Should you pick UPS or NPS? It depends on the risk of inflation

Even if the nominal annuity appears adequate at retirement for the NPS, persistently high inflation can significantly reduce the real value of the monthly payout.

The Print
29 January 2025

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.

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.

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.

Indians can’t invest retirement funds internationally. Govt should study the viability

With the Union Budget coming up, there are a host of measures India could take to improve its pension system. The first one is clarifying the difference between NPS and UPS.

The Union Budget is around the corner. And this article makes a few suggestions on measures the government could take to improve India’s pension system.

Difference between NPS and UPS

In August 2024, the government announced that central government employees in the National Pension Scheme (NPS) would have the option to switch to a “Unified Pension Scheme” (UPS). While the details of the UPS remain unclear, it is likely that the UPS will have a component of assured returns, and will strain public finances over the long term. If the UPS is perceived as synonymous with the NPS, it could mislead those not employed by the central government into thinking that the NPS offers guaranteed returns. The government must promptly clarify the UPS’ details and ensure clear communication to distinguish it from the NPS.

Choice between the EPF and the NPS

The Employees’ Provident Fund (EPF) managed by the Employees’ Provident Fund Organisation (EPFO) is the retirement vehicle for those in the private sector. The EPFO provides assured returns while NPS returns are market-linked. The EPFO is the default choice in most private-sector firms. Participation in the EPFO is mandatory only for employees who earn a basic salary of less than Rs 15,000 per month and are employed in specific formal sectors. It is potentially voluntary for those who earn more than Rs 15,000 per month. The Ministry of Finance could clarify this provision to further facilitate employees to choose between the EPF and the NPS. Critics would argue that EPF provides assured returns while NPS does not, and therefore, no one would want to shift to the NPS. That may well be true. The legacy advantages of the EPF may mean that most members will likely stay with the EPFO. But the point of such a policy is to only provide the opportunity for choice. Individuals should ideally have the freedom to decide what best secures their future. In fact, choice between the NPS and the EPF can spur healthy competition between schemes.

Partial withdrawals at retirement

The EPF currently only allows for lumpsum withdrawal at retirement. The NPS, on the other hand, requires the member to use at least 40 per cent of the corpus to purchase an annuity. While a full lumpsum withdrawal might mean that the retiree runs out of wealth over time, mandatory annuitisation might mean that the retiree does not get her money’s worth, especially if the annuities markets are not mature. Annuitisation also implies that the wealth cannot be bequeathed to heirs, if the retiree dies relatively early. A scheme for partial withdrawals might provide a middle ground—allowing retirees to keep their wealth, while drawing it down over the years. The government should consider alternatives for both the EPF and the NPS, such as allowing retirees to manage their funds through systematic withdrawal plans or offering annuity products with greater flexibility and transparency. These changes will require an amendment to the respective Acts, and should be done through a process of stakeholder consultations.

Leveraging NPS and APY for gig workers

The gig economy has become an important component of our informal sector workforce. There have been multiple efforts at providing social security for gig workers. But more schemes under newer welfare boards are not going to provide retirement security. The Budget could take the opportunity to announce the intent of building the necessary infrastructure to integrate gig workers into the NPS and the Atal Pension Yojana (APY). Both schemes are already functioning, scalable, and can accommodate diverse segments of the population. The NPS is a flexible scheme, and has a low-cost structure. Gig workers with irregular income can contribute to the NPS when they have the funds. The APY provides guaranteed returns and can provide a safety net for those at the lower end of the income spectrum. Rather than fragmenting the market with new schemes, the government should invest in awareness campaigns, simplified enrolment processes, policies to accommodate gaps in the contributions due to job loss or lack of income, and digital tools that make participation in these existing systems seamless. Further, the government should ensure that the APY continues to be financially sustainable. These measures can ensure that gig workers are not left behind in the broader push for financial inclusion and retirement security.

Evaluate international diversification

India’s retirement savings are invested domestically. The Pension Fund Regulatory and Development Authority Act for example does not allow for funds to be invested in international markets. A lack of international diversification means that Indian savers miss out on the growth and stability opportunities presented by global markets. Critics would argue that international diversification would subject retirement funds to greater risk without adequate returns, especially in an environment of global uncertainty. However, this is an empirical exercise that can certainly be conducted for historical data. The government could announce its intent to constitute a committee that would study the issue of international diversification in retirement savings. The committee could examine best practices from other countries, and evaluate the risk-return trade offs. The study could simulate what portfolio returns and risks would have been had we allowed for international diversification decades ago, including historical periods of economic turmoil. This could become the basis for a phased approach to incorporating global investments into Indian retirement portfolios.

Social pensions

Social pensions—non-contributory payments provided by the government to destitute elderly—play a vital role in ensuring basic income security. The Indira Gandhi National Old Age Pension Scheme (IGNOAPS) under the National Social Assistance Programme (NSAP), provides pensions to elderly individuals living below the poverty line. One of the policy agendas on pensions has to be to evaluate how well the IGNOAPS is faring on the adequacy of benefits, coverage and delivery mechanisms. Accordingly, budgetary allocations must be made to improve its outreach and impact.

The decisions made in the upcoming Budget have the potential to affect retirement wealth for millions of workers. By prioritising choice, flexibility, and global integration, the government can lay the foundation for a system that provides adequate benefits while being financially sustainable.

The article was published in the Print, 15 January 2025.

India’s BUDS Act needs urgent review. Flaws show govt didn’t do cost-benefit analysis in 2019

The Banning of Unregulated Deposit Schemes Act 2019 provides local police the power to search and seize without a judicial warrant.

It has been more than a decade since the Saradha and Rose Valley schemes, which had taken money from households with the promise of high returns, made headlines. The Government of India enacted the Banning of Unregulated Deposit Schemes Act 2019, also known as the BUDS Act, to protect investors from such fraudulent products and practices. Further, the Central Registry of Securitisation Asset Reconstruction and Security Interest of India – CERSAI – was designated as the authority to establish a publicly accessible portal that would provide information on deposit takers.

Since early 2024, CERSAI has been requesting information from all regulated entities defined under the BUDS Act, including capital market players such as mutual funds and Alternative Investment Funds (AIFs). This brings to light the first flaw in the drafting of the BUDS Act – the definition of a regulated deposit scheme. This assumes more importance because of the second flaw in the Act – the power to carry out search and seizure operations without a judicial warrant.

Deposits and capital markets

In the context of finance, a deposit is a sum of money that is given with the expectation that the money will be repaid with or without returns. We put down a deposit when we want to rent a house, and invest in a fixed deposit expecting an agreed upon rate of return. The defining feature of a deposit is the assurance of repayment, in that the landlord or the bank does not have the discretion to not return the money. This obligation is central to the essence of a "deposit".

In contrast, the defining feature of capital market products such as equities, mutual funds, and AIFs, is the absence of the promise to return the money invested. When we buy shares of a company, we acquire ownership of the company to the extent of our shares. When we invest in mutual funds, we buy into a pool of diversified assets, whose value fluctuates based on the underlying assets. When we invest in an AIF, we buy into even more sophisticated risk-return tradeoffs. The essence of all these products is that there is no assurance of a return, and no money-back guarantee. This distinction has regulatory implications. Deposits are subject to more stringent regulations around risk-taking as there is a promise that has to be honoured. Capital market regulations protect against fraud, but not against risk.

The definition of a deposit in the BUDS Act recognises this distinction. According the Act, “A deposit is an amount of money received by way of an advance or loan or in any other form, by any deposit taker with a promise to return whether after a specified period or otherwise, either in cash or in kind or in the form of a specified service, with or without any benefit in the form of interest, bonus, profit or in any other form…"

But the Act contradicts its own definition of a deposit, ignoring the fundamental difference between a deposit and a capital market product by including the latter in the definition of “regulated deposit schemes”. It is possible that capital market products were included in this list because they are regulated products. But just because one is a regulated product does not mean it should be classified as a deposit scheme.

Search and seizure

The BUDS Act further provides local police the power to search and seize without a judicial warrant. For example, if the police receive information about a company running an “unregulated deposit scheme”, it can raid the premises without seeking approval from a court. It is not hard to understand where the desire for granting such powers is coming from. It’s important for authorities to take swift action to protect vulnerable depositors from fraudulent schemes. However, if this protection comes at the cost of the erosion of procedural safeguards, there’s the possibility of unchecked power leading to harassment, extortion, or targeting of political and business rivals.

Further, unchecked state power has economic and social consequences. Businesses that operate genuine deposit schemes may feel threatened by the possibility of sudden interventions by authorities on the basis of information that may be false. Citizens may begin to perceive the law not as an instrument to help them, but as an instrument of coercion. Unchecked power, however well-intentioned, carries the seeds of its own excess. The sidelining of judicial oversight is to risk undermining the legitimacy of the law itself.

It is not clear whether the BUDS Act, passed in 2019, went through a rigorous process of cost-benefit analysis and stakeholder consultation. It is likely that it didn’t because these gaps would have been recognised in the process. Further, any legislation should be reviewed every few years to understand if it has had the intended impact, and to measure unintended consequences that may have arisen. The BUDS Act should go through such a review.

The article appeared in the Print on 8 January 2025.