NPS used to be a good product in a bad market. It has now shifted over to being a part of the bad market. It can now neither compete on costs with ETFs nor in simplicity
ICICI Prudential Mutual Fund’s new fund offer (NFO) of Bharat 22 exchange traded fund (ETF) is in the market this week seeking investor money for the government’s disinvestment programme. Looking through the document, I was struck with the expense ratio of this fund. At 0.0095% per year, this is the cheapest ETF in the market today. Understand what this cost means first. The expense ratio describes the price you pay for the facility of handing your money over to a fund manager and it is charged on your funds under management. For example, a Rs10 lakh corpus, with an expense ratio of 1%, will cost you Rs10,000 a year. You don’t have to cut a cheque for this cost since it is taken by the fund house out of your corpus—that’s why it is called net asset value, it is ‘net’ of costs. Expense ratios have a big impact on investor returns over a lifetime of investing. At 0.0095%, Bharat 22 will cost you Rs95 a year. Reliance AMC’s CPSE ETF (the first government disinvestment fund) costs 0.07% or Rs700 a year. A 2% managed fund expense ratio costs you Rs20,000 a year.
ETF costs have been falling over time in India. Three of the cheapest broad market ETFs (these track indices like Sensex and Nifty) cost 0.05% currently and there are more than 10 ETFs with costs of 0.10% or less. Other than an expense ratio, ETFs have other costs— brokerage and depository fees and charges—with brokerage costing about 0.20% to 0.40% of the investment and depository participant (DP) costs between Rs300-700 a year. Some of these costs are negotiable with your service provider and some are shared with the other direct equity trades you may do. But it is safe to say that ETF costs are now wafer-thin. Here’s a prediction, as the ETF market gets bigger, I expect that it will eat the lunch of the erstwhile low-cost and simple product, the National Pension System (NPS). NPS was supposed to be India’s very-low-cost, mass-market pension product that had a simple product structure, few cost heads and was misselling-proof. All that is history now. With constant tinkering to the basic structure, the NPS today is a mess with more than 10 cost heads (see this excellent story by my colleague Deepti Bhaskaran for a table of costs). Worse, it is open to manipulation by the distributor for gathering a higher commission.
A colleague got a WhatsApp forward that compared the incentives of selling NPS versus mutual funds. Aimed at the distributor of financial products, the message was using a strategy that would yield a higher commission for the NPS seller over mutual funds. Pension Fund Regulatory and Development Authority (PFRDA) rules allow an upfront commission of 0.25% of the investment, subject to a minimum commission of Rs20 or a maximum of Rs25,000 a year. Some pension fund managers are encouraging NPS sellers to break a single investment of Rs2,000 into Rs1,000 monthly contributions to harvest more commissions (see table). Till a monthly investment of Rs8,000, it makes sense for the distributor to switch from annual to monthly contributions. After that the arbitrage goes away.
NPS at its core was designed to keep such situations of arbitrage at bay. Encouraging a systematic investment plan (SIP) to get rupee cost averaging is a different story from encouraging it to harvest commissions. Where did the NPS lose its way? It began with the Bajpai Committee that was set up by the erstwhile PFRDA chairman Yogesh Agarwal. The report practically overhauled the NPS product to make it more competitive than other products in the market—life insurance and mutual funds. The first tinkering began then with the basic structure of the product and PFRDA has gone on chipping away at it so that today the NPS has a complicated cost structure, is allowed to invest in actively managed products (earlier NPS could only invest in index-linked equity products which are lower risk than managed funds) and has upfront commissions that the investor pays. There are 10 heads under which charges are levied and it does look as if PFRDA has lost the plot. It wants to take the battle to the insurance industry by encouraging commissions, but a 0.25% commission won’t cut any ice when the competition is doing 40% plus. The hiking of upfront costs from Rs125 to Rs200 (read this story for more) and an additional persistency charge of Rs50 a year is not enthusing distributors but is encouraging commission arbitrage strategies that don’t have investor interest in mind. PFRDA should have followed the example of the mutual fund product structure that puts all the costs under one head—expense ratio—and leaves the apportioning of costs to different functions under the bonnet. A bureaucratic tinkering of costs and heads has destroyed the NPS.
NPS used to be a good product in a bad market (see this video where I make that case). It has now shifted over to being a part of the bad market. It can now neither compete on costs with ETFs nor in simplicity. Risk-averse investors who do not want fund manager risk (the risk of the decisions of a fund manager going wrong) but want to take a generic, that is, they are fine with getting an index-based return, will do well to use the ETF route to long-term wealth creation targeting their retirement. The extra Rs50,000 tax break that the NPS enjoys may finally not be worth the while.
Monika Halan works in the area of consumer protection in finance. She is consulting editor Mint and on the board of FPSB India.