Real Returns. Four tricky questions on the NPS

Thinking of signing up for the National Pension System (NPS) this fiscal? The NPS poses four tricky multiple choice questions to all newbie investors. So here’s how you can answer them.

The money you invest in the NPS is managed by pension fund managers who are selected by the Pension Fund Regulatory and Development Authority (PFRDA). While signing up, you need to choose one pension fund manager from a menu of seven.

It would be prudent to use two criteria while selecting your pension fund manager. One, restrict your choices to managers with a five-year track record.

As both equity and debt investments are subject to cycles, it is best to bet on managers who have delivered reasonable returns over an entire bull and bear cycle. So of the seven managers, only five make the cut presently — ICICI Prudential, Kotak, Reliance Capital, SBI and UTI Retirement Solutions.

Two, go for the ones with the best five-year track record. As of April 10, 2016, the five-year CAGR from different equity managers ranged from 6.76 to 7.78 per cent; that on government securities (G-Secs) from 9.44 to 9.90 per cent and corporate bonds earned 10.79 to 11.6 per cent.

ICICI was the top performing manager across equity, G-Secs and corporate bonds over the last five years, but your choice may not always be so easy. As you are allowed to choose only one manager across all three asset classes, go in for the one who delivers the best show on equities. This, because equities offer the most opportunity for the manager to deliver higher-than-benchmark returns. Do remember to review your choices every year, so that you can make switches if you are unhappy with the performance. As the PFRDA reshuffles its managers once in every three years, be prepared to make switches if your favourite manager drops out of the race.

The second question the NPS form pops at you is on asset allocation — would you like to go for the ‘active’ choice or the ‘auto’ choice?

If you sign up for the active choice, you get to decide on your own asset allocation between the three asset classes on the menu — equity (E), corporate bonds (C) and G-Secs (G). You can park a maximum of 50 per cent in E and divide the rest between C and G.

The auto choice is meant for investors who aren’t savvy enough to make this call.

So, if you’re 35 or younger, you get a 50 per cent allocation to E (the riskiest asset), 30 per cent to C (moderately risky asset) and 20 per cent to G (the safest option). Once you hit 36, your allocation to E drops by 2 per cent each year and that to C falls by 1 per cent; all this money is swept into G. This automated asset allocation plan will thus leave you with 20 per cent in equities, 15 per cent in corporate bonds and 65 per cent in G-Secs by the time you turn 50.

While putting your allocation on autopilot may seem attractive on paper, the auto choice trims your equity exposure too early in your career. This may deprive you of higher equity returns over the long term. We would advocate a far simpler option.

Take the active choice and allocate 50 per cent to E, 30 per cent to C and 20 per cent to G. When you hit 55, cut back your equity exposure to 20 per cent (or even less) to protect your corpus from swings in equity markets. This way, your equity investments will have enough time to deliver.

Many investors, in practice, may not rely only on the NPS but may also use other vehicles — including direct equities and mutual funds to save for retirement. If you belong to this category, be sure to sync your NPS with the rest of your portfolio to decide on the allocations. You may like to keep two factors in mind.

One, if you’re an aggressive investor willing to take a fair bit of risk, you may like to take less of your equity exposure through NPS and more through actively managed equity funds (they would offer better liquidity too). By investing mainly in index stocks and rarely trading on them, NPS managers take a play-it-safe approach, which leads to tame returns.

Despite their much higher costs, actively managed multi-cap equity funds have managed a 9.8 per cent return over the last five years, over 2 percentage points higher than the NPS managers.

But the caveat is that you should be able to choose good funds and continue with your investments through bear cycles.

Two, unlike the equity portion, the debt portion of the NPS offers a pretty good deal to investors. The ultra-low management fee charged by the NPS (0.0009 per cent of assets), as against 1.5 to 2 per cent by debt mutual funds seem to prop up returns from the NPS.

Five-year returns (as of April 10) show that actively managed bond funds and G-Sec funds have delivered returns of about 8 per cent in the last five years. The NPS’ C and G options topped 9 and 10 per cent, respectively.

The NPS allows you to invest lumpsums, monthly instalments or any combination of the two. But even if you have money to spare, it would be best to spread out your investments in the NPS through the year, akin to mutual fund SIPs. Both equity and debt markets are increasingly getting volatile and, therefore, it is best you protect your retirement corpus from the ill effects of timing.

Taking the SIP route (you can have standing instructions at your bank to invest regular sums each month) ensures that your returns are shielded from the impact of timing.