The increase in the deduction limit was not the only surprise in the budget speech. The second big surprise was the initiation of the process that will give the choice between EPF and NPS to employees. Why is NPS superior? For one, it exposes long-term savings of subscribers of the scheme to the bump of returns only possible with equity investments. It does this in a sensible manner by cutting out Rambo fund managers and sticking to the safety of index funds. The average annual index return since the beginning of the Sensex is 17.43%. Other than offering a superior pension product, the government’s push to NPS is shaking the EPF organization out of its monopolist sloth and slumber.
There are, however, problems that NPS is still to resolve. The biggest one is its being back-loaded at the moment. It arises mainly from the lack of a developed annuity market in India. The NPS product gives 60% of a subscriber’s corpus at age 60 as a lump sum and 40% becomes a lifetime annuity.
The lack of an efficient annuity market leaves the money in the hands of the state insurer not known for either its efficiency or its transparency on products. The other big problem is the differential in the taxation rules between EPF and NPS. The former follows the exempt exempt exempt pattern—an investment under EPF is exempt from tax during investment, accumulation and exit phases. NPS attracts tax at exit—both the 60% corpus and the annuity components are taxable. But NPS wins over the tax-unfriendly regime it faces by offering higher returns. One calculation puts the extra return that NPS needs to earn at about one percentage point higher than EPF to nullify the tax difference. This is achievable. The five-year average return on the government bond fund in NPS is 9.09%, on the corporate bond fund it is 10.65% and on the equity fund the return is 13.25%. If one compares this with the average EPF return since FY10 at 8.7%, returns on NPS look much better. If NPS, after accounting for the tax differential, gives just one percentage point over EPF, the difference in return over a 40-year period is over 30%.
If problems with NPS are solvable, what lies ahead for the product? Two steps need to be taken. One, the pension regulator, Hemant Contractor, should now work to get the armed forces included in this state of the art pension system and move the over 1.3 milllion workforce from a defined benefit system to a defined contribution one. One must remember that parity is what the one-rank-one-pension argument has been all about. Parity will mean the defence forces personnel get the same pension system as the Union government employees who have been with NPS since 2004. Two, the government needs to give NPS the Jan Dhan advertising push.
No state pension system in the world has run without a big information push by governments. A big bang advertising push that takes the product to the masses is needed to make the product familiar. But we must remember that NPS is a wholesale product and must be sold to aggregators, companies and associations, rather than to individuals. Those in the pension policy space must stop trying to emulate front end incentives to make NPS a me-too mutual fund or life insurance policy.