Ajay Shah notes that the new changes suggested by the Parliamentary Standing Committee to the government, on the National Pension Scheme, are essentially a reversal of reforms.

An essential feature of the NPS was that it was a defined contribution system. India has a long history with getting into trouble with guaranteed returns. UTI's assured return schemes turned into a problem for the exchequer. EPS, run by EPFO, is bankrupt.

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rough calculations show that the implicit pension debt on account of the traditional civil servants pension in India (the one which was replaced by the NPS) stand at roughly 70% of GDP. This is a very big price to pay, for a tiny sliver of the workforce.

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But now, a new existential threat seems to have come up : the Parliamentary Standing Committee on Finance seems to be saying that the fundamental idea of the NPS -- defined contributions -- should be scrapped. This would amount to a major reversal of India's economic reforms.

He points us to a livemint article by Deepti Bhaskaran, which mentions that the committee suggested that NPS returns need to be have a minimum guarantee, meeting at least the EPFO return (currently 9.5%)

In 2004, government employees were moved to the NPS, with their pensions moving from a defined-benefit scheme (that is, you get a fixed amount that’s based on your salary) to a defined-contribution scheme (that is, you contribute a fixed amount each month, and investments happen at market rates).

NPS was going to be managed by professionals – six fund managers were chosen and given the kind of low fees that were unheard of. The managers did it because honestly, in this country, just the fact that you manage a few thousand crores can yield you a great reputation, and for real money, they always have the ability to do some front running or side deals if they felt like it. (Not saying they will, but let’s face it, this shit happens all the time).

There are three groups of investments: Equity, Corporate debt and Government debt. Government debt would be at least 50% of your investment, and for the rest you can choose a scale of more “G” or a mix of “E” and “C”. You can also choose your fund manager.

The NPS did well. It was recently thrown open to private participation, though it didn’t latch on because it wasn’t defined as a “tax saving” entity; that is, your contributions wouldn’t be exempt from tax and any returns were likely to be fully taxable, which made it less useful compared to other instruments such as insurer’s pension schemes. Also, there were steep charges for the lower end of contributors, and nickle-and-dime kind of fees.

Tier 1 accounts – the standard NPS scheme – didn’t allow withdrawals, so they started withdrawable Tier 2 accounts. In 2011, the NPS contributions were brought under 80C, allowing you a tax exemption on entry.

They also started the Swavalamban scheme, where “NPS-Lite” accounts would be funded with Rs. 1,000 per year for five years, by the government, if the account holder kept her account going with her own funds as well. The scheme saw only a small number of accounts opened, and vastly underused the 100 cr. allocation last year, and has since been extended for another two years. NPS-Lite is meant for the economically weaker class, but the language allows any entrepreneur to apply. (There are currently 743,000 subscribers)

The concept was that NPS returns would be market determined. But the returns have been less than stellar, recently, and some fund managers have underperformed in both equity and debt markets. It’s strange to view a one year return though, since this is a battle for retirement. The committee thinks that instead of that, the scheme should keep a system of fixed returns.

Not really defined benefit

Now this is slightly different from a defined benefit scheme; the traditional defined-benefit was that you would get, say, 50% of your last salary, adjustable up for inflation. This is not the case if you guarantee returns, which is still a percentage return of a defined contribution.

But guaranteed returns dilutes the impact of a defined-contribution scheme; now, if there is a shortfall in returns, who will make up for the rest? If it’s the government, then why is there any incentive for the fund managers to outperform? If they underperform, the government will cover for them; if they outperform, the fund will see good returns. That means we as taxpayers backstop this silly system, and we should have no more of that.

You might argue that if the government supports the system for shortages, it has a right to take away outperformance as well. In which case the guaranteed return is not a floor, it’s a ceiling.

Guarantees defeat the purpose

Defined contribution was supposed to take the onus of retirement benefits away from the government (and thus, taxpayers) to the individual. If you want a higher retirement income, save more, and hope the market follows. It doesn’t often happen; with such a scheme, a Japanese employee thirty years ago would have seen his retirement money drop below his investments if it was invested entirely in the stock markets (their government bonds return next to nothing anyway). America has seen 10 years of nothingness in stocks.

But the answer to this is not to guarantee returns. If you see the mess that is US Social Security today, a lot of it stems from earlier created defined-benefit schemes. We create long term unsustainable guarantees only to fail us when it will hurt us the most. Yes, we are a young population and it is likely that we can continue to collect money from new, younger employees to pay off the older ones. But at some point, the cycle breaks (like in Japan and now, the US) and you find it’s too late to do anything about it. If we have to change things, we have to do it now.

What serves the purpose then?

Look, retirement vehicles are not the solution to retirement. Locked in schemes like the NPS, EPF or such are better off not used; it may be infinitely more useful for every individual to chart their own plans and invest directly.  Yes, you do defer some taxes by contributing to pension funds , but you introduce a larger problem that these funds are locked in, and therefore, are exposed to the vagaries of fund managers and shady governments.

In addition, tax concepts will change. Annuities in India are horrendous, you get a far better deal with a long term government bond; yet, the pension funds force you to buy an annuity with the retirement money. You will have less than you think.

But they do give you more money – your employer contributes as much as you do, which is good money that would otherwise, perhaps, not be available to you. In all likelihood, we will spend a lot of time figuring out what our retirement managers are allowed to do and how they should do it, rather than working towards retiring rich ourselves; but then hey, this blog wouldn’t exist.

Your own contribution had the exemption upto Rs. 1 lakh, an overall limit for all such tax saving avenues such as insurance payments, children's education fees, ELSS mutual fund investments ad so on. Earlier even the employer's payments came into the same deduction, and employers weren't allowed to reduce that amount as a business expense.

Now the employer's payment does not come into the 1 lakh limit, and they can expense it. But if it's not taxed to your employer (i.e. the money is allowed as an expense), does that mean it will be taxed as a perquisite? We don't know - the bill doesn't say!

Two cases then: one, the employer's contribution is taxed in your hands as a perk. What's the point, then? You pay taxes today on money you can't touch till you retire, and when you get that money you pay taxes on it again.

Second, that such employer's contribution is not taxed in your hands. That makes sense, and brings it on par with other superannuation fund payments (like pension schemes). This is cool, but remember any withdrawal from a pension scheme is taxed, so all you're doing is deferring the tax. Nevertheless, policy clarity would be welcome.

This post is written by Deepak Shenoy, at Capital Mind.

Recall that the Tier 1 account was not withdrawable – you put money in, it stays in till retirement, and then you put 40% of the corpus as an annuity and the rest you can take out (but is fully taxed when you do).

The annuity is a pain – as I’ve mentioned, annuity rates are very low in India. Plus, the non availability of money in the interim is a mess as well; what happens if you have an emergency, and you need cash urgently? Like a medical situation where the retirement money is hardly worth saving instead of saving a loved one? Or a time when you simply want to retire and enjoy yourself, but you’re not 60 yet? (Note: You try to withdraw from a Tier 1 account before you’re 60, they make you put 80% into the annuity. Another collossal waste of money)

The best outcome, really, is to die. Then your spouse gets all the money as a lumpsum, no annuity and all that. But that doesn’t work out quite that well for you.

The Tier 2 lets you get a better outcome without needing to die. Anything that you don’t need to die for is a good thing; regardless of what Bryan Adams might sing.

With Tier 2, you can withdraw the money anytime, and any amount. Only, you need an active Tier1 account to open a Tier 2 account. You can transfer money from Tier 2 to Tier 1 as well. NPS has a silly need to transact four times a year at least – but if you put the money into the Tier 2 account, you can simply instruct a transfer (hopefully, online) and that should work for the minimums.

There’s a minimum account balance of Rs. 2,000 (you can start with 1,000 and put in four contributions of Rs. 250 each). You don’t get charged the annual maintenance fee of Rs. 350 that Tier 1 charges, but you pay about Rs. 30 per transaction. Fund choices, management fees etc. remain the same.

The NPS has returned over 12% as of September 2009, managing government employee funds. The regular returns for non-govt. will be higher from the high equity component. The post tax returns are quite attractive, though perhaps not comparable to ELSS. Add the low management fees, the zero entry and exit loads and the no annuity requirement; as a stable retirement product NPS Tier 2 looks like it will rock.

* When will they stop calling it “New”?

This post is written by Deepak Shenoy, at Capital Mind.