There are broadly two ways in which you accumulate a retirement corpus during your working days. The traditional way is the defined benefit pension system, in which you are guaranteed an assured pension. The modern way is through defined contributions, where pension is calculated based on your contributions and the fund’s returns. Let’s understand these concepts through Employees’ Pension Scheme (EPS), which is more of a defined benefit product, and National Pension System (NPS), a defined contribution plan.
EMPLOYEES’ PENSION SCHEME (EPS)
If you are a salaried individual, a part of your Employees’ Provident Fund (EPF) money goes towards EPS. However, the pension coming from EPS is not calculated based on contributions but by a fixed formula. This is average monthly salary of the last five years of service multiplied by the number of years of service divided by 70.
Every month, you contribute 12% of your salary in the EPF account, and your employer matches it. But 8.33% of that goes into EPS. Typically, the employer calculates this contribution on the capped wages, which is currently Rs.15,000 per month. So even if you are earning more than Rs.15,000, the employer would contribute 8.33% of this amount (Rs.1,250) to EPS. The balance is invested in your EPF account.
You are entitled to pension under EPS when you turn 58 years of age and after 10 years of continuous service. But since your employer contributes on capped wages, the pension is calculated on a monthly salary of up to Rs.15,000 only.
Defined benefit plans may bring comfort, but changing demographics—a growing ageing population and a shrinking working population—creates pressure on the government to manage defined benefit programmes. In fact, as per the current rules, EPS is not applicable for a new employee who joins the workforce after 1 September 2014 and earns above Rs.15,000 a month.
NATIONAL PENSION SYSTEM (NPS)
A defined contribution calculates pension based on the amount you contribute and returns the fund earns. Retirement products such as EPF and NPS are defined contribution products. Under NPS, you invest till the age of 60 years. You can begin with a minimum annual contribution of Rs.6,000. There are three funds to select from. One is scheme E (equity), in which you can put up to 50% of your investment in equity. In scheme C, you can invest in fixed income instruments other than government securities. Scheme G lets you invest in government securities. At 60, you need to buy an annuity—a pension product that gives you periodical payouts—with at least 40% of the proceeds. The annuity rates are guaranteed for life, but pension amount will depend on the accumulations and the type of annuity you buy.
