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Missing The Big Picture

While the remodelled National Pension Scheme is a step in the right direction, it is not the perfect retirement plan

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India is waking up to the burgeoning need for a more structured, well-planned, and aggressive approach to retirement planning. One of the more recent measures taken by the government in this regard was the opening up of the NPS (National Pension Scheme) to all citizens of the country in 2009. Prior to 2009, only government employees had access to it.

The NPS investors can either actively manage their own split between E, C and G, (equities (E), corporate bonds (C), and government securities (G)) or opt for a lifecycle fund that balances their asset allocations automatically based upon pre-decided conditions. The former option caps equity allocation at 50 per cent.

The NPS architecture consists of two types of accounts: Tier-1 and Tier-2. Tier-1 accounts have rigid lock-in criteria, whereas Tier-2 accounts are more liquid. Over and above the Rs 1.5 lakh tax exemption under Section 80(C), NPS investors also qualify for an additional tax benefit of Rs 50,000 under Section 80CCD(1) and up to 10 per cent of employer contributions under Section 80CCD(2). All tax breaks accrue only to Tier-1 investments.

Upon maturity, it is mandatory to purchase an annuity from one of the seven designated ASPs or annuity service providers with 40 per cent of the accumulated corpus. Forty per cent can be withdrawn as a tax-free lump sum and 20 per cent as a taxable lump sum.

The PFRDA (Pension Fund Regulatory and Development Authority) made four significant amendments to the NPS architecture in 2016. In light of these changes, does the NPS warrant a place in your retirement planning portfolio? Let us find out.

Partial Withdrawal
In March 2016, the PFRDA released a circular allowing withdrawals of up to 25 per cent of the “self-contributed portion” of the corpus, for NPS investors who had completed at least 10 years. There is a specified list of reasons for which these withdrawals are permitted. These are: your child’s education or marriage; the purchase or construction of your first residential house; or the treatment of specified medical conditions including cancer or serious accidents. A maximum of three separate withdrawals are allowed, a minimum of five years apart.

While this amendment will likely be hailed by investors, it remains true that an ideal retirement plan, from a financial planning standpoint, is one that enforces a hard lock-in on one’s funds till their retirement date. Early withdrawals can prove to be unexpectedly detrimental to the size of the final corpus, and should therefore, ideally be disallowed. It is very likely that a large number of NPS investors will choose to exercise the early withdrawal option between the ages of 45 and 50, dealing a self-inflicted blow to their retirement funds at the penultimate moment.

“This is a welcome move, but investors need to be educated to use this option only in case of emergencies; as it might otherwise defeat the bigger purpose,” cautions Tarun Birani, Founder and CEO of TBNG Capital Advisors, a leading SEBI registered investment advisor.

The restrictive nature of the withdrawal will limit the extent of this damage. For instance, a monthly NPS investment of Rs 5,000, assuming a return of 11 per cent per year, will grow to Rs 22.73 lakh within 15 years; with the individual’s own contribution standing at Rs 9 lakh. In this case, the norms would allow a maximum withdrawal of 25 per cent of Rs 9 lakh, or Rs 2.25 lakh; roughly 10 per cent of the total accumulated amount. Assuming that the Rs 2.25 lakh thus withdrawn, would have grown at 10 per cent per annum for the remainder of the investment period, even this seemingly small withdrawal could have an impact of Rs 10 lakh-25 lakh on the final size of the nest egg, depending upon the years remaining until retirement. Had the withdrawal clauses not been this restrictive, the impact could have been colossal.

Minimum Annual Contribution
In August 2016, the PFRDA reduced the minimum stipulated annual contribution amount to Rs 1,000 from Rs 6,000. The intent behind this was clearly to draw a larger number of investors into the fold. However, this move is of no value from an investor’s standpoint; neither an annual contribution of Rs 6,000 nor Rs 1,000 will suffice to create a corpus that is even close to what will be required for one’s comfortable retirement. A monthly investment of Rs 500 made for a period of 30 years, at a projected growth rate of 11 per cent per annum, would result in the accumulation of an inconsequential sum of Rs 14 lakh. While this move might benefit the industry broadly by increasing the number of new NPS accounts, it creates no tangible value for the retirement saver per se. In the long run, investors would rather benefit more from a mandated aggressive annual step up.

New Life Cycle Funds
In November 2016, the regulator announced the launch of two new life cycle funds termed ‘Aggressive’ and ‘Conservative’ respectively. The Aggressive Fund maintains an equity exposure of 75 per cent until the investor turns 35. This is good news for those who start investing into the NPS early on, as they stand to benefit from the higher growth potential of equities for a few additional years.

The trouble with the so-called Aggressive Fund is that post 35, it starts slashing the equity allocation at the rate of knots. At age 45, the hapless investor is left with an undesirably low equity allocation of 35 per cent; at age 50, just 20 per cent. This is an overkill in the direction of conservativeness; even low to moderate risk retirement savers would do well to maintain an equity exposure of at least 60 per cent until the five years leading up to their retirement. NPS investors would be much better of switching out of the Aggressive Fund at age 41, self-regulating their asset allocations and sticking resolutely to the maximum allowed cap of 50 per cent for the remaining 19-year period.

“The accelerated reduction provision of 4 per cent every year after attaining age 35 under LC 75 (or Aggressive Life Cycle Fund) option could have been done more prudently,” observes Birani. “Also, a 100 per cent equity option should be made available keeping in mind the higher wealth creation potential from equities.”

The Conservative Life Cycle Fund or LC 25 allows a maximum equity allocation of just 25 per cent, and is really nothing short of a gross retirement planning misstep. Investors who stay invested into LC25 for the long term could end up severely compromising their retirement funds.

NPS Architecture: Salient Features

- Defined contribution
- Two-tiered structure
- Choice between active management and life cycle fund
- Three fund categories: E, G and C n 7 designated pension fund managers
- 7 designated annuity service providers


Asset Class ‘A’
In November 2016, the PFRDA announced the creation of a new asset class called asset class ‘A’. This freshly created asset class will deploy moneys into alternative investments such as mortgage backed securities, asset backed securities, infrastructure investment trusts and alternate investment funds (AIFs). Asset class ‘A’ is accessible to active mode subscribers, and exposure to it is capped at 5 per cent.

There are two reasons why the practical benefits of this move are a moot point. First, the impact of a 5 per cent allocation will be insignificant at best. Second, alternative investments might actually prove unsuitable for retail investors, who will likely possess only a rudimentary understanding of such complex instruments. Some might even find the general opacity and the lack of clarity on the returns earned from these funds to be unsettling.

“This move seems to be directed at financially savvy investors who are familiar with the risks and rewards of such investment products,” says Alok Agrawal, senior director, Deloitte Haskins & Sells LLP.

The Bottom Line
Make no mistake, the NPS is a noteworthy step-up from the severely damaging habit of diverting long-term retirement assets into low growth instruments such as traditional life insurance plans or bank deposits. However, key structural issues remain unaddressed.

First, the mandated purchase of an annuity with 40 per cent of the final corpus sticks out like a sore thumb as the largest deficiency of the NPS architecture. Annuities are low return products that can severely impact one’s post-retirement cashflows. A typical annuity product provides investors with a pre-tax income of Rs 7 lakh-9 lakh per year on a corpus of Rs 1 crore, and there are far better ways to create a reliable post-retirement income stream.

Understandably, the PFRDA’s noble intention here is to ensure that at least part of the corpus is actually utilised to generate a post-retirement income, but forcibly diverting almost half the fund into an annuity just works to the detriment of the retiree.

The second structural flaw is the excessive conservativeness during the accumulation phase. Although the Aggressive Life Cycle Fund is aimed as a solution to the above, it could be further amended to ensure a stable minimum equity allocation of 80 per cent in the accumulation phase, leading up to the last five years preceding one’s retirement; during which one should ideally de-risk their retirement corpus systematically and aggressively.

The third serious problem ailing the NPS structure is the abject underperformance of the NPS equity funds vis-à-vis mainstream large cap mutual funds. Some have attributed this to the fact that the prohibitively low-cost structure of the architecture keeps good talent at bay; the NPS is, in fact, one of the cheapest pension plans in the world. Such an obsessive focus on cost control at the expense of fund performance is akin to missing the woods for the trees, and might even change in the times to come.

Investors are advised to watch out for further developments on the above points in 2017. Until then, stick to SIPs (systematic investment plans) in top performing equity mutual funds for your retirement. Those concerned about foregoing the associated tax breaks may opt for an ELSS (equity linked savings scheme) to fulfil their purpose, albeit partially.