Debt market volatility plays spoiler to NPS returns

Average YTD returns for Central and State Govt Schemes at 0.29% and 0.24% respectively, as on September 27, 2013

While the government continues to promote its flagship National Pension Scheme (NPS) and looks to instill investor confidence in the defined contribution retirement system, the news on the returns front is not very encouraging, especially in recent times, says a Morningstar India Research  report.

NPS offers different classes of schemes, all of which are market-linked. Due to this, performance can vary significantly on a year-on-year basis. In 2012 this proved to be favourable as most schemes delivered good returns. Central government (CG) and State government (SG) schemes delivered double-digit returns. Equities, corporate bond and government bond schemes also delivered double-digit returns with equity portfolios delivering an average return of nearly 30 per cent. However, so far this year, the market-linked nature of these schemes has proven to be more of a detriment, write Dhruva Raj Chatterji and Gaurav Dutta of  Morningstar India Research in the report.

In 2013, markets took a turn for the worse, and so did the returns on NPS. In a year where equity markets remained flat to positive, debt markets played the spoiler. With over 85 per cent allocation to corporate bonds and government securities and an average maturity of over 10 years, the central and state government schemes, which manage most of the NPS corpus, took a heavy beating. The numbers largely remained flat on a year-to-date (YTD) basis --- a significant drop from the double-digit performance recorded in the previous year. At the end of May 2013, Scheme CG and Scheme SG were sitting on average YTD returns of 7.8 per cent and 8.20 per cent respectively.

Currently, the average YTD return for Scheme CG and Scheme SG stand at 0.29 per cent and 0.24 per cent, respectively, at the end of September 27, 2013.

Returns over the last three months testify to the volatility witnessed in the fixed income space. The Reserve Bank of India's (RBI) various liquidity tightening measures to curb rupee depreciation, has put bond yields under pressure, therefore, driving down returns. Further, the unexpected hike in repo rate in the recent monetary policy review has once again added to the pressure, and further dampened sentiments in the fixed income markets. The central and state government schemes have lost 4.72 per cent and 5.13 per cent respectively, on an average, over the last three months.

SBI Pension Fund, which was sitting on an average maturity of around 14 years for Scheme SG & CG at the end of June 2013, was the worst hit by this volatility. The last 3 month’s return stood at (-)5.58 per cent and (-)6.1 per cent, for its central and state schemes, while the YTD return was also below the peer average, says the report.

The equity schemes invest primarily in index funds that replicate the portfolio of either the S&P BSE Sensex or CNX Nifty. These schemes by nature are passively managed, hence are totally dependent on the performance of the underlying index. Since this year, they have been given the option of active management. Equity scheme performance has been middling, albeit better than government employee schemes, so far this year. Average YTD return of this scheme has been around one per cent, and returns over the past 3 years are flat, or in the red.

The corporate bond option, has been the best performer of the lot. Although the recent turmoil in fixed income markets has eaten into returns, it has still managed to deliver an average return of 3.1 per cent so far this year, and an average return of 9 per cent (annualised) over the past 3 years, say Chatterji and Dutta.

The government bond scheme, has been the worst hit so far this year. Far from shielding the portfolio from market uncertainties, government securities have instead induced more duration and interest rate risk into the portfolios, in the current environment.

The higher duration profile of funds in government scheme, has especially hurt returns over the past three months, and caused them to underperform other long term gilt funds available in the industry by a significant margin. But then again, pension products have a much longer investment horizon compared to mutual funds. Although their longer duration stance may hurt in the short term, it may help to realise better yields over the longer term, and also cut down on re-investment risk.

NPS returns have been disappointing so far this year especially due to the volatility witnessed in the fixed income space. But for an investment vehicle with a horizon spanning till retirement, long term returns become even more relevant. The 5-year trailing return for the central government scheme stands at an average of nine per cent (annualised), higher than the average return of 8.7 per cent on Employee Provident Fund or 8.4 per cent on Public Provident Fund over five fiscal years. Meanwhile, the 3-year trailing returns for central government scheme has been moderate, and stands at an average six per cent (annualised), primarily due to the poor or lackluster performance of equities and government bonds in year 2011 and so far in 2013 as well, says the report.

NPS is still the most cost effective investment avenue and provides tax benefits over and above the deductions under Section 80C. It offers investors the flexibility of varying allocation to debt and equity markets and switching fund managers. All things considered, the NPS is a worthy investment alternative, delivering competitive returns over the long term, with possibility of minor blips in the short term, due to its market-linked nature, say Chatterji and Dutta.