Let’s start with a quick intro about National Pension Scheme(aka NPS). NPS is basically a government-initiated pension scheme. Salary employees and the self-employed lot can voluntarily invest in this scheme and claim tax deductions under Section 80CCD. NPS investors can claim an additional tax benefit up to Rs. 50,000 under Section 80 CCD (1B) too in retirement.
NPS is a major step taken by the government to turn India into a pensioned society. And with tax benefits being the key driver of investment decisions here, NPS is quite a lucrative option.
Tier I is Pension Account and mandatory.
Tier II is Savings Account and optional. Government Servants appointed on or after 01.01.2004 can open only Tier II Account since Tier I is maintained by their DDOs.
BENEFITS OF NPS
Some of the benefits of the National Pension System (NPS) are:
- It is transparent – NPS is transparent and cost effective system wherein the pension contributions are invested in the pension fund schemes and the employee will be able to know the value of the investment on day to day basis.
- It is simple – All the subscriber has to do, is to open an account with his/her nodal office and get a Permanent Retirement Account Number (PRAN).
- It is portable – Each employee is identified by a unique number and has a separate PRAN which is portable i.e., will remain same even if an employee gets transferred to any other office.
- It is regulated – NPS is regulated by Pension fun regulatory and development authority with transparent investment norms & regular monitoring and performance review of fund managers by NPS trust.
- Corpus is only partially tax-free At age 60, maximum 60 per cent of the corpus can be withdrawn while annuity is paid on the balance 40 per cent of accumulations. Although, maturity corpus was made partially tax-free by giving tax-exempt status to 40 per cent of the corpus amount, the balance 20 per cent of the corpus that can be withdrawn still remains taxable. One may, however, defer the lump sum withdrawal till age 70, or to avoid paying taxes on this balance, one may club it with 40 per cent annuitisation amount to buy annuity.
- Funds get locked in for long
NPS is a retirement-focused investment scheme. Typically, there are two stages for someone who wants to accumulate funds for retirement. First is the accumulation phase during which one keeps investing till the vesting age, i.e., the retirement age, and the other is the de-accumulation phase when one starts getting the annuity or the pension.
- No 100 per cent equity option
Saving for retirement is a long-term goal. Several studies have shown that equities have delivered high inflation-adjusted return as compared to other assets such as debt, gold, and real estate, over long-term. NPS currently offers a choice to invest 50 per cent of investment into equity under the scheme E fund option. About 50 per cent of one’s investment in NPS even in the scheme E fund option is into debt.
- Lack of active fund management
NPS fund management currently follows a passive approach. Various NPS funds track different indices. Alternatively, one may invest through a mix of actively traded open ended equity and debt mutual funds during the accumulation phase to create a corpus. The Pension Fund Regulatory and Development Authority (PFRDA) is, however, considering active fund management in near future.
- Compulsory annuitisation hampers diversification On the vesting age (maturity age) in NPS, minimum 40 per cent of the accumulated corpus has to be compulsorily invested in an Immediate Annuity scheme which has to be purchased from an insurance company. The amount gets locked in for lifetime. Illustratively, if one creates a corpus of Rs 50 lakh in NPS, then Rs 20 lakh (40 per cent, if exiting NPS at age 60, and 80 per cent if exiting before age 60) will be used to buy Immediate Annuity scheme that will fetch pension for lifetime. The amount of Rs 20 lakh will never be returned to the individual.
- Annuity is taxable
Annuity is entirely taxable in the hands of the individual in the year of receipt. The income in the form of pension, therefore, adds up to the tax liability of the retiree. On the other hand, dividends from mutual funds are either tax-free (equity-oriented) or have lower incidence of taxation (indexation benefit on non-equity funds).
- Corpus used for annuity is not returned
By its very nature, an immediate annuity product does not have the provision of return of capital to the investor himself. The corpus or the amount used to purchase annuity is never returned to the individual. There are about seven to 10 different pension options, including pension for lifetime for self, after death to spouse and post that the return of corpus to heirs.
- Low annuity returns
The annuity returns across various pension options are currently at around 6 per cent per annum. Such low returns will hardly be able to beat inflation. In decreasing interest rate scenario, these may appear fine, unless insurers revise them downwards. The rates are guaranteed for the entire term of the pension option as chosen by investor.
It is a very long-term investment product, so make sure you understand the implications and the working of NPS before opening an account. Estimate the amount of monthly savings required to meet your post-retirement expenses, keeping the inflation and your life expectancy in mind. Diversify across various investments, including mutual funds and NPS, but do not bank entirely on the latter.Annuities can provide a baseline support to meet household during retired years, but choosing NPS to accumulate a retirement corpus remains a choice which one needs to take now. A corpus created through a mix of mutual funds can still buy you an Immediate Annuity scheme when you are 60, with all your savings at your disposal.Listen to the call of your distant retirement and start saving for it now. Remember that delaying and procrastination can be damaging.
National Pension Scheme (NPS) will not provide you the pension or annuity
One of the biggest myth many of us holding since long is that National Pension Scheme (NPS) will provide us the pension when we retire. Sadly the answer is NO. National Pension Scheme (NPS) will help you to accumulate the retirement corpus. Using this retirement corpus you have to buy an annuity product or pension product from Life Insurance companies like LIC’s Jeevan Aksya VI.
Risks in Scheme G (Govt Securities) Fund and Scheme C (Corporate) Fund
Do you feel SAFE if your money is invested in Scheme G (Govt Securities) Fund or Scheme C (Corporate) Fund?? It is not so safe like what you thought?
Before I point out the risk, you must understand three important principles of the bond market and they are as below.
- Credit Risk-
Your National Pension Scheme (NPS) invest in Government securities and in Corporate Bonds. The credit quality of these underlying instruments are measured in terms of ratings.Usually higher the ratings lead to lower the return or risk. It is a misconception among many that credit risk refers to risk of default by the bond issuing entity. However, the truth is something different.There is a possibility that the credit rating of a bond or instrument the fund is holding may change at any point of time. Let us say ABC Debt Fund holding the bond of XYZ which is rated as AAA by credit rating agencies (highest rating).
- Modified Duration-
It is a measurement of a bond’s sensitivity to movements in interest rates. It is usually measured in years. For example, if debt mutual fund with the modified duration of 3.1% means if there is a 1% interest rate movement then the fund will undergo the movement of 3.1%.Hence, higher the modified duration means higher the interest rate risk.
- Average Maturity-
A debt fund portfolio usually consists of a number of bonds where each could have a different maturity date. Maturity is the time period remaining before which a bond comes up for repayment by the issuer. Average maturity is simply the weighted average time left up to the maturity of the various bonds in a portfolio.Higher the average maturity greater the interest rate risk of a debt fund.