The Hindu Business Line : New Pension System : Is it an optimal retirement vehicle?

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New Pension System : Is it an optimal retirement vehicle?

B. Venkatesh

Last week, this column discussed about asset location — a process of locating various asset classes inside the tax-advantaged sleeve and taxable sleeve, while retaining the target asset allocation. In this context, we mentioned about the New Pension System (NPS) and how it could help investors in the asset location process. We received several questions from readers on whether NPS is an optimal retirement vehicle.

This article discusses NPS in the context of the core-satellite framework.

It explains why the asset allocation for a retirement portfolio should be driven by a sustainable withdrawal rate. It also shows how annuities are useful for generating post-retirement income.

New Pension System

NPS places several constraints on its subscribers. It does not allow more than 50 per cent exposure to equity. Further, investors are required to use at least 40 per cent of the money to purchase annuity at the time of withdrawal at age 60.

Is NPS an optimal retirement solution despite these constraints?

A retirement portfolio has to be viewed in the context of the core-satellite framework.

The core portfolio contains low-cost market (beta) exposure and the satellite portfolio, alpha (excess returns over the benchmark index) strategies.

An optimal allocation within the core portfolio would be exposure to low-cost equity index funds, government bonds and public provident funds (PPF).

The NPS fits well within this framework, as it provides such exposure at a low cost.

The problem, however, is that the NPS is not exempt from tax at the time of withdrawal as is the PPF.

But this could well change, as the Pension Fund Regulatory and Development Authority has urged the Government to treat the NPS on par with PPF.

The NPS could, hence, constitute an integral part of the core retirement portfolio.

The next question is: what should be the optimal allocation within the NPS sub-portfolio?

Sustainable withdrawal rate

The retirement portfolio would be the primary source of income for many in the post-retirement phase.

This means that the investor has to withdraw some portion of the portfolio each year to sustain her lifestyle.

How much can an investor withdraw each year? If the investor withdraws too much, she may outlive her investments.

If she withdraws too little, she may not exhaust her money and importantly, not achieve her desired lifestyle.

The spending rate (withdrawal rate) should, hence, be optimal to sustain the investor through her post-retirement phase and yet maintain her lifestyle.

The asset allocation has to be viewed in this backdrop. Higher allocation to equity could increase the spending rate, as stocks typically generate higher returns than bonds.

Studies have shown that equity allocation between 50 and 75 per cent allows for a withdrawal rate of 4 per cent each year without causing portfolio ruin (running out of money).

Within the constrain of a maximum exposure of 50 per cent to equity, the asset allocation inside the NPS sub-portfolio would be a function of how much income an investor requires each year post-retirement, an assumed rate of return and volatility on stocks and bonds, and a sustainable withdrawal rate.

An investor wanting to take a higher exposure to equity can do so through index funds outside the NPS sub-portfolio.

The final question as regards NPS is whether purchasing an annuity is optimal.

Conclusion

It is true that annuities are costly because of adverse selection problem; insurance companies price annuities on the assumption that individuals who purchase these contracts are the ones who are likely to live longer!

Despite this, using a proportion of the retirement portfolio to purchase an annuity helps, as it enables steady stream of income during the investor’s post-retirement phase, reducing the risk of portfolio ruin.

Of course, it would help if such annuities have the Cost of Living Adjustment to protect from increasing price levels in the economy.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. He can be reached at enhancek@gmail.com)