NPS: Out Of Sight, Out Of Mind Mantra Meets The Magic Of Compounding

Out of sight, out of mind. This mantra applies to more than just a few aspects in life. But it meets the magic of compounding in National Pension Schemes. The scheme has been one of India's favorites to invest towards retirement.

This partially taxed investment is known to be an almost invisible investment that most people forget about. Especially, if there is an SIP that is set up, this investment is not visible on one's investing portfolio and investors stay invested till they reach retirement.

"One unique advantage of NPS is that you don't see this investment. One does not see it, so they do not bother about the portfolio size or returns. One does not go check on this and the compounding starts happening," said Gajendra Kothari, chief executive officer of Etica Wealth.

There are two types of investment options that investors have under the NPS. Tier 1 is primarily an investment for retirement that comes with tax benefits. And, tier 2 works like an investment account with allocation that can be spread across four asset classes. The four asset classes are equity, corporate bonds, government securities and other alternate assets.

Investments one makes into this account is not capped, but its important to remember that withdrawal from tier 2 is taxed. The amount will be added to the investor's income and then taxed at slab rate.

"If it was capital gains tax that applied here, then many people would have moved from mutual funds and invested here," said Kothari.

The only advantage for tier 2 investments is the ability to switch between the asset classes. Until withdrawal, investors can rebalance their portfolio.

There is a Rs 1,000 lower limit per year on an NPS account. If deposits have not been made, then this calls for penalties. There is also the SIP option that can be set up for the NPS, to avoid the account being deactivated.

"There was no separate exemption for NPS as a vehicle. The government, in a move to popularise it, has an additional Rs 50,000," said Kothari.

There's one thing that most people and employers might not know. Under Section 80 CCD2, up to 10% of one's salary can go into the NPS, along with contributions from the employer, according to Kothari. Up to Rs 7.5 lakh per year can be invested into the NPS by the employer.

"This amount gets invested compulsorily every month. Again, you don't see this, so you don't touch this. This comes as a big bonus during retirement. There's also a 30% tax advantage for the higher tax brackets," he said. Its crucial that one should push the employer to invest into the NPS as well.

Active management is for those who know where they want to invest. Here, the investor can build their portfolio with up to 75% in equities and up to 100% in corporate bonds and government securities and not more than 5% in alternative assets.

This is till the age of 50. One needs to choose and rebalance the portfolio according to the decrease in the allowed allocation. The allocation and fund managers can be changed twice in a year on the NPS website.

"There are eight fund managers with a decent track record and one can see these records online," said Kothari.

The second option is auto choice, where an option can be picked depending on the risk tolerance of the investor.

Lifecycle 75 or LC75 is for the aggressive equity investor, with 75% investment of the fund into equities.

LC50 is for moderate equity investor. This option invests half of the funds into equities and invests the rest across other asset classes.

LC25 is for a conservative investor with the minimum allocation of 25% going into equities. The details of the functioning of these auto choices are available on the website.

If there are emergencies, there are a few cases outlined by the government where one is allowed to withdraw with a tax exemption.

"Between 60 and 70 years of age, one can break 60% of the corpus tax free. The 40% needs to go into annuity purchase that's given as pension. This monthly pension is taxable," he said.

If one does find themselves needing money on a monthly basis after retirement, then there are certain strategies that one can adopt.

"So 60% of the corpus can be withdrawn from here and invested into mutual funds. A systematic withdrawal plan can then be set up. This is far better option tax-wise because annuity is taxable," said Kothari.

The unique logic behind the NPS, being a hidden investment potentially delivering better returns is simple.

"In mutual funds, there's liquidity and you see it day in, and day out. You tend to panic, and take actions. For NPS, you just leave it there," he said.

The returns of all funds under the NPS have been over 20% CAGR. Over the long term we have seen corporate bonds and government securities have given returns that hover around 8.5%.