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The National Pension System (NPS) is part of the small savings schemes launched by the government of India to promote Indian citizens to invest for their retirement. Launched in 2004, this scheme was earlier meant only for government employees; but from 2009, it is open for any eligible Indian who voluntarily wishes to invest in the NPS.

Eligibility

Any Indian citizen between 18 and 65 years of age can invest in the NPS. An non-resident Indian (NRI) can also invest through NPS, but the account will be closed if the citizenship status of the NRI changes.

How does NPS work?

An investor contributes up to 10% of his/her salary every month, into a pension account. The employer matches this contribution every month. On retirement, a certain part of the accumulated amount can be withdrawn, and the remaining is invested in an annuity that yields regular pension income to help through retirement.

Under this scheme, which is regulated by the Pension Fund Regulatory Authority of India (PFRDA), the investor has to open an NPS account at a point of presence (PoP). Various financial institutions, including private and public banks, are empanelled as PoPs, and an investor can open an NPS account at these PoPs by submitting the necessary documents physically. The account can also be opened online with the help of your PAN card and Aadhaar card.

Tier-I vs tier-II

On opening an NPS account, the investor receives a 12-digit unique number called the Permanent Retirement Account Number (PRAN). Once the investor has a PRAN he/she has two options—tier-I and tier II. Tier-I is the default option for anyone who chooses to invest through NPS, and it permits no withdrawal till retirement. Tier-II is the voluntary option under which premature withdrawals are permitted but tax benefit is limited there.

So, while tier-II option offers no tax benefit, the withdrawal facility and no lock-in period make tier-II option appealing. While some investors only look at NPS as a pension product, the truth is that through NPS, an investor can invest in various asset classes such as equity, corporate bonds, government bonds and alternative assets such as Real Estate Investment Trusts (Reits) and Infrastructure Investment Trusts (InvITs)", says Nishith Baldevdas, a registered investment adviser and founder of Shree Financial.

Active vs auto

An investor must also choose between active and auto options depending on how he/she wants the money to be invested in the asset classes mentioned earlier. The investor who picks the active option has to decide the asset allocation pattern and percentage allocation towards each asset class in which he/she wants the pension fund to invest his/her money.

“It is advisable to choose the active choice only if you have a good understanding of how equity, debt and alternative investments work, and how they can be used to achieve financial goals," says Baldevdas.

If one takes the auto option, the money is automatically invested by the pension fund managers (PFMs) in accordance with the age of the investor. With a maximum asset allocation of 75% to equity, and a constant reduction in equity exposure with increasing age, this choice is good for those who are saving for their retirement and don’t have in-depth knowledge about financial planning and asset allocation.

Choosing a PFM

The investments made in NPS are managed by designated PFMs such as Birla Sun Life, HDFC, ICICI Prudential, Kotak Mahindra, LIC, SBI, and UTI. These PFMs manage the NPS investments as per the age, risk profile and asset allocation of the investors. While the NPS scheme does not have fixed returns such as interest, the funds managed by PFMs provide annual returns in the range of 4% to 15% per annum depending on the asset class chosen. It is very important for an investor to choose an asset allocation and PFMs that meet his/her requirements.

Contributions and withdrawals

The investor must invest a minimum amount every year to keep the NPS account active and must remain invested till the age of 60. At 60, the investor can withdraw up to 60% of the corpus tax-free. 40% of the corpus must be used to buy an annuity from a specified insurance company. This annuity will provide monthly pension income to the investor, thus helping an investor after retirement.

Before attaining the age of 60 years, the investor can make partial withdrawals up to 25% of corpus for specified purposes such as a child's education or marriage, meeting a medical emergency or buying a house. However, for these partial withdrawals at least three years must have lapsed from the date of opening the account. Such withdrawals are limited to only three times during the entire tenure. Under tier-II the investor can withdraw any number of times without any restrictions.

Tax benefit

An investor under tier-I, is eligible for a deduction of up to 150,000 under Section 80CCD of the Income Tax Act on the employer and employee contribution. An additional 50,000 is also exempt from tax under Section 80CCD (1B) on an individual's self-contribution. Thus under tier-I, an investor can get a tax deduction up to 200,000 every year. Under tier-II, an investor who is a government employee can claim benefits under Section 80C; however other investors get no tax benefit.

Advantages and disadvantages

Apart from tax saving, the other advantage of NPS is how it helps investors systematically prepare for retirement. Further, NPS is also a low cost investment with government backing.

“Even though NPS is preferred for retirement, the fact that it enforces at least 40% of the accumulated corpus be invested in annuities, is a drawback for some investors. It is especially so for investors who may not want a monthly pension and instead want to grow their money. Further investors can choose only one PFM who may or may not be having expertise in all the different asset classes covered by NPS," says Baldevdas.

NPS is still a good way to start investing for retirement as annuity meets the monthly income needs of many retirees. The NPS is also for those investors who are either conservative or those who do not have adequate knowledge or time to invest money. Such investors can select the auto choice wherein the asset allocation and rebalancing is done automatically. All in all, NPS is a systematic way to save for retirement in combination with other equity investments like mutual funds and stocks.

Listen to our podcast on the National Pension System here.

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