The improved NPS fixes the wrong problem
To popularise the New Pension Scheme, the government is offering a larger tax break, while keeping firmly in place all that makes it second-rate. Here's what the NPS gets wrong.
The New Pension Scheme (NPS) hasn’t lived up to the hype it generated when it was introduced in 2009. The long-term equity link is thought to be a major reason for this, as investors look for safety in their pension products. The government appears to hope for a change, as it has decided to boost tax benefits related with the scheme.
In 2014, NPS contributions up to Rs1.5 lakh were eligible for a rebate under Section 80C. So a Rs1.5 lakh investment in your Public Provident Fund, for instance, would disqualify your NPS contribution from a deduction completely. Starting 2015, however, the government is giving an additional Rs50,000 as a tax benefit for the NPS alone.
In general, tax benefits tend to significantly increase interest in products. However, it would be unfortunate if people did start buying into the scheme. Here’s why!
This isn’t because of increased equity exposure, but because the NPS has several problems that could easily be overlooked by the lay investor.
So what’s wrong with the NPS?
Compulsory annuity: This is a pension product, so the idea is to create an income stream. Therefore, on retirement, 60% of your NPS fund can be withdrawn while the remaining 40% must be invested in an annuity. The compulsory purchase of an annuity, which generally gives returns of 5-6%, makes the scheme unappealing.
Restrictive terms: Another problem with the NPS is its inflexibility. Once you’re in, your withdrawals are governed by the strict rules of the scheme, even though it’s your money. So, for example, if you happen to retire before you turn 60 or if you simply need to make a withdrawal before you retire, the NPS requires you to buy an annuity with 80% of the sum you had invested, rather than 40%. Given the low returns of an annuity, this rule is not particularly beneficial to the investor. An FD currently offers better post-tax returns.
Exempt-Exempt-Tax: So while your money is invested tax-free, the returns are ultimately taxed at the slab rate when you retire. This goes for both the amount that’s withdrawn when you retire as well as the annuity. Given that the annuity earns 5-6% a year to begin with, this is not a lucrative investment. The Direct Tax Code does plan on making the NPS exempt on withdrawal, but until that happens, all your returns will be taxed.
Low equity exposure: Equity, as an asset class, tends to be relatively safe in the long run. Given that NPS requires long-term participation, the scheme should be heavily invested in the stock market. Unfortunately, equity investment has been capped at 50%. This is too low to provide good returns post-tax and after taking inflation into account.