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For Indian savers, National Pension System (NPS), a retirement saving instrument first set up in 2004, brings some powerful advantages. It is low-cost, allows exposure to equity (up to 75% of the corpus) and is reasonably tax-efficient. NPS is compulsory for government employees who joined service after 2004 and it was opened to the private sector in 2009. Despite its many advantages, a set of key limitations have prevented it from realizing its full potential as a market-oriented retirement product.

In this piece, we explain the advantages and limitations of NPS and how savers can integrate it into their retirement planning.

Source: Value Research
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Source: Value Research

Advantages

Under NPS, the pension you get depends on the performance of your investments. You can choose between equities, government bonds and corporate bonds with equities capped at 75% of the corpus. NPS contributions are eligible for tax deduction under Section 80C of the Income-tax Act, 1961, up to 1.5 lakh and also under Section 80 CCD (1B) up to an additional 50,000. However, the product falls short of the exempt-exempt-exempt (EEE) treatment that Employees’ Provident Fund (EPF) and Public Provident Fund (PPF) enjoy.

While 60% of the accumulated corpus is tax-free on maturity at the age of 60, the remaining 40% must be used to buy an annuity (fixed pension) which is taxable.

Some investors look to investing in mutual funds and insurance products to build their retirement savings. However, compared to these, NPS is extremely low-cost. Pension fund manager fees in NPS is currently capped at 0.01% and a proposed hike in the next round of fund manager licences may bring them up to 0.09%, which is far lower than what most other financial products charge. For example, mutual fund expense ratios are capped at 2.25%, while insurance policies come riddled with even higher charges. Unit-linked insurance plans (Ulips), which are market-linked, generally have premium allocation, administration, fund manager and mortality charges. Normally, the overall charge in Ulips is 2-3% if you don’t surrender mid-way. The charges can vary from policy to policy.

“The objective of NPS investment is to have a retirement corpus which will help the retiree to meet his expenses and annuity generated through the NPS corpus helps achieve that. To bring flexibility in the same, NPS allows subscribers to withdraw up to 60% of the corpus as a lump sum at the time of retirement which is completely tax-free. The remaining 40% of the corpus needs to be invested into an annuity plan provided by various annuity service providers," said Sanjiv Bajaj, joint chairman and managing director, Bajaj Capital.

limitations

NPS has some major limitations.

Long lock-in period: If you started investing in NPS at the age of 35, your money will get locked up for 25 years. Partial withdrawals of up to 25% of your contributions are permitted, but only on specific grounds such as higher education or marriage of children, covering expenses related to the treatment of coronavirus, among others.

So, if you don’t like your money to get locked in for a long time, and want a greater degree of control on your finances, NPS may not be right for you.

“A combination of greater flexibility in terms of reinvestment of the corpus and higher tax breaks on withdrawals will go a long way in making NPS a preferred investment option," said Adhil Shetty, CEO, Bankbazaar.

However, Mrin Agarwal, founder director, FinSafe came out in favour of the lock-in. “Actually, I feel that this is a good feature of NPS since it makes the investor hold till retirement and, hence, they benefit from the compounding effect. Otherwise, people are prone to withdrawing for their needs (like EPF is often withdrawn for a down payment of house or education) and this affects the retirement corpus in a big way. The lock-in benefit in NPS provides a nudge to have more at 60 years," she said.

You are forced to buy a taxable annuity: When investors reach their retirement age of 60, they are forced to put 40% of the corpus in a low-yield and tax-inefficient option. If they exit before the retirement age, 80% of the corpus needs to be used to buy an annuity. This annuity, when received, is taxable in the year of receipt.

“The lack of flexibility in reinvestment options post maturity is one of the main issues. At least 40% of the corpus mandatorily needs to be invested in an annuity. The yields from annuities are paltry, in the range of 3-7% pre-tax, making it an incompetent instrument to beat inflation," said Shetty.

However, the Pension Fund Regulatory and Development Authority (PFRDA), which regulates NPS, is contemplating some changes. In an interview with Mint, PFRDA chairman Supratim Bandyopadhyay has proposed to the government to make annuity tax-free for senior citizens in the upcoming budget (read here: bit.ly/3swYLe2).

Despite the above limitations, NPS is an effective tool for building a retirement corpus, said Shetty. “There are various equity and debt options to invest in based on your risk appetite, ranging from 100% investment in government bonds to 100% investment only in high-quality corporate bonds to 75% investment in equity. At all times, at least 25% of the investment remains in debt options, which increases the security of capital without compromising on the returns in a big way," Shetty said.

Experts are also optimistic about future reforms. “At present, NPS has remained a market-linked pension scheme but PFRDA recently said that an assured returns plan is also in progress, which will attract more subscribers who are seeking guaranteed returns," Bajaj said.

Watch this space to know if the new budget will have some reforms in store for NPS.

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