What makes the NPS shine

You are, perhaps, accumulating retirement wealth by contributing to your provident fund and channelising some of your savings into a stock-bond portfolio. But, are you also using the National Pension Scheme (NPS) for your retirement savings?

In this article, we discuss why the NPS, as a retirement savings vehicle, is appealing for behavioural reasons — that is, how the features in NPS nudges you to take action that you may otherwise find difficult to implement due to lack of self-control or because you want to avoid regret or because of procrastination.

Behavioural architecture

The discussion below does not consider the hidden or explicit costs of operating an NPS account. It is based only on how NPS moderates certain behavioural biases.

As humans, we want exit route. That is one reason why we do not prefer closed-end funds or 20-year illiquid but tax-free bonds. Interestingly, we feel the need for liquidity only when we are told that a particular investment is not liquid!

But liquidity can often be harmful to you. Illiquid investments impose self-control and helps you stay focused on your goals. You do not sell your illiquid real estate investment even if property values fall but you may be tempted to sell your liquid equity investments if prices decline. NPS imposes such self-control by locking-in your investments till age 60.

Should you allocate 30 per cent, 40 per cent or 50 per cent of your capital to equity? The proportion of your equity investment could determine your wealth at retirement. Taking such an important decision could force you to procrastinate when you are uncertain about your asset allocation choices. NPS helps you overcome this problem by letting you choose a default asset allocation, and a reasonable one at that. The default choice is a lifecycle fund in which your equity allocation gradually declines till age 60.

Choosing a fund

It is difficult to select an active fund — a fund that has a mandate to outperform its benchmark index. A fund could have performed well in the past because the fund manager was lucky or skilful. And you cannot easily differentiate between luck and skill. You could, therefore, buy an active fund that eventually underperforms its benchmark. The regret that you experience from the wrong choice could affect your future decisions. NPS moderates this feeling of regret. The fund managers of NPS are allowed to invest only in the stocks constituting the Sensex or the Nifty index in the same weights as in the index. And any two index funds will provide similar returns as they have similar portfolios.

Finally, if asked today, you would prefer to receive stable cash flows in your retired years — fixed income every month, perhaps, even adjusted for inflation. But at retirement, you will not prefer to buy an annuity — a product that offers such stable cash flows till you live! Stable cash flow products offer lower returns compared to stock-bond portfolio; an annuity will typically offer pre-tax yield of about 7 per cent, which is lower than your bank fixed deposit. Yet, annuity can moderate your longevity risk — the risk that you will outlive your investments. The NPS architecture moderates your changing preference towards stable cash flow products by converting a proportion of your accumulated wealth at 60 into annuity.

The NPS architecture helps you overcome certain behavioural biases. But you should weigh the costs of operating an NPS account before you decide to open one to invest your retirement savings. Importantly, you should have compelling reasons beyond tax considerations to operate an NPS account. And remember this: You can have an NPS account in addition to your provident fund or public provident fund account. Your NPS account would essentially act as a substitute for a stock-bond retirement portfolio.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. Feedback may be sent to knowledge@thehindu.co.in )

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