Nishant Batra, Research Head
In this Article, I will be writing about NPS, it will be a long article, covering a lot of aspects. Government employees with joining date prior to 01st January’2004 are lucky enough that they will get pension and increments on pension as well. For all the new recruits who have joined government job on or after 01st January’2004 are by default covered under National Pension Scheme. Self-employed or salaried person working in private sector can also opt for National Pension Scheme. Let us understand some of the concepts before exploring the main topic.
What is a defined benefit plan?
A defined benefit plan is a retirement plan where you know in advance the pension amount or the formula to calculate the pension amount. And irrespective of the market conditions, you will keep getting pension for entire life. The pension amount is a function of salary history and the number of years into the service.
However, of late, central government as an employer has taken a shift from defined benefit plans and has adopted defined contribution plans for employees recruited on or after 01st January’2004
What is a defined contribution plan?
Contrary to a defined benefit plan, the pension amount is not known in advance in defined contribution plan. Here, the pension amount depends on your contribution, your employer’s contribution and the returns generated by the asset allocation and investment manager chosen by you. Employer contributes a fixed amount (function of Basic + Dearness Allowance) towards the pension fund of the employee and the investment risk is borne by the employee. It allows the employers offset the liability by contributing a fix amount.
The National Pension Scheme is an example of a defined contribution plan.
An annuity is a contract between insurance company and the policyholder which aims at generating stable & secured income during retirement, where in lump sum payment is made by the policyholder to obtain certain amounts, at regular intervals, immediately or at some point of future.
National Pension Scheme
Now let’s comes to the core of this article and understand NPS from scratch. Contributions to National Pension Scheme can be made in two buckets, Tier 1 Account and Tier II Account. Tier I is the main retirement vehicle whereas Tier II account is like a flexible side cart. Tier II Account can only be opened by Tier I subscribers. I will come back on Tier I and Tier II differences later in the article.
NPS can be broadly classified into two categories, Government Sector & Non-Government Sector. The non-government sector is further sub-classified into corporates and all India citizens. Regulations in certain aspects are different for all these categories. I will be highlighting the same throughout the article.
NPS offers you two approaches, four asset classes and seven portfolio managers to choose from:
A. Active choice
B. Auto choice
Following are the assets classes available for investment under NPS:
A. Equity or E- A ‘high return-high risk’ fund that invests predominantly in equity market instruments
B. Corporate Debt or C – A ‘medium return-medium risk’ fund that invests predominantly in fixed income bearing instruments
C. Government Securities or G – A ‘low return-low risk’ fund that invests purely in Government Securities
D. Alternative Investment Funds or A –In this asset class, investments are being made in instruments like CMBS, MBS, REITS, AIFs, Invlts etc.
According the PFRDA guidelines on FDI, foreign sponsor company cannot breach the 49 per cent limit and the sponsor limit was getting breached as Nippon Life was increasing its stake in Reliance Nippon Asset Management. To over this, the company made the request to surrender their licence under NPS. It was one of the eight companies to manage funds for NPS Subscribers. Below image captures the list of 7 Pension Fund Managers.
Assets managed by Reliance were transferred to LIC and subscribers were given one-month window to change their Pension Fund Manager, if they want to.
Selection of Asset Class and proportion & Portfolio Managers
Tier I Account
An NPS Subscriber is required to choose the Pension Fund Manager (PFM) as well as scheme preference from the various options. In NPS Tier I Account, the options for government employees are limited and restricted when compared to non-government sector. Thanks to the circular issued on 01st June’2020, some of these restrictions have been relaxed but still options are limited when compared to non-government sector. Prior to this circular, the contribution of all the Government Employees was invested in default scheme. In the default scheme, the contribution was allocated to three Pension Fund Managers viz. SBI Pension Funds Private Limited, UTI Retirement Solutions Limited and LIC Pension Fund Limited in a predefined proportion and each of the PFMs invest the funds in the proportion of 85% in fixed income instruments and 15% in equity and equity related instruments. After the circular, these subscribers are allowed to choose any one of the PFM including the private sector pension fund managers. However, those who are not making any changes, the default scheme will remain the default option. Apart from choosing the PFM, relaxation was also given in choice of investment pattern with three choices:
- Default Scheme = In the default scheme, the contribution was allocated to three Pension Fund Managers viz. SBI Pension Funds Private Limited, UTI Retirement Solutions Limited and LIC Pension Fund Limited in a predefined proportion and each of the PFMs invest the funds in the proportion of 85% in fixed income instruments and 15% in equity and equity related instruments.
- Scheme G = 100% in government securities
- Auto choice for lifecycle fund:
A. LC-25 Scheme – This Life cycle fund provides a cap of 25%
of the total assets for Equity investment. The exposure in Equity Investments starts with 25% till 35 years of age and gradually reduces as per the age of the Subscriber.
B. C-50 Scheme – This Life cycle fund provides a cap of 50% of the total assets for Equity investment. The exposure in Equity Investments starts with 50% till 35 years of age and gradually reduces as per the age of the Subscriber.
Government employees can change their option for PFMs once in a year and investment pattern twice in a financial year.
It should also be noted that legacy corpus was not allowed to be shifted in light of effect on market due to the movement in huge corpus. However, it has been promised that PFRDA will draw up a scheme in next five years to enable change of PFM or investment patter. (Five years is a long period, don’t know why this task should become another panch varshiye yojna).
There are far more choices for Non-Government subscribers (we are still discussing Tier I account). The subscriber can choose between active choice (customized) and one of three Life Cycle Fund in auto choices.
In the active choice, among the E, C, G & A asset classes, investor can choose any proportion subject to:
- Maximum permitted equity allocation up to the age of 50 years is 75%, thereafter it goes down 2.5% every year till it reach 50% at 60 years. Subscriber can continue with 50% equity in case of continuation of account (which is allowed up to 70 years). The tapering off in equity allocation is on birth date of the subscriber.
- Subscriber cannot allocate more than 5% in Alternative Investment Funds
- Total Allocation of E, C, G and A must be equal to 100%
Depending upon the risk appetite of Subscriber, there are three different options available within Auto Choice – Aggressive, Moderate and Conservative. Here, the proportion of funds invested across three asset classes will be determined by a pre-defined portfolio (which would change as per age of Subscriber)
LC75 – Aggressive Life Cycle Fund: This Life cycle fund provides a cap of 75% of the total assets for Equity investment. The exposure in Equity Investments starts with 75% till 35 years of age and gradually reduces as per the age of the Subscriber.
LC50 – Moderate Life Cycle Fund: This Life cycle fund provides a cap of 50% of the total assets for Equity investment. The exposure in Equity Investments starts with 50% till 35 years of age and gradually reduces as per the age of the Subscriber.
LC25 – Conservative Life Cycle Fund: This Life cycle fund provides a cap of 25% of the total assets for Equity investment. The exposure in Equity Investments starts with 25% till 35 years of age and gradually reduces as per the age of the Subscriber.
Tier II Account
With respect to Selection of Asset Class and proportion & Portfolio Managers, NPS Tier II account for all categories of investor is similar to the rules for non-government subscribers in Tier I Account.
But in case the contribution is made by Central Government employee under recently introduced NPS Tier II Tax Saver Scheme 2020, it will mandatorily be invested 10-25% in equities and the rest in government and corporate bonds in no fixed proportion. I have discussed the tax exemption of this under Contributions & Tax Breaks.
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Contributions & Tax Breaks
A Subscriber is required to make minimum initial contribution of INR 500 for Tier I Account and a minimum initial contribution of INR 1000 for Tier II Account at the time of registration. Subsequent minimum contribution amount is INR 500 for Tier I subject to a minimum of INR 1000 contribution per Financial Year. Subsequent minimum contribution amount is INR 250 for Tier II Account and yearly contribution in Tier II Account is not mandatory.
- Section 80CCD(1)
- Contribution made by Government Sector Subscriber (salaried), Non-Government Sector Subscriber (Private Sector Employees and Self Employed persons). All these contributions come in overall cap of INR 1.5 Lakh
- Section 80CCD(1B)
- Additional deduction of INR 50,000 over and above Section 80CCD(1)
- Section 80CCD(2)
- For Contribution made by Employers (Government Sector Subscribers as well as Non-Government Sector Subscribers) for their employees
Under Section 80CCD(1), Non-Government salaried employees can claim tax exemption on their NPS contribution in Tier I Account up to 10% of their (Basic + Dearness Allowance) or 10% of their gross total income, whichever is less. The limits for Government Employees is 14% of their (Basic + Dearness Allowance) or 14% of their gross total income, whichever is less. And the limit for self-employed is 20% off their gross total income.
Total exemption for all categories of subscriber under section 80CCD(1) towards NPS Tier I contributions in a year cannot exceed the overall cap of INR 1.5 lakh a year.
INR 1.5 lakh tax exemption could had already been utilized in various avenues like PPF, Sukanya Samridhi, Employees Contribution towards Provident Fund, Voluntary Provident Fund, Equity Linked Savings Scheme, Tax Saver Fixed Deposit, National Savings Certificate. Even the expense towards child tuition fees can be claimed in this head. Premium paid for life insurance also comes under this section. Then, Why NPS?
The Budget of 2015 inserted a new sub-section Section 80CCD(1B), which allows the assessee to claim additional deduction from gross total income of up to INR 50,000 by contributing in National Pension Scheme.
Under section 80CCD(2), employers contribution (Government Sector Subscriber as well as Non-Government Sector Subscriber), also gets tax breaks up to 10% of salary for non-government sector employee and 14% for government sector employee. It will be prudent on my part to highlight that effective 01st April’2021, the employer’s contribution in excess of INR 7.50 lakh towards Provident Fund, Superannuation Fund and NPS will be treated as perquisite and will be added to salary of the subscriber and taxed at slab rate. Moreover, interest and other income relatable to this excess contribution will be added to his income year after year.
Government Sector subscribers can claim INR 1.5 lakh deduction from gross total income under 80C by contributing INR 1.5 lakh in NPS Tier II Tax Saver Scheme 2020 subject to a lock-in period of 3-year lock-in and specific conditions on selection of asset classes (discussed below).
Taxation on Returns Stage
Similar to a mutual fund scheme with growth option, returns in NPS are captured by the movement in NAV. The taxation on this change in valuation is zero or we can say exempted in Tier I account.
Tier II Account taxation is discussed later in this article. Remember, in Tier II, contributions can be made and withdrawn any time, except for the contributions made by Government Sector subscribers in NPS Tier II Tax Saver Scheme 2020.
Withdrawal, continuation beyond maturity & Tax implication
Tier I Account
On maturity i.e. when the subscriber turns 60, withdrawal can be made but there is a caveat. 40% of the corpus has to be mandatorily invested in a monthly annuity. Subscriber can choose the type of annuity and annuity service provider. Remaining 60% can be taken as lumpsum, no question asked, use it the way you like it. In case the accumulated corpus is less than or equal to Rs. 2 Lakh at the time of Superannuation or attaining age of 60 years, it can be withdrawn fully as lumpsum, no need for annuity. It is at the discretion of subscriber to defer withdrawal of lumpsum or annuity or both. The subscriber can opt for continuation and can also keep contributing in the Tier I account up to the age of 70 years. Opting for continuation doesn’t have any firm lock-in, subscriber can back track and exit from NPS.
The purpose of Tier I Account is to prepare the subscriber for their retirement that’s why pre-mature partial withdrawals have been discouraged by imposing strict restrictions. Only when following conditions are met, partial withdrawal can be done:
- Subscriber should be in NPS atleast 3 years
- Withdrawal amount will not exceed 25% of the contributions made by the Subscriber. Please note 25% of the contributions made, irrespective of the market value of the corpus.
- Withdrawal is allowed only against the specified reasons:
- Higher education of children
- Marriage of children
- For the purchase/construction of residential house (in case the subscriber already owns either individually or in joint name a residential house or flat other than the ancestral property, no withdrawal under these regulations)
- For treatment of Critical illnesses
- For establishing of own venture
- Towards meeting the expenses by subscriber for skill development or re-skilling or for any other self-development activity.
It is also noteworthy that withdrawal can happen maximum of three times during the entire tenure of subscription. In case of Pre-mature Exit- If total accumulated corpus is less than or equal to Rs. 1 Lakh, the Subscriber can avail the option of complete Withdrawal. However, you can exit from NPS only after completion of 10 years.
Voluntary Retirement is treated as pre-mature exit. 100% of the accumulated corpus can be withdrawn on pre-mature exit but 80% of the maturity proceeds will go towards purchase of monthly annuity. 20% can be taken as lumpsum and can be used at the subscriber’s discretion. If the accumulated corpus is below INR 1 lakh, it can be withdrawn fully as lumpsum, no need to buy annuity. Subscriber will not have the option to defer the lumpsum withdrawal in case of pre-mature exit.
In case of disability of the subscriber, the exit from NPS will be treated as normal exit. 60% as lumpsum and 40% goes to annuity. Subscriber has to submit, disability certificate from government surgeon or Doctor. Percentage of disability should be more than 75% and in the opinion of doctor, the subscriber shall not be in a position to perform his regular duties and in high probability may not be able to work again for the remaining period of life.
In case of death of the subscriber before retirement, the entire accumulated pension corpus will be paid to the nominee or legal heirs and whether to purchase any annuity or not will be at the discretion of legal heirs.
Tier II Account
Confusion and different interpretation, nothing clear in Income Tax Act and a lot of ambiguity. I can move on to the next point but let me give my take on this. Tier II NPS Account is like a low-cost portfolio manager without any exit load, you can contribute and withdraw at you will. As of now to be on safer side, taxation can be assumed to be like that of interest income i.e. all the gains will be taxed at marginal rate of taxation of the assessee without any indexation. Although, I expect, at sometime in future, the taxation of NPS Tier II Account will become similar to that of Non-Equity Mutual Funds.
If continuation of Tier I account is opted, Tier II account can also be extended till 70 years. Only Tier II Account cannot be extended. On closure of Tier I account, tier II account will also be closed.
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Karna kya hai, yeh batao
Bhahiyaa ji, soch kar samaj kar invest kar. Taxes saved or deferred can play in a huge role in financial planning. Higher the tax bracket you are in the more I will recommend you National Pension Scheme. Why? Refer below example:
Let’s say X has Annual Income post adjustment of all exemptions, deductions and everything of (INR X + 50,000) and this incremental INR 50,000 falls in 30% tax bracket. If X doesn’t invest in National Pension System, the tax outflow will be INR 15,000. After this tax outflow, X will be left only with INR 35,000. On the contrary, if X decides to invest in National Pension Scheme and claim deduction under Section 80CCD(1B), he would have saved tax of INR 15,000. It means, X has to forgo liquidity of only INR 35,000 to invest INR 50,000 worth of contribution in NPS Tier I Account. On day 1, X has earned 42.85% (15K/35K) of return. That’s an awesome return which provides cushion to ride through most severe of market crashes. The number of 20% tax bracket and 10% tax bracket is 25% and 11.11% respectively. Thing here to be noted is I have not considered Health & Education Cess of 4% which will make the case more appealing to invest in National Pension Scheme. In case of assesses with income greater than INR 50 lakhs even surcharge will come into picture and make the case even stronger.
The biggest drawback in National Pension Scheme is the Annuity:
- The pension becomes taxable. A person with other sources of income may not want to generate income taxable at slab rate. This person will prefer capital gains over pension income.
- The amount of differential in long term G Sec yield and the yield provided by insurance company. Let’s consider this example:
Mr. Pensioner got retired on 23rd November’2020 (date of birth 22nd November 1960) on attaining the age of 60 years. He opts to exit the NPS and take 60% as Lumpsum and buys an Annuity (Annuity for life with return of premium) from balance 40%. Let say that balance 40% is equal to INR 1 Crore. In the below table, I am showcasing the monthly pension available from different insurance companies for immediate annuity with return of 100% capital to nominee.
Now let us calculate the amount of monthly interest one could generate on a 30-year government of India bond, it is close to 55,000 per month.
- One of the tricks to manage the annuity part is to defer the withdrawal of annuity to 70 years. Also, opt for return of principal in annuity, this portion will be left as inheritance. Nomination and Will is recommended.
- Tier II Account should not be touched with barge pole till the time there is not enough clarity on its taxation. This is a big regulatory risk, what if the gains get taxed at slab rate. No point in touching this black box.
- Regarding the asset allocation, NPS should not be viewed separately, to achieve retirement goal, INR 50,000 per annum in NPS is not enough, one should have mutual funds, EPF/VPF/PPF as main vehicles. Asset allocation for a goal should be viewed holistically. Avoid Alternative Investment and allocate among E,C & G as per over portfolio positioning.
- Employees having high salary income (Basic + DA > 60 lakh), should not take NPS from their company. Effective 01st April’2021, the employer’s contribution in excess of INR 7.50 lakh towards Provident Fund, Superannuation Fund and NPS will be treated as perquisite and will be added to salary of the subscriber and taxed at slab rate. Moreover, interest and other income relatable to this excess contribution will be added to his income year after year.
- The cost in NPS is so low that it should be the last bucket (even the lumpsum after maturity) to withdraw.
- Low cost is also a concern for me as equity is managed actively. At such a low cost, I have my doubt for active equity management. PFRDA should make it passive and make the equity portion replication of Nifty 50 or Nifty 100.
- Before exiting the account, make sure you make some partial withdrawals for any of the approved reasons, it will help in bringing the Annuity Corpus down.
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Nothing in this article should be constructed as investment advice; readers are advised to consult their advisors before making any investment decisions.