If you are someone who wants an active say in asset allocation—to decide how much to put in equity and debt funds—the National Pension System (NPS) may not excite you because investors today can’t invest more than 50% in equity through active choice. That’s about to change to an extent as the Pension Fund Regulatory and Development Authority (PFRDA) has released a concept note for public comments on allowing investors to increase their equity allocation to 75%. Not a 100% yet, but better than 50%. The note is up for comments and you can read it here.
While this change would impact mostly those who choose ‘active choice’ investing, it is also proposed that at age 50 the equity investments will begin to taper so that by 60 (when the investment matures), equity is not more than 50%. Higher allocation to equity is good for long-term investors but will it make NPS the go-to retirement product? Not yet, because you will need to commit 40% of the maturity corpus to a pension product. Let’s see how this will impact you.
The NPS currently offers four investment funds to choose from. These are: government securities fund or scheme G; corporate bonds fund or scheme C; equities fund or scheme E; and alternative investment fund or scheme A.
There are two ways to invest in these. First, your money can be invested according to a predetermined plan (life cycle based approach), in which your investment is structured to your age and tenor of your NPS investment. NPS had started with a moderate life cycle plan where the maximum exposure to equity was 50% till 35 years of age; this reduced to 10% by age 55. In 2016, as per recommendations of the Bajpai Committee report—which was set-up to review the investment pattern of NPS—two more life cycle funds were launched: aggressive and conservative. The aggressive life cycle fund starts with equity allocation of 75% till 35 years of age, and the conservative option starts with equity allocation of 25% till 35. The aggressive fund tapers equities to 15% by age 55 and the conservative fund tapers it to 5%. Life cycle funds don’t invest in the alternative investment fund.
Those who choose the other option—active choice—can never put more than 50% in the equity fund. However, they are free to decide their asset allocation and can invest in any of the four schemes in the proportion they want, within the overall caps, which includes a 5% cap on alternative investments. PFRDA wants to raise the limit on equity allocation to 75% under this option, from the earlier 50%.
Raising the limit in active choice helps because the life cycle fund doesn’t solve the problem for, say a 45-year-old who wants an aggressive investment strategy. Even under the aggressive life cycle scheme, equity would be capped at 35% for her. This is where the proposal to increase equity allocation to 75% under active choice investing comes in. But this flexibility is allowed only till 50 years of age. After that, you will need to reduce your equity investment each year so that when you retire, you have no more than 50% in equity. The money freed from this tapering can be invested in other funds.
The genesis of PFRDA’s proposal is in the Bajpai Committee’s report, which recommended complete flexibility: investors should be able to put all their money in equity. To achieve this, the committee recommended allowing an increase in equity to 75% through the life cycle fund first, then 75% allocation in the active choice and finally lifting the cap. PFRDA’s concept note says, the proposal to hike equity allocation is also inspired by customer demand and the fact that as India moves to a developed economy, the interest rates are expected to come down; so allowing a higher equity allocation will enable fund managers to generate better returns.
NPS has a low fund management charge of 0.01%, which could go up, said Sumit Shukla, chief executive officer, HDFC Pension Management Co. Ltd. “NPS funds are actively managed which means they have the capability to generate an alpha. An investor benefits from this but at the price of passive funds," he said. Another advantage of NPS is its tax benefit. There is an extra deduction of Rs50,000 under section 80CCD (1b) of the income-tax Act, which is in addition to the overall deduction of up to Rs1.5 lakh under section 80C.
However, a big drawback is that NPS mandates subscribers to use at least 40% of the maturity corpus to buy an annuity product. “NPS is illiquid, as you can’t withdraw the money completely but have to buy an annuity with a portion of that money. Annuities mostly have low returns and if someone is putting money in NPS today, then she is locking a portion of her money to annuities at a future date, when the interest rates could be really low. I would recommend mutual funds with a combination of debt and equity with a systematic withdrawal plan (SWP) to tailor retirement income," said Deepali Sen, founder, Srujan Financial Advisers LLP.
Also, the tapering of equity exposure from 50 years doesn’t sit with some planners. “Even at 50, a person has minimum 10 years left for aggressive investment, so NPS should leave the choice to the investors. NPS makes sense for the not-so-savvy investors but they should park only a portion of their investments in NPS. Owing to its illiquid nature, it’s still not the main retirement product I would recommend," added Nikhil Vikamsey, partner, Alpha Capital.
Greater equity is welcome but you should diversify to target retirement and not treat NPS as the sole vehicle for retirement planning.