By Gautam Bhardwaj & Kulin Patel
The National Pension System (NPS) is based on market-linked returns. Pension benefits are, therefore, mainly a function of the amount a subscriber saves in NPS over time, and the returns generated by investing her savings in a mix of government bonds, corporate debt and equities. The scheme also provides a life-cycle “default” option where allocation between equities and debt is automatically rebalanced as a person grows older. This ensures optimum investment returns with an automated, gradual reduction in market volatility risk.
The Pension Fund Regulatory and Development Authority (PFRDA) is now putting together the framework for a new NPS product option with guaranteed returns. This is in line with Section 20 of the PFRDA Act which mandates that “…the subscriber, seeking minimum assured returns, shall have an option to invest his funds in such schemes providing minimum assured returns” using a “market-based guarantee mechanism”.
On the face of it, ‘assured returns on NPS’ seems like a good idea. After all, there is a clear retail bias towards products that guarantee returns, and a large share of household savings therefore continue to flock to bank fixed deposits (FD), Public Provident Fund (PPF) and postal savings.
While PFRDA proceeds with the policy, some important questions arise. Will a guaranteed-return NPS deliver optimum retirement benefits? How useful will this really be, especially for lower-income households who may be more attracted to this option? And could market-based guarantees create a contingent fiscal liability?
Although NPS returns are not yet guaranteed, the scheme has delivered annual returns of nearly 10% since inception and has outperformed the Employees’ Provident Fund (EPF) and PPF by over 2%, and FDs by nearly 4%. This is due to NPS’s unique architecture, PFRDA’s well-designed investment regulations, strong oversight by the NPS Trust, and extremely modest costs and charges.
While over 70 lakh civil servants are also saving in NPS, it was originally intended to provide India’s 400 million informal sector workers a secure and easy way to accumulate savings for old age. A majority, including farmers, domestic workers, small retailers, gig workers and self-employed women, may be able to afford only modest NPS contributions. For them, high real returns (net of inflation) on retirement savings are their only hope of escaping old-age poverty. Traditionally, returns on equities over multiple-decade investment horizons have consistently outperformed other investment classes. A retirement portfolio with equities is especially important for lower income savers—since an equity premium can help convert even modest savings into a meaningful retirement corpus.
This may change with guarantees on NPS. A market-based guarantee could force fund managers to sidestep equities, and invest predominantly in low-risk, low-yield government bonds to ensure that actual returns at least mirror guaranteed returns. This would depress investment returns, lower the value of pension benefits, and could cause many subscribers to outlive their savings. Also, NPS fund managers would be obliged to substantially increase their capital, and bring in new solvency margins, in line with growth in guaranteed assets. This would in turn increase their costs. Higher costs would result in higher fees, which would further reduce the overall returns for subscribers. A triple whammy, of lower (real) returns, higher fees and charges, and a lost potential upside from market-linked returns, could make the guaranteed NPS option less useful for most Indians.
Additionally, the more immediately visible cost of guarantees may appear modest to most people and obfuscate their long-term adverse impact on terminal savings. For example, just 1% lower returns on NPS could reduce retirement benefits by roughly 30% over a 30-year savings horizon.
Nevertheless, guaranteed returns will certainly appear attractive, especially to people with low financial literacy. With a “guarantee” tag, the public, and indeed many tasked with selling NPS, may also not fully appreciate (or even care about) the guarantee “fine print”. As a result, many could run the risk of foregoing a considerable upside for the level of assurances they think they value and are receiving. This would be even worse if subscribers invest a high a proportion of their contributions in an assured return option.
Unless a significant public awareness effort is made to clearly explain the guarantee and its long-term cost, this may also create unintended and incorrect public expectations—especially since NPS is a government-endorsed scheme. The experience with the erstwhile Unit Trust of India’s US-64 that inadvertently created a wrong perception of an implicit guarantee, and which the government was ultimately forced to honour, should perhaps be kept in mind.
As things stand, a guaranteed return pension product already exists in the form of the Atal Pension Yojana (APY). The APY is already being implemented by PFRDA-regulated intermediaries. In this situation, the government could consider working with PFRDA to instead further strengthen the APY and make it more universally available—including to those aged 40 years and above. An NPS with assured returns certainly appears attractive and easier to sell. However, we also run the risk of introducing a scheme that may ultimately cost much more than most Indians can afford.
Bhardwaj is co-founder of pinBox Solutions and contributed to the design of NPS, and Patel is the lead consultant for pinBox Europe.
