Your retirement goal gives you only one chance
When planning for retirement, investors and MFDs have a dilemma between NPS and Mutual funds. I look at the two investments from two different perspectives, financial planning perspective and the behavioral finance perspective, to try and find some answers.
Financial planning perspective
Let’s first compare how the long term returns have been stacking up for NPS and large-cap funds. Here I am comparing large cap funds because NPS can only invest in large-cap funds. (Now NPS is allowed to invest in midcap, most PFMs have kept their exposures to Midcap well below 5%* )
*moneycontrol https://tinyurl.com/544jwhwf
Let’s peel the returns first
In the table above, the first column shows the average return of the top tertile (top 1/3rd) of MF / NPS PFMs. The schemes compared here are regular mutual fund schemes to keep them more conservative. For direct schemes, the return may be higher by approximately 0.5%.
The second column is the upper half mean comparison, which means the average of the returns of the top 50% of the mutual funds. The third column is the average return of all schemes studied under mutual funds and NPS. The fourth column is the standard deviation of the 10-year returns of different fund houses, showing how much it matters from fund house to fund house. And the last column is the number of schemes studied with a 10-year+ record. All returns shown above are 10-year returns.
A few observations upfront: mutual funds are in large numbers and have large deviation in performance from fund house to fund house. average returns of all mutual ?funds schemes is being dragged down to 14%, below that of NPS at 14.41% in above table. Clearly, there are some mutual fund schemes which are destroying wealth.
The next observation is interesting, average returns of top 50% of the mutual funds schemes in regular plans is 15.14%, higher than the average of returns of top 50% of the schemes of NPS at 14.74%. So, for an average investor who does not know anything about investing and picks up a scheme randomly has a 50% chance that he will pick in the top half of mutual funds, just by chance, and still be better off than NPS. But is that good enough?
So what if investors are able to do better than 50% chance ? If investors themselves, or with help from their MFDs, are able to catch funds in top tertile ( top 1/3rd), they do even better with 15.41% returns in MFs as against 14.79% returns in PFs. And how are investors actually doing in selecting funds?
Top 33% mutual funds schemes (top tertile) account for 56% AUMs in these large cap mutual funds. That’s quite impressive. That’s not all, investors are smart, even by chance. A whopping 90% of the AUMs of these large cap funds are in top 50% funds, which beats the NPS.
Is that all ?
PF regulations do not allow more than 75% of investments to go in equity. For a long 10- to 25-year investment horizon, this restriction is a big dampener. 25% of funds will be laggard, for no reason. Asset allocation should be left to investors.
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The biggest plus for NPS is that you are allowed, with some restrictions, to switch between asset classes throughout the year without any capital gain taxes. Another big plus is that portability is allowed between PF fund managers without any capital gain tax. So if you don’t like performance of your fund manager, you can just shift to another without any capital gain taxes. Both of these are not allowed in mutual funds and are a big plus. Over a 15-20-year period, both these advantages may just compensate for slightly lower returns on NPS.
Behavioural Finance perspective
Comparing returns is not the end-all of investments. Comparing returns is just half the story. There are many more considerations.
Is lack of liquidity in NPS a good or a bad thing? In general, you would assume that liquidity is good and lack of liquidity is bad. But it’s a matter of perspective. Think like this: since you do not have liquidity, you would not be able to withdraw NPS funds on impulse (except for the small amount that is allowed to be withdrawn prematurely), and hence you are more certain that you will not end up using your funds for other purposes.
Next consideration is extremely important one. If you are not sure you will be able to catch a mutual fund from top 50%, it is better to stay with NPS, which has less variability in returns from fund house to fund house. Given the way PFRDA functions, investment options will remain in tight range for all NPS FMs, ensuring less variability from fund manager to fund manager in NPS and returns closing following benchmark returns. Retirement is one important goal in life, and the only goal for which you will not get a second chance!
At maturity, again, there are considerations to be attended to. In MFs, you can do a systematic withdrawal plan, or SWP, by keeping some amount in equity and some in debt, and get higher returns, which are not guaranteed. Or you can do what NPS investor has to compulsorily do: buy a pension annuity. So in MFs, you retain the option with you; in NPS, you give away the option**, and have to compulsorily convert it into an annuity (an annuity is the pension you are planning for, a monthly amount you get). Keeping this option is valuable.
**You can withdraw up to 60% of the funds and invest them in MFs to get SWP, only 40% has to be invested in annuity
In conclusion
If you are not well versed with the world of equity investments, start with NPS. In NPS, if you do not choose active management, you don’t even have to worry about your asset allocation.
Even if you are well versed in the world of investments, some part of your planning comes from NPS due to the behavioral considerations mentioned above: a forced lack of liquidity and less variability between fund NPS managers.
Having said this, you may not want to give up the extra returns that MFs offer due to active management, and there are also no restrictions on investing 25% in the non-equity asset class (NPS has a mandate of at least 25% in non-equity). You also should retain some of your liquidity freedom, and have option to decide what to do when you get your pension corpus at the end.
Lastly, you may not have enough money to spare today for investments, and you may want to look at bumping up your returns through investments in mid-cap or small-cap funds, even if in small amounts. Equity MFs help you fine-tune your asset allocation the way you want.