Retirement planning can be tricky. First there is inflation eating away at your savings. Then there are unscrupulous bankers and agents, out to missell unsuitable products. Add to this the tendency to invest in traditional avenues like gold and real estate and you have all the ingredients for an unstable future. However, the silver lining are the two dedicated retirement vehicles— the humble EPF and the more recent NPS. Both are now evolving— adding new features, granting more choices and introducing flexibility in investments and withdrawals.
Though the plan to allow portability between EPF and NPS has been junked, consider how you can leverage both while planning your retirement.
In this week’s cover story, we focus on the changing retirement landscape and find out how you can make the most of these two instruments to ensure that your golden years are secure.
For salaried individuals, the monthly contribution towards the Employee’s Provident Fund (EPF) remains the only forced savings mechanism. Every month, 12% of your basic salary, along with a matching contribution by your employer, flows into the EPF account. From the employer’s contribution, 8.33% goes into a pension vehicle—the Employee’s Pension Scheme (EPS). Not only is the contribution eligible for tax benefits under Section 80C, both the interest earned and money received on superannuation is tax-free.
The EPF ensures your contributions keep rising steadily, in line with rise in salary. Since the contribution is a fixed proportion of the basic, the outgo rises in step with your income. This facet is critical for building a sizeable retirement corpus. However, to really benefit from the EPF, you should consider the following points:
Hold account till retirement
Many dip into the EPF corpus to meet short-term needs. Recent changes in withdrawal rules have perhaps made matters easier. Partial early withdrawal from EPF is now permitted for a child’s marriage, higher education and making a down payment for a house, subject to conditions
(see table). Members are also allowed to withdraw the entire amount if they remain unemployed for more than two months.
EPF now fetches a much higher rate relative to PPF and other avenues
While a certain degree of flexibility can be a relief in a genuine crisis, experts say you should not touch the EPF money until retirement. The essence of the EPF lies in letting compounding work its magic. The corpus, if allowed to build up with incremental contributions each year, can reap huge benefits in the long run. For instance, an individual with a basic salary of Rs 15,000 and 30 years left for retirement can attain a corpus of Rs 60.75 lakh at the age of 58, assuming a 5% yearly rise in contribution.
If the corpus is withdrawn partially in the accumulation phase, it takes away the compounding benefits accrued over years. Suresh Sadagopan, Founder, Ladder 7 Financial Advisories, says, “EPF is a retirement vehicle. Abusing the withdrawal flexibility during the accumulation phase will hurt one’s retirement phase.” Even if your PF becomes dormant due to job loss, maintain the account as interest will be payable on the balance until the age of 58.
Enhance contribution via VPF
Some recommend enhancing the contribution beyond the mandatory 12% through the Voluntary Provident Fund (VPF). The VPF is an extension of the EPF that allows you to invest beyond the 12% threshold while providing the same tax benefits and return. While the PPF carries an investment limit of Rs 1.5 lakh per annum, there is no such restriction on VPF. Besides, unlike PPF returns that fluctuate in line with 10-year government bond yield, the interest rate on VPF is the same as that of the EPF. The current interest rate of 8.65% is much higher than that of PPF’s 7.9%.
Hiking PF contribution will obviously mean lesser take home pay. However, experts contend that having a little less spending power now could mean more financial stability later. Says Tanwir Alam, Founder & MD, Fincart, “If you are close to retirement, consider enhancing contribution through VPF. At this stage, don’t take the risk of equities to achieve a bigger corpus.” Younger contributors must remember that VPF comes with withdrawal restrictions. The money is locked in till retirement or until the time you leave the job.
Besides, any ramp up in PF contribution should be done with broader portfolio asset allocation in mind. Sadagopan argues, “If you are over-exposed to debt as per your asset allocation, do not invest more in PF. Instead, opt for instruments with a greater wealth creating potential like equities.” Young savers would be better off opting for a higher equity component through the NPS or equity funds rather than enhancing their debt allocation through VPF.
Rollover account with jobs
When changing jobs, transfer your existing EPF balance to the new employer. Withdrawing the accumulated balance is a strict no no. There are several downsides if the amount is not transferred or withdrawn and is kept idle. First, it could increase your tax liability. Even after you leave the job, the account continues to fetch interest until it becomes inoperative upon retirement. This accrued interest component becomes taxable, even if you do not withdraw money from the account.
Further, if the balance is not transferred, the five year continuous service clause for tax exemption is reset to the starting date of the new account, points out Kuldip Kumar, ED, Tax & Regulatory Services, PWC. Any withdrawal within a few years of job change may become taxable even if you have completed five years of continued service spread over the two employers. Failure to transfer EPF balance also means that previous employment stints will not be counted towards pension eligibility upon retirement under the EPS. An individual is eligible for pension benefit once he has completed 10 years in service.
Moreover, the EPF account transfer, if not done within 3 years after leaving a job, becomes a tedious process. Therefore, ensure the accounts are clubbed for continued capital appreciation. Rohit Shah, Founder and CEO, Getting You Rich, says, “Be meticulous in following up with your previous employer and the EPFO about the transfer.” While the Universal Account Number (UAN) remains the same across EPF accounts, it is not the same as balance transfer.
The National Pension System (NPS)
When the NPS first became available to the general public more than 10 years ago, it was plagued by rigid rules and a tax- unfriendly structure. In recent years, this dedicated pension offering has evolved to become more tax efficient, offering more flexibility and options. At the same time, it continues to be the lowest cost offering, despite multiple layers of charges. The NPS now permits deployment of up to 75% of the corpus in equities, giving it the potential for faster wealth creation over the longterm. The EPF on the other hand currently invests only 15% of the incremental corpus into equities. Here is how you can make the most of the NPS:
Get multiple tax benefits
While capital gains from equity funds now face 10% tax above the Rs 1 lakh threshold, taxability of NPS is gradually moving in the opposite direction. Earlier, only 40% of the 60% accumulated corpus allowed to be withdrawn as lumpsum at the time of retirement was tax free. The remaining 20% was taxed at normal rates. Now, the entire 60% is tax free. The balance 40% still has to be compulsorily put into an annuity, which is subjected to tax. NPS thus falls somewhere between the EEE and EET (exempt-exempt-taxable) regime.
While some find the mandatory annuity restrictive, it may be a blessing. By putting the subscriber onto a forced annuity, it ensures that people don’t dip into the retirement corpus for other goals or spend it recklessly. Sumit Shukla, CEO, HDFC Pension Funds, argues, “The annuity component actually takes care of longevity risk by making sure retirees don’t eat into the corpus quickly.”
NPS Auto choice option sharply cuts equity allocation from early on
NPS subscribers can claim tax benefits under different heads
(see chart). Investments are eligible for deduction under Section 80CCD(1) with an overall ceiling of Rs 1.5 lakh under Section 80C. Self-employed persons can claim deduction on contribution up to 20% of their gross income, subject to the maximum limit of Rs 1.5 lakh. This apart, both salaried and self-employed can claim additional deduction of up to Rs 50,000 under Section 80CCD (1B). In the 30% tax bracket, this means additional tax savings of Rs 15,600. Together, subscribers can claim deduction up to Rs 2 lakh for contributions towards NPS.
There is more. Subscribers can bring down tax liability further if their employer puts up to 10% of their basic in the NPS under Section 80CCD(2). There is no upper limit for this deduction. If your basic is Rs 50,000 per month and you are in the 30% bracket, you can cut your tax outgo by almost Rs 18,720 if your company contributes 10% of basic in the NPS. Planners say if the employer offers NPS as part of the package, salaried persons should not miss out on the opportunity. Shah suggests, “If you are not disciplined in savings, avail of the multiple windows afforded by the NPS.”
NPS Active choice allows for higher equity exposure until later years
Beyond tax savings
Don’t invest in NPS for tax benefits alone. For instance, putting aside Rs 50,000 per year in NPS for the additional tax benefit may not add much to your retirement corpus. Placing a limit creates an artificial ceiling for your savings. Besides, it will deprive you of adequate pension benefits.
A 30 year old putting aside Rs 50,000 per year—in monthly installments—into NPS would effectively accumulate a corpus of around Rs 93 lakh at 60, assuming 10% annualised returns. However, you cannot deploy the entire Rs 93 lakh upon retirement. About 40% of this— Rs 37 lakh— will go towards compulsory annuity. At current annuity rates of 6%, this corpus would fetch a monthly pension of around Rs 18,600. In all likelihood, annuity rates at that time will be much lower, implying even lower pension. This will hardly suffice for most individuals. Experts say make NPS one of the cornerstones of your retirement planning, along with other avenues like EPF and equity funds. Says Shah, “Instead of opting for NPS purely for tax benefits, take a holistic view of your portfolio for a better sense of your requirement.”
Multiple benefits under NPS allow sizeable tax savings
At times, your requirement may even be much lower than what you are putting aside. Persons with an already beefed up retirement portfolio may not need to put aside put a large sum in NPS. You may end up unnecessarily locking up money for a long time purely for tax considerations.
Use switches judiciously
In a previous avatar, the NPS only allowed fund managers to take pure passive exposure to equities via index funds. Now, however, the NPS permits active fund management. This is to potentially deliver market beating returns to the subscriber. However, with active investment comes the element of human bias and judgment. Your investment experience would depend on the execution capabilities of the fund manager, apart from the vagaries of the market itself.
Given this added variable, it is critical that NPS subscribers choose the fund manager carefully and keep monitoring the performance. If the selected fund manager lags behind others, you can switch to another fund manager. NPS now allows two switches in a year, without any tax incidence. However, subscribers should not abuse this flexibility by constantly changing fund managers, says Alam. Shift only if underperformance persists over three or more years. Likewise, NPS also permits subscribers up to two switches in asset allocation in a year. Use this flexibility in moderation. Avoid shifting asset mix in response to market fluctuations. Remember that the NPS automatically rebalances the portfolio according to your chosen asset mix.
Opt for active choice for greater control
The NPS offers subscribers the choice of two investing modes—Active choice and Auto choice
(see table). Under Active choice, you can choose your own asset mix, deciding the split between equity, corporate bonds and government bonds. Otherwise, you can opt for lifecycle funds where the asset mix changes automatically as the individual grows older. Three life cycle funds—aggressive, moderate and conservative—cater to investors with different risk appetites. The gradual decline in equity exposure protects the corpus against volatility as retirement nears.
However, auto choice can get restrictive as this moderation in equity exposure begins too early. Whatever your risk profile, the exposure starts coming down from age 36. Even for a subscriber who opts for ‘aggressive’ option for higher equity exposure, the allocation reduces sharply from 75% up to age 35 to 55% by the time he hits 40 and further to 35% by age 45. With 15-20 years still to go for retirement, experts feel this could be a missed opportunity for the subscriber. A common rule of thumb suggests that individuals should hold a percentage of stocks equal to 100 minus their age. So, for a typical 45-year-old, roughly 55% of the portfolio should ideally be in equities.
Investors who have a fair understanding of the market should opt for the Active choice model, planners say. “Auto choice is for lazy investors. Those who are planning their finances carefully should take the Active route,” suggests Harsh Roongta, a Sebi registered investment adviser. Assuming you are already contributing to EPF, your NPS asset mix should have a high-equity bias initially. Only those who are adequately invested in equity funds as part of their retirement portfolio may consider a more conservative approach.
Reduced PF contribution
Reports suggest the government is considering giving employees the flexibility to reduce their PF contribution, currently pegged at 12%. Allowing lower PF contribution is aimed at enhancing your take home pay. However, experts feel such a move will dilute the forced savings nature of the vehicle and compromise your nest egg. For instance, for a 30-year-old earning a basic salary of Rs 30,000 a month, if the contribution is reduced from 12% to 10%, the retirement corpus will shrink from a potential Rs 92 lakh to Rs 76 lakh by the time he retires. Besides, lower contribution to EPF will mean less tax benefit. Financial planners say you should maintain the contribution at 12% at the very least.
SWP in place of annuity
At present, NPS subscribers on retirement have to compulsorily buy taxable annuities from insurance companies using 40% of the accumulated corpus. However, the high cost and low yield of these annuities is perceived as a hindrance. Reports suggest the government is considering a proposal to introduce systematic withdrawal plans (SWP) as a more efficient alternative to annuities.
In mutual funds, a SWP allows the investor to define a fixed sum to be withdrawn from the scheme at regular intervals for a defined period of time or until the amount gets depleted. The amount in the scheme continues to fetch return till it is completely withdrawn. All retirement oriented products launched by mutual funds offer the SWP facility. Experts say this benefit should be extended to NPS subscribers. Subscribers should be allowed to hold on to the NPS even after the retirement (currently allowed until age 70) and then permit SWPs. This will allow subscribers the freedom to pull out money in a staggered manner as per their needs rather than being locked on to interest rates offered by an insurer. At the same time, it will prevent them from squandering the corpus. Investors may also be able to limit tax incidence under the SWP, as tax may only be levied on the interest component.