compared with the benchmarks that we have taken, these funds have done remarkably better. The average return since inception of the government bond schemes (launched in FY10) is 9.09%; in comparison EPF has given an average of 8.70% since FY10. The corporate bond fund, or scheme C, has returned an average 10.65% over the same period. The equity fund, or scheme E, has given an average return of 13.25%.
But should returns alone swing your decision? “For a conservative investor, EPF still holds value. The fact that EPF has an attractive tax structure makes it a very good risk-free product, which we recommend even now. NPS is good for those who can stomach some amount of risk. So, the decision to choose between the two will also be guided by the investor’s profile," said Suresh Sadagopan, a Mumbai-based financial planner.
Although you now get extra tax deduction for what you invest in NPS, the maturity proceeds are still taxable. This fact holds most financial planners from throwing their weight firmly behind NPS.
The contribution in NPS qualifies for a tax deduction. Under section 80CCD of the Income-tax Act, 10% of the salary contributed in the NPS is eligible for a tax deduction up to ₹ 1.5 lakh. Over and above this, you get an additional deduction of ₹ 50,000, taking the total deduction benefit to ₹ 2 lakh. Apart from this, if your employer, too, chooses to contribute to your account, then contribution equal to 10% of your salary is deductible in your hands under section 80CCD(2).
“Most companies that we know take the employer route of contribution. So, the special allowance component given to the employee, which is taxable, is invested in NPS and that money becomes tax deductible in the hands of the employee. Doing so is useful as most employees would have exhausted the ₹ 1.5-lakh deduction limit through other products," said Amit Gopal, senior vice-president, India Life Capital Pvt. Ltd, an investment and legal consulting company that specializes in retirement benefits.
Under the EPF, you get a deduction of only up to ₹ 1.5 lakh under section 80C. But the proceeds from it are tax-free.
NPS maturity corpus is taxable. This means you have to pay income tax on the 60% that you withdraw from NPS. The annuities that you get are again considered income and are taxable. “In comparison, debt funds will make more sense because after three years an investor only needs to pay tax on the long-term capital gains. This effectively means 5-6% compared with income tax (rates) on NPS funds. Once the rules change and NPS, too, becomes tax-free, it will become a very good product due to low costs and structure," said Sadagopan.
Even as this tax anomaly is likely to get corrected, some feel this alone won’t be a deal-breaker. Manoj Nagpal, managing director and chief executive officer, Outlook Asia Pvt. Ltd, explained with an example. “Our calculations show that the thumb rule to achieve break-even to nullify the tax difference is 33 divided by the tenor. This takes into account like-to-like withdrawal assumptions in both EPF and NPS. So, for a 25-year-old with a tenor of 35 years, she will need to generate 0.95% additional return annually in NPS to nullify the tax difference. This is achievable and, so, EET (exempt-exempt-tax) treatment may not be a real deal-breaker."
Even as the government is working towards giving investors more choice, it will need an amendment to the labour laws, which make EPF mandatory for establishments with over 20 employees, for the choice to become truly relevant. This could be a long-drawn process.
But the good news is that NPS has been given a much needed boost through the additional tax break for investors instead of increasing commissions for distributor to push NPS. “We are also looking to make it more transparent. We have started publishing the net asset values (NAVs) and returns on our website, and in coming days, we will take further steps to improve transparency," said Contractor. The returns can be seen on www.npstrust.org.in.
In the coming months, other aspects of NPS such as investment guidelines and fund management charge will also get formalized. Then you can take a better decision on NPS.
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