Still work to do in India
The Oasis report of 2000 was the blueprint for the massive ongoing reform of the Indian pension structure. As Gautam Bhardwaj describes, the challenges for India when it comes to ensuring security in old age for its population are immense. In response to this, the last decade has seen substantial progress in setting up funded pension schemes, with a wide coverage and a reasonable investment policy.
The size of the Indian workforce is 450 million, of whom 100m are unpaid family members. Out of the 350m paid workforce, only less than 40m formal sector workers currently have the benefit of some sort of old age security through a pension scheme. Of these, 25m are in the central government and state civil service, with the balance in employer-led pension and provident funds.
The civil service schemes are entirely tax-financed, which itself is a cause of concern in many Indian states where the pension and salary expenditures can be higher than the revenues. The employer-led pension and provident funds have been predominantly managed by the government with $50bn of assets so far. Another $25bn had been privately managed, but this has recently been mandated to join the government sponsored schemes. The management of the assets here has been outsourced to 4 fund managers through a highly competitive bidding process that resulted in fees of less than 0.25bp of assets under management being paid to the managers; HSBC, Reliance, State Bank of India and ICICI Prudential. The attraction for the fund managers is that with an annual increase of $2.5bn -$3bn from new contributions, there is a guaranteed steady increase in the size of assets under management.
The mechanics of the employer-led pension and provident fund schemes still need a lot of work to be done, according to Bhardwaj, in areas like the setting up of central record-keeping, individual accounts and portability across employers. The structure of the scheme is partly defined benefit, with a pension linked to the last pay according to a set formula. The total contributions are split between the employer paying 12% of wages, the employee paying 12% of wages and the state paying 1.6% of wages. 35% of the total goes to the pension scheme whilst the balance goes to a provident fund that provides a lump sum on retirement based on the contributions, which are mainly invested in government securities. In practice, most of the money in the provident fund tends to get withdrawn before retirement. However, as the returns on the provident funds can be relatively low, whilst the payouts are heavily influenced by politicians, the longer term viability does raise concerns. Unfortunately, since the defined benefit pension component was introduced in 1995, this scheme has also developed a shortfall of $10bn. In contrast to the private sector, the civil service enjoys a very generous pension package of 50% of the final salary indexed for inflation and wage increases effected through pay commissions every 10 years. Bhardwaj in a paper written with Surendra A. Dave, ex-Chairman of the Securities & Exchange Board of India (SEBI) estimated that the implicit debt of the Indian State arising from the pension liabilities from the central (civil) employees, state
government employees and the funding gap of the Employees’ Pension
Scheme, as of 2004, worked to 65% of GD, which is comparable to the explicit public debt of the government of India at 85% of GDP.
“Given this scenario, it is not difficult to figure out what to do”, says Bhardwaj. “The investment guidelines need to be changed. Private sector managers brought in to manage the assets at low fees, and individual accounts introduced for participants whilst the back office needs to be cleaned up.” He adds: “The other overriding requirement is to stand at the door and ensure that individuals do contribute to the pension schemes. This is happening now for 12m people through deductions from their pay made by their employers and passed to the government.”
The Oasis report prepared by Bhardwaj and his colleagues, became the basis for pension reform known as the New Pension Scheme. It was to be regulated by a statutory regulator and designed for the informal sector of 300m who, until then had no pension provisions whatsoever. In 2003, the central government decided to accept the same structure for new employees to the civil service and following this, 21 out of India’s 28 states adopted it for their own new employees.
So far, one million civil servants have been covered by the NPS, which has $2.5bn of assets. But implementation has been slow. “A lot of the individual accounts have not yet been set up so most of the money has not yet been passed onto the pension fund management firms sponsored by the Unit Trust of India (UTI), Life Insurance Company of India (LIC) and State Bank of India (SBI).” The fund managers have set up new pension fund companies to specifically manage the assets for a fee of 3-5bp. The difference between the fee structure here and those for the provident schemes reflects the fact that they were organised by two separate agencies and the provident funds represented a much larger base of assets.
More recently, in August 2008 , then Finance Minister P Chidambaram announced the extension of the civil service NPS to the rest of India, with a start date of May 2009. Six new fund managers were selected; UTI, SBI, Kotak, Reliance, ICICI Prudential and IDFC. But as Bhardwaj points out, the fee levels set at 0.09bp, would not even pay for the travel expenses of the board members to attend board meetings! In addition to the fund managers, there are 23 other entities such as banks, who have the task of selling the NPS to customers through their distribution networks. The investment guidelines for the NPS is that each fund manager will offer the same 4 products. The first would be 100% in equities; the second is invested in corporate bonds; the third is purely government securities whilst the default option is a lifestyle balanced fund. One problem is, as Bhardwaj points out, that the equity portfolios are invested only through using the NSE50 index or the 30 stock BSE Sensex, so investors would be exposed to a very narrow range of stocks, rather than a broad index. However, that is a less important issue in many respects than actually getting the systems running and working effectively.
In principle, the structure and investment arrangements set up for the NPS sound eminently reasonable. The major drawback in the current arrangements is that it is not clear that the right incentives have been put into place to incentivise distributors to sell the pension schemes. As experience has shown in the developed world, distributors inevitably sell the product that pays them the highest commission rather than what is best for the customer.