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The unknown risk in NPS that few people talk about

24 Feb 2022 - Contact Sayan Sircar
14 mins read

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.

The unknown risk in NPS that few people talk about

Table of Contents

What is NPS?

National Pension Scheme (NPS) is a retirement plan launched in May 2009 with the following features:

  • it is a mutual fund like scheme where residents can invest money regularly to be used for retirement expenses
  • the corpus is locked until age 60. Post 60, the subscriber can withdraw and use the money for retirement as a mixture of annuity/pension plan and other investments
  • there are some tax benefits in investing, and 60% of the corpus on withdrawal at age 60 is tax-free

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.

Sequence of returns risk in 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 an 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:

  • 60% corpus is withdrawable tax-free, and the rest 40% corpus is used to purchase an annuity compulsorily
  • you can defer withdrawal up to age 75 if you wish to
  • to withdraw before 60, you can withdraw only 20%, and the rest 80% goes to an annuity

The problem happens if the following two conditions come true together at the same time:

  • there is a fall in either equity or bond markets just before age 60
  • you do not have any other corpus outside NPS to allow you to defer NPS withdrawal in the hope the fall will recover

Recap of asset classes in NPS and their recent returns

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.

Limits of asset allocation

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:

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NPS Asset allocation for active choice

Active choice gives a lot of flexibility to the investor with the maximum equity allocation capped as per the image above: up to 75% until the age of 50 and then reducing by 2.5% a year to 50% at the age of 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:

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NPS Asset allocation for auto choice

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Returns from NPS demonstrate considerable SRR

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.

Point-to-point returns

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: for the period ending 31-Jan-2022

Rolling returns

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NPS rolling 1-year returns

Rolling risk

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NPS rolling 1-year risk

We note from the data above that:

  • NPS does not offer an asset class that is safe or low risk
  • G or C classes have lower risk than E
  • at age 55 or higher there is considerable risk exposure to the portfolio (see below)

Return and risk exposure at various asset allocation levels

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.

Rolling return for auto choice portfolios

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NPS rolling 1-year return for auto choice allocation

Rolling risk for auto choice portfolios

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NPS rolling 1-year risk for auto choice 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:

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NPS rolling 1-year forward return for auto choice allocation

How to mitigate this Asset allocation risk

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 pension like this:

  • 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 mostly equity in the form of index mutual funds

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:

  • make a list of all the assets held for retirement: inside NPS and outside
  • enter them in sheet “assets” in the planner. NPS assets under schemes A and E goes into equity column while G and C goes into the Debt column. Other assets for retirement, like stocks and mutual funds held outside NPS (or in NPS Tier 2) should also be entered
  • estimate your retirement expenses using this tool
  • then follow the instructions in this article to set up and use the plan
  • the sheet will output the SIP amounts for retirement and the correct asset allocation

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 your 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:

Defer NPS withdrawal

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.

Invest more outside NPS

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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