Unfortunately for NPS investors like the Agarwals, there is no way to escape the impact of rising bond yields or even the declining equity markets. Other market-linked investment products such as Ulips and pension plans from insurance companies offer a liquid option where investors can park their money to earn low but positive returns. The NPS does not have a liquid fund option, and investors are forced to choose between the four categories–equity, gilts, corporate bonds and alternative investments.
While the Agarwals will have to remain invested in the NPS, what they can do is tweak the fund combination in their portfolio to minimise the impact of rising interest rates. Gilt funds of the NPS hold bonds of slightly longer maturities than corporate bond funds. The average maturity of bonds in gilt funds is 7.26 years, compared to 4.44 years of corporate bond funds. Experts say that when interest rates are rising, it is better to stay in shorter duration bond funds to reduce the interest rate risk.
The Agarwals will also find this week’s cover story useful. It examines the performance of Tier I funds of the NPS and identifies the best pension funds. As in earlier years, we have not looked at the performance of individual schemes because investors spread their money across a combination of funds. We have, therefore, looked at blended returns of four different combinations of equity, gilt and corporate bond funds.
Aggressive investors are assumed to put 60% of the corpus in equity funds, 20% in corporate bond funds and 20% in gilt funds. Balanced investors allocate 33.3% to each of the three classes of funds. Conservative investors put only 20% in stocks, 30% in corporate bonds and 50% in gilts. And ultra-safe investors shun equities altogether and put 40% in corporate bond funds and the balance 60% in gilt funds.
Though investors can also allocate 5% to alternate investment funds, we have not included that in the calculation. The returns are along expected lines. In the short term (6-12 months), the aggressive and balanced portfolios have suffered due to the downturn in the equity markets. The impact of equity exposure has even pulled the returns of conservative investors into the red.
But while equity exposure has brought pain in the short term, it has proved bountiful in the long term. Aggressive investors who bet heavily on equity funds have made good gains (see table). The long-term returns are in double digits and way above what other allocations have earned during the same period. Ultra-safe investors who stayed away from equities may not have suffered any losses in the short term, but their long-term returns are 3-4 percentage points lower than those earned by aggressive investors.
In this story, we identify the best performing funds for various types of investors. We hope our research will help you choose an appropriate asset mix for your NPS investments as also identify the best pension fund manager.
Allocation to equities can boost returns, but till four years ago, NPS subscribers could invest no more than 50% in equity funds. The PFRDA raised this cap to 75% in 2018, allowing younger investors like Shikha Malhotra (see picture) to give their retirement savings a bigger exposure to equity funds. However, the PFRDA does not want older subscribers to bet too heavily on equities. After the subscriber turns 50, the maximum equity exposure starts reducing by 2.5% every year. In 10 years, when the subscriber is ready to retire, the maximum exposure to equity funds is only 50%. While calculating the returns for the Aggressive portfolio, we kept the allocation to equity funds at 60%.
It is noteworthy that there is not a huge variation in the returns earned by the seven pension funds. Pension fund managers have had to operate within the tight guidelines laid down by PFRDA. The investment norms were relaxed a few years ago, allowing pension fund managers to look beyond the index and invest in stocks in the F&O basket. But the stocks must have a market cap of at least Rs 5,000 crore.
Given this restriction, all NPS equity funds have nearly 90% allocation to the large-cap segment. Fund managers will have to search for alpha in the mid-cap territory, where stocks have a greater potential to grow. But though mid-cap stocks outperform large-cap scrips in the long term, they are also more volatile and prone to higher drawdown during market downturns.
Balanced investors who divided their corpus equally across the three asset classes have had the best of both worlds. Equity exposure has pushed up their long-term returns, while gilt funds and corporate bonds shored up their returns in the short term. The 3-5 year SIP returns are better than what the EPF has given in recent years.
A stable performance is what many investors like Anuj Razdan (see picture) are looking for. This senior manager in a Mumbai-based company wants to opt for the NPS benefit after the new tax rule for contributions to the Employees’ Provident Fund. Besides the mandatory `15,500 contribution to the EPF every month, Razdan used to put an additional `25,000 through the Voluntary Provident Fund. Now that it will earn taxable interest, Razdan is looking at the NPS.
The market-linked NPS is very different from the EPF that offers assured positive returns. But his contribution to EPF was not fetching any tax benefit while the contribution to NPS is eligible for deduction under Sec 80CCD(2). This benefit is especially useful for people in the higher income brackets. “If my company puts 10% of my basic pay in the NPS every month, my annual tax will reduce by almost Rs 50,000,” says Razdan. If he puts in `50,000 more in the NPS under Sec 80CCD(1b), his tax will reduce by another Rs 15,600.
Conservative investors, who entrusted only 20% of their corpus to equity funds, have also fared well. Their short-term returns have been impacted, but long-term returns have been able to stay ahead of inflation. A 100% debt based portfolio will not be able to beat inflation. If your investments are not growing at the same pace as inflation, you are actually losing money, though you don’t see it.
This should be a wake-up call for investors like Bengaluru-based Damini Natarajan (see picture) who don’t want equity exposure. Natarajan has most of her money in debt instruments and insurance policies, and even her NPS corpus is devoid of equity exposure. “Low returns don’t bother me. I just hate the thought of losing money,” she says. At her age, she can afford to take a little risk and allocate about 15-20% of her NPS corpus to equity funds.
While equity funds hold promise in the long term, even the corporate bond funds and gilt funds in conservative portfolios are expected to do well. The average yield to maturity of NPS gilt funds was 6.9% on 31 March when the 10-year government bond yield was 6.83%. The government bond yield has since shot up 60 basis points to 7.43%, so fresh purchases by gilt funds would increase the average yield to maturity. So, while gilt fund NAVs might have crashed last week, this may be a good time to start loading up on these funds now. NPS is a long-term investment and funds usually hold bonds till maturity because there is no redemption pressure. The high yield to maturity would translate into good gains from gilt and corporate bond funds.
Ultra-safe investors with no exposure to equities are paying the price of their obsession with safety. The hike in interest rates and fall in bond prices have pushed the average 3-year SIP returns below 5%. Even the 5-year SIP returns are not very attractive.
But for some investors like Shankar Deshpande (see picture), an equityless portfolio is necessary. Deshpande is retiring this year and cannot afford to expose his NPS corpus to the extreme volatility of equity markets. He shifted out of equities last year and has put the entire corpus in gilt funds.
While he did the right thing by shifting out of equity funds, he should opt for corporate bond funds instead of gilt funds. As mentioned earlier, corporate bond funds are holding bonds of shorter maturities compared to gilt funds. The average maturity of bonds in gilt funds is 7.26 years, compared to 4.44 years of corporate bond funds. So corporate bond funds will not suffer so much if interest rates are hiked.
To be fair, gilt funds have higher yields to maturity than corporate bond funds. But Deshpande is retiring this year and may not remain invested for the long term to be able to benefit from that higher yield. However, he could consider staying invested even after retirement. Under the new rules, an investor can stay invested in the NPS till the age of 70.