Government employees contribute to the National Pension System (NPS) whereas private sector employees typically have a Provident Fund (PF) account. In this article, we compare the two retirement products.
NPS vs. PF
Your investment in NPS is technically locked-up till age 60. Locking investments ought to be good because you cannot take the accumulated sum and spend it before retirement. But NPS is structured to earn capital appreciation. The issue is lock-in is not good for capital appreciation products. Why? What if the equity or the bond market declines in any year? You cannot take any action to reduce your losses. Also, you may not have enough time to recover losses if the market were to decline closer to your retirement.
Remember, it takes more effort to recover unrealised losses than it takes to give-up unrealized gains of the same magnitude — a 20 per cent unrealised loss requires a 25 per cent increase to recover the losses, whereas 20 per cent in unrealised gains can be wiped out with less than 17 per cent price decline. Also, the downside risk on bond investment (government and corporate bonds) is much greater than the upside returns.
Reinvestment risk
What about PF? True, interest is compounded but you are exposed to reinvestment risk. This is the risk your investments will be compounded at a lower rate as the rate could decline in the future. This is because PF does not pay fixed rate through the life of the account; the rate is decided every year by the government.
Technically, the accumulated amount is locked till retirement but that should not be a cause for concern as there is negligible risk of earning negative returns on your PF account.
Conclusion
The expected returns on NPS is greater but PF provides stability in returns. True, higher returns from NPS will make you happy but negative returns in any year can cause more pain than the higher returns can give you happiness. You must consider these products in the context of your goals. It is optimal to have two asset classes in a goal-based portfolio- equity (ETFs and mutual funds) for capital appreciation and bonds (typically bank deposits) for interest income. Interest income from PF is tax exempt. The long-term capital gains tax on equity is 12.5 per cent.
Capital appreciation on NPS is tax-exempt. But all your interest income on bonds (deposits) will be taxed at your marginal tax rate (30 per cent).
(The author offers training programmes to individuals for managing their personal investments)