EPF Versus NPS. Should You Switch?

Good old EPF or 'new kid on the block' NPS? While Indian retirement savers await clarity from the Government on the precise modalities of the proposed option to switch from EPF to NPS, it's worth taking a moment to consider whether such a switch will be in your interest (no pun intended!), if and when the option should come up.

EPF and NPS are fundamentally different investments per se. EPF provides a fixed rate of return (revised by the Government from time to time), whereas the NPS provides a variable, market linked return in the same way that a mutual fund would. In fact, it is mutual fund companies that operate these pension funds as appointed 'pension fund managers'. The current EPF rate stands at 8.6 per cent.

NPS provides three fund options: E (Equity), G (Government Bonds) and C (Corporate Bonds). Given that the maximum 'E' exposure is capped at 50 per cent, NPS essentially functions like a balanced mutual fund.

Various factors, such as the taxability of maturity proceeds, the expected long term returns, annuity clauses and political influences on both products complicates the choice between NPS and EPF greatly. In the end, you'll be surprised to discover that there's not much to separate the two.

Rather than spouting jargon, I'll use a simplistic example to illustrate the relative merits and demerits of both sides to you, before giving you my final recommendation.

How the numbers add up
Let us assume you're 35 years old (which is when most people seriously start thinking about their retirement), and you start putting away Rs. 5000 per month, stepping this up by 10 per cent per annum (a reasonable estimate). Using long term returns from balanced funds as a yardstick, you'll likely end up earning between 10 per cent and 11 per cent (annualized) on your NPS corpus - leading to an accumulated fund of 1.65 to 1.87 Crore. As a reasonable estimate, let's assume that this amount will be 1.75 Crore.

In addition, you'll receive an additional tax saving of up to Rs. 16,000 per annum under Section 80CCD by investing into NPS. Assuming you'll receive this average benefit for around 15 years, that amounts to a total tax saving of roughly Rs. 2.5 lakh over the course of 25 years. Not much to write home about.

Historically, EPF rates have varied from 8 per cent to 12 per cent per annum. Keeping that in mind, let's assume that the long term average return from your EPF investments will be close to 8.25 per cent. In such a scenario, your final balance will be close to 1.44 Crore (a 20 per cent lower amount compared to a reasonable NPS estimate). No surprises there - it's a known fact that over the long run, a 3-4 per cent difference in annualized returns can make a significant difference to one's final accumulated amount.

Intuitively, the 'percentage difference in final fund value' between NPS and EPF will be lesser for shorter time frames - the estimated corpus difference is 13 per cent for a 20 year saving time frame, and just about 8 per cent for a shorter time frame of 15 years.

Different exit point clauses
NPS rules currently mandate that 40 per cent of the final corpus must necessarily be used to buy an annuity from a life insurance company, whereas 20 per cent of the proceeds will be taxable. 40 per cent of the corpus can be withdrawn as a non-taxable lump sum. EPF rules impose no such restrictions.

Continuing with our previous example, this implies that the NPS investor will need to buy an annuity for Rs. 70 lakh and will receive another 94 lakh (ballpark) after taxes as a lump sum amount. Annuities are low return products, and their returns are fully taxed - this would imply that the NPS investor would receive a post-tax annuity of approximately Rs. 35,000 per month from this annuity, and be free to generate a synthetic income (from rent, mutual funds, bonds and the like) from the remaining 94 lakh.

The EPF investor, on the other hand, will receive a tax free amount of Rs. 1.44 Crore (recent scares notwithstanding!), and be free to generate a synthetic income from this entire corpus.

Taking a reasonable assumption of a 10 per cent annualized return (post tax) on the retirement corpus in both cases, a life expectancy of 85 years, and inflation of 6 per cent - the EPS investor would actually be able to make post retirement drawings of close to 4.6 Crores from ages 60 to 85, compared to the NPS investor's 4 Crores (annuity income included). That's a significantly higher number.

So here's the conclusion: under a rational set of assumptions, it would seem that sticking with an EPF investment is in fact a better bet. NPS is a great investment on paper, and the intentions associated with it are undeniably noble (diverting a larger percentage of Indian retirement savings to high growth equity assets). However, the taxability and the forced annuity purchase tilt the balance in the favour of it's more trusty counterpart, EPF. Having said that - if any or both of the above factors were to change materially, this evaluation would warrant a revisit.

A final word - why not look beyond government mandated schemes and look at plain vanilla mutual fund SIP's as a long term retirement savings option instead? Most top ranked funds will likely continue to outperform the broader indices, and there are no restrictive clauses attached to what you can do with the final proceeds. To my mind, they represent the best retirement saving tool available to investors today.