Are you National Pension Scheme (NPS) investors? Are you investing just for the purpose of additional tax benefits? Or are you investing thinking that it is Government managed product and hence there is the highest degree of safety? Let me clear all your these myths in this post.
As I pointed above, many of us invest in National Pension Scheme (NPS) with the sole intention that it gives additional Rs.50,000 tax benefit which is beyond the Sec.80C limit. For few Central and State Government Employees (even for few private sector employees) it is mandatory to invest.
Few invest in this scheme thinking that it is a Government launched product. Hence, there is no RISK in this. All these investors are unaware of the 5 biggest disadvantages of National Pension Scheme (NPS). Let me clear one by one.
# National Pension Scheme (NPS) will not provide you the pension or annuity
One of the biggest myth many of us holding since long is that National Pension Scheme (NPS) will provide us the pension when we retire. Sadly the answer is NO. National Pension Scheme (NPS) will help you to accumulate the retirement corpus. Using this retirement corpus you have to buy an annuity product or pension product from Life Insurance companies like LIC’s Jeevan Aksya VI.
However, many of us have the biggest belief that NPS itself will provide pension or annuity.
# Do you know the National Pension Scheme (NPS) tax treatment once you attain retirement age?
PFRDA, media and many middlemen pitch for tax benefits available while investing in National Pension Scheme (NPS). Sadly we just believe in these benefits and start investing. However, the National Pension Scheme (NPS) taxation when you attain retirement age is horrible to hear.
Assume that you attained Rs.1 Crore retirement corpus from National Pension Scheme (NPS). In this corpus, you have to buy an annuity or pension plan for Rs.40 lakh. This 40% mandatory buying of an annuity is mandatory.
The annuity or pension which you will receive regularly during your retirement from this Rs.40 lakh investment is taxable to you like salary income. Hence, as per your tax slab, you have to pay the tax on it.
Rest of the Rs.60 lakh you can withdraw. However, in that only Rs.40 lakh is Tax-Free. Rest for the Rs.20 lakh, you have to either pay the tax as per your tax slab or buy an annuity to defer the tax.
NONE WILL BOTHER ABOUT THIS HORRIBLE CURRENT TAX TREATMENT OF NPS.
# Risks in Scheme G (Govt Securities) Fund and Scheme C (Corporate) Fund
Do you feel SAFE if your money is invested in Scheme G (Govt Securities) Fund or Scheme C (Corporate) Fund?? It is not so safe like what you thought?
Before I point out the risk, you must understand three important principles of the bond market and they are as below.
Your National Pension Scheme (NPS) invest in Government securities and in Corporate Bonds. The credit quality of these underlying instruments are measured in terms of ratings.
Usually higher the ratings lead to lower the return or risk. It is a misconception among many that credit risk refers to risk of default by the bond issuing entity. However, the truth is something different.
There is a possibility that the credit rating of a bond or instrument the fund is holding may change at any point of time. Let us say ABC Debt Fund holding the bond of XYZ which is rated as AAA by credit rating agencies (highest rating).
It does not mean that this rating is permanent. It may change at any point of time if the company XYZ’s finance changes.
Hence, never be in a misconception that credit rating refers to default risk and also credit rating of the bond will NEVER CHANGE.
I know that there will not be any default risk in Government Securities. However, there is always a credit risk in various level when it comes to the corporate bond investment of NPS.
It is a measurement of a bond’s sensitivity to movements in interest rates. It is usually measured in years. For example, if debt mutual fund with the modified duration of 3.1% means if there is a 1% interest rate movement then the fund will undergo the movement of 3.1%.
Hence, higher the modified duration means higher the interest rate risk.
A debt fund portfolio usually consists of a number of bonds where each could have a different maturity date. Maturity is the time period remaining before which a bond comes up for repayment by the issuer. Average maturity is simply the weighted average time left up to the maturity of the various bonds in a portfolio.
Higher the average maturity greater the interest rate risk of a debt fund.
Average Maturity of National Pension Scheme (NPS) Government Securities and Corporate Bond Funds
Now in case of National Pension Scheme (NPS), let us consider only about the average maturity of Government Securities and Corporate Bonds it is holding.
You noticed that in case of Government Bonds and Corporate Securities, all fund managers holding long-term maturity bonds.
Now due to 2-3 quarters RBI’s policy that to hold the interest rate due to higher inflation, crude price rise and other factors, there is a lesser return from these two categories since two years. You may notice that by referring below images.
Notice that one-year returns for all fund managers in case of Government securities is below 4%.
However, due to a different set of credit rating and average maturity, Corporate Bond Scheme performed well than Government Securities Scheme.
What it proves? It proves that due to their long-term bond holding your money is riskier to interest rate volatility. Do you think what will be the situation of a person who is about to retire?
Let us consider Auto choice option of NPS. Here, assume that you are 55 years of age and opted for Aggressive Life Cycle Fund, then 75% of your asset will be in Government Securities, 10% in Corporate Securities and rest 15% in Equity. Therefore for 55 years of an aged person, his retirement corpus is still at high risk as the fund manager holding higher maturity Government Securities. If there is a fall in inflation and RBI started to reduce the interest rate, then he has to end up with 2% to 3% return on his long-term accumulated retirement corpus.
Below image will give you a clear picture of how your asset is classified under the auto choice option of NPS as per the age. However, the risk will not be reduced. But as per NPS, they are reducing your risk by moving your money to debt. But in debt, you will see how much volatility is there due to these fund managers long-term bond holdings.
However, even if you have not opted for the auto choice option, you have no other options to switch between their default equity, corporate and Govt securities portfolio.
Hence, debt portfolio of NPS is also riskier like equity.
# Expense ratio of National Pension Scheme (NPS) is lowest but unclear!!
Yes, I noticed the same when I was writing a post “NPS Returns for 2018 – Who is best NPS Fund Manager?“. The reason for my doubt is from below image of PFRDA.
Just concentrate on the marked part of Kotak Fund Manager’s Equity holding for Tier 1 Scheme of NPS.
You noticed that Fund Manager investing in Equity Mutual Funds and this holding constitute around 47% of the overall equity portfolio.
The funds which Kotak Fund Manager investing are Large Cap Fund-ICICI Focussed Equity (2.23%), Multi-Cap Fund-DSPBR Opportunities Fund (2.18%), Large Cap Fund-Birla Sunlife Top 100 Fund (2.32%), Large Cap Fund-Birla Sunlife Frontline Equity Fund (2.21%) and Multi-Cap Fund-SBI Magnum Multiplier Fund (2.09%). The values mentioned in the bracket are respective funds expense ratios (as per valueresearchonline).
Kotak Fund Manager investing in 3 large-cap funds and 2 multi-cap funds. This constitutes the 47% of the portfolio. You also notice that the expense ratio of these funds are well above 2%.
In such a situation, how Kotak Fund Manager managing the NPS subscribers money at the low cost of 0.1%? Why NPS subscribers have to pay the double cost (one to Kotak Fund Manager and another cost to mutual funds)?
I think none have noticed it or there are no clear disclose to investors in this regard. This as per me, is the biggest risk to investors.
# It is a marriage between you and NPS irrespective of partial withdrawal rules
Yes, it is a marriage between you and NPS for the long-term commitment of up to your age of up to 60 years of age. Yes, I agree that there is certain liquidity is possible but only under strict conditions. Refer my earlier post in this regard “National Pension System (NPS)-New Partial Withdrawal and Exit Rules“.
Hence, I feel this as the biggest hindrance. Because irrespective of the performance or your need, you have to stick to 8 fund managers and their style or stick your money up to your retirement age of 60 years.
Hope this much information will be enough for all readers to open their eyes before jumping into investing in National Pension Scheme or NPS.