National Pension Scheme(NPS) – A Retirement Product

I was getting lots of queries for the Nationa Pension Scheme (NPS), how does it work?
NPS is completing 15 years this week for the general public and what would be a better time to write more about this product.

Over the 15 years, NPS has undergone many changes and become more of a retirement-friendly product, The Pension Fund Regulatory and Development Authority (PFRDA) has made the scheme more flexible and introduced new features and the finance ministry played a role in introducing separate income tax section for NPS tax deductions and making 60% of maturity corpus tax-free.

Still after 15 years, many folks are unaware of the benefits offers, the main reason I found out it is 40% compulsory annuitisation of maturity corpus

Retirement is one goal on which everyone should plan. You cannot get it wrong else you will run out of money in old age And you don’t want that. So gradually building a sufficiently large retirement corpus is an important aspect of financial planning. NPS offers everything that one looks for in a retirement saving product, it’s a long-term with a low-cost and low-risk profile product.

NPS have two phases:
1. Accumulation Phase
2. NPS Annuity (Pension) Phase

During your active employment period, you invest in NPS over several years to build the carpus according to your risk profile and capacity, while on retirement the second phase kicks in and part of NPS carpus is used to generate a steady stream of income (annuity/pension) for the life and plan you choose, The accumulated NPS corpus would depend on the contributions made and the returns generated from the investments made during the accumulation phase.

So if I describe the product in very simplistic language
Under the National Pension System (NPS), you contribute to the NPS account before retirement in working years. Your NPS investment earns market-linked returns, and when you retire, you can withdraw a portion of the accumulated NPS corpus as a lump sum while the remaining is to be utilized to purchase an annuity plan which provides pension during retirement years.

So Let’s answer the question
Question: Why someone should invest in NPS and what makes NPS better than other retirement products already available in the market.
NPS offers everything that one looks for in a retirement saving product, it’s a long-term with a low-cost and low-risk profile product, and the investors can start at the age of 18 and stay invested till the age of 75. Let me give you 5 reasons to invest in NPS.

1. Very low expense ratio which in turn translates to higher returns over a long period.
2. The tax benefits available over and above 80C.
3. Fund manager’s choices/flexibility to pick and choose which one they like
4. Flexibility of Asset mix available across (Equity/Debt/Alternate investments)
5. The government support to make NPS as a default option for pensions.

Let’s talk about these 5 reasons in detail

1. Very low expense ratio which in turn translates to higher returns over a long period.
If you don’t know what’s the expense ratio for any fund, please see the AMFI definition here, The fund management charges of NPS are very low compared to what mutual funds and typical insurance investment plans charge, the NPS by far is the cheapest option available. The below table compares various category expense ratios vs NPS tier 2 expense ratios, for tier 1 also it would be more or less similar.

2. The tax benefits available over and above 80C.
Tier I investment option in NPS comes with tax incentives, There are 3 ways to save tax with NPS
1. Firstly contributions of the the scheme are eligible for deduction in the overall 1.5 lakhs limit under section 80C.
2. Secondly there is an additional deduction of 50,000 available under section 80CCD(1b), this is over and above section 80C deduction and only available for NPS subscribers, people with a 30% tax bracket can save around Rs 15600/- by investing 50,000 in the scheme, which translates to a net outflow of Rs 34,400/-.
3. The third and the biggest tax-saving option available if your employer provides corporate NPS plans, under section 80CCD(2) up to 10% of the basic salary put in NPS is tax-free, for example, if your basic monthly salary is 100000, the employer will reduce 10000 from the salary every month and deposit to NPS, effectively 120000 will invest into NPS will be reduced from annual tax salary and effectively if you are into 30% tax bracket you will save Rs 36000/-, the good news is even if you opt for New tax regime 80CCD(2) section is available.

3. Fund manager’s choices/flexibility to pick and choose which one they like.
Investors can choose from 11 pension fund managers, and they are also allowed to change their fund manager once a year, also in 2024 PFRDA made an important modification where investors are allowed to pick 3 fund managers across asset classes (Equity/debt/Alternate investments) and invest where ever they see higher returns and more comfortable.

Fund Managers available in NPS (latest May 2024)
Aditya Birla Sun Life Pension Management
Axis Pension Fund Management
HDFC Pension Management
ICICI Prudential Pension Fund Management
Kotak Mahindra Pension Fund
LIC Pension Fund
Max Life Pension Fund Management
SBI Pension Funds
Tata Pension Management
UTI Retirement Solutions
DSP Pension Fund Managers

4. Flexibility of Asset mix available across (Equity/Debt/Alternate investments)
The NPS has also become more flexible over time and subscribers can now alter their asset mix 4 times a year, the best part changing asset classes in NPS will not have any implication on tax, unlike mutual funds when you switch from one plan to another it considered as withdraw and invest again and any gain will be taxable.

5. The government support to make NPS as a default option for pensions.
There is a myth that locking up the money until 60 years or until retirement, just like in the case of Public Provident fund (PPF) withdrawal is allowed for specific reasons

There is another option which is proposed for variable annuities, I also believe this could be a game change once it is proven and have some history in returns.

Other important details and my viewpoint:
1. Many think a compulsory annuity of 40% of the corpus is a deal breaker to invest but I feel annuity/pension should not be looked down upon, almost everyone at some point in time would require a fixed and assured returns income for the life, it’s almost like a fixed deposit, you still have 60% carpus given back which can utilize the generate high returns, see below the annuity plans available to use.

2. In the past NPS equity funds were only allowed to invest in index-based stocks but in 2021 PFRDA allowed investments in the top 200 stocks, which gives fund managers a bigger universe to choose the stocks and look at the long-term perspective.

3. NPS Tier I and Tier II account, remember Tier II is just like a large-cap mutual fund without any tax benefits.

Hope you find this article helpful and I would update this based on the changes coming to the scheme.

Happy Investing!