Why I will still NOT invest in NPS?

With the recent announcement of a long term capital gains tax on Mutual funds, investors have been looking at alternatives to make their investments. An older debate that has surface again is that if it makes sense to invest in NPS. Really?

So, my friend called me again on the weekend.

“Hey Vipin, couple of years ago you had said that Mutual funds, even after paying taxes, are better than NPS. Of course, they were also tax free then. Now that there is a LTCG of 10%, do you want to revise your view?”

He was referring to the additional deduction of Rs. 50,000 from your taxable income if you invest in NPS (Section 80 CCD(1) or the National Pension Scheme.

I wasn’t particularly enthused about the change (didn’t make a difference). But the thought stayed with me. After some dilly dallying, I decided to take a shot at the numbers. Remember, we are primarily talking tax here. 

Here’s what I did.

NPS or My own portfolio

For our working purpose, we assume that a 30 year old starts investing in NPS to take the tax benefit on investment of Rs. 50,000 per year. He does that till the next 30 years, that is, till he turns 60 and retires.

On the other hand is ‘me’, a younger me at age 30. I decide to skip NPS, pay my tax on the Rs. 50,000 and invest that money with my own preference. Let’s assume that I do that too for the next 30 years.

Now, I could be in the 10% (currently 5%), 20% or 30% tax bracket and accordingly the amount available to invest with me is going to be lower than Rs. 50,000, because I pay the taxes.

When I invest my own money, my preferred allocation is 80:20 in equity:debt. In contrast, the maximum equity exposure in NPS is 50%.

No bias here. NPS has its limitations and doesn’t allow me to invest as per my allocation.

As a result, the expected weighted return from my own portfolio is 11% while from NPS, the expected returns will be 9.5%. We are not taking into account any deft management skills here but purely index investing ( for equity as well as debt). No alpha only market returns.

Here’s a summary of the assumptions:

1. The amount of investment in my own portfolio is based on my tax bracket. So, we work with 3 scenarios.

2. I pay taxes and build my own portfolio with 80:20 allocation to equity:debt.

3. The weighted return of such a portfolio is expected to be 11%.

4. You invest Rs. 50,000 in NPS every year for 30 years. Maximum allocation to equity is 50%, as per current rules.

Basis the above assumptions, after 30 years of investing, this is what the final corpus of NPS and My portfolio look like.

As you can see, there are 3 scenarios for my portfolio based on the tax brackets. You can pick a scenario that is applicable to you.

Lower my tax bracket, higher the investment I am able to make, higher the maturity amount at age 60. The maturity amount is before tax.

So far, so good.

The fun part starts now.

Let’s effect the curse of taxes on the portfolios

So, I am at age 60 and I now know the current values of my portfolio, NPS and personal. What happens now?

You know the rules for NPS.

1. You can withdraw 40% of the NPS corpus as tax free lumpsum.

2. You can withdraw another 20% money as lumpsum, after paying tax as per tax bracket.

3. You have to cumpulsory buy an annuity with the remaining 40% of the money. It means that you will receive an annual fixed income for the period of annuity.

Again, for the sake of simplicity and understanding, let’s assume that you take out 40% of the lumpsum money today, tax free and buy an annuity with the remaining 60% for 30 years, that is, till age 90.

This annuity income is calculated at 7% interest and does not provide any return of the original investment or principal. So, you get an annuity income till age 90, nothing beyond that.

When you receive an annuity, you also have to pay taxes as per your tax bracket. You can be in a 10%, 20% or 30% tax bracket.

As for my portfolio, the investments will mostly be in index mutual funds. The new capital gains tax rule says that if I sell my equity funds after 1 year of purchase, I have to pay a 10% tax on long term capital gains of more than Rs. 1 lakh. The Rs. 1 lakh exemption limit is for each financial year.

To take the benefit of this rule, I divide my entire corpus into 30 buckets and I will withdraw 1 bucket each year (much like the annuity). I also assume that all the portfolio will be subject to the same 10% gain without indexation. This will result in higher taxes than usual. In reality, my tax will be lower.

So, I will get to use the Rs. 1 lakh benefit and also deduct the original investment in mutual fund for calculation of capital gains. At the end of 30 years, I will exhaust all the money, no principal left.

NPS vs My Portfolio – What do the numbers look like?

Here’s a table that summarises our discussion so far.

As you can see, based on the tax bracket you fall in, the investment in my portfolio changes. The 3 different rows represent my current 3 tax bracket scenarios.  

Also, for NPS, since there will be annual tax liability post retirement based on the tax bracket, you can see 3 different columns for the 3 tax brackets. These are the post retirement tax brackets.    

Since the annuity in NPS and withdrawals from my portfolio are cash flows in the future (over 30 years), I calculated their present value using a common rate of 7%. This keep the numbers comparable.

For the annuity, the 40% tax free lumpsum is added to the present value of the post tax annuity receipts.  (Since increased to 60% tax free lumpsum withdrawal on maturity)

What do the numbers say?

Purely from a numbers point of view, if you are in the 30% tax bracket now and hope to be in less than 30% tax bracket later, an NPS may make sense.

The numbers present no significant benefit of investing in NPS.

And I am not even taking into account the benefit of a better management of my own portfolio.

But is that the real reason for not investing in NPS?

As you can realise, tax savings was never my main reason to invest in NPS.

If lower tax is the only reason of making  investments, I would rather take up agriculture and enjoy 100% tax free income.  

The single biggest reason I don’t invest in NPS is its inflexibility.

With NPS, investments continue to remain behind bars for a lifetime – not just during the investment but also after. I have no choice but to live with the shoddy annuity product for a substantial part of the portfolio and over which I have no control. It feels like I will be on ration.

As an individual, that doesn’t work well with me. I continue to skip NPS.

What about you? I am happy to read your side of the argument. 

Note: You can take a return of principal option for annuity, but then you will get a lower annuity rate of say 5% and hence lower income every year.  

In NPS, there is an auto allocation option, the aggressive mode of which has 75% allocation to equity till age 35, after which it reduces 4% every year. Even for this option, an average of 50:50 allocation works out to be a reasonable assumption.