WHERE SHOULD I PUT MY MONEY?
How investments in National Pension System Tier 2 stack up against those in mutual funds
When looking for an investment, cost is usually an important factor. On that count, National Pension System (NPS) investments score well above financial products like mutual funds, since NPS management fees are as low as 0.01 per cent.
While investing in the NPS is mandatory for central government employees (except members of the armed forces), it is a voluntary retirement savings product for non-government employees. There are two kinds of accounts investors can open—Tier 1 (NPS1) and Tier 2 (NPS2); but those seeking to invest in NPS2 must already have an NPS1 account. The main difference between them has to do with liquidity. Under NPS1, investors are allowed to withdraw only 60 per cent of the corpus on retirement; the balance must be invested in an annuity. NPS2 accounts have no limit—investors can withdraw as much as they want, whenever they want. This makes NPS2 accounts comparable to mutual funds in terms of liquidity. These accounts also score well on returns, outperforming mutual funds under government and corporate bond categories (see accompanying table).
However, not many people with NPS1 accounts seem to have
opted for NPS2 investments. The total NPS2 assets under management total to just Rs 857 crore as on June 1, 2019.
One reason NPS2 accounts haven’t caught on may have to do with how many decisions are required. First, investors must decide between ‘active’ and ‘auto’ allocations—choosing between micromanaging their investments (‘active’) or opting for a preset portfolio type (‘auto’). Secondly, there are four asset classes that funds may be invested in—equity, government bonds, corporate bonds and alternative assets (Real Estate Investment Trusts, Infrastructure Investment Trusts, etc). Under ‘auto’, investors must choose one of three portfolio types— aggressive, moderate or conservative, based on their risk appetite. (An aggressive portfolio will have a greater exposure to equity than others.) ‘Active’ investors must decide how to allocate their funds among these four classes themselves, subject to regulations—for example, investors may allocate a maximum of 75 per cent of their funds to equity, and a maximum of 5 per cent to alternative assets. In the absence of professional advice, choices like these can prove too complicated for everyday investors. As Rahul Jain, head, Personal Wealth Advisory, at Edelweiss says, “There is too much compartmentalisation in the overall structure, which requires investors to make choices at every stage. This makes the process of investing cumbersome and intimidating at times.”
Another reason for the lacklustre investment numbers in NPS2 accounts may have to do with ambiguities over taxation. As Saraswathi Kasturirangan, partner, Deloitte India, says, “There are no specific tax benefits available for contributions to NPS2 accounts, and no clarity on how withdrawals from NPS2 accounts will be taxed, in the absence of specific provisions in the Act or clarifications from the government.” This is one area that mutual funds score over NPS accounts— investors know exactly how much they will have to pay at the time of withdrawal, and what sort of tax deductions are permissible.
As mentioned, NPS investments have the lowest fund management charges among investment products. However, the cost does increase when other factors—such as initial subscriber registration charges
THERE ARE NO SPECIFIC TAX BENEFITS AVAILABLE FOR INVESTMENTS IN NPS2 ACCOUNTS, AND NO CLARITY ON HOW WITHDRAWALS FROM THESE ACCOUNTS WILL BE TAXED
(Rs 200) and contribution upload charges (0.25 per cent per transaction, to a maximum of 25,000) are factored in. Even so, the overall cost of investing in NPS schemes still works out lower than mutual funds. However, while these low charges do benefit consumers, they also mean that investment distributors have a lower incentive to sell them, since they earn lower commissions. As Jain says, “Since NPS investments are low-cost, there is no incentive for financial intermediaries to distribute or promote them, leading to reduced awareness among investors, leaving them on their own to open, operate and manage these accounts.”
Another issue with NPS2 investments is that there is very little choice in terms of investment managers and options in NPS schemes. First, NPS investors only have eight fund managers to choose between, while there are 47 fund houses for mutual fund investors to choose from. Second, mutual fund investors have a much wider group of assets to choose from, with 11 categories of equity and 16 categories of debt. Third, NPS investors may change their fund allocation only twice in a single year; there is no such limitation for mutual funds. (However, there is a silver lining—NPS investors may switch fund allocations without incurring any tax liability, while mutual fund investors will be taxed if they do so.) And then there are the restrictions on investment—NPS investors can only allocate a maximum of 75 per cent of their assets to equity investments. “Under NPS, the choice of fund managers is limited to eight. And one can choose only one fund manager to manage all the schemes. Compare that with mutual funds—they offer a wide variety of funds to choose from,” says Jain.
NPS2 funds invested in government and corporate bonds have delivered better returns than mutual funds in those categories (see table). However, this pattern has not been replicated in equity investments. Experts believe that this may be a result of conservative management, as equity fund managers must also provide liquidity to their customers, which reduces their risk-taking capabilities. However, experts also say that mutual funds are a better choice for those looking to invest in debt. “Debt mutual funds have indexation benefit after three years, NPS2 does not. And both are managed by fund managers and take risks. I think mutual funds are more transparent and give you more options compared to NPS,” says Shweta Jain, founder, Investography.
CHOOSING A SIDE
While NPS2 investments do have a cost advantage over mutual funds, experts say that the choice should not be oversimplified. “Costs are not the only thing that should determine your choice. It should be one of the factors,” says Shweta. With a lack of clarity on taxation rates and no tax incentives for NPS2 investors, experts still believe that mutual funds are the better option. “If you look deeply, there aren’t any apparent advantages of NPS2 investments over mutual funds, except for the fact that NPS funds are managed conservatively and with a lower expense ratio,” says Jain. However, experts also say that if NPS2 investments are granted tax benefits, that could make them more attractive. “The NPS is an evolving product. Tax benefits would definitely boost its appeal, because investors love anything that gives them tax benefits,” says Shweta. And it does seem likely that NPS2 investments will gain some benefits in the upcoming budget. “There are no tax benefits for NPS2 investments as there is no lock-in period and the funds are freely withdrawable. However, in December 2018, the Union Cabinet approved a proposal providing tax benefits—deductions under section 80C of the Income Tax Act, subject to a lock-in period of three years. This was not incorporated in the interim budget announced on February 1, 2019; it is likely to be incorporated in the upcoming full budget,” says Kasturirangan.
As of now, mutual funds certainly do look like the better option.
NPS2 INVESTMENTS IN GOVERNMENT AND CORPORATE BONDS HAVE DELIVERED BETTER RETURNS THAN MUTUAL FUNDS IN DEBT CATEGORIES —Renu Yadav