Wait, NPS still has issues as a retirement asset

Wait, NPS still has issues as a retirement asset 1
The recent announcements on improvements in the New Pension Scheme (NPS see here) have created a lot of buzz around the scheme. The most impact is seemingly from the new ‘Exempt-Exempt-Exempt’ (EEE) nature of NPS. In this post we see why NPS is still not a good enough choice for most people as a retirement asset. This is mainly due to constraints on asset mix, early withdrawals and distribution. The discussion focuses on the non-government models in NPS.

Design of NPS

Before we discuss the suitability of NPS, let us look at some salient factors of NPS that are relevant to the discussion.  NPS is a reasonably complex system with multiple facets.

NPS models

NPS started off as a replacement for the previous, defined-benefit, pension system for central government employees. It was later extended to all citizens of India. However, there are 3 models of NPS and they differ quite significantly in many aspects. 
  • Government Model – This is applicable to the employees of the central government. Those who joined after Jan 1, 2004 are compulsorily part of the system. Many state governments and PSUs are also part of this model.
  • Corporate Model – This is applicable to corporates who want to enrol their employees in the scheme. This could be in addition to, or as a replacement of, EPF
  • All Citizen Model – This is open to all citizens of India, including NRIs. Any person can be part of this model – of course if they are not covered by the above two models.
This article would mainly look at the choices and constraints in the Corporate and All Citizen models. The Government Model is influenced by the government employees and the changes in it have happened separately from other models.

NPS investment choices

A major touted benefit of NPS (over EPF and similar schemes) is that the investor can choose to invest in equity also. Overall, NPS defines the following asset classes. Asset Class E- Investment in predominantly equity market instrument. Asset Class C-Investment in fixed income instruments other than Government Securities Asset Class G- Investment in Government Securities Asset class A: Investment in Alternative Investment Schemes including instrument like CMBS, MBS, REITS, AIFs, InvIts etc. The models differ on the choice of asset classes and the maximum permissible limit in them. Please note that for all the models, the maximum permissible limit in ‘E’ – Equity is 50%.  The subscriber can actively allocate the contributions towards these asset classes, or choose one of the three pre-defined allocation methods. A very big constraint here is that private sector subscriptions in ‘E’ are limited to either BSE Sensex or NSE Nifty. Yes, as of now, the only equity choices are large cap indices.

Fund Managers and Charges

Another touted benefit of NPS is the low charges. NPS defines an entity called Pension Fund Managers – these are the equivalent of AMCs and they manage the investment on your behalf.  They are specifically empanelled by the Pension Authority (PFRDA). Currently there are 3 for government sector (which would go up) and 8 (including the 3) for the private sector.  The current managers are indeed maruqee names in the mutual fund industry.  But the AMCs directly don’t manage the pension funds; it is done by separate legal entities. The fund charges are indeed quite low in NPS – 0.01% for fund management. It is unlikely in the near future that the expense ratios in typical mutual funds, even index funds, would come close to this level. However, please note that there is another 0.01% to be paid to the NPS trust.  And there is a sort of entry load – a fee 0.25% – to be paid to the intermediary collecting your payments.  If you add these charges (see here for a list) the expenses are not too different from a direct plan index fund.  Index fund is a very good comparison because private sector subscriptions in ‘E’ are limited to either BSE Sensex or NSE Nifty.

Distribution Choices

Any retirement plan can be divided into two major phases:
  • Accumulation Phase – Contributions are made during active income period towards building the corpus
  • Distribution Phase – Withdrawals are made from the corpus during retirement to fund expenses
NPS has specific rules regarding distribution – called Exit in the terminology.  When you turn 60, you can exit the scheme and withdraw 60% of the corpus in one go. The other 40% has to be used to buy an annuity plan from what are called Annuity Service Providers (ASP).  See this article for a description of annuity plans. Annuity Plans – What, Why, and Why Bother  Annuity plans as such are not bad, and could be useful in some situations. However, being forced to buy an annuity plan is an irritant in NPS. This irritant is bigger in case of early retirement. If you exit before 60 years of age, you can withdraw only 20% of the corpus and have to buy an annuity for the other 80%. Till this year, 40% of the withdrawal was tax-free. The recent changes made the other 20% also tax free. However, the annuity is considered pension and is taxable. This is unlikely to change in the future.  In other words, NPS still is not fully EEE.  The last E does not apply to 40% of the corpus – or 80% in case of early exit.

So why is NPS not the best choice for retirement?

Limited choice of investments

If you build a retirement corpus on your own, you have a wide choice of asset classes. If your company offers it, EPF is an excellent debt instrument.  You can top up the contributions from your side via VPF. You can invest upto 1.5 lac per year in PPF. Further, you have a wide choice of debt mutual funds.  For equity portion, you again have a wide choice of equity mutual funds. You can invest in direct equity too.   In NPS, your choice is limited to 7 fund managers, and 3 funds provided by them. A major benefit of NPS, compared to say EPF, is the ability to invest in equity. This indeed can be a benefit. But the contribution is capped at 50%. A very big constraint here is that private sector subscriptions in ‘E’ are limited to either BSE Sensex or NSE Nifty. Yes, as of now, the only equity choices are large cap indices. To make a more direct comparison, you can choose a basket of these products:   Various PF schemes, Liquid funds,  Nifty Index funds.  These would have an overall expense ratio comparable to, or even lower than, the charges in NPS.  In summary: NPS gives you a limited choice of investments, while costing almost as much as other products

Inflexible tenure

NPS was designed as a pension product.  The tenure of the scheme was tied to a specific age milestone – 60 years. The full benefits of the scheme kick in only when you exit at this age.   Indeed, 60 is the typical retirement age in India. A large majority of government and PSU employees retire at this age.  But in the private sector, amidst the major macro changes, it is difficult to see many people working till the age of 60. You can exit NPS earlier; but you can withdraw only 20% of the campus.  Compared to this, EPF has a flexible tenure. You can completely exit the scheme after 60 days of no employment.  PPF has a tenure of 15 years; you can indefinitely extend this in blocks of 5 years, and still withdraw much of the corpus. Mutual funds of course have no exit issues, with the small, short exception for ELSS funds.  So if you build a diversified portfolio, you have the flexibility to begin the distribution phase any time. But in NPS, you are incentivized to exit at 60. In summary: NPS forces you into a tenure linked to your age rather than your earning situation

Forced choice of Annuity

Depending on when you exit, you have to use 40-80% of the corpus to buy an annuity.  This excellent article describes a variety of ways to get inflation proof income from a lump sum.  But for NPS subscribers, these options can be used only for a part of the corpus.  But that is only a part of the problem. The real bummer in the scheme is that the Anniuty Service Providers (ASPs) are the standard life insurance companies who offer annuity plans to anybody. If my financial plan requires an annuity, I can always go to these companies, pay a one time premium, and buy an annuity plan. The recently launched Jeevan Shanti is an example of annuity plan. (See here for a short analysis on it: LIC Jeevan Shanti Annuity – Should You Buy)  Many of the annuity plans provide a small incentive to NPS subscribers – and that is all you get for being locked into a scheme for all of your working life.  In summary: NPS forces an Annuity plan on you regardless of suitability

Conclusion

NPS may have advantages when compared to specific products. However, if you take a portfolio approach to build your retirement corpus, you get most of these advantages in other products too.  Then the constraints of NPS – limited investment choice, long tenure, forced annuity – outweigh the possible benefits of additional tax deductions. Overall, despite the improvements, NPS is still not the best choice for your retirement.

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