Why NPS is the correct instrument to build a retirement corpus
Planning for your retirement can be daunting and confusing. One of the major challenges while planning for retirement is a lack of clarity on the financial instruments to choose to reach the objective of having a financially secure retirement. While there are several products in the market that address this need, in this article, we will analyse why you should consider the National Pension System (NPS).
What is NPS?
Designed as a voluntary contribution scheme, NPS, as the name suggests, has one mandate, to help its investors build a retirement corpus, or a stable stream of income in the form of pension.
When you open an NPS account, you are given 2 options: Tier I account and Tier II account.
Tier I account is compulsory, and the investments in this account are eligible for tax benefits. However, you cannot withdraw your investment from this account until you turn 60. Owing to the limit of investments you can claim for deduction under Income Tax rules, you should only consider investing the maximum amount allowed for deduction in this account.
The Tier II account acts as an add-on to Tier I account, and is voluntary. With Tier II account, there are no withdrawal limits, and all the extra contributions you wish to make should ideally be made in a Tier II account.
Where will my money go?
While the NPS corpus is managed actively by fund managers, portions of your money go to the following asset classes, based on your risk profile.
- Equity– for the investors looking to build wealth via investing in equity, it is a high-risk, high-reward strategy.
- Corporate Debt– for investors looking at slightly better returns than FDs, with medium risk via investing in fixed income instruments issued by corporates.
- Government securities– for investors looking to play it safe, this involves investing mainly in low-risk government securities.
- Alternative Investment Funds – assets like REITs (Real estate investment trusts), InvITs (Infrastructure investment trusts), MBS (mortgage-backed securities) are part of this asset class, primarily looking at slightly better returns with slightly higher risk than corporate debt.
When you open an NPS account, you are given a choice to design your own portfolio. With the Active option, you can invest up to 75% in equity. If manually deciding the portfolio mix sounds difficult, you can also choose the Auto option that helps you decide portfolio mix, and assets allocation for you is dynamically done based on your age. The aim is to reduce the risk of your portfolio as your age nears retirement.
Benefits of NPS
- Taxation- Investment up to Rs 1.5 lakh in Tier I account is eligible for tax deduction under Section 80C. On top of this, a deduction of up to Rs 50,000, is allowed under Section 80CCD of the Income Tax Act.
- Cost- A mere 0.01% fee is charged for managing the NPS corpus, making it the lowest-cost pension product.
- Flexibility- Other than flexibility with your asset allocation, you can also change your NPS fund managers if you are not satisfied.
Limitations of NPS
- Liquidity – pension funds are designed for retirement, and therefore have strict rules with only 3 partial withdrawals allowed until retirement.
- Annuity investment at maturity – 60% of the investment can be withdrawn at retirement and attracts zero tax. However, the remaining 40% has to be invested in annuity plans.
- Market linked investments – This is not a drawback, but highlights risks.
NPS is a good instrument to build a retirement corpus. It is pocket-friendly, offers market exposure, and taxation benefits. If liquidity is not a problem, then a proportion of your portfolio should be in an NPS.