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07 June 2009

New Tension Scheme

The awareness about the just-launched New Pension Scheme is abysmally low. That is unfortunate because the NPS may turn out to be the best long-term investment product

From May 2009 onwards, Indians have had access to another investment avenue to plan for retirement in the New Pension Scheme (NPS). The scheme had been in the pipeline for at least five years but it finally took shape in 2007-08. Although the government was pushing for the scheme after a law providing statutory backing to the regulator was enacted, the Left parties, which were supporting the UPA government, did not allow the passage of the Bill. So, last year, the government decided to go ahead by allowing the NPS Trust to enter management agreements with fund managers. What benefits does the NPS offer? Who is eligible? Business Standard provides a ready-reckoner.

Who can join the New Pension Scheme?
Any Indian citizen between 18 and 55 years. At present, only tier-I of the scheme, involving a contribution to a non-withdrawable account, is open. Subsequently tier-II accounts, which permit voluntary savings that can be withdrawn at any point of time, can be opened. But to be eligible to open a tier-II account, you need a tier-I account.

How do I enrol?
You will need to visit a point of presence (PoP), fill up the prescribed form with the required documents. Once you are registered, the Central Recordkeeping Agency (CRA) will send you a Permanent Retirement Account Number (PRAN), along with telephone and internet passwords.

How much can I invest?
There is no investment ceiling. But the minimum investment limit has been fixed at Rs 500 a month or Rs 6,000 annually. Subscribers are required to contribute at least once a quarter but there is no ceiling on how many times you invest during the year.

What is the penalty for failure to make the minimum payment?
You will have to bear a penalty of Rs 100 per year of default and will need to pay it with the minimum amount to reactivate the account. Also, dormant accounts will be closed when the account value falls to zero.

Are my investments guaranteed?
No. There is no guarantee since NPS is a defined contribution scheme and the benefits depend on the amount contributed and the investment growth up to the time of exit.

How should I select my investment option?
You can choose the investment mix between equity or E (high risk but high returns), mainly fixed income instruments or C (that come with medium risk and returns) and pure fixed investment products or G (which offer low returns but have very low risks associated with them). Equity investment is capped at 50 per cent.

At present, the equity investment consists of index funds that replicate the Sensex or Nifty portfolio. The C segment includes liquid funds, corporate debt instruments, fixed deposits and public sector, municipal and infrastructure bonds. The pure fixed investment instruments include state and central government securities.

There is a trade-off between risk and returns, with a younger investor placed better to take risks.

If you are unable to decide the investment mix, the default option will kick in.

What is the default option?
The default option, called auto choice lifecycle fund, will see the investment mix change according to the age of the subscriber. At the lowest entry age of 18 years, auto choice entails an investment of 50 per cent in E, 30 per cent in C and 20 per cent in G.

The ratios will remain unchanged till the subscriber turns 36, when the ratio of investment in E and C will decrease annually, while the proportion of G rises.

By the time the subscriber is 55 years, G will account for 80 per cent of the corpus, while the share of E and C will fall to 10 per cent each.

Who will decide the fund manager?
At the moment, the Pension Fund Regulatory and Development Authority (PFRDA) has selected six fund managers — State Bank of India, UTI, ICICI Prudential, Kotak Mahindra, IDFC and Reliance — on the basis of a bidding and technical evaluation process. You have to select one fund manager at the time of deciding your investment option; later, PFRDA may allow subscribers to choose more than one fund manager.

Can I change my investment mix and the fund manager?
You can shift from one fund manager to another from May 2010.

What happens if I relocate to another city?
The PRAN remains the same and you can access a toll-free number (1-800-222080). The details of your PRAN and the statement of transactions will be available on the CRA website (www.npscra.nsdl.co.in).

How can I exit the scheme?
The normal retirement age has been fixed at 60 years. At 60, you will be required to use at least 40 per cent of your accumulated savings to buy a life annuity from an insurance company. A phased withdrawal is also allowed but the lump sum benefit has to be availed of before you turn 70 years.

For those looking to exit before turning 60, there is an option to withdraw 20 per cent of the accumulated savings but buy an annuity with the remaining 80 per cent.

If the subscriber dies before he or she turns 60, the nominee can receive the entire pension corpus. Alternatively, a subscriber can exit if the account value falls to zero or if the citizenship status changes. The age of exit will be reviewed by PFRDA from time to time. There will also be the option to select an annuity that will pay a survivor pension to your spouse.

Are there tax benefits for NPS?
At present, the investment is covered under section 80CCD of the Income Tax Act and a tax will be levied if you withdraw the money. You can avoid paying tax by transferring the entire corpus to the annuity service provider. PFRDA has, however, approached the government to treat investment in NPS on a par with instruments like Employees Provident Fund and Public Provident Fund, for which no tax is levied at the investment, accumulation or withdrawal stage.
Sources: The Economic Times, Business Standard and Hindu Businessline

A new pension system (NPS) for the unorganised sector has been launched on 1 May 2009. The scheme is meant for any individual who can start a pension account to enable him/her to save for retirement. The NPS is open to private individuals as well as all central government employees who joined service after January 2004. What are the pros and cons of joining the NPS? Are there better ways of saving for your retirement? Will the NPS also go the way of mutual funds – good only when the wind is in the sails but marred by poor application, at other times? After all, in the US, a decade of poor returns destroyed the expectation of retirees of being able to live a peaceful and comfortable life. In fact, considering costs, time and investment strategy, NPS may be a better than any long-term investment option available. Most people, though, have not yet understood this. They see NPS only as a retirement option.For instance, Vikas Vasal, executive director of consulting company KPMG begins his assessment of the NPS as follows: “The idea is commendable. There should be a scheme available to ordinary citizens so that their expenses are taken care of when they retire. Today, when we look at the retirement funds, what are the options available? Whatever they are, they are for the people who are in the organised sector, not for the rest.” His positive introduction, however, soon gives way to scepticism: “There are several points that need to be addressed before NPS becomes popular.” The NPS has two distinct disadvantages compared with conventional retirement options:

a. Sovereign Guarantee: First, the existing retirement schemes, like provident fund (PF) and public provident fund (PPF), are associated with some sort of a sovereign guarantee of capital as well as the returns on it.

b. Tax Exemption: Second, such conventional post-retirement schemes in the organised sector have the ‘Triple E’ or EEE (Exempt-Exempt-Exempt) status. That is, they are tax exempt at all the three stages: the contribution stage, the earning stage and at the withdrawal stage. But the NPS falls into the EET category – exempt at the first two stages but taxed at withdrawal.

However, the NPS has its own advantages vis-à-vis the conventional schemes, points out Mr Vasal. Today, you do not know the exact amount lying in your PF account – the balance, the accumulated interest, etc. The data that comes to you is old. And getting back the money is a big hassle. On the other hand, in the NPS, it’s all online, transparent and up-to-date. Is that enough?

Dhirendra Swarup, chairman of the Pension Fund Regulatory & Development Authority (PFRDA) concedes that “the NPS does not have tax advantages, and that is a negative.” Then he assures, “We have sought tax exemption from the government. There is no reason why the government, in the next Budget, will not accede to our legitimate demands.” The ultimate USP of NPS is, as Mr Swarup puts it, that “when you consider that a person is 25 or 30 when he invests in it and then continues with it for the next 30-35 years,” it is “the longest-term contractual saving scheme” for all those who are not in the government sector.

It is a great, probably the greatest long-term investment scheme available as, we shall see. But how do potential investors see the NPS? Unfortunately we have discovered that ignorance about the true merits of NPS is absolutely widespread. Shyamal Chakraborty is a senior manager (accounts) at Devyani International Ltd, the sole Indian licensed marketer for KFC and Pizza Hut. He is 39 and has a degree from the Institute of Certified Financial Analysts of India. For him, the picture was still hazy. “It seems the NPS has two phases. The first deals with creating the corpus fund by investment and the second with re-investing the accumulated amount after maturity into an annuity scheme which will pay a monthly/annual pension,” he says. He does not think the second part is clear. “Does the investor have to re-invest the accumulated fund on his own or will the regulator decide on that?”

Mr Chakraborty inquires and wonders if “a matrix can be formulated taking a hypothetical figure and plotting the same into that by showing the monthly pension amount that one might get after maturity of the corpus fund.” It is clear he is looking for guaranteed returns.

Mr Chakraborty is not likely to go for the NPS, as yet. His seniors in the office had asked him to prepare a presentation on the Scheme and explain it to the employer as well as employees. He has come up with the following doubts in the process:

1. There is no guaranteed return and no alternative plan at the time of maturity;

2. The market conditions are volatile; they do not favour any investment whether in debt or in equity;

3. The tax benefits offered by the NPS are not in line with PPF or EPF; and

4. Prima facie, it looks like any other equity/market-linked investment plan floated by various financial institutions like insurance companies.

A big issue is how people react to the ‘government’ tag attached to the NPS. It may mislead people.“Because it’s by the government,” opines Srilekha Sahu, “it must be guaranteed, my husband says!” Ms Sahu is 30. Her husband, Sabyasachi Sahu, is now working with Punj Lloyd as deputy manager (project control) in Doha, Qatar. Years ago, Mr Sahu defended the PF scheme saying, “My father got my sister married with PF money.” He had posed: “Where else would you get an assured 8.5% on your investment in these times?” PF was launched at a time when people hardly had any choice in investment opportunities, compared to the wide array now. But he still expects that the NPS would give him guaranteed returns, since it’s a scheme mooted by a government agency. This is despite the fact that all risk factors were made clear to him through an e-mail before seeking his response!

Sanket Dash, analyst at Deloitte LLP’s Indian office in Hyderabad, says, “It’s a good idea to invest in NPS as it gives a mix of security and returns. More importantly, one can choose his own mix. The fund is expected to give a higher return than the current interest rates on pension as Indian equities are expected to give good long-term returns, despite short-term volatility.” But do most investor’s have the ability to monitor their investments? Dash is not sure of that. Why is it better than other mutual funds? “First, NPS will invest in risk-free government securities and, second, the investor can change fund managers.” Shoaib Daniyal, business analyst at Evalueserve, a KPO in Gurgaon, argues: “NPS is a step in the right direction. It gives us more options. The consumer can choose his risk profile according to his needs, rather than being straitjacketed into a one-size-fits-all model. It’s also a significant move by the government wherein it can slowly start dissociating itself from the PF system. In India, where millions are deprived of even the basics, it’s criminal that the government wastes crores on subsidising the middle class.” Palak Mathur, a software engineer with Infosys Technologies, Pune, says: “At first glance, this seems to be just like any other mutual fund scheme available in the market. I will think about its pros and cons before making an investment. I find two demerits. This scheme does not guarantee my capital, let alone the returns on it. Tax is levied on withdrawal of money that makes it less attractive than schemes like PPF. On the other hand, NPS offers a lot of flexibility. Whenever one wishes to contribute, he can. Suppose I skip a month or two, it can be adjusted, as long as my minimum annual contribution is intact (one is required to make a contribution at least once in a quarter). The minimum annual investment is Rs 6,000 which is much less than what is required in mutual funds. There is no upper limit for investment. The number of times one can invest is not limited. So, in my opinion, if the scheme is made tax-free on maturity, like PPF and EPF schemes are, then it would be a coveted scheme. Everything considered, I am investing in NPS.” As we can see, there are huge misconceptions about the NPS in the minds of employees. Maybe they have not had the time to examine the details. Maybe nobody has bothered to explain the features of the NPS to them. Some even question the government’s intention behind the Scheme. Why has the government launched the Scheme now? Mr Chakraborty thinks: “People are holding on to their money and so are companies. It’s not that everybody is flush with funds. But they are all apprehensive at the moment. The government wants to take money out of our pockets.” This view is echoed by another accountant who works with a telecom company. On condition of anonymity, he says, “Maybe it’s another way for the government to make more money flow into the financial markets by extracting money from stingy people. And right now, we are all stingy.” Whether this is accurate, bizarre or somewhat close to the truth is not the point. The PFRDA certainly has a huge perception battle on its hands.

The NPS made a quiet debut on 1st May and there has not been much of an awareness campaign by the PFRDA. Those who are interested have so far had to depend on newspaper reports and articles. In a country where financial literacy is pathetic and many people working in the financial sector too are unaware of all the financial/investment options available to them, how will the NPS take off? Mr Swarup asserts, “We can only have pull factors and no push factors.” He says that his selling model is not – and cannot be – like that of, say, insurance companies. Yet, he adds that the advertising campaigns to publicise the Scheme will be scaled up “as soon as a new Budget is passed.” Then he advertises the Scheme: “You must look at the Scheme in terms of its flexibility of investment options and portability of switching from one fund manager to another.” Mention the word ‘fund manager’ and a host of new issues come up – track record, competency, malafide actions and so on that have kept pre-tax returns from equity mutual funds unattractive. If fund houses have been unable to sell a credible story over the past two decades of existence, what additional skills will they bring to the table to manage pension money? And how would investors choose their fund managers? Mr Vasal says it would be a ‘learning experience’. Except that the learning never seems to stop. How can it? Even a financial expert like Mr Vasal seems to live in a different era when he argues that “people may initially have more faith in public sector undertakings though the only difference that these managers have vis-à-vis the private ones is that they have more stringent risk assessment procedures.” The fact is that it was the mutual funds promoted by public sector banks in the 1990s and the old Unit Trust of India, under direct control of the ministry of finance, that destroyed investors’ wealth the most.

There are many ifs and buts about the NPS but it is a giant step in methodical investment planning for the long term. If the government does remove the tax anomaly, either making PF, PPF and mutual funds taxable or making NPS returns tax-free, the NPS will be the best investment option ever for Indian citizens even without a government guarantee.

The NPS Jargon: Who and What
Regulator: Pension Fund Regulatory & Development Authority.

NPS Trust: A trust, set up under the Indian Trusts Act - responsible for taking care of the funds under the New Pension Scheme and protecting subscriber interests.

Points of Presence (PoPs): It is the first point of interaction. The 22 registered PoPs have authorised branches to act as collection points and extend services to customers.

Central Record-keeping Agency (CRA): The back office for maintaining records, administration and customer service functions. National Securities Depository Ltd has been designated the CRA.

Pension Fund Managers: At present, there are six fund managers: State Bank of India, UTI, ICICI Prudential, Kotak Mahindra, IDFC and Reliance.

Trustee Bank: Bank of India is the designated agency to facilitate fund transfers across various entities such as subscribers, fund managers and annuity service providers.

Asset Allocation
The key to building long-term wealth is asset allocation. How you distribute your assets, between equity, bonds and other assets and when you buy them, determines how much money you will have, years from now. The conventional idea is that when a person is young, he can take more risk and go for a higher component of equity. As he crosses middle age, he is supposed to reduce his equity investment and shift more of his money to fixed-income instruments like bonds. As he gets closer to retirement age, he wants return of capital rather than return on capital. Investors in the NPS will be able to follow this conventional – and simplistic – notion of asset allocation.

Under the NPS, one can choose between a few simple, standard schemes with different proportions of equity or E (high risk but high returns), fixed-income instruments or C (which have medium risk and returns) and risk-free instruments or G (that offer low returns but protection of capital).

Equity investment is capped at 50% under the NPS and will consist of index funds that replicate the Sensex or the Nifty portfolio. The C segment includes liquid funds, corporate debt instruments, fixed deposits and public sector, municipal and infrastructure bonds. Pure fixed investment instruments include state and central government securities. Investors can select an auto choice option to shift from one mix of asset allocation to another mix, as the years go by.

Will such asset allocation work? It probably will. The NPS will force fund managers to simply create a mirror portfolio that follows the Nifty or the Sensex. They will also have to automatically rebalance the portfolio, moving from debt to equity, according to the needs of the investor as he gets on in years (see Table). That means the NPS fund managers will not be allowed to use their brains to pick stocks or time the market as they do for mutual funds. In that case, the NPS may turn out the best investment returns among all available instruments for the long term – especially if they are made tax-free as well.

Costs: The Silent Killer
It is hard to assess what an investment will do for you over the long term. One factor is how much you are spending on having fund companies manage your money. Costs can eat up your returns like termites. By and large, investors pay far too little attention to the costs of investing. When so many costs are hidden (transaction costs, front-end sales charges, taxes incurred on realised gains) or when the stock market returns are high or when investors are focused on short-term returns, the impact of cost over an investment lifetime is ignored. But costs can kill. Here is how. Assume that the stock market generates an average return of 10% a year over 30 years. Now let’s assume that the costs of the average mutual fund are 2.5% a year. Result: a net annual return of just 7.5% for the average fund.

Now, if someone invests Rs 10,000 in year-1, it will grow to Rs 1,74,494 in 30 years, a remarkable illustration of the magic of compounding returns over a lifetime of investment. In the early years, the line showing the growth at 7.5% annual rate doesn’t look all that different from the growth in the stock market returns. But slowly, the lines begin to move in different directions, accelerating at a dramatic rate in the later years. By the end of 30 years, the value accumulated in the mutual fund totals just Rs 87,550, an astounding shortfall of Rs86,944 to the cumulative return delivered by the market.

John Bogle, writes in The Little Book of Commonsense Investing: “In the investment field, time doesn’t heal all wounds. It makes them worse. When returns are concerned, time is your friend. But where costs are concerned, time is your enemy.” This is underlined when we consider how the value of the Rs10,000 investment is eroded with each passing year. By the end of the first year, only about 2.5% of the return has vanished (Rs11,000 Vs Rs10,750). By the 10th year, 21% has disappeared (Rs25,937 Vs Rs20,610). By the 30th year, 50% has vanished (Rs174,494 vs Rs87,550) from the market returns, thanks to the killing impact of costs. As Bogle would say, the investor, who put up 100% of the capital and assumed 100% of the risk, earned only 50% of the market return. The longer the period, the worse is the return. “The system of financial intermediation, which put up zero percent of the capital and assumed zero percent of the risk, essentially confiscated 50% of that return. What you see here – and please don’t ever forget it! – is that over the long-term, the miracle of compounding returns is overwhelmed by the tyranny of compounding costs.”

This is where the NPS scores. The investment management fee is a ridiculous 0.009% per annum while mutual funds charge you 2.5% a year! Besides, the annual cost of record-keeping in the NPS is Rs380 and each transaction will cost Rs6. Thanks to such low costs, over the long term, compounding will make a massive difference to your returns. All else being equal, an NPS investor can make at least 50% more than a fund investor over 25 years only due to low charges. ULIP investors will fare worse than mutual fund investors.

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Surajit Dasgupta treats no individual, organisation or institution as a holy cow.