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Most of our clients as well as my friends are attracted towards NPS as a tax saving tool. Unfortunately, they are not fully aware about the pros and cons of parking funds in NPS. Through this article, I am attempting to simplify the concept of NPS. I would also attempt at throwing some light on how NPS works, comparison of NPS with other available financial products apart from the tax implications, to evaluate NPS as an investment avenue.

With an intention to evolve India as a pensioned society, Government of India rolled out NPS to all the citizens of India (including NRIs) from May, 2009 and corporate sector from December, 2011. The person (employee/citizen) who joins the NPS will be known as "Subscriber" in the NPS. There is no defined benefit that would be available at the time of exit from the NPS. In other words, NPS is designed on “Defined Contribution Basis” wherein the subscriber contributes to his account, which accumulates along with the income generated from investment of such wealth to become the corpus or the Accumulated Pension Wealth. It is however to be noted, that contributions made by NRIs are subject to regulatory requirements as prescribed by RBI and FEMA from time to time. If the subscriber’s citizenship status changes, his/her NPS account would be closed.

Every subscriber is identified through a unique “Permanent Retirement Account Number (PRAN)”. There are 3 account options offered under NPS:

1. Tier 1 NPS Account: This is the compulsory and non-withdrawable account. In other words, contributions made to this account cannot be withdrawn before the age of 60 years.

2. Tier 2 NPS Account: This is the voluntary savings account and offers flexibility of withdrawals. The pre-requisite for opening a Tier 2 NPS Account is an active Tier 1 NPS Account.

3. Swavalamban Scheme: This scheme is exclusively for lower income group people who are not employed on a regular basis in an autonomous body. In this scheme the Government pays INR 1,000 per year for a period of 4 years.

Every subscriber investing in NPS gets to choose between two scheme preferences. The following are the available scheme preferences:

• Active choice: Here, the subscriber has to select a Pension Fund Manager (PFM) and actively decide as to how his/her pension wealth is to be invested. Every subscriber will have the following four options to decide from:

  1. Asset Class “E”:  Investments in predominantly equity market instruments 

  2. Asset Class “C”: Investments in fixed income instruments (like corporate bonds, fixed deposits, etc) other than government securities

  3. Asset Class “G”: Investments in Government securities (like treasury bills)

  4. Asset class “A”: Investment in Alternative Investment Schemes including instrument like Commercial mortgage-backed securities (CMBS), Mortgage-backed securities (MBS), Real estate investment trusts (REITs), Alternative investment funds (AIFs), Infrastructure investment trusts (InvIts) etc.

Subscriber can choose to invest his/her entire pension wealth in C or G asset classes and up to a maximum of 50% in equity Asset class “E” and upto a maximum of 5% in Asset class “A”. Subscriber can also distribute his/her pension wealth across E, C, G and A asset classes, subject to such conditions as may be prescribed by PFRDA. 

• Auto choice: NPS offers an easy option for those participants who do not have the required knowledge to manage their NPS investments. In case subscribers are unable/unwilling to exercise any choice as regards asset allocation, their funds will be invested in accordance with the Auto Choice option.

In this option, the investments will be made in a life-cycle fund. Here, the proportion of funds invested across asset classes will be determined by a pre-defined portfolio (which would change as per age of subscriber), with the investment in Asset class “E” decreasing and in Asset class “C” & Asset class “G” increasing with the age of the subscriber.

Three Life Cycle funds are available under this Auto Choice:

1. LC75 - Aggressive Life Cycle Fund: In this Life Cycle Fund, the exposure in Equity Investments starts with 75% till age 35 and gradually reduces as per the age of the subscriber

2. LC50 - Moderate Life Cycle Fund: In this Life Cycle Fund, the exposure in Equity Investments starts with 50% till age 35 and gradually reduces as per the age of the subscriber

3. LC25 - Conservative Life Cycle Fund: In this Life Cycle Fund, the exposure in Equity Investments starts with 25% till age 35 and gradually reduces as per the age of the subscriber

 The default auto choice if the subscriber is not choosing any of the above option is Moderate life Cycle Fund.

As per Pension Fund Regulatory & Development Authority (PFRDA) Exit Rules, following withdrawal categories are allowed:

1. Upon Normal Superannuation:  At least 40% of the accumulated pension wealth of the subscriber has to be utilized for purchase of annuity providing for monthly pension and the balance is paid as lump sum to the subscriber. In case the total corpus in the account is less than INR 200,000 as on the Date of Retirement (Government sector)/attaining the age of 60 (Non-Government sector), the subscriber (other than Swavalamban subscribers) can avail the option of complete Withdrawal.

2. Upon Death: The entire accumulated pension wealth (100%) would be paid to the nominee/legal heir of the subscriber and there would not be any purchase of annuity/monthly pension.

3. Exit from NPS Before the age of Normal Superannuation: At least 80% of the accumulated pension wealth of the subscriber should be utilized for purchase of an annuity providing the monthly pension and the balance is paid as a lump sum to the subscriber. 

It is to be noted that the above withdrawal rules are applicable for the accumulations made under Tier 1 NPS account only. Accumulation made under Tier 2 NPS account can be withdrawn anytime. Tier 2 accumulations does not attract any lock in period, and hence no tax benefits are applicable to Tier 2 contributions.

The following table gives a quick comparison between NPS and other available retirement benefit schemes:

* In case of corporates, it is to be noted, that NPS can be used as an effective tax saving tool by employer to the employees in highest tax slab. The employer can contribute 10%  of salary (Basic pay + Dearness Allowance) which employee can claim tax exempt. The other advantage being the fact that it is not mandatory under NPS scheme for both employer and employee to contribute like in EPF Scheme. Tax benefits listed in the table above is applicable for employees contribution towards NPS Scheme.

Some of the concerns of investments in NPS are as under:

1. Liquidity is one of the important facets of any investment. Lock-in period until the age of 60 except under the circumstances of any critical illness or buying / constructing a house makes NPS a highly illiquid investment product.

2. Annuities are high-cost, low-return products of life insurance companies. Mandatory purchase of annuity (minimum of 40% of the corpus after the age of 60 years and a staggering 80% of the corpus in case of premature withdrawal) makes NPS less attractive.

3. Even for a very long time horizon, a maximum of only 50% allocation to equity for active scheme preference and 75% upto the age of 35 years for auto scheme preference can hamper the possibilities of maximising / optimising returns.

4. While much is made of the very low fund management charge, there are multi-level charges at various offices and levels of the NPS system, the cumulative effect of which makes NPS a far more expensive system than what it appears at first glance.

Suitability of NPS would depend a lot on the investor’s situation, life cycle goals and risk appetite.

Note: This article is for information purposes only.