Many choices make NPS complicated

Both debt and equity can be allocated in different proportions depending on your age and risk profile

The National Pension System (NPS) is gaining popularity. According to figures provided by the Pension Fund Regulatory and Development Authority (PFRDA), enrolment in the all-citizens model rose 148 per cent to 215,372 in March-end 2016, from 86,774 in March-end 2015. The primary factor is tax benefits. "The effective tax benefits on investment in NPS increased from Rs 1 lakh in FY15 to Rs 2 lakh in FY16," says Hemant Contractor, chairman, PFRDA. This was due to the ceiling on deduction under Section 80CCD (1) being hiked from Rs 1 lakh to Rs 1.5 lakh, and an additional benefit of Rs 50,000 on NPS being provided under Section 80CCD 1(B).

NPS offers a number of choices. But before opting for it, here are some key things you need to know.

Changes to look forward to

• Existing: Allocation to equities can’t exceed 50 per cent
• Proposed: Two additional choices under the auto-choice option: One of them, with maximum investment of 75 per cent in equities
• Existing: 40 per cent of the corpus has to be compulsorily annuitised at 60 and 80 per cent if you exit NPS before 60
• Proposed: The regulator is exploring other avenues to park the money that goes into annuities

Tier-I and Tier-II account: Opening a Tier-I account is compulsory. This is your main retirement account on which you get the tax deduction.

The Tier-II account is an optional from which one can withdrawal any time. There are no benefits on it. Financial planner Arnav Pandya says: "People who have extra funds may open a Tier-II account. However, don't use it as a savings account. Use it to invest for long-term goals."

There are a couple of issues with the Tier-II account. According to Manoj Nagpal, chief executive officer, Outlook Asia Capital, "There is ambiguity about how money withdrawn from the Tier-II account will be taxed. Will both principal and capital gains be taxed or will only capital gains?"

Since the Tier-II account does not offer tax benefits, its only advantage is the low expense ratio. Its disadvantage is that even investors with the highest risk appetite can't allocate more than 50 per cent to equities. Aggressive investors can have an equity allocation as high as 75-80 per cent for long-term goals. Such investors should opt for mutual funds, where they can have whatever equity exposure they desire.

Auto choice or active choice: Investors have to decide how to carry out the asset allocation for their money. They have access to three asset classes: Equities (E), corporate bonds (C) and government securities (G). In the auto choice option, allocation till the age 35 is 50 per cent to E, 30 per cent to C, and 20 per cent to G. From the 36th year onward, allocation to E is reduced by two percentage points, that to C is reduced by one percentage point, and that to G is increased by three percentage points. This continues till 55, when allocation to E and C falls to 10 per cent each, and that to G rises to 80 per cent.

Says Roopali Prabhu, head of investment products, Sanctum Wealth Management, "For people who have traditionally been fixed income investors, auto-choice is in principle a good option, as they would otherwise not have any exposure to equities." For evolved investors, she says, this option would be a little conservative. Such investors should opt for the active choice.

Deciding on equity exposure: If you have chosen the active choice option, first decide your equity allocation. "Equity allocation should depend on age, risk appetite, and the overall exposure to equities in your entire portfolio," says Nagpal.

The popular rule of thumb used to decide equity allocation is 100 less age. This should be modified, depending on your risk appetite. If your exposure to equities in other parts of your portfolio outside NPS is already high, you can be more conservative within NPS.

Deciding between C and G: Next, you need to decide how to split your debt allocation between a corporate bond fund (C) and a government securities fund (G). G funds invest only in sovereign debt paper and, hence, carry zero credit risk. But, since these are long-maturity papers, these funds carry duration risk. C invests in corporate bonds that would carry some credit risk.

Broadly, a corporate bond fund would be more risky than a government securities fund, but would also have the potential to offer slightly higher returns. According to Pandya, investors with a higher risk appetite should allocate more to C and less to G.

The right pension fund manager: Seven pension fund managers (PFMs) are currently available. Remember that you have to choose the same fund manager for all three asset classes (E, C and G). According to Nagpal, the returns of different fund managers are quite similar in C and G categories, since they have to follow hold-to-maturity (HTM) rules for the larger part of their portfolios in debt funds. Among equity funds, too, the difference in long-term (5-year) returns between one fund manager and another is not too high, since all of them were following the passive investment approach until recently.

Most of the chosen PFMs are established players that run large mutual fund houses. Pandya suggests that you should go with the PFM that you will be comfortable investing with not just today but over the next 25 years. Nagpal says that the only possible differentiator is commitment to the pension fund management business, as indicated by assets under management. SBI and ICICI Prudential have the two highest equity AUMs in private NPS.