New tax norm likely to make National Pension System more attractive

Only those who can invest in more liquid instruments and will not need the money before 60 should opt for it

Recently, the government announced that 60 per cent of the National Pension System (NPS) corpus that can be withdrawn at age 60 as lump sum will become tax free. Earlier, of the lump sum corpus, 40 per cent was tax free while 20 per cent was taxed. While this makes NPS more attractive, it is still not a product that everyone should opt for. Moreover, it is quite a complex product with a number of options. Investors should understand them well and make the right choices. 

EEE, but in a different way: NPS being made EEE (tax exempt at entry, investment, and maturity) is a major step in its evolution. Says Sumit Shukla, chief executive officer, HDFC Pension Fund Management: “This step will take the popularity of NPS to a new level altogether.” However, NPS is not EEE the way Employees’ Provident Fund (EPF) and Public Provident Fund (PPF) are, where the investor gets the entire corpus tax-free at one go on maturity. In NPS, up to 60 per cent of the corpus withdrawn as lump sum at 60 will be tax-free, while at least 40 per cent of the corpus will have to be used to buy an annuity, income from which will be taxed at slab rate. 

Beware of lack of liquidity: NPS is not a very liquid product (only 25 per cent of contribution can be withdrawn tax-free for emergencies). Says Deepesh Raghaw, founder, PersonalFinancePlan.in, a Sebi-registered investment advisor. “Someone who invests in NPS should ideally be in the 30 per cent tax bracket. Investing in NPS should not crowd out his ability to invest in other products. And he should not need the money till 60.” He recommends investing up to Rs 50,000 per annum to avail of the tax deduction under Section 80CCD (1B).

Raghaw’s rationale for suggesting that only those in the 30 per cent tax bracket should invest in NPS is that the tax benefit is the highest for them. For these investors, locking in their money for so long makes more sense. NPS should also not crowd out other investments. Given its features as a retirement product (long lock-in and compulsory annuitisation), investors should have other investments they can fall back on in case they need funds. Finally, only those who will not need the money until 60 should invest in NPS. If an investor withdraws prematurely, he gets only 20 per cent lump sum and the rest 80 per cent has to be annuitised. Thus, NPS will not fulfil his liquidity needs.

Low cost and auto-rebalancing advantage: The fund management charge of NPS is a meagre 0.01 per cent. Only low-cost exchange-traded funds (ETFs) come close to it in this regard. NPS also introduces discipline and leads to enforced saving for retirement. Moreover, an exclusive tax deduction of Rs 50,000 under Section 80CCD(1B) has been provided for NPS contributions. 

NPS also ensures asset allocation which many do-it-yourself investors ignore. They also get the benefit of automatic rebalancing at no cost. In mutual funds, when investors rebalance by selling, they face tax liability on the sale of both equity and debt fund units. 

High annuitisation on premature withdrawal: If an NPS investor retires before 60, as many in the private sector do, he faces an issue. If he withdraws his money, he will have to annuitise 80 per cent of his corpus. “The mandatory annuitisation of 80 per cent on premature exit is too high,” says M. Pattabiraman, associate professor, IIT Madras and founder, freefincal.com. Another issue for such an investor is that the rate of return on annuities is lower if purchased at a younger age. 

The low fund management charge in NPS also creates the risk of closet indexing (see table).  

NPS is also a complex product wherein the investor has to make many choices. These should be made carefully.  

  

Opt for tier II account? The rece­ntly introduced Section 80C tax benefit on tier II account is only for central government employees. Wait and watch to see if this benefit gets extended to the All Citizens model as well.  

Get your asset allocation right: Most investors need a high allocation to equities to be able to meet their retirement goals. “In the auto choice options, the equity allocation drops at too early an age. It is also difficult to target a certain rate of return if your asset allocation keeps changing. So, most savvy investors should opt for the active choice option,” says Pattabiraman. Choose your equity allocation based on your risk appetite (maximum 75 per cent is allowed under active choice) and keep it steady. On the debt side, sometimes corporate bonds (C) do well and sometimes government bonds (G), so divide your allocation equally between C and G. “Avoid investing in alternative assets (A) at present since a 5 per cent allocation will not make much difference to your returns,” says Raghaw.

Not much to choose among pension fund managers: The major difference in return will come in equities, so go with a fund manager who has been able to fetch a higher return there over the longer term and has at least average returns in C and G. Alternatively, go with a brand you trust, since the difference in returns of various PFMs over benchmark is marginal at present (see table). 

Choose the right annuity type: Take into account your family structure and circumstances. If you believe that your spouse is financially savvy, opt for an annuity where you get a pension for your lifetime, and then she gets a lump sum after you. But if you think that your spouse may not be able to manage a lump sum, go for one where your spouse too gets a pension after you. Those who want to leave a legacy should buy an annuity with return of purchase option. Once you have selected the appropriate variant, buy an annuity from the insurer offering the best rate of return.