NPS is still the best retirement planning vehicle for private sector and young govt employees

The newly-announced United Pension Scheme (UPS) has reignited the debate about retirement planning in India. UPS has unofficially replaced the New Pension Scheme (NPS) launched in 2005 as a replacement for the classic Old Pension Scheme (OPS). 

NPS was India’s first contribution pension plan, unlike OPS which was a defined benefit pension. Under a defined contribution plan, the employee and the employer (taxpayer in case of a government employee) save a portion of their basic pay every month to create a retirement corpus. 

This corpus is then invested in a range of financial instruments such as bonds and equity to generate returns. The accumulated value of the corpus at the time of retirement becomes the retirement kitty for the employer. A portion of the kitty can be withdrawn as a lump sum and the balance is paid out as a monthly pension. 

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Why NPS has an edge over others

As the structure of NPS suggests, the final amount of the monthly pension is not pre-determined and entirely depends on the market performance of the instruments in which the NPS corpus is invested and the size of the corpus at the time of retirement.

Under NPS, subscribers or employees could opt for an aggressive investment style (equity-oriented), a conservative investment style (bond-oriented) or a hybrid investment style for their corpus.

In contrast, OPS was a defined benefit pension plan. Under OPS, government employees were guaranteed a starting pension equivalent to 50 percent of their last drawn basic pay. In the old regime pensioners also get dearness or inflation allowance like full-time employees. Thanks to this indexation benefit, pensions would grow year after year in line with retail inflation. This indexation benefit is not present in NPS. The year-on-year growth in pension was entirely a function of the returns generated by your retirement corpus.

An absence of a clearly defined starting pension amount and inflation protection was a sore point for government employees covered under NPS. This created resentment among young recruits covered under NPS and old-time employees who continued to enjoy the iron-clad benefit of OPS.

The newly launched UPS attempts to marry the contribution and market-based returns approach of NPS with the assurance of the old pension system. 

OPS guarantees a starting pension equivalent to 50 percent of the employee's average basic pay in the last year of her service. It also offers inflation protection with pension payments adjusted to the All India consumer price index for industrial workers.

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The additional benefit under UPS, however, comes with a higher monthly contribution and a government employee must complete 25 years of service to get all the benefits. Under NPS, an employee contributes 10 percent of her monthly basic pay plus the dearness allowance and the government contributes 14 per cent of the basic pay plus the dearness allowance to the corpus every month.

In UPS, the employer contribution has increased to 18.5 percent of the basic pay plus the dearness allowance. This may translate into lower take-home pay for government employees unless there is a hike in the overall salary.

Also, unlike NPS which was designed to be universal and open to private companies and individuals, UPS is only for the central and the state government employees.  

So, in effect, UPS changes nothing for the majority of professionals and workers in India who either work for the private sector or are self-employed. NPS remains the best retirement planning tool for them.  

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However, a mass migration of government employees to UPS creates some uncertainty about the future of NPS. There is a possibility that a decline in corpus due to the exit of government employees may increase the fund management charge in NPS which could reduce the net returns for subscribers.

However, as things stand, there is still no clarity on the operational details of UPS and how its corpus will be managed and invested. Many experts believe UPS corpus will also be managed by NPS given its experience which will be a boon for its subscribers in the private sector.

Lastly, if the equity markets in India continue to do well and deliver double-digit returns over the long term as in the past, then NPS could still deliver higher pensions to its subscribers than UPS or even OPS. This is especially true for young subscribers who stay invested for 20 years or more and opt for aggressive investment options under NPS.

In the last twenty years, the BSE Sensex has delivered annualised returns of nearly 15 percent including dividends, more than twice the returns from fixed-income products such as government bonds. If Sensex could sustain this performance over the next 20 years then NPS may be a winner eventually.

(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist).

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