NPS: The potential game changer in retirement security

By: Parizad Sirwalla- Executive Director Tax and Rambir Dalal- Associate Director Tax, KPMG

Across the globe, providing income security to the country's retired population has always been a challenge for governments. A well-designed pension system can help societies in addressing this concern about their elderly.

One of the principal challenges for every economy is to spread the responsibility of providing a comfortable post-retirement life for its working population among the employee, employer and the government.

A good pension system plays an important role in securing income after retirement and ensures accumulation of assets during the working life of an individual. It also leads to aggregation of financial savings which can satisfy the investment appetite of its industry.

The Government of India ('GOI') has been taking initiatives to provide a secure post-retirement life to its citizens. In India, there are three pillars for assured post retirement income, namely Employees' Provident Fund System ('EPF'), National Pension System ('NPS') and Superannuation Funds. The EPF system requires mandatory contributions for the employees; however the other two constitute voluntary investment.

Retirement planning

It is important for an individual to plan prudently for his retirement by saving consistently to build a sizeable corpus. A significant percentage of working population invest only through EPF system as mandated by GOI or invest in certain tax-saving instruments for availing the tax benefits that these instruments enjoy .

It is observed that individuals often take impulsive decisions to invest in tax-saving instruments. In the process, they end up buying products that save some tax but may not yield high returns in the long run. Therefore, it is imperative that tax planning should be linked with financial planning to derive optimal results.

In the process of choosing the right product for retirement planning, it is very important to consider various factors like return, rate of inflation, portability, tax benefits etc. The rate of return from an investment avenue should be commensurate with the rate of inflation in the country as inflation eats into the capital of investors.

Features of NPS

NPS is an initiative taken by GOI to enable the individuals to make optimum decisions regarding their future and provide for their retirement through systematic savings. NPS is a defined contribution scheme where the final corpus at the age of 60 will depend upon the contribution made by subscribers and the returns generated by the fund managers.

NPS has been opened for all citizens of India since 1 May 2009 where they can save for retirement between 18 and 60. NPS is regulated by Pension Fund Regulatory Development Authority (PFRDA) with transparent investment norms and regular monitoring and performance review of fund managers by NPS trust.

NPS gives investors an option to invest according to their own choice and risk appetite among the asset classes of equity, corporate bonds and government securities. An individual can invest up to 50% in equities that may fetch higher returns over longer horizons from their NPS portfolio. If the individuals are unsure about their investment strategy, they can go for the default option known as auto choice and the funds will be managed by the fund managers on the pattern of a lifecycle fund.

At the time of opening a NPS account the individual has to comply with certain Know Your client (KYC) norms and is allotted a Permanent Retirement Account Number (PRAN).  A person retains the same unique PRAN, even on change of job, city or pension fund manager. NPS has a two-tier structure. The Tier I account is a long term pension account which puts restriction on withdrawals before the age of 60.

The Tier II account is one of the biggest attractions in NPS as Tier II account is just like a savings account as there is no restriction on number of withdrawals and provides flexibility of funds invested. The accumulations in Tier II account can be migrated to Tier I but not vice-versa. The Finance Act 2011 has brought significant tax benefits for the NPS subscribers to propel retirement savings in the country.

Finance Act 2011 provisions for NPS

For Employers:

Employer's contribution to employees' NPS accounts is deductible up to 10% of specified salary.

For Employees:

Employer's contribution is allowed as deduction up to 10% of specified salary over and above the overall limit of Rs 100,000 (under section 80C)  for specified investments.

Employee's contribution is allowed as deduction  up to 10% of salary subject to the overall limit of Rs 100,000 for specified investments

Conclusion

With the recent amendments in the provisions relating to tax for employers and employees, NPS can potentially alter the retirement landscape in India. The proposal of exemption from tax for the entire NPS withdrawal proceeds under the Direct Tax Code Bill, 2010 just adds the additional incentive for NPS.

Employers can give the option of NPS to their employees in addition to the EPF and superannuation fund in their compensation structure. NPS can also become a great attraction to highly compensated employees for generating higher levels of pension income through this tax advantaged scheme.

Indeed, NPS has the potential in bridging the massive pension coverage gap in India. As India is becoming richer, the standard of living and life expectancy are going up steadily.

While the performance of the fund managers would also play a crucial role, NPS can be a revolutionary and efficient architecture for addressing the twin challenges of rising standard of living and longer post-retirement life.