NPS- National Pension Scheme and The Marshmallow Experiment

It's been almost 72 years since India became independent and all the while the general public suffered from one basic aspect and that was The old age pension system and a social security system.

Traditionally up to 1991 the earning populace was so used to putting their money in FD and RD at 12% that it never really mattered for them to look anywhere beyond NSC or other post office schemes and of course the omnipresent LIC.

Last was the Ocean into which the public was throwing away its money which spoiled the investment culture so badly that people would rush to them for princely returns of 5% over 20 years and more.

Just like the story about frog who was put into a pot of water and slowly it was heated;  in a similar way the government kept reducing the interest rates on all small savings PPF and fds and to add insult to injury also introduced TDS on the fixed deposits.

Around this time something deceivingly spectacular made its way into the Indian market and it was called ULIP.

ULIP came riding piggyback on the mutual funds which had already made an entry about eight years  before.

Mutual Funds were not so aggressively sold so less than 1% of the investing public invested their hard earned money in them.But the ULIPs were being sold heavily at mind boggling commissions and hence were thrust down the throat of the higher income group.

Slowly few people caught on to the mutual funds and started making money with the return in excess of 15% on rolling basis.with this kind of return the people did not even mind losing the money to Ulips as they had tasted blood.

It seems very automatic to them that putting money in mutual funds was a sure shot way of gaining minimum 15% next year unless of course Y2K and 2008 happened.

The Dotcom bust in year 2000 and the global subprime crisis of 2008 pulled away a lot of people from the equity market.

Around the same time in 2009 NPS was introduced after being tried out for Govt employees in 2004.

It was supposed to be a path breaking plan backed by government of India and controlled by PFRDA.

NPS was supposed to be sold on the back of infinitesimally low expense charges , in fact fraction of what Mutual Funds were charging but having the same 8 fund houses as the fund managers.

The mechanics of NPS is a little complicated. You have 3 streams or asset classes to allocate your money to viz Equity, Government bonds and Corporate bonds. As a conservative gesture the government did not initially allow more than 50% allocation to equity (now it is max 75%). After a lock in upto the age person could take out 60% of the Corpus on his 60th birthday but 40% minimum would be allocated to buy annuity from insurance company . Annuity in simple language meant that 40% of the Corpus would be given to the insurance company of your choice who will continue to give you a monthly pension at a fixed rate which was not very high until subscriber’s death. At the time of death  the pension could be continued for the nominee or the annuity sum would be returned to the nominee.

What was important was that NPS was opened not only to the organised sector but a it also replaced the government pension scheme and was open to anyone who wished to open NPS account.

The next 10 years brought in a lot of changes and another asset class was added as Alternative Investments or AI. 40% of the Corpus which a person withdrew was made tax free and the lock in period or the period till which a person could defer its annuity was extended upto 70 years of age.

As things stand today there are 8-9 fund managers and NPS operates in Tier 1 and Tier 2 mode.

Tier 1 mode is compulsory with a minimum of 1000 rupees subscription and can be used for tax saving under 80C up to a sum of rupees 2 lacs. The lock in up to 60 years of age is in Tier 1 only.

Tier 2 also operates exactly like Tier 1 except that there is no lock-in and you can distribute your money into various asset classes.It is important to note that as soon as the funds appear in Tier 2 you can withdraw them anytime at a short notice.

The Unpopularity: the Indian middle class who had tasted the returns of mutual funds had become used to the instant liquidity nature of various types of funds.

Some of them preferred MFs over FDs also which is a very good thing.

The main thing which was pulling away the Indian public and even those who did not have any retiral benefits for gratuity and pension were not in a mood to keep their money locked in for such a long time till the age of 60.

This is precisely why I have written this article.

I am a self made mutual fund investor who started with the first mutual fund introduced in India. I have made my portfolio in due course of time but I would say one thing at this stage that, if something like NPS was available to me and everybody 30 years ago then probably Mutual Funds may not have been so popular.

In addition to the lock in the people refuse to believe in anything which is backed by the government or is sovereign in nature. This mistrust comes on the back of the famous US 64 debacle , through which the government royally cheated the investors.

Having considered both our aspect what I also feel is that with the popularity of the equity market and mutual funds people have lost the concept of pension.

It is a mindset which makes them feel that they can take care of their own Investments.

While this is a healthy thinking but if it is not backed by adequate qualification or determination and discipline it could actually prove to be undoing.

Most of the investors whom I know have invested or started investing in the last 10 to 15 years. In these years also they're on the constant look out for a good and a better fund hence exiting and entering various funds every year. This mindset does not give constancy and in certain cases people exit at a low and enter at a high. They confuse mutual fund investing with direct equity investing and carry the same mindset here.

This I refer to as the marshmallow syndrome.

Most of the investors are in such a bad habit of looking at the returns every week or every month that they cannot digest a little fluctuation in their NAVs.

If the downturn in the market continues for a few months in a year then they are quick to exit instead of investing more. NPS dissuades a person from this.

However much we talk about long term investing and compounding, the investor can never take a look beyond 5 years. The slow and boring process of compounding can produce spectacular returns is something that a person refuses to acknowledge or even consider.  

Considering the NPS as the investment and security avenues I feel that Tier1 should be made as an investment and also a tax saving Avenue and a small amount of money can also be deposited in the Tier 2. 

Tier 2 is exactly like normal Mutual Funds but at a much lower cost than the index funds or the ETFs. The taxation is also of the same level.

Due to low expenses The returns as seen in the last 5 years have been a little higher than the mutual funds in both equity and debt segment.

So what is keeping the Indian citizen away from an excellent pension scheme which has almost equivalent allocation as a equity hybrid fund.

As I have mentioned the first detractor is the lockin which  can be for almost 35 years for a youngster who is barely 25.

The second aspect is the annuity which is actually controlled by the insurance companies as PFRDA does not have a system of managing it on its own.

Strategy for the self-employed or those in the Merchant Navy: NPS provides a much simpler way of managing your savings and channeling them on a long term basis into a relatively secure system.

in my opinion one must open NPS account as soon as one starts working and should start investing smaller amounts equivalent to at least 15 days of salary. The option must be kept with maximum equity allocation which is 75% at present 15% Government bonds and 10% corporate bonds.

As one grows in age one will be able to see the consistent rise in the Corpus and if encouraged by that one can keep increasing the allocation to Tier 1. 

Along with this one can experiment by putting smaller amounts in Tier 2 which one will be able to withdraw as and when one needs it.

As one approaches the retirement age that is from 55 onwards one should increase the allocation into Tier 1.

5 years of increased allocation will boost the overall courses on the back of the returns that one sees over extended period of time.

In my opinion it is the very lock in nature of one's money which will give it the necessary boost even if it is against one's liking.

Since NPS also serves the central and State Government employees it is my feeling that it will never be allowed to be diluted and The returns that one sees will be greatly enhanced.

I cannot see for sure but as a speculation I feel that a part of the annuity could also be made tax free in future.

Hence as the government sector gains on the back of various improvements in NPS the common man should not be left behind.

2018 has seen the large cap return dwindle in the actively managed MF but higher in the index funds or ETFs.

By extrapolating this hypothesis I can say that in future the actively managed funds will continue to generate lower and lower Returns but before the exchange traded funds or index funds beat the actively managed funds , NPS would have beaten them fairly and squarely.

CONCLUSION: I am a fervent supporter of mutual funds and the basis of my propagation of Financial literacy rests on the versatility of Mutual Funds.
Mutual funds are beyond doubt very flexible when it comes to selection and allocation of funds. But one aspect that they severely suffer from is the ability to be purchased because of 47 Fund houses and each having at least 200 odd variety to pick from. Add to this the severe shortage of good advisors and distributors who can advise going beyond personal benefits.
NPS gives a secular platform to the Lowest Common Denominator to start investing his money in a fairly diversified manner, all the while knowing how much he is generating as returns from each asset class.
He has just 8 Fund Managers to chose from and hence choice is simpler even if he has to change the fund manager every year, which comes at a very small cost.
Apart from allocating funds to the NPS Tier 1 and 2, one can for comparison purposes invest in 1 Hybrid Equity fund and 1 Multi Cap fund.
After a few years of sustained investing, he will be able to decide for himself which is the best course for him.