Benefits of National Pension Scheme

The Benefits of National Pension Scheme can change drastically, if you know these options

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The benefits of national pension scheme changes drastically if you know the options available. The benefits of scheme can vary if you choose these options wisely.

The national pension scheme follows some sort of investment philosophy which we will discuss here. It’s categorized into two sections as per the investment philosophy.

The national pension scheme follows two investment philosophies broadly.

The first one is the Active investment asset allocation and the second one is the Auto investment asset allocation.

Both investment asset allocation depends upon the risk appetite of the investor. Some investors are keener to take a high risk to grow his/her wealth and some are more conservative and want more protection for their funds.

So before starting an investment, know your risk appetite because here is a matter of your retirement planning. A small mistake could cost you a lot & benefits of national pension scheme can change as per your preference.

There is a simple formula to knowing the risk appetite and that simple formula is if you are sleeping well after doing an investment, it means you are on the right way or vice versa. 

You have to make a balance between growth and protection of funds, and it varies from person to person.

So never ever just go by the advice of your colleague because he may not be the financial expert. You should take the advice of a financial expert to know the bits & pieces of this scheme then go for investment.

At the end of this read you would be able to understand the difference between active & auto investment asset allocation & how the benefits of national pension scheme changes with these allocations.

So let’s first discuss the active investment asset allocation.

Active Investment Asset Allocation

In the active investment asset allocation, we are the decision maker in which category we have to put our funds. There are four categories of asset allocation in the NPS that subscribers can choose.

Equity

The national pension scheme subscriber can choose the first category, which is the Equity investment class.

You can opt for an equity asset allocation maximum of 75% till the age of 50 years. After that with a reduction of 2.5% each year for the next 10 years.

Hence 25% equity exposure will reduce till attaining superannuation age. But still with 75% equity exposure till the age of 50yrs, you can make a good corpus, and with these benefits of national pension scheme changes drastically.

This feature itself has its own pros & cons.

The con of this scheme is that, suppose you have a good risk appetite and a good understanding of the stock market, then this will go against you.

But at the same time if your risk appetite not so good and your priority is the protection of your funds then it will work for you.

Ultimately you have to rein over your greed and fear.

Corporate Bonds Funds

The next asset allocation class for NPS investors is the corporate bond funds in which he can opt for a maximum of 100% funds allocation.

But before opting for it you must know what a corporate bond fund is.

Corporate bond funds are the funds in which private & public companies issue bonds to raise capital for a variety of reasons.

It may be for plant expansion, working capital requirements, or buying equipment.

Corporate bonds funds have a maturity time of more than one year and it’s a medium to long-term investment instrument.

The good thing about these bond funds is that it has to invest at least 80% of its asset in high-rated AA+ or above bond funds.

So, the security level of invested capital increases & earns more rate of interest than government securities with little risk.

In the event, that company bankrupts, in that case, corporate bonds funds holder get priority over equity investors.

They will get their money first then the shares holder of that company.

Government Securities

Government Securities asset allocation is limited to a max of 100%.

This is a safer investment option than the earlier two.

Persons who are very conservative and very near to their retirement can opt for this asset allocation.

The government securities are the bond funds that are issued by the central government and state government of India.

The issuance of these funds occurs when the central or state government is in need to raise the capital for building the infrastructure.

The bond funds issued by the central government are called the G-Sec bond funds while bond funds issued by the state government are called state development loans (SDLs).

These funds have a maturity time from 5 to 40 years.

Because these funds are issued by the central and state government, there is no risk of default and this feature enhance the safety of NPS invested capital but the benefits of national pension scheme reduces in terms of low return on investment.

Alternate Assets

The last asset class in Active Investment is Alternative Investments.

This asset class was created for the private sector national pension scheme investors in addition to the existing asset classes as stated above.

The maximum asset allocation in alternative funds is limited to a maximum of 5%.

These funds invest in REITs (Real Estate Investment Trusts), and IInvTs (Infrastructure Investment Trusts) regulated by SEBI (Securities and Exchange Board of India).

Along this, investments are also being done in commercial or residential mortgage-based securities, asset-backed securities regulated by SEBI, and Alternative Investment funds (AIF category I & II) registered with SEBI.

Now we will discuss the second investment asset allocation type which is called Auto Investment Asset Allocation

We have here three options to invest as per our risk appetite. Risk appetite plays a very pivotal role here.

Because in auto investment asset allocation, we have to do nothing except timely put money in NPS. So, let’s first understand first what risk appetite is.

Risk Appetite

Every investment asset allocation comes with its own level of risk.

Some investment options have a high-risk, high-return profile whereas some investment options have a low-risk, low-return profile.

Investors should understand their own investment behavior first.

It is generally observed that investors start their investment with the expectation of a high return but when the midway of their investment sees turmoil in their investment, they panicked and switch to some other safe investment options.

This is the biggest mistake committed by investors ever. That is why they never make a good amount of money in the end.

The meaning of risk appetite is the maximum amount of risk that you, as an investor, are ready to afford to fulfil your future objective before risk outweighs the benefits.

Suppose to get a return on investment of 15% CAGR (compounded annual growth rate), you have the chance to lose your capital by 30%.

But still want to invest in that investment option, then you fall under the high-risk appetite category.

High-risk appetite investors always prefer appreciation of their invested capital.

Because you already know if something went wrong, you could lose 30% of your capital.

In the same way to get a return of 8% CAGR, if you have the chance to lose your capital by 10% then you fall under the low-risk appetite category.

Low-risk appetite investors always prefer to preserve his /her capital first then appreciation.

Classification of investors based on their risk appetite.

Investors can be classified into three categories based on their risk appetite namely Aggressive, Moderate, and Conservative.

Aggressive Investors

Aggressive investors are those as already discussed always prefer their capital appreciation at the risk of losing a large chunk of their invested capital.

They prefer to invest in high-risk investment options like the stock market or equity mutual funds.

Moderate Investors

Moderate investors are those who want the preservation of their invested capital along with moderate to high returns.

They are risk-neutral people for their investments generally. They have a balanced approach toward their investments.

Conservative Investors

Conservative investors are those who always prefer the preservation of their investment although they have to suffer for inflation-adjusted returns.

They are risk-averse people. Such people prefer to invest in bank fixed deposits, government securities, bonds, and gold.

They are over-cautious with their investments.

So in the auto asset allocation mode in NPS, three options are given to choose

Auto Investment Asset Allocation

Investment Ka Gyan | The Benefits of National Pension Scheme can change drastically, if you know these options

Aggressive Life Cycle Fund (LC-75) Asset Allocation

In an aggressive life cycle fund asset allocation, you can invest up to 75% in the equity (E), 10% in Corporate Bonds Funds, and 15% in the Government Securities asset class till the age of 35 years.

The aggressive life cycle divided into three parts

Equity (E) exposure reduces by 4% per annum till the age of 45 yrs i.e., 40% reduction in equity exposure and only 35% equity exposure.

The reduced 4% part is invested into two other asset classes (C, G). 1% in corporate bonds (C) and 3% in government securities (G) till the age of 45 yrs.

Up to this equity (E) asset class has 35% exposure, corporate bonds (C) asset class has 20% exposure, and Government Securities (G) asset class has 45% exposure.

Equity (E) exposure reduces by 3% per annum till the age of 50 yrs i.e., 15% reduction in equity exposure and only 20% equity exposure.

Next to 45yrs till 50yrs the reduced 3% per annum equity exposure is invested in government securities and no exposure to corporate bonds funds asset class increased for next 5yrs.

Up to this equity (E) asset class has 20% exposure, corporate bonds (C) asset class has 20% exposure, and Government Securities (G) asset class has 60% exposure

Equity (E) exposure is reduced by 1% per annum till the age of 55 yrs i.e., a 5% reduction in equity exposure and only 15% equity exposure remains.

Then next to 50yrs till the age of 55yrs, the reduced 1% equity exposure annum invested in government securities along with a 2% exposure reduction per annum in corporate bonds bunds allocated to government securities for the next 5yrs.

Up to this equity (E) asset class has 15% exposure, corporate bonds (C) asset class has 10% exposure, and Government Securities (G) asset class has 75% exposure.

Moderate Life Cycle Fund (LC-50) Asset Allocation

In a moderate life cycle fund asset allocation,

you can invest up to 50% in the equity (E) asset class, 30% in the corporate bonds funds, and 20% in the Government Securities till the age of 35 years.

It’s the default option if the NPS subscriber does not choose any option from the ECG asset class.

The moderate life cycle (LC-50)

Equity (E) exposure reduces by 2% and corporate bonds funds exposure reduces by 1% per annum till the age of 55yrs i.e., Only 10% equity and 10% corporate bonds funds exposure left till the age of 55yrs

The reduced 3% part is invested in government securities (G) till the age of 55 yrs.

Up to this, the equity (E) asset class has 10% exposure, the corporate bonds (C) asset class has 10% exposure, and Government Securities (G) asset class has 80% exposure.

Conservative Life Cycle Fund (LC-25) Asset Allocation

This asset allocation is for those NPS subscribers who have a low-risk appetite.

In the conservative life cycle, the equity class has 25%, the corporate bonds class has 45%, and the Government Securities class has 30% exposure till the age of 35yrs.

The asset allocation of funds in a conservative life cycle is done till age 55yrs as follows.

Equity (E) exposure reduces by 1% and corporate bonds funds exposure reduces by 2% per annum till the age of 55yrs i.e., Only 5% equity and 5% corporate bonds funds exposure left till the age of 55yrs

The reduced 3% per annum part is invested in government securities (G) till the age of 55 yrs.

Up to this, the equity (E) asset class has 5% exposure, the corporate bonds (C) asset class has 5% exposure, and Government Securities (G) asset class has 90% exposure.

Conclusion

Based on the active/auto investment style, the benefits of National Pension Scheme can be varied to a large extent.

In the auto investment style, which one option do you choose out of three (aggressive, moderate, conservative), again makes the difference.

So, choose your investment style wisely as per your risk appetite.

Historically it’s observed that the equity asset class outperformed any other two asset classes ( C&G).

But as I already told you that NPS is a retirement solution and a long-term commitment, so you should have exposure to equity thoughtfully.

So, understand your risk appetite first then choose your investment style because the end-of-day peace of mind is above anything else.

What do you think about it? please comment.

Next, we will discuss asset allocation at the micro level & will understand how one pension fund manager outperforms another.

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5 Major Changes in National Pension Scheme What are 3 R of Investment? What is risk aversion? What is Risk Appetite? 7 Reasons To Invest in National Pension Scheme
5 Major Changes in National Pension Scheme What are 3 R of Investment? What is risk aversion? What is Risk Appetite? 7 Reasons To Invest in National Pension Scheme