Wednesday, January 23, 2013

New Pension Scheme

Mr. Gerard Colaco: The article reveals the dismally poor quality of financial journalism in India today. Let us subject the New Pension Scheme (NPS) now called the National Pension Scheme, to pitiless analysis. NPS is available to citizens of India from 1st May 2009. It is one of the worst choices for retirement investment, more so when there is a long time horizon of two decades or greater. The one advantage of the NPS is that there is no maximum limit to the contributions. The maximum tax benefit of course is limited to Rs 1 lakh by Section 80C.

There are two types of accounts, TIER-I accounts, where the contributions cannot be withdrawn until the stipulated age of 60. The second is TIER-II accounts. Here, the savings can be withdrawn at any time. However, in order to have a TIER-II account you must also have a TIER-I account. Thus the backbone of the NPS is the TIER-I account. It is this account which will be analyzed here. My first argument against the NPS is that it militates badly against the basic investment principle of liquidity. If an individual starts saving in the NPS at say 23 and at 43 he is diagnosed with a terminal disease with only perhaps a year to live, how does the NPS benefit him if the funds therein are to be locked until he reaches the age of 60? ELSS, tax saving bank deposits and even the PPF have much better premature liquidity provisions.

Second, the NPS is open to persons between the age of 18 & 60. There are a lot of people who live two or three decades beyond the age of 60. Such people cannot join the NPS even if their financial resources permit and they need tax saving.

Third, when an NPS account holder reaches the age of 60, she can withdraw the balance in the NPS. But only 60 percent of the amount withdrawn can be utilised by her freely. The remaining 40 percent must be used compulsorily to purchase annuities from insurance companies. In case of premature withdrawal before the age of 60, only 20 percent of the amount withdrawn can be utilised freely and annuities must be compulsorily purchased with the remaining 80 percent. This is my main argument against the NPS. Let us say an individual invests in the NPS for 40 years between the ages of 20 and 60. A huge sum may be accumulated. Even such a disciplined investor will now see 40% of his corpus going into high-cost, poor-investment and low-return products such as life annuities.

Fourth, the maximum amount allowed for equity investment in the NPS is 50 percent. This is crazy. If a youngster aged 20 lands a reasonably good job and wants to put by something for retirement every month, I would advise 100 percent in equity through an SIP into either an index fund or direct equity portfolio for at least the first 20 or 25 years. Even if the NPS had an option by which an investor could choose equity to the extent of 75 percent up to say the age of 40, that would be infinitely better than foolishly limiting the equity component to 50 percent regardless of the age and time horizon of the investor.

My fifth argument against the NPS is the multi-layered charge structure involved. Much has been made of the fund management charge of 0.0009% per annum, which is indubitably low. But there are other charges about which, surprisingly, no one speaks. The account opening charge is Rs 50/-. The annual maintenance charge per account is Rs 280/-. The charge per transaction is Rs 6/-. The initial charge for subscriber registration is Rs 40/-. The charge for any subsequent change in subscriber registration is Rs 20/-. The custodian charge is 0.0075% per annum for the electronic segment and 0.05% per annum for the physical segment. Finally, there is the fund management charge of 0.0009% p.a.

For the reasons mentioned above, I would neither touch the NPS nor recommend it to anyone. I will not waste my time commenting about the article itself, which does not address the important issues of liquidity, asset allocation and the compulsory dumping of annuities on investors. I will just criticise one point in the article as an example of just how poor financial journalists are in sound investment knowledge.

According to the writer, one of the “most outstanding features” is the “life cycle fund”. It is the default option for someone who has not indicated the desired asset allocation and those who are not financially aware and can’t manage asset allocation themselves. Those who are not financially aware must find and consult a competent adviser or better still acquire sound knowledge themselves before venturing into an avenue of investment they know nothing about.

The life cycle fund is simply a strategy by which 50 percent of the NPS corpus is in equity and 50 percent in bonds up to the age of 35 years, after which the percentage allocated to equity decreases by 2 percent per annum until at the age of 55, there is only 10 percent in equity and 90 percent in bonds. I shudder to think of a 55 year old who is going to live to 90 on this asset allocation.

As Prof Burton Malkiel puts it to so well, “No asset allocation will fit all 30-year-olds, 50-year-olds or 80-year-olds. Even an 80-year-old might want an asset allocation more suitable for a 30-year-old, if she plans to leave most of her estate to her children or grandchildren. The appropriate allocation of those planning bequests should be geared to the age of recipient, not the age of the donor, for that part of their total investment."

When I went through the article, I was reminded of this old saying, which appears to be getting more relevant by the day: “There are four types of persons involved with the market. Those who do not understand the market, but have money to invest, are called investors. Those who understand the market but do not have the money to invest are called brokers. Those who understand the market and have the money to invest are called tycoons. And those who neither understand the market nor have the money to invest are called financial journalists."