Long lock-in, but safe investment: What NPS can do for your financial goals

NPS is an excellent product for retirement planning, provided you stay put till maturity

Tier-one equity schemes of the National Pension System (NPS) have given a category average return of 34 per cent over the past year. Government bond funds (G) have given 10.6 per cent while corporate bond funds (C) have given 8.6 per cent return over this period.

Takeaways

One thing that is clear from these returns is that equity portfolios are being managed actively. “The significant deviation from the return of the Nifty 50 index indicates that Pension Fund Managers (PFMs) are taking substantial exposure to stocks outside the Nifty 50,” says Deepesh Raghaw, a Securities and Exchange Board of India (Sebi) registered investment advisor (RIA).

The average return of C funds is in line with those of comparable mutual fund categories. The average return of G funds is also close to that of 10-year constant maturity gilt funds, which shows that PFMs are taking exposure to longer-duration government bonds with maturity of 10 years or more. “These returns, which are in line with market trends, are welcome. In the fixed-income space, too much alpha should set the alarm bells ringing as it indicates that fund managers may be taking too much risk,” says Raghaw.

Pension funds with larger assets under management (AUMs) are generating higher return against the benchmark than their peers with smaller AUMs. “This is primarily because larger the fund’s AUM, smaller is the fee, as mandated by the Pension Fund Regulatory and Development Authority (PFRDA). It becomes a cycle where higher returns lead to larger inflows, which in turn result in lower fund management fees and better returns on the invested corpus,” says Abhishek Kumar, a Sebi-registered investment advisor (RIA) and founder, SahajMoney.

Should you invest in NPS?

Many investors are likely to be attracted to NPS after seeing these returns. They should, however, first answer the question whether NPS is suited for them.

“In the case of young investors, who usually have limited funds available for investment, it’s important that an investment in NPS does not crowd out their other investments,” says Raghaw. Remember that NPS is a relatively illiquid product (you can withdraw limited amounts under specific circumstances during its tenure). If you are 25, your funds in NPS will get locked in for the next 35 years. If you need access to your money within the next five to ten years and a large portion of your savings are in NPS, that could create problems.

Investors who have opted for the new (default) tax regime must bear in mind that they will not receive tax benefits for their NPS contributions (they will still, however, receive tax benefit under the new tax regime if their employer contributes to their corporate NPS account).

However, at a time when equity and debt funds, as well as select insurance products have become taxable, NPS remains an excellent product for retirement planning, provided you don’t mind the long lock-in.

What should your asset allocation be?

On asset allocation, assuming you opt for the active choice, Raghaw suggests a balanced approach with a 50:50 allocation to equity and debt. The debt portion could be split as follows: 25 per cent in a corporate bond fund (C), and 25 per cent in a government securities fund (G). If you prefer to avoid credit risk entirely, you may allocate the 50 per cent debt portion entirely to G.

“A 50:50 split is simple and straight forward. If you rebalance regularly, you will get the rebalancing bonus,” says Raghaw. When equity markets fall and you rebalance, you get to purchase units of the equity fund at a lower cost, which boosts returns. Raghaw says there is no guarantee you will end up with a higher return if you opt for a 75:25 allocation (75 per cent to equities, 25 per cent to debt). A 50:50 allocation will also limit volatility.

Remember that in NPS rebalancing does not give rise to tax incidence (unlike in mutual funds).

If you wish to take higher equity exposure, do so through mutual funds, which offer a broader range of funds compared to NPS, where you have access to a single equity fund. In mutual funds, you can tailor your investment to your risk appetite. If you’re inclined towards higher risk, you can opt for mid-cap, small-cap, or factor funds. For a more conservative approach, you may opt for a Nifty 50 index fund or a balanced advantage fund.

Time to rebalance?

Check your overall weightage in equities, including the exposure to NPS and MFs. If you are overweight on equities, rebalance by selling units of equity funds belonging to NPS (as there will be no tax incidence).

Rebalancing should ideally be rule-based: either on a specific date (say, January 1 or your birthday); or based on certain threshold levels (plus or minus 5 or 10 percentage points vis-a-vis the original allocation). It can also be based on a combination of these two criteria.  

Over the long-term (five, seven and 10-year periods), returns from NPS equity funds have been in line with the Nifty 50 index. This bolsters the case for having a PFM who offers passive funds in this space.

As NPS is a long-term investment product, new investors should not get swayed by short-term returns. “Look at the investment management fee of the PFM. Those with larger AUMs would charge lower fees, which would help in increasing the overall return for investors over a long period of time,” says Kumar. He emphasises comparing returns over longer horizons – five, seven and 10 years – while selecting the equity fund manager.

As for choosing the debt fund managers, Raghaw says: “E can be with any PFM. But my allocation to C and G would be with one of the bigger investment managers. For bigger fund houses the reputation risk is too high, so they are unlikely to take undue risks chasing higher returns,” says Raghaw.