Align NPS allocation with risk appetite, not recent performance

Invest in NPS if you can tolerate its long lock-in

Tier one equity schemes of the National Pension System (NPS) have delivered a category average return of 34 per cent over the past year. Government bond funds (G) have given 10.6 per cent while corporate bond funds (C) have given an 8.6 per cent return over this period.

Key takeaways

Equity portfolios are being actively managed. “The deviation from the return of the Nifty 50 index (28.9 per cent over the past year) indicates that pension fund managers (PFMS) are taking exposure to stocks outside the Nifty 50,” says Deepesh Raghaw, a Securities and Exchange Board of India (Sebi) registered investment advisor (RIA).

The average return of C funds is slightly higher than those of corporate bond funds of mutual funds (7.4 per cent). The average return of G funds is also higher than that of 10-year constant maturity gilt funds of MFS (8.52 per cent), which shows that PFMS are taking exposure to longer-duration government bonds with maturity of 10 years and more.

“These returns, which are in line with market trends, are welcome. In the fixedincome space, too much alpha should set the alarm bells ringing as it indicates that fund managers may be taking too much risk,” says Raghaw.

Should you invest in NPS?

Investors attracted to NPS after seeing these returns should first evaluate its suitability for them. NPS has several advantages: low fund management fee, a range of asset classes and PFMS to choose from, tax-free rebalancing, active and auto choice options, and so on.

However, investors should also pay heed to a couple of caveats. “Young investors with limited funds should ensure that investing in NPS does not crowd out their other, more liquid, investments,” says Raghaw. NPS is an illiquid product (only limited withdrawals are permitted under specific circumstances).

Investors who have opted for the new (default) tax regime will also not receive tax benefits for their NPS contributions (they will, however, receive tax benefit under the new tax regime if their employer contributes to their corporate NPS account).

How to decide asset allocation

Investors should not decide their asset allocation based on recent returns. “Currently, the data shows positive returns for equities across all timeframes. This trend may not persist. Your asset allocation should reflect your ability to tolerate potential losses,” says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors.

Asset allocation should also depend on the time left until retirement. “An investor whose retirement is decades away may adopt a more aggressive asset allocation,” says Dhawan.

For investors who decide to go with the active choice option, Raghaw suggests a 50:50 allocation to equity and debt. The debt portion could be split equally between C and G. Investors who prefer to avoid credit risk entirely may allocate the debt portion entirely to G.

“A 50:50 split is simple and straightforward. If you rebalance regularly, you will get the rebalancing bonus,” says Raghaw. When investors rebalance during a market downturn, they get to purchase units of E at a lower price, which can boost their future returns.

He suggests that investors who wish to take a higher exposure to equities should do so via mutual funds, where they would get a broader range of funds (higherrisk options include midcap, smallcap, factor funds, etc.) than in NPS, where only a single equity fund is available.

Investors who don’t want to decide on their asset allocation may go for the auto choice option, where they can choose one of three life-cycle (LC) funds: LC 75, LC 50, and LC 25 (suited for aggressive, moderate and conservative investors respectively). In these funds, equity exposure gets reduced progressively with age and rebalancing is automatic.

Time to rebalance

Active-choice investors should check their overall exposure to equities (via both NPS and MFS). “Rebalance by selling units of equity funds in NPS as doing so will not give rise to tax incidence,” says Raghaw.

Rebalancing at least once annually will ensure that the portfolio remains aligned with the investor’s original allocation and risk appetite. “Investors should steer clear of attempts to time the market, which would involve large-scale shifts in asset allocation,” says Dhawan.

Rebalancing should ideally be rulebased. It should be based on a specific date; on certain threshold levels being crossed (plus or minus 5 or 10 percentage points vis-a-vis the original allocation); or a combination of both these criteria.

Which fund manager?

Over a 10-year horizon, investors with 75:12.5:12.5 allocation have earned returns ranging from 12.7 to 13.6 per cent. This is broadly in line with the Nifty 50’s 10-year return of 13 per cent over the same period. Financial advisors say this bolsters the case for having a PFM that offers investors the option of passive funds in the NPS space.

Investors should also pay heed to fees. “Look at the PFM’S investment management fee. Those with larger AUMS would charge lower fees, which would help them increase the return for investors over a longer period,” says Abhishek Kumar, a Sebi-registered investment advisor (RIA) and founder, Sahajmoney. He also emphasises giving higher weight to consistency of performance over the longer term when selecting the equity PFM.

As for choosing debt PFMS, Raghaw says: “For C and G, going with one of the bigger fund managers is advisable. The reputation risk is too high for them, making it less likely that they would take undue risks to chase higher returns.”