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Commenced: 26th September, 2023.
First draft: 12th November, 2023
Final draft: 10th November, 2024
One person pretends to be rich, yet has nothing;
another pretends to be poor, yet has great wealth.
~~ Proverbs 13:7, The Bible
Key words and themes: Building a family corpus and legacy; Financing the family's future; Annuities and their import; The meaning of capital; The definition of a marketable security; Savings vis-a-vis investing; Warehousing of marketable securities; Being a banker unto oneself;
Preface
When it comes to money, the prudent course of action for most individuals is to park their savings inside regulated and standard arrangements. Indians are a lucky lot as they can avail of two off-the-shelf ready-to-cook products called the Public Provident Fund (PPF) and The National Pension System (NPS) open to the general public since May 2009. In addition, there is an important role for the much derided (and more often than not, wrongly sold) non-term life-insurance policies, provided the policies are simple and straightforward, without too many bells and whistles attached, and are purchased at the right time through the right channels.
Yet, time and again, individuals are tempted by the esoteric, the novel, and the popular. The constant desire to act and move money around without rhyme and reason results in an avoidable inevitability: inspite of earning much many fail to let their money make a material difference to the quality of the choices they make through the remainder of their adult lives. More money then only lands up in engendering more hassles.
While this primer centres on the NPS it does so from an overarching personal finance architecture outlined here. Being a product of many moving parts, the NPS affords an excellent opportunity to use its service to bring out some principles of life-long importance that underlie that architecture. Thus, even though this primer starts from the NPS, it ends up on a very different note: the idea of being a 'banker unto oneself'.
That is a powerful idea which can cut both ways and for that reason not meant for everyone. It will appeal largely to those who love getting under the skin of their money-management – which involves having familiarity with the basics of accounting and book-keeping, possessing an interest in keeping abreast of regulatory changes, and finding that time everyday to curate their balance-sheet. They will be able to appreciate and implement it. It is not advisable that the casual reader blindly apply what is stated hereunder.
Nonetheless, this primer has something to offer even to the casual reader in form of an intuitive grasp of the NPS along side some interesting terminologies and concepts. Self-education, after all, is never in vain, and clearly what is presented is not financial advise but a financial perspective and an education based thereon.
Given its educational emphasis, this primer is not an instruction manual, scarce supplying read-made answers, being content instead to provide concepts, use-cases, and examples, all in the aid of building a system of thinking about deploying hard-earned savings.
In the same vein, while this primer eschews the specific, it is nonetheless detailed, explicit and repetitive so as to drive key concepts home. This repetition will prove valuable for those who will most likely constitute this primer's primary audience: those not earning high income but who still take pride in handling their money responsibly. Their lack of financial training is no deterrent to their discharge of this responsibility as they are those who wish to create an inter-generational family nest-egg. For,
A good man leaves an inheritance for his children's children,
but a sinner's wealth is stored up for the righteous.
~~ Proverbs 13:22, The Bible
Repetition and details may therefore help such individuals to bring common financial terms inside their daily family conversations. It may also be noted that instruments like the PPF and the NPS are subject to regulatory changes from time to time, and while every effort may be made to keep this primer updated there is no guarantee that some regulatory change has not overtaken this primer. Hence, the reader is strongly cautioned to cross-check and verify the regulatory aspects stated hereunder directly from the concerned website of The NPS Trust.
Ultimately, when it comes to savings, financing, and investing, there is no substitute for a paper and pen ready-at-hand. To come to terms with any concept in finance requires working it out by hand – several times sometimes – before it sinks deep as accounts and arithemtic upon which the edifice of finance rests engage in no correspondence with the desires of the heart. They are governed by strict conventions and rules and strictness is learnt by following it faithfully. This duet of pen and paper helps inscribes the rules of finance onto the mind, and once firmly imprinted it is difficult to dislodge them, perhaps even to the irritation of those around.
(N.B. The reader will find this primer punctuated by text in brackets such as this, beginning with N.B. in italics. He may skip over it on the first reading without incurring significant loss of meaning, but inside many of them he may come across a few first-principle concepts that have little to do directly with the field of finance.
While finance is about money, money itself cannot be spoken of without reference to the principles that govern how men live. And it is for this reason that quotes from The Qur'an and The Bible are also suitably interspersed as in their brevity they compress more truths about financial wisdom than what the textbooks of finance struggle to get across. For, without exception, it is ultimately wisdom which gives feet to knowledge.)
For those who are curious to know the sources that sparked the building blocks of this primer, may make note of the following books, publications and sundry online material. (These are in addition to those listed at the link given above.)
1. "Security Analysis" by Benjamin Graham and David Dodd (Seventh Edition).
2. The letters of the Chairman to the shareholders of Berkshire Hathaway.
3. The Merriman Financial Education Foundation.
4. "The Infinite Banking Concept" by Nelson R. Nash (Fifth edition).
5. "A Safety-First approach to Retirement" by Wade Pfau (2019).
6. "In defense of annuities: from accumulation to decumulation" by Moshe A. Milevsky (2021).
7. The mechanics of money as it exists today, as covered through the library of videos housed at the "Eurodollar University" channel on YouTube.
8. Michael W. Green, who is able to bring an integrated approach to thinking about finance, i.e. piecing together variables from real economy with financial ones to forge a narrative which intuitive thinking can absorb. His writings are accessible at his Substack.
9. The nuances of practising 'privatized banking' as outlined in point #4 (above) at the level of a family / family-business at "The Money Advantage Podcast" channel on YouTube.
If the diligent reader, for lack of time, wishes to pick up only one of the above, the recommendation is to pick #4, i.e., "The Infinite Banking Concept" by Nelson R. Nash. It is bound to change the way what the mind makes of money.
Introduction.
To begin a consideration of the NPS is to start from the idea of accumulation: the notion of taking a portion out of a family's monthly savings kitty and putting it aside undisturbed so that it builds up over a period of a generation – twenty to twenty-five years – thereby accumulating a sizeable corpus. (It is important to note that accumulation is carving out a small yet vital portion of the total savings and not appropriating entirety of the savings.)
The purpose of such a family-corpus is to meet known expenses of the future when other source(s) of income are likely to prove inadequate. And for long, life-insurance policies were used to serve this purpose, and they still can and do. But today along-side them, it is also possible to use the idea of warehousing marketable securities.
The decision to use marketable securities however is governed by the time-to-the-future when the services of such a corpus may be called upon. If such time lies at some distance then it offers the possibility to divert a reasonable portion of family-savings to marketable securities, i.e., stocks and bonds. And for the vast majority of lower and middle-class urban Indian families, the mechanism of the NPS is a convenient means to do so.
The usage of the term 'family' may seem quaint but it is not without reason: for neither the terms 'individual' nor 'household' quite fit the charter. In choosing to contract long-term financial arrangements lies the act of stewarding money which by necessity demands a purpose.
That purpose cannot draw from the wells of "fulfilling one's passion" or "to exercise the ghosts of YOLO". Such desires suffer not only from superfluity but are not befitting the sacrifices that instruments with a very long lock-in such as the NPS demand. Money is commaned by only one singular purpose: to give tomorrow a chance to raise itself upon the good graces of today.
Family is the smallest and the most versatile as well as adaptable of social units tasked with this charge. Values, which form the soil of civilisational continuity, cannot gain hold outside the confines of a family or a family-like set-up. Behind the act of stewarding of money is revealed the convergence of the entire system of values of any family.
Accountability towards money therefore presents the singular test of how the present has behaved with regard to the past and what is it going to direct to the future. The attitudes and actions inculcated with regard to money are what join or break apart at least three generations. Money in its essence, is an ability to lay claim on the material resources of today so that we sustain and further ourselves in the right manner tomorrow.
And when We said: "Enter this city, and eat freely of it wheresoever you will. And enter the gate in submission, and say: 'A mitigation! We will forgive you your offences, and will increase the doers of good."
Then those who did wrong changed the saying to other than what was said to them, so We sent down a scourge from the sky upon those who did wrong because they were perfidious.
~~ 2:58-59, The Qur'an
This act of stewardship over long periods of time makes it particularly suited to the idea of marketable securities. In shorter time-frames all long-term marketable securities are afflicted with unpredictable changes in their prices: for them to fulfil the purpose implied by their name ('a security"), they necessarily demand longer holding periods. It is an inconvenient but inescapable truth.
This idea of a holding period is more properly labelled as time-preference in the field of economics. Traditionally, the notion of wealth was primarily confined to productive tangible objects including agricultural land, forest land, cattles, and physical metals amongst others. All of these, without exception, demanded that their owner keep them for long for them to be of proper use to their master.
For instance, forests harvested for a particular kind of wood did not grow in a matter of a year, 5 years, or 10 years. It took at least one generation to cultivate a forest area for the next generation to reap its rewards. Thus, the idea of very low time-preferences (i.e., long holding periods) was intuitive and integral to predecessors of modern and post-modern minds.
Today, though, when wealth has come to overwhelmingly represent tradeable claims on activities of others through financial contracts (i.e. marketable securities), this notion has been nearly erased from intuition leading to genuine financial ignorance. But that ignorance can scarce excuse the fact that matching family-needs with nature of the underlying financial contracts lies at the heart of any family financial plan, and financing in general.
For, every family is in effect not an investor but a financier of its own future, notwithstanding the propaganda surrounding the cult of 'investing in markets and remaining invested at all times for all needs'.
This cult has all but succeeded in making a speculator out of an average saver as someone who is attracted by and attached to movements of prices of financial contracts, rather than what the contract itself promises to supply over a very long period of time. In all of the pseudo-talk of investing, it is this very attitude to investing which is most notable by its absence.
It is surprising – or perhaps not – to see people feel exhilarated at rising prices and commiserate at falling ones. To forego the temptation of rising prices is indeed difficult; as it is difficult indeed to constantly carry the reminder that those who chase rising prices will at some later stage get trapped in the whirlwind of falling ones. The edges of this forgetfulness are plentifully lubricated by the craving for more money as well as the envy of the neighbour inherent in every soul.
The NPS, as will be seen, is an instrument to help families lay claim to the idea of investing, that of reallocating their savings to long-term, financial contracts, in the proper sense of the term, provided they invest to finance their future needs. Much of what follows, therefore, is geared for those who grasp this axiom.
Now, were a family to hold such an attitude, how much of a corpus ought it accumulate? However inconvenient that be, the fact of the matter is that it depends on every family's collective income earning potential, the weight of its own past, and the degree of luck it enjoys in regard to sound physical and mental health. What, however, is always within a family's reach is the system-of-values it adopts with regard to from where it chooses to source its income and how it chooses to spend what it earns. (Income earned righteously and upon which taxes are paid honestly is more likely to be spent wisely and the resultant savings retained longer than otherwise would be the case.)
It pays never to forget that there are always four forces that are bound to work against any such long-term savings plan: costs, taxes, inflation, and callousness of the self. The NPS is designed as a one-stop shop to counteract each of them. Along with the Public Provident Fund (PPF), it is one of the most well-designed savings scheme available for securing long-term savings. In the vein of PPF, it is a highly regulated and low-cost scheme with attractive tax-exemptions and set rules for contributions and withdrawals.
Being clear.
While the nomenclature of NPS has the term 'pension' within it, the NPS itself does not provide a pension. In technical terms, the NPS is strictly a defined-contribution plan and not a defined-benefit plan, or, as the NPS website labels itself, which is a market-linked voluntary contribution scheme. It is also not a wealth-building tool whereby the sheer act of putting money into the NPS is no guarantee that that pot of money will grow at a fast clip.
What it is is a mechanism to accumulate small sums consistently over several decades, after which a whole or a part of the savings thus accumulated may be converted to some form of a guranteed source of income to meet core household expenses, preferably through the use of annuities. It is best thus to think of the NPS as warehousing marketable securities to then sell (liquidate) them in an orderly fashion in order to provide a minimal level of income support at some point in a family's life. While a mouthful, it is as close to a definition as is possible.
A word on annuities.
Annuities command attention as the rules of the NPS mandate that a portion of the corpus gathered under it be compulsorily converted to annuities. Thus, before committing family-savings to the NPS, it is important to reflect on what an annuity really is.
(N.B. The proposition of compulsory annuitisation is not an unsound one, even though it be a restraining one. Behavioural restraint is not something which has endeared itself to modernity, especially the version of it which comes dressed in the neoliberal garb.
Under such a zeitgeist, notions such as annuities will always be construed as a thorn under the hasty feet of a generation indiscrimantely peddled the addiction of instant gratification. Since presently such a generation presently constitutes a critical 'customer-base' for the financial industry as a whole, the clause of compulsory annuitisation will always face a precarious existence. It is particularly susceptible to rescission under influence from that corner of the industry whose livelihood depends on continuously expanding its "assets under management".
Be that it may, it behooves that a responsible family always work under a self-imposed stricture that a certain portion of the NPS corpus has to be compulsorily converted to annuities, whether or not regulations stipulate it. As any prudent saver will inevitably come to a realisation that restrictionsare, on the whole, helpful rather than harmful, and since most learn the lesson too late in life, be not amongst those who regret.)
An annuity is a simple transfer-of-risk insurance contract: a lump sum is handed over to an insurance provider who, in return, agrees to take on the risk to provide guaranteed income for the remaining life of the insured (also called the annuitant). An annuity contract is in effect a tool to partition any lump sum across time in a hassle-free manner so that it can last for as long as possible.
In practice, this simple arrangement varies due to the ability to tweak certain features of an annuity contract: in particular, whether to take the annuity singly or jointly with a spouse; whether to start the income support right away or after deferring it for a few years; whether to give the entire lump sum, once and for all, to the insurance provider, or to demand some or all of it back upon death; and whether the support is required for the rest of the life, or for a fixed term.
An annuity may appear an outdated notion in a financial environment where interest rates are high which, in turn, breeds a misplaced conviction in a family's ability to make a corpus withstand the test of time. Such conviction, though, is laid bare during prolonged periods of low interest rates, followed by violent upheavels in them. Times such as these spurn a realisation that individual smartness is shamefully inadequate to cover the risk of establishing a life-long guaranteed income-floor, and that only the concept of risk-pooling executed by quality insurance providers can (assure that floor).
(N.B. The fact that annuities are the oldest form of income longevity-protection, pre-dating the beginning of the Christian Era, should say something of their maturity as a 'product class'. It is also one of the oldest known forms through which the Sovereign borrowed from the publicsuch as the instance of the French and the English Governments fought one of their most pivotal battles at the turn of the 19th century by borrowing from their citizens through issuing annuities.)
As societies reach a level of mature organisation and a degree of cumulative material prosperity, non-term life insurance in general and, annuities in particular, become increasingly important. However, to accept annuities requires refraining the mind from subjecting every financial contract to the mechanical arithmetic exercise of 'rate of return'. More generally, an appreciation of more complex financial contracts demands a definite level of emotional maturity of the kind which allows the intellect to discriminate between a piece of tradeable and dematerialised electronic contract, compressed into a numerical blip on a flashing screen, versus a contractual and legally-binding commitment. In other words, it requires gaining a conviction that the need for insurance far outweights that of investment with the passage of time and age. (And no, term-life insurance is not the all-encompassing cure it is made out to be and is only one amongst many others in the swiss-army knife of insurance.)
The previous section stated the intent behind the NPS as "It is best therefore to think of the NPS as warehousing marketable securities to then sell (liquidate) them in an orderly fashion in order to provide a minimal level of income support at some point in a family's life". The existence of annuity contracts allows the second-half of this definition to be restated thus: "... to then sell (liquidate) them in an orderly fashion in order to transform them into an annuity-ladder so as to establish and maintain a guaranteed minimum life-long floor on family-income".
This idea of an annuity-ladder is then the conceptual bridge which converts the NPS, from what is essentially a cost-effective storage-place for marketable securities, into a provider of income security. The present regulatory mandate of compulsory annuitisation effectively then makes the NPS less of an investment vehicle and instead imparting it, in turn, more of an insurance character. The hope is that this fundamental character of the scheme is not trampled with as it is a wholesome product to fulfil a wholesome need.
What is a marketable security?
A security is a type of contract, i.e. a legal agreement, which sets out the terms under which capital is invested with an expectation to earn profit. It (a security) is a promise, as opposed to say a non-term life insurance contract which is a guarantee. This difference is not merely technical: it is the difference between having something in hand right now versus a promise of being given something tomorrow.
The word capital refers to that portion of any set of possessions which ranks front & centre. Capital need not always reference money as it may refer to skills, time, or some other valuable but latent productive capacity. Specifically, when it comes to finance, capital refers to the monetary ability, or in other words the strength of balance-sheet, to take calculated risks with an expectation to earn profit. As a corollary capital is created when money is managed in a manner to develop such a balance-sheet capacity.
(N.B. By extension, a capitalist is that who happens to be in possession of such capacity, and capitalism is that system of social organisation which then allows such capacity that is available with different individuals to be pooled together in an arrangement mutually beneficial to its owners and the society at large. This of course sounds noble in theory; practice, as is its wont, reveals behaviour much at variance with theory.)
(N.B. A possession is called front & centre, or has capital value, if it is devoid of any encumbrances such as money that is detached of debt, or skills detached of ill-health while being available in surplus to expend, and which also makes itself amenable to practical deployment with a view to derive benefits for self and society therefrom.
Take, for instance, the case of non-agricultural land: it cannot be labelled capital if it cannot be deployed for residential, commercial, or industrial use due to, say, regulatory restrictions or geological peculiarities. If it can be, then it has capital value.
Likewise, consider a child prodigy: if the child suffers from psychological scars due to bad parental upbringing, its genuis remains on paper failing to constitute the family's capital.)
The term investment comes from the Latin term investire and it traditionally meant to cover oneself in clothes and applied to the field of finance, it conveys the meaning of giving capital a new form of dressing. Thus, investing capital means giving that portion of possessions which is front & centre a new form by tying it to a productive economic enterprise so that that capital may be expected to earn a reasonable profit.
In light of the above definitions then, a security can be understood as a particular regulatory arrangement which, under contract law, gives legal recognition, sanction and protection to this action of 'investing capital'. A marketable security, by extension, is that contract which can be traded on regulated public markets or through partly-regulated or unregulated over-the-counter (OTC) markets.
It may then be asked that how is it possible to trade a contract which is nought but a piece of paper containing terms and conditions which cumulatively govern how a certain sum of capital may be invested? The answer lies in recognising that even if a security contract is a product of a legal convention, it can nonetheless be priced, and it can be priced because it can be valued probabilistically, that is with a reasonable degree of assurance.
Now, the publicly-traded securities most accessible to a family are those which lay-down claims of ownership (or, in sea-faring terms, drop anchor) upon some portion of the balance-sheet of a corporeal undertaking.
Such claims, in turn, are of two types. The first is the one which grants a right to earn some form of regular interest with a promise of return of principal at some point in the future, and the second is a right to take a share of the total profit remaining after payment of all expenses, interest and taxes. The former claims are often referred to as fixed-income securities, or more popularly as notes or bonds; and the latter, stock securities, or stocks, or more popularly, and oddly enough, as equities.
It should never be forgotten that behind these legal claims lie actual assets. In finance, something is an asset if it is expected to deliver a stream of future benefits to those who have established their claims upon it.
Thus, marketable securities, of the kinds that the NPS provides access to, are contractual claims (either in interest or stock-form) upon assets of publicly-listed corporations and finances of State and Union government, so as to establish a reasonably strong possibility to earn and accumulate a continuous stream of income over time.
Now, these securities (or claims) can be valued because it is possible, as Benjamin Graham elaborated eloquently almost a century back, to arrive at an intelligent estimate of this income-generation potential of theirs. What is possible to value can, by definition, be priced.
Now, this proposition holds easily for securities of entities in the public domain, including the government, if for nothing else than the regulations that govern such entities. They enforce compliances and disclosures which force these entities to routinely share information with its security owners. This act of disclosure is what makes these securities marketable as it places their information in the hands of a greater number of interested parties who have every incentive to appraise their value from time to time. This involvement of a critical mass of self-interested parties endows these securities with an ability to be bought and sold (trade them) through regulated open-markets, such as a stock-exchange.
(N.B. While it is true that there is frenetic trading that happens of these security contracts on a public exchange, there is still a price-to-value equation that governs such trading. It is possible indeed for a prudent man to say whether the price is out of line with the value and not buy something because it is too dear in relation to its value.)
The journey, thus, from 'capital' to a 'marketable security' is a conceptually involved one, and it is a journey many have forgotten due to the denegration of that societal institution called the 'stock-market' into an open-for-all gambling den. For those who care to refresh their remembrance may, however, still benefit from understanding the conceptual engineering behind terms that are bandied (about) without much forethought and responsibility.
The difference between saving and investing
Perhaps no term gets bandied more carelessly than the term profit. It is deserving of more attention than the scraps (of attention) thrown at it. One reason for its lax use by the tongue is that its accounting identity could not be simpler: revenue less expenses. But an accounting identity does not a definition make; instead, a definition is that which provides a key to unlock its meaning.
A gentleman might correctly say that the term profit represents benefits accrued over a time-frame after all the costs, without exception and exclusion, have been honestly accounted for. A slight turn of the language and the term profit is removed from the clutches of money! It may now be said that while profit may be measured, or more correctly accounted for, in terms of money, it itself is not money.
For, all benefits, by definition, accrue when capital is put to work, or invested. What is therefore invested is capital and not money. This distinction is akin to that between the heaven and the earth: ignoring it will not make for a fruitful living.
To recap then, money is a unit of account (and medium of exchange) and not the unit of capital, and least of all a unit of investment. Money, when managed properly, constitutes capital, and capital when actively and systematically handled constitutes investment. Investments may result in benefits and those benefits, in turn, are measured back in money.
This confusion (between money and capital) is common because typically everyone sees what goes in as money and what comes out as money and, in the process, a unit of account is construed as a unit of well nigh everything else.
(Much as the reality of the distance between two points is independent of the unit of its measure, so is the quantum of real capital at one's disposal is independent of the unit in which they are accounted for.)
And it is this real capital, a family's real set of endowments, that is available with every family is what truly matters. It is also that which every family actually invests. And, without exception, every family is given enough to make what it will of it. For,
Have they not considered the birds made subject
in the air of the sky? There holds them only God; in that are proofs
for people who believe.
~~ 16:39, The Qur'an
When a family invests its real capital, i.e., it puts its endowments to work, it accrues real benefits. While some of these benefits are accounted for in money-terms, many others remain intangible and hard to account. Those accounted for in money-terms represent quantification, or monetisation, of capital through investing. Those (benefits) that cannot be (accounted for in money-terms) are still real even though intangible.
Thus, the result of a family investing its capital leads to accrual of current as well as future benefits, both tangible and intangible. A portion of current tangible benefits may be realised in money-terms and thereby may be said to constitute the savings of the family as the term is commonly understood.
(N.B. The watchful reader would have realised that a critical, if not the majority, of the benefits that a family receives are tacit, unmeasurable and unseen. Yet, modernity has trained the mind to value and chases only the seen ignoring thereby the much larger value embedded in the unseen. For,
And with Him are the keys of the Unseen; and none
knows them but He and He knows what is in the land and
the sea; and not a leaf falls but He knows it; nor is there a
grain in the darknesses of the earth, and nothing moist or dry,
but it is in a clear writ.
~~ 6:59, The Qur'an)
Now, when the family 'appropriates' these savings and houses it under the protection of certain vehicles: be it a bank deposit, PPF account, life-insurance policy, mutual fund scheme, or the NPS: it is more properly storing its savings. The family is do doing is not investing but safeguarding its savings. Over time, as these savings grow in value, they constitute the monetary capital of the family.
In summary then, starting with its initial endowments the family has managed to monetise them, thereby giving itself an additional form of capital (monetary). The common-error of thinking at this stage is to start believing that just because there is money at hand, the act of putting it to work is an act of investing. It is critical that every family cleanse itself of this notion at the earliest possible.
A family is not an investor of money but always, and forever, a saver of its monetary savings, unless it chooses to actively engage in allocation of its savings in earnest by acquiring the skill of investing monetary capital. Very few (families) either have the time or the ability to do so, and instead, what they really invest is their real capital, i.e., their God-given endowments.
For a majority of families therefore instruments like the NPS, even though they deploy savings in marketable securities, should be considered as means of safeguarding savings. It is foolhardy to presume that the sheer dint of taking exposure to marketable securities is an act of investing, and rather, if the family saves its money intelligently, it may then be able to actually invest its other forms of capital more effectively.
Why save in the form of marketable securities?
Now, if at the end of the day all that marketable securities are are nought but contractual ownership on a promised income-stream, unlike contractual guarantees embedded in a life-insurance contract, then it is but natural to question that does affixing monetary savings to promises – however much they be legally sanctified – constitute an act of intelligence? If so, why?
It is a fair question but with no fair answer. For, while governments have always occupied the place of an important societal institution, whether one likes it or not public corporations today have sinewed their way into how societies operate. A material portion of money moves increasingly under their covetous eyes, and it is through them indeed that individual constituents of society have come increasingly to interact with each other.
There is no doubt that a promise (on corporeal claims) implies that the end result will likely differ from initial expectations with a family landing up with more or less than it had expected. But then the same argument holds true of other life-long important responsibilities: be it marriage, earning a living, raising a family, or enjoying good health. In coping with these responsibilities every family takes upon itself a measure of risk while trying best to protect itself against gross errors. It is thus hard to imagine dealing with the responsibility of money falling outside of this frame of thinking.
Nonetheless it is true that the risk which untolerably attaches to money boils down to not having it in adequate supply when it is truly needed. For, though today may not call into service the savings ear-marked for tomorrow, rest assured that that tomorrow is always waiting at the corner bend. And the steady passage of time guarantees that many such corner bends are bound to be encountered.
Now, in order to satiate this (need of timely and adequate supply of money) commands (that) a family stitch together a motley collection of guarantees in the form of long-term life-insurance contracts – preferably permanent whole-life or some variant thereof – with an intelligent speculation on the future through collecting claims of ownership on engines that own a critical mass of society's capacity to produce goods and services. It is through this combination that savings are capitalised, i.e., transformed into a base of monetary capital.
And it is only as part of just such an assemblage that marketable securities have a capital role to play and never outside of it. Indeed, never has this role been more pronounced in mankind's history than today and that is due to a phenomenon which has vividly stamped its authority over the viscera of societies of the few centuries past, much to the delight of the Merchants and the regret of the Lords.
On one side of this phenomenon phenomenon lies the unrelenting advance in the science of material engineering to harness the potential energy inside every molecule that nature has to offer, with ever and ever greater efficiency. And on its other side lies hidden the murky trail-of-transformation of money from that singed to noble metals to one composed of only circulating credit in the form of bank IOUs (lit. I Owe You) minted gleefully with an ever-increasing carnal appetite.
Money and energy, a moment's reflection will serve to show, have never been one apart from the other; they are instead very much joined at the hip so that changes in one flow over to the other side in lock-step. Their relationship constitutes in the systems-thinking language of today a dynamic. And it is this defining dynamic around which modern society continues to organise itself.
Its most recent manifestation reveals itself as an abundance of energy financed with debt held on the balance-sheets of private banking channels and the Sovereign, debt that the ordinary saver naively believes to be his hard-earned savings. It makes for strange times indeed to try to seek an honourable survival whilst this dynamic continues its march face forward, showing little signs of abating, with no precedence to bank upon. There is no parallel in recorded history to match the scale and intensity of what has happened on the planet in the past two hundred years.
The difficulty (for the ordinary family) is further compounded by the ingrained ignorance regarding this dynamic amongst those who, bake their bread teaching economics and happen to occupy high-chairs at important public posts, who in turn, produce an equally clueless army of pupils who then go on to glibly manage the hard-earned savings of others. When the doctors aren't properly trained to diagnose, how trustworthy is the medication administered to the patient?
At first sight it seems a mystery for sure that a group of individuals, who otherwise have the intellectual equipment to solve complex algebraic formulations, fail to grasp the presence and gravity of such a potent dynamic. The answer for all of recorded history has always been the same: when you serve men an opiate they present themselves as able and willing to get addicted and to commit to remember less whilst forgetting much.
A simple question has also always sufficed to identify the opiate pervasive in the modern era: what does the mass of mankind worship today? The answer, as they say, is blowing in the wind. The skill that mankind has mastered with reference to the money-energy dynamic compels that mankind necessarily create a new world-wide cult called efficiency. (Modern lips may haughtily smile when their eyes read of the fertility cults of yore in history textbooks since the modern man prides himself much on his logos and not so much on his eros.
Yet, it is hard to comprehend how the incessant pursuit of efficiency remains any distant apart from worshipping the "cult of fertility". For that matter, the requisite ritual edifice is very much in place as this self-invented goddess of efficiency may only be pleased by a continual sacrificial offering of "GDP growth" at her altar. The spectre of deflation haunts her, a bit of inflation greases her, while a lot of inflation inflames her.
And fabricating this "growth" in order to please the goddess requires an unrelenting cranking up of the lever-of-leverage through creation of more and more of bank IOUs out of thin air so that a majority of men consume in abundance today what they would otherwise have left as legacy for posterity to prosper. The fact that all of this is carried in the name of progress makes the whole show a preposterous farce.) All in all, efficient in production and consumption for sure, but to what end and at what cost?
(N.B. This self-reinforcing money-energy dynamic and its accompanying cultic idol-worshipping culture has without doubt led to a rapid expansion of and access to untold material production. But it is an inescapable law of action that as one set of dynamic expands, it must automatically be matched by the wilting into the willows of another; and in this particular case, it begins with the visible decline of other, more intangible, forms of truer societal capital. The overall resultant may more properly be labelled a Faustian bargain.
And it is a bargain whose knowledge no longer remains confined to hushed voices inside private chambers but circulates as an open-secret amongst those with some critical ability to raise the right questions. The unflowering of this virgin secret, so zealously guarded by a section of the wheelers and dealers of money and ignored by the intelligenstia, makes it increasingly plain that chasing the deity of efficiency has caused irrevocable harm to beneficial forms of co-existence, with the notion of family being the first in line of shooting.
This fissuring of family has been achieved through the corrosive and continuous chipping away of the idea of individual and collective moral responsibility. And a collapsing family structure draws within its destructive fold the palpable loss of heritage, traditions and variety in cultures. For, the double-edged knife of shame and regret that restrain the appetite has been dealt a body blow. For,
O children of Adam: We have sent down upon you raiment
to hide your shame, and as adornment; but the raiment of
prudent fear, that is the best. That is among the proofs of God,
that they might take heed.
~~ 7:26, The Qur'an
O children of Adam: let not the satan subject you to means
of denial as he turned your parents out of the garden,
removing from them their raiment, that he might make
manifest their shame to them. He and his kind see you
from where you see them not. We have made the satans
allies of those who do not believe.
~~ 7:27
O children of Adam: take your adornment at every place of
worship; and eat and drink, but commit not excess; God
loves not the committers of excess.
~~ 7:31
And every man: We have attached his fate to his neck; and
We will bring forth for him on the Day of Resurrection a writ
which he will find unrolled:
"Read thou thy writ! Thy soul this day suffices as reckoner
against thee."
~~ 17:13-14
Seclusion too, the last refuge for the frayed soul, no longer remains an option for that levity of material abundance has certainly come at the cost of significant, and in many ways, irreplaceable degradation and deprevation of otherwise prime and pristine commons.
But ultimately, where this bargain most burns the stomach is when high-voltage material inequality meets the sight of the last remnants of power flocking towards fewer and fewer societal stations deploying means deceptive, devious, perfidious, and perverse. In other words, one set of power-broking elites replaced by only power-brokers of the crass, uncouth and bigoted variety.)
The net effect is a society bed-ridden with sharp, sudden, discontinuous and unpredictable twists and turns. An ordinary family, unwilling to forsake its moral compass in the midst of this madness, is surely bound to be wearied simply withstanding this whirlpool. It must stretch itself forward at all times not knowing what its future heralds while not lose its tensile strength to forbear the present. This predicament, though not new in its character, is certainly exceptional in its magnitude. For,
"But if they strive with thee to make thee ascribe a
partnership to that of which thou has no knowledge, then
obey thou them not. And accompany thou them in the World
according to what is fitting; but follow thou the path of him
who turns to Me. Then to Me is your return, and I will tell you
what you did."
~31:15, The Qur'an
Wisdom recommends that withdrawal from society, especially one so neurotic as today's and with all escape doors shut, does not make for successful living. The test may lie instead in the dictum of being with society without becoming of it, application of which in matters financial requires a thoughtful allocation of a small portion of savings to marketable securities.
Marketable securities, through the gyrations in the daily quotations that attach to them, reflect the contortions under-girding the political economy. The accumulated effect of these ephemeral price fluctuations, mediated through an ever evolving security market mechanism, is what allows a family to entwine its own balance-sheet to the current fluctuating fate of society it happens to find itself in, and in the measure it wishes to, for the better or the worse. In doing so, however, a family must take care not to be tripped over by the society it has chosen to dance with.
It may seem a paradox that that which symbolises the errors of society may also serve as a shield against those very errors. Or, in other words, the drug that addicts can also cure if it be administered in the right dosage.
For, so long as the structural winds of the political economy – as evidenced most in the dynamic dance of energy and credit – keep blowing with vigour, marketable securities have a role to play. And as and when that dynamic reaches its breaking point as it is wont to — for every few centuries every political economy revisits the grounds upon which it stands — it will send sufficient warnings in advance for society to take heed and make amends. And when the inevitable become imminent and the ship of society does indeed start to sink in the quagmire of its self-created, heedless and persistent pursuit of efficiency, matters far graver than money will stir the soul of a family.
It is precisely at such time that being on the right side of the law is what will hold most water over any other consideration. And it is also very much this quaint notion of adherence to law – specifically contract law – which rescues marketable securities from the dustbin of gambling and offers them a chance for redemption by reminding their owners that these securities are governed by the contract law.
For, as Nelson Nash fondly reminded that it is the contract law which underpins the fabric of every society; and history helpfully testifies that the written word, under common-law, has always carried weight when it comes to matters financial. It would seem strange, therefore, that in as information-a-heavy and literate-a-society as today's, the import of the written word, such as a security contract, should fail to carry fiduciary heft of some consequence.
But while the contract law rules the roost, it is also no denying the unseemly fact that every so often – in fact, more than what memory can hold – there arise episodic fits of subversion of this convention of 'rule by common-law' and common-sense. And it too is a fact that these episodes arise in no small measure and, at times, exclusively because of, regulatory negligence, complicity, or willful withdrawal of institutional safeguards.
Free rein, at such times, is provided to a select cohort to profit at the expense of all others: an act which, in times earlier, would have been castigated as nought but treason against the interest of the sovereign. Such subversions, though, do not subsist for long. They eventually lead to an unstable socio-political equilibrium, forcing a restoration, some times through means violent and brutal, whereby the written word is rediscovered once again, and for some time, to prevail.
The contractual essence of marketable securities, thus, moves them beyond the unappealing realm of mere flipping of pieces of paper or bits of information everyday; instead, it forces them to effectively codify a set of relationships that a family enters into with the society it happens to cohabit. In times today, rejecting them outright is a position difficult for a family to maintain for any considerable period of time without imparting damage of a permanent nature to the purchasing power of its property. But at the same time, the degree to which they be considered bears heavy caution: by committing a majority of its savings at their altar the family opens itself to the charge of sacrilege of grandma's wisdom on money-management.
For, marketable securities are contractual promises and not contractual guarantees, and there always exists the temptation for one party to promise and the other to expect more than may be delivered, without question the ultimate bane of all fortune and fame. As a result, marketable securities, by definition, harbour a peculiar risk called the counter-party risk — the risk that the party at the other end of a contractual promise fails to fulfill its end of the bargain because it found itself having entered into commitments with so many other counter-parties that, after a fashion, it was overwhelmed by the complex web of contracts it managed to carelessly weave for itself.
(N.B. This is no theoretical after-thought: the follow-on repurcussions of the crisis of 2008, which was, in essence, a monetary crisis whereby a range of money-related contracts that underpinned world-wide money flows came undone, remain yet to be fully resolved. The world, it is safe to say, has not been the same since 2008, and if there was one proof needed of why contract law matters, the recent past makes for expert witness testimony.)
Nonetheless, just because the world changes in many aspects does not imply that traditional wisdom is in search for replacement: on the contrary, the resonance of its importance resounds even more loudly. All said and done, the idea of being a banker unto oneself (introduced towards the end of this primer), which tries to strike a middle ground between contractual guarantees and contractual promises, may remain the most sensible option to shelter savings for many ordinary families. For,
He who observes the wind will not sow,
and he who regards the clouds will not reap.
As you do not know the way the spirit
comes to the bones in the womb of a woman with a child,
so you do not know the works of God who makes everything.
In the morning sow your seed,
and at evening withhold not your hand,
for you do not know which will prosper,
this or that,
or whether both alike be good.
~~ Ecclesiastes 11:4-6
Why the NPS: warehousing of marketable securities
In light of the above lengthy digression, it is now possible to think of the NPS as part of a system-of-saving supplying the means whereby to attach a portion of the surplus capacity of a family's balance-sheet – its monetary savings – to claims of ownership on income-producing assets of other entities through purchase of their publicly-issued securities, and till such time these savings need to be converted back to income (through annuities). In order for any savings vehicle to play this role – one of capitalising savings through marketable securities – it needs to possess certain features which the design of the NPS seems to have captured.
To appreciate these features, it is worth recalling, once more, that a security is a legal entitlement of ownership (on an asset) under contract law. It is the contract law which, first and foremost, 'secures' the value behind a security, by providing sanction to the rights of the security holder, and abuse of which, in turn, can call into permanent doubt the worth of the security itself.
(N.B. This is different from, say an insurance contract, wherein the policy-holder is the true owner of the cash put in, and the insurance company is a custodian of that cash and is beholden to fulfill its contractual obligations, provided the policy-holder fulfills his own.
But even an insurance contract provides a weaker form of ownership than direct physical ownership of gold, an act which alone is free of all counter-party risk, thereby qualifying gold as the only true medium of inter-generational capital preservation.)
Now, the fact that most families will purchase marketable securities through some or the other intermediary – an Asset Management Company or brokerage – already weakens their ownership of the assets behind those securities. For, when money is transferred to an intermediary, it is that intermediary who buys the securities and is the actual owner of those securities.
As a result, those who contribute to, say, a mutual fund scheme have legally established a claim on the assets of the mutual fund scheme itself, and not the securities that the schemes owns in turn. Effectively, then, their ownership of those securities becomes one-step removed from true ownership (and that of the assets underlying those securities, a further two-steps removed).
With increased digitisation of information, it is hardly a surprise that over time this chain-of-distancing of ownership has expanded further, with the introduction of exchange-trade funds (or ETFs) being a case in point.
In the case of ETFs, a financial intermediary, essentially a Sponsor, buys an entire basket of securities and holds it on its own balance-sheet, acting as a warehouser of securities. The Sponsor then, with help of a specialised broker, issues a new type of security – called a share in the ETF parlance – which serves the office of a legal claim on this entire basket (of securitites). Thus, those who contribute to an ETF actually purchase these shares that are effectively created and issued by the Sponsor.
To an untrained eye the mechanics appear the same across both the mutual fund and the ETF: exchange some cash for claims. However, there is a paramount difference and that differences arises on the steps and sequence of operations between these two schemes of intermediation.
In a mutual fund, the Asset Management Company collects monies, creates and issues units at a face value and then goes out into the market to purchase securities. It is these units that then become the property of the participant in a mutual fund undertaking.
In the case of an ETF, on the other hand, the Sponsor first assembles a basket of securities, and then creates and issue shares upon this basket. Furthermore, it then makes these shares tradeable by floating them on a public exchange, much like other publicly-traded securities. It is when others purchase these shares is when the ETF receives money.
This sequence makes it possible, in turn, for someone to purchase an ETF share in the morning, only to later turn around and sell that share in the afternoon, effectively trading an entire basket of securities without ever owning it in the first place. The underlying basket of securities remains unmoved on the balance-sheet of the EFT intermediary, since for every buyer there is a seller. And when none is found, it is that specialised broker who helpfully offers to buy it up, a function that is deliciously labelled "market-making".
Were it not for the legal sanction that this arrangement has received, anyone would be correct in conflating this whole operation with the dealings of a mafia cartel. But it is an unspoken law of finance that the more technical tools that make themselves available in the hands of money-dealers, they will, rest assured, find more and more creative ways to separate the saver from true ownership of his savings.
Where mutual funds were akin to buying a bag of different fruits and vegetables together, ETFs are like a grocer issuing receipts on a bag of fruits and vegetables. With mutual funds, one at least owns the bag; with the ETFs all one has are the receipts. Admittedly, the ETFs do have their uses in builing complex financial portfolios, improving trading liquidity, or insuring against risks related to liquidity (i.e. market-making).
While an intimate knowledge of these use-cases is hardly necessary in building a family's nest egg, they do highlight the fact that financial engineering is forever underway to create newer and newer methods to warehouse and trade marketable securities, and that some of these methods may create a substantial distance between owning a security outright and owning it through someone else. And critically, what on surface seems as only a legal distinction has a singular bearing on deciding on how to attach savings to marketable securities.
For, if the money of the family is in reality only a claim on the balance-sheet of an intermediary, who, in turn, establishes claims on actual income-producing assets, what matters most to any family is to choose the right intermediary; or, in other words, to assess the fiduciary capabilities of that intermediary. This, by no means, is an easy task: it is equivalent to finding the right business partner to trust for the long haul. A consideration of this nature therefore demands that the intermediary, such as the NPS, possess features that provide fiduciary surity.
Fiduciary surity
The first noteworthy aspect of the NPS is that, like the PPF, it is centrally regulated. Therefore, the savings held under its custody are governed by a set of publicly available, transparent and non-discretionary rules hosted at the website of the NPS Trust (https://www.npstrust.org) that seek to give a sense of safety for scarce capital. The additional fact that the NPS online user-interface provides an easy way to access all the pertinent information and execute all transactions, provides an added degree of comfort to its user: arguably, this interface is amongst the most easy to use 'investment interfaces' that exists today in India.
Now, the NPS, by design, has to provide custodianship to savings of millions for the longest period amongst all other competing market-linked savings alternatives. This period, stretching two or more decades, starts with the day contributions are made to the NPS account to when the contributor reaches the age of sixty or crosses the age of superannuation, whichever is earlier.
The knowledge that its savings can be held for a long time under the purview of a regulated custodian offers the family a paramount behavioural advantage: it allows itself to securely wean itself away from its savings. For, nothing could be better for a family's financial health than to put aside a portion of its savings and forget for as long as possible; and if there be a choice of only one market-linked security-warehousing instrument to opt-for, the NPS offers itself as a trustworthy default choice.
It also offers the distinctive benefit in disbursing of what has been accumulated. It is easier to acquire marketable securities whose prices jump around daily, but surprisingly difficult to get out of them. One reason simply is technical: one is never sure when is the right time to sell, which may result in needless hesitation.
But beyond this hesitation, which confronts the buyer of every asset, is a conundrum which confronts the owner of an asset: it is difficult to let go of what you have spent a life-time acquiring. This only goes to compound that initial hesitation, leading to confusion and then, inevitably to haste and error.
Surely a man goes about as a shadow!
Surely for nothing they are in turmoil;
man heaps up wealth and does not know
who will gather!
~~ Psalms 39:6
Against this hesitancy, the NPS provides a simple anti-dote through two sets of rules. One set (of rules) governs the rebalancing between different types of securities, and the second governs the withdrawal of the proceeds, both being covered in some detail later.
The withdrawal rules, in particular, force an effective liquidation of the accumulated savings at some point in time or another, depending on the age of the contributing family-member. This event of liquidation occurs irrespective of the prevailing market conditions and whether the funds accumulated are needed or not, leaving the family, in turn, with an annuity contract and a lump sum of cash in hand. The lump sum component may be withdrawn in its entirety, or in parts, or through some form of a systematic withdrawal plan. Meanwhile, if the contributing family-member dies prematurely then, upon death, the accumulated corpus is transferred to the nominee as a lump sum, unless the nominee opts for an annuity.
This is but one example of the characteristic, rule-based nature of the NPS that leaves a family little in way of choice, and it is always good to have a part of the volatile section of a family's balance-sheet governed by rules rather than discretion or emotion. For this reason, the NPS, like the PPF, may be considered an important pillar for construction of a family's balance-sheet and must, therefore, be attended to with care.
As an added point of comfort: government employees (Central and State) are compulsorily required to contribute a part of their salary to the NPS. This diktat by law ensures that the NPS is unlikely to be grossly mismanaged given that the financial future of public-servants too is tied to the quality of its operations. In other words, even if the NPS falls from grace, its fall may be comparatively tolerable.
Is the NPS tax-efficient?
Now, some financial arrangements are more tax-efficient than others if they reduce current or future tax liabilities in a legally-permissible, transparent and simple manner.
Taxes may either be waived-off or deferred. The waiver – more properly, exemption of taxes – is a rare ocurrence, and today in India, it is restricted to only three financial instruments amongst those accessible to all families: the balance held in the Public Provident Fund account and interest earned thereon; non-term life insurance policy proceeds provided the contributions to them meet specific qualifications; and the lump sum withdrawal made out of the NPS Tier 1 account at the time of its closure.
In lieu of the grant of this exemption by the Sovereign, all three instruments demand a minimum lock-in period. In addition, certain tax-free bonds issued by PSUs may make an appearance from time to time wherein the interest earned is exempt. However, seeing the burgeoning public deficits, their occurrence may be an increasing rarity, and thus they cannot be relied upon to build a financial plan.
(N.B. In fact, it is foolhardy to assume that the tax-exemption on these three instruments will persist for life and across generations. Public taxation is closely related to the underlying social contract which governs any polity, and every polity is constantly dealing with conflicting and competing interests. The choices it makes thus with regard to taxation are as much a political decision as an economic one. But whatever these changes, they are unlikely to be made on an ad-hoc basis.
For, in any civilised society it is not considered advisable to steal away benefits that have accrued from promises made in the past through tax legislation that has retrospective effect; but it certainly is possible to restrict future benefits of past actions. So, for instance, it is quite possible for a future political dispensation to remove tax-exemption from the PPF for individuals above a certain income floor, or those having accumulated a certain balance; or, for that matter, to rescind the 60% tax-exemption on the lump sum component of the NPS on contributions made after a certain date. The hand of every Sovereign is always very long, and it has a habit of not sitting still for long.
For any regular family though there is little it can do on this front except to recognise that such possibilities exist, and try not to get wedded too firmly to the comfort of tax-exemptions. Nonetheless, the broader point holds: some financial instruments and contracts happen to be more tax-efficient, or at least more tax-advantaged, than others due to Sovereign largesse.)
The mechanism of tax-exemption also relates to another aspect of the NPS: that of moving savings from one type of marketable security to another: typically from stocks to bonds and vice-versa. As discussed later, the NPS allows a family to allocate its savings amongst various types of securities contracts and typically, shifting from one to another requires first selling one contract, paying a capital-gains tax upon proceeds of the sale, and then purchasing another. Within the NPS these types of switches, though, are exempt from the reaches of capital-gains taxes.
(N.B. It may be countered that hybrid mutual funds, such as balanced funds, also enjoy this advantage. However, hybrid mutual funds do not allow the saver to actually decide the allocation and physically make the changes; instead, they do on the saver's behalf. Furthermore, such funds display a single consolidated Net Asset Value (NAV) unlike the NPS which has a NAV for each class of security that is owned.)
Taxes can also be saved by deferring their payment, i.e., what is due today can be paid tomorrow. For the purpose of accumulation, tax-deferral provides two advantages. First, by not withdrawing a portion out of today's savings to pay taxes, savings can continue to earn interest or grow in totality instead of on a reduced base. Furthermore, deferring taxes for as long as possible may subject the savings to a lower rate of taxation. For instance, the rate of taxation in old age coud likely be lower than in the 40's or 50's simply because of a lower overall income.
(N.B. One implication of the above is that those who wish to minimise taxes, should not automatically strive to withdraw the highest permissible amount in the Tier 1 scheme as a lump sum, unless they need the same. While this act of lump sum withdrawal may result in tax-exemption at the time of withdrawal, the proceeds will, in turn, have to safeguarded by attaching them to one or another financial contracts that may have higher-tax incidence (such as bank deposits).
An annuity, on the other hand, from the stand-point of taxation involves a contractual transfer of a lump sum to an annuity provider (lit. an insurance company) who converts it into a stream of smaller but regular cash income. The tax on this income, being taxable at the marginal rate, stands the chance of declining with increasing age.)
Given the above considerations then, is the NPS tax-efficient?
The answer is, surprisingly, that it depends. And what it depends upon is the attitude of the saver to the idea of a certain portion of the Tier 1 balance being forcefully converted to an annuity. For, forced annuitisation removes the right to direct that portion of the accumulated corpus to other uses, and instead, converts it into taxable income. (It is always possible to both defer this act of annuitisation or to purchase annuities that in turn defer their pay-outs, thereby further elongating the time at which this portion of corpus really is exposed to taxation.)
Even this would not be anathema except for the fact that forty-percent of the original contributions and the subsequent gains accrued on them are both annuitised and thereby exposed to taxation. Some may chose to view this as an incidence of double-taxation, especially if their original contributions to the Tier 1 account came from after-tax income. They would naturally be disposed to view their contributions being taxed twice: before they were put in and after they were taken out.
And it is understandable why this resistance may arise when comparable options of savings are considered. For instance, in the case of bank deposits only the interest is taxed, or in the case of mutual funds only the gains are taxed. In either case, taxation is not applied to the principal itself.
This act of forced annuitisation resulting in an incidence of double-taxation may not make a material difference to those in the lower income-tax brackets but would likely prove a sore point for those in higher tax brackets, who are likely to make larger contributions throughout their earning years, are more likely to be left with a larger accumulated corpus, and, therefore, naturally averse to a reasonable portion of their life-savings being compulsorily made subject to taxation.
This permanent life-long tax bill, even though it be in form of deferred taxation, wil be something the reasonably well-off are, therefore, prone to detest. They would naturally prefer instead to divert their savings to mutual funds and pay tax only on the capital gains so realised.
The system of taxation of the NPS Tier 1 account demonstrates one thing: it is fundamentally a savings-oriented instrument and not an investment. Savings, by definition, are done for a clear purpose — in the case of the NPS, to create a floor for income in old-age through following a consistent and conservative warehousing of financial securities. With respect to this purpose, annuitisation is a desirable feature and not a design flaw.
But there is a further subtler message within this system: essentially, those who have been fortunate to accumulate a larger corpus, will have to pay back a higher portion of it to society than those who have accumulated a smaller corpus. The forced annuitisation, in effect, is an instance of 'progressive taxation'. For some it may reek of socialism in the grab of a market-linked savings instrument.
To each family, then, its own political preferences. For those who view annuitisation as inevitable in their financial planning, the NPS is tax-efficient, while those who intend never to consider it, the NPS is not. If ever in the future this feature of annuitisation be removed, rest assured, the taxation-policy of the entire NPS Tier 1 account will likely undergo a significant overhaul: for, the Sovereign never relinquishes the right to tax in one form of another what it considers as due to society has to be paid back.
Broadly speaking then, the NPS (its Tier 1 account that is) is a boon for a vast majority of families who are likely to see lower marginal rates of taxation throughout their lives, while it is likely to prove a dilemma to those who are fortunate to earn more: a dilemma that they should consider themselves fortunate to have and one that they will have to learn to resolve for themselves.
Customising the NPS.
This optionality and flexibility, however, attaches not only to the tax-efficiency of the NPS. Despite being rule-governed, the NPS is surprisingly customisable when it comes to choosing where to put money, with whom and when to close the account.
To begin with, the NPS allows a saver to choose from several fund managers. It is preferable to use a fund manager who handles monies of government employees, yet is privately-owned. The NPS allows shifting the managers not only for the entire pool of money, but also for individual investment categories. That is, it is possible to choose different managers for stocks, corporate bonds, government securities and alternative investments.
The NPS has two different types of accounts: a compulsory Tier 1 account to which all of the restrictions and tax-benefits apply; and, an optional Tier 2 account, which enjoys neither the benefits nor imposes any restrictions, i.e., it is open-ended. Indeed, as will be demonstrated later, it is the presence of the Tier 2 account, under the NPS umbrella, that enhances the utility of the overall NPS system by allowing for multiple use-cases.
Across both the Tier 1 and Tier 2 accounts, the cash contributed may be invested across four categories of securities: stocks or equity investments (E), corporate bonds (C), government securities (G) and alternative investments (A). Deciding how much of the contribution should go into which of these categories (components) is called defining the asset-allocation. For its Tier 1 account, the NPS provides either an auto or active choice when it comes to asset-allocation.
Under the auto-choice, the NPS rules automatically determine, based on the age of the contributor, how the current and future savings will be allocated, with more and more of the savings directed away from (E) and (C) to (G) with advancing age. In other words, from claims on private enterprises to funding of public budgets, and from securities with high expected short-term volatility to those with lower expected short-term volatility.
(N.B. The term expected refers to the fact that based on history, stock prices tend to gyrate more wildly than prices of fixed-income instruments such as bonds in time-frames ranging from 1 day to 15 years. Over 15 years though stocks by their very nature have proved a more reliable ally; but then not every family has the luxury of 15 years for all of their money.)
This auto-choice mode is helpful for many who have very little understanding or experience with market-linked securities. Within auto-choice, there are three types of sub-options to avail of with varying expected returns ranging from the highly conservative to slightly aggressive. Each of these three options differ in the rate at which they reduce the allocation to the (E) by the time the saver reaches the age of 60.
For instance, under the most conservative option (also called 'Conservative life-cycle fund'), the (E) component starts at 25% below the age of 35, and falls to 5% by the age of 55. Meanwhile, under the so-called aggressive option ('Aggressive life-cycle fund'), the (E) component starts from 75% and falls to 15% by the age of 55. The moderate option, as the name suggests, stands between the two, with the (E) component starting at 50% (at age 35) and falling to 10% by the age of 55.
While this has a seeming sense of scientific comfort, for those willing to self-educate themselves, the active choice is to be preferred. Though it is always possible to switch between the auto and active choices, it is preferable to make an informed choice at the time of opening of the NPS account itself. Those who are unsure should stick with auto-choice (preferably its moderate option), and when they gain more exposure and confidence may choose to switch to active choice.
Asset allocation.
There is a theory that since the prices of stocks (which are but claims on current and expected surplus of a business operation) are highly volatile in the short-run, corporate bonds and government securities help to off-set that volatility. While true also in practice, care should be taken to not overdo the allocation to fixed-income instruments inside what is essentially a market-linked savings product; that too at an early-stage in life when several years of accumulation are still on the horizon.
In the short-run, while the prices of equity securities are certainly unpredictable — a fall of nearly fifty percent (50%), or more, within a span of a few weeks or months may not be ruled out — in the long-run they are more stable than fixed-income instruments. This, though, seems a contradiction: how can something which loses its sense of balance every day still manage to provide long-term stability? It certainly does not correlate with typical human experience.
An intuitive way to understand this is to realise that equity securities, or stocks, are claims on residual profits of public corporations, viz., profits which remain after everyone in sight has been paid-off, including the salaries of personnel, taxes to the Government, the lessors and the creditors. This feature of taking what remains is called 'optionality'.
It is akin to a party which runs on a rule that a particular individual will get the share of what remains at the end. With some shrewd planning and good-luck that particular individual may land-up with a fat share, and with luck, and stupidity, may be left with nothing. Now, imagine if this game is played everyday for several years and decades: in that case, what is the probability that this particular player actually acquires the largest share of the proceeds compared to all of the other participants?
A competent participant stands a good chance to maximise his share of the pie provided he can afford to be vigilant over all these years without fail. Stocks of sound corporations are like these competent participants; on the other hand, stocks of unhealthy corporations are like a participant found sleeping at the wheel, or engaging in deceit and fraud, for which they are eventually taken to task, even though more often than not it takes a long-time to take them to task.
It is this optionality which also gives stocks as a whole adaptability. Consider the participant in the party-example above: with years of experience, he acquires an enviable acumen to manoeuvre himself through the maze better than those who are simply content to take their fixed portions. In fact, the rules of the game leave him with no choice but to adapt as he will only get what is left over, so he better be extra-vigilant about safeguarding his interests.
In layman's terms: stocks as a whole are more adaptive to changing circumstances than bonds which by definition are contracts with fixed terms and conditions. It is this adaptability to long-term structural forces which enables stocks to bring a level of long-term stability to any portfolio of marketable securities.
Both, stocks and bonds, have their respective uses. But, if one has the luxury of time, good health, sound coginitive abilities, and a reasonable pool of cash – in form of life-insurance policies, public provident fund account or bank deposits – then it is advisable to have a healthy exposure to stocks, as they allow the savings to adapt to inflation, taxes and other macroeconomic forces much more efficiently than if it was the case that the majority of savings were held in bonds.
However, the idea of reducing short-term volatility of a portfolio of marketable securities as one ages is an academic convention deeply entrenched in the psyche of financial planners. It is no surprise that its effects, therefore, are also seen in the rules that govern asset-allocation in the NPS Tier 1 account, especially of its auto-choice options where the exposure to (E) is reduced at an increasing clip from the age of 40 onwards.
In contrast, under the active-choice option, the prevailing rules require that by the age of 60, exposure to stocks cannot be more than half (50%) of total balance outstanding. As the governing intent behind the design of NPS is to provide minimal stream of income in retirement, putting the brakes on stock exposure at 50% by the age of 60 under the active-choice is, on the whole, neither too restrictive nor too liberal, and may be termed as striking an appropriate balance.
The behaviour of the auto-choice options, on the other hand, may be driven by the life-cycle assumption for typical employees, i.e., they will contribute to the NPS from an early stage of employment, and by the age of 40, would have built up a substantial sum of savings (in relation to their incomes) inside their NPS accounts. As a result, going forward, it will be more important to reduce the volatility of their balance.
But, both today, and going forward, the idea of a stable stream of income during working years may be an option which may increasingly be confined to a smaller and smaller minority of the labour-force. In an era of increasing gig-economy, contract-based work, independent professionals, more entrepreneurial set-ups, the notion of a stable and secure employment may have long past its expiry date.
Thus, what should be safe-guarded is to ensure that allocation to stocks within the NPS does not fall below 50% prematurely at an early stage, all the while when the need to work for longer beyond the age of 60 may actually be on the rise. For instance, within the auto-choice options, by the age of 55, the (E) component hovers between 5 to 15 percent.
On the other hand, if such a course of action is indeed chosen, then it must be carefully thought through. The saver, without realising, may accidentally and inadvertently end up increasing the fragility of his savings by drawing out prematurely long-term adaptability from them.
Account opening and contributions.
With any long-term savings solution it is prudent to register at the earliest permissible age: in the case of the NPS, it happens to be eighteen (18). It is also highly advisable to remain invested for as long as possible: again, in the case of the NPS, it is seventy-five (75) as per extant rules. These figures may be revised in the future, and the reader must verify the same from time to time.
A recent amendment allows the parents or a guardian may set-up and run a NPS Tier 1 account on behalf of their children till they reach the age of eighteen. While an excellent idea in general, it is more prudent to first direct savings for children to their PPF accounts and life-insurance policies, and the surplus left, in any, may then be directed to a child's NPS account.
Meanwhile, for someone who has crossed the age of sixty and does not have a NPS account, the option of opening one is also available until the age of sixty-five (65). The reader is advised to refer to the latest guidelines on the website of the NPS Trust for the same.
Next, comes the decision of how much, how and for how long to contribute. For an average middle-class family, allocating at least a third to half of its monthly savings to the NPS may be helpful. If possible, this amount may be increased by 3-5% with each passing year. These contributions to the Tier 1 account should be made steadily and regularly given that they are flowing into market-linked securities instead of in ad-hoc amounts at irregular intervals.
Now, when should the contributions cease? This depends on the asset-allocation that is likely to prevail nearer to the point of withdrawal or closure. If the intended asset-allocation is highly conservative (say (E) under a sixth of the Tier 1 account balance), then the contributions may be continued till the date of closure.
On the other hand, if the allocation is moderate (say (E) more than sixth but less than a third) then it is prudent to reduce the contributions year to one to three years before the intended closure of the NPS account.
However, in case (E) is more than a third, then, perhaps, significantly reducing, or ceasing, contributions to the NPS at least three years before draw-down, may be prudent so as to ensure that the last few contributions are not over-exposed to the vagaries of the stock-market.
Withdrawals out of the Tier 1 account.
Now, upon reaching the age of sixty or superannuation, there are five choices available. The first is to close the account, withdraw a lump sum of upto sixty percent (60%) tax-free (at once, in parts or through a systematic withdrawal plan), and convert the balance forty percent (40%) into an annuity. While convenient, it is advisable to bear in mind that a collection of marketable securities is not the same as a provident fund account. In particular, to liquidate an entire portfolio in one go will expose it to the whims and fancies of two factors: movements in interest rates and movements in stock prices, both being largely unpredictable.
The second option is to avail the annuity at the age of 60 (or superannuation) but defer the withdrawal of the lump sum, and instead, spread it over installments till the age of 75. It may, of course, be withdrawn in fewer instalments or even all at one go. The larger point is that this option makes eminent sense if the retiree needs some basic income right now, but has other supplementary sources of income giving time for the corpus to compound further.
The third option is a variation of the second, whereby it is possible to defer both the purchase of the annuity and the withdrawal of the lump sum. The annuity can be deferred by a maximum of three years (after the age of superannuation or 60, whichever is earlier). But, like in the case of previous option, the withdrawal of the lump sum amount can be spread over instalments till the age of 75. This option may be chosen, for instance, if the working years happen to get extended, or there are other sources of income that happen to be available, and/or the state of the stock-market happens to be unpleasant.
The fourth option again is a variation of the third, whereby it is possible to defer both the purchase of the annuity and withdrawal of the lump sum till any such time until the age of 75. Like in the case of the second and the third options, the lump sum may be withdrawn at once, or in instalments. It is highly likely that this option will be chosen by those who have other sufficient sources of income for some more years, and have a sizeable NPS corpus which they do not wish to add to further and only need to call into service when they are well in their 60s.
The fifth and final option is to continue the Tier 1 account, i.e., to continue to contribute, upto a maximum age of 75 years, with the option to close it anytime in-between. If personal financial circumstances permit, then this may, by far, be the most sensible option to avail of. And for the obvious reason that it gives the accumulated corpus time to compound as long as possible, as well as an option to continue to contribute to what is essentially a highly tax and cost-efficient instrument. It must be noted that this is the default option under the rules of the NPS, and that the subscriber must expressly choose this option at least 15 days before the age of 60 or superannuation, whichever is earlier.
In the particular case of death of the contributor, the accumulated savings get transferred to the nominee. It is important to seek answers to three questions before filing a withdrawal claim upon death: first, is the entire saving to be withdrawn as a lump sum, or part of it used to purchase an annuity? Second, what are the tax implications of receipts of such funds in the hands of the nominee? Third, when is the right time to withdraw, shortly after death, or to wait for a while in case market conditions are unfavourable at the time of death? The rules of the NPS that govern these three considerations may be periodically updated and it is important to study them before filing the death claim.
Customisability and volatility.
In the general discussion on the NPS what is not appreciated enough is its inherent flexibility. From the outside, its long lock-in period and its rule-based nature give an impression of a frigid product much as in the mould of a non-term life-insurance policy.
But, just as in the case of a non-term life insurance policy, the NPS is a financial instrument with many features. The trick lies in knowing all of them and then tuning them in the right proportion to suit personal circumstances. And, like in the case of non-term life insurance contracts, those willing to apply heuristics, intuition, imagination, creativity and caution may find highly interesting applications for the NPS.
Given the set of all possible fine-tunings, for those financially fortunate to have other sources of substantial savings, the NPS can not only be a useful solution for income-retirement, but also a very useful product to accumulate a legacy for the next generation, or to build a general-purpose endowment.
Whichever way the NPS is looked at, the flexibility of the NPS can be boiled down to answering the following questions in the context of every family's unique financial circumstances. While the previous section covered these questions, it is worth re-considering those answers bearing in mind the fact that the NPS is a market-linked and market-driven instrument, i.e., it is volatile.
1. When to open the Tier 1 account?
2. How much and how long to contribute?
3. When to close and withdraw from it?
4. How to withdraw from it and what to do with the withdrawal proceeds?
5. How to set its asset-allocation?
6. Does it make sense to open the Tier 2 account, and if so, how to manage it?
When and how much?
The first question, based on all of the discussion earlier, has a short answer: as early as the law and family savings allow.
The second question, typically, is given scarce thought, with the fifth question (on asset-allocation) getting most attention from savers. But, in fact, it is the second question that is of the utmost importance. In effect, it asks the family to make a choice on what portion of its savings it wishes to direct to marketable securities on a consistent basis over an uncomfortably long holding period.
The best way to arrive at an answer is to reconsider the NPS as an insurance contract for adaptation for which premiums have to be paid every month without fail, else the contract will lapse. The question may then be framed as: what is the premium that a family is comfortable paying unconditionally and without fail its insurance contract?
Now, common-sense implies that every household will only risk that part of its savings to a very long-term insurance policy — that too one investing in volatile assets — after providing for liquidity and solvency needs. The answer will therefore be arrived at considering the fact that the household does not find itself short of cash while befriending the market.
(N.B. A purchase of a marketable security involves exchange of cash-in-pocket today for a promise and not guarantee of payment (or a series of payments) tomorrow. The term 'security' therefore implies a 'promise to pay that is secure'.
This act is, then, effectively exchanging the surety of today for the possibility of an even better tomorrow, not unlike being a creditor to a borrower. In going from today to tomorrow it is important to keep more than some spare change in the family pocket. How much of a spare change depends on how bright tomorrow appears relative to today and how long is the road leading there.
The answer to these questions does not lie in a rational calculation of figures alone; it involves a high degree of subjectivity concerning the family's own circumstances. The preceding definition, if anything, makes one thing clear: it is not as easy to be a saver of long-term capital as is typically made out to be. It is less about what the economy, markets or society will do; much depends on how a family will cope with life in general.
But the cult of investing provides many means to forget this fundamental distinction between exchanging today for tomorrow, between society and self, between cash that can pay bills today versus pieces of paper that promise to pay bills tomorrow. This cult forever presents a temptation to over-allocate to markets under the 'religious belief' that "markets always bounce back", "stock investing is a sure thing" and that not allocating enough is "missing out".
But converting the act investing to one of 'insuring' serves to remove many such temptations. More importantly, thinking of 'investing' as one form of 'insurance' ensures that there is little regret at having missed out.)
Withdrawals
While the second question, which matters much, has an answer grounded in some technique, the third and fourth questions are the most difficult to come up with answers to suit everyone's personal circumstance. The reason again is that the NPS is a portfolio of marketable-securities, and as a result, its value fluctuates.
The idea that possessing lots of long-term government securities reduces this variability is a dangerous axiom to rely upon when the time comes for withdrawal. In periods of great uncertainty, such as wars, pandemics, turmoil in domestic political economy, etc., the government bond market may turn from an ally to a foe: the prices of government securities can gyrate quite rapidly to spoil the best laid plans.
Of course, after a sudden surge of volatility there is also a period of relative calm. Volatility in prices of bonds, it is true, returns to normalcy sooner than stocks after a massive rout. It is therefore prudent to always wait for some sense of normalcy (to return) before making a withdrawal decision. What is important therefore is to ensure that there is available always a span of time over which to make the decision of withdrawal.
Out of the five withdrawal options highlighted earlier, barring the first the remaining provide this range of time, while the first obviously precludes it. So, as a general rule-of-thumb, it is preferable to be careful to not jump to the first option, if it is possible to avoid doing so.
The second rule-of-thumb is to stretch the withdrawal of the lump sum component over a period of time rather than at one go. Both, the second and the third options, allow for this. Of this, the third option is preferable to the second, as it extends the waiting period for both the annuity and the lump sum.
(N.B. It should be noted that answers to the first two questions have a bearing upon the third and the fourth. For, if contributions happen to the NPS Tier 1 account over a longer period of time, family takes advantage of what is called "rupee-cost averaging"; i.e., when prices of vegetables are low, it is possible to buy more with the same amount than when they are high.
Thus, the more these purchases are made systematically over a longer period of time, the more the average cost of purchase is contained, thereby providing an embedded form of insurance against future market volatility.)
Irrespective of the (withdrawal) option chosen, the best use of the NPS, as pointed out earlier, is to use the (accumulated) corpus to provide a minimal level of passive family-income through building an annuity-ladder.
Thus, the portion which is received as lump sum can also be used to purchase a series of annuities: either immediate or deferred, with or without riders or qualifications. If these purchases (of annuities) are staggered appropriately, and the mix of annuities chosen with prudence, then the contractually guaranteed income generated by this 'annuity ladder' will likely exceed those available from comparable fixed-income options.
In addition, annuities also provide protection against changes in the path of the future rates of interest (viz., the yield-curve), what is also termed as the interest-rate risk, and more generally, as reinvestment risk.
(N.B. Those individuals who rely on interest on past savings, interest-rate risk is more detrimental than what the stock-market does. If the future rates of interest go down, then, upon maturity the proceeds of their deposits or other fixed-income alternatives will have to be invested at a lower rate of interest; or the tenure of these deposits need to be lengthened (viz., the duration increased). In old-age, this is like being fired from a job: the adjustments that would then have to be made to the life-style can be psychologically and physiologically very taxing.)
On the other hand, if it be decided to not use the lump sum withdrawal for the purpose of passive family-income, and instead, to use it for, say inheritance, then a different approach to handling large sums of cash may be warranted, including, but not restricted to, use of other forms of non-term life insurance contracts.
(N.B. Of course, for the very well-off, the lump sum may serve simply as surplus funds, and can be converted into 'capital' by investing for the inordinately long-term in productive business activities, preferably through the public stock-market.)
In short, the customisability of the NPS when it comes to withdrawal, may seem cumbersome at first, but it is, in fact, a blessing in disguise. While there is only one way to put money into the NPS, there are many (ways) to take it out, in order to help the family navigate volatility.
This brings the discussion to the last two questions, and the features that can, perhaps, be tailored the most to suit the family's circumstances: asset-allocation and the possibility of adding a Tier 2 account.
Setting and rebalancing the asset-allocation with passing age.
During the accumulation phase, there are two questions that can occupy a family's mind with regard to the NPS: what ought to be the asset-allocation when opening the Tier 1 account, and what should it be closer to the time of withdrawal?
Before moving forward it is important to remember: all rebalancing carried out within the NPS, whether in its Tier 1 or Tier 2 account, does not result in capital gains tax in the hands of the saver. This is unlike if mutual funds were rebalanced manually. Thus, inside the NPS, the rebalancing can be carried out thoughtfully and systematically without reference to tax considerations.
Asset-allocation at the point of account opening
The question on asset-allocation will, by definition, not apply to those who have not opted for auto-choice. Similarly, it will also not be applicable to those who are in their 50's: if they have opted for auto-choice, it is best they start with the asset-allocation set at 50% (E): 25% (C): 25% (G), or a lower (E) depending on the period of contribution.
(N.B. As a rule-of-thumb, a higher starting allocation to (E) is preferable to a lower one. The reason for dividing the balance equally between (C) and (G) is a matter of heuristics and convenience; not much will be gained by trying to find the optimal allocation between corporate bonds and government securities.)
The question of asset-allocation is also less relevant for those who have opened their NPS account in their early to mid 60s. Their reasons for entering the NPS may be other than to produce retirement income: perhaps, they want to park a portion of their life's savings in a tax-sheltered account and annuitise later; or, it could be for reasons related to bequest, endowment or tax-deferal. In such cases, they are better-off choosing a more conservativetive-to-moderate allocation to (E), perhaps, allocating anywhere between 15 to 33% (but not more) of their savings to (E).
On the other hand, those in their 20s, 30s or even in their early 40s, with a longer planned horizon of contribution and who have opted for active-choice, can afford to set their starting allocation to (E) at 75%. The balance may then be equally divided between corporate bonds and government securities giving a resultant allocation of 75% (E): 12.5% (C): 12.5% (G).
(N.B. The figure of 75% also happens to be the maximum permissible limit for allocation to stocks under the extant Tier 1 rules. This, on the whole, is a sound rule, and can serve as a general boundary condition: even if the rules allow for great allocation to stocks in the future, it is preferable to not exceed this limit.
Putting all the eggs into one basket has never been a prudent financial act, and there is little to break from prudence when it comes to dealing with an instrument like the NPS which is likely to prove integral to balance-sheets of many ordinary families.)
However, for those who have opted for active-choice but do not forsee a long horizon of contribution, restricting the maximum allocation to stocks at 50% may be advisable. This then gives rise to the starting asset-allocation of 50% (E): 25% (C): 25% (G). Is the figure of 50% based on some impeccable financial logic? Of course not, but it is, again, a simple and intuitive heuristic to work-off.
Meanwhile, those opening their NPS accounts in their early fifties, but who clearly intend to hold it for at least ten to fifteen years may consider setting their starting stock-allocation at one-third, i.e., 33%. This figure is not without relevance: there is a large constituency in work-force today that will soon near the end of their full-time active working years, but who have never taken exposure to market-related instruments. For them, the figure of 33% is a meaningful and manageable starting heuristic (to work-off).
Whether it be 75%, 50% or 33%, or any figure in between, the important point to remember is that the starting value of (E) is not, necessarily, the one that will remain for the remainder of the time that the Tier 1 account is active. It will, by necessity, have to be brought down, nearer to the time of account closure.
Asset-allocation at the point of closing.
So, what should the allocation to stocks be at the time of withdrawal? As noted earlier, the menu of auto-choices bring down the range of (E) between 5 to 15% by the age of 55. In contrast, those opting for active choice will be require to restrict their stock-allocation to 72.5% by the age of 51, 70% by the age of 52, and so on, till it reduces to 50% by the age of 60. After that, it may be maintained at this level till the point of closure.
This act of actively changing the asset-allocation, which in turn will shift past contributions from stocks to bonds, and direct a larger share of future contributions to fixed-income securities may be termed as rebalancing under the NPS.
The question of rebalancing the Tier 1 account is closely tied to the the previous questions on time of closure and method of withdrawal.
For those who intend to continue their Tier 1 account well past the age of 60, say in their 70s, bringing down the (E) to 50% by the age of 60, as per the rebalancing path mandated under the active-choice, is perhaps as good as it gets.
However, those who intend to not contribute further to their NPS account upon reaching the age of 60 but who instead desire to keep the account active for sometime by deferring annuitisation and withdrawal of the lump sum, setting (E) at no more than 33% will allow them to retain the optionality provided by stocks without getting burnt by their volatility.
On the other hand, those who intend to withdraw the entire proceeds of Tier 1 account in one go at a certain age, should ensure that they have no more than 15% allocated to stocks closer to their planned date of withdrawal.
Glide path
Whatever be the starting and ending stock allocations (i.e. values of (E)), the final question is at what age should the process of rebalancing begin and at what rate?
For instance, for those who intend to contribute their Tier 1 accounts well into their 70s, it is best to begin from the age of 50 and not earlier, and each year reduce their exposure to stocks by 2.5%. So that if they started with 75% allocated to stocks by the time they reach the age of 75, their stock exposure would fall by 2.5% x 25 years = 50% to 25%.
Meanwhile, for those who intend to close their Tier 1 accounts upon reaching the age of 60, or shortly thereafter, beginning the rebalancing earlier, say by the age of 45, may be prudent.
There are a couple of caveats though, the first being the size of the savings accumulated inside the NPS. For those who have not had a chance to contribute a lot to their Tier 1 account, and the amount of savings is not material in relation to their income, or other pools of savings, it is best to not actually rebalance beyond what is strictly mandated by the NPS rules.
(N.B. The fact that the Tier 1 account is not material to the family's balance-sheet means it can afford to delay the closure/withdrawal from the Tier 1 account. This lower dependency and consequent ability to delay means that the family can afford to take a calculated risk to capture the upside, if any, that the stock market may charitably provide.)
The second caveat concerns the starting allocation to stocks. If the starting allocation is low, say 33%, then instead of an equally-spaced rebalancing, the rebalancing may be done gradually at first, and then accelerated later. It is best to actually draw up a table of the planned reduction of (E) by passing age in such a case.
In the end, as regards the right glide path, there is little point in splitting hairs over imponderables and circumstances whose probabilities can only be computed with precision in hindsight. The options for withdrawal provide sufficient room to make decisions slowly and carefully.
Having a mechanical set of rules for asset-allocation helps to stick to a course independent of market considerations with an important part of family's capital. The intent is to strike a balance between taking exposure to the stock-market but rebalancing out of it at the right time and as gracefully as possible.
But any choice made on this front is always likely to leave room for regret. For instance, continuing to reduce stock exposure further may result in less than desirable level of balance in the Tier 1 account when the time beckons for withdrawal because the investments missed all of the upside of the stock-market in the intervening period.
On the other hand, maintaing the stock exposure at, say half, may result in finding oneself on the wrong-side of the market movement closer to the time of withdrawal causing an unexpectedly large shrinkage in the Tier 1 balance.
This, then, is where the last lever of flexibility of the NPS system joins in.
The Tier 2 account: 'investment' versus 'capitalisation' merit.
So far the attention has focused only on the Tier 1 account where the bulk of the long-term savings accumulate. Much of the discussion concerned the theme of saving in a fashion so as to protect these savings from the the short-term volatility of marketable securities, while at the same time to gain from the optionality of stocks.
The Tier 2 account is like the less appreciated younger sibling wherein the elder child takes all the honours and accolades. The Tier 2 account can be opened any time after opening the Tier 1 account, and like the Tier 1 account, it too is highly cost-efficient and regulated. However, lacking the tax-advantage(s) of the Tier 1 account causes it to fall out of favour.
It, however, makes up for this short-fall through the greater autonomy it enjoys: there are no constraints attached to the Tier 2 account, be it with regard to contributions, withdrawals, asset-allocation or asset rebalancing. On the face of it, this autonomy makes it look like any other open-ended equity or balanced mutual fund, in turn begging the question: of what then is its real utility?
The fact that it is part of the NPS umbrella with its enviable cost-advantage and regulatory oversight makes the Tier 2 account most suitable to address the question on how much to allocate to stocks with passing age. It is so because the freedom of asset-allocation provided under the Tier 2 account allows increasing or decreasing, i.e., calibrating, the totality of the exposure to the stock-market inside the NPS.
But before moving forward, it is important to note that the Tier 2 account must be closed when the Tier 1 account is closed; or, it must be terminated upon death of the account holder. These withdrawals from the Tier 2 account can either be redeemed in cash, or transferred to the Tier 1 account. Barring the event of death, this can be done in a planned manner over multiple transactions, or even several years till such time as the Tier 1 account is active.
Use-case #1: Minimising regret by increasing allocation to stocks
Now, to use the Tier 2 as a 'stock calibration tool' it is first necessary to not transfer all the planned contributions to the Tier 1 account. Of the total amount set-aside in the family budget for the NPS, a useful heuristic may be to contribute four-fifths (80%) of it to the Tier 1 account and the balance one-fifth (20%) to the Tier 2 account.
Secondly, when opening the Tier 2 account, it is worthwhile to keep its initial asset-allocation at 50% (E): 25% (G): 25% (C) independent of the age, and hold it steady till the age of 50 years. Over time, this pool of savings in the Tier 2 account keeps accumulating in a less volatile manner compared to the Tier 1 account.
Now, as noted earlier, beginning the ages from 45 to 50, the allocation to stocks in the Tier 1 account will progressively reduce so as to align with the planned time of withdrawal and the particular manner in which the withdrawal is intended to be executed. This unwinding of the (E), in turn, led to the question of: will the Tier 1 account run the risk of having too little in stocks?
Imagine, having two portions of something: one large and another one quite small. If experimentation must be done, it is always prudent to do so on the smaller portion. With this in mind, what if the question of asset-allocation is set up as follows: as exposure to stocks is removed from the Tier 1 account, how about increasing it in the Tier 2 account at the same time, and in the same proportion?
So, for instance, if allocation to stocks is being reduced by 2.5% annually from the Tier 1 account, what if it is increased by 2.5% in the Tier 2 account by reducing the (C) and (G) accounts equally? Over time, the (E) in the Tier 2 account will grow, and in certain cases, even reaching 100%.
It must, however, be noted that this asset-allocation in the Tier 2 account is on a much smaller pool of savings (as only a fifth of the contributions were directed into it). So, while the (E) may appear large in percentage terms, in absolute rupee terms, when compared against the total savings held in the Tier 1 account, it will not result in a proportionate and dramatic increase in the fluctuations in prices of the total cumulative savings held inside the NPS.
The Tier 2 account, thus, allows for tweaking the exposure to the stock-market to minimise regret: if there is a stampede in stock prices then the upside can be gathered swiftly enough, and, on the other hand, if the stock-market undergoes trouble then the tweaking can be paused without causing a significant dent in the value of the savings.
This method allows the Tier 1 account to be operated in a strictly formulaic fashion with all the experimentation being confined to the Tier 2 account.
There are two follow-up questions to using the Tier 2 account: how long should contributions be continued to the Tier 2 account and when is it advisable to start withrawing from it?
Contributions can of course be continued along-side this rebalancing; but they should not be excessive. Unfortunately, there are no rule-of-thumbs here that may be offered as easy generalisations.
The decision to withdraw is more tricky as money may be transferred out of the Tier 2 account either as transfer to the Tier 1 account, or redeemed in cash. Strictly, from a taxation stand-point, the best withdrawal strategy for the Tier 2 account is to transfer its balance to the Tier 1 account in a staggered, and preferably systematic, manner, over a period of time.
Whatever be the mode of withdrawal, given that the Tier 2 account may have higher exposure to the stock-market, the withdrawal must be staggered over a period of time rather than transferred or redeemed in one go, unless there is a compelling reason to do the same.
Use-case # 2: Deferring the closure of the Tier 1 account by ensuring an income floor
The possibility of availing direct redemptions out of Tier 2 account allow it to serve the purpose of being a source of running income post peak earning years, thereby delaying the closure of the Tier 1 account as well as to hold a slightly higher allocation to stock in the Tier 1 account. This, in turn, allows the possibility of a higher and tax-efficient growth of savings within the Tier 1 account.
Recollect, that the Tier 1 account, where the majority of the corpus is held, has to maintain a conservative allocation to stocks closer to the time of withdrawal, in order to safeguard the corpus from the effects of short-term market volatility.
While the NPS rules provide sufficient flexibility to elongate the tenure of withdrawals, this alternative use (of the Tier 2 account) can be used to further add to that 'withdrawal flexibility'. It is of especial aid to those who understand the importance of having higher allocation to stocks, but are unsure of when they would need to withdraw their Tier 1 corpus.
In particular, it enables those who may have otherwise opted for the second withdrawal option (purchase of annuity and deferal of lump sum), to consider opting for the third or the fourth options (deferral of annuity and lump sum). Likewise, those who may have otherwise opted for the third or the fourth option to feel more comfortable to consider the fifth, i.e., continuation of the Tier 1 account.
Now, for the Tier 2 account to serve this role, its asset-allocation has to be calibrated in the direction opposite to that in the first use-case. Thus, with passing age, as the (E) of Tier 1 account is reduced, it is simultaneously decreased in the Tier 2 account. But there is a caveat: for the Tier 2 account, instead of allocating the difference equally across both the (G) and (C) components, the entire rebalanced amount is directed to the (C) component.
The reason is that corporate bonds (C) provide two advantages over Government securities (G): they have a shorter average duration, and offer a higher rate of interest. Now, public corporations, by definition, cannot borrow for the same tenure as a Government (can). Therefore, at any point in time, a representative basket of their bonds will be of shorter average maturity than that of Government securities.
Further, as experience shows, a representative basket of high-grade corporate bonds, on average, offers higher yield than a basket of government securities without compromising significantly on safety. Of course, not all the corporate bond securities held within the NPS investment accounts will be of higher-rated quality: the rules do permit taking exposure, in a limited manner, to securities of slightly lower quality (but not too much). Nevertheless, the duration of the corporate bond portfolio inside the NPS account will necessarily be lower, and the average interest rate higher than government securities.
Now, duration is a measure of sensitivity to movements in rates of interest. Thus, tilting any portfolio of marketable securities towards intermediate-term corporate bonds means that the short-term volatility of a combined portfolio of stocks, government securities and corporate bonds is lowered.
At the same time, the growth of the portfolio is also lower but, on the other hand, there is a possibility to earn a steady and higher rate of regular interest income. This type of 'corporate-bond tilting' asset-allocation constitutes the basis for this alternative use of the Tier 2 account.
The fact that the Tier 2 account can tax-efficiently rebalanced to the desired asset-allocation means that it is possible to convert the entire starting asset-allocation (posited earlier) of 50% (E): 25% (G): 25% (C) to either 100% or predominantly in corporate bonds (C) over a period of time. This effectively creates a layer of low-volatility with steady interest income.
Further, it is possible to withdraw funds out of this layer as and when needed without worrying too much about adverse market-movements. This, in turn, provides the financial wherewithal and psychological comfort and flexibility to defer the closure of the Tier 1 account.
Under this use-case, the path to rebalance the Tier 2 account can be as follows: at a certain age, preferably mid 40's to early 50's, the Tier 2 account is systematically rebalanced anywhere between 1.25 to 2.5% annually by reducing the (E) component and increasing the (C) component. As an illustration: considera starting asset-allocation of 50% (E): 25% (G): 25% (C). Then, assuming a rebalancing of 2.5% annually, after ten years (a decade) the asset-allocation would stand at 25% (G): 75% (C).
While this hardly invites any complications, the trick lies in recognising the cumulative effect of three forces: benefits of higher allocation to corporate bonds over government securities and stocks; the tax-efficiency of rebalancing within the Tier 2 account as compared to a mutual fund; and the ability to withdraw funds out of the Tier 2 account in a lump sum or staggered manner.
Together, these three features create a pool of savings which can be accessed as and when need be to serve as a source of income. In doing so, this low-volatility savings layer provides a choice to defer Tier 1 account closure. This, in turn, creates space for greater allocation to stocks inside the Tier 1 account.
'Investment' versus 'Capitalisation' merit
Use-case #2 is an example of giving emphasis to the 'capitalisation' merit of a financial instrument over its investment merit. Now, 'investment' merit implies that the intent is to grow the savings to meet a future need, while 'capitalisation' merit implies making the savings serve as reserves and/or collateral to meet contingent needs of today.
Such contingent needs include the need for credit, income, providing minimal guarantee or setting a floor to the balance-sheet, and so forth. Capitalising something means designing it such that it can be accessed when needed. Investment, on the other hand, means giving up the control of access to the savings in return for an expected higher reward.
This distinction, best articulated in the Infinite Banking Concept of Nelson Nash, is missed by most financial advisors. For instance, a non-term life insurance policy possesses three measures of value: insurance; custodianship; and capitalisation. It possesses very limited, if any, investment merit. A pure annuity, meanwhile, has purely an insurance merit: to provide life-long guaranteed income no matter what.
On the other hand, stocks have only investment merit. Relying on the stock-market to provide custodial or insurance services, or serve as a source of capital, is an abuse of the use of the stock-market.
The solitary axiom of prudent financial planning is to capitalise first, then invest: the part of the family's balance-sheet devoted to capitalisation should be higher than (that for) investments. This is because the value of being able to access your own 'capital' when truly needed far exceeds the expected growth that may be derived by handing over access to your capital to, say, the stock-market.
In purely financial terms, the value of a call option that may be executed any time, and multiple times, on a pool of savings far exceeds that of an arrangement wherein those savings are held hostage to the whims of behaviours of others, such as managements and other share-holders of public corporations for instance.
This, of course, stands in complete opposition to the prevailing financial strictures that advocate the opposite. In finality, each family must make its own choice in this matter. The NPS, on the other hand, due to its flexibility, is able to supply several of these roles under one umbrella.
Use-case #3: Tax-efficient custody of windfalls and other large proceeds
Having recognised this distinction between investment versus capitalisation merit – and the fact that it may be designed for under the aegis of a NPS through its Tier 2 account – it is possible to advance more cases in its favour that exploit Tier 2 account's capitalisation merit.
In particular, it is possible to extend the Use-case #2 further for those individuals who have the financial capacity to extend their closure of the Tier 1 account to the age of 70s, and beyond, by taking advantage of the prevailing tax treatment of the NPS Tier 1 account.
Consider the case of a family which receives large proceeds when the primary earning member(s) is nearing retirement. These proceeds could arrive in the forms of inheritance, withdrawals from the Employee Provident Fund account, gratuity proceeds, proceeds upon maturity of life-insurance policies, or some combinations thereof.
An important point when handling large sums of cash is taking care to channel them towards the desired purpose in a tax-efficient manner, else the sudden increase in attendant tax liability can be pyschologically and financially unsettling for those not used to it.
Now, if the intention is to leave a portion for the next generation, then, contrary to popular opinion, non-term life insurance policies are a sound option (to park large sums). They provide a safe and tax-efficient custody for large sums of cash for an extended period of time with contractual guarantees of custodianship and return of principal.
However, if a part of these proceeds are intended to be consumed within the span of one to two decades, then open-ended mutual fund schemes (debt or balanced-funds) have a role to play (for such a portion). These are more tax-efficient than fixed deposits as well as provide access to these funds as and when needed.
Now, an improvisation on mutual funds is to use the Tier 2 account with a conservative asset-allocation (such as in the Use-case #2 above). Since the Tier 2 account is open-ended, it provides all the benefits of either a debt mutual fund, or a conservative hybrid mutual fund, at a significantly lower cost.
If it happens to be the case that the portion of windfall proceeds parked in the Tier 2 account remain unused, then there is the option to transfer the balance to the Tier 1 account before the latter's closure. In such a scenario, the Tier 1 account will consist of contributions made to it, their growth over the years, and the large balance from the Tier 2 account.
Recollect, as discussed at the outset, the Tier 1 account enjoys dual tax-benefits in form of exemption as well as tax-deferral: the 60% lump-sum withdrawal is tax-exempt while the annuity is a means to defer taxes. Thus, the large proceeds put into the Tier 2 account come out of the Tier 1 account with a more favourable tax treatment.
This funnelling operation then is equivalent to applying the tax-efficiency of the NPS to mutual fund schemes. Before these funds are funnelled, they are housed inside the Tier 2 account and available for withdrawal. These withdrawals are taxed similarly to mutual funds. Once transferred to the Tier 1 account, the same funds are now available for withdrawal through a combination of tax-exempt lump sum and tax-deferred annuity proceeds.
Use-case #4: Setting up a tax-efficient contingency reserve
Use-case #3 highlighted that with a conservative asset-allocation, the Tier 2 account can provide a custodial function. It can house funds in a cost-efficient way, provide liquidity by enabling withdrawal when needed, and, by eventually funnelling the funds into the Tier 1 account, ensure tax-efficiency.
This utility of the Tier 2 account can be used for another critical purpose in old-age: to maintain a separate and sufficiently large contingency reserve to meet large and sudden expenses related to health as well as with capital spends related to housing and vehicles.
From an early age, it is possible to direct contributions to the Tier 2 account with this aim in mind. The asset-allocation (of Tier 2) for this purpose, can be set somewhat as 50% (E): 25% (G): 25% (C). With time, this asset-allocation, as discussed in Use-case #2 can be tilted more towards bonds.
If, at the point of closure of the Tier 1 account, there is balance left (in the Tier 2 account), the same can be funnelled to the Tier 1 account as illustrated in Use-case #3. Thus, it is possible to build a market-linked, volatility-contained, low-cost and tax-efficient emergency reserve through the modus operandi of the Tier 2 account.
By the time of retirement, this can help accumulate a sufficiently large pool of savings inside the Tier 2 account. Given the bond-heavy asset-allocation of the Tier 2 account by then, these savings are also safe from short-term volatility shocks. Furthermore, they are also available for withdrawal when need be.
Combining the PPF and the NPS: synchronising investment and capitalisation merit.
The variety of use-cases (of the Tier 2 account) drive home an important point: like a non-term life insurance contract, the NPS can be made to serve multiple ends by making the Tier 1 and Tier 2 accounts talk to each other.
It also showcases the fact that for most of the ordinary families in India, the NPS along with the PPF, is a powerful combination. The PPF can be built-up to represent the 'capitalisation' part of the balance-sheet, and the NPS can start with serving the 'investment' part, but then evolve at some point to tightly intertwine itself with the 'capitalisation' end.
Say, a family starts to save in both the PPF and the NPS. (It bears mention that a family is not just restricted to a single PPF account, but may open one for each of its family members. For the sake of illustration here, though, only one is assumed.)
Now, the PPF has a 15 year lock-in period, wheren in after completing 15 years (counted from the end of the first year of opening the account), the PPF account holder has the option to close the account, and withdraw the entire balance.
However, the option also exists to continue the account for a further period of 5 years, either with or without contribution. This arrangement, it should be noted, can continue indefinitely. During this period of continuation, the rules of PPF allow the account holder to withdraw a portion of the corpus once a year without any questions asked. This amount withdrawn is, however, limited to a certain percentage of the total balance outstanding as of a particular date. Anyone will recognise that, unless circumstances irrevocably compel, the value of the option to continue outdoes the one-time decision to permanently close the PPF account, irrespective of the interest rates.
Now, say, the first period of 15 years has elapsed, and the family has decided to continue staying with the PPF account for as long as possible. Over time, the account balance will grow tax-free, and at the end of every financial year, in March, the interest will be credited to the account.
Now, it is possible to take out a portion of this interest credited annually, and transfer it in a systematic and staggered manner to the Tier 2 account. Taking money out of the PPF for purposes other than genuine need should be done only in the month of March, i.e., at the end of the financial year.
(N.B. This is because a PPF account, under extension or continuation, allows for only one withdrawal per financial year. Typically, this option should be made use of only if there is an emergency which demands that a large lump sum is required at short notice. Today, there is no better source of emergency reserve than the PPF in India.
Therefore, if withdrawal is made for reasons other than for emergency, it should be deferred until the latter half of the month of March. With only a few days left for the financial year to end, there is a possibility to make another withdrawal request, if such a need arises, immediately in the first week of April.)
Over time, as the PPF balance continues to earn interest, a portion of that is channelled to the Tier 2 account wherein it is invested in a mix of stocks and bonds. Over a period of a decade or more, the NPS Tier 2 account balance will provide a higher possibility (but not certainty) of growth to that interest as opposed to if the interest were to simply reside inside the PPF account. With time, the corpus accumulated inside the Tier 2 account may be a reasonable fraction of the total balance held inside the PPF.
Now, as the time draws near to close the Tier 1 account, as described in the Use-cases #2, #3 and #4, the asset-allocation of the Tier 2 account can be made more conservative. Finally, closer to the time of withdrawal, the balance in the Tier 2 account can be optionally funnelled through the Tier 1 account to avail favourable tax-treatment.
It must be remembered that while channelising funds from the PPF to the NPS in this manner, the family has access to the original contributions made to its PPF account, which too are growing, as not all of the interest is transferred out. However, along with this growing PPF balance, the family is also building up another pool of reserves, incrementally, inside the Tier 2 account. This, effectively, may be termed as trying to recycle cash.
While not as cost-efficient as the PPF (which has zero transaction and management fees), the Tier 2 account enjoys much greater cost-efficiency than what any mutual fund can offer. Importantly, it provides greater liquidity than the PPF account by allowing the saver easier access to that portion of the PPF that is transferred to the Tier 2 account.
Indeed, the interest earned on the PPF can serve as an input to Use-case #4, i.e., to build an emergency reserve. This, incidentally, complements the original purpose of putting money inside a PPF account of creating a pool of accessible emergency reserves through cost-efficient, tax-advantaged and highly regulated structures.
Finally, while there is no financial instrument that can match the tax-efficiency of the PPF, the Tier 2 account comes close due to the option of handing over (funnelling) its proceeds to the Tier 1 account at some point or another.
However, the Tier 2 account, or the NPS in general, is no substitute for the PPF account with its sovereign guarantee. Likewise, the NPS is no substitute for a non-term life insurance policy with its contractual guarantees. It is, however, possible to integrate the NPS intelligently into an integrated financial architecture of a familiy's savings plan by understanding the concept of a self-owned bank.
Building a self-owned bank.
In the words of Nelson Nash, founder of the Infinite Banking Concept, the goal is for each family to become its own banker. The family, which is an owner of this banking system, is also its governor, manager, depositor and creditor. It is free to set its own terms of how much to borrow, when and how to repay.
Nash, of course, wrote it for a Western, and in particular, a North American audience. It is not possible to exactly reconstruct the concept in the Indian context due to the lack of whole-life insurance policies offerred by mutual life-insurance companies. Nonetheless, it is possible to come close using what has been discussed so far.
Now, the first component of such a self-owned bank is contributions made to the PPF account over a 15-year period. This builds the foundation upon which such a banking system may be established. These contributions (to the PPF) in effect become a reserve asset to meet any contingent liability that the bank may encounter in the future. Every bank needs something to start its business: for a family wishing to become its own bank, it is the PPF account, or something analogous.
Next, the second component comprises the contributions made to term-life nd health insurance policies. They set-up large contingent assets, and if purchased early on in life, they can be purchased cheaply.
The third – overlooked and under-appreciated – component is the addition of one or more non-term life-insurance policies. These policies provide contractual guarantees to the whole balance-sheet in three ways: as a custodian of incremental savings; provision of secure collateral (in the form of growing surrender-value) againt which to borrow in times of distress; and the additional life-insurance component which ensures that whatever savings are put in, are at least available on death. Together, these three features work to provide a floor to the value of the balance-sheet.
Furthermore, if such policies are reasonably well-chosen then they also provide an additional service of converting the savings into planned and structured cash-flows to coincide with important spending points in a family's journey.
(N.B. Notice that the mention of reversionary, cash or terminal bonuses routinely attached to policies is elided. These bonuses are useful in a self-owned banking construct to the extent they increase the surrender-value over time. More of them are always welcome, but they can never be the basis for purchase of such policies. Unfortunately, the central marketing pitch of the life-insurance industry routinely harps on this chord at the expense of its true value to society — which is its ability to help small savers build their own growing pile of cash-collateral underpinned by legally enforceable contractual gguarantees, independent of the whims of the market, prying eyes of own family members, and the Government's ever greasy hand of taxation.)
The PPF and insurance policies (of various kinds), together, define the heart of such a banking system. Each of them sets up a different type of asset to provided fortitude to the balance-sheet, and a foundation upon which to plan further.
Now, a life-long need of any family is credit. Today, credit is used either to lever up or to consume recklessly. Often, however, what counts as productive is speculation in disguise: this includes the purchase of a large house or a vehicle which the family neither needs nor constitute tangible and productive capital in any real sense of the term.
(N.B. The matter of what constitutes capital or not capital may be a matter of judgement; but certainly there is no confusion between the tangible and intangible. For instance, procuring a large student loan for higher education is certainly in the realm of the intangible as well as speculation.)
Now, if the family is in possession of the above-mentioned 'reserve-system' – its own banking capital – then it can borrow from it or against it.
The third need of any family, after minimal surety against future exigencies and credit, is income: to be able to continue a minimal basic honourable standard of living even in face of crises.
The self-owned banking system above, constructed with assets backed by safety and guarantees, ensures that they throw out minimal income in form of interest on PPF and cash-flows from life-insurance policies.
Having such an income floor allows the family to not break its long-term investments, to meet its temporary credit needs without touching the principal, or to recycle this income back into its banking system through additional contributions to the PPF account, and/or purchase of more insurance policies. In short, the interest earned from the bank further perpetuates the solvency of the bank itself.
Now, attaching the NPS to this banking system adds an 'investment' merit to the bank and provides the bank with a minimal degree of inflation-protection. Further, as the use-cases for the Tier 2 account demonstrate, it is also possible to take the income from the core banking system and channel it into the NPS.
More broadly, this interplay between a highly conservative self-owned banking system and a highly disciplined and systematic warehousing of marketable securities (i.e., claims on future cash-flows of public corporations) ensures that the marketable securities can be held for the longest possible period to realise most value out of them. Further, as the ability to hold them expands, the amount of cash required to be directed to them also declines.
In other words, longer the duration, greater the potential benefit, and greater the potential benefit, lesser the amount needed to get the same bang for the buck.
Altogether, this leads to the doctrine of 'hold as long as possible without putting too much in' which constitutes the heart of the self-owned banking concept. This is in stark contrast to prevailing financial wisdom to stake the majority of the family's future on the stock-market by diverting a material part of savings into it.
Viewing personal finance through this prism makes the role of a simple income annuity very clear. Income annuities (whether immediate or deferred, life-long or for a 'certain period') provide a mechanism which 'apportions over time this banking estate' and converts it into a structured stream of guaranteed cash-flows. This 'chunking into cash-flows' then is the surest way to secure an honourable old-age.
Courage and creativity.
On the whole, building and managing a self-owned bank in its entirety requires courage and creativity in equal measure. It is not for those who follow the masses (where the 'm' may be silent). It requires imagination to see that it is possible to meet the needs of liquidity, solvency and inflation-protection in a conservative manner, while at the same time meeting the family's credit needs in an independent manner.
This courage, creativity and imagination is, in turn, a result of exceptional patience: the patience which is needed to weave various financial instruments together slowly and meticulously over time. An integral part of this patience is to engage continuously in the book-keeping and administrative paper-work which most individuals are wont to avoid. In doing so, they then lose the leverage that could otherwise have been gained by making three highly regulated, rule-based and transparent systems – PPF, non-term life-insurance and NPS – speak to each other intelligently.
Importantly, persisting with this mindset forces every familly to think in terms of matching assets with liabilities — the real essence of being a banker versus an investor. Doing so over time improves the financial acumen of the family and its ability to make more intelligent use of a variety of instruments to refine its asset-liability equilibrium.
After all, possessing a banker's balance-sheet is less about earning a lot of income; it is always, without fail, about treating whatever income comes into hand, by God's grace, with the diligence it demands. The icon of "Saraswati" has many hands: it is a hint that it takes knowledge of many kinds of instruments to carefully hold "Lakshmi".
It matters less how much money a family has at any point in time; but it bears repeating that it matters most whether it can access that money when it needs it, for the purpose it needs it, and on terms that make sense. Why depend on the whims of other's behaviours when it is possible to control one's own by capitalising first and investing later.
For, true wealth is nought but the sum of an infinite series of call options on capital available, and a put option on health and life. Investment is but only one amongst a range of techniques to be marshalled in service of this aim. Custodianship, collateral, insurance and credit are equally important.
The fact that such optionality can be exercised under the refuge of instruments with lots of rules and caveats, is something which escapes the intuition of those individuals who have been schooled to detach themselves from the methods-of-money of their grand-parents. Indeed, the very fact of there being rules, penalties and limitations is what fosters the discipline for imagination to burst forth. Those who grasp this will be happy with little; those who fail to, will lead a life of discontent and envy despite possessing much.
The latter are bound to join the ranks of many who compromise their soul for the sake of the size of their wallet — whose rightful place, after all, is only behind the ass. That last word accurately captures the plight of many with much money in their hands, but who have failed to convert the copious sum of money to true capital: that which they truly own, control and can access when they wish to.
NPS against (and with) Mutual Funds.
Now, when it is possible to accumulate and warehouse marketable securities as part of a self-owned banking system so cheaply with active management under the NPS, why buy index funds or for that matter actively managed funds? The answer should be obvious to everyone except perhaps the investment advisory services business which thrives on sales and advice based upon an incentive to promote and sell, rather than practical intracies of each family's distinctive position, as well as age-old norms of prudence and common-sense.
Nonetheless, two sound reasons exist to actually buy actively managed funds and make them synchronise with the NPS. These two reasons are: diversification and a permanent store of value.
The first of these reasons stems from the fact that the securities held inside the NPS are restrained by regulation to purchase public-market securities meeting certain thresholds. Thus, the securities purchased under the NPS account(s) excludes many otherwise useful securities for individuals with a long time horizon, including small capitalisation stocks, or foreign stocks. Actively managed funds are, obviously, a great aid here.
The second reason (to contribute to actively-managed funds) also stems from the regulated nature of the NPS. As per its statute, the NPS will have to hold a representative basket of public-market securities. This may result in the NPS holding securities which otherwise may anathema to many minds: such as shares of Companies whose habits of Governance leave much to be desired.
Actively managed funds can certainly provide this quality-filter (though it is also a fact that many do not) thereby providing access to a curated basket of residual claims on only the highest quality stocks. Effectively, a set of equity mutual funds focused exclusively on quality-stocks bought with price-consciousness constitute a permanent store of value, equivalent to Gold.
Such a basket is a strong (and some may say the most potent) hedge against inflation, i.e. debasement of currency which is a lived reality for every citizen. This permanent store-of-value, in turn, serves the purpose of the ultimate bequest or endowment. At the same time, it must be emphasised, that such considerations: diversification and store-of-value: are for individuals with too much time and money at their disposal.
For the vast majority, concerned with income in retirement, the NPS, with its focus on annuities and its customisability with regard to asset-allocation, is sufficient to provide for a family's core income needs. It is this constituency which may most benefit from channelling a material portion of their savings into the NPS (and PPF) and not get swayed by mutual fund adverts.
Bringing it all together.
Please refer to or download this diagram as the following discussion makes reference to it.
The above diagram brings it all together. It tries to model a family's internal financial flows, i.e. how cash flows between its earnings, its reserves (self-owned bank in the diagram) and its investment portfolio (labelled inflation-protecting the bank in the diagram). Importantly, it brings to the foreground a thorn in the shoe of every family: the constant diversion of earnings towards either building or fixing or maintaining a fixed-asset base.
While there are many arrows in that diagram, it needs but half-an-hour for any family to map this picture to their own circumstance. As the diagram makes amply clear, having a growing pile of savings is not about being a better investor, but really a good cash-flow manager and financier of one's own needs. There is no escaping the details involved.
For the ultimate objective is only one-fold: to create a base income-floor so that the family may never have to stretch its weary hands in front of anyone. Seeking dignity through financial self-reliance so as to be able to help self and others is the only real purpose of wealth. Remainder is to appease vanity. Or, as The Qur'an pithily exhorts: spend (channelise fruitfully) of what We have given you.
P.S. Distortions of the market.
A financial market is a place to exchange, or trade, claims on cash-flows. There are a variety of instruments today, especially since the markets for all kinds of derivatives have exploded since the mid 1980's in the West. All households, though, are concerned primarily with two types of markets, by and large those dealing with fixed claims (bonds) and residual claims (stocks).
Financial markets are where balance-sheets of governments, households, businesses, insurance companies, banks, hedge-funds, currency brokers, and a myriad of other entities all interact. Today, they are the most complex markets that civilisational history has ever operated. It is therefore next to impossible to predict what interactions of balance-sheets — transfer of either cash or security or some derivative claim, from one balance-sheet to another — will do to prices of financial claims on a daily basis.
In other words, the unpredictable movements in prices of financial claims is baked into the way the financial market as a whole work, i.e. its structure. Now, this market-structure is never static for a very simple, intuitive and observable phenomena: reflexivity.
Reflexivity, as the name suggests, is the fact that the behaviour of others reflects upon our own response and behaviour, and vice-versa. In as complex and tightly-integrated market, such as the financial markets, it is self-evident that reflexivity can be viscerally felt, most notably in the movement of prices of all kinds, including those of individual stocks that nowadays move by the second.
Thus, there is no escaping volatility, and if there was no volatility, then the above article would have been perhaps one-fifth its current size. What is worth remembering is that volatility is not something that is external to any market: it is a characteristic of every market. Thus, the act of buying any financial claim is, at the same time, the act of buying, willy-nilly, into its underlying volatility.
(N.B. It is for this reason that Warren Buffet, and Charlie Munger, are right when they say: volatility is not risk. For, how can a feature of something be its risk? And as Buffett pointedly reminds: risk is a permanent loss of capital which occurs when you capitulate to volatility.)
The central thesis of buying stocks is not that they yield greater returns: but residual claims, by definition, are more adaptable to changes than fixed-claims. Now, if something is more adaptable then it will also by definition show greater variation (or volatility) in its behaviour on a day to day basis than something that is more placid and even-tempered. How else is it then expected to adapt?
Now adaptability, of a constructive kind, demands a certain kind of volatility profile. An adaptable creature is not prone to wild fits of temper, else it will lose its balance and incur fall. Thus, if the stock-market has truly to serve a public purpose, i.e. retain its institutional character, then its volatility should be along the lines of something that seems natural and rational.
Pray, what makes volatility of the stock-market natural? It is natural if the reflexivity underlying it is largely based on natural considerations. This is possible if those who are engaged in the act of buying and selling stock securities are prudently exercising their judgement. Put in other words, the majority of the crowd involved is making decisions that are discretionary in nature and prudent and rational in their respective contexts.
Of course, the above has never held true in practice. The stock market, more than any, has shown a penchant for sporting an unnatural volatility profile, driven by sentiment and speculation. This has been its known history so it should not come as surprise to anyone that the same reasons of sentiment and speculation will continue to upset the natural volatility profile of an adaptable financial instrument.
But this sentiment and speculation are still based on discretionary behaviour: a behaviour where there was some agent who was acting on some thought process tethered to his context. What happens, however, when that agent is replaced by rule-based methods of participation devoid of a finer understanding of the surrounding context?
The financial markets today are in the midst of an increase of this kind rule-based behaviour: either through coded algorithms, or fund managers that have chosen to operate stricly by rules all in the name of simplifying things for the masses. Of the first kind are quantitative trading strategies, and of the latter, special mention must be made of index-investing.
In particular, when index-investing (buying a chunk of the most popular pieces of stock certificates independent of their prices) is adopted by large institutional managers of savings, then, clearly, rule-based strategies start acquiring a dominance over time.
In India today, for example, a certain percentage of the incremental cash-flows of the Employee Provident Fund are channelled to the stock-market; likewise contributions made into the NPS accounts of salaried employees too have to be compulsorily put to work in a short period of time. Similarly, the cult of stock-investing also means an unconditional adoption of monthly contributions into the stock-market no matter what.
Taken in isolation, none of these practices are harmful. But as the pile of cash behind them grows larger, reflexivity demands that an interesting phenomenon starts to arise. And that is, the free-float of stock available for buying or selling starts declining. In India, where a meaningfully large share of public corporations are still family-controlled, taking note of this phenomenon is of more than passing academic interest.
If, to the stock of promoter-ownership is added the rule that whatever flows received by institutional managers – who hold savings with long-term lock-in periods – are channelled into the market based on a set of rules (and not manager discretion) – largely with a view to mirror the underlying market – then, over a period of time, a larger and larger pool of shares are simply held, and less and less are actively traded every day.
If this shift from discretionary purchase and sell (sensitive to fundamental factors and valuation, and financial context of the buyer) to less context-sensitive rule-based purchase and sell continues abated, the character of the underlying financial market – in this case the stock-market – can itself change.
The net effect of unabated rule-based buying, not matched by commensurate selling, ultimately results in hoarding of marketable securities inside the accounts of Employee Provident Fund, the National Pension System, insurance companies and index-funds for an extended period of time. At the same time, the habit of monthly contributions makes sure that, inspite of hoarding of the commodity, demand for it continues, and perhaps grows further with a growing population that is coming of age.
Ultimately, what does hoarding-like behaviour do to any commodity? It makes the demand for it price-insensitive; i.e., demand for it slowly starts having little relation to the price of the commodity. This behaviour in economics is called price inelasticity.
Now, a needed feature of any stock-market is its elasticity, i.e. its ability to respond to pressures of buying and selling in an adaptable (flexible) manner. But if price inelasticity gains currency over time, then this adaptability is replaced by erratic behaviour.
It is easy to see why: consider the case that there is a large stock-pile of any commodity but there are not many holding it who are willing to sell. As a result, inspite of a large stock, the liquidity is low. And sustained low liquidity results in small increases in demand leading to disproportionately large increase in prices. In other words, Companies that are already considered valuable, become even more valuable and leave many others behind.
For, it is quite evident that when rule-based gains traction, the majority of funds are directed to purchase stocks of most highly valued Companies. But when liquidity is low and the buyer must buy, then clearly even a small sum of money results in wild price swings upwards, at the expense of their less popular peers. It brings to fore the famous metaphor of Keyne's of the stock-market as a beauty contest "where the judges are rewarded for selecting the most popular faces among all judges, rather than those they may personally find attractive."
Clearly, a beauty contest is by no means fit to be characterised as a public institution. In particular, if the metaphor is persisted with, the market acquires directionality, marching over time in only one direction, leaving in dust the cardinal rule of sound investing: reversion to the mean, the idea that there is a centre of gravity to the market, and if it gets too high or low, it ultimately reverts to the mean.
Thus, reflexivity in an increasingly rule-based market regime runs the risk of erosion of the idea of mean-reversion. Now, why is mean-reversion of such central importance? Because that is the mechanism through which the stock-market adapts: bad companies get thrown out, expensive ones get cheaper, strong but unloved ones come to favour. In other words, in a good functioning market-economy reversion to the mean is arbiter of capitalistic justice.
But if the judge himself is thrown out of the court-room then the court-room becomes a free-for-all. In other words, visible sidelining of discretionary investing is akin to making Marx's prediction, that Capitalism will sow its own destruction, come alive. Except, that the proleteriat, instead of unseating the capitalistic society through a revolution, simply usurped its central citadel: the stock-market. (For, nothing symbolises Capitalism in the minds of the laity as the enchanting gyrations of the stock-market do.)
And how did the proleteriat do it? Simply by choosing to index blindly through the means of large institutional fund houses who were averse to doing the leg-work required to invest and hold themselves publicly to account in case they fail in their calls. They, effectively, became the judges who lost the courage to select the contestant they personally found the most beautiful and preferred to side in the safety of selecting the most popular one.
This kind of a scenario bodes ill for the institutional strength of any stock-market: for it is of an order lower than even rank speculation. Speculation persists till there is money in the pocket, or access to sympathetic lines of credit. Systematic, unthinking, month-on-month investing can persist as long as there is delusion which takes to a cult-like behaviour. This behaviour, unlike speculation, has no foreseeable limit.
(N.B. Incidentally, a similar scenario is unfolding across two other public institutions: education and health. There is a creeping conformity and homogeneity to side with the crowd rather than operate them based on first principles of what education and health truly mean. Accounting and law long-ago fell prey to their own versions of the beauty contest. Management consulting, incidentally, was not even a contender: it started as a beauty contest.)
Now, why does any of this matter for the average household? For, just as strained liquidity richly and unfairly favours the valuations of a few Companies when the flows are coming in, it can likewise bring down violently the same Companies when the flows go out. In other words, the stock-market in general is likely to exhibit directionality most of the times, with little or no reversion to the mean, and violent up or down-swings a few of the times. But the timing of these few may prove fatal for someone near retirement.
(N.B. Arguably, it matters beyond an individual or a family. It has implications for the polity as a whole: for the stratospheric rise in valuations of the stocks of already richly valued Corporations armours them with a special currency of their own — their own highly-valued stock. This currency may then be used to further lever up their own operations, gain monopoly privileges, and effectively, affect the usurpation and allocation of capital at a societal level. The most egregious example of this in recent times in India is the case of Adani Enterprises and its cohort of Companies.
It was a classic case of cornering the available free-float, draining the public-market liquidity and then using it to advantage to inflate the stock-price beyond any reasonable analytical measure and common-sense. The whole country witnessed the spectable which is still playing out as the date of this writing. While it may be argued this was an extreme case, a stock-market dominated by rigid rules which constrain market liquidity is not averse to throwing out such case-studies at regular intervals.
For, it must always be remembered that the mala-fide Corporation in such a market has the ability to create an alternative to fiat currency, even for a short-period of time. While the Government may be busy chasing counterfeit currency operations, the most blatant cases may be being incubated right under the noses of its regulatory mechanism for the market. Thus, the significance of a lack of adequate mean-reversion is a matter of concern not just of the individual but of the polity to which he belongs.)
Does it then imply a change in the way a household should look at the stock-market itself? Perhaps. Writing on the eve of the outbreak of the second World War, the authors of Security Analysis had raised this question at the outset of that time-honoured tome: what had changed in the behaviour of the public which led to the stock-market mania which ultimately imploded and symbolised the start of the pain of the Great Depression.
They observed that while previously the stock-market was considered a field for intelligent speculation — meant for those well-off and well-acquainted with the risks it entailed — it came to evolve to appeal to a broader segment of the population, and in turn, became a casino when it became possible to buy stock on margin money for the average public.
Indian stock-market is certainly not in that league of a casino, as yet. But it is clear that what was once considered the domain of a few, is now democratised for the many. When such democratisation is attended with the assurance that all that the individual has to do is to trust his hard-earned savings to an expert and leave the rest to the good offices of the market, then it does demand, in the words of Benjamin Graham, a careful scrutiny of the attitude of the 'investor'.
Rather than consider the stock-market as a toy to make money, it is best to view it as a useful addition to give adaptability to the overall savings policy in light of the technological, demographic, monetary and broader changes in the political-economy the household finds itself in any given era. At the same time, being aware that there is a possibility, however remote, that the stock-market may sport increasingly non-discretionary behaviour, will ensure that the household exercises great caution and prudence in its use of the public-institution that ought to be the stock-market.
It is also quite likely that the scenario of a rule-based stock-market regime is a remoter possibility in India than what has transpired in the West, and the USA, in particular. The regulatory changes which happened in the USA, which set the stage for many of the outrageousness of valuation seen in some corners of its markets, may skirt the Indian shores. It helps that, India is a growing economy and has the benefit of new supply of shares that will come to the stock-market from time to time to wet its increasing appetite.
Nonetheless, what is clear is that if India is rapidly urbanising and converting into a market-economy, the stock-market is, whether one likes it or not, an important constituent of such an economy. While the approach of shunning it altogether remains unviable, embracing it in totality is also ill-advised. The middle-course is one of finding the right approach to engage with it. It is in this context that what is described of the NPS and the idea of a self-owned bank above holds water.
For, the idea of capitalising first, investing later, while of use in itself across all times, is of particular merit in an environment where the rule of mean-reversion is increasingly blunted, leading to voracious bouts of volatility. Holding adequate liquidity and solvency implies that the household is able to safeguard itself against such vicious volatility, and at the same hold onto its investments long enough to be able to skim-off some of the advantages that the embedded optionality of stock certificates offer.
But perhaps, more than anything else, it brings to the fore the need for true financial self-education: entrusting hard-earned family savings to the advise of a cohort of professionals, however well-meaning they be, is no substitute for learning to understand some of the complexities associated with the variety of instruments discussed earlier. That is one investment that, in the long-run, may outbeat even the stock-market, and the earlier it is made, the greater the compounding there will be.
Such investment begins by not accepting what one reads and hears at face value, but asking questions of them. It is not necessary to ask questions of everything in sight, but at least of those instruments that one is considering to use. As was discussed earlier, asking questions of the NPS such as: what is it, what are its features, how much to contribute, when, how, when to withdraw, etc. go a long way in this process of self-education.
Importantly, this asking of questions ensures that the family, while using a rule-based instrument, itself is not operating by rules set by others, but is very much a discretionary actor. In doing so, it is both contributing to the institutional strength of the stock-market, and by the law of reflexivity, playing its little role in ensuring the market remains not dumb, algorithmised and mechanized, but alive, vibrant and a place for healthy contestation. For, that is what the definition of any market really is.
In summary, maintaing a discretionary vigil boils down to one simple rule: always, and without fail, match your assets with your liabilities. Let not your liabilities run ahead of your assets: which means save and then spend of what God has given, and not any more, and cast not a glance at the neighbour, his wife, his car and his home.
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