Navigating pension reforms
India is ageing, and children are increasingly unable to supply old age support. Hence, there is much interest in a formal pension system, which allows people to plan for a few decades of old age based on financial instruments instead of children.
The basic architecture of a pension system consists of two phases. In the "accumulation phase", the individual is working, and makes steady contributions (i.e. payments) into the pension system. Upon retirement, the individual finds himself with a stock of wealth. This wealth can be used to buy an "annuity", which is a life insurance product which gives a monthly payment until death.
What is wrong with India's pension sector today? The three biggest problems, as of today are:
- Most citizens have no pension system. Existing formal pension provisions only apply for government staff, and for individuals in large firms.
- Most existing pension provisions are an extremely bad deal for participants. The investment strategy all across the pension system is badly done, giving low returns. The pension system has extremely low standards of customer service, making it highly inconvenient for individuals to know where they stand, or exercise any control upon their assets.
- Other existing pension provisions are an unsustainable fiscal crisis. The civil servants pension, and the EPS program, involve large liabilities for the government. The government does not have the fiscal strength to deal with these claims.
The puzzle in pension reforms consists of obtaining a pension system which can reach out to India, as opposed to a tiny group of organised sector workers, and offer an escape from poverty in old age at the price of the smallest possible pension contributions. The puzzle in pension reforms consists of doing this without paying pensions from the coffers of the State.
In the last three years, there have been several efforts in thinking about reforming the pension system. The pioneering effort was Project OASIS, setup by the Ministry of Social Justice in 1998. The World Bank has done an excellent report on Indian pensions, which should be released within a month or two. Robert Gillingham of the IMF has recently written a paper on Indian pensions. Finally, there is a study of the operations of the EPFO that is presently underway, which has been funded by the ADB.
In some sense, India is a late starter in thinking about the pension sector. We benefit from extensive experience with mistakes and success stories from other countries. These experiences have been thoroughly studied; the research community now has a solid body of work on pension reforms.
Using this literature, it is useful to flag off a few important mistakes which have been made in other countries, which we should seek to avoid:
Lesson #1: Avoid bundling.
The pension system consists of distinct steps: gathering contributions, investing them in the accumulation phase, and possibly buying annuities in old age. There is a great temptation on the part of many people to put these together into a single bundled product (the EPS is one such example). This temptation is strongest with insurance companies and insurance regulators, who see such a design as a way for insurance companies to obtain a competitive advantage in the pension sector.
Such bundled products become extremely non-transparent. It is not possible to easily discern incompetent asset management, or liabilities upon the government, when such bundling is done. With bundling, it becomes hard to obtain multiple competing providers with choices in the hands of individuals. With bundling, it becomes hard to give individuals choices about their own risk tolerance.
The bundled pension system is called a "defined benefit" (DB) product. One lesson that is well understood in the literature on pensions is that DB pensions are replete with difficulties in governance and political economy. This is something to avoid.
Lesson #2: Avoid having the government as a pension provider.
The best design of a pension system is where a private sector fund manager handles the accumulation phase. Competition should be used to keep the fund managers under check. Upon retirement, if an individual wants an annuity, he should go and purchase it from a private sector insurance company. Competition should be used to keep the insurance companies under check. At both steps, the individual should not deal with the government.
There are several dangers with having the government performing either the asset management or the annuity functions. If the government is a monopolist, then we have the well known dangers of poor performance and high prices. The EPFO is a thriving example of the consequences of having the government be a player in the pension system. Further, if any assets are controlled by the government, we will face political pressures where high asset returns are sacrificed for other political goals. There is a risk of investing too much in government bonds, where the government uses the pension sector to fund its own deficits. If a government agency buys shares of private sector companies, it raises the spectre of back-door nationalisation. Finally, if the government is a player, there is the risk of politicians announcing over-generous returns or benefits, which ultimately turn into liabilities for the government.
Lesson #3: Sound institutional infrastructure is essential.
The opposite danger is that of policy makers doing too little. It is unfortunately not possible for the State to walk away from the pension system, leaving it to purely private initiatives. If this were done, there would be a serious gap in terms of the lack of public infrastructure for a soundly functioning pension system. We need to have public goods in the form of regulation and institutional infrastructure for the pension sector.
Consider one example of a role for the State. In several countries, we have seen extremely large payments going out from the pension system for sales, marketing and overhead fees of pension fund managers. These are not small numbers which can be ignored: It has been estimated that these overheads can take away as much as 50% of the pension wealth of a poor participant in India!
Project OASIS has offered an innovative design, involving the creation of a new public agency which performs certain recordkeeping functions (much like the depository), which drastically reduces the administrative overhead in the pension sector. Project OASIS has also proposed to select a finite list of pension fund managers who bid (and pre-commit) the lowest fees and expenses in an auction. These two initiatives would dramatically reduce the overheads of the pension system. They would have the sharpest benefits for the pension wealth of the poorest participants.
In summary, the high level of interest in pension reforms is a very healthy phenomenon. A sound pension sector would be an important component of social sector policies in India; it would reduce poverty, fertility and strengthen financial markets. We should undertake sharp surgery in the existing pension system, where all components are presently badly malfunctioning.
At the same time, we should be careful to (a) avoid defined benefit designs, (b) avoid any role for the State as a player, and (c) take the bull by the horns in terms of having a role for the State in building public infrastructure.
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