Monday, May 4, 2009

An effort to understand the New Pension scheme of India

Overview
I heard about the New Pension Scheme (NPS) in India that is being launched for all Indian citizens from May 1st 2009. Since I like reading about the financial activities that can affect my current as well as future life so I thought I will try to understand what the new scheme is all about. Since I anyhow would be spending sometime in exploring the NPS so I thought why not put my understanding of the scheme in a blog so that others can benefit from the same. In case you find anything that is not correct then please let me know.... "To err is human". NPS is the voluntary pension scheme where individuals can decide on the contribution that one wants to make and also where to invest their money. Unlike existing pension funds that offer assured benefits, NPS has defined contribution and the returns depend on market conditions. The value of your investment in NPS may rise or fall accordingly.
Eligibility
The very first question that comes to mind whenever such a scheme is launched is who all are eligible to participate in the scheme. So as per what I found on net the scheme is for Indian citizens who are between 18 and 55 years of age. You have to register for the scheme and that can be done at any of the 285 Points of Presence (POPs). Though there are plans to increase these POPs to more than 10000.These are run by the following banks- SBI and its associates, ICICI, Axis, Kotak Mahindra, Allahabad Bank, Citibank, IDBI, Oriental Bank of Commerce, South Indian Bank and Union bank of India. The POPs are also run by financial institutions - LIC, IL&FS, UTI Asset Management and Reliance Capital. Upon registration you will receive a Permanent Retirement Account Number (PRAN). The investor’s account will be kept by a record keeping agency appointed by the PFRDA. The investor will need to interact only with the POP, where he can deposit his annual /monthly contribution. The scheme gives investor the option of shifting from one fund manager to another by instructing his POP to do so. The account would also be Online accessible. A subscriber can even shift his pension account from one POP to another. Subscribers can retain their PRAs when they change jobs or residence.You would also have an option of selecting an annuity which will pay a survivor pension to your spouse. On the death of the participant the nominee can not continue to operate the account. But the balance standing to the subscriber's account may be transferred to the nominee's account after following regulator KYC procedure.
Annual Contributions
Once you have opened the account the second question that comes to mind is about the contributions that can be made to the account. The minimum amount per contribution is Rs 500, to be paid at least four times in a year. Minimum annual contribution is Rs.6, 000. In case you don’t contribute the minimum amount the account would become dormant. A dormant account will be closed if the account value falls to zero. In order to re-activate the account, pay the minimum contributions, along with penalty due of Rs.100 per year of default. There is no upper limit on the contribution per installment or on the number of installments. Under the scheme, you can invest any amount, though tax benefits will be available only up to Rs 1 lakh under Sec 80C. Also, someone else can also make contributions on your behalf.
Fund Allocation and Risks
Subscribers can choose from six different pension fund managers (PFMs) — ICICI Prudential, IDFC, Kotak Mahindra, Reliance Capital, SBI and UTI. You have to select only one fund at a time as per the current rules, you can not select more than one pension fund to manage your savings. The PFMs would invest the money in three asset classes, equity, government securities and debt instruments that entail credit risk, including corporate bonds and fixed deposits. Subscriber can choose from the following fund options
low risk low return
medium risk medium return
high-risk high-return investment
Fund management will charge annual fees of 0.0009% of the invested amount, which is less than one paisa per Rs 100. The cost of opening and maintaining a permanent retirement account, and the transaction charge on changing address, pension fund manager, etc are estimated to be around Rs 400. Since the NPS is meant for post-retirement financial security, it does not permit flexible withdrawals as are possible in the case of mutual funds.If you do not select any investment option then all your contributions would be channeled into a life-cycle fund or 'auto choice’ option. Under this option, for those aged 18-35, 50% of the amount in their pension account will be invested in equity, 30% in corporate bonds and the remaining 20% in government securities. Above the age of 35, the default proportion going to equities would come down and the proportion going to government securities, go up. By the age of 60, these investments will gradually be adjusted so that only one-tenth remains in equities, another one-tenth in corporate bonds and 80% in central and state government bonds. Investment in equity is, however, subject to two significant caveats. First, it cannot be more than 50% of the amount in investor’s account. Secondly, fund managers cannot invest in shares of individual firms, but only in index funds linked to the BSE’s sensex or the NSE’s Nifty. The Pension Fund Regulatory Development Authority (PFRDA) has now stipulated that only half of an individual’s savings can go into equities even if he opts for a high-risk high-return investment. The auto (default) choice for persons who do not make an investment choice also caps the equity exposure at half of the savings. This limit could change in future.
Account Closing/Exiting
You can retire from the scheme at age 60. A person who exits NPS between age 60 and 70, will have to compulsorily invest a minimum of 40 percent of your pension wealth to purchase a life annuity from an IRDA-regulated life insurer. The remaining pension can be withdrawn as lump sum or in installments. An annuity is a steady stream of payments for the rest of the annuity holder’s life. On attaining 70 years, your account would automatically be closed with the benefits transferred to you as Lump Sum. In case you want to retire before age 60, you have to compulsorily invest a minimum of 80 percent of your pension wealth to purchase a life annuity from an IRDA-regulated life insurer. The remaining 20 percent may be withdrawn as a lump sum. The account can also be closed due to the following circumstances: death, account value reduces to zero and change in citizenship status. If a subscriber dies, the nominee has the option to receive the entire pension wealth as a lump sum.
Regulation/Tax benefit
The Pension Fund Regulatory and Development Authority is the regulator of the scheme. NPS is a defined contribution scheme and the benefits would depend upon the amounts contributed and the investment growth up to the point of exit from NPS. The contributions would grow and accumulate over the years, depending on the efficiency of the fund manager. A central record keeping agency will maintain all the accounts, just like a depository maintain demat accounts for shares.Under the scheme, you can invest any amount, though tax benefits will be available only up to Rs 1 lakh under Sec 80C. Long term savings have three stages: contribution, accumulation (interest earned) and withdrawal. The NPS was devised when the government was planning to move all long term savings to a tax regime called exempt-exempt-taxed (EET), standing for exempt at the time of contribution, exempt during the period when the investment accumulates and taxed at the time of withdrawal. In any case, the amount spent on buying an annuity would be exempt from tax. The pension fund regulator is currently lobbying with the government to change the tax treatment of the scheme from EET to EEE (exempt-exempt-exempt). As the other pension scheme such as the Public Provident Fund (PPF), General Provident Fund (GPF) and Employees Provident Fund (EPF) are completely exempt from tax (EEE).
My 2 pennies on the Scheme: (I am not a pro in financial analysis so you can ignore this if you want to)
The pension scheme lacks the full tax exemption status which makes it less attractive as compared to other pension schemes. This scheme involves a greater risk for the investors as the returns are not fixed. The scheme can run into similar troubles as 401K scheme in US, where the returns are market dependent and after a certain age withdrawal is mandatory no matter what the pension status is. So it could be very risky for someone to take out the money compulsorily during a bear (down) market. Also since this scheme only allows to invest in SENSEX or NIFTY. This might inflate the stock prices of these selected companies beyond fundamentals. This could result in huge swings (ups and down) in the markets. The most important being people who know nothing about market could get trapped in the market cycles due to the pension schemes. Clear message should be sent to the masses that even though this is PENSION SCHEME. Then also it does not guarantee even 1% return on the investments. Pension scheme name could be misleading to many households.So as per my view a person should not think the scheme as pension scheme but as long term investment which will be taxed on maturity. I think the status have to change to EEE before it gains any considerable support from masses. To stand a better change against other pension scheme at least government should make withdrawals tax exempt up to a certain limit.If we compare NPS to Fixed Deposit. The NPS scores over FD when is comes to contributions as contributions are tax exempt for NPS. NPS and FD are same when it comes to maturity where both will be taxed on maturity. FD scores over EPS when it comes to assured returns on maturity. NPS can give better as well as negative returns in comparison to FDIf we compare this to Mutual Funds (MF). The NPS scores over MF when it comes to contributions as contributions are tax exempt for NPS. NPS and MF are same when it comes to returns on maturity, as both are market linked. NPS scores over MF in terms of fund cost so that could result in better returns for NPS if both the scheme have same investment portfolio. MF (help for than 1 year) scores over NPS as the maturity return for MF is tax free but for NPS it is not.If we compare this to Unit Linked investment Plan (ULIP) or Tax-Saving MF (TSMF) (Lock in of 3 year).The NPS and ULIP/TSMF are same when it comes to contributions as contributions are tax exempt for both. NPS and ILIP/TSMF are same when it comes to returns on maturity, as both are market linked. NPS scores over ULIP/TSMF in terms of fund cost so that could result in better returns for NPS if both the scheme have same investment portfolio. ULIP/TSMF scores over NPS as the maturity return for MF is tax free but for NPS it is not.Finally, if we compare this to Public Provident Fund (PPF).The NPS and PPF are same when it comes to contributions as contributions are tax exempt for NPS. PPF scores over NPS when it comes to assured returns. NPS can give better as well as negative returns in comparison to PPF. PPF scores over NPS as the maturity return for PPF is tax free but for NPS it is not. Also partial withdrawals is also allowed in PPF as compared to NPS where partial withdrawal is not allowed.

No comments:

Post a Comment