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Impact Investing

IPE special report May 2018

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Politics holds up full implementation

The investment scenario in India has dramatically changed for the better. In 2005 foreign institutional investor (FII) flows touched a record $10.6bn (€8.34bn) compared with $8.5bn in 2004 and $2.84bn in 2001. The indications are the 2006 figures will easily exceed the 2005 total.

When pension reforms were initiated in India in 1997, demographic transition into an aged population was not the primary reason, as has been the case with most other countries. Only 8.9% of the Indian population is estimated to be above 60 by 2016, rising to 13.3% in 2026.

One driver of the pension reforms effort was the abysmally low coverage of the Employee Pension Fund Organisation (EPFO), which is mandatory for large private firms.

In addition, there was an unfunded DB system for civil servants. These two components added up to a coverage of around 11% in the late 1990s. This was clearly not a social security system for the great mass of India.

The second driver was fiscal pressure. Even though existing pension provisions covered only 11% of the workforce, they were inducing substantial fiscal stress. The civil servants pension was unfunded, and the programs of the EPFO involved substantial transfers from the general exchequer.

Thus, pension reforms strove to obtain:

■ Better coverage and outreach,

■ A system that was sustainable and scalable in terms of the fiscal implications,

■ Higher returns, better levels of transparency, better choice of investment to the

worker,

■ Better accountability and regulation.

Two unique features of India shaped the architecture of the new system: low income levels, and a dominant presence of the "unorganised" sector, comprising small firms or self-employed workers. Per capita GDP in India is around $580. In the 1999 census, only 15% of the labour force had stable, salaried jobs. 53% were self-employed and 31% worked as contract labour.

Around 20% of Indian people remain below the poverty line. A pension system designed to service this workforce had to be focused on very low costs of collection, management and delivery. It had to confront a large number of small value transactions, and the complexities of reaching individuals rather than firms.

In 2002, an implementation of the reforms proposal called the New Pension System (NPS) commenced. The NPS is mandatory for new recruits into the government, with a contribution rate of 20%. It will be made available to other individuals on a voluntary basis. The NPS has the following features:

■ A defined contribution system

■ Individual accounts

■ Centralised record-keeping infrastructure

■ Portability of pension accounts across job changes, and of pension assets across multiple fund managers and investment products

■ Standardisation and commoditisation of investment products

■ Procurement of fund managers through an auction focused on fees and expenses

■ EET tax treatment

■ A new pensions regulator

India's prior experience with pension
programmes suggested there were serious prob-lems with DB schemes, from the viewpoint of obtaining high returns, protecting the funds against political compulsions, and setting up the administrative capacity to deliver benefits.

The problems of non-transparency, poor governance, and weak supervision also supported the idea of individual accounts. It was felt that individuals have good incentives to protect their interests, in the context of an individual account system, so the NPS would involve reduced political risk.

A key innovation of the NPS is an unbundled architecture where the pensions problem is broken up into four components: front-end services, recordkeeping, fund management and annuity production. Under the NPS, each of these is proposed to be handled by specialised agencies focused on performing each role at a low cost. It is hoped thatstandardisation of products, transparency of pricing, ease of switching and competitive procurement through auctions, will drive down the prices at each of the four components.

Fund management is passive, which helps with cost reduction and better monitoring of accumulations and regulations. Fund managers are chosen through an auction based on the lowest fees.

The front-end services and recordkeeping are proposed to be done through a new Central Recordkeeping Agency (CRA). The CRA will maintain individual records on behalf of the contributors as well as for the fund management agencies. The CRA will also channel contributions from contributors to fund managers, and vice-versa, while obtaining cost reductions through netting.

One benchmark of the feasibility of a CRA to deal with the high level of low-value transactions comes from the Indian equity market. The third and fifth biggest stock markets, by number of transactions, are found in India, with an average transaction size of $200, and the cost per transaction comes to around 25 basis points.

In summary, important strides have been made in India in setting up a new pension system since 1997.

The NPS has been operational from 2004 onwards, with mandatory participation by new recruits into the civil service in most parts of the central and state governments.

The NPS has been vociferously opposed by the communist party, which has a veto power over the present ruling coalition. As a consequence, while NPS implementation is making progress, the law that creates the new pensions regulator has been blocked. It is likely that this law will be enacted after the next general elections, in 2009.

The key bones of contention are the lack of guaranteed returns, investment into equities, investment into foreign assets and the use of non-public sector funds managers.

Susan Thomas is assistant professor at the Indira Gandhi Institute of development research in Mumbai.

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