Why NPS should be part of your retirement portfolio

For starters, NPS was introduced by the government in 2004 to overhaul its pension plan by transitioning from a defined benefit plan to a defined contribution plan. In the former, the government distributed a certain amount periodically after retirement. Post the transition, there is a fixed contribution amount and the amount to be disbursed depends on the size of the corpus that has accumulated at the time of retirement.

Contribution to NPS enjoys superior tax treatment compared to mutual funds on two fronts. Firstly, tax deductions of up to ₹50,000 can be claimed per year, over and above the ceiling of ₹1.5 lakh that an individual is eligible for under section 80C of the income tax Act.

To illustrate its benefit, let us assume that a person in the 30% income tax bracket wants to invest ₹50,000 in an NPS account. The individual can claim tax deductions for contribution towards NPS at the end of the financial year while filing returns and can so save ₹15,000, a sum which would otherwise be deducted from salary as tax

This is not the case with mutual funds, unless they are equity linked savings schemes (ELSS) that one can claim as deduction under section 80C. There are no deductions for investments in other types of mutual funds. Thus, investing in NPS gives a 15% head start over that in mutual funds (non-ELSS).

Besides the ₹50,000 per year, about 10% of a corporate employee’s basic salary and dearness allowance up to ₹7.5 lakh can be claimed as deductions if it is registered as an employer’s contribution.

Subscribers to NPS also get another benefit. There is no tax at the time of withdrawing the corpus (although NPS annuity is taxed). However, capital gains on equity mutual funds are taxed at 10% at the time of redemption and that for debt mutual funds at the slab rate.

Ravi Saraogi, co-founder of Samasthiti Advisors, said NPS is suitable for most individuals who don’t have much time to spend on investments, while those with the required expertise or support from advisors can make better asset allocation with mutual funds. However, NPS is better than solution-oriented funds like retirement mutual funds, as such funds cannot create individual specific asset allocation and all investors in a retirement mutual fund are assigned the same asset allocation portfolio whereas in NPS, the asset allocation changes dynamically for each subscriber based on their age.

To be sure, any amount invested in NPS is locked in till the age of 60. After that, you can take out 60% of the corpus as a lump sum and the remaining can be invested in an annuity product. The periodic interest from the annuity is fully taxable at the slab rate. After one attains the age of 75, it is mandatory to exit NPS and invest 40% of the corpus in an annuity product.

On 30 October, the NPS got a new update. The Pension Fund Regulatory and Development Authority (PFRDA), which regulates NPS, released a circular allowing a systematic lump sum withdrawal plan (SLW) for its pensioners. This simply means that investors can now withdraw a part of the 60% lump sum amount based on their desired intervals (monthly, quarterly, half-yearly, or annually) and also decide the amount they want to withdraw each time.

Prior to this mechanism, people had to withdraw the entire lump sum amount all at one go on attaining the age of 60 or place redemption orders annually to take out their funds. With the SLW, which is similar to the mutual fund withdrawal plan, they can now automate this process.

Assuming a person has accumulated ₹2 crore in an NPS account at the age of 60, then ₹1.2 crore or 60% of the corpus can be withdrawn as a tax-free lump sum and the remaining ₹80 lakh can be annuitized. The interest on the annuity part will be taxed as per the slab rate.

Some tax experts have taken the view that returns on pension corpus after maturity (typically, age of 60) will be taxable. However, even if this is the case, the effective tax rate on SLW is likely to be small.

One criticism that NPS faces is the mandate to compulsorily invest 40% of the corpus in annuity products. This is because annuities yield a meagre 6-7% interest compared to NPS Tier 1 Equity funds that on average give about 13.31% returns annually. The 10-year average return of NPS Equity funds (13.31%) is also better than Nifty Bees (13.27%) and large cap mutual fund (12.21%).

Sumit Shukla, managing director and CEO of Axis Pension Fund, said people can use the SLW facility for regular pensions and delay the annuity till they turn 75. That way, the 40% that is invested in annuities can also enjoy longer tax-free compounding for another 15 years till the individual turns 75.

Prior to SLW, subscribers of NPS could take out the 60% lump sum amount and put it in a debt or equity mutual fund and opt for systematic withdrawal. The disadvantage here is that capital gains tax has to be paid during such withdrawals, apart from the applicable entry and exit loads. Also, if at any point, MF unitholders want to change the scheme they have invested in, they will have to pay the applicable capital gains tax and exit loads. In NPS though, the fund manager could be chosen once or twice a year without any charges.

You can also withdraw up to 25% from the NPS corpus before turning 60. This function is called ‘partial withdrawal’. The NPS Trust website has specified certain instances when you can avail of this withdrawal facility. These include the higher education of children, marriage of children, purchase or building of a house, hospitalization of self or a family member, medical expenses arising out of disability, reskilling (as permitted by PFRDA), or for starting a new venture or a startup. You can use this withdrawal facility only three times during the tenure of the NPS account.

On the other hand, if you want to exit completely from the NPS scheme, you will only get 20% of the corpus amount as a lump sum while the rest has to be invested in annuities. Corpus of up to ₹2.5 lakh can be fully withdrawn as a lump sum. “These are tough conditions and premature exit is not recommended. In the case of death, the entire money goes to the family," said Shukla.

 

NPS allows people to choose where they want to invest their money. There are broadly four asset classes to choose from: equity, corporate debt, government bonds and alternative investments. The maximum allocation one can have in equities is 75%. The maximum allocation to alternative funds is capped at 5%.

On the other hand, NPS also has an automatic choice option called ‘life cycle fund’ which pre-decides the allocation to each asset class according to age. As the age increases, more volatile assets like equity and corporate debt keep reducing from the portfolio.

According to your risk appetite, you can choose one among three ‘life cycle funds’ available namely: aggressive, moderate, and conservative life cycle funds.

Aggressive fund starts with a maximum equity exposure of 75% until age 35 and gradually reduces it to 15% when the individual is 55 years old. In a moderate life cycle fund, the maximum equity allocation is at 50% till 35 years and kept at 10% after the age of 55. In a conservative life cycle fund, the maximum equity allocation is capped at 25% till age 35 and it keeps reducing from there to 5% in those aged 55 and above.

NPS subscribers also have to choose a pension fund manager from among three government firms and 5 private pension managers.

“Mutual funds are for shorter term goals, but the NPS is built for very long term goals like retirement. Here, the structure and fund managers are also such that the funds are managed to keep in mind the retirement needs. In pension products, we cannot afford to get swayed by short-term euphoria like how small-cap funds are picking up in the MF space" said Shukla of Axis Pension Fund.