Rate Watch. Flip-flops make EPF less reliable

The Centre has done it yet again! After rolling back two contentious proposals concerning the Employee Provident Fund (EPF), relating to restrictions and tax on withdrawals, the Centre on Friday increased the EPF rate to 8.8 per cent from 8.7 per cent approved only a few days back. This is in line with the rate recommended by the Central Board of Trustees (CBT) of the Employees’ Provident Fund Organisation (EPFO).

But repeated policy flip-flops around the EPF only re-inforce the Centre’s intention to move investors away from the dreary EPF to the market-linked National Pension Scheme (NPS). Even if rates have now been revised back to earlier expectations, the Centre may intend keeping EPF rates in sync with the market rates and rates of other long-term instruments, going forward. Hence, rather than wait with bated breath for a largesse each year from the Centre, it may be time to consider the market-linked National Pension Scheme (NPS) to earn superior returns than the EPF over the long term.

In the last 15 years (since 2001-02), EPF returns have been largely fixed, higher than PPF (in 12 years). The interest rate is decided by the EPF trustees who announce the rate every year. Rates for PPF are fixed by the Finance Ministry every year. For 2015-16, PPF would earn 8.7 per cent while EPF would earn 8.8 per cent. What does this mean to investors?

Assume you invested ₹5,000 every month over the last ten years in PPF and EPF. For simplicity, we have assumed only your contribution in EPF for our workings. Over the last 10 years (from 2006-07 to 2015-16), a monthly contribution of ₹5,000 in EPF would leave you with a corpus of about ₹9,35,000.

Your investment in PPF, on the other hand, would have been a tad lower at ₹9,22,500. Until five years back, the divergence in rates of EPF and PPF was large. The higher rate of interest set for EPF has certainly added spunk to your returns.

But this trend may change in the coming years. Recently, to bring rates on small savings schemes at par with market rates, the Centre slashed rates across these schemes for this fiscal (2016-17).

Unlike in the past, when these rates were reset every year, the Centre will now revise them every quarter based on the prevailing rates on government bonds.

After fetching 8.7 per cent in 2015-16, the government has cut rates on the good old PPF by 60 basis points to 8.1 per cent for 2016-17 (applicable from April-June). Further cuts through the year cannot be ruled out, in a falling rate cycle. With the government in no mood to announce returns disconnected with the markets on debt instruments, it is very likely that EPF rates may also take a knock next year (for 2016-17).

This indicates that you can no longer ignore the NPS if you want superior returns.

The Centre has been batting for NPS in recent times by doling out more tax concessions. With NPS, you have the flexibility to choose between different asset classes to invest in — equity, corporate bonds and government securities. As you get to take some exposure with equity, you can earn higher returns over the long term.

Going by the track performance, equity-oriented NPS funds have delivered 7.4 per cent to 8.3 per cent annually in the last five years. Government securities funds have given 9.4 per cent to 9.9 per cent and corporate bond managers 10.8-11.6 per cent. The debt portfolio’s outperformance vis-à-vis equity is thanks to its steady run over two to three years, when equities were feeling the heat. But these returns being market-linked can fluctuate from year to year.

Let us consider two scenarios. If you invested 50 per cent in equity, 20 per cent in government securities and 30 per cent in corporate bonds, your monthly ₹5,000 investment would have given you a corpus of ₹3,79,000 at the end of five years.

If, on the other hand, you invested 65 per cent in G-Sec (considered most conservative), 20 per cent in equities and 15 per cent in corporate bonds, you would have built a kitty of ₹3,82,000.

Under EPF or PPF, taking the trend in interest rates over the last five years, your corpus would have been a lower ₹3,71,000. Over time, the difference could widen, as NPS is likely to earn higher returns over the long term.

Note that while over a ten year period, EPF was a better wealth creator than PPF, in the last five years, both have generated similar corpus. This is because, in one year-- 2012-13, PPF earned a hefty 8.8 return vis-à-vis EPF’s 8.5 per cent, offsetting the latter’s better returns in other years.