The All India Citizen's model of the National Pension Scheme (NPS) was introduced to provide retirement security to those not covered under the scheme as a part of employer-employee relationship. The model is aimed at both private sector employees as well as self-employed. While the government has made several changes in the features and taxation of NPS to make it more attractive, it still has some distance to cover before beating one of its major competitors — creating a retirement portfolio primarily consisting of equity mutual funds.
Here I will list how NPS All Citizen's Model and mutual funds fare against each other for retirement planning:
NPS subscribers can choose between the Active Choice and Auto Choice (Lifecycle Fund) for asset allocation. Under the active choice, the subscribers can distribute their contribution across one or more asset classes based on their risk appetite. Asset classes offered are government bonds, corporate debt, equity and Alternative Investment Funds. While the subscribers can choose single or multiple asset classes, the maximum allocation for equities can go up to 75% of total portfolio till the attainment of 50 years of age by subscribers. After that, the maximum permitted equity proportion for NPS account will steadily reduce by 2.5% each year to 50% on the attainment of 60 years of age.
Subscribers lacking required knowledge and skills for managing their asset allocation can opt for Auto Choice, which comes with a pre-defined proportion of different asset classes based on the age of the subscriber. Subscribers have three types of Lifecycle Funds to choose from — Aggressive Life Cycle Fund, Moderate Life Cycle Fund and Conservative Life Cycle Fund — with maximum equity exposure cap of 75%, 50% and 25%, respectively, till the age of 35 years. Thereafter, the equity proportion will steadily reduce with the increasing age as per the pre-set asset allocation.
In case of equity mutual funds, at least 65% of the funds' portfolio has to be invested in equities. ELSS, popularly known as tax-saving mutual funds, 'large and mid-cap funds' and large cap funds have to hold at least 80%, 70% and 80% of their corpus in equity and equity related instruments. As equity as an asset class beats other asset classes by a wide margin over the long term, the higher exposure to equities through equity mutual funds will allow mutual fund retirement portfolio to outperform the National Pension System in wealth generation over the long term. Those lacking the skills for managing their own asset allocation can invest in aggressive hybrid funds, balanced advantage funds and multi-asset allocation funds, which dynamically increase or decrease exposure to equities and other asset classes depending on the changing market conditions.
Tax exemptions on investments
Among mutual funds, only Equity Linked Savings Schemes (ELSS) qualify for tax deductions of up to Rs 1.5 lakh under Section 80C. In case of NPS All Citizen's Model, subscribers qualify for an additional deduction of up to Rs 50,000 under 80CCD (1B) apart from the Rs 1.5 lakh deduction available under Section 80C. Thus, the scope of tax deductions on investments is greater in NPS than equity mutual funds. However, investments in Tier II A/c of All Citizen's Model do not qualify for any tax deduction.
Taxation of withdrawals/maturity
Currently, at least 40% of the NPS corpus on maturity has to be used for purchasing annuities and the rest can be withdrawn lumpsum. Part of the corpus used for purchasing annuities is tax free although the interest income derived from it is not. The Budget 2019 has made the lump sum withdrawal of the rest of the NPS maturity corpus fully tax-exempt, bringing in tax parity with other retirement solutions, such PPF and EPF.
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Equity mutual funds are slightly at a disadvantage as far as the taxation of the investment corpus is concerned. Gains made on redeeming equity mutual funds are subject to LTCG taxation @ 10%. However, this taxation will only apply to gains exceeding Rs 1 lakh in a financial year. Moreover, the outperformance of equity mutual fund over NPS in terms of wealth creation might neutralise NPS edge in tax savings.
Lack of liquidity is a major drawback of the NPS scheme. Premature withdrawal is allowed only after 10 years whereas partial withdrawals are allowed after 3 years for just 25% of the investor's contribution. Moreover, partial withdrawal is allowed for only three times during the entire subscription period for specified reasons — purchase/construction of residential house, children's higher education and marriage, and treatment of critical illness. In case of premature exit, at least 80% of the accumulated NPS corpus has to be used for purchasing annuities and the rest can be withdrawn lumpsum. The subscriber can opt for 100% lumpsum withdrawal only if the accumulated corpus is not greater than Rs 1 lakh. However, there are no restrictions on redemption or closure of Tier II NPS account.
Equity mutual funds, except the close-ended funds, do not have any restrictions on withdrawals apart from the lock-in period of 3 years in ELSS. Investors are free to invest and redeem their equity mutual fund schemes based on the changes in the market conditions, risk appetite and their own fund requirements. Thus, retirement portfolio consisting of equity mutual funds outscore NPS in terms of liquidity.
Under the NPS scheme, mandatory investment of at least 40% of accumulated corpus in annuities is aimed at providing stable post-retirement income to their subscribers. However, returns generated from annuities are very low and may not beat inflation rates. Moreover, interest earned from annuities is taxable too. The rising life expectancy along with inflation rates may render the pension income insufficient.
A retirement portfolio consisting of equities might be better suited to deal with the post-retirement expenses. Once an investor nears the retirement age, say 2-3 years away from his retirement, he can initiate the Systematic Transfer Plan (STP) in his equity funds to steadily redeem pre-determined amount each month from his equity funds for investment in short-term debts funds. Short-term debt funds have very low risk of capital erosion but still generate higher returns than bank fixed deposits. Once the retirement life sets in, the investor can initiate Systematic (SWP) in those debt funds to derive monthly cashflows for meeting his daily expenses. While setting the STP, the investor should try to remain invested in equities for at least 15 years after his retirement age. This will allow him to continue to benefit from the higher upside potential of equities while beating the twin challenges of inflation and increased life expectancy.
(The author is Director & Group Head (Investments), Paisabazaar.com)