Big Story. Decoding the NPS options

With the all-citizen model under the National Pension System (NPS) completing 10 years, it is a good time to look back at its journey till date.

Despite its low-cost structure, it had earlier not found takers due to rigid investment and withdrawal rules, and higher tax incidence. But, over the past few years, the government and the pension fund regulator, PFRDA (Pension Fund Regulatory and Development Authority), have been proactive, bringing many reforms relating to taxation, investment norms, charges, transactions and withdrawals.

Recent regulatory changes have made NPS a more attractive retirement savings vehicle. It, therefore, pays to be aware of the returns in the various NPS options, portfolio holdings and attendant risks, so that investors can make informed choices.

We analysed the portfolio and the performance of the funds across categories of the eight NPS fund managers to give you a holistic picture. Five pension fund managers — ICICI Prudential, Kotak, SBI, Reliance and UTI — have been around for 10 years; LIC and HDFC are about to complete their sixth year; Aditya Birla Sun Life pension fund began its operations just two years ago. All the data here pertain to Tier-I offerings alone.

One key finding of our analysis has been that both aggressive and conservative allocations have worked in the past 5-10 years, thanks to the alternating rallies in the equity and debt markets, thus satisfying investors with varied risk appetites.

Investment options

Currently, subscribers under all-citizen and corporate schemes are allowed to invest their regular contribution in four fund options —Scheme E (primarily equities), Scheme G (government securities), Scheme C (corporate debentures) and Scheme A (alternative investment securities).

Subscribers are allowed to allocate up to 75 per cent of their investment amounts in Scheme E; in Schemes C and G, one can allocate up to 100 per cent of the contribution; only 5 per cent allocation can be made in Scheme A.

Scheme E (Equity)

In the initial few years, the investment universe for Scheme E was restricted to Sensex, Nifty 50 and Nifty 100 stocks. Most of the funds were passively managed, and the fund managers preferred to hold a major portion in large-cap MFs and ETFs (exchange-traded funds). Portfolios were not churned that actively.

These Scheme E funds had delivered returns on par with those of large-cap indices, but marginally underperformed actively managed large-cap mutual funds.

NPS funds charge 0.01 per cent for asset management per annum, while large-cap MFs charge 1.5-2.5 per cent. But keep in mind that lower expenses need not always necessarily mean better returns. Also note that NPS levies other charges, too, including account maintenance and transaction fees.

However, a series of changes implemented in the investment strategy by the NPS regulator has created room for fund managers to take active calls and cherry-pick stocks beyond the large-cap universe.

As per the current investment strategy, Scheme E can invest in listed shares with market capitalisation of above ₹5,000 crore. They are also allowed to take derivative positions in F&O stocks. These funds are adding mid- and small-cap stocks to their portfolio. For instance, the Scheme E managed by Reliance, UTI, HDFC, LIC and SBI have allocated 2-7 per cent of their total assets to mid-cap stocks (as of March 2019).

This change has helped NPS funds generate strong returns (14 per cent on an average) in the past three years (see table). Large-cap MFs delivered an average return of 12 per cent in this period. However, both NPS and MFs have underperformed the Nifty 50 TRI in this period, largely due to choppy market conditions. It is true that the past two years have been bumpy for most diversified equity funds. But near-term gyrations should not deter you from parking money in equity funds. Over a longer period, these funds are wealth builders and help you beat inflation.

Over the 10-year time- frame, ICICI Pru and UTI pension funds have topped the charts and delivered a CAGR of around 11 per cent.

Performance, as measured by three-year rolling returns, shows that the Scheme E from HDFC and UTI have delivered consistently, outperforming their peers’ returns over the last six-year period. The best way to get a sense of the consistency of funds during a particular period is through the rolling returns. Rolling returns are the average of the point-to-point returns calculated for a given period.

Many funds have now pruned their exposure to mutual fund units as the regulator’s guidelines restricted this holding to 5 per cent from August 2018.

Scheme G (Govt securities)

Scheme G invests predominantly in Central government securities and State development loans across maturities. The default risk in such G-Sec funds is almost nil, but they are exposed to interest rate risk.

Therefore, fund managers of gilt and debt funds take calls on the interest rate outlook and churn the maturities of the instruments to maximise returns.

NPS gilt fund managers have managed to juggle the average maturity profile of their holdings to gain from the changing interest rate scenarios.

Scheme G from all the pension managers have managed to outperform the benchmark — I-Sec Sovereign Bond Index — as well as gilt mutual funds across time-frames. Investment in the NPS Scheme G costs less than that in gilt mutual funds. NPS charges just 0.01 per cent for asset management, while debt mutual funds have expense ratios of 0.5-2.1 per cent.

Performance, as measured by the rolling returns, shows that Scheme G from LIC, SBI and Kotak have been consistent performers in the past six years.

LIC has been the best in the category, delivering the highest returns across three- and five-year periods. Its portfolio’s average maturity was 20 years in June 2017, which was recently altered to about 16.12 years. LIC delivered 1-2 percentage higher returns than its peers in FY15, FY17 and FY19, when interest rates were on a downward trajectory. The performance of SBI has been notable over the long run as it has managed to contain the losses well in the rising rate scenarios.

Scheme C (Corporate bonds)

Scheme C invests mainly in the listed securities issued by corporates and infrastructure-related debt instruments. The pension fund regulator has progressively allowed investments in instruments down the rating curve over the years. Initially, investment was allowed only in the highest-rated AAA to AA securities.

From May 2018, further leeway was provided to pension funds, allowing them to invest in corporate bonds which have a minimum of A rating, subject to a cap on investments between A and AA- rated bonds — less than 10 per cent of the portfolio. Although low-rated securities increase risks, higher returns can compensate it to some extent.

Over the 10-year time frame, ICICI Pru, SBI and Kotak Scheme C funds have registered 10-10.3 per cent CAGR. They have outperformed the Crisil Composite Bond Fund Index and the average of medium-to-long and long-duration MFs by 2-2.5 percentage points. Performance, as measured by the rolling returns, shows that the Scheme C from ICICI Pru, Kotak and HDFC have delivered consistent performance over the last six years.

Most of the funds are not that much active in juggling their portfolio average maturity. They have maintained the average maturity between five and eight years over the past few years.

Over the last one year, a spate of corporate bond downgrades and defaults have impacted the performance of debt mutual funds. The bonds issued by the IL&FS, DHFL, Essel Group and Reliance ADAG Group have all been downgraded sharply.

A few NPS managers were also caught in this trouble. Kotak Mahindra, UTI, HDFC, LIC and SBI pension funds held the troubled IL&FS bonds in the Scheme C portfolios of their Tier-I accounts, valued between ₹30 lakh and ₹ 4.3 crore (March 2019). Though the exposure to these distressed assets is small, it may impact the retirement kitty of investors.

Investors with long-term goals need not worry, as such small losses will be compensated by the overall capital appreciation.

Conservative investors who want to avoid such credit risk can shift their assets to Scheme G.

It will also help if pension funds offer an investment option where funds are invested in very short-term debt instruments similar to liquid funds. Risk in such funds are lower and hence suitable for ultra-conservative investors or those nearing retirement.

Scheme A (alternative assets)

Introduced in October 2016, Scheme A invests mainly in Alternative Investment Funds (AIF Category I and II), Real Estate Investment Trusts (REITs), Infrastructure Investment Trusts (InvITs), Basel III Tier 1 bonds and securitised papers. As the subscribers are allowed to allocate only up to 5 per cent in this asset class, the overall AUM base is very small (around ₹19 crore).

Over the past year, Scheme A has delivered an average return of around 8 per cent.

Alternative investments are typically for high net-worth individuals looking to diversify across asset classes. They may not be suitable for investors looking to save for retirement.

Choose the right asset allocation

Subscribers can choose between active and auto choices based on their preferred asset-allocation pattern. If you are a seasoned investor, you can opt for the active choice and decide the allocation on your own.

Under the active choice, allocation to equity funds is restricted to 75 per cent till the age of 50 and reduced by 2.5 percentage points every year. Subscribers aged 60 and above can allocate up to 50 per cent to equity funds.

Investors without sufficient knowledge or time to actively monitor their portfolios can take the auto choice and opt for any one of the three pre-defined lifecycle funds.

These are: Aggressive fund (maximum equity exposure is 75 per cent up to the age of 35); Moderate fund (maximum equity exposure is 50 per cent up to the age of 35); and Conservative fund (maximum equity exposure is 25 per cent up to the age of 35). In each of the lifecycle funds, the exposure to equity reduces gradually as the subscriber ages. Investors can choose any one of the lifecycle funds based on their risk profile.

As per the current regulations governing NPS investments, subscribers can change the existing pension fund once in a financial year. A change in the investment option (active or auto choice) as well as the asset-allocation ratio (allocation among Schemes E, C, G and A) is allowed twice in a financial year.

Performance of lifecycle funds

We calculated the performance of all the three lifecycle funds from the historical returns of the NPS fund managers.

The data show that most of the pension funds delivered double-digit returns over five- and 10-year time-frames (see charts).

In the aggressive fund portfolio (75 per cent equity + 10 per cent corporate bond + 15 per cent G-Secs), ICICI Prudential is the clear winner in the 10-year period as it outperformed both its benchmark and peers, with the equity portion contributing handsomely.

ICICI Pru generated 11 per cent compounded annualised return (CAGR) during the period. In the five-year time frame, HDFC leads the chart, followed by UTI. Both generated returns of 12 per cent during the period.

Over a five-year period, investors opting for a moderate fund portfolio (50 per cent equity + 30 per cent corp bond + 20 per cent G-Secs) ended with almost similar returns to that of the those in the aggressive portfolio. HDFC funds have delivered annualised returns of 11.5 per cent in the last five years. In the 10-year time- frame, the top performers are ICICI Pru (10.6 per cent), UTI (10.1 per cent) and Kotak (10 per cent).

In the five-year time-frame, all the pension funds with a conservative portfolio (25 per cent equity + 45 per cent corp bond + 30 per cent G-Secs) delivered similar returns. ICICI Pru, SBI and Kotak are the top performers in both the five- and 10-year time- frame.

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