The unknown risk in NPS that few people talk about
What should you do if there is a fall in your NPS corpus just before retirement at 60? This post details the problems and shows how to remediate the risk.
What should you do if there is a fall in your NPS corpus just before retirement at 60? This post details the problems and shows how to remediate the risk.
National Pension Scheme (NPS) is a retirement plan launched in May 2009 with the following features:
NPS is a vast subject that will be dealt with detail in a series of articles and we will examine in detail who should invest in NPS, who shouldn’t, asset allocation, post-NPS portfolio construction and other analyses. This particular post is the first in our series on NPS.
The concept of sequence-of-returns risk (SRR henceforth) refers to the order or mix of positive and negative returns in risky assets like equity and debt. We have dealt with SRR in detail in this post: How does sequence of return risk affect your goals?.
When applied to NPS, SRR causes a unique problem that does not exist with other products usually used for retirement planning:
What if the stock or bond market falls just before the NPS corpus “matures” at 60?
This particular problem is unique to NPS since generally, the corpus becomes eligible for withdrawal at 60 as per the following rules at age 60:
The problem happens if the following two conditions come true together at the same time:
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:
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.
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.
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.
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.
To understand where this risk comes from, let us look at the permissible asset allocation between E,G,C in NPS. NPS offers two asset allocation choices: active and auto.
Active choice:
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 up to 75% until the age of 50 and then used to reduce by 2.5% a year to 50% at 60.
Auto choice:
NPS offers three options under auto choice with asset allocation slowly becoming more conservative as time passes, as shown in the chart below:
We show returns from Tier 1 NPS funds below. All NPS subscribers must have a Tier 1 account which is why these particular returns are shown. Tier 2 NPS investments are optional, and their performance is in-line with Tier 1 scheme.
While equity fluctuations are widely known, investors should be wary of the returns in the C and G categories in the table below, especially by comparing the 1-year returns vs. the historical returns. We will show more such cases in the charts below.
Duration | Tier 1 - G | Tier 1 - C | Tier 1 - E |
---|---|---|---|
3 Months | 0.0% | 0.6% | -1.5% |
6 Months | 2.0% | 2.4% | 9.2% |
1 Year | 1.6% | 4.9% | 28.3% |
2 Years | 7.2% | 8.9% | 21.0% |
3 Years | 9.1% | 9.6% | 17.4% |
5 Years | 7.6% | 7.9% | 14.8% |
7 Years | 8.5% | 8.8% | 10.8% |
10 Years | 9.2% | 9.7% | 13.9% |
Source: https://www.npstrust.org.in/return-of-nps-scheme for the period ending 31-Jan-2022
We note from the data above that:
We see below the rolling return and risk exposure to an investor in the auto choice portfolios at the age of 55 onwards when the portfolio asset allocation is as per the table below:
Asset allocation at 55 | E | C | G |
---|---|---|---|
Aggressive Life Cycle Fund (LC75) | 15% | 10% | 75% |
Moderate Life Cycle Fund (LC50) | 10% | 10% | 80% |
Conservative Life Cycle Fund (LC25) | 5% | 5% | 90% |
Investors in the active choice portfolios will see fluctuations depending on their asset allocation.
As the above charts show, even at the conservative ranges recommended by PFRDA under the auto choice, NPS investors need to be mindful that their portfolios will fluctuate considerably since the large allocation to bonds introduces both interest risk (C and G category) and credit risk (C category). We can estimate the 1-year forward return ranges for these investors in any of the auto choices like this:
Max return = 1-year return + 3 * 1-year risk
Min return = 1-year return - 4 * 1-year risk
Using these formulae, we can estimate the ranges of the returns of the auto choice investors like this:
There is no guarantee that portfolios will recover after a fall in time for the corpus withdrawal at the age of 60. This post shows that the time taken for debt fund (G or C) recovery after a 1% rise in interest rates can be high as a year or more. If the investor retires at this point and withdraws the NPS corpus, the loss get crystallized from a paper loss to a real-life loss.
If you are approaching retirement with a correct asset allocation of debt and equity, then you will be ready to create a three-bucket portfolio with a pension like this:
Given that 40% of the NPS portfolio, once withdrawn, will be used for purchasing a pension plan, we need to take the following steps now using the comprehensive goal-based investing plan:
This exercise ensures that you have enough to fill the gap in Bucket 1 after the income from the pension plan on the date of retirement. You might see that your current corpus is not enough for your desired retirement horizon, say at age 60, due to the fall in NPS assets since the SIP amount you will be shown will exceed the monthly investments you can make after other commitments. If you can afford the extra SIP, then invest outside NPS. If not, there are two choices at this point:
NPS allows deferment up to age 75 in case you wish to let the corpus grow more after a fall. You can defer either the lump sum or pension or both. If you are within 1-year of retirement, this retirement with pension calculator will show you which option is better based on the assets you have today.
Just because NPS is a retirement product, it does not mean that you need to invest only inside NPS for retirement. In this case, you need to invest enough, while you still have income, using low-risk (<1 year Modified duration, low credit risk) funds from this list. This plan will help you grow your Bucket 1 assets on time for retirement, while the assets inside NPS will take care of Buckets 2 and 3 once the corpus is available.
If you do not have adequate assets for retirement investments, consider deferring other goals, like children’s education or marriage since you can take loans for that, or selling other assets like investment properties or downgrading to a cheaper house/location post-retirement.
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This post titled The unknown risk in NPS that few people talk about first appeared on 24 Feb 2022 at https://arthgyaan.com