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NPS Investment options: Build the best NPS portfolio for your needs

NPS or National Pension Scheme returns are linked to the market. Unlike other popular Government saving schemes there is no “NPS interest rate”. Instead investors can build their own portfolio by choosing between multiple pension fund manager (8 currently), 4 different asset classes and 2 asset allocation options: Active choice vs. Auto choice. Making so many investment choices may seem daunting at first but it is also an opportunity. By understanding the different investment options, investors can customise their NPS portfolio to best suit their own needs. This while enjoying the tax benefits offered by NPS.

In this post we discuss the different NPS investment choices. In particular,  we look at the:
  • Asset classes available under NPS : E, G, C and A
  • Asset allocation options: auto vs. active choice. 
  • 8 Pension fund manager with whom you can currently invest
  • The process of changing your investment choices, how often you can do that and the charges for doing so
NPS Asset class E (Equities) has garnered the most attention. This is understandable since NPS is a retirement product and equities are critical to long-term wealth building. So we specially look at the maximum equity exposure rules in NPS. 

We also look at some of the other things that NPS is doing right but do not get talked about much such as life cycle approach to investing, annual rebalancing and how it allows you to dynamically change your portfolio composition at relatively low costs.
However one question that we are not answering in this post is which is the best NPS scheme or best NPS fund manager. Our focus here is on right portfolio construction. This is because in NPS you can choose only one PFM manager to manage your entire portfolio (all 4 asset class funds). And hence the answer to best Pension Fund Manager will depend on which portfolio option you choose. So we will discuss the selection of pension fund manager in a future post. 

Unless otherwise specified the discussion here is applicable to the All Citizens Models of NPS.

Asset classes choices in NPS

NPS gives you the option to invest in 4 asset classes:

Asset class E: Equities and related instruments

Funds in Asset Class E are ‘high risk-high return’ equity funds that are allowed to invest in the following kinds of equity instruments:
  • Equities of companies listed on the BSE or NSE which have:
  1. Market Capitalization of Rs 5000 crore or greater as on the date of investments, and
  2. Equity derivatives being traded on their shares on either of the two exchanges. Exception to this derivative rules is in the case of IPO. But in this case, derivatives should be available on the stock on either of the two exchanges within one year to remain invested in the stock.
  • Mutual funds which have 65% investment in equities listed on NSE or BSE. This would mean that investment is allowed in both Balanced and Equity Funds. However post a PFRDA circular in August 2018 (PFRDA/2018/56/PF/2), investment in mutual funds should not exceed 5% of the total portfolio and fresh investment should not exceed 5% of the new funds that year.
  • ETFs or Index Funds on the BSE Sensex or Nifty 50 index
  • Special ETFs constructed only for investing in shares of companies/PSUs being disinvested  by Government of India
  • These funds can also invest in exchange traded derivatives, whose underlying shares/index meet the criteria detailed above. But this should be with the sole purpose of hedging and the amount invested in derivatives (in terms of contract value) should not exceed 5% of the total amount invested in other equity instruments.
  • The investment in any single equity stock is limited to the lower of 10% of the issued capital of the company or 10% of the total AUM of the fund. In the case of sponsor group companies of PFMs this number is 5%.
Based on the guidelines, we expect Asset Class E funds in NPS to have similar equity portfolio as conservative Large-cap funds.

Asset class G: Government Securities of Central and State Government

Funds in Asset Class G are ‘low risk-low return’ Government Debt funds that can invest in the following instruments:
  • Predominant investment will be in interest-bearing securities or bonds issue by the State and the Central Government. 
  • Other securities where the principal and interest are fully and unconditionally guaranteed by the Central Government or any one of the State Governments – This should not exceed 10% of the portfolio invested in Government Securities.
  • Units of MFs that invest in Government Securities - This should not exceed 5% of the total portfolio invested in Government securities and fresh investments should not exceed 5% of the new funds that year. 
We expect Asset Class G funds in NPS to have similar risk-return characteristics as Gilt mutual funds. However the guidelines do not impose any restrictions on the maturity of debt to be held. This is dependent on manager discretion. In general, funds with higher average maturity of debt will have higher return and higher risk.

Asset Class C: Corporate Debt

Funds in Asset Class C are ‘medium risk-medium return’ funds that investment predominantly in interest-bearing securities issued by entities other than the Government.These include the following:
  • Listed (or proposed to be listed in the case of fresh issue) securities issued by Corporate, (including Banks and Financial Institutions) which have a minimum residual maturity of 3 years from the date of investment. 
  • Rupee Bonds issued by the International Bank for Reconstruction and Development, International Finance Corporation and Asian Development Bank having an outstanding maturity of at least 3 years. 
  • Fixed Deposits of duration 1 year or more issued by Scheduled commercial banks which meet certain criteria (with regards to profitability, solvency, NPAs and net worth) which have been set to ensure that the bank is ‘safe’. More details on these criteria can be found in the PFRDA circular on Investment Guidelines for NPS Schemes (PFRDA/2017/18/PF/2).
  • Units of Debt Mutual Funds (excluding Liquid Mutual Funds)
  • Infrastructure-related debt securities
  • Listed and proposed to be listed Credit Rated Municipal Bonds
  • At least 90% of the portfolio has to be invested in securities with AA rating or above. Max 10% of the portfolio can be invested in securities with rating between A and AA-.
  • The investment in any single company is limited to the lower of 10% of the networth of the company or 10% of the total AUM of the fund. In the case of sponsor group companies of PFMs this number is 5%.
We expect Asset Class C funds in NPS to have similar risk-return characteristics as Credit Funds. Since guidelines explicitly prohibit investments with less than 1 year maturity, risk and return will be higher than Ultra-short term credit funds. Exact return-risk profile is dependent on manager discretion. In general, funds with higher average maturity of debt and/or lower rated debt will have higher return and higher risk.

Asset Class A or Alternative Investment Funds

These are the most recent asset class funds which have been introduced which are allowed to invest in the following “Alternative” securities:
  • Mortgage-backed Securities (MBS) – both Residential and Commercial, 
  • Units of Real Estate Investment Trusts (REITs) regulated by SEBI
  • Asset-backed securities regulated by SEBI
  • Units of Infrastructure Investment Trusts regulated by SEBI
  • Alternative Investment Funds (AIF Category 1 and 2) regulated by SEBI

Please note that Asset class A are only available for Tier 1 investment accounts.

These securities are called “Alternative” because their returns are expected to be different from traditional asset classes such as equities and bonds. As a result they can be a diversifier in the portfolio. However in reality, these asset classes do behave very much like equities. In fact they can be considered a riskier version of equities since they have an added risk of illiquidity. It is because of this reason that Asset class A has not be made available for Tier 2 accounts which can be withdrawn anytime. Also weight of Asset class A has been significantly capped even in Tier 1 accounts at 5% - a topic which we come to next. 

Some other guidelines with respect to asset class funds

In addition to the guidelines mentioned above, there are some guidelines which are applicable across all asset class funds: 
  • For any single PFM, investment across all asset class funds, in a single Industry (as per Level 5 of NIC classification) has been restricted to 15% to prevent excessive exposure to a single industry.
  • Only up to 5% of any asset class fund can be invested in short-term liquid securities such as Money Market instruments, Liquid Mutual Funds and Fixed Deposits with less than 1 year maturity.
  • Pension Fund Managers cannot charge Investment Management Fees on the amount invested in Mutual funds (excluding the investment in Liquid Mutual Funds), ETFs or Index Funds.  This is an investor friendly measure introduced to ensure that investors do not end up paying double fees to the managers of the underlying funds as well as the Pension Fund Manager.

NPS Asset Allocation: Active choice vs. Auto choice

The 4 asset class funds described above are the building blocks which can be used to build portfolios. Even with portfolio building, NPS offers subscribers a choice to either go with Active choice or Auto Choice. 

Subscribers can choose a different portfolio for their Tier 1 and Tier 2 accounts.

Active Choice option

Under NPS Active choice, a subscriber can chose their own asset allocation weights based on their risk appetite. The investor first needs to choose a Pension Fund Manager and then select the weight on the Asset class funds from that Manager.
Some restrictions have been imposed on weights to prevent investors from taking on too much risk:
  • Exposure to Asset class A or Alternatives is capped at 5%. Investment in Asset Class A is only allowed in Tier 1 accounts. It is not allowed in Tier 2 accounts.
  • Maximum NPS Equity exposure (Asset Class E) is capped at 75% till the age of 50 years. After that the cap on equity weight tapers off in the line with the table below. If a subscriber becomes in violation of this limit, then the extra funds over the limit will be transferred to Asset Class G Fund by default.  This reallocation is carried out once in a year on the date of the birth of the subscriber. However the subscriber has the option to allocate these funds between C and G funds as they desire.
  • There is no cap on exposure to Asset classes G and C and these can be as high as 100%.

Maximum exposure to Equities and other Asset Classes under Active Choice

NPS Maximum exposure to equities, debt and alternatives

Why have the NPS architects chosen a tapering cap for Equity exposure? A fixed cap would definitely be easier to explain!  The tapering cap ensures that subscribers can invest more in equities (or risky assets) when they are young. As the subscriber’s age increases and they come close to their retirement goal, exposure to equities (or risky assets) is expected to come down, which is reflected in the cap coming down.  

‘Cutting of exposure to risky assets as age increases ‘ is in line with the principle of “Lifecycle Investing”.  Lifecycle investing is currently the most widely accepted principle for retirement investing. It is also the very foundation for the second option under NPS – the “Auto-choice” option.  Hence before discussing the Auto-choice option we look at what exactly is Lifecycle investing.

What is Lifecycle Investing?

The main idea behind Lifecycle investing is that a person’s portfolio should vary with their age. A young person should hold a more risky portfolio or a more equity-heavy portfolio and as their age progresses they should shift to a safer portfolio or a more debt-heavy portfolio.

The intuition behind this is the following: We know that more risky assets like equities have the potential for higher returns in the long-term. But equities tend to move in cycles. They can be in multi-year bull markets and in multi-year bear markets. The key to get maximum returns out of equities is to be able to see through the bear markets – you should not be forced to sell your equity portfolio at these times. Debt, on the other hand, gives lower but more consistent returns.  Now when a young person is saving for retirement, they have a lot of time ahead of them. Hence they can afford to ride through multiple equity bear markets. So to maximise return, they should invest more in equities. But as the same person comes closer to retirement, time is no longer on their side. And hence they should invest more in debt. This way their returns during the later years may be lower but they avoid the possibility of finding their portfolio in a bear market right at the time of retirement!  

Another reason for going with the lifecycle investment philosophy is to do with risk appetite.  A young person has majority of their earning years ahead of them. Their potential lifetime wealth is significantly higher than the current size of their portfolio. For a middle-aged person it is the other way round – most of their earning potential has been realised and a majority of their wealth is in their retirement corpus. So a young person can afford to take more risk in their portfolio while a middle-aged person should play it safe.

Auto-choice option 

This is a dynamic investment option in which the subscriber does not choose weights. Instead they can choose a Lifecycle fund. A Lifecycle fund is essentially a set of weights that that evolve with the age of the subscriber – moving from more risky to less risky portfolio as the age of the subscriber increases. This is line with the principle of Lifecycle investing.

An Auto-choice investor has to make two choices:
  • First, they need to choose a Pension Fund Mananger
  • Second, they have to choose between three Life-cycle funds: Aggressive (most risky), Moderate and Conservative (least risky). This is to accommodate the individual risk-appetite of the subscriber. We have listed the weight matrix for each option blow. As you can see, Equity allocation under Aggressive option at any particular age > Equity allocation under Moderate option> Equity allocation under Conservative. And vice versa for Debt.
The default choice if the subscriber does not choose an investment option and asset allocation is the Moderate life Cycle Fund. 

Dynamic rebalancing of weights across schemes as per the age wise allocation ratio will be carried out on the date of birth of the subscriber. 

NPS Auto-choice investment options: Aggressive (LC-75), Moderate (LC-50), Conservative (LC-25)

NPS Auto-choice Aggressive, Moderate, Conservative options

NPS Auto choice equity exposure

Equity exposure in NPS Auto choice Aggressive, Moderate and Conservative options

Maximum Equity Exposure in NPS

NPS equity exposure has been a topic of some debate. Earlier the cap on Maximum Equity exposure in Active choice option of NPS used to be 50% and only the Moderate Life Cycle Fund was available under Auto Choice which again had a maximum equity exposure of 50%. However this has now been rectified by the authorities, Post all the changes, a maximum equity of 75% is possible till the age of 50 years which should be sufficient for even the most risk-taking investors. A higher  exposure to equities than this is not recommended by us.

Pension Funds Managers (PFMs) under NPS

Subscribers under the All Citizens model have a choice of 8 Pension Fund Managers (PFMs):
  • HDFC Pension Management Co. Ltd.
  • ICICI Prudential Pension Fund Management Co. Ltd.
  • Kotak Mahindra Pension Fund Ltd.
  • LIC Pension Fund Ltd.
  • Reliance Capital Pension Fund Ltd.
  • SBI Pension Funds Pvt. Ltd.
  • UTI Retirement Solutions Ltd.
  • Birla Sunlife Pension Management Ltd
Each of these Pension fund Managers offers Schemes for Asset Classes E,G, C and A. There are separate schemes for the Tier 1 and Tier 2 account given the greater liquidity requirement in Tier 2 accounts. (See NPS Withdrawal rules to know more about how withdrawals from NPS Tier 2 are easier than NPS Tier 1 accounts).

Since Tier 2 account investors cannot invest in Asset class A, so each PFM offers 7 schemes. This is apart from the special schemes that they offer for Central Government, State Government employees, Corporate, NPS Lite etc. 

NPS rules mandate that each NPS subscriber needs to select the Pension Fund Manager first and then buy all Asset class schemes from this manager. However a subscriber can have different Pension fund Managers for their Tier 1 and Tier 2 accounts.  

Automatic Rebalancing – A salient feature of NPS investment

Another investment principle which NPS gets right but which does not get discussed often enough is rebalancing which hapens automatically every year.

What is rebalancing under NPS?

For the sake of simplicity suppose there are only two asset classes, E and G. And an investor has a corpus of 2 lakhs and wants a 50-50 allocation to each asset class. So to start with,  he/she invests 1 lakh in each E and G. After 1 year, both asset funds will have different returns. Suppose E has a return of 20% that year and G has a return of 7%. So the 1 lakh invested in E will have grown to 1.2 lakhs while the 1 lakh invested in G would have grown only to 1.07 lakhs. If we look at the final corpus of 2.27 lakhs, actually it is no longer invested in E and G in  the 50-50 ratio. The new allocation is actually ~53% in E(1.2/2.27) and ~47% in G (1.07/2.27) – slightly shifted from the original allocation. If not corrected, this difference between target and actual allocation will only increase in future years.

NPS corrects for this. Once every year, on the date of birth of the subscriber, the actual asset allocation is calculated based on how the NAV of different funds has moved. Units are then redeemed or purchased in the different categories to ensure that actual asset allocation is same as the target asset allocation. 

Why is rebalancing important?

It is clear that rebalancing is important from a risk perspective, You chose a certain target allocation because you are comfortable with its risk characteristics such as how much fluctuation you will see in year on year returns, how much max the portfolio can go down by etc. If actual allocation moves too far away from target allocation you may end up holding a portfolio with a completely different risk profile. 

What is not immediately clear is whether rebalancing adds value from a returns perspective. In our above example, suppose equities continued to outperform debt in year 2 also, then an investor who had not done any rebalancing may actually have been better-off from a returns perspective since they will have more invested in equities. However individual counter-examples aside, empirical studies show that rebalancing increases returns on an average. The most logical explanation for this seems to be that asset classes such as equity move in cycles. If equities have been doing very well for some years, then they are bound to go down at some point. In such a situation by rebalancing away from equities every year, an investor keeps locking their gains while equities are doing well and has less invested in the asset class when the eventual downturn comes. 

How to change your NPS investment option (and charges for doing that)

Changing your NPS investment option can mean two things:
  1. Changing the PFM/Scheme: Subscribers in the All citizens model have the option to change the Pension Fund Manager once in a financial year and separately for the Tier 1 and Tier 2 accounts. 
  2. Changing the Investment choice and asset allocation: Subscribers can change their investment choice:  Auto vs. Active choice and the asset allocation percentages (in case of Active choice) two times every year and separately for Tier 1 and Tier 2 accounts.
A request for Investment option change can be submitted in two ways:
  • Online using i-Pin: Under the Main menu of “Transactions”, there should be a sub menu "Scheme preference Change".  You need to select the account type (Tier 1 or Tier 2) and change the Scheme preference as intended.
  • Offline request submitted in-person to the POP (Point-of-Presence) with whom he/she is registered: In this case subscriber has to submit the (i) Application Form UOS-S3 and (ii) copy of PRAN card at the POP/POP-SP In case the Subscriber wants to change Scheme Preference for both the Tiers then he/she should submit separate forms for each Tier.
Charges for changing your NPS preference are minimal. Since this qualifies as a Non-financial transaction, there are POP (Point of Presence) charges of Rs 20 which are deducted upfront. There are separate CRA (Central Record keeping Agency) charges which are ~Rs 4 and are deducted through cancellation of units.   

Dynamic portfolio construction in NPS vs Mutual Funds

Under NPS transactions such as rebalancing, changing your scheme manager (allowed once a year) and changing your asset allocation (allowed two times a year) are free except for nominal charges. If one was to conduct the same transactions using mutual funds there would be significant exit loads and tax implications. In this sense NPS is much better suited for running a dynamic portfolio which is responsive to economy,  investor's changing risk preference etc. compared to mutual funds.

Conclusion

NPS offers investors a wide menu of investment options and also allows them to change their investment choices relatively easily. Maximum equity exposure under NPS used to be a bone of contention but according to us, that has now been satisfactorily resolved. As such we believe, that NPS provides investors all the tools and investment choices needed to build a dynamic portfolio best suited to their preferences. 

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