#BQMutualFundShow: The NPS Vs Mutual Funds Debate
How will you fare if you parked money in the national pension scheme when compared with mutual funds?
The National Pension System can’t be pitted against mutual funds as they are not strictly comparable.
Yet, a lot of people plough Rs 50,000 in the NPS every year because of the tax advantage and invest in no other instruments. While that may not be wrong, it’s important to know what your money will do if parked in the pension scheme when compared with mutual funds.
Vijay Mantri of Buckfast Financial Advisory Services explains the calculations in BloombergQuint’s Mutual Fund Show.
The assumptions:
- The investor is 30 years old and will invest the maximum permissible Rs 50,000 in NPS.
- Rs 15,000 tax saved from NPS is invested in a debt/equity instrument every year.
- The amount is invested for 30 years.
- Mantri assumed rate of return of 6-7 percent for NPS and 12 percent for an equity mutual fund.
NPS gives similar returns if the tax saved is invested in an equity/debt-linked instrument. That increases that capital allocated by 15 percent every year. And NPS scores over a lot of debt schemes.
What takes away some of the sheen is that 40 percent of the amount accumulated in NPS has to be invested in an annuity product at the time of withdrawal at the age of 60.
Again, the exercise is not aimed at people who already have equity exposure, but at those who don’t invest in mutual funds or stocks but are contemplating investing in NPS to save tax.
Here are edited excerpts from the interview.
You should know the math and numbers when you are investing.
Exactly. I don’t think we are saying that NPS is a bad product, it is a very decent product. In the last couple of years, we have seen that the product has improved. As the product gets more mature, it will get better. My information suggests that there are a couple of things in NPS which are in the process of being ironed out. If that happens then it could be a very good product. Even today it is not a bad product but a very decent product.
NPS provides additional tax saving opportunities. Section 80C allows you to invest Rs 1,50,000 in tax saving instruments. NPS has given an option to invest in another Rs 50,000 to save tax. Is that correct?
Yes. In NPS, there are two provisions. One is, an employee or a normal citizen of this country including an NRI can invest Rs 50,000 per annum which is the additional tax benefit exclusively available to NPS.
Besides that, an employer can contribute to the extent of 10 percent of the basic salary plus DA of any employee, towards NPS, and that will go as expenses in the income and expenditure account of the employer, but it will not be treated as an income for the employee. So, it is tax-free income for the employee.
These two sections are mutually exclusive. It means that you can take the benefit of both the sections. So, you as an employee, can contribute Rs 50,000 and your company can contribute up to 10 percent of the basic plus DA under NPS.
If I am contributing Rs 50,000 to NPS, can I decide where that money should be parked? Is there any option available?
There are three options available. One is the equity option in which maximum allocation to equity is 50 percent. In that, there are two variants available. You can start 75 percent allocation to equity, and every year the equity allocation comes down by 4 percent. Suppose you start at the age of 30, your equity allocation is 75 percent, then next year it will come down to 71 percent, to the extent that it reduced to 15 percent. It doesn’t go below 15 percent. But by and large, there is 15 percent allocation in equity. Balance 15 percent you can keep in corporate debt or government security, whichever you want to choose, or a combination of it.
Second is the corporate debt option which is 100 percent corporate debt, and third is government securities option where there is 100 percent government securities. So, there are three broad options available to invest. You have to pick and choose when you do want to invest in NPS.
Also Read: How Can Investors Prepare For Volatility?
What will happen if at the age of 30 you start investing with Rs 50,000 each year, either in NPS or other investments?
Suppose you invest Rs 50,000 per month for next 30 years. So, in a 30-year period, you end up investing Rs 15 lakh. We assume a 12 percent growth in our equity portfolio over a 30-year period. So, Rs 15 lakh becomes Rs 1.35 crore over a 30-year period at the age of 60.
When you invest Rs 50,000 in NPS, you get Rs 15,000 tax benefit. Assume that of Rs 15,000 tax deduction you get, you invest that in a debt product. So, when I choose NPS plus debt, so you are investing Rs 50,000 in NPS plus Rs 15,000 in debt, where we assume 7 percent return.
In the second option, if you are investing Rs 50,000 with Rs 15,000 investing in equity option. Earlier, the investment has been Rs 15 lakh but here the investment has been Rs 50,000 + Rs 15,000 which is Rs 65,000 per annum which is Rs 19.5 lakh of total investment. Since you are saving Rs 15,000 in form of tax, your total cash outflow in all three-above situations is Rs 15 lakh.
Why is there so much difference between the value of retirement in NPS and in NPS + debt and NPS + equity?
In the case of mutual funds, we assume that the 30-year old is investing 100 percent in equities for thirty years. That creates Rs 1.35 crore at the age 60.
In NPS + debt, we assume that of the Rs 50,000 which you are investing, Rs 25,000 goes to equity which delivers 12 percent return, and balance Rs 25,000 goes to debt which delivers 7 percent return over the 30-year period. The Rs 15,000 tax benefit that you get from investing in NPS, we assume is being invested in debt products, which again delivers 7 percent return. So, that creates a corpus of Rs 1.08 crore.
In NPS + equity, we assume that Rs 50,000 goes to equity which is assumed as 12 percent return. Balance Rs 25,000 goes to debt assuming a return of 7 percent. The balance Rs 15,000 will go into equity where the rate of return is assumed as 12 percent, which creates a corpus of Rs 1.33 crore.
What is the withdrawal policy in NPS versus a mutual fund?
In a mutual fund, you can take money out anytime. There are just exit loads and tax considerations which you have to keep in mind, otherwise there is no other restriction. In NPS, there are restrictions on how you can withdraw. One restriction is that you can’t withdraw except in emergency in which you can withdraw 20 percent of your contribution after three years. Second option is you can withdraw after contributing for minimum 10 years.
Even after 10 years, you can only withdraw 20 percent, and 80 percent goes into annuity. But let us assume that everybody invests in NPS for retirement purposes and that people will start withdrawing at the age of 60.
The rule is: 40 percent of your accumulated corpus is tax-free in NPS, so you can take that out. 20 percent is taxable at the marginal rate of tax, which straightway gets added to your income. Balance 40 percent compulsorily needs to be converted into annuity. So, there are two purposes of NPS. One is the accumulation phase till the age of 60, and the distribution phase after the age of 60.
Because of the annuity factor, people don’t take entire 100 percent out and 40 percent will give you regular income till you retire. The 20 percent which is taxable, suppose you have Rs 1 crore corpus at the retirement, Rs 20 lakh is 20 percent of it which is taxable. But in that, suppose you own contribution is Rs 8 lakh and Rs 12 lakh is a gain. So, ideally only gains should be taxed but here the entire Rs 20 lakh gets taxed. So, your entire contribution of 20 percent gets added to your income including your investment amount.
Mutual Funds
- In the Rs 1.35 crore corpus, 20 percent withdrawal works out to Rs 27 lakh, 40 percent works out to Rs 54 lakh. So if one withdraws 60 percent in total, that works out to Rs 81 lakh. (This is just for illustration purposes, as there’s no limit for withdrawals from mutual funds at any stage.)
- The person will pay altogether Rs 7.2 lakh tax on withdrawal of 60 percent of the corpus.
- Net of taxes, you will get Rs 73.87 lakh.
NPS + Debt
- 20 percent of the total Rs 1.08 crore corpus works out to Rs 21.6 lakh.
- If you withdraw the maximum permissible 60 percent on retirement, then it works out to Rs 64 lakh, on which you pay Rs 5.88 lakh tax.
- The remaining amount gets converted into an annuity compulsorily.
- Net of taxes, you will get Rs 58.92 lakh.
NPS + Equity
- 20 percent of the Rs 1.33 crore corpus works out to Rs 26.7 lakh.
- If you choose the 60 percent option, you withdraw Rs 80 lakh and pay Rs 7.7 lakh tax on that.
- So, after paying taxes, you have net withdrawal of Rs 72.3 lakh at the age of 60.
What will happen after the age of 60 in all three options?
So, 40 percent gets converted into annuity compulsorily. In NPS + debt, of Rs 43.2 lakh, we assume, the entire amount will go into debt because when annuity takes this amount from you, and whenever the investor dies then the same amount is given back to the investor. Suppose you give Rs 43.2 lakh to the insurance company at the age of 60, whenever you die then the entire corpus is available to your nominee. What you get is a return of Rs 43.2 lakh. Most insurance companies put this money into debt fund. We assume 6 percent return on this because 7 percent is a return on debt but life insurance companies will also have its charges. So, net return available to an investor in 6 percent. So, Rs 21,993 is the annuity which you are going to get for next 20 years provided your NPS + debt. Here we assume that you are also investing in debt which continues to be around 7 percent. In NPS + equity, you get Rs 34,533 per month for next 20 years. At the end of 20 years, Rs 53.35 lakh is the corpus.
But in a mutual fund, since the balance at the age of 80 is growing at 12 percent, you end up withdrawing 2.5 times more than you can withdraw through the NPS system. The annuity number is higher because you are investing 100 percent in equity. In NPS, automatically the entire amount goes into debt product of a life insurance company.
On a debt product, if someone is opting for 100 percent debt plan, today NPS doesn’t have any competition from anybody. If you look at the return of NPS product from August 2013 till today, most NPS + debt products are outperforming mutual funds or any other category. Because the charges are 0.1 percent, if you are opting for debt option then there is no competition with NPS.
NPS has challenges because only 50 percent is being allowed to go into equity which, I believe, is undergoing changes. 50 percent is first step and I think you will see 75 percent and choice is being given to investor to go up to 100 percent very soon. If it goes to 100 percent, then there is game on mutual fund.
The annuity component today is going compulsory to insurance company. The money can stay there, and the customer can do a systematic withdrawal plan like a typical mutual fund option. If that happens, then NPS will become much more competitive.
If you compare NPS with a mutual fund product, then there are two things to keep in mind. One is, in NPS maximum allocation to equity is 50 percent but it could change. Second is annuity, right now you are compulsorily giving annuity to life insurance company but over a period of time the money could be allowed to stay here. So, you have 12 percent equity earning and 7 percent debt earning, and you can opt for a systematic withdrawal plan.
So NPS is a good option for someone without any debt exposure?
NPS is the best option, because you are only paying 0.01 percent expenses.
For those without equity exposure, and those willing to overlook that Rs 15,000 tax savings every year, how does the mutual fund option stack up?
I don’t think any product can actually be compared with mutual funds, as it is the mother of all financial products. It is not right to compare NPS with a mutual fund or any other product because the kind of other things with mutual funds are not available in any other product. I think NPS has to be compared with endowment plan of life insurance companies because there you are investing for 20-30 years. That is the right comparison. and NPS beats that hands down. Instead of buying life insurance product, give that money of Rs 1,50,000 and Rs 50,000 in NPS instead of putting money into life insurance product.