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Direct taxes code will make NPS even better
July, 12th 2010

The New Pension Scheme (NPS) is a defined contribution pension scheme open to any Indian citizen in the 18-55 age group.

In a defined contribution scheme, the individual invests a certain amount till he retires. At retirement, he is allowed to either withdraw the money accumulated or buy an immediate annuity from an insurance company to generate regular income, or do both.

The option he exercises depends on the way the pension scheme is structured.

Keeping aside the question whether the NPS has reached the masses as intended, we shall discuss and examine its various facets and how it is an important and beneficial savings and retirement tool.
Why you need the NPS?
With the setting up of the Pension Fund Regulatory and Development Authority (PFRDA) and the launch of the NPS, the long-awaited pension reforms have become a reality.

For the most part, the Indian pension scenario has been dominated by employer-sponsored plans, with contribution from the employee to a certain extent. Conventional retirement options like the Employee Provident Fund (EPF) and the EPS (Employee Pension Scheme) give fixed or defined benefits that may not be adequate to meet post-employment expenses. NPS primarily aims to bring into the pension fold a huge population that is part of the unorganised/ non-government sector.

NPS structure
The unique option that the NPS gives to subscribers is a selection of fund managers with whom they wish to entrust the management of their funds.
Pension fund managers offering services under the NPS:

ICICI Prudential Pension Funds Management Company Ltd
IDFC Pension Fund Management Company Ltd
Kotak Mahindra Pension Fund Ltd
Reliance Capital Pension Fund Ltd
SBI Pension Funds Private Ltd
UTI Retirement Solutions Ltd
Subscription types:
To apply for the voluntary pension scheme, there are two types of accounts:

Non-withdrawable account: The Tier-1 account is the basic NPS account which is non-withdrawable till retirement or in the case of death of the subscriber.

Withdrawable account: A Tier-2 account is available to only those who are subscribers of the Tier-1 account. The unique selling point of the Tier-2 account is that money contributed into this can be freely withdrawn as and when the subscriber wishes except for a minimum balance that needs to be maintained at the end of each financial year.
Asset allocation class options:

Asset Class E Most aggressive option where the cap for equity investment is 50% of the investment corpus.
Asset Class C Medium-risk option
Asset Class G Low-risk option
Investment options
Auto choice Lifecycle fund: Your contributions are pooled into a lifecycle fund and then invested as per pre-defined asset allocations that change over the lifecycle of the subscriber. For example, up to 35 years, 50% goes into the aggressive class E with 30% and 20% in asset classes C and G, respectively. As retirement nears at age 55, only 10% is invested in class E and C, and 80% is transferred to the less-risky class E.

Active choice: You can choose not only the fund manager but also what asset allocation to go with. Once subscribed, there is also a switch window available every year in May.

NPS The cheaper option
Shown in the table above is a projection of how an investment of Rs 1 lakh per annum would behave over a period of 30 years. This is considering that all three options give similar returns at the rate of 10% pa. For the sake of this projection we have considered funds that would match the asset allocation pattern followed by the aggressive portfolio under NPS.

NPS being the option with the lowest costs eats into the investments the least and hence delivers the highest returns.
The chart shows how the progression of the invested amount happens over 30 years. An important fact to remember is that, as of today, NPS is taxed under the EET (exempt-exempt-tax) regime. This however may change or could be amended to bring all other retirement instruments at parity when the direct tax code (DTC) is introduced.

Tax advantage
Investment vehicles are taxed in two ways currently: one is the EET (exempt-exempt-tax) and the other being the EEE (exempt-exempt-exempt) framework.

Under the EEE method, the first E means that the contributions towards certain savings products are deductible from taxable income, the second E represents that the accumulation from the investment are exempt, and also all withdrawals at any time are exempt from tax in case of the third E.

The draft of the DTC, which is expected to bring about a consolidation of the current tax laws and bring about some changes in the tax laws, has recently been made public.

With the draft of the DTC, there seems to be a decided push for making the NPS more attractive. The major change that the DTC will bring about in the retirement products scenario is that Ulips (currently in the EEE category) will now also be taxed under the EET regime. This means that unlike in the current scenario, withdrawals from Ulips will not be tax exempt.

It has long been seen in the Indian investments market that the behaviour of the retail investors is largely guided by tax concerns. There is always a rush to invest to save tax. However, with the provisions in the new DTC, the NPS will be taxed in the EEE framework while Ulips and MFs will be in the EET regime. This will invert the tax situation among retirement products with investment benefits.

NPS remains a very good product for its purpose and by aligning the distributors interests with the PFMs would greatly help the NPS increase its strike rate. Re-iterating that NPS is a post-retirement safety tool, it is a very effective tool that covers capital protection and also provides a growth opportunity. With its lowest charges, it also is the cheapest way to get an exposure to the market. For the thousands and lakhs of employees in the unorganised sector who have negligible or no post-retirement social security benefits, NPS is a boon.

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