Even before we begin to discuss the risk vs return options in the National Pension Scheme or NPS, know that it is mostly a low-risk instrument. For starters, NPS is a retirement scheme that is well regulated by the central government through PFRDA.
Before discussing these further, let’s understand the NPS asset classes investors can subscribe to:
|Asset Classes||Where do they invest?|
|Government Securities||These include money market instruments and securities issued by the state and central governments.|
|Equity||These include equity market instruments like mutual funds, stocks, shares, derivatives and bonds.|
|Corporate Debt||These include infrastructure companies and bonds issued by Public Sector Undertaking (PSUs) and Public Financial Institutions (PFIs)|
|Alternative Investment Funds (AIFs)||These include unlisted equities, Real Estate Investment Trusts (REITs), Commercial Mortgage-backed Securities (CMBS) etc.|
Now let’s look at the 2 NPS investment formats. They are called:
- Active choice in NPS
- Auto Choice in NPS
Regardless of whether Auto choice or Active Choice is selected, the equity exposure is capped based on the subscriber age. The maximum possible equity exposure in NPS is 75%. These guardrails ensure that the risk reward equation will always be attractive from a long-term perspective.
Additionally, since withdrawal is only allowed when the subscriber’s age is at least 60, the risks associated with short term stock market corrections are also minimized.
The main benefit of equity exposure is that NPS is able to deliver much better returns than comparable long-term fixed-income schemes with lock-ins like PPF/EPF etc. What’s more, unlike other comparable instruments, it allows investors to make specific investment choices, and you can also change your fund manager once annually and asset allocation twice a year.
Now, let’s understand the two investment formats in NPS in detail.
Active Choice in NPS
This format is best for subscribers who understand the market and, therefore, wish to fix asset allocation for their NPS on their own. Active choice in NPS allows applicants to decide the precise ratio in which their corpus will be invested in various asset classes listed in the table above.
Simply speaking, here you are in total control of your NPS asset allocation, sans a few regulations. Refer to the table below to understand the upper caps for each asset category.
Permissible Allocation via Active Choice in NPS format
|Government Securities||Equity||Corporate Debt||Alternative Investment Funds|
|Up to 100%||Up to 75%||Up to 100%||Up to 5%|
Auto Choice in NPS
If you’re a passive investor, or a beginner, who doesn’t understand the ins and outs of the market, the auto choice in NPS is the correct format for you. This format selects the asset allocation on your behalf. The selection algorithm takes a lifecycle approach, where it begins with an equity-heavy portfolio when you’re younger and switches to a debt-heavy policy as you get older and approach retirement.
This automated strategy cushions you from market volatility while optimising returns. Within this format, your corpus is invested in a lifecycle fund. There are three categories of lifecycle funds:
- Conservative lifecycle fund
- Moderate lifecycle fund
- Aggressive lifecycle fund
Let’s quickly understand the difference between the three:
Conservative Lifecycle Fund
As you’ve probably guessed, the conservative lifecycle fund follows a conservative approach by investing a maximum of 25% of your corpus in equity. The rest, 75%, is distributed between government securities, corporate debt and AIFs. It further goes below 25% with the increasing age of the investor.
Moderate Lifecycle Fund
This is the default option when you go for the auto-choice format. The moderate lifecycle fund caps your NPS equity exposure to 50%. Similar to the conservative fund, it goes below 50% with the increasing age of the investor.
Aggressive Lifecycle Fund
As the name suggests, this is the most aggressive NPS investment category, where 75% of your corpus is invested in equity. It keeps going below 75% as the investor gets older.
Which to Choose?
Safe to say, if you’re a beginner, it is prudent to go with the default option of auto-choice. As you learn more about the market currents, you can switch from auto choice to active choice. Either way, you stand to make significant returns in the long run.
Expected Returns in NPS
Even though NPS is market-linked, it is considered a low-risk instrument. Primarily because it typically has a long-investment horizon, and you can never invest all of your corpus in equities.
This scheme has been in effect for the last decade, and the expected returns in NPS have ranged from 8 to 10% annually. However, if you start investing in NPS at a young age, you can choose a more aggressive strategy to earn higher returns in the long run. Remember that no matter how high your stake is in equities, it reduces by 2.5% every year after you reach the age of 50.
This regulation is in place to safeguard your corpus from market volatility and stabilise your NPS risk-return equation.
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