 "Minimum guaranteed returns under NPS may not be good")
The National Pension System (NPS) has been in operation for quite some time now, but it has not yet found too many takers. The number of subscribers is very low, considering that there is a dearth of avenues for investors to save for their retirement.
The passage of the Pension Bill promises several changes for investors of the National Pension System (NPS). One of the changes proposed is assuring minimum guaranteed returns for investors. Given that the returns from the NPS cannot be predicted (since they are dependent on market conditions), this may seem like a good option for investors. After all, who likes volatility? But insisting on minimum returns may not necessarily be a good option for investors. Read on to find out why.
Minimum assured return
The uncertainty about the returns in the NPS is different from what investors are used to in their long term investment products. The usual long term options like the Employees Provident Fund (EPF) or the Public Provident Fund (PPF) or some long term bonds all have an element of surety attached to them. While the capital is protected for sure, there is a certain assurance that the returns from these instruments will be of a certain level.
Though theoretically the returns from the EPF and PPF can see a sharp fall in case the overall economy sees a slowdown, there is still an element of confidence in these products. But in the NPS even the debt option could end up in negative territory if the bond market conditions turn unfavourable. Hence, the proposal to offer a minimum assured return option for investors. This would ensure that investors are able to get a certain return that is guaranteed from the scheme.
The belief is that this will give some element of comfort to them with regard to their long term investments. This might seem like a simple solution to the overall problem. But the fact is that this might actually do more harm than good for investors over the long run and, hence, this is something to be watched closely.
Absolute level
There is the question of the absolute level of return that will actually be earned under the minimum assured return plan. Since this has to be paid out or earned no matter what is the prevailing situation in the markets, then the absolute level is likely to be low. In such a plan, the fund manager has to ensure that the investments are made in such a manner that there is protection of capital and a specific return that does not have much volatility. To meet these requirements, it is likely that the absolute figure will be lower than the prevailing market rate. This means that there could be other investments which look better in comparison. This could be the first negative point.
Opportunity cost
Every investor who invests money into a certain fund or scheme for the long term will compare the rates that are present on various instruments in the market. This will happen to NPS. Investors will compare the returns from NPS with returns that can be earned elsewhere. In this sense the minimum assured return fund could very well turn out to be an underperformer because the returns here could very well lag other options.
In this case, the comparison is likely to be with the EPF that currently gives a return of 8.5 per cent, while the PPF gives a return of 8.7 per cent.
Another drawback is that the minimum assured plan could also end up giving the least returns especially when times are good. So this, too, will work against the NPS.
Real rate of return
The main aim of retirement planning is to invest for a very long time. The goal of the investment is to build a decent corpus so that there is an adequate amount available as pension. The central goal of the investment is, thus, to beat inflation so that there is a real rate of return earned, which also helps in the process of wealth creation.
Selecting the minimum assured return plan is likely to result in a long-term situation where the inflation rate ends up being far higher than the amount earned. This could lead to a loss of value in purchasing power terms and this is something that investors would not want with their investment.
Mismatch of risk
Since retirement planning is for long-term period, there could be a mismatch between the right kind of risk perceived for the investment product and the actual risk.
Long-term investments are where some additional risk can be taken. But what is being proposed is just the opposite. Even the smallest amount of risk is being removed from the investment. This is not likely to give the best results at the end of the day and that is something that the investor should think about.
The passage of the Pension Bill promises several changes for investors of the National Pension System (NPS). One of the changes proposed is assuring minimum guaranteed returns for investors. Given that the returns from the NPS cannot be predicted (since they are dependent on market conditions), this may seem like a good option for investors. After all, who likes volatility? But insisting on minimum returns may not necessarily be a good option for investors. Read on to find out why.
Minimum assured return
The uncertainty about the returns in the NPS is different from what investors are used to in their long term investment products. The usual long term options like the Employees Provident Fund (EPF) or the Public Provident Fund (PPF) or some long term bonds all have an element of surety attached to them. While the capital is protected for sure, there is a certain assurance that the returns from these instruments will be of a certain level.
Though theoretically the returns from the EPF and PPF can see a sharp fall in case the overall economy sees a slowdown, there is still an element of confidence in these products. But in the NPS even the debt option could end up in negative territory if the bond market conditions turn unfavourable. Hence, the proposal to offer a minimum assured return option for investors. This would ensure that investors are able to get a certain return that is guaranteed from the scheme.
The belief is that this will give some element of comfort to them with regard to their long term investments. This might seem like a simple solution to the overall problem. But the fact is that this might actually do more harm than good for investors over the long run and, hence, this is something to be watched closely.
Absolute level
There is the question of the absolute level of return that will actually be earned under the minimum assured return plan. Since this has to be paid out or earned no matter what is the prevailing situation in the markets, then the absolute level is likely to be low. In such a plan, the fund manager has to ensure that the investments are made in such a manner that there is protection of capital and a specific return that does not have much volatility. To meet these requirements, it is likely that the absolute figure will be lower than the prevailing market rate. This means that there could be other investments which look better in comparison. This could be the first negative point.
Opportunity cost
Every investor who invests money into a certain fund or scheme for the long term will compare the rates that are present on various instruments in the market. This will happen to NPS. Investors will compare the returns from NPS with returns that can be earned elsewhere. In this sense the minimum assured return fund could very well turn out to be an underperformer because the returns here could very well lag other options.
In this case, the comparison is likely to be with the EPF that currently gives a return of 8.5 per cent, while the PPF gives a return of 8.7 per cent.
Another drawback is that the minimum assured plan could also end up giving the least returns especially when times are good. So this, too, will work against the NPS.
Real rate of return
The main aim of retirement planning is to invest for a very long time. The goal of the investment is to build a decent corpus so that there is an adequate amount available as pension. The central goal of the investment is, thus, to beat inflation so that there is a real rate of return earned, which also helps in the process of wealth creation.
Selecting the minimum assured return plan is likely to result in a long-term situation where the inflation rate ends up being far higher than the amount earned. This could lead to a loss of value in purchasing power terms and this is something that investors would not want with their investment.
Mismatch of risk
Since retirement planning is for long-term period, there could be a mismatch between the right kind of risk perceived for the investment product and the actual risk.
Long-term investments are where some additional risk can be taken. But what is being proposed is just the opposite. Even the smallest amount of risk is being removed from the investment. This is not likely to give the best results at the end of the day and that is something that the investor should think about.
The author is a Certified Financial Planner