What is the National Pension System (NPS) Scheme?

Retirement planning is gaining importance in India due to increased life expectancy and evolving employment opportunities, and many individuals may not have a pension plan after retirement. Hence, planning for one’s retirement during working years is important.

The National Pension Scheme (NPS) is a regulated retirement savings scheme provided by the Government of India for retirement planning. The scheme supports individuals in accumulating a pension corpus through regular investments made during their working years.

However, there are many complexities related to the NPS. There are various types of accounts, investment options, pension fund managers, tax provisions, and withdrawal conditions under the scheme. Thus, what exactly is the NPS? Who can invest in the NPS? How does NPS operate? This article answers these questions and covers everything you need to know about the National Pension Scheme (NPS).

What is the National Pension Scheme?

National Pension Scheme (NPS) is a defined contribution pension scheme managed under the guidance of the Pension Fund Regulatory and Development Authority (PFRDA).

It was launched by the Government of India for Central Government employees on January 1, 2004, except for the armed forces. Later, NPS was made available to citizens voluntarily, allowing citizens, whether employed in the government sector or not in the government sector, to apply for NPS.

The basic principle is quite simple: You deposit a certain amount of money into your NPS account during your working years. The deposited amount is then invested in financial assets such as equity, corporate bonds, and government bonds, depending on the investment option chosen by you. Upon retirement or exit from the scheme as per the relevant rules, a portion of the accumulated retirement corpus is available in lump-sum form, while the remaining portion is utilised to purchase an annuity that can provide regular pension income.

Unlike a traditional pension, where the pension amount is predetermined under a defined benefit pension scheme, NPS is a defined contribution scheme. Hence, the retirement corpus will depend on parameters such as the contribution amount, investment performance, tenure, and exit rules.

How is Money Invested Under NPS?

The NPS scheme does not retain the money that you pay into the scheme as cash. It invests the money in various asset classes.

Asset classes under the All Citizen Model in the Common Schemes are:

• Equity (E): This includes investments in equity and equity-related instruments.
• Corporate Bonds (C): These include investments in corporate debt and debt-related instruments.
• Government Securities (G): These include investments in government securities and government-related securities.

Under the current framework for Common Schemes, the subscriber can also have exposure to investments in alternative investment funds, subject to the respective investment options and the prescribed limit for that asset class.

The key thing here is that NPS returns are market-linked. They are not fixed interest rates. This implies that the NPS corpus can increase or decrease depending on the performance of the underlying investments and how well they have performed. Therefore, one should select an investment strategy depending on one's age and the time remaining until retirement.

How Does NPS Work?

NPS is an investment scheme designed for retirement purposes. Let us consider a simple example to understand how NPS works.

Imagine a person starting to contribute to NPS at a young age. All the contributions will be credited to the NPS account. The contributed amount is then invested through a PFRDA-registered Pension Fund Manager according to the investment choices made by the subscriber.

All NPS accounts have a Permanent Retirement Account Number (PRAN). There are several specific entities involved in the NPS structure, such as the NPS Trust, the Central Recordkeeping Agency, the Pension Fund Manager, the Trustee Bank, the Point of Presence, the custodian, and the annuity services provider.

This separation of responsibilities helps make the system more transparent and less dependent on a single intermediary.

Portability is another distinguishing feature of an NPS account. It means that an NPS account can remain the same if a subscriber changes their employer or place of his/her residence.

Eligibility Criteria to Invest in NPS

The following are the eligibility criteria for the National Pension Scheme:

• For the All Citizens Model, NPS is available to Indian citizens, including resident Indian citizens, non-resident Indian citizens, and Overseas Citizens of India (OCIs), according to applicable eligibility criteria.
• As per PFRDA, individuals aged 18 years and above but below 85 years can enroll in NPS.
• NPS is also offered through the corporate sector, where an employer can use NPS as a retirement savings plan for its employees.

However, for Central Government employees enrolled under NPS, the structure of contributions varies. According to PFRDA, the employee contributes 10% of their salary, including basic salary and dearness allowance, whereas the Central Government contributes 14% of basic salary and dearness allowance towards the NPS Tier I account.

NPS Tier I and Tier II Account

NPS has two types of accounts.

The Tier I account is the principal retirement account. This kind of account is used primarily for retirement savings only. In addition, this account has certain withdrawal restrictions. Considering that money invested in Tier I can be withdrawn only under certain conditions, it should be regarded as retirement savings and not as emergency money.

The Tier II account is an optional account. Its advantage lies in its higher withdrawal flexibility, and it can serve as an additional investment account.

In case the investor’s main objective is to create a corpus for their future retirement, a Tier I account becomes central to NPS. It is important to note that NPS should not be perceived as a regular savings bank account.

Active Choice and Auto Choice Under NPS The National Pension System offers subscribers an array of choices when it comes to investing. Active Choice Under Active Choice, the subscriber decides how to allocate their contributions between the asset classes offered within the limits specified by PFRDA.

In the case of All Citizen Model’s Common Schemes, equity exposure may go as high as 75%, whereas corporate bonds and government securities can individually be allocated up to 100%, provided that the total allocations across asset classes remain within the applicable limits. Auto Choice Auto Choice is the second choice available to the subscribers.

The investment allocation under this option changes automatically based on the age of the subscriber. Why? Well, younger subscribers are usually expected to have a longer investment horizon, while older subscribers are closer to retirement. Consequently, asset allocation can get more conservative as the subscriber ages. Auto Choice is available through the following Life Cycle Funds:

Benefits of Investing Via NPS

NPS has several benefits that can make it useful for long-term retirement planning.

• Encourages Regular Retirement Savings: It promotes systematic saving in the form of regular investments. This allows subscribers to create a retirement corpus incrementally without having to rely on savings made in the final years of their employment.
• Portable Across Employment: It is portable in nature. Thus, the subscribers can continue their NPS account even if they change jobs or move cities in search of new job opportunities.
• Offers Investment Flexibility: It offers subscribers the flexibility to decide how their contributions are invested. Depending on the framework that is applicable to them, subscribers are allowed to choose a Pension Fund Manager and decide whether to invest actively or through an age-based investment option.
• Provides Tax Benefits: Under the Income Tax Act, NPS offers certain tax benefits, but these depend on the subscriber's chosen tax regime and applicable conditions.
• Regulated by PFRDA: NPS is governed by the Pension Fund Regulatory and Development Authority (PFRDA), which regulates the intermediaries involved in the NPS structure.

Limitations of NPS

However, there are some limitations of NPS, and one needs to understand them before opening an NPS account.

• Market Risk: Returns from the NPS scheme are linked to the market, and hence returns are neither guaranteed nor fixed.
• Liquidity Risk: Tier I is primarily intended for retirement purposes, and withdrawals are governed by applicable regulations. This implies that NPS may not be the right option for investing money that you may need in the short run.
• Annuity Obligation: Another aspect is that there is an annuity obligation upon exiting the scheme under relevant regulations. A certain portion of your corpus may have to be utilised to purchase an annuity, depending on the applicable exit rules. The annuity scheme then provides a regular income, although the pension will depend upon the terms of the annuity scheme and the rates prevailing at the time of purchase.

National Pension Scheme Taxation

One of the reasons why many people consider NPS is the tax advantages it offers. However, tax rules depend on the applicable tax regime and individual circumstances, so investors should check the rules applicable to them when making a tax decision.

The Income Tax Department currently includes the deductions connected with NPS in Section 80CCD. This provides an additional deduction of up to ₹50,000 for eligible contributions to the pension scheme, subject to the applicable conditions

A deduction is also available for employer contributions, which are eligible under Section 80CCD(2). Presently, the Income Tax Department has stated that the limit for such deductions can be up to 14% of salary for employer contributions, provided that the relevant rules and conditions are met.

Investment in NPS should not be based solely on the tax treatment since the main objective of the scheme is retirement planning; moreover, as tax rules may change over time, investors should check the latest applicable tax rules before making any investment decisions.