This post is only relevant for Indian Tax residents (individuals who pay their taxes in India).
I am usually surprised by the lack of awareness around the National Pension System as an investment option.
It has all the great features of what a great investment option should look like, especially if you are in the 25 - 40 year age bracket.
Great way to diversify your investment portfolio
Extremely long term horizon (it is not timing the market but time in the market)
Tax benefits (benefits beyond typical 80C bucket)
Can be automated - so no tracking, switching funds required.
In this article, I will try to provide strong reasons why you should invest in NPS & will cover some of the common concerns people have with NPS.
Reason 1: Your gift to the 60-year old self
Consider NPS as a means via which the 30-year you is giving a gift to your 60-year version. Without the 29 versions of you (31 - 59) in between having a chance to change your mind mid-way. It is extremely important to understand this part.
How will your 31-59-year-old versions intervene in your long-term commitments?
In most long-term investments, the lock-in period is around 5-7 years. That means after every 5 to 7 years, either you have to take a decision on what to do with the money or there is a temptation to put the money in the next hot investment on the horizon.
NPS on the other hand has a lock-in till you turn 60.
The lock-in till you turn 60 years means that (a) you don’t have to make a decision about this specific part of your investment portfolio and (b) if ensures you don’t give in to temptations and disturb the steady compounding that is happening automatically for you.
Reason #2: Tax savings!
NPS investments are tax-exempt at both source and withdrawal, what does this mean?
In the case of NPS, if you want to contribute 50k to your elder-self, you only need to contribute 34,440, the rest of the ~15,000 will be contributed by the Government of India in terms of tax savings.
All other investment options are taxable at withdrawal, if not income tax then tax on Capital Gains. NPS withdrawal after retirement is completely tax exempt.
Concern#1: I am already investing in EPF/PF, why another investment?
Yes, EPF/PF & NPS have some similarities in the way that they both target extremely long-term retiral plans. But there are also some key differences that mean we need to consider NPS as an additional option beyond EPF.
NPS offers benefits beyond PF/VPF/EPF.
| Criteria | EPF/PF/VPF | NPS |
|---|---|---|
| Tax Benefits | Comes under 80C, so the same 1.5L limit applies. As most of us are already hitting that limit, we are basically parking our after-tax income |
It has a separate section from Tax deduction point of view.
NPS contribution is the only way to avail Tax benefits under section 80CCD |
| Interest rate | It is fixed and decided by the Governing body. Currently at 8.5% |
You decide the allocation of your funds based on your risk appetite.
Long term returns vary from 8% to 12% (depending on the fund manager, Debt Vs Equity exposure) |
| Lock in mechanism | You can withdraw up 50% after 7 years of contribution | Minimum 10 years of contribution, but it doesn’t make sense to withdraw before you turn 60, so better stay invested till you hit 60 |
The comparison doesn’t mean that you need to invest in either of the two, you need to maximize the tax-free investment in both the investment instruments.
Concern #2: I can manage my own investment better than a retirement fund
NPS is not your typical retirement fund, with NPS you can choose your investment strategy. If you have a higher risk appetite, you can select the fund with higher equity exposure.
It is just like selecting a Mutual Fund, although with limited options.
If you believe you have better options with Mutual Funds or individual stock picking, understand that your NPS investment will have a head start of 30% due to tax savings, which is near impossible to beat in the long run.
Consider a scenario where you have a surplus of 50,000 to invest,
With an independent mutual fund, you will be investing 35000 in 2021 (Vs 50,000 in NPS) and managing it over 30 years (tracking, switching funds with additional transaction costs). Most importantly, beating the market over a long-term horizon even by 1% is extremely difficult, and we are talking about a 30-year horizon.
Still not convinced? Do this exercise, pick what you believe is the best performing mutual fund in the market right now (pick a fund that has been around for more than 10 years), based on any parameter. Look at their last 1-year return and look at the returns of the same fund over 10 years, compare that with an Index fund. Now do the same exercise for 15 years. What you will realize is even the best performing funds of today had a rough patch in the past, in an extremely long-term horizon, you always end up with almost index fund returns.
The 10-year condition is important as we are looking at a 30-year horizon, and the difference in long-term returns is only evident only when you look over a horizon beyond 10 years. Unfortunately, it is extremely difficult to filter mutual funds based on their time in the market or 10-year returns. Most agencies selling Mutual funds know this and would rarely provide you an option to filter by “time in the market”.
Concern#3: What about the mandatory annuity of 40%?
Yes, that is one genuine concern. You can only withdraw 60% of your total investment, the rest of the 40% of your corpus goes to a mandatory annuity.
What does an annuity mean?
Let’s take an example, let’s say you start investing 50k every year in NPS in a tier 1 type E account.
In 2051, considering a return of 12%, your corpus would be 1.6Cr (not a huge amount, given 2051 prices, but still a gift with no taxes).
You can only withdraw 96 Lakhs out of it immediately. The remaining 64 Lakhs have to go to an annuity. An annuity is an investment option that will give you a fixed monthly income over a long period, say up to 20 years.
Given that this is a pension scheme, the government wants at least 40% of your income to go towards a pension - a steady monthly income. It is still your money, it is just that you get in form of a monthly income rather upfront. Do consider that your investment decisions would be very different when you are 60, annuity might actually make sense then vs now.
If you are convinced it makes sense to invest in NPS, you should try to maximize your tax savings via NPS.
What does maximizing NPS contribution even mean? Aren’t tax deductions only applicable up to 50k investment?
NPS provides Tax rebates under two different sections:
80CCD(1b): Voluntary investment up to 50k each year - you should definitely do it!
80CCD(2): Up to 10% of base salary deducted at source.
To contribute under 80CCD(2), your employer needs to offer that as an option. In that case, 10% of your base will be directly contributed to NPS, from a taxation point of view, your taxable salary goes down by your contributed amount. And there is no absolute limit to this contribution, irrespective of your base salary. But to contribute NPS under 80CCD(2), your employer’s payroll provider needs to provide this as an option.
Long term investments actually make you look beyond 5-10 year horizon
Now, time to get philosophical (these are pure opinions, so you can ignore this section if it doesn’t apply in your case). With time you should gradually spend more time and money on things that would only matter after 20-30 years.
Just imagining what you would be doing in 2051 and taking steps in that direction gives you a very different perspective on day-to-day decisions. It helps us build nostalgia for the future, instead of the past, gives us more reason to stay productive and vital.
The above opinion is a re-articulation of a passage from a 1960 book, ‘Psycho - Cybernetics’, by Maxwell Maltz. (Recommended read)
I believe it is applicable for all the decisions that would matter in the 20-30 years. Contributing to NPS is just another such commitment where you are forcing your subconscious to think extremely long term.