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regular-article-logo Thursday, 18 July 2024

Pension posers: decoding National Pension Scheme

Apart from creating a retirement fund that can be availed when the investor turns 60, the NPS also allows investors to claim income tax deductions through the investment period

Adhil Shetty Published 26.04.21, 01:00 AM

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The National Pension Scheme is a government-backed retirement savings programme. It allows the public to invest in a mix of pension funds which manage equity, government bonds, and corporate debt. The ratio can be selected according to the investor’s age and risk appetite.

Apart from creating a retirement fund that can be availed when the investor turns 60, the NPS also allows investors to claim income tax deductions through the investment period. Upon maturity at age 60, investors can withdraw 60 per cent of the corpus tax-free, but need to invest 40 per cent of the balance in an annuity plan. An annuity plan is an income scheme that you purchase from one of India’s 12 annuity service providers (ASPs) and receive a monthly income — a guaranteed pension for life. This requirement, a pet peeve with NPS investors, is expected to undergo moderate change.

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What changed?

Earlier in April, the chairman of the Pension Fund Regulatory and Development Authority (PFRDA) announced that it is considering modifying the rules of the scheme, which would impact the investor’s options on maturity.

At present, if your NPS balance is up to Rs 2 lakh, you can withdraw the whole amount on maturity and not have to purchase annuity. The PFRDA is mulling raising this limit to Rs 5 lakh so that more eligible investors can make a full withdrawal on maturity and not be stuck with an annuity plan that pays peanuts as pension.

Why this change?

Interest rates have plummeted in recent years. Pension plans being guaranteed income schemes invest in securities generating assured returns. Since assured returns have reduced due to falling interest rates, pension plans pay a paltry 5-6 per cent now before tax.

As pension is taxable according to the slab rate, the net returns may be negative after accounting for inflation.

Therefore, annuity plans in their current form don’t make for great investments. PFRDA acknowledged this. Therefore, they now propose a full withdrawal for investors with a balance up to Rs 5 lakh.

However, this still leaves those investors, who will retire with much bigger balances, to buy annuity plans compulsorily and be stuck with the same problems. Would the NPS get rid of the annuity requirement completely in the future? We do not know.

Pros of NPS investing

Let’s consider why people invest in NPS. It offers tax deductions. Against your NPS contributions, you can claim deductions up to Rs 2 lakh under Section 80CCD, which covers the 80C limit of Rs 1.5 lakh. Those who meet the 80C limit through other means such as PPF can still deduct the additional Rs 50,000 for NPS contributions under 80CCD.

Second, the NPS is an extremely low-cost investment scheme, cheaper than an active mutual fund, for example, and comparable to other low-cost investments such as index funds and ETFs.

Third, investing in this scheme could potentially provide you better long-term returns in comparison to other retirement schemes such as the Public Provident Fund (7.1 per cent per annum) or Employees’ Provident Fund (8.5 per cent).

Under the NPS, several equity schemes have provided five-year returns exceeding 10 per cent per annum; many of its government and corporate debt schemes have returned over 9 per cent over the same period. However, these returns would be lower compared to investments in equity-oriented mutual funds.

The problems

The Tier 1 NPS account needs you to adhere to the lock-ins, but that’s not the worst thing about the scheme. When you invest in PPF or EPF, you get your whole money back on maturity.

With NPS, you are forced to buy annuity which offers low, fully taxable returns.You could anyway generate this return on your own by parking the same fund in a fixed deposit scheme, or investing for higher returns in the securities market, and you could liquidate those investments at any moment. Therefore, viewed in balance, NPS offers benefits which get diluted by the annuity requirement.

What you could do

The reduced access to your own funds is a problem. However, the NPS recognises this. How the scheme may evolve in order to address this issue remains to be seen. Till then, you could access NPS for the benefits it offers, namely tax deductions, low costs of investing, and above-average long-term returns, but also understand your alternatives.

For example, if you invested Rs 50,000 once every year for 30 years assuming a rate of return of 9 per cent, your corpus will be approximately Rs 69 lakh, plus you’ll get additional value through tax-savings of Rs 4.5 lakh assuming the 30 per cent slab.

Therefore, the projected value of this investment plan would be under Rs 75 lakh. Conversely, you could create about the same value through a systematic investment plan in a mutual fund, investing Rs 4,167 (that’s 50,000/12).

At annual rates of 9 per cent, 12 per cent, and 15 per cent over 30 years, this plan could create approximately Rs 77 lakh, Rs 1.47 crore, or Rs 2.92 crore.

You may not get additional tax deductions against this investment but the result may be the same.

The mutual fund would also provide you instant liquidity without lock-ins and other cumbersome rules that come with NPS withdrawals.

The other alternative is that you may simply invest via a Tier 2 NPS account to make withdrawals at your convenience but forgo the tax deductions. In summation, NPS has benefits which get offset by its limitations. Your options are many. Choose one that’s best for you.

The writer is CEO of BankBazaar.com

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