India's Saving Grace

Wall Street Journal [link], 17 April 2007

Recent news from India will warm the hearts of pension reformers around the world. New Delhi's decision to shift newly recruited civil servants to a new defined-contribution plan is reason enough to celebrate. But even better, the introduction of India's "New Pension System," or NPS, demonstrates how well-designed pension reform can survive even the staunchest political opposition.

The latest reform replaces the traditional defined-benefit pension for civil servants, under which the government promises pension payouts from future tax revenues. All bureaucrats who have joined the ranks of the federal or most state governments since January 2004 are instead enrolled in NPS, a defined-contribution program in which workers save a portion of their wages in their own retirement accounts. The program is set to be rolled out over the next six to nine months. Within two years, 2.6 million people are expected to be enrolled in the new plan, paying 20% of their wages into a fund that will then have assets of $4 billion. NPS will also be open to India's informal-sector workers on a voluntary basis.

Pension reform is always a political hot potato and India was no exception, but several factors helped make the new system possible. India's demographics are more favorable than China's, for example -- its population is simply younger. And there is no large population- wide pension system. Thus, India sidestepped a major obstacle to reform in other countries: a bankrupt pre-existing system that is politically difficult to change.

Indian policy makers had been trying to harness this window of opportunity since 1998, but they faced a slew of all too familiar problems, both practical and political. Transaction fees were at the top of the first list. Conventional fees, which are calculated on a per transaction basis, would eat up the pension savings of the many Indians who can afford only meager contributions and maintain small balances. If such fees were applied to the kind of personal accounts likely to be prevalent in India, accumulating pension wealth would be an uphill battle for many participants.

To solve this problem, the NPS creates a Central Recordkeeping Agency (CRA). All contributions flow to the CRA, which holds a single database about all participants. The CRA enables small investors to aggregate their transactions to capture economies of scale. Participants give instructions to the CRA for switching between asset classes and/or pension-fund managers. The CRA nets these flows and executes a single bulk transaction with each fund manager every day. The CRA enables a competitive environment in which participants can easily switch between fund managers without the fear of transaction costs eating their savings.

Other elements of the NPS have been designed to combat high transaction costs, such as the introduction of three or four standardized fund-management products, with a small number of fund managers. This will enable direct competition between managers with identical asset allocations. The government may auction the right to participate in the program to the lowest bidder, with fund managers competing to offer the lowest fees in order to participate in the program.

In addition to breaking ground in pension-plan design, India is also charting new territory in encouraging broad participation. In India and beyond, the informal sector tends to be averse to voluntarily participating in defined-contribution pension systems when overheads imposed by transaction costs are disproportionately large relative to their contributions.

The NPS envisages innovative solutions to these problems. The new system will use groups like occupational associations and microfinance organizations to provide informal-sector workers with access to the pension system. These groups will spread the word about the program, pool members' savings and personal data, and then plug that money and information into the CRA on behalf of the small investors.

Early work in developing this framework has begun already, especially thanks to the efforts of Unit Trust of India (a large mutual fund), SEWA Bank (a microfinance organization) and Invest India Economic Foundation (a think tank). On a pilot scale, pension accounts have been established for roughly 100,000 members, with each member contributing between $2 and $4 a month. In a few years, this line of attack will hopefully reach 10 million members making contributions of $4 a month into the NPS. This will require using all levers of policy to achieve low costs. At the same time, this widespread participation in itself fuels cost reduction by bulking up the scale of operation of the NPS.

India's experience offers a valuable lesson on how to overcome political opposition to pension reform. The fundamental design of the NPS traces back to the 1999 report of the Old Age Social and Income Security committee. But it has been a long journey. In 2002, the National Democratic Alliance government decided to implement the committee's proposals by placing all new government hires in the to- be-created NPS starting in January 2004. This move led 19 of 28 states to adopt a similar program.

Yet even after it had been approved, implementing the NPS took an act of political will. For the past two years, all the employee contributions have been retained within the government while paying out an administratively set interest rate. Only now will that money be able to move into true pension plans.

The NDA lost the 2004 general elections, but the party's successor, the United Progressive Alliance, endorsed the reforms. Not so UPA's Communist coalition partners, however. These left-wing parties tried to scuttle the reforms by blocking the creation of a Pension Fund Regulatory and Development Agency (PFRDA) that was supposed to regulate the program.

As it became clear in recent months that the Communist parties would not accede to creation of the regulator, the UPA decided to move ahead with the plan without a new regulator. PFRDA now exists as a unit of the Finance Ministry and is overseeing implementation of the NPS, but does so without true regulatory authority.

New Delhi's reform victory didn't come a moment too soon. India has a large number of young people entering the labor force for the next 20 years. A rapid implementation of the NPS allows them to build up pension wealth invested in sound portfolios of stocks and bonds, thus reaping more benefits from their nation's growth.

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