Trouble with India's National Pension System: Why non-government employees are looking elsewhere

Launched amid much fanfare in 2003, the New Pension Scheme was expected to herald a new dawn in India’s financial architecture. The Pension Fund Regulatory and Development Authority was set up to oversee the scheme, and by 2009 the government opened it up to all citizens—it was made mandatory for government employees recruited after January 1, 2004.

The scheme, renamed the National Pension System (NPS), represented a major departure from the past, at least in the public sector, since it involved defined contributions from employees that are matched by the employer. Before NPS, the government offered defined benefits schemes that guaranteed a certain pension. But as the NPS nears its twentieth anniversary, its private sector subscriber numbers have failed to match those expectations, despite its low-cost model. Now, even in the public sector, there have been increasing calls to shift back to the old pension scheme (OPS) and its defined benefits, a demand that has found its way into election of manifestos in state after state. The biggest reason for the low popularity of NPS is the presence of more lucrative market-linked options.

On this front, its main challenger, perhaps, is the mutual fund (MF). Consider this: The total number of MF accounts stood at 151.4 million as on July 31, while NPS subscriptions stood at just 16.8 million as of August 5. Besides, the Indian MF industry’s assets under management (AUM) stood at Rs 46.28 lakh crore, compared with the NPS AUM of Rs 9.65 lakh crore. And this is despite studies indicating that the equity returns offered by the NPS is almost equal to those provided by equity MFs. Critically, the Atal Pension Yojana (APY) introduced in 2015, garnered 46 million subscribers thanks to its assurance of returns exceeding 9 per cent. However, it was discontinued for taxpayers from October 1, 2022.

WHY THIS LAG?

On the surface, it is not readily apparent why the NPS has suffered. The scheme does offer a slew of benefits. It has very low costs for investors compared with other investment vehicles, and it provides tax benefits that private options do not.

And yet there are other reasons for this low popularity. One appears to be its complexity as it requires a certain level of financial understanding. For instance, knowledge on choosing the best pension fund managers, deciding on the equity-debt mix, etc. Experts believe many employers may not be fully aware of the potential long-term benefits it can provide employees. “NPS has a complex investment structure,” says Adhil Shetty, CEO of BankBazaar.com. “It has a two-tier structure: a pension account that gives tax benefits and is mandatory to open for NPS, and an optional account with withdrawal flexibility. Risk profiles, returns, and tax benefits have very different functions. While the underlying complexity is essential to enable the scheme to offer multiple investment choices, it can also confuse some investors,” says Shetty.

Another drawback is that when an employee turns 60, they must invest at least 40 per cent of the corpus in an annuity scheme, the yields of which are a paltry 3–7 per cent pre-tax. Besides, the pension income from annuities is taxable per the slab rate, so the net returns may be negative after inflation. “Considering inflation, the returns offered by the NPS are relatively low. Further, these plans are cumbersome to set up and administer. These are associated with costs if outsourced for record-keeping, investments and administration,” says Maneet Pal Singh, Partner at chartered accountancy firm I.P. Pasricha & Co. The quantum of equity allocation, too, is an issue. “NPS subscribers can only invest up to 75 per cent in equity (the rest is invested in corporate debt and government bonds), and consequently, the returns are also lower,” adds Sowmya Kumar, Partner at INDUSLAW. Then there is the risk that low commissions can act as a disincentive for pension funds. “In financial products like MFs or unit-linked insurance plans (ULIP), a dis[1]tributor makes around 200 basis points (bps) or at least 100–75 bps. In the NPS, pension funds make 9 bps,” explains Sumit Shukla, MD and CEO of Axis Pension Fund. NPS investments also have low liquidity. Once invested, the money is locked in until the investor turns 60, with only partial premature withdrawals allowed under specific conditions. “The contribution and withdrawal rules of NPS might not suit some investors’ specific financial goals or preferences. Moreover, NPS has a long lock-in period, especially for the Tier I account, where withdrawals are limited until retirement age,” says Shetty.

THE EPF WALL

One huge hurdle that the NPS has come up against is the Employees’ Provident Fund (EPF), which is mandatory for employees with salaries below Rs 15,000 a month. And even though it is voluntary for those who earn more than that, the NPS has come to be viewed as an additional option— one that is not as tax-efficient on maturity as the former. “The EPF has more tax benefits because it largely operates on an Exempt-Exempt-Exempt model (except for highly paid employees). In NPS, subscribers can claim tax deductions depending on the type of account; after that, only the withdrawn lump sum corpus has tax exemptions, while the income earned from the annuity is fully taxable,” says Kumar of INDUSLAW. Under Section 80C of the Income Tax Act, NPS contributions are eligible for annual tax benefits up to Rs 1.5 lakh. An additional deduction up to Rs 50,000 under Section 80CCD (1B) is also allowed. Nonetheless, investors are discouraged by the taxation applicable upon withdrawal. Besides, for employers, the NPS represents an additional financial burden that involves a fixed outlay of cash. “While employers have an obligation to contribute a certain percentage of the employee’s salary to the NPS, some companies may hesitate to do so due to financial constraints or a focus on short-term profitability rather than long-term employee welfare,” says Singh. EPF subscribers can port to the NPS only once. However, transferring funds from EPF to NPS is a complex process. Also, once subscribers shift from EPF to NPS, they forego benefits from the Employees Deposit Linked Insurance and Employees’ Pension Scheme as they are deemed to have exited from these schemes.

RETURN OF THE OPS

The NPS has also suffered recently amid demands from government employees that the OPS be brought back. Under the OPS, an individual could expect a defined monthly pension upon retirement, whereas under the NPS the final payout depends on the portfolio’s performance. While the NPS can provide higher returns due to its equity exposure, it doesn’t guarantee this. Moreover, market volatility brings an element of uncertainty that many are uncomfortable with. Meanwhile, the OPS provided a guaranteed, albeit lower, return. The pressure has been such that many states have reverted to the OPS for government employees. These factors have ensured that the NPS has remained a shadow of what it was intended to be. Consider this: Less than 10 per cent of private sector employees have opted for the NPS. And yet, despite these drawbacks, the NPS remains a good tool for retirement savings because it calls for a greater balance between financial flexibility and long-term growth. It’s now up to the government and financial institutions to simplify the scheme and make it more appealing, primarily by enhancing its liquidity without compromising its potential for wealth creation.