Sunday, February 5, 2012

Problems with the NPS (National Pension System), India

The Indian Govt launched the National Pension System with high hopes and much fanfare. Unfortunately, despite several positives, it has not taken off as expected. Some blame it on the lack of incentive for intermediaries (agents, financial institutions etc) to sell the scheme. While true to a certain extent, why do you really need an incentive for higher offtake if it was so good for the public? True that agents will sell it more if they get better commissions, but at the same time it is also true that many (if not most) agents will mis-sell any product which gives them higher commissions, whether good for the investor or not.

There are several other pension products in India and none of them seem to be doing too well. May be they are doing a bit better than NPS due to the mis-selling being done by agents. Here I look at the most basic flaw or shortcoming of pension products in India including NPS.

"On attaining the Normal Retirement Age (NRA) of 60 years – You will be required to compulsorily
annuitize at least 40% of your pension wealth and the remaining 60% can be withdrawn as a lump
sum or in a phased manner; in case, you opt for a phased withdrawal"

Not just that, "Withdraw any time before 60 years of age– In such case, you will have to compulsorily annuitize 80% of your accumulated pension wealth"

Basically what Govt is telling us is that they kind of control our choice on what we want to do with our money on retirement. There are 2 basic flaws as I see it:

1. If a person is sensible enough to invest in a pension scheme, he would be sensible enough to know what to do with the money he receives on retirement. Govt. really has no business dictating what to do with the our hard earned money on which we have already paid tax. It's high time Govt start treating citizens of the country as adults. If we are mature enough to elect Govt to take decisions for the country, we are mature enough to take decisions for ourselves.

2. We may still be able to tolerate Govt limiting our options on what to do with our money if Govt provided us any sensible options. The only option Govt provides is to take Annuity. We don't know what kind of annuity options will be available to us when we retire. But at least today the annuity options available in market are probably the worst investment options.

Let's take a look at the annuity options in market today. There are 2 broad kinds of annuities available in the market today:
a) Annuity without the return of capital
With this, one receives the pension till one is alive. After that, the money is gone!! Stupid enough. It might work well in western societies where most people live their lives independently of their children. This probably won't work well in India, where people expect that their children benefit out of their savings when they are no longer there.
E.g. For a corpus of Rs 10,00,000 (i.e. 10 lakh), the pension may be around Rs 7500-8000 per month till the person lives. Once the person dies, the amount of 10 lakh is gone!! If a person dies 5 years after retirement, he/his heirs would have effectively received only Rs 4,50,000 out of the Rs 10,00,000 he invested.

b) Annuity with the return of capital
This probably is more suited to Indian needs as such plans return your original capital to the legal heir or the nominee. But there is a catch - the annuity amount (pension) given is very pathetic. E.g. For a corpus of Rs 10,00,000 (i.e. 10 lakh), the pension may be around Rs 6000-6500 per month. So, even though it returns the capital, it provides substantially lower returns than the annuity with return of capital.

Then there are other variations of the above 2 basic kinds of annuities, but the common theme across all of those is the meager returns they offer.

Compare the returns from annuities in market today with the Monthly income plans (MIP) available in the market today. With a lump sum of Rs 10,00,000, you can get a monthly income of around Rs 7500 per month and return of capital at the end of the tenure which is typically 5 years. Post office has some of the best schemes for senior citizens.

Note that the examples used above are based on current rates in the market. The pension/monthly income offered by such schemes changes with interest rates in the market, this is similar to how rates on fixed deposits change with interest rates in the market. Once you book a FD, the rate is fixed for the tenure of the FD. Same with annuities or MIPs.

One risk with monthly income plans is that when you get back your money after the tenure, you need to invest it again at that time to get regular income. And the interest rates at that time may not be the same. So you do have a risk with MIPs which is not there with annuities. As with annuities the rate is fixed (the pension amount if fixed) when you buy the annuity. But that has an even bigger catch:

The same interest rate risk is present in a much bigger way with NPS. Who knows what the interest rates will be like when you retire? You will be forced to buy annuity at that point of time even though it may not be a good time to buy annuity, if the prevailing interest rates are low.

Instead if Govt gives us our money back, we could choose whether to buy an annuity or MIP or some other investment. Or if we want to defer buying an annuity for some time.