Rethinking old age income security in India
All societies face a question about how the elderly are to obtain consumption in old age. The traditional answer was that parents would live with children. This answer was compatible with traditional social mores. This is changing dramatically through a combination of factors:
- Life expectancy is improving. Today in India, once a person has survived to age 60, survival till age 75 is the average outcome. When health and education is good, survival beyond age 80 is likely. This puts a whole new complexion to the problem, where people have to plan for two decades of life after retirement.
- Changes in society and culture are breaking down the joint family. It is hard for parents to spend twenty years after retirement with children. Labour mobility implies that children often work far away from where their parents are located.
- Traditionally, having an elderly family member was a low-cost affair. This is incompatible with modern standards for health expenses.
In this situation, formal mechanisms which generate old age income security for the elderly are desirable. So far, in India, the main strategy which has been taken towards meeting this objective is the establishment of the gigantic system of provident funds. These ask employees to put aside some money ("contributions") every month. These should yield a corpus at retirement date. This corpus can be converted into a monthly pension through "annuity providers" who convert a lump-sum payment (at age 60) for monthly payments till death.
At present, this system is unable to deliver old age income security. The average person leaves the PF system at age 60 with Rs.20,000 in assets. This is after a life of contributing at some of the highest rates in the world. We, in India, are asking workers to put aside above 20% of their income into the PF system, which is a steep sacrifice given low income levels. In exchange for this sacrifice, the system is unable to solve the problem of income security at age 60. In addition, the provident fund system is notorious for poor customer service and high administrative costs, which helps generate an atmosphere where workers view the PF as a tax. This inspires creative energies being applied to evasion.
The Ministry of Social Justice and Empowerment recently setup "Project OASIS" to rethink old age income security in India. Part of this effort was the creation of the Dave Committee to devise a new pension system in India. The report of this committee will be in two parts, and the first part was released recently. The argument of this report may be summarised as follows.
The existing systems are not working. As mentioned above, when the average person suffers a tax of 20% through life and then obtains Rs.25,000 upon retirement, the existing systems are simply not working. In addition, there is a serious gap in coverage, for the existing PF system only covers a minor fraction of the population.
Low contribution rates are not the problem. One obvious response to the situation would be to ask workers to tighten their belts and pay higher contribution rates. However, without structural changes to the pension system, higher contribution rates will simply not solve the problem. In any case, to ask for higher savings in an environment where India's workers are amongst the poorest in the world is not defensible. Our challenge is to find a way to harness these high contribution rates to genuinely obtain income security in old age.
Diagnosis. The two central flaws of the existing system lie in (a) excessive early withdrawals and (b) low rates of return. Saving for retirement requires compounding over multi-decade horizons at the highest possible rates of return. In India, such efforts are negated by rules that allow early withdrawal, and poor rates of return. The terminal wealth is highly sensitive to the rate of return. A person who saves a modest Rs.10 per day, from age 25 to age 60, ends up with Rs.2.9 lakh at age 60 assuming a 4% real rate of return; this rises to an astonishing Rs.19.8 lakh if a 12% real rate of return is obtained (all numbers are in 1999 rupees). The PF system in India has given an abysmal real return of 2% in the last decade. The long run average real return on the equity index has been 12%.
Going beyond the EPFO, the PPF, today, is little more than a tax evasion device. In its present form, it is hard to justify its existence.
Encouraging accumulation. Early withdrawals can be checked using a variety of initiatives. The EPFO should create a single account for each individual in the country, which is portable across all jobs, so that the accumulation is not broken at each job change. Early withdrawals should be penalised with a 10% withdrawal tax. This allows individuals to withdraw money in a crisis, but gives them a strong incentive to not withdraw wherever possible. Finally, high rates of return are the best way to assure workers that the PF system is not a disguised tax. Until high rates of return are achieved, workers will continue to look for loopholes to escape the PF system.
Specialisation. Today, the State takes responsibility for sourcing contributions, investment, and annuitisation (where applicable). This should be unbundled into three distinct, specialised activities. There is a distinct function for sourcing contributions and doing customer service, which could be done by the State. Asset management is best done by competing asset managers. Annuities are best obtained from competing annuity providers.
Governance structure. Decisions at the EPFO, today, are made by a large and unwieldy board formed of trade unionists and employer associations. Questions of investment, however, require skills in finance and economics. The Committee has recommended that we need a highly compact board, which should recruit experts in finance and economics.
Maximising rates of return. There is a great attachment for a "12% nominal rate of return" in India. This should be abolished, in favour of market determined rates, which move in response to interest rates and inflation. Investment in corporate bonds and equities are the way through which rates of return can be much higher. The Committee recommends that this should begin. In advanced countries, we see pension investments having allocations like 50% in equities, 30% in corporate bonds and 20% in government paper. The Committee thinks that equity investment should only be done using index funds using the NSE-50 or the BSE National indexes.
These recommendations are primarily about strengthening the existing institutional mechanisms for old age security in India. When the PF system is strengthened in this fashion, it could play a role in old age income security. The incremental expansion of the coverage of the system could then extend these benefits to a larger fraction of India's workers.
Going beyond this, a few major questions remain: (a) the unfunded pension obligations of the Indian State, (b) a new pension system that should reach the unorganised sector, (c) a regulatory framework for the pension system, and (d) poverty alleviation programs designed for the elderly. These will be dealt with in the Phase II report of the Dave Committee.
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