National Pension Scheme (NPS) is a defined contribution retirement plan launched in May 2009 with the following features:
withdrawable only at 60 years of age, of which
60% can be withdrawn as a lump sum tax-free
the remaining 40% is compulsorily invested in an annuity to provide a lifelong pension
NPS contributions are tax-deductible under 80C. There is an additional deduction under section 80CCD for 50,000 i.e. tax payable reduces by 30% (slab rate) times ₹50,000 or ₹ 15,000 per year under Section 80CCD(1B). There is even more tax deduction available if your company has corporate NPS as well.
This ₹ 15,000 tax benefit is the largest and only carrot that incentivises investment in NPS. We have argued before that investors should avoid NPS investment beyond the ₹50,000/year needed to save tax: Is NPS the right option for your retirement planning?.
In this article, we will talk about where it is worth investing ₹50,000 in NPS vs. paying the tax and investing in mutual funds. The other two options are not considered since:
the corporate deduction is not available to everyone
Note: If you choose the new tax regime after 1st April 2023, as per Budget 2023, then there is no tax deduction under Section 80CCD(1B). Therefore such investors do not have any incentive to invest in NPS for ₹50,000 tax deduction.
Asset allocation in NPS
The investment options in NPS are governed by the Pension Fund Regulatory and Development Authority (PFRDA) rules. NPS funds are essentially mutual funds with the following four asset classes described below:
Equity option (Scheme E)
This class invests in stocks like other equity mutual funds, and risks/returns are in line with other equity mutual funds. Large fluctuations in equity funds are considered normal, say 40% or worse falls in a year or 60%+ rise in other years. Unless they have entered the stock market since the post-Mar 2020 bull run, investors are well aware of the nature of this fluctuation.
Government bond option (Scheme G)
This class invests primarily in RBI, i.e. Government bonds. These bonds have a sovereign guarantee, i.e. no risk of default. However, based on the time to maturity of each bond in the portfolio, they have interest or duration risk. We extensively cover the concept of duration risk here: Should you match debt portfolio duration with goal duration?, but the summary is that the Scheme G NAV will fluctuate considerably due to interest rate changes in the economy.
This fact may surprise investors new to the concept of duration risk or who have only seen high returns from this category due to falling interest rates in line with global economic trends.
Corporate bond option (Scheme C)
This class invests in corporate bonds, i.e. debt issued by companies, not the Central/State Governments. Apart from duration risk, this category has credit risk also since there is always the risk that the company that has issued the bond can fail to pay back interest and principal.
Alternative Investments option (Scheme A)
This class invests in alternative investments in products like Alternative Investment Funds (AIF), Mortgage-Backed Securities (MBS), REITs, InvIts, and other similar investments. Due to their nature, these products are high-risk investments and have existed since 2016 only in NPS. Therefore, we are excluding their discussion in this article. Still, the sequence of return risk applies to this category as well. Since the allowed allocation to this category is capped at 5% of the corpus, it does not make a material difference to the returns of the NPS portfolio.
We have argued before that investors should use the Active choice option with the same equity to debt asset allocation as their retirement corpus held outside NPS.
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Active choice gives a lot of flexibility to the investor with the maximum equity allocation capped at 75% up to age 60 as per the image above. Before 20-Oct-2022, the allocation to equity for active choice was capped at up to 75% until the age of 50 and then used to reduce by 2.5% a year to 50% at 60.
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Assumptions made to compare NPS with MF
In this comparison, we will assume the current tax benefit of NPS continues and therefore
the tax bracket of the investor is 30%
₹50,000/year is invested in NPS (Tier 1 account) via the active-choice mode (75% equity up to age 60, the rest in government bonds)
Equity returns are 11% post-tax on average and debt returns are 4% post-tax on average
Average NPS returns will be 0.75 * 11% + 0.25 * 4% = 9.25% while equity MF will return 11% on average
We will perform ₹10,000 tax harvesting on equity profits every year. NPS returns will be tax free while for equity there will be 10% tax on profits above ₹1 lakh
We will assume linear returns for both equity and debt to keep the calculation simple. We acknowledge that a better alternative will be to perform a Monte-Carlo simulation with historical risk/return data which we will cover in a future article
NPS vs Equity MF comparison
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The chart shows that the further the retirement age of 60, the more the chance that your equity mutual fund investment overtakes the amount in NPS. Investors can use this chart like this:
take your age and subtract it from 60. Say it is 25
find 25 on the x-axis in the chart
locate the corpus numbers for both NPS and MF in the chart on the y-axis
invest in the option which has the higher corpus after 25 years
At this point, investors should understand that in the bigger scheme of things, their retirement corpus goes into crores: How much corpus is needed to spend 1 lakh per month in retirement?. Saving 15,000 tax sounds significant at the beginning of the career when income is lower but becomes insignificant very soon given the unfortunate risks in NPS beyond the forced annuity clause and lock-in until 60. It will be simpler to avoid investing in NPS completely to preserve the liquidity of the corpus both before and after retirement.
What happens after 60?
An interesting comparison can happen when the NPS corpus becomes eligible for withdrawal at 60%. As per current rules, 40% of the corpus needs to be invested in an annuity. Given that annuity returns are both fixed (i.e. does not increase with inflation) and taxable, we will be forced to endure poor post-retirement returns vs. a diversified and liquid portfolio of equity and debt mutual funds. We have covered this topic here:
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The conclusion is:
adding a pension plan dramatically lowers the chances of completing retirement
the gap vs equity only portfolio lowers at lower SWRs but at such low SWR levels, there is enough wealth to make the investor ambivalent about the choices
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This post titled Which is better: save tax by investing 50,000 in NPS or 35,000 in equity mutual fund? first appeared on 11 Sep 2022 at https://arthgyaan.com
