When investing towards long-term goals such as retirement, your final returns are decided more by your asset allocation than by your choice of products or fund managers. That’s why one of the most important decisions you’ll make on your NPS account is this one – in what proportion you’ll divide your annual contributions between equities, bonds and the rest.
The NPS certainly doesn’t make your job easy as it throws many multiple-choice questions at you at every step. Here’s our simple guide to navigating the NPS asset classes. This will help you get the most bang for buck from your NPS account.
Go for Active choice
When making investment decisions, allowing an autopilot to take over is tempting no doubt. But in the case of the NPS it can actively dent the size of your investment corpus.
On signing up, NPS requires you to choose between an Active and Auto choice to allocate between the four categories of assets on its menu – Equities (E), Corporate Bonds (C), Government Securities (G) and Alternative Investment Funds (A).
In Auto choice, your money is automatically divided between these assets at proportions pre-decided by the fund. These allocations are also tweaked with age, to reduce risks. There are three risk-based sub-options within Auto choice – Aggressive Lifecycle Fund, Moderate Lifecycle Fund and Conservative Lifecycle Fund in Auto choice. Each of these starts you off at a different E and C weight, which is trimmed each year until you attain the age 50. The table below shows how this works.
As the table shows, whichever risk profile you choose, the E allocation under Auto choice is highest for investors upto 35 years of age. Thereafter, it is compulsorily trimmed back every year until you hit age 50. The Corporate bond allocation too starts off at a high level and is tapered steadily each year.
While this formulaic approach may look like a neat way to manage your allocation across life stages, there are three significant disadvantages to it.
# 1 Impedes compounding: It doesn’t allow you to reap the benefits of compounding. To make the most of your equity investments, you need to stay invested in the asset class for 10 plus years.
- The automatic rebalancing feature of the Auto choice starts trimming back your equity allocation right from year one.
- The age (35) at which it starts reducing your equity holdings is also far too early. To reap the rewards of equity investing in your final retirement corpus, it would be best to retain a sizeable equity allocation until you turn 55 and use the next 5 years until retirement to gradually reallocate your equity positions. With Auto choice however, your E allocations would already be down to 16%, 12% or 6% by the time you’re 55!
- The same problem exists with corporate bonds, which deliver excellent compounding benefits in India. But the Auto choice meddles with this too, by cutting back your C exposure right from age 35.
# 2 Not optimising earning capacity: By aggressively cutting back on your E and C allocations in your 30s, 40s and 50s, the Auto choice prevents you from ploughing significant amounts into these high-return assets when your career and earning capacity are at their peak. That’s again sub-optimal for your retirement corpus.
# 3 Robotic rebalancing: While periodic rebalancing between assets is certainly a good thing to smooth out returns in a long-term portfolio, it works best when it based on the relative performance of assets. It’s certainly a good idea to cut back on equities and add to debt when stock markets are soaring. But the Auto choice takes a robotic approach to the rebalancing and trims weights to equities based on age. You may end up reducing your equity exposure in a falling market.
We therefore feel that the Auto choice is too conservative with your allocations to equities and corporate bonds, the two assets that can really boost your long-term returns.
In the Active choice though, you are free to choose how to divide your money between various NPS assets subject to two basic restrictions – your total allocation to Alternative assets (A) cannot exceed 5% and your total equity exposure cannot exceed 75%.
We therefore recommend that you go with the Active choice for its ability to ensure higher allocations to high-return assets.
- If you have ten years plus left to retirement and the NPS is the key vehicle you’re leaning on, allocate upto 75% of your contributions to equities, 20% to corporate bonds and 5% in gilts.
- If you have other equity options like MFs that you’re using towards retirement, you can opt for a 50% E allocation in the NPS and peg your C allocations at 30% and G at 20%.
- Keep a check on your equity allocations as you get closer to retirement. If your accumulated equity weights in NPS exceed 75% with less than 10 years to retire, tone down your incremental allocation to E and go with C and G.
NPS Asset classes: Avoid A, stick to E/C/G
The NPS allows you to distribute your annual contribution between four asset classes that go by the code names E, C, G and A. Before deciding how to do this though, it helps to know where your investments would go under each of these categories. NPS’ private fund managers are allowed to invest only in specific classes of securities defined by PFRDA’s investment guidelines within each asset class. Here are the permitted investments.
Equities (E): Restricted mainly to the large and mid-cap shares. NSE/BSE listed stocks with market capitalisation of Rs 5000 crore or more, or shares traded in the derivatives segment. Upto 5% of this equity portfolio can be parked in equity mutual funds provided they too invest only in the above defined universe.
Corporate bonds (C): Listed bonds from companies, financial institutions, government-backed infrastructure players and banks, with a minimum residual maturity of 3 years. There’s a 10% leeway to invest in bonds with less than 3-year maturity. 90% of the corporate bond portfolio has to be in bonds rated AA or above, while upto 10% of it can be in bonds rated A to AA. Debt mutual funds that comply with these norms are eligible too. Term deposits of profitable banks are allowed, provided the bank has a minimum capital adequacy of 9% and Net NPA less than 4%. AT 1 bonds from banks are allowed upto a 2% limit.
Government securities (G): Central and State government securities or bonds guaranteed by them. Upto 5% of the g-sec portfolio can be parked in gilt mutual funds.
Alternative assets (A): Exotic assets like mortgage-backed securities, asset backed securities, units of REITs or Invits. All of these need to be rated AA and above by two rating agencies. SEBI registered category 1 & 2 AIFs, subject to a Rs 100 crore size and 10% limit. Investments in AT 1 bonds of banks are allowed too.
In addition, funds are allowed to park upto 5% of their corpus in short term debt and liquid funds to manage liquidity in volatile times.
As things stand, it is best for NPS subscribers to avoid asset A and to stick to E, C and G. Instruments like mortgage-backed securities or Alternative Investment Funds require the fund manager to put in a great deal of due diligence in product selection and these options are seldom available on tap, requiring the fund manager to park money in liquid instruments awaiting good opportunities.
Given the ultra-low management fee for NPS, it appears unlikely that the fund managers will put much effort into sifting through alternative assets. Presently, due to deployment challenges, the A portion in most funds seems to be parked in AT1 bonds from banks which are dicey propositions, and liquid and overnight mutual funds, which don’t offer much of a return kicker. (Check out the portfolios of different fund managers here)
On E, NPS managers stick mainly to the index and large-cap names in the market with a smattering of mid-caps. The NPS funds tend to be less actively managed than the open-end multicap, large and midcap funds of AMCs. However, the cost advantage arising from the ultra-low management fee of 0.01% helps the NPS equity funds still deliver reasonable returns to subscribers.
The table below shows that the Equity funds under NPS have delivered 8.4% to 9.9% CAGR over 10 years, which is quite comparable to the category averages of 7-9.5% for actively managed open ended large cap and large and mid-cap funds and betters the BSE200 ten year return of about 7% CAGR. The latest month-end returns for different assets are available here.
If you are shooting for more spectacular equity returns in your retirement kitty, supplement your NPS equity allocation with holdings in actively managed mid or small-cap equity funds, which have averaged 10-11% in the last 10 years.
Max out C
Given their unadventurous stock choices and the tendency to be passive with their management, it can be debated if the E portion of the NPS is the best investment option you can have in the market for your equity money. Index funds and ETFs may offer you more variety at competitive costs.
But the debt options of the NPS score over most comparable fixed income options in the market including actively managed debt mutual funds. While the open-end nature and the race to top the return chart leads actively managed debt mutual funds to take on over-sized risks that often backfire, the buy-and-hold strategy and the high rating requirement for NPS-managed debt funds has made for a relatively smooth journey for subscribers.
The NPS debt funds feature an annual expense ratio of 0.01% compared to ratios of 0.20-1% for direct plans of Corporate Bond Funds and 0.20-0.80% for PSU& Banking Debt Funds and this too is likely to give a significant leg-up to subscriber returns.
The table below shows that the NPS C option has managed a respectable CAGR of 9.6-10.7% over ten years, beating even equities.
Between the C and G options, C is the better choice for subscribers looking to maximise compounding in the long run. The PFRDA’s high quality bar that actively discourages NPS fund managers from dabbling in unlisted and lower rated bonds and exotic instruments has helped the C portion of NPS reap the rewards of high corporate bond spreads while avoiding most of the credit accidents that debt MFs have suffered. Though a few NPS managers did suffer write offs from DHFL, they managed to avoid defaults related to the Reliance ADAG group, Essel and other dicey corporate names.
Given that returns on the C option rely more on interest accruals than capital gains, the C portion has also delivered a smoother journey to subscribers than G. Returns on G have tended to fluctuate based on rate movements in the market.
In the year ended June 2018 for instance, most gilt funds delivered negative returns on the spike in market interest rates. The G options of NPS delivered losses of between 0.41% and 1.68% for this one-year period. During the same period though, the C option managed to hold its head above water with one-year returns of 1.4 to 5.5%. This makes a good case for allocating more of your contribution to C than G until you turn 55, when you can move to a more defensive portfolio that favours G.
To summarise, here are six pointers to make the most of NPS asset choices:
- Ignore Auto choice and opt for Active choice
- Avoid A and stick to E, C and G
- If you have 10 years plus left to retire, peg your equity allocations at 75% and corporate bond allocations at 30% to maximise returns
- Check the share of E in your portfolio, every year, when you are less than 10 years away from retirement and reduce E contribution if the share exceeds 75%. In addition, begin switching to more defensive positions once you have 5 years left to retire.
- The E part of NPS is rather conservatively managed. If you have a fair appetite for risk and plenty of time to retire, peg your E allocation at 50% and use actively managed mid and small-cap MFs to top up your retirement corpus
- The debt fund options in the NPS offer excellent returns with limited volatility owing to their ultra-low fees, quality bias and buy-and-hold approach. Make the most of them.
- Have a higher allocation to C than G to max out compounding
Also Read : Who’s the best NPS Fund Manager?