Pension Plan Or Mutual Fund: What Works Best For Retirement?

"How much do I need for my retirement?" Every woke investor tries to find out an answer to this haunting question quite early in his/her life. On the other hand, there are those blissfully ignorant people who keep walking ahead in life without any coherent financial, investment or a retirement plan. Planning for retirement is something which you can't afford to put on a hold, it needs to be dealt with on a priority basis.

Suppose you are in your mid-30s and you haven't made any plans for your retirement yet, the alarm bells are ringing for you. It's high time you start planning and investing. The reason is, upon calculating the amount you would need to maintain your's and your spouse's lifestyle after retirement, the number, after factoring in inflation and taxes, would be frighteningly high. To accomplish all your financial goals you need a lot of time and a plenty of help from investment instruments like Mutual Fund, PPF, Pensions Schemes, etc.

Amongst all the investment instruments, Pension scheme is particularly peculiar. Its name suggests that it has been devised for retirement investment, which it is, but the important question is--can you trust pensions schemes (govt. or private) to build a handsome retirement corpus? Let's find out.

What Is A Pension Scheme?

There are various pension plans. There are plans which are maintained by employers where the part of the employee's salary goes to a pension account. And there are individual plans where individuals save in the schemes of government or private banks to secure their financial future and protect them from any uncertainties that might arise post-retirement.

National Pension Scheme

National Pension System is the most cost-effective yet least known Government supported pension scheme for Indian citizens in the age group of 18-60. The scheme was launched by Pension Fund Regulatory and Development Authority (PFRDA) in 2004. The minimum annual contribution for this scheme is Rs.6,000, which can be paid in one go or in small portions not lower than Rs.500.

National Pension Scheme (NPS), initially, it was only for the government employees. However, in 2009, the scheme was reviewed and was opened for all the sections of society. The scheme allows you to contribute on a regular basis in a pension account during the time you are working. After retirement, you can withdraw a part of the corpus in a lumpsum and the remainder of the corpus is used to buy an annuity to get a regular income post-retirement.

Opening an NPS account is extremely easy. All you have to do is approach the entities known as Point of Presence (POP). Point of presence simply means banks (both private and public) who have enrolled as POPs. Most of the financial institutions also act as POPs. The job of these POPs is to act as the collection points.

NPS is open for any Indian citizen between the age of 18 and 60 years. However, the only condition is that the person should adhere to Know Your Customer (KYC) norms prescribed by the government. Even NRI can join NPS. But the NPS account gets closed if there is any change in the citizenship status of an NRI.

NPS offers two accounts: Tier-I and Tier-II account where Tier-I is an obligatory account while Tier-II is voluntary. The difference between the two is on withdrawal of money invested in them. In Tier-I account, you cannot withdraw the entire amount until retirement. Even after retirement, there are certain restrictions on withdrawal. On the other hand, in Tier-II account, the subscriber is free to withdraw the entire money.

Things That Don't Work

Despite NPS being a government-sponsored scheme, there are lots of things about it which make investors a little sceptical. The rigid conditions imposed on the withdrawal of post-retirement corpus and many such drawbacks force investors to look for better and more flexible investment options. Let's shed some light on some of the disadvantages of NPS.

100% Equity Option Not Available

Saving for retirement is a long-term goal. However, this long time has to be used wisely to build one's retirement corpus. Over the period of time, it has been proven that equity has delivered the best inflation-adjusted return as compared to any other assets class i.e debt, gold, and real estate. The problem with NPS is that currently, it offers a choice to invest 50 percent of your money into equity under the scheme E fund option. The other 50 percent of your investment, even in the scheme E fund option, is invested in debt instruments.

Mandatory Annuity Investment

In most of the investment schemes, at the end of your investment term, you get to withdraw your entire corpus. However, in NPS, once your term matures, it is mandatory to invest minimum 40 percent of the accumulated corpus in an Immediate Annuity scheme through which you get a regular pension. This scheme has to be purchased from an insurance company. Moreover, this amount is locked in for a lifetime.

For example, if one builds a corpus of Rs.80 lakh in NPS, then Rs.32 lakh (40%, if you are exiting NPS at age 60, and 80% if exiting before 60) will be invested in an Immediate Annuity scheme that will give you a pension for the lifetime. Hence, the amount of Rs.32 lakh will never be returned to the investor.

Annuity Is Taxable - Which Means Portion Of Principal Gets Taxed

Here is the catch. NPS is a tax-free scheme. But if you do the microanalysis, you will see the cracks appearing. As we learned above that 40% of your corpus is invested in an Annuity scheme, the portion of the annuity that you receive, which is a part of your own capital (savings made during the investment phase) is taxable. It virtually means, you are paying tax on your own investment and not on the income earned. Moreover, the amount of pension that one gets after inflation-adjustment is about equal to the amount one saves during the investment phase. Therefore, it is merely deferring taxes during the accumulation phase as the annuity is fully taxable.

Equity (Mutual Fund/Stcok Investment) Vs National Pension Scheme

To this point, we have learned a lot about the NPS and how investors should look at it. Now let's pit it against the alternatives which stand as a competition or let's say promise to deliver better results than NSP. The options that come to mind are equity mutual fund or even direct equity investment. Let's see how NPS fares against these investment instruments.

Flexibility in Investment and at Maturity: Unlike NPS, in mutual funds, there is no mandatory condition of purchasing the annuity. If you wish you can always get an annuity. It comes in handy in old age. But the point to note is that you have an option to buy or not buy. In NPS, a huge sum of your investment, 40% to be precise, goes to annuity schemes. An investor never gets this amount back. On top of that, though NPS is a tax-free scheme, the annuity is taxable.

Offers Better Tax Prospects: The Annuity income you get is taxed in the year of receipt. As the purchase of the annuity is must with NPS you have to pay the tax every year. On the other hand, the mutual fund investments, are far more tax efficient. You get to withdraw your investment whenever you want via Systematic Withdrawals Plans (SWP) which can also work like an annuity. Rules of taxation are applicable on capital gains on equity and debt mutual funds. As you get long-term capital gains on equity and balanced funds, you are exempt from tax. However, in debt funds, long-term capitals gain are taxed at 20% less indexation.

No Restrictions On Exit: The best part of the investment in mutual funds is you can exit the funds anytime you want. If you exit before completing one year, you might have to bear some exit load, however, post one year, you can exit at any time without any additional charges. Exit load is only for first few years. In most of the pension plans, including NPS, cost of early exit is quite high. On top of that, the entire accumulated corpus gets taxed in the year of surrender, which can be a huge tax burden. Also, if you exit NPS before the age of 60, the contribution to the annuity is 80% which is quite a high price to exit early.

Better Control Over Investments: In mutual fund investments you are free to choose your asset allocation on your own. You have a variety of funds to choose from i.e. equity funds, debt funds and liquid funds. This kind of freedom is totally missing from pension plans. Hence, in terms of control over investments, mutual funds fare way better than NPS.

Direct Equity Investment For Retirement?

Investing in the stock market for retirement is an extremely unconventional idea. Even though the historical data suggests that investments held in equity on the long-term basis have outperformed all other investment mediums, the general investor class tends to stay away from it. As you must be aware that equity investment offers uncapped growth, it clearly has an upper hand in terms of returns. However, with the help of proper channels like portfolio management services and stock advisory firms the risk factor can be competently reduced considerably. The point to note here is that while it is rewarding it also poses an extremely high risk. This is the point where mutual funds start to look far more attractive than going direct.

Hence, the ideal way of going about your entire investment planning is to strike a perfect balance in government schemes (NPS & PPF), mutual fund and direct equity investment. With this combination, you can get returns, safety as well as tax efficiency.

Final Word - Should A Smart Investor Invest In National Pension Scheme?

For any investment plan, the best parameter to judge its performance is its return on investment. How much has your capital appreciated over the period of time? Should be the first question. However, a lot depends on whether you are judging your short-term investment or long-term. There are no complications in the former but the latter is a lot more complex. In long-term investment, you have to factor in inflation, tax benefits, transfer options, etc. As we are discussing National Pension Scheme, one thing is quite certain that it can't be your primary investment avenue. It offers safety but returns are not up to the par.

Hence, when you are planning for long-term goals like retirement you need a lot more than just NPS. It should be a part of your portfolio, however, it shouldn't be given much weightage as it doesn't offer 100% equity investment option. Also, the rigid conditions of investment and withdrawal make it an unfeasible option. Thus you have to look for options which are better. You have conventional routes like real estate, gold and dynamic and smart investment alternatives like equity mutual funds and direct equity investment (stock market). Striking a perfect balance in all segments with thoughtful allocation to best asset classes holds the key to success in investment.