National Pension Scheme (NPS) – Why it is not a good Investment Option?

The Government of India rolled out the National Pension Scheme (NPS) for all the citizens of India from May 1, 2009 and for corporate sector from December, 2011. Any individual whether employed with private sector, self employed or professional can avail of pension benefits and plan his or her retirement by enrolling in this scheme. The person (employee/citizen) who joins the NPS will be known as “Subscriber” in the NPS. Under the NPS, each Subscriber will open an account with Central Record keeping Agency (CRA). This account is identified through unique Permanent Retirement Account Number (PRAN). The Centre made NPS scheme mandatory for all the employees who joined the service on or after January 1, 2004. It has since been adopted by most state governments also. Currently, NPS has more than 1.13 Crore subscribers with total Asset under Management (AUM) of more than Rs. 1.09 lakh crore. Most of my blog readers have chosen NPS for two main reasons – i) for tax saving purpose & ii) No other choice than to invest as contribution to NPS has been made mandatory for the Govt employees. Unfortunately, majority of the subscribers are not aware of ‘how NPS scheme works’ and invest in it just to save some taxes. Most of us are eager to know about the tax benefits that are being offered while contributing to NPS but are not worried about the applicable taxes at maturity. In this post, let’s understand – Is NPS a good investment option? What are the drawbacks of National Pension Scheme?

National Pension Scheme – Why NPS is not a good Investment?

A long-term investment option for your retirement planning should ideally have below features;

• It should be simple and easy to understand
• Should be flexible
• Should have high liquidity
• Should be a tax efficient product and ideally should fall under Exempt – Exempt – Exempt category.
• You should be able to withdraw the whole corpus at the time of retirement and you should be allowed to re-invest the corpus as per your choice/requirements.

Retirement planning is a long-term goal, so when we are investing for a longer period, I prefer to invest in a simple, flexible, easy to understand, tax efficient & highly liquid investment option. According to me, National Pension Scheme is not a great investment option for your retirement goal. It does not meet any of the above criteria. Let’s understand why it is not a good choice;

• Lock-in Period : National Pension Scheme has a high lock-in period. The retirement age is fixed at 60 years. You can not withdraw the entire corpus till your reach 60 years of age. If you look at other tax saving investment options like PPF, ELSS, EPF, NSC etc., then they all have low lock-in period. PPF has a 15 year lock-in period, 3 year lock-in period for an ELSS fund, you can withdraw EPF if you are unemployed for 2 months and so on.
• Pre-mature withdrawal : Up to 10 years, no partial withdrawals are allowed. Partial withdrawal up to 25% of own contribution (excluding contribution from the employer) only is allowed after 10 years for defined expenses. In the latest rule change, PFRDA (Pension Fund Regulatory And Development Authority) has relaxed the withdrawal norms to the effect that now the subscribers can withdraw upto 25% of contributions starting from the third year of opening of NPS (National Pension System) account. These revised NPS Partial Withdrawal rules are effective from January 10, 2018.
  • These defined expenses are for higher education, medical treatment & construction of house. There are certain other restrictions as well for making partial withdrawals.
  • Latest update (20-Jan-2018) : ‘Latest NPS Partial Withdrawal rules (2018) | Revised NPS Premature withdrawal rules‘.
• Withdrawal at maturity : After attaining 60 years of age, you are allowed to withdraw only 60% of the total Corpus amount.
• Annuity Plan :
  • At least 40% of the accumulated wealth in the NPS account needs to be utilized for purchase of annuity/pension plan when you turn 60 years.
  • Let’s understand this with an example : If your total corpus is Rs 100 at the time of retirement (60 years), you can withdraw Rs 60 as a lump-sum amount and Rs 40 (minimum) has to be used to buy an Annuity plan from a Life insurance company. Out of the sixty rupees, Rs 20 will be taxable as per your income tax slab at the time of retirement
    • (Latest update : Dec 2018 – W.e.f 1st April, 2019, this Rs 20 would also be tax-exempt) and the Rs 40 is tax-free amount. From FY 2018-19, this partial tax-exemption on NPS withdrawal is now extended to self-employed individuals also .
  • Kindly note that the taxes are applicable on the corpus amount and not just on the Gains. (The minimum quantum of investment in Annuity product depends on WHEN you choose to exit from the NPS account).
  • If you invest Rs 40 (lump sum) in an Annuity plan offered by a life insurance company, they in-turn will give you pension/annuity at periodic intervals. Unfortunately, even this annuity income or pension income is taxable as per the current laws.
  • Annuity income is taxable under the head ‘income from other sources’. Why do you want to receive an income which is chargeable to tax during your ‘retirement age’?
• NPs falls under EET Category : The contributions made during the accumulation phase are exempt from income taxes, the returns earned during the accumulation phase are exempted but at maturity the corpus amount (60%) is subject to taxes. Latest Update (Dec 2018) : This 60% withdrawable corpus is made tax-exempt w.e.f. April, 2019. So, we can consider NPS under EEE category. But, do note that Annuity income earned is still a taxable income. 
  • The contribution to Tier-I account of NPS is only eligible for tax benefits.
    • Latest Update (Dec 2018) : Contribution by government employees (only) under Tier-II of NPS will now be covered under Section 80 C for deduction up to Rs 1.5 lakh for the purpose of income tax provided there is a three-year lock-in period. This is w.e.f April, 2019.
  • Low Annuity rates :
    • The annuity rates offered by the life insurance companies are pretty low.  Kindly remember that the pension amount is dependent on the annuity rates.
    • What is annuity rate? – In return for a lump sum; the money you have saved in your pension pot, an annuity provider (insurance company) will give you an annual income for the rest of your life.
    • The yields on annuity products offered in the market today are in the range of 5 to 7% only. This is low when compared to other conservative products like Debt mutual funds, Senior citizens Savings Schemes, Post office MIS, or MF MIP Schemes etc.,
    • So, low annuity rates (pension rates) may not beat inflation.
    • I personally believe that it is like you accumulate wealth and lose all the wealth to Annuity Plan Provider.
  • Types of Funds & Allocation :
    • NPS Scheme has three different types of Funds – i) Equity fund, ii) Corporate Bonds & iii) Government Securities. Under Equity Fund option, subscriber is allowed to invest only up to 50% of contribution amount. When you are investing for longer period, why should you restrict your equity exposure to just 50%? In case of Govt employees, the total equity portion of the tier I account cannot be more than 15% (increased up to 50% w.e.f. April, 2019).  Government employees also do not have the option to change the contributions made to each fund.
    • Latest Update (29-Nov-2016): The existing ‘Life Cycle Fund’ with 50% max equity exposure is renamed as ‘Moderate Life Cycle Fund’. The new allocation option would be ; 50% equity exposure till the age of 35 and reduces it by 2% every year till the age of 55.  A new fund option called ‘Aggressive Life Cycle Fund (LC-75)’ has been introduced. The fund invests 75% in equities till age of 35 and then cut exposure by 4% every year. The cuts will slow down to 3% per year between 45-50 years and to 1% per year between 50 and 55 years.
    • Latest update (04-March-2017) : With effective from 1st April 2017, NPS subscribers can change their investment option and asset allocation ratio ‘twice’ in a year than the existing once in a year.
  • Equity funds Investment Strategy : Till last year (2015), equity funds of NPS were mirroring the returns of the index because pension funds were supposed to invest in index stocks (Large Cap Stocks) only. But from September 2015, fund managers (SBI/ICICI/UTI/LIC/HDFC/Kotak/Reliance) have been allowed to invest in a larger universe of stocks and follow an active investment strategy that does not mirror the index. But, most the fund managers are yet to follow or implement these new guidelines. Most of the funds do not even have more than 10% of their equity corpus allocated to non-nifty stocks (mid-cap stocks).

If it is mandatory for you to contribute to NPS then you do not have any choice but to contribute. If you want to make voluntary contributions then I believe that NPS is not a great investment avenue. (Read : List of Best Investment Options) If maturity proceeds are not taxed, and if buying an annuity product is made optional then National Pension Scheme can be a better option. But as of now, it is a complex and less tax-efficient long-term investment option. Do you prefer NPS to other investment options like Mutual funds? Kindly share your views on NPS. (Image courtesy of Mister GC at FreeDigitalPhotos.net) (Post published on : 22-July-2016)