As you already know, the National Pension System or NPS is designed to save for retirement by making a contribution during the work life. Though most people still don’t give retirement planning the importance it deserves (read why?), the government has nevertheless tried to incentive people to saving for their retirement by offering tax benefits.
Just as a reminder, NPS Is a Defined Contribution Pension Plan. That is, in defined contribution pension plans (unlike defined benefit plans) you are only in control of the contribution you make to the pension account. You do not control your eventual pension income at retirement as it will depend on the NPS investment corpus accumulated by then (Free NPS Excel Calculator) and the then prevailing annuity rate.
And as you know, NPS has two accounts: Tier I and Tier II. The investment in Tier I account gets a number of income tax benefits including extra Rs 50,000 tax savings for NPS exclusively under section 80CCD(1B). But being a retirement product, its not easy (nor advisable) to withdraw money before 60 though partial withdrawals and premature exit is allowed in specific cases. You can read more about the latest NPS Exit and Withdrawal Rules too.
Now let’s see what are the investment options available for NPS subscribers.
And first, let’s take a brief look at the different asset classes in which the various funds under NPS can invest. There are basically 4 asset classes:
- E: Investments in Equity instruments
- G: Investments in Government Debt securities
- C: Investments in Corporate Bonds, i.e. debt instruments other than government debt securities
- A: Investments in Alternative Investments (like REITs, Infrastructure Investment Trusts, AIFs Cat I and II, etc.)
While the asset classes remain the same for all subscribers, the allocations to each one can and will differ based on what the investor chooses. It goes without saying that the total allocation of E + G + C + A should be 100% and depending on NPS investment choice made, the Equity Exposure (E) is capped for a different choice of asset allocation as will be seen shortly.
Now comes the important part.
NPS allows you to manage your investments in 2 ways:
- Auto Choice
- Active Choice
I am sure you would be curious to know the difference between ACTIVE choice and AUTO choice in NPS. So here are the details:
NPS Auto Choice
The NPS Auto Choice is an option provided for those NPS subscribers who do not have the required knowledge or time to manage their investments or do not want to manage it on their own. Under this choice, the investments are made in a life-cycle fund.
For the Auto Choice, there are 3 Life Cycle Funds (LC) to choose from:
- Aggressive Life Cycle Fund (LC75)
- Moderate Life Cycle Fund (LC50)
- Conservative Life Cycle Fund (LC25)
The idea of these Life Cycle options is to assist individuals who need help in deciding their investment’s asset allocation. Let’s see one-by-one how these NPS Life Cycle Funds differ in their asset allocation.
Aggressive Life Cycle Fund (or NPS Auto Choice LC 75)
As the name suggests, this is suitable for investors who want higher exposure to equity in their investments.
Under this option, the equity (E) component is at 75% up to the age of 35 and then, it gradually tapers down to 15% by the time investor is turns 55. After 55, the allocation remains the same (at 15%) until he exits NPS. Here is how the equity component comes down from 75% initially to 15% eventually:
Conservative Life Cycle Fund (or NPS Auto Choice LC 25)
This life cycle fund is suitable for investors who are conservative and don’t want a very higher exposure to equity. They being risk-averse investors, are best suited for low equity component in their investments via NPS.
Under this option, the equity (E) component is at 25% up to the age of 35 and then, it gradually tapers down to 5% by the time investor is turns 55. After 55, the allocation remains the same (at 5%) until he exits NPS. Here is how the equity component comes down from 25% initially to 5% eventually:
Moderate Life Cycle Fund (or NPS Auto Choice LC 50)
This life cycle fund is suitable for more balanced investors who lie between the conservative and aggressive risk appetite.
Under this option, the equity (E) component is at 50% up to the age of 35 and then, it gradually tapers down to 10% by the time investor is turns 55. After 55, the allocation remains the same (at 10%) until he exits NPS. Here is how the equity component comes down from 50% initially to 10% eventually:
Under all the Auto Choice option (LC75, LC50 and LC25), the rebalancing (or reallocation) among the asset classes happens automatically once every year (on date of birth) as given in the Life cycle Investment Matrix. The asset allocation is changed (if required) and the existing assets are redeemed and reinvested as per the new ratio of allocation. The NPS subscribers do not have to do any asset allocation on their own and hence the name Auto Choice NPS.
So this life-cycle based ‘NPS Auto Choice’ approach not only tries to optimize overall returns but also attempts to cushion the NPS corpus from market volatility as it approaches maturity.
That was the Auto Choice. Next is the Active Choice – where you get a say in what allocation your NPS portfolio should have.
NPS Active Choice
The name is self-explanatory. This choice is for those who want to decide the asset class allocation on their own. In the NPS Active Choice, the subscriber has the option to choose the ratio in which his / her funds to be invested among various asset classes. That is, you get a say in your asset allocation.
Are there any limits on the asset classes in Active Choice?
Yes, there are. But not as comprehensive ones as in the Auto Choice.
Under the Active Choice, the NPS investor can have a maximum of 75% in Asset Class E (Equity). This is up from the earlier limit of 50%. But when the subscriber reaches the age of 50, the equity portion will taper off by 2.5% each year till it reaches 50% percent by the age of 60 years. This is according to a fixed schedule as set by PFRDA for NPS Active Choice:
Those are the basic differences in Auto Choice and Active Choice of NPS.
And while active choice is meant for those who want a greater say in their asset allocation, the auto choice is meant for investors who prefer a more passive approach and/or need some advice on proper retirement savings asset allocation.
By the way, you may ask as to how many times can one change the NPS Choice from Auto to Active or from Active to Auto? The answer is that a subscriber can change of scheme preference once in a financial year for each of Tier I and Tier II account. And when you move to Active choice (from Auto choice), then you are also allowed to change your asset allocation once in a given financial year.
You can read more useful FAQs about NPS investment schemes here.
Apart from being able to decide your asset allocation (Actively via Active Choice or Passively via the Auto Choice), you can also choose your Pension Fund Manager (PFMs).
These PFMs are actual entities who invest the NPS funds as per the guidelines issued by PFRDA from time to time. As an NPS Subscriber, you have the option of selecting any a PFM. At present, there are following NPS Pension Fund Managers
- LIC Pension Fund
- SBI Pension Fund
- UTI Retirement Solutions
- HDFC Pension Management
- ICICI Prudential Pension Fund Management
- Kotak Mahindra Pension Fund
- Birla Sun Life Pension Management
- Reliance Capital Pension Fund (license cancelled in 2019)
To find out the Best NPS Pension Fund Manager and their returns across various assets, please refer to this updated NPS Pension Fund Manager Returns or you can have a look at the NAV of NPS Pension Funds.
And subscribers are also allowed to change the Pension Fund Managers once a year free of cost.
Before we move forward, here is a refresher on NPS Tax benefits. The investment of up to Rs 50,000 in Tier I NPS Account in a financial year qualifies for additional tax deduction under Section 80CCD (1B) of the Income Tax Act. This Rs 50,000 extra tax deduction is in addition to the Rs 1.5 lakh allowed under Section 80CCD (1) for investment towards NPS and those under overall sections 80C.
Before 2004, the government employees were eligible for pension under the Old Pension Scheme (OPS) system. Under this scheme, the pensioner used to get a starting pension of 50% of the last drawn salary. This was a defined benefit system, unlike NPS which is a defined contribution system. There was no concept of choosing how your investments will be allocated across different assets via asset allocation that is possible via NPS. Do check the difference between NPS and OPS to know more.
All said and done, now you know how NPS offers you two choices to manage your investments. But…
Active or Auto Investment choice in NPS – Which is better (2023)?
It must be remembered that NPS is a product made for retirement savings. That is, it’s a very long term investment product assuming you still have several years if not decades left for retirement. So ideally and as I keep telling you every now and then, for long term investing, high allocation to equity is the best option.
So if NPS has a high equity allocation in any of the choices we discussed, then it should be fine from a retirement savings asset allocation perspective. But being a market-linked, defined-contribution retirement savings product, the NPS corpus depends on the returns of the NPS funds chosen.
And to help you decide between what is right – Auto or Active Choice for your in NPS, think of it in this manners – Go for the Active NPS option if you have a clear understanding of the asset classes and their movements; or you can actively switch at an appropriate time, and more importantly you have the risk tolerance for volatility of equity if occasionally your equity component will be high. Or you can even go for active choice if you are following a Retirement plan made by SEBI registered Investment Advisor. A good advisor can help decide proper asset allocation for your retirement savings.
On the other hand, the advantage of the Auto option is that it considerably reduces the decision-making and effort that is required from you into NPS account management. It’s on auto-pilot and takes Age as a criterion for Asset Allocation (which may not be the best way to invest).
But there is no one right or wrong answer here. Depending on the NPS subscriber’s unique situation, the ideal option may be Active or Auto Choice.
But having said that, do note that its best to keep NPS’s asset allocation as a part of your overall strategic allocation. So if you are conservative investor, then NPS should also be conservatively deployed. On the other hand, if you are Aggressive Investor, then maybe NPS too should be deployed accordingly. But different situations may require different NPS strategies.
It’s best to give it a deep thought or take proper advice from Fee-Only Financial Planner to plan your retirement properly.
One more thing before we end. Many people just look at NPS in isolation only for the tax benefits. That is wrong.
NPS is a long-term retirement-focused savings scheme. And when it comes to retirement and if you aren’t investing the right amount every month, your NPS corpus is not going to grow significantly to meet your entire retirement needs. So instead of randomly investing just Rs 50,000 in NPS every year, you should instead link the NPS investment to your retirement plan which should also contain SIP in good Equity Funds, EPF and PPF.