The pension regulator has finally taken cognizance of the fact that pension fund managers (PFMs) under the National Pension System (NPS) shouldn’t outsource fund management to mutual fund companies. A circular issued by the Pension Fund Regulatory and Development Authority (PFRDA) on 20 August puts a cap on the amount of corpus the PFMs can invest in MFs to manage the equity corpus. PFMs can’t put more than 5% of their corpus in MFs for equity investment, and can’t levy an investment fee on this corpus.

If you are an NPS investor, it is good news for you as this directive forces PFMs to develop their internal fund management capabilities and saves you from paying double cost: an investment fee levied by the PFM and underlying costs of MFs. As a result of this circular, as things stand today, one PFM, Kotak Mahindra Pension Fund Ltd, gets affected because it had invested its entire equity portfolio in MFs. We explain the impact and what it means to you, but first some background.

Equity investment in NPS

The original architecture of the NPS rested solely on passive management for equity investment. As a subscriber, you couldn’t put more than 50% of your money in the equity fund and as the fund manager, this equity corpus had to be managed passively through index funds. But in 2015, going by the recommendation of the G.N. Bajpai committee, PFRDA allowed active investment—where the fund managers take a call on the scrips instead of replicating an index. The committee was of the view that active management would generate better returns.

In designing the investment guidelines for active management, PFRDA allowed PFMs to invest in MFs to allow them flexibility. However, the regulator didn’t specify the cap, making it possible for PFMs to invest the entire corpus in MFs. PFMs can only levy an investment fee of 0.01% of the investment corpus and this, for some PFMs, was insufficient to get the required skill set in-house for active fund management. MFs seemed a better choice.

For Kotak Pension Fund, investing in MFs was not one of the strategies but the only investment strategy. “The regulator allowed us to invest in MFs and that made a lot of sense for us because we don’t have a huge corpus size and despite the underlying costs of MFs, we were able to give better returns to investors," said Sandeep Shrikhande, chief executive officer, Kotak Pension Fund. Even LIC Pension Fund Ltd invested around 11-13% of its equity portfolio in MFs.

After the circular was issued, both PFMs diluted their MF holding. LIC Pension Fund now has less than 4% in MFs for private sector NPS and Kotak Pension Fund has around 50% of its corpus in them. Kotak Pension Fund is waiting for the exit load period to get over on some of the MFs it has invested.

What it means for you

If you are invested in Kotak Pension Fund, your fund performance may have seen a drop. As on 12 September, Kotak Pension Fund’s one-year return has been the poorest among all eight fund managers at 7.77% compared to an average one year return of 10.83% of all the eight fund managers and this the fund manager attributes to poor performance of underlying MFs and not to liquidating the portfolio for direct investment. “MFs have undergone some crucial reforms since December. First, it was the levy of long- term capital gains and then scheme re-categorisation. We have invested in 11 large cap diversified equity mutual funds and the returns reflect the return of these funds. If you were to look at returns till December, we were right on top," said Shrikhande.

We took an average return of large-cap diversified equity funds for the same period and the returns were lower at 6.56%.

The returns of Kotak Pension Fund don’t inspire confidence, but since NPS is a long-term investment vehicle, it’s in your interest to track the performance over a period of time before deciding to switch. Remember NPS allows you to change your fund manager twice a year at no extra cost online. You can also approach your point of presence, and switch the fund manager, by paying a nominal charge of around 20.

If you are a new investor, treat Kotak Pension Fund as a new fund manager as it has just started direct equity investment. “New investors should first check out the track record of other fund managers who are investing directly. Over time, once Kotak’s performance is established, investors can always make a switch," said Suresh Sadagopan, founder, Ladder7 Financial Advisories.

Mint Money take

Although a bit late, the circular will now make it difficult for pension fund managers to invest through MFs. “Investing in mutual funds was leading to layering of costs. Nowhere in the world this layering of costs is acceptable plus fund managers need to be able to manage funds on their own," said Sumit Shukla, chief executive officer, HDFC Pension Management Co. Ltd, which does not invest through MFs. “Also, the guidelines laid down and market cap requirement to invest in mutual funds will make it close to impossible to invest in mutual funds," he added.

The circular has upped the ante for PFMs to develop in-house skill set and it’s crucial given that now you can invest up to 75% of your money in equity funds which can go up to 100% in the coming years.