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The National Pension Scheme is a Social Security scheme introduced by the Central Govt for providing post-retiral benefits. Unlike many other Social Security schemes, this scheme allows the subscriber to choose a desirable amount of equity exposure (subject to maximum 75% for subscribers below 35 years as on the day of this writing) and also choose his/her fund manager. I will not go into details of NPS as there as several good resources on the same. In the Union budget 2015-16, the Govt allowed an additional deduction of Rs 50,000/- on NPS contribution. It is this additional contribution which I have tried to analyze in this post. Surely the additional amount helps in saving tax, but does it maximize returns in the long run?
First, let us look at the returns generated by various NPS fund managers in the last 7 years and 10 years.
I have not included Alternate funds above as there is not sufficient data available for a 7-year period.
As you can see, the NPS performance over a 10-year period is actually quite good for almost all the funds as compared to other Govt. Schemes. However, please note that the returns on most other Govt. schemes are guaranteed whereas in the case of NPS, it depends on the market and performance of fund manager as well. Anyways, we'll cover the various Govt. schemes in another post.
From the above table, it is safe to assume a long term weighted growth rate of around 9-10% (Max 75% allocation in equities + rest in other schemes).
Let us also look at the returns which some of the mutual funds have delivered in the past.
Disclaimer: In no way am I recommending the above mutual funds or suggesting that these funds should be invested in. My intention here is to only show historical long term returns of some good funds so that we have a reference point for comparing the NPS returns.
As can be seen from above, the equity market has given much higher returns. For a 10-year period, all the category averages are higher than 12% while some funds have performed exceedingly well and delivered much higher returns. Even the returns from the aggressive hybrid fund (Overall composition pretty much similar to NPS) is higher than 12%. Also, the above returns seem to be from regular plans (with much higher expense ratio) and not direct plans.
The point I am trying to make here is that in the long term, direct equity exposure has given higher return than NPS by at least 2-3% if not more. If the returns from equity were to go down in the future, the NPS returns should also accordingly go down as well. However, I expect direct equity investment/ mutual fund investment to continue maintaining the alpha of 2-3% over NPS returns and my analysis is based on this very assumption.
Hence, for my analysis below, I have assumed 10% return from NPS and 12% from equity investments/ mutual investments.
We now see if it is actually worth investing the additional 50K in NPS to save on taxes and the impact on returns in the long run.
For someone in the 30% tax bracket, he essentially has two options:
Invest Rs 50,000/- in NPS
Invest post tax (@31.2%) = 34,400/- directly in equities/ equity oriented mutual funds.
(For 20%/ 10% tax bracket, the amount available to invest in equity oriented instruments would be even higher)
Let us see how the money grows based on the above 2 scenarios:
As seen from the above graph, there is bare any difference between the growth rates of NPS investment and equity. Infact, equity investment start giving much higher returns after 30-year period (for someone around my age, we are actually looking at a 30-year period when we are investing in NPS since withdrawals are allowed only after turning 60 normal scenarios). The difference can be better visualized from the below graph:
Delta return from NPS seems to peak at 20 years after which it starts falling exponentially. However, what happens if you can achieve returns of 13% or even higher from your equity investments?
In this scenario, NPS hardly gives any benefit at all in the short run and in the long run, the difference in returns and overall corpus is huge. This is in-spite of paying taxes on initial investment and starting with a much small investment value as compared to NPS.
In addition to this, equity oriented investments gives you full liquidity and has no conditions on withdrawal as compared to NPS. Even though returns from NPS are exempt (upto 60% based on current rules, rest needs to be invested in an annuity which is fully taxable at the marginal tax rate), the equity investment still provides a much higher return.
The above comparisons have been made assuming 30% tax bracket. It is easy to see that at 20% tax rate, the returns from direct equity oriented investments will be much higher.
Note: The above article only seeks to compare additional investment of 50,000/- on which additional tax exemption has been provided. NPS can prove to be a better investment option than many other Govt. Schemes and depending on a person's age, risk appetite, goals, etc. However, this needs to be analyzed on an individual basis.
Please do let me know your thoughts. You can view all my other posts here.
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