National Pension Scheme (NPS): Benefits and Drawbacks (Series-2)
National Pension Scheme is one of the Government social security initiatives which aims to provide financial cover to the individuals post retirement. The scheme is being widely promoted by the Government and even Corporate Houses are encouraged to avail the scheme so that employees working in private sector are also benefited from the same.
The National Pension Scheme (NPS) is hailed as one of the cheapest and citizen friendly scheme while Personal Finance experts are terming it as an ordinary retirement benefit plan. However, in my opinion it is a decent retirement plan, and like any other financial product it too has its own shares of pros and limitations. In my previous article, I have discussed about the NPS in detail. In this post I will try and reflect on the potential benefits and drawback of NPS.
The Benefits of Investing in National Pension Scheme (NPS):
Low Cost Pension Plan/Ease of Investing: National Pension Scheme is a low cost retirement benefit plan. Thus, Individuals with limited fund may also chose to invest in the fund. The minimum contribution to the Scheme is Rs 1,000/- per annum. The fund management fee is levied at just 0.1%.
Investment in NPS is simple and contribution may be made online and Subscriber may easily monitor the performance through the e-NPS portal.
Tax Deduction Available on Investment: Contribution upto Rs 50,000/- made towards your NPS account is eligible for Tax Deduction U/S 80 CCD (1B), which is up and over the deduction of Rs 1,50,000/- available U/S 80C. So individuals who are looking for additional tax saving options may also look to invest in Scheme.
Partial Tax Exemption on Withdrawal at the time of Retirement: As announced during the Budget 2016, upto 40% of the fund withdrawal at the time of retirement is exempted from tax. Earlier, the entire withdrawal amount was taxable. Thus partial tax exemption is not ideal but better than nothing at least. This implies if 60% of the fund is annuitized then no tax will be required to be paid on the balance withdrawals.
Mandatory Investment in Annuity Scheme: Referred as drawback by many, Individuals have to mandatorily invest 40% of the fund to purchase pension annuity. If you look at it with investment perspective it is a bad idea to invest in Annuity plans as they are not tax efficient and returns are also pretty low. However, do understand this is a social security scheme and aims to provide a pension to the retired so that they can sustain themselves. Therefore, I guess this rider is in place to make sure the funds are not ill utilized or spent entirely to meet some other purpose. In this regard, I feel this mandatory purchase of annuity is good although the annuity payout is quite low.
Diversification of Funds:Investment in NPS is diversified into 3 classes of funds, namely Equity (E), Fixed Return Instruments (C), Government Bonds (G). Individuals have the option to chose the allocation of funds based on their preference and appetite to take risk. However, Investment in equities is restricted to 50% of the contribution.
Thus, it ensures that Individuals benefit from the equity market. At the same time, allocation to Government and Fixed Return instruments ensure that in case of equity market under performing Subscribers don’t lose out heavily on their investment.
Low Cost Investment: This is one of the Low Cost investment options available to the Subscribers and is one of the key selling points of the scheme. But the charges may soon go up as Fund Managers are demanding higher fee to actively manage the funds. Subscribers are required to invest minimum of Rs 6,000/- annually in the scheme.
Professional Management of Funds: The fund is currently managed by notable Fund Managers which promises optimization of funds to ensure better returns to the Subscribers, which may not be possible for Individuals to achieve at a personal level.
However, everything is not perfect with the National Pension Scheme and there are few aspects of the funds which one should know and evaluate before investing.
The Drawbacks of Investing in National Pension Scheme (NPS):
Limited Exposure to Equities: It is observed that equity market offers better return over a longer period of time which is generally higher as compared to other fixed return instruments. Fund Allocation to Equities has been restricted to maximum of 75% of your investment (Under Life Cycle Fund). This may not be an big issue with short term investors but for young individuals in their 20’s-30’s this means potential loss of opportunity to accumulate more wealth through maximum exposure to Equity Market. The contribution under the Life Cycle Fund (LC-75) to the Equity class will gradually reduce post the Subscriber attains 35 years of age.
Restriction on Withdrawal: One of the major drawbacks considered by many is the restriction imposed on withdrawal of your contribution. Only 25% of the total investment may be withdrawn at any point after completion of 10 years active subscription also discourages many to invest in the scheme. Moreover, if the entire investment is withdrawn before the age of 60, then 80% of the fund is to be used up buying an annuity plan which makes it unviable plan for many individuals.
Portion of Withdrawal and Annuity Payout Taxable: Although 40% of the withdrawal is exempted from tax, but rest of the amount is taxable as per the Income Tax Act. Even the fund used to purchase an annuity carries a deferred tax liability on the same, meaning, that tax will be applicable on the Annuity payout received by an individual.
Low Returns on Annuity Plans: Minimum of 40% of the maturity amount needs to be vested in Annuity Plans which will provide you with monthly pension. However, the Annuity plans offer very poor returns on investment and are not at all tax efficient. Thus, one ends up with poor returns on the vested amount.
Better Alternatives Available: Mutual Funds are offering better Retirement plans as compared to NPS which promises better returns, tax efficiency and flexibility making them lucrative alternative for investment. Individuals may explore those options before investing in NPS.
Return on Investment Not Guaranteed: The investment in this scheme does not guarantee any minimum or fixed return as of now as it is subject to fund performance over a period of time. Hence, Individuals cannot be sure of the return on the investment and have to observe the fund performance closely. This again means one has to keep an eye on market trends which will reflect in the performance of the funds as well.
Should One Invest in National Pension Scheme (NPS)
Most of the personal finance experts do not approve of this scheme and I’m also not a great fan of this scheme. However, I would recommend this scheme to the individuals provided; they are able to diversify funds among NPS, Equity Mutual Funds, Public Provident Fund (PPF) and other Retirement Mutual Funds. As it will help them to enjoy tax benefits and strikes a good balance between wealth maximization and security.