The popularity of the National Pension System (NPS), the market-linked vehicle, has been soaring with investors desperately seeking retirement options. But for a newbie investor, investing in NPS can be very much like visiting a Starbucks outlet for the first time. The scheme offers so many choices that one is unsure where to start. With a little help though, you can use NPS’s large menu to your advantage.
Tier I and Tier II
One of the first choices you’ll need to make while opening an NPS account is whether you need just a Tier I account or want to add on a Tier II account as well. If retirement savings is your goal, a Tier I account should suffice.
The Tier II account is a voluntary investment vehicle where you can put in and withdraw money at any time. It is only under the Tier I account that your contributions earn tax breaks of up to ₹1.5 lakh a year under section 80C and the additional exemption of ₹50,000 a year under section 80CCD (1B). Tier II contributions do not earn any tax breaks. While the NPS Tier II does offer advantages such as flexibility and low fees, there are alternative products such as mutual funds that you can consider too, for such voluntary investments.
Which fund manager
The NPS lets you choose who will manage your money.
The scheme currently has 7 pension fund managers (PFMs) on its menu – Birla Sun Life Pension Management, HDFC Pension Management Company, ICICI Prudential Pension Management Company, Kotak Mahindra Pension Fund, LIC Pension Fund, SBI Pension Funds and UTI Retirement Solutions.
Given that the NPS is market-linked, there’s no easy way to gauge which fund manager will deliver the best performance in future.
However, their past return record can be a useful guide. The NPS Trust publishes the last 1-,3-, 5-,7- and 10-year returns of all PFMs weekly at http://www.npstrust.org.in/re
turn-of-nps-scheme . This table shows performance separately for equities, corporate bonds and government securities. However, as you can choose only a single PFM, it is best to go for one with a reasonable performance across all three.
In market-linked products, the true performance of a fund manager can be gauged only over a complete market cycle. Of the seven PFMs, only four have a 10-year track record. UTI Retirement Solutions, ICICI Pru Pension and SBI Pension have a good 10-year record.
Which asset classes
The NPS allocates your accumulated contributions into four asset classes – Equity (E), Corporate bonds (C), Government Bonds (G) and Alternative Investment Funds such as private equity funds, REITs, Invits (A). Your allocation among these is critical to your final returns.
These assets carry varying risk profiles. Equities can get you to a double-digit return in the long run with a significant risk of capital losses.
Corporate bonds can get you to a high fixed return with some risk of defaults. Government bonds fetch you a moderate fixed return with complete safety of capital. Alternative investment funds, usually targeted at high net worth investors, target supernormal returns by investing in unlisted or exotic assets, but carry high risks.
For ordinary investors, allocations to E, C and G are sufficient to build a sound retirement portfolio. How you divide your money should be based on your risk appetite.
Auto or Active choice
To implement an asset allocation, the NPS presents you with two possibilities — an Auto choice and an Active choice. The Auto choice helps you put your allocation in self-driving mode. The Active choice lets you to control how your contributions will be divided.
Earlier, opting for the Auto choice meant sticking to a single asset allocation plan. But today, the Auto choice has three readymade menus within it. So, there’s the Aggressive Lifecycle Fund that starts with a 75% equity allocation, 10% in corporate bonds and 15% in government bonds.
There’s the Moderate Lifecycle Fund which starts out with a 50% equity allocation, 30% in corporate bonds and 20% in government paper. There’s the Conservative Lifecycle Fund with a 25% equity allocation, 45% in corporate bonds and 30% in government bonds. Do note that these allocations are only the starting point and apply to NPS subscribers up to 35 years of age.
As you age, the Auto choice steadily trims your equities and raises your bond exposures. The automatic rejigs ensure that, by the time they turn 55, Auto choice subscribers have only 5-15% of their corpus invested in equities, with 85-95% in bonds.
In the Active choice, you get to decide how to mix and match E, C, G and A in any proportion, subject to just two conditions. One, the maximum you can invest in equities is 75% and that too up to 50 years of age. Beyond 50, your maximum equity limit gets reduced by 2.5% for every additional year. Two, you cannot park more than 5% in Alternative Investment Funds.
The Auto choice may certainly look appealing for folks to whom finance is Greek and Latin. But the flip side is that your returns at retirement may be sub-optimal. The Auto choice’s propensity to cut back on your equity exposures right from the age of 35 can leave you with a very bond-heavy portfolio in your 40s and 50s, when your earnings are likely to be at their peak.
To maximise the retirement corpus you accumulate, it is desirable to opt for the Active choice. Peg your equity allocations at 60-75% to begin with, park 15% in corporate bonds and the rest in government bonds. You can sit tight on this allocation until you turn 55. That will be a good time to shift allocations to government bonds in order to reduce risks in the home run to retirement.
Finally, one of the most investor-friendly features of NPS is that it allows you to change your choice of PFMs and asset allocations once a year, without any costs or tax implications. Review the performance of your PFM at least twice a year and exercise the switch option if there’s a big lag.
