NPS Gets A Facelift. How Good Is It, Really?

Under the NPS, investors have the choice of defining their own asset allocation or choosing a “Life Cycle Fund” that puts their asset allocation on auto-pilot

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02 December, 2016

by Aniruddha Bose

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The PFRDA made a few amendments to the NPS recently. Touted as a viable alternative to the trusty EPF, the NPS is yet to pick up steam in India - with the aggregate corpus across all Tier-1 accounts barely scraping past Rs. 5,000 Crores as on date. It would be worthwhile to explore whether these changes tilt the balance in favour of the NPS, or are more changes still required. Some weeks back, I compared the EPF with the NPS and advised clients not to switch, in this article here:

EPF Versus NPS. Should You Switch?

Here’s a step by step evaluation of the key changes introduced.

LC-75: The “Aggressive” Life Cycle Fund
Under the NPS, investors have the choice of defining their own asset allocation or choosing a “Life Cycle Fund” that puts their asset allocation on auto-pilot. Roughly half of all Tier-1 investors use Life Cycle funds instead of choosing their own asset allocation. The first major change has been the introduction of a new asset class called the “LC-75” or the Aggressive Life Cycle Fund.

The Aggressive Life Cycle Fund essentially starts off as 75% equity oriented and 25% debt oriented – a welcome move, considering that the bulk of one’s retirement savings should in fact be diverted towards aggressive assets that are placed higher on the risk-reward spectrum. However, here’s the dampener – from the age of 35, the fund cuts equity allocation aggressively, by as much as 4% per annum! That’s a 40% equity component reduction over the course of a decade, leaving a 45-year-old with a wide time horizon of 15 years with an equity component of just 35%, that too reducing year on year. From a Financial Planning standpoint, it doesn’t make much sense.

One would, in fact, be better off switching from the Life Cycle fund at the age of 45 and managing their own asset allocation– at the very least, they’ll be able to keep their equity exposure constant at 50% (which is still too low for a 15-year time window, in my view).

Investors who choose to manage their own asset allocation still have their equity exposures capped at 50%. An drastic increase in this ceiling limit for active investors would have been a welcome move.

Deferred Annuity Purchase
By far, the most restrictive feature of the NPS is the one that mandates an annuity purchase with 40% of the amount at the end of the maturity period. I wrote earlier about the perils of locking in your retirement moneys into annuities here:

Should You Buy An Annuity?

There are far superior ways of generating investment income post retirement. The EPF imposes no such restrictive clause, and this, despite its lower potential for wealth creation, tilts the balance in its favour.

The revamped NPS now allows for a 3-year window (until age 63) to purchase an annuity. But alas! This is just tantamount to delaying the inevitable. While this move will likely lead to an increase of a few basis points of returns in the overall post-retirement cash flow table, it won’t turbocharge your corpus in any material way.

Bottom line – this feature is a marginal improvement, but the entire annuity purchase clause really needs to be done away with altogether to make the NPS completely effective in fulfilling its objective.

Alternate Assets – Asset Class “A”
The revamped NPS has introduced a new asset class called “Asset Class A”, which is an available option for active investors (not Life Cycle investors) only. Asset Class A invests into Alternative Asset Classes, and the maximum exposure is capped at 5%. For those who aren’t aware: Alternative Assets include fancy sounding investments like REIT’s, MBS’s and CDO’s, among others.

There are two points to be made here: One, 5% is too insignificant an exposure to make any material difference to overall portfolio returns. Two, why would a retail investor want to look beyond equities as a high-risk asset class in the first place? Investing into assets which you don’t fully understand can lead to much heartbreak and disillusionment in the long run. The NPS was meant to be a simple investment product that serves the interests of the unseasoned, lay-investor. The addition of Asset Class A is an unnecessary step in the wrong direction. Active Investors would have been better off, had they been allowed to allocate this incremental 5% towards equities instead!

Early Withdrawals for specific purposes
Noble intentions notwithstanding, the new clause that allows a withdrawal of up to 25% of your contribution for specific purposes (first house construction or purchase, treatment of critical illnesses and your child’ education or marriage) is, counterintuitively, a misstep.

Discipline and a certain degree of hard-headedness are in my experience two critical hallmarks of successful retirement savers. When a goal is as far away as retirement usually is, the innate tendency to make premature drawings is always imminent. The earlier on in the savings lifecycle these drawings are made, the more exponentially damaging their effect on your final corpus.
A great retirement product will (at the cost of creating angst for the saver), enforce a hard lock in on the saved amount till their retirement age. Any deviation from this rule is bound to create a ripple effect that cannot have a long-term positive outcome. Allowing this ‘flexibility’ is tantamount to being penny wise, pound foolish. I can only hope that most investors opt not to exercise this clause.

Reduced Minimum Investment
The minimum investment into NPS has now been dropped to Rs. 1,000 per annum. The previous floor amount was just Rs. 6,000 (Rs. 500 per month), so I see limited value creation from this step - barring of course the fact that it may draw more savers into the fold.

However, what then? What if the entry level saver, comforted by this low threshold requirement, buries his head in the sand and just continues to save Rs. 1,000 per month for 20 years? Assuming a reasonable growth rate of 10% per annum, it would lead to the accumulation of a meagre Rs. 63,000 – a pittance! Forced to invest Rs. 6,000 per annum, it would have led to an accumulation of Rs. 3.82 Lacs, also a shamefully low number.

The reduced investment threshold needs to be coupled with a mandatory, aggressive “step up” to become effective. Not having such a clause in place can lead hapless retirement savers into an extended fool’s paradise, only to be left clutching at straws when they turn 60.

The Bottom Line
The bottom line here is that the NPS remains a well-intended product that still requires massive structural improvements to become a really effective solution to the problem of retirement planning in the country. Some of the changes are baby steps in the right direction whereas others are just moot points or steps backwards. A combination of EPF and aggressive equity oriented funds (with a bias towards the latter) remains a better proposition for long-term investors saving for their retirement.