The date: 5 February 2034. In two days’ time, Krishnan Murthy retires after 30 years of service. He has liquidated the equity portion of his retirement savings in the New Pension Scheme (NPS). When he checks his bank balance, he is shocked to find that the amount credited is Rs 5 lakh less than what he had anticipated.
Till last week, the equity portion of his NPS corpus was worth Rs 50 lakh. But only Rs 45 lakh is showing in his account. Murthy calls up his NPS fund manager to know what’s wrong. The manager explains that the market fell 6% over the past week due to a mix of the global oil crisis and local budgetary policies. Although the reasons for the decline are normal enough, Murthy bears the brunt of the market agony and loses Rs 5 lakh in the process.
Can investors avert risk?
Murthy’s story could be that of any investor because risk and expected returns are inseparable. The regulator is yet to wake up to this possibility. However, it is not too late to implement risk management strategies to plug holes in existing guidelines. Most investors are aware of the potentially high returns in systematic investments yet are oblivious to systematic withdrawals. When equity assets are held for the long term, the market rewards investors over a 20-30 year horizon.
However, the trend is non-linear. The markets go up and down reflecting global and local information before giving an overall positive holding period return. If the retirement date of an investor coincides with bad news in the market, his portfolio will suffer. The reason NPS investors haven’t faced it yet is because the scheme is only 14 years old. The regulator must realise this shortcoming and proactively put in place risk management measures to prevent portfolio erosion at retirement.
Missing pieces in the puzzle
To begin with, the regulator must allow prospective retirees to withdraw the equity portion of their contributions at least 12 months before the retirement date. This is easy to implement, comprehend and is a costfree way to manage market risk. Another possibility is use of derivative instruments to mitigate downside portfolio risks. The current guidelines prescribe that pension fund managers can invest up to 5% in equitybased derivatives.
On the other hand, the minimum level of underlying equity investment is at 10%. This is a mismatch in terms of hedging because at worst, 5% of someone’s hard earned money is still exposed to market risk. Employing derivatives come at a cost which may marginally erode returns, but this is a small price to pay for safeguarding the gains accumulated over 30 years.
Also Read: How to open an NPS account online
Role of fund managers
Substantial work needs to be done by the pension fund managers for using equity derivatives. As of February 2018, all eight pension fund managers’ equity portfolios were limited to investments in equity shares and mutual funds only. There is no evidence on investments in equity derivatives. Since regulations allow for at least 5% investment in derivatives, one wonders why derivatives are not used to mitigate downside risk.
The NPS is designed to multiply our money over time so that after retirement, our economic and social wellbeing is taken care of. As the investments are market linked, it’s time regulators and fund managers come together to protect investor gains. Their role is more important today than ever before.