8th July – Fix design flaws in NPS to make it more appealing

By 2031, the elderly population in India is expected to grow as much as 75%. However, as the RBI Household Finance Committee highlights in its report, a large fraction of the elderly does not have adequate resources to finance consumption during retirement.

There is hope—the National Pension System (NPS) is, by and large, a good product. However, several problems with its design and tax incentives have impeded Indian households from adopting it.

Fix design flaws in NPS

The NPS –

  • NPS is a strange hybrid. It offers tax deduction on commitments—an NPS-specific deduction of ₹50,000 in addition to a ₹1.5 lakh umbrella deduction for long-term savings (including Employees’ Provident Fund and PF contributions) under Section 80C.
  • However, it also exempts some withdrawals—lump sum withdrawals (up to 60% of the amount)—though the annuitised fraction (a compulsory 40%) is taxed.

Flaws in the design –

There are at least three problems with this design.

  1. The first is the complexity involved in NPS tax treatment. Anything difficult to explain is difficult to sell to households, who respond strongly to tax incentives.
  2. The second problem with NPS is that the design complexity is counterproductive in other ways. The scheme taxes annuitised amounts, but rebates exempt lump sum withdrawals. This disincentivises annuitisation.
  3. The third problem is that NPS-specific tax deduction of ₹50,000 is tiny relative to the income level of the desired savers. According to the Ministry of Statistics and Programme Implementation (MOSPI), the per capita income in FY2018 was ₹1.13 lakh per annum. This income level is certainly many multiples higher for the segment of the population that has the resources to invest in NPS.

What must be done?

In order to tackle the above mentioned challenges, respectively, we should –

  1. Streamline these incentives—either tax only on entry, or only on exit.
  2. Treat lump sums in the same way as annuitised amounts; and push up the compulsory annuitised fraction while you’re at it.
  3. Raise the deduction exemption threshold for NPS commitments.

Way forward –

  • Changes to the design should be complemented by changed incentives to distribute NPS. The current low level of distribution incentives are clearly insufficient to persuade distributors to sell the product. The government could raise these caps, perhaps by increasing trail commissions.
  • Another solution is to enrol households into NPS by default, when they enter formal employment. This could be complemented by rationalising the current pensions vehicles (EPFO, PF, Atal Pension Yojana), in favour of backing a single product with excellent design features.

Conclusion –

Help for current and future retirees is a continuing need. While the NPS wasn’t fixed in this budget, let’s hope it will be in the next one.


Also read: 6th July – The case for a nudge in the right direction