Pension Funds: Choosing The Right Investment For Your Future

Choosing the right pension fund is an important decision, and there are many options to consider. Pension funds are a type of retirement plan that allows individuals to build a substantial corpus to achieve their goals and fulfil their family's aspirations after retirement. In India, one of the most popular pension products is the National Pension Scheme (NPS), which offers low-risk investment options with good returns and tax benefits. When deciding which pension fund to invest in, it is essential to consider factors such as investment horizon, risk tolerance, and post-retirement income requirements.

Pension fund managers

When choosing a pension fund manager, it is important to examine their past performance and returns. Different pension fund managers perform well in different asset classes, so you can choose to have different fund managers for different asset classes. However, for Scheme A, you will have to choose one of the three fund managers that you selected for Schemes E, G, and C.

• ICICI Prudential Pension Fund Management: Offered the highest 1-year returns on equity investment in Tier-1 accounts (28%).
• Tata Pension Management: Their Tata AIA Top 200 pension fund gave the highest returns of 27.30% in the past 5 years.
• HDFC Pension Management: Ranked as the best pension fund manager based on average 5-year rolling returns across different asset classes.
• Aditya Birla Sun Life Pension Management: Ranked within the top 3 for average 5-year rolling returns in Scheme E and Scheme G.
• LIC Pension Fund: Ranked within the top 3 for average 5-year rolling returns in Scheme G and Scheme C.
• SBI Pension Funds Pvt. Ltd.: Ranked within the top 3 for average 5-year rolling returns in Scheme E and Scheme C.
• UTI Retirement Solutions Ltd.: Generated the best returns of 8.89% in the past 5 years under the NPS Central Government Scheme.

Tier 1 and Tier 2 accounts

When it comes to pension fund investment, individuals have various options, including Tier 1 and Tier 2 accounts. These two types of accounts represent distinct retirement plan options with different benefits, risk levels, and flexibility. Here is an overview of Tier 1 and Tier 2 accounts to help you understand their key features and make informed decisions about your financial future:

Tier 1 Accounts:

Tier 1 accounts, also known as defined benefit (DB) plans, offer a guaranteed payout or retirement income based on factors such as years of service and salary. This means that employees can expect a steady and predetermined income stream during their retirement years. The financial risk associated with Tier 1 plans falls on the employer, ensuring that employees receive their promised benefits regardless of market fluctuations. Tier 1 accounts are often tied to specific employers or industries, and they may have less flexibility in terms of investment choices and portability between jobs. Additionally, Tier 1 accounts usually come with a longer lock-in period, restricting early withdrawals.

Tier 2 Accounts:

Tier 2 accounts, on the other hand, are known as defined contribution (DC) plans. In this type of plan, the employee and/or employer contribute a set amount to a retirement account, and the final payout depends on the performance of the investments. Tier 2 accounts offer more flexibility in terms of investment options and portability. Employees have greater control over their investment choices and can tailor their portfolios to their risk tolerance and financial goals. Tier 2 accounts typically do not have a lock-in period, allowing for more accessible withdrawals. However, it's important to note that Tier 2 accounts do not offer the same guaranteed payout as Tier 1 and carry increased risk for employees, as their future retirement income depends on investment performance.

Key Differences:

The main differences between Tier 1 and Tier 2 accounts lie in the calculation of benefits, risk levels, flexibility, and responsibility for funding and managing retirement savings. Tier 1 plans provide a guaranteed payout, financial security, and stability, while Tier 2 plans offer flexibility, control over investment choices, and easier portability between jobs. Tier 1 plans are often associated with higher costs and financial risks for employers, which has led to a shift towards offering Tier 2 plans in recent years.

National Pension System (NPS) in India:

In India, the National Pension System (NPS) offers Tier 1 and Tier 2 accounts. NPS Tier 1 accounts serve as the primary retirement fund-building option, while Tier 2 accounts provide greater flexibility for deposits and withdrawals, similar to a voluntary savings account. NPS Tier 1 accounts offer tax benefits under various sections of the Income Tax Act, allowing for deductions of up to a specified limit. While NPS Tier 2 accounts do not offer the same tax advantages, they provide subscribers with the ability to make early withdrawals to manage different expenses.

Both Tier 1 and Tier 2 accounts have their advantages and disadvantages. Tier 1 accounts offer guaranteed income and financial stability, while Tier 2 accounts provide flexibility and control. When planning for retirement, it is essential to understand the differences between these accounts and make informed decisions based on your financial goals and risk tolerance.

Active vs auto investment choice

When investing in the National Pension System (NPS), you have two options for managing your money: Active Choice and Auto Choice.

Active Choice

The Active Choice option is for those who wish to take control of their investments by deciding their asset mix. You can choose the ratio in which your contributions will be invested among the four available asset classes: Equity, Corporate Debt, Government Bonds, and Alternative Investment Funds. However, there are limitations to this option. For instance, the maximum allocation to equities is restricted to 75%.

Auto Choice

The Auto Choice option is suitable for people who prefer a passive investment approach. This option is for passive investors who want an automatic allocation to decide the proportion of money spread across the available asset classes. The allocation adopts a life-cycle-based approach, starting with an equity-heavy portfolio during the subscriber's younger age and reducing equity exposure as the subscriber gets older. Under the Auto Choice option, you can choose between three life-cycle funds: Aggressive, Moderate, and Conservative.

Active vs Auto Choice

The Active Choice option is best for those who understand the nuances of equity and debt allocation and how it works over time. If you have the time and skill to actively switch/rebalance your NPS corpus regularly and in line with your risk tolerance and goals, then the Active Choice is for you. On the other hand, if you are unable to do any or all of these and want to outsource asset allocation decision-making, then the Auto Choice is a better option.

Tax benefits

Pension funds are a type of plan where employers, employees, or a combination of both pay into a fund to provide retirement benefits to employees. Typically, pension funds don't have to pay capital gains taxes, which allows the assets in the funds to grow faster over time. However, while the pension fund itself does not have to pay these taxes, the distributions to the employees will be taxed at the beneficiaries' income rates.

In India, the National Pension Scheme (NPS) is one of the country's most accepted pension-oriented products. The NPS scheme allows all Indian citizens and NRIs to invest in low-risk equity funds, security funds, or alternative investments with good returns. Investing in NPS will give you an edge over fixed-income schemes and allow you to avail tax benefits up to Rs.1.5 lakh under Section 80C and Section 80CCD of the Income Tax Act, 1961, depending on the type of account, i.e. Tier-I or Tier-II. While the lock-in period on NPS schemes is until retirement, you can choose to withdraw your funds prematurely in specific cases to cater to unforeseen financial requirements.

In the United States, traditional pension plans, known as defined-benefit plans, are becoming less common. They are being replaced by defined-contribution plans such as the 401(k) retirement savings plan, which is less costly for employers. Both types of pension plans allow the worker to defer tax on the retirement plan's earnings until withdrawals begin. This tax treatment allows the employee to reinvest the full complement of dividend income, interest income, and capital gains, which can generate a much higher rate of return over the years before retirement compared to if they were taxed.

Overall, pension plans offer tax benefits that can help individuals save for retirement. However, it is important to consider the specific rules and regulations that apply to pension plans in different countries and the potential tax implications of distributions.

Withdrawal options

The National Pension System (NPS) offers two types of accounts: Tier 1 and Tier 2. Tier 1 is a compulsory retirement account with a longer lock-in period of 15 years, even for partial withdrawals. It is designed to provide income after retirement. On the other hand, Tier 2 is more like a savings account, offering greater flexibility in terms of withdrawals. However, investments in Tier 2 do not offer tax deductions.

Tier 1 accounts offer additional tax deductions of 50,000 per year. Under the Income Tax Act, 1961, investing in NPS can provide tax benefits of up to Rs.1.5 lakh under Section 80C and Section 80CCD, depending on the type of account. While the lock-in period for NPS schemes is until retirement, premature withdrawals are allowed in specific cases to cater to unforeseen financial needs.

The NPS scheme also allows subscribers to choose between auto and active investment choices. With the active choice, subscribers can manually determine the plan and percentage of funds they wish to invest in across different asset classes: equity, government securities, corporate debt, and alternative investment funds (AIF). The auto choice, on the other hand, allocates investments based on the subscriber's age and risk profile.

It is important to note that the rules regarding the withdrawal of funds and mandatory clauses should be understood before investing in NPS. Additionally, there are different pension fund managers to choose from, and it is vital to examine their past performance and returns before making a decision.

Frequently asked questions