March 8, 2017

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National Pension System: A trap or a gold mine? (Part – 2)

What Is an Annuity and How Does It Work?

In its simplest form, an annuity is an agreement in which the individual makes one or multiple payments in exchange for receiving a set amount of income for a period of time from the insurance company. Annuity products have been in the market for a long time. They are commonly used by conservative retirees who want to make sure that they will have a regular income for the rest of their lives. Even though annuities are a way to invest money, they are actually an insurance contract and, therefore, are sold only by insurance companies.

Alternatives

Some experts are of the view that mutual funds (MFs) can be used as better retirement plans as compared to NPS. They feel MFs promise better returns, tax efficiency, and flexibility, making them lucrative alternative for investment. They feel that everything is not perfect with NPS, and are of the opinion that it is actually a trap.

Pension freedom in the UK

The UK government had provided exemption from income tax on contributions to pension, exemption from tax during accumulation, and an option to take 25% tax-free lump sum on retirement. The balance 75% has to be compulsorily invested in an annuity policy. This has been the scenario for many years. Annuity as a product was sold in good numbers due to these tax rules. The UK market also has some special features like income drawdown, which allowed individuals to draw some income from their pension corpus, even before their retirement. A radical change in the pension market has been implemented in 2015. It’s the new pension freedom, the freedom from buying compulsory annuities. The customers have been given freedom to use their pension corpus in whatever way they want. Though this is expected to lead to a decline in the annuity business, it has prompted the introduction in various other post-retirement investment products which are more attractive.

NPS in the future

The government is considering migrating employees from the compulsory Employees Provident Scheme (EPF) to NPS. EPF currently enjoys EEE (Exempt, Exempt, Exempt) tax concession. As per current provisions, withdrawals under the NPS attract tax under the EET (Exempt, Exempt, Taxable) system. This differential tax treatment will hinder transition from EPF to NPS. However, as per the draft of the DTC presented in Parliament, an EEE tax regime for NPS is being proposed.

History tells us that the Indian insurance industry follows the UK market. So, there is every possibility that the compulsory annuity condition now imposed under the NPS might not remain for long. Several experts are of the opinion that this is acting as a major stumbling block for many prospective customers to join NPS. Already, there is talk of allowing systematic withdrawals from the pension corpus like the income drawdown in the UK. Therefore, there exists a great chance of total tax-free pension freedom in NPS. The day it comes, NPS will surely turn into a real gold mine; that day is not far off.