NPS Rebooted

The National Pension System has become more friendly in recent years. But some dampeners remain. Here’s how the key changes affect you as an investor

When it comes to investment products, the government has a favourite child — the National Pension System (NPS).

This low-cost, market-linked, ‘defined-contribution’ pension scheme has been given an aggressive makeover and push by the government. That’s because it wants to bring more Indians under the pension umbrella. At the same time, the government wants to move away from assured-returns based ‘defined-benefit’ plans such as the Employees Provident Fund (EPF) that result in big financial liabilities.

The NPS, promoted by the government, aims to provide post-retirement income to the country’s citizens; all Indian citizens including non-resident Indians between the age of 18 and 60 can join the scheme. But it being market-linked, the risk lies with the investor, not the government. Recent reports suggest that the government plans to increase the maximum entry age into NPS to 65 years from 60 years currently.

Under NPS, there are two main account types — Tier I and Tier II. Tier I is the primary retirement account in which withdrawals are restricted until the age of 60 or retirement. Tier II is a savings facility that can be opened once you have a Tier I account; there are no withdrawal restrictions in the Tier II account.

Recent Budgets have given big sops for investment in the NPS Tier I. Budget 2015 provided an extra tax break of ₹50,000 in addition to the existing ₹1.5 lakh deduction eligibility under Section 80C. Budget 2016 allowed tax-free withdrawal of 40 per cent of corpus on maturity, mitigating a major drawback of the scheme. Budget 2017 exempted partial withdrawals from tax.

That’s not all. The NPS has seen a slew of other changes in recent years. These include making account opening and investing simpler and cheaper through eNPS, reduction in minimum investment limits, broadening the equity investment universe, more choices in asset allocation for investors and flexibility to change the mix more often, allowing conditional partial withdrawal, and providing extended time on exit and on buying the annuity. It also helps that the NPS has done well — across major asset classes, time periods and fund managers (See: NPS puts up a strong show).

Not all’s great, though. One, overall costs are set to inch higher with pension fund managers allowed to charge more, though the NPS still remains highly cost competitive. Two, drawbacks remain. You have to use at least 40 per cent of the final corpus to buy an annuity; the remaining 60 per cent can be withdrawn, of which 20 per cent is taxable.

The compulsory purchase of annuity with at least 40 per cent of the final corpus forces investors to lock into a fixed, lifelong, low-yield taxable return. Annuity rates at present are about 6 per cent, lower than many other fixed income options and there is no saying where these rates will head in the future.

Besides, these annuity payments are taxable, which further lowers returns. Also, while withdrawal of 40 per cent of the final corpus has now been exempt from tax, the tax on the remaining 20 per cent, if withdrawn, can still pinch. This puts the NPS at a disadvantage vis-à-vis EPF in which the final corpus can be fully withdrawn, tax-free. Three, unfavourable tax treatment on NPS Tier II withdrawal inhibits investments into this flexible scheme. (See: Should you invest in NPS Tier II?). That said, in the coming years, to improve the competitiveness of NPS, the government is likely to continue easing rules.

Here’s how some of the key changes in the NPS over the past few years affect you as an investor.

More tax benefits

Three big changes have made the NPS Tier I more tax-efficient. First, the extra tax break of ₹50,000 on investment in the scheme under Section 80CCD over and above the ₹1.5 lakh tax break eligibility under Section 80C. The additional tax benefit can mean annual savings of ₹5,150 for those in the 10 per cent tax slab, going up to ₹15,450 for those in the 30 per cent tax slab.

Next, the tax-free withdrawal of 40 per cent of the final corpus on maturity means big tax savings. Earlier, at least 40 per cent of the corpus had to be used to buy an annuity while the remaining 60 per cent that could be withdrawn as lumpsum was fully taxable at the investor’s slab rates.

Even now, 40 per cent of the corpus has to be used to buy annuity. But after the tax exemption for 40 per cent withdrawal, only 20 per cent withdrawal is now taxable.

Say, you are in the 30 per cent tax slab and choose to withdraw 60 per cent from a ₹1 crore corpus; earlier you would have paid ₹18.5 lakh as tax but now the tax outgo will be ₹6.18 lakh, 66 per cent lower.

Three, NPS subscribers have been allowed the option to defer withdrawal of the lumpsum (60 per cent) up to the age of 70 years in maximum 10 annual instalments. Earlier, they had to exercise the option of lumpsum withdrawal at the age of 60 or at superannuation. The deferred withdrawal period allows for tax planning.

Say, you are in the highest 30 per cent tax slab at the age of 60 or at superannuation, due to receiving retirement benefits. If you can defer the NPS lumpsum withdrawal to future years when your income may be lower, thus putting you in a lower tax slab, you could save a tidy sum.

NPS subscribers also have the option of deferring purchase of annuity for up to three years from the age of 60 or superannuation; this can be beneficial if the annuity rates at the age of 60 or superannuation are not healthy and improvement is expected. It can also help in tax planning.

Non-government subscribers (all citizens model) also have the option of contributing to the NPS during the extended period till the age of 70. In such cases, for the purchase of annuity using minimum 40 per cent of the corpus, the amount at the time of final exit from the NPS will be considered.

Tip: NPS is in exempt-exempt-taxable (EET) tax category of investments. Deferral of the lumpsum withdrawal at maturity can help reduce tax outgo.

Partial withdrawal flexibility

A big drawback in NPS – Tier I was its rigid withdrawal criteria. An investor could withdraw the lumpsum of 60 per cent of corpus only at the age of 60 or at retirement. Withdrawals before that meant that 80 per cent of the corpus had to be used to buy annuity and only 20 per cent was given lumpsum. But changes in 2015 have allowed partial withdrawal of up to 25 per cent of the contributions made by the subscriber. But there are strings attached.

One, the partial withdrawal is allowed only for specified purposes such as higher education or marriage of children, purchase or construction of own house, or for treatment of specified illnesses. Next, the subscriber should have been in the NPS for at least 10 years.

Also, a maximum of three such withdrawals are allowed, with a gap of at least five years between each withdrawal; this gap restriction is not applicable in the case of treatment for specified illnesses. Note that the partial withdrawal is based on the subscriber’s own contribution and not on the corpus that includes gains. Budget 2017 has exempted such partial withdrawals from tax.

Tip: The partial withdrawal flexibility is welcome, but it is best not to touch funds meant for retirement and pension unless there is a dire emergency.

More choices and flexibility

Investing in the NPS always involved much picking and choosing for private sector subscribers. For starters, you had to open an NPS Tier I account and then became eligible for a Tier II account too. Then, you had to select between the active choice and the auto choice. In the active choice, you could decide the allocation each year among equity (E), corporate bonds (C) and government securities (G), with E restricted to 50 per cent.

In the auto choice, depending on your age, the allocation was set and adjusted on the basis of a life cycle approach — till the age of 35, equity (E) exposure was set at 50 per cent, corporate bonds (C) at 30 per cent and government securities (G) at 20 per cent. This was then adjusted gradually each year, with allocation to E reducing by 2 per cent, C reducing by 1 per cent and a corresponding 3 per cent increase in G. At the age of 55, the allocation was E (10 per cent), C (10 per cent) and G (80 per cent) and remained fixed thereafter. Then, you had a choice from among many pension fund managers, including UTI, SBI, Reliance Capital, LIC, Kotak, ICICI Prudential and HDFC, to manage your NPS money.

All these choices remain; just that the menu got bigger last October. Now, in the active choice, in addition to E, C and G, there is one more asset class — Alternative Investment (A), which includes specialised instruments such as real estate investment trusts, infrastructure investment trusts and asset backed securities. In the active choice, allocation to E remains capped at 50 per cent while it has been capped at 5 per cent to A.

In the auto choice, there are now three options — aggressive life cycle fund, moderate life cycle fund, and conservative life cycle fund. The moderate life cycle fund is the original one with equity exposure set at 50 per cent till age 35 and then tapering up to age 55.

In the aggressive life cycle fund, till age 35, exposure to E, C and G is set at 75 per cent, 10 per cent and 15 per cent; every year thereafter, exposure to E tapers while that to C and G rises till at age 55, it reaches 15 per cent in E, 10 per cent in C and 75 per cent in G. Finally, in the conservative life cycle fund, until age 35, allocation to E, C and G is 25 per cent, 45 cent and 30 per cent, which is adjusted each year to reach 5 per cent in E and C and to 90 per cent in G at age 55.

Decide on scheme choice and asset allocation based on your ability and willingness to take risk. Typically, it makes sense to go for high equity exposure when you are young and can take risk for potentially much higher returns compared with debt options.

In such cases, go for the aggressive life cycle option till the equity exposure gets down to about 50 per cent; then shift to the auto choice with equity exposure at the maximum 50 per cent until you get to the mid-50s when exposure to debt can be upped. It’s best to avoid the Alternative Investment (A) class — an unknown entity with scarcely a track record.

There are also likely to be new pension fund managers added to the list. Reports say that the Pension Fund Regulatory and Development Authority (PFRDA) has decided to award licences to all the nine entities that had bid for managing private sector NPS schemes in the last round; currently there are eight managers.

Fund managers can change every five years when their tenure ends; so, keep watch to see if your fund manager is still on the list. Go with a fund manager with a good long-term record, as the fee differential between them is likely to be minimal.

From 2017-18, you can change your NPS investment option (auto or active) and also the asset allocation twice a year; earlier you could change this only once a year. But you can change the pension fund manager only once a year. The minimum amount to be invested in NPS Tier I has been reduced from ₹6,000 a year to just ₹1,000 a year, and has been done away for the Tier II accounts.

Tip: If youhave the risk appetite, gofor the choice with high equity exposure until you need to reduce risk. Choose a pension fund manager with a strong long-term track record.

Cost churn, online investing

There are multiple entities in the NPS structure such as points of presence (agents), pension fund managers, central record keeping agencies, custodian, trustee bank and NPS Trust. Unlike mutual fund where all costs are reflected in the net asset value (NAV), the different entities in NPS charge their costs separately in a differentiated cost structure. For instance, the agents charge upfront, pension fund management charge is adjusted in the NAV while the record keeping agencies adjust charges against units. Points of presence charge 0.25 per cent of the contribution amount subject to a minimum of ₹20 and a maximum ₹25,000.

Pension fund management fees, rock-bottom earlier, have been rising and could go to up to about 0.1 per cent in the latest bids. But this is still very low compared with mutual funds. On the other hand, with the introduction of a new record keeping agency, charges on this front have come down sharply.

Also, registering and investing using Aadhaar on the eNPS portal via net banking is cheaper than going through the points of presence. Card payments on the eNPS portal involve higher gateway charges.

All said, overall costs in NPS investing are still very competitive (under 0.5 per cent) compared with options such as mutual funds that charge up to 3 per cent, depending on the fund.

Tip: Register and invest on the eNPS portal through Aadhaar and net banking for the best deal.

Summing up

OverallNPScosts remain very low and returns are robust. Tax breaks add to the attractiveness of NPS Tier I. But compulsory annuity purchase using at least 40 per cent of the final corpus is a dampener. So is the tax on low annuity payments. Invest in Tier I to the extent of the additional tax break (₹50,000 a year), but don’t go overboard, especially when you have more flexible, high-return options such as mutual funds to build your retirement kitty. Favourable changes in the future on annuity purchase and tax exemption for the balance corpus could tilt the scales in favour of NPS Tier I.

Should you invest in NPS Tier II?



NPS Tier II schemes, similar to NPS Tier I schemes, are low-cost and have given robust returns. But there are key differences between them.

One, there are no tax breaks on investments in NPS Tier II. On the other hand, NPS Tier II is highly liquid unlike NPS Tier I — you can withdraw from it anytime.

Essentially, NPS Tier II schemes are akin to mutual funds, with investments in equity, corporate debt and government securities. Low costs have meant that they have also done better than many mutual funds. But NPS Tier II has not quite taken off — the total corpus across schemes and pension fund managers is just about ₹400 crore so far.

The key reason for this seems to be unfavourable tax treatment which puts NPS Tier II schemes at a disadvantage compared with mutual funds. Gains on equity mutual funds are exempt from tax if the units are held for over a year, and taxed at 15 per cent if held for a year or less.

On debt mutual funds held for more than three years, gains are taxed at 20 per cent with indexation benefit. No such benefit for NPS Tier II schemes. All gains on NPS II accounts are taxed at the investor’s slab rates.

Says Neha Malhotra, Executive Director, Nangia & Co, “Unlike mutual funds, there is no tax benefit on withdrawals from NPS Tier II accounts. Hence income earned at the time of withdrawal is liable to tax at the applicable slab rate.”

Suresh Surana, Founder, RSM Astute Consulting Group, concurs with this. He says, “In case of NPS Tier II, no separate guidelines with respect to taxation on withdrawal have been provided. On withdrawal from NPS Tier II, the accruals in the account shall be income, which shall be taxable based on the slab rate of the individual. The reference to taxation based on classification of mutual fund units i.e. short term or long term, shall not be relevant.”

There have been reports that the entire amount withdrawn (not just gains) from NPS Tier II accounts is taxable. But tax experts think that this is not the case.

Amarpal Chadha, Tax Partner & India Mobility Leader, EY India, says, “Since the deposits in Tier II account are not entitled to any tax benefits, in the absence of any specific provision, the whole of the withdrawal cannot be taxable; only the gains should be taxable. Taxing the entire withdrawal amount will lead to double taxation.”

Even so, with the gains on NPS Tier II withdrawals considered taxable at slab rates in the absence of specific provisions, their post-tax returns will likely be lower than mutual funds, at least for long-term investments.

But NPS Tier II can be a good choice if you are looking to park money in debt for the short term, that is, up to 3 years; in this case, it does not suffer tax disadvantage compared with debt mutual funds and low costs can translate into superior returns.

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