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 (Photo: iStock)
(Photo: iStock)

Opinion | Fix design flaws in NPS to make it more appealing

An obvious solution is to find ways to increase households’ retirement savings, especially given the compressed fiscal headroom the government now faces

This was an eagerly awaited budget, one that followed a landslide political victory. An important imperative is to spur growth, and such immediate priorities will likely take precedence over longer-term considerations. But ignoring longer-term considerations can be perilous.

By 2031, the elderly population in India is expected to grow as much as 75%. However, as the RBI Household Finance Committee highlights in its report, a large fraction of the elderly does not have adequate resources to finance consumption during retirement. Moreover, retirees are particularly vulnerable to adverse health shocks, necessitating additional consumption. It gets worse in the event of an economic downturn—increased demand on public health services, compressed government resources, and diminished private income together make for a grim scenario.

An obvious solution is to find ways to increase households’ retirement savings, especially given the compressed fiscal headroom the government now faces. There is hope—the National Pension System (NPS) is, by and large, a good product. However, several problems with its design and tax incentives have impeded Indian households from adopting it.

Tax incentives for pension plans around the world are generally structured in one of two ways. The ISA in the UK and the Roth IRA in the US are tax-free “wrappers". Investments inside these wrappers grow free of taxes and withdrawals are untaxed. However, commitments into these schemes come from post-tax income. An alternative, like the 401-k plan in the US, is to tax investments at the point of exit, but to provide tax exemptions at the point of commitment.

NPS is a strange hybrid. It offers tax deduction on commitments—an NPS-specific deduction of 50,000 in addition to a 1.5 lakh umbrella deduction for long-term savings (including Employees’ Provident Fund and PF contributions) under Section 80C. However, it also exempts some withdrawals—lump sum withdrawals (up to 60% of the amount)—though the annuitized fraction (a compulsory 40%) is taxed.

There are at least three problems with this design. The first is the complexity involved in NPS tax treatment. Anything difficult to explain is difficult to sell to households, who respond strongly to tax incentives. Streamline these incentives—either tax only on entry, or only on exit.

The second problem with NPS is that the design complexity is counterproductive in other ways. The scheme taxes annuitized amounts, but rebates exempt lump sum withdrawals. This disincentivizes annuitization. One reason that annuitization is beneficial is because households (and indeed governments) are notoriously poor at estimating longevity, which has been steadily increasing over time. Squandered lump sums plus longer-than-expected life spans mean that the government is ultimately on the hook to bail out retirees. The recommendation is simple—treat lump sums in the same way as annuitized amounts; and push up the compulsory annuitized fraction while you’re at it.

The third problem is that NPS-specific tax deduction of 50,000 is tiny relative to the income level of the desired savers. According to the Ministry of Statistics and Programme Implementation (MOSPI), the per capita income in FY2018 was 1.13 lakh per annum. This income level is certainly many multiples higher for the segment of the population that has the resources to invest in NPS. If we assume an income of 10 lakh per annum for this group, we get a ratio of the tax-exempt amount to income of 1 to 20. In the US, which has a flatter income distribution than India, the average per capita income is 53,000, and the annual 401-k tax contribution limits are 19,000 giving us a ratio of roughly 1 to 3. Recommendation: raise the deduction exemption threshold for NPS commitments.

Changes to the design should be complemented by changed incentives to distribute NPS. Currently, the pension fund management company receives capped management fees (contribution charge of 0.25% with an annual management fee up to 0.10% per annum). These levels are inconsequential compared to similar systems elsewhere (contribution charge of 1.80% with an annual management fee of 0.30% per annum in the UK). These nugatory distribution incentives are clearly insufficient to persuade distributors to sell the product. The government could raise these caps, perhaps by increasing trail commissions. Another solution is to enroll households into NPS by default, when they enter formal employment. This could be complemented by rationalizing the current alphabet soup of pensions vehicles (EPFO, PF, Atal Pension Yojana), in favour of backing a single product with excellent design features.

Help for current and future retirees is a continuing need. While the NPS wasn’t fixed in this budget, let’s hope it will be in the next one.

Tarun Ramadorai is professor of financial economics at Imperial College, London

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