Not having to worry about money is almost like not having to worry about dying ~Mario Puzo
Retirement is that phase of life which appears so far off in future that most people tend to almost ignore it. People make plans for immediate need like kid’s education and often ignore retirement planning. Earlier, people in government jobs had mostly defined benefit pension plan. This was a great feature as it meant people didn’t need to worry to much about retirement planning as they will get inflation-linked pension (in most cases). However, now most people have defined contribution plan which means your pension corpus will depend on how much you contribute to your pension plan and what return your investments generate. We discussed earlier How much you need to retire comfortably and here we discuss options for reaching our target retirement corpus.
Now we have two main investment options for retirement – National Pension Scheme and Employee Provident Fund.
In this article, we compare features of the two options. We then do some number crunching to identify which is better option.
Based on above discussion:
NPS: More investment flexibility, potentially higher return but less favourable taxation
EPF: Better taxation but less flexible asset allocation and potentially lower return
What return to expect from EPF and NPS respectively?
The interest rate on employee provident fund has been coming down. In the early 90s when inflation was at peak and the country was on the verge of default, EPF rate peaked at around 12% and remained there for most of 1990s. However, since then, the interest rate on EPF has been coming down. As the financial position of a country improves, its FX reserves improve, its credit-rating improves, the yield on its bond decreases. The interest rate on EPF is linked to the yield on 10-year bond yield. It will be reasonable to assume that average EPF rate over next 20 years will be around 7.5%.
Now, the return on NPS will depend on asset allocation. I think given the long investment time horizon, most people with more than 5 years to retire should look at 50% equity allocation and 50% fixed income allocation. If we assume fixed income component of NPS to deliver 7.5% and equity component to deliver 13.5%, the average return from NPS can be assumed to be 10.5%.
Comparing NPS and EPF corpus
The main reason why people are reluctant to invest in NPS compared to EPF is the taxation of corpus and mandatory nature of annuity purchase. Personally, I think that eventually the taxation of NPS will be at par with EPF. We already see some signs of efforts to bring NPS at par with EPF.
Given that NPS with higher equity allocation is more suitable long-duration retirement saving product. Now 40% of the NPS corpus is tax-free. 20% of the NPS corpus can be taxed. Even if this portion is taxed at 30%, the post-tax NPS corpus is almost 94% of the original corpus.
Below we compare the size of NPS corpus with that generated by investing in EPF. Our assumptions are:
NPS annualized return = 10.5%
EPF annualized return = 7.5%
Retirement Age = 60 years
Initial monthly investment is 12500 and this increases at 6% every year until retirement.
Our analysis suggests that:
- NPS retirement corpus will be substantially greater than EPF corpus (75% more for person at 25 years)
- Younger the person, more beneficial is to save for retirement through NPS
- Even if NPS corpus were to be taxed, post-tax corpus of NPS will be greater
To conclude, even with existing taxation and annuity provisions, NPS is far superior retirement saving option than EPF for people below 45 years of age. Younger the person, more is the compounding benefit of excess return NPS offers and more compelling NPS becomes for saving for retirement.
Disclaimer: The above content is just for information and should not be construed as an offer to buy or sell or recommendation. Contact your financial advisor for guidance on any investment related query.
Disclaimer: The above content is just for information and should not be construed as an offer to buy or sell or recommendation. Contact your financial advisor for guidance on any investment related query.
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