Lifecycle investing through NPS

Under the auto choice pension option, the composition of portfolio will change over time.

The introduction of the New Pension Scheme (NPS) for individuals is likely to give them an important option for lifecycle investing. The scheme has been designed in such a manner that investors are given quite a few choices, depending upon their risk appetite and age.

However, before we get into the nitty-gritties of NPS, let's understand the concept of lifecycle investment. This is a mode of investment where the instruments match the changing needs of the person.

Over time, the needs and risk taking ability of an individual will change greatly because of changing priorities. As a result, a different kind of investment approach has to be followed over time. And there will be regular changes to composition of the portfolio.

In simple terms, this calls for investing in a manner that in the earlier years, there is a higher exposure to risky instruments like equities. And as one grows older, the portfolio balance has to shift towards safer debt instruments. In other words, if it is a 90:10 equity:debt ratio in the 20s, it has to come down to 30:70 when one is say, 50 years.

At present, an investor has to do this reallocation himself or with the help of a financial planner. However, under NPS this will be done automatically.

In the case of NPS, there are three options that are being offered by fund managers.

Equity (E): The maximum amount of investment in equities cannot exceed 50 per cent. Even in case of equities, the investment will be done through index funds that track the Sensex or the Nifty, and not directly in shares.

Debt (G): The money will be mostly invested in government securities of both state and central governments.

Debt (C): Investments will be made in credit risk-bearing fixed income instruments. These will consist of liquid schemes of mutual funds, rated bonds or securities of public financial institutions, public sector companies, municipalities and infrastructure bonds.

These are the three main choices for investors. And they are allowed to go for a mix-and-match among these three. However, there is another option, which is called Auto Choice. Here's how it will work:

In Auto Choice, funds will be invested automatically. In terms of the investment process, this will take place over the lifetime, where investments will be made under predefined parameters. That is, funds will be divided among various instruments, according to predefined percentages. And these percentages will keep on changing over time.

This implies that an investor is clear that at a particular age, the money will be invested in this manner. Also, there is clarity about the way things will change over the years.

There are specified percentages that have been announced under the Auto Choice option. The allocation to different options (E, G and C) are fixed till the time that a person touches 35 years of age. This will consist of 50 per cent in equities (E), 30 per cent in credit risk bearing fixed income instruments (C) and the remaining 20 per cent in government securities (G).

As each year passes, the fund managers will change the portfolio allocation to the three options. The first reallocation will take place on October 1, 2009. Thereafter, it will take place on each birthday of the individual investor.

The investor will find that every passing year the allocation to E class and C class will reduce by 2 per cent and 1 per cent respectively. This 3 per cent will be transferred to the G class.

Let's understand this with an example. For instance, X is 30 years of age and has contributed Rs 20,000 under the Auto Choice. The amount would be distributed as Rs 10,000 in the E class, Rs 6,000 in the C class and Rs 4,000 in the G class.

This will remain the same till he turns 36. After this, there will be a redistribution of the amount. Assume a situation where the E class has become Rs 20,000, the C class Rs 10,000 and the G class Rs 6,000 at age 36.

At this stage there has to be 48 per cent in E (Rs 17,280), 29 per cent in C class (Rs 10,440) and the remaining 23 per cent in G class (Rs 8,280).

When he turns 55, say his portfolio is worth Rs 5 lakh. At this point, Rs 50,000 each will be allocated to the E and C class while the remaining Rs 4 lakh will be in the G Class.

Investors need to understand that every year, there will be a rejig of the two parts of the entire allocation - fresh inflows and existing money. The latter may have grown larger or smaller depending on the performance of the fund.

The writer is a certified financial planner