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Introduction
National Pension Scheme (NPS) is touted as a one-stop solution for retirement planning. It was launched in 2004 when the Government of India realized that it will become impossible to continue with defined benefit (DB) pension plans. Instead, a defined contribution (DC) plan where the participant invests and takes on market risk was put in place. In a DC plan, you bear the risk of the investments not doing well since they are linked to the stock and bond markets, unlike the DB plan where the government takes the risk.
You invest in the NPS from your current income, and once you reach 60, you have to use:
40% of the corpus to buy an annuity or pension plan
60% of the corpus is tax-free for investing in retirement
You can defer withdrawing from NPS if you want to: either the annuity or lump sum or both can be delayed.
NPS is effectively a wrapper around mutual funds with available equity, debt (government and corporate), and alternative investment options.
This post targets individuals nearing retirement age or who have recently received their retirement corpus from NPS and other sources like superannuation and provident fund. Since this is a rather large amount, it needs to be invested properly to fund the necessary lifestyle in retirement.
Alternatively, you can make it a percentage of your current expenses based on a 3-point scale based on :
minimal lifestyle: 70% of current lifestyle expenses
similar lifestyle: 100% of the current lifestyle expenses
luxury lifestyle: 120% of the current lifestyle expenses
You will have to set these percentages first by your desire and then based on running the numbers for your retirement plan. We will assume 6 lakhs/year (50,000/month) and 7% inflation for 30 years in retirement. We will use the simple web based retirement calculator to plan for retirement. The cases below will have screenshots from the calculator.
We will exclude all real estate investments in the corpus unless it is sold and included as liquid assets. You can use the rent from such investments to lower the expense in retirement.
Case 1: age just before 60, retirement benefits not received
(click to open in a new tab)
At this point, you are not yet eligible for NPS withdrawal. Instead, you should estimate your retirement total benefits from multiple sources like provident funds and other investments in mutual funds, stocks, bank deposits and other sources.
Let us assume that the age is 56, and the total corpus available is ₹1 crore split like this:
40 lakhs in PF, gratuity and other benefits. This amount is locked until retirement
25 lakhs outside NPS in other investments like MF, equity and bank deposit
35 lakhs in NPS
The calculator shows that
you need to invest the ₹ 100 lakhs lumpsum amount as ₹ 47 lakhs in equity and ₹ 53 lakhs in debt today. This equity allocation is to ensure that your corpus can beat inflation in retirement
setup a SIP of ₹87,561 per month, of which you should invest ₹32,054 in equity and ₹55,507 in debt. This SIP amount will have to be increased by 5% yearly to stay on track as a step-up SIP
You need to adjust the NPS and outside investments to match the asset allocation shown. The target 47 lakhs in equity should be invested outside NPS as much as possible since NPS has strict limits on equity allocation. This post will tell you how to choose funds for investing.
In this case, we need to be mindful that there are no “low-risk” investments inside NPS and hence managing the portfolio with the right expectations is essential. This topic is discussed in more detail here: The unknown risk in NPS that few people talk about.
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Case 2: age just before 60, retirement benefits received
At this point, you are still not yet eligible for NPS withdrawal. But you have already received your retirement benefits from multiple sources like the provident fund. Let us assume that the age is 58, and the total corpus available is ₹1 crore split like this:
40 lakhs received from PF, gratuity and other benefits
25 lakhs outside NPS in other investments like MF, equity and bank deposit
35 lakhs in NPS
(click to open in a new tab)
The calculator shows that
you need to have 43 lakhs in equity assets and the rest in debt. This investment has to be split inside and outside NPS
Since there is no income, you cannot do the SIP, but it does mean that your equity allocation will have to go up from 43 lakhs to at least 43L + 24 * 30458 = 50 lakhs plus over the next two years.
The debt amount outside NPS should be equal to a 12-month emergency fund and inflation-adjusted 6 lakhs/year expenses for 5 years. This amount is around 40 lakhs and should be invested in short term debt funds using this guide: How to choose a debt mutual fund?
Given that 35 lakhs is inside NPS and 65 lakhs is outside, the equity allocation of the portfolio can be only 25 lakhs and not 43 as the asset allocation shows. We will bump up the equity allocation when NPS corpus is withdrawable.
Case 3: age is 60, NPS withdrawal allowed
Let us assume that the age is 60, and the total corpus available is ₹1 crore which is split like this:
65 lakhs outside NPS in other investments like MF, equity and bank deposit
35 lakhs in NPS that is withdrawable: 40% i.e. 14L will go into annuity purchase, and the rest 60%, which is 21L that is withdrawable without tax
To construct a retirement portfolio using these funds, follow the bucket method with a pension. You need to create three buckets:
Bucket 1: Cash assets for immediate expenses: The purpose of this bucket will be to hold living expenses for the next five years
Bucket 2: Income assets for stability and future income: The purpose of this bucket is to hold assets that generate income
Bucket 3: Growth assets to grow the corpus to beat inflation: This bucket will have everything that is not there in buckets 1, and 2 above and will be primarily equity in the form of index mutual funds
If the number of years supported in retirement out of the current assets is very low, you have several options:
if both stock and bond markets are at a high, then redeem everything from NPS, take the annuity and live off that annuity for as long as possible. You will invest the rest of the assets as per the three-bucket plan
if the bond markets have recently fallen due to rising rates, you need to wait for them to recover. So defer both lump sum and annuity from NPS and invest some money outside NPS from equity to debt to take advantage of the situation
if the equity markets have recently fallen, then defer the annuity and take out the remaining 60% of the NPS corpus to invest a part in equity. Inside NPS, you cannot have more equity after 60
We have already covered how to invest a large sum of money into equity as a lump sum or split over a few months. Timing the market is not an exact science and is a delicate balance between:
regret minimization: what if the market falls by 20-30% immediately after you invest?
having the proper asset allocation in retirement: we need the right amount of equity, as required by the model, to beat inflation
This is an excellent time to revisit the probabilities of a market crash, as discussed in this post, like this:
a 50% or worse fall is expected once every 10 years
a 40% to 50% fall is expected once every 5 years
a 30% to 40% fall is expected once every 2 years
a 20% to 30% fall is expected once every 11 months
a 10% to 20% fall is expected once every 6 months
Suppose a market crash of a certain magnitude has recently occurred. In that case, the chances of recovery are higher and can be used to plan the investment.
What is the impact of the annuity component on the retirement portfolio
We have performed a detailed analysis of the result of the forced annuity purchase. We already understand that annuity rates are going down as the economy develops and low annuity rates increase the risk of running out of money in retirement.
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This post titled How to invest your NPS corpus to get most returns in retirement? first appeared on 06 Mar 2022 at https://arthgyaan.com
