National Pension Scheme: Features, Benefits, and Comparison to Mutual Funds

The National Pension Scheme (NPS) has gained popularity as a retirement planning tool for Indian investors with long-term growth potential and tax benefits. This article explains what NPS is and how it is structured. We will also look at how NPS compares to investment options such as mutual funds when it comes to growth potential, liquidity and taxation.

Table of contents

1. What is NPS (National Pension Scheme)?
2. Key objectives NPS
3. Types of NPS accounts: Tier I and Tier II explained
4. Exploring investment options under NPS
5. Eligibility criteria for the NPS scheme
6. Calculating pension with the NPS formula
7. Important features of the national pension system
8. Advantages of investing in the National Pension Scheme
9. Tax benefits associated with NPS
10. How to open an NPS account: online and offline procedures
11. NPS vs mutual funds

What is NPS (National Pension Scheme)?

NPS is a government-backed retirement investment scheme that seeks to potentially provide a regular income stream post-retirement through fixed contributions.

It offers market-linked returns by investing in stocks and debt instruments. It also offers several tax benefits. While returns are not guaranteed and depend upon market conditions, the government’s backing can provide a degree of relative stability and risk mitigation.

Investors contribute a certain amount annually – some organisations also offer NPS options where employees and employers both contribute monthly to the scheme. The amount is locked in until retirement, with part-withdrawal available for specified requirements. After retirement, a part of the corpus can be withdrawn lumpsum while the rest is released in installments (like a pension) through an annuity plan.

Key objectives NPS

The primary objectives of NPS are:

• Retirement income: To provide a potentially steady income stream for retirees.
• Wealth accumulation: To encourage regular savings that potentially grow over the long term.
• Financial discipline: To instill a habit of regular investing among individuals.
• Flexibility and choice: Choice of asset class based on risk appetite and market dynamics.

Categories of NPS accounts explained

NPS offers distinct account types to cater to different investor segments:

• Tier I account: This is the primary account for retirement savings with restrictions on withdrawals. It is designed to build a retirement corpus gradually.
• Tier II account: A voluntary savings account offering liquidity and flexibility. Although linked to the NPS platform, it allows investors to withdraw funds without significant restrictions. This tier does not offer tax benefits.

Types of NPS accounts: tier I and tier II explained

NPS offers distinct account types to cater to different investor segments:

• Tier I account: This is the primary account for retirement investments with restrictions on withdrawals. It is designed to build a retirement corpus gradually.
• Tier II account: An additional voluntary account offering more liquidity and flexibility. This tier does not offer tax benefits and a tier I account is required to open a tier II account.

Read Also: NPS vs SIP : Key Differences and Which is a Better Investment Plan?

Exploring investment options under NPS

NPS provides a diverse range of asset classes, each with a specific allocation strategy:

• Equity (E): Invests primarily in equity and related investments (up to 75% of the portfolio), which have the potential for higher returns over time but also come with higher risk.
• Corporate bonds (C): Invests in high-quality corporate bonds aimed at offering relatively stable return potential with moderate risk.
• Government securities (G): Invests in government bonds and related instruments for more stability and reasonable return potential.
• Alternate assets (A): Allocates a part of the portfolio (maximum 5%) to alternate assets such as alternate investment funds (AIF), real estate investment trusts (REIT) etc.
• Auto choice: Invests in a mix of stocks, corporate bonds and government securities in a pre-determined proportion as per the age of the subscriber. The equity allocation gradually declines every year as the investor nears retirement.

Eligibility criteria for the NPS scheme

The following can invest in NPS:

• Indian citizens
• Overseas citizens of India (OCI)
• Non-resident Indians (NRIs)

Investors must be aged between 18 and 70 and should be KYC compliant.

Calculating pension with the NPS formula

Understanding the NPS Formula can help assess future pension benefits. First, you accumulate a corpus based on your regular contributions and the expected rate of return. The future value (FV) of your investment can be approximated using the future value formula:

FV=P×{[(1+r)−1]/r}

Where:

• P is the regular contribution amount.
• r is the periodic interest rate.
• n is the total number of contributions.

Example calculation:

• Monthly contribution, P: Rs. 5,000
• Investment period: 30 years (i.e., n = 30×12 = 360 months)
• Expected annual rate of return: 8%
• Monthly Rate of Return, r: 8%/12 ≈ 0.006667 (or 0.67%)

Plugging these values into formula:

This estimated corpus of approximately Rs. 74.55 lakh is what you could expect at the end of 30 years, before any deductions or fees.

Now, let's suppose the annuity conversion factor is 8% per annum. This means each year, 8% of your corpus can be converted into a pension income.

Conversion formula:

Using the example values:
Corpus: Rs. 7,455,000
Annuity Conversion Factor: 8% (or 0.08 per annum)

Thus, based on these assumptions, the investor could receive an estimated monthly pension of around Rs. 49,700.

Important features of the national pension system

Some of the notable features of NPS include:

• Portability: The scheme is portable across jobs and locations, ensuring continuity in your retirement savings irrespective of career changes.
• Flexibility: Investors can change their asset allocation between equity, corporate bonds, and government securities based on market conditions.
• Transparency: Regular disclosures and performance reports ensure that investors stay informed about the health of their investments.
• Regulatory oversight: NPS operates under the supervision of the Pension Fund Regulatory and Development Authority (PFRDA), ensuring adherence to strict governance standards.

Advantages of investing in the National Pension Scheme

Investing in NPS comes with multiple benefits:

• Long-term savings discipline: The scheme promotes regular, disciplined investing for retirement.
• Diversification: With multiple asset classes available, your investment is diversified, mitigating overall risk.
• Cost-effectiveness: NPS is known for its low-cost structure, which helps in maximising returns.
• Attractive returns: While returns are market-linked, the blend of asset classes aims to provide a balance between risk and reward.
• Enhanced retirement income: The annuity component ensures a steady income stream post-retirement.

Tax benefits associated with NPS

NPS offers tax benefits under the old regime of the Income Tax Act, 1961, under the following sections:

• Deduction under section 80CCD(1): Contributions up to 10% of the salary (basic plus dearness allowance) or up to 20% of gross income for self-employed are eligible for tax deduction (within the ceiling of Rs. 1.5 lakh under all investments eligible under Section 80CE of the Income Tax Act, 1961).
• Additional deduction under section 80CCD(1B): An additional deduction of up to Rs. 50,000 (over and above the Rs. 1.5 lakh ceiling under Section 80CE) is available for contributions to NPS.
• Employer contributions: These contributions, up to a defined limit, are also eligible for tax benefits.
• Withdrawals: Amount invested in purchase of annuity it tax-exempt, but annuity income released after retirement is subject to income tax. Up to 60% of the total corpus withdrawn in lump sum is exempt from tax.

How to open an NPS account: online and offline procedures

You can open an NPS account through two main methods:

1. Online Method via eNPS Portal:

The online process is quick and convenient. Here's how you can proceed:

• Visit the eNPS Portal: Access the official eNPS portal.
• Choose registration option: Select the appropriate registration option based on your preference and available documents.
• Provide necessary details: Fill in your personal information, contact details, and bank account information.
• Upload documents: Upload a scanned copy of your PAN card, address proof, photograph, and signature.
• Receive PRAN: Upon successful registration, you'll receive a Permanent Retirement Account Number (PRAN), which will be sent to your registered email and mobile number.

2. Offline Method via Point of Presence (PoP):

If you prefer an offline approach, follow these steps:

• Locate a PoP: Find the nearest Point of Presence (PoP), such as authorized banks or financial institutions.
• Complete application form: Obtain and fill out the NPS subscriber registration form.
• Submit KYC documents: Provide self-attested copies of your identity proof, address proof, and a recent passport-sized photograph.
• Receive PRAN: After processing, you'll receive your PRAN, which can be used to access your NPS account online.

NPS vs mutual funds

Mutual funds can also be a suitable avenue for building wealth over time, with equity-oriented mutual funds offering long-term growth potential. Here is how NPS vs mutual funds compare on different parameters:

Tax benefits:

• NPS: Offers several tax benefits under the old regime of the Income Tax Act, 1961.
• Mutual Funds: Equity Linked Savings Schemes (ELSS) offer tax deductions of up to Rs. 1.5 lakh under Section 80C of the Income Tax Act, 1961. Other schemes do not provide specific tax benefits.

Growth potential:

• NPS: Allows a maximum equity exposure of 75%, which can limit growth potential.
• Mutual funds: The equity allocation depends upon the scheme category and investment approach. Equity mutual funds can theoretically invest up to 100% in equities, though fund managers may choose to include some debt instruments in the portfolio to maintain short-term liquidity and relative stability. The greater the equity allocation, the more the long-term growth potential.

Liquidity:

• NPS: Features a mandatory lock-in period until the age of 60, with partial withdrawals permitted after three years under specific conditions, limiting immediate access to funds.
• Mutual funds: Open-ended schemes offer higher liquidity, allowing investors to redeem their investments at any time, subject to exit loads and taxes, providing flexibility to access funds as needed. ELSS, however, has a lock-in period of three years, after which the entire corpus is accessible.

Withdrawal strategy:

• NPS: Requires allocating 40% of the corpus to purchase an annuity upon retirement, with the remaining 60% withdrawable.
• Mutual funds: Offer flexibility in withdrawal without mandatory annuity purchase, though withdrawals are subject to capital gains tax.

FAQs:

What is an NPS account?

An NPS account is a retirement savings account under the National Pension Scheme. There are two types of accounts, Tier 1 and Tier 2. Tier 1 is the pension account meant for long-term retirement planning and offers tax benefits. Tier II is available as an additional investment avenue, with no restrictions on withdrawals, but no tax benefit either.

What is the full form of NPS?

The NPS full form is the National Pension Scheme, a government-backed initiative that helps investors save for retirement.

What is a Pension Fund Manager?

Pension Fund Managers are entities responsible for managing and investing the contributions made by subscribers. Their primary role is to ensure that these contributions are allocated across various asset classes—such as equities, corporate bonds, and government securities—in line with the investment guidelines set forth by the Pension Fund Regulatory and Development Authority (PFRDA) and the asset class or option chosen by the investor.

What is a Permanent Retirement Account Number (PRAN)?

A Permanent Retirement Account Number (PRAN) is a unique identification number assigned to every NPS account holder, for seamless management and tracking.

What is Auto Choice in the National Pension System (NPS)?

Auto Choice in NPS is a mechanism where the allocation of funds among equity, corporate bonds, and government securities is predefined and is automatically adjusted based on the investor’s age and market conditions.

Who is eligible to invest in the National Pension Scheme?

Any Indian citizen, including resident and non-resident Indians, who meets the age eligibility criteria prescribed by the regulator may invest in the National Pension Scheme, subject to applicable terms and conditions. Eligibility and onboarding requirements may change from time to time, so investors are advised to check the latest guidelines before investing.

How is the pension calculated using the NPS formula?

There is no fixed or guaranteed formula for calculating pension under the National Pension Scheme. The pension amount depends on factors such as the total contributions made during the investment period, the returns generated on those contributions, the age at exit, and the portion of the accumulated corpus used to purchase an annuity. The annuity amount further depends on the annuity rates prevailing at the time of purchase and the option chosen. As returns and annuity rates can vary, the final pension amount may differ from investor to investor.

Can NPS funds be withdrawn before retirement?

NPS is designed as a long-term retirement savings scheme, and withdrawals before retirement are generally restricted. However, partial withdrawals are allowed after three years under specific conditions such as higher education, marriage, medical treatment, or purchase of a house, subject to eligibility criteria, limits, and regulatory guidelines. Rules may change over time, so investors should check the latest provisions before making a withdrawal request.

What is the difference between Tier I and Tier II NPS accounts?

Tier I: Mandatory retirement account, locked till 60, tax benefits, partial withdrawals allowed under specific conditions.
Tier II: Optional flexible savings, no lock-in, no tax benefits, anytime withdrawal.

How to change the investment option in NPS (Active vs Auto choice)?

An NPS subscriber can change the investment option between Active Choice and Auto Choice by submitting a request through the NPS online portal or through their Point of Presence (PoP). Such changes are allowed as per the rules prescribed by the regulator and may be subject to limits on the number of times a change can be made in a financial year. Investors are advised to review the applicable guidelines and disclosures before making any changes.

What to do in case of the demise of an NPS subscriber?

In the event of the demise of an NPS subscriber, the accumulated NPS corpus is paid to the nominee(s) or legal heir(s) as per the nomination details on record. The nominee or claimant needs to submit a claim request along with the required documents through the NPS portal or the designated Point of Presence (PoP). The settlement process is carried out in line with the guidelines prescribed by the regulator, and timelines and requirements may vary. Nomination details should be kept updated to help ensure a smoother claim process.

Can NRIs invest in NPS?

Yes, NRIs/OCIs (18-70 years) can invest in Tier I/II via NRE/FCNR accounts.

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