The union government has recently notified the Unified Pension Scheme for its employees. The details of the scheme and its implementation will become clearer over the next few weeks. The information that is available, however, does provide some insight into the relative benefits of the National Pension System and the Unified Pension Scheme from an employee’s perspective. Both schemes have their risks, and employees will have to choose the risk that they are able to bear best.
How will assured pension be calculated?
Under the NPS, the employee and the government (as the employer) contribute 10 per cent and 14 per cent of the basic salary of the employee to the individual retirement account. Under the UPS, the employee will continue to contribute 10 per cent of salary to an individual fund. The government will match this amount of 10 per cent. The employee is likely to have some element of choice in how these contributions are invested in both NPS and UPS. Up to this point, the UPS is similar to the NPS.
In the UPS, the government will make additional contributions of 8.5 per cent to a pooled fund in the name of the employee. These contributions will be invested by the government, and the employee will not have a choice. While the sustainability of this approach depends on the investment strategy and governance structure of the pooled fund, the details are not yet clear.
There are three possibilities at retirement under UPS, assuming the employee has completed the minimum length of service.
Case 1: The individual fund value is equal to the individual’s value in the pooled fund. In this case, the employee will get a small lumpsum amount and a minimum assured pension equal to 50 per cent of the last twelve months of salary, plus dearness relief (or inflation adjustment).
Case 2: The individual fund is greater than the pooled fund. In this case, the individual can take the amount greater than the value of the pooled fund in addition to the minimum assured pension and the lumpsum.
Case 3: The individual fund is less than the pooled fund. The individual will have to make additional contributions to the pooled fund or have her pension reduced proportionately.
The gazette notification gives us several illustrations of how this would work. For simplicity let’s take the example of someone with a 50 lakh corpus and an average salary of Rs 45,000 at retirement. Under the UPS, the person ends up with a lumpsum of Rs 3,44,250 and an assured pension of approximately Rs 22,500 per month plus dearness relief. Further, the spouse is entitled to 60 per cent of this pension after the death of the employee.
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How does this compare to NPS?
Under the NPS, the final accumulation at retirement is used to buy an annuity from the market. Let’s look at the current annuity rates of the LIC immediate annuity plan. A corpus of Rs 10 lakh will buy you a joint annuity—similar to that of the assured pension—of about Rs 83,800 per year. Let’s take the example of Rs 50 lakh corpus. A lumpsum withdrawal of about Rs 3,50,000 leaves us with a corpus of Rs 46,50,000. This can buy an annuity of almost Rs 3,90,000 per year, or about Rs 32,500 per month. If one were to assume that the dearness relief is about Rs.10,000, then at current rates, the NPS annuity is competitive with the UPS pension.
The value of the UPS relative to the NPS depends on two factors. First, is the amount of time spent in the NPS. Employees who joined the NPS later in their careers might find it beneficial to join the UPS, as they would not have built up their corpus to buy a significant annuity. This is not true of those who will be in the system for 30 years or more.
Second, is the amount of dearness relief that employees can expect. This is the most important differentiator between the NPS and the UPS. The annuity in the NPS is not inflation-indexed. At best one can buy an annuity that increases by 3 per cent every year. The monthly payout in this case would be Rs 28,500 per month instead of the Rs 32,500 described earlier. However, this option does not provide the spouse with a pension.
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The risks in the two systems
In the NPS, the employee bears two main risks. First, the returns on the contributions will be low, and therefore, the employee will not build a higher corpus leaving the employee unable to purchase a good annuity.
Second, is the risk of inflation. Even if the nominal annuity appears adequate at retirement, persistently high inflation can significantly reduce the real value of the monthly payout. Over decades, a high inflation environment could render the nominal annuity insufficient to meet basic living expenses. The impact of the inflation component depends on how successful we expect the inflation-targeting regime to be. If the RBI is able to stick to a target of 4 per cent (or lower), then the erosion in purchasing power may be less corrosive.
In contrast, the UPS—designed to provide a defined benefit—faces the risk of a low pension at retirement, at least relative to what the corpus can buy in the market. As described in the example above, it is quite possible that annuitising the corpus will provide a payout at retirement that is higher than the 50 per cent replacement rate. The UPS provides better inflation protection than the NPS, because of the dearness relief component. However, it runs the risk that future pay commissions may adopt a more conservative stance on dearness relief adjustments.
Finally, the sustainability of the UPS depends on how well the government manages its pooled fund. The assumption that any losses on that fund will always be recouped because governments never renege on pension payments may be the biggest risk.
Renuka Sane is managing director at TrustBridge, which works on improving the rule of law for better economic outcomes for India. She tweets @resanering. Views are personal.
(Edited by Theres Sudeep)
This is a downright misleading article. I suggest that all people opt for UPS without hesitation.
The author, like all other authors on this topic, has taken an accountant’s view of the two options. This article represents the narrow view of bean-counters.
In NPS, an employee needs to be financially smart.
In UPS an employee with no financial acumen, which is most Govt. employees, will get pension every month. If the employee is financially smart, he can separately invest in financial instruments over and above UPS.
That is not all there is to it. What about the psychological and emotional sense of security that there will be money coming in at the beginning of every month after retirement – priceless. What about the sense of security that the spouse will get family pension after the employee’s death – even more priceless.
The proof of the pudding is in the eating. I predict that more than 95% of the Govt. employees will switch from NPS to UPS. Almost all women employees are likely to switch to UPS due to the sense of security it gives over the long term. For men employees, even if they want to go with NPS, a few discussions with their wives and looking at their children will convince them to go with UPS.
The author and other bean counters don’t seem to understand that the older one gets more money is not so important as guaranteed money every month.
Once again, I recommend all to go with UPS over NPS to avoid a lifetime of regret.