What next on the New Pension System?

Business Standard, 4 January 2006

I am normally an optimist about democracy, but there are times when this optimism is sorely tested. In recent months, we have seen a strange hijack of the Indian State by the fringes of the political spectrum. The CPI(M) -- which got a princely vote share of 5.66% in 2004 -- now controls all legislation. So the consensus of the CPI(M) Politburo, rather than the consensus of Parliament, calls the shots. Pension reforms has been one of the important areas where Indian economic policy has been hijacked by this fringe.

One big component of Indian pensions is the EPFO. The EPFO was created in the 1950s, when there was very little understanding about pension economics. A major role in the governance of EPFO was given to trade unions. But trade union leaders are not known for their knowledge of economics and finance. Hence, EPFO has steadily made policy mistakes.

In terms of administration, EPFO is a mess. Participants do not get account balance statements. When a person moves from one job to another, the account does not move with the person. There are concerns about fraud such as removal of balances from inactive accounts, with the connivance of EPFO staff.

The Employee Provident Fund (EPF) is a defined-contribution (DC) scheme. But it is riddled with bad policies. There is only one monopoly fund manager. Participants do not have any choice, either about the fund manager or about the investment pattern. The investment guidelines ensure that high returns cannot be obtained over the multi-decade horizons that are found in pension investment. The trade union leaders have tried to overcome the problem of bad investment guidelines by extracting resources from the government. But 85% of the subsidy to EPFO goes to 15% of the accounts, and poor people are never part of EPFO. So, as with the LPG subsidy, the left parties are really fighting for the interests of the rich.

The Employee Pension Scheme (EPS) is a recent blunder. It was created in 1995. At a time when the whole world was waking up to the problems of defined-benefit (DB) schemes, and pension reforms everywhere were switching from DB to DC, India created a brand new DB scheme! EPS is now the biggest single disaster in Indian finance. Information about the funding gap in EPS is weak, but it probably exceeds Rs.22,000 crore. This would make EPS a bigger crisis than UTI.

As with the erstwhile UTI and LIC, EPFO mixes up all sorts of functions, of policy making, regulation, and monopolistic service provision. In the case of UTI and LIC, now there is a separation where SEBI and IRDA are regulators, and the industries are competitive. But this kind of clarification has not yet taken place with EPFO.

Solving the problems of EPFO requires amending the law, and this is unlikely to happen easily. In parallel, from 1998 onwards, other efforts at pension reforms have been taking place, starting with Project OASIS created by the Ministry of Social Justice and Empowerment. These efforts have led to the New Pension System (NPS), and the proposed regulator PFRDA (see my pensions page).

The people who are responsible for the rot in EPFO now seek to block PFRDA. Three claims are being made: There should be no private sector fund managers, there should be no pension investments in private companies, and there should be defined benefits as in EPS.

Why do we need competing private fund managers? Because, as we have seen in sector after sector, competition improves performance. Competition between telecom companies has given better results than the DOT monopoly. Private banks are well liked by their customers, and have pushed PSU banks to perform better. Everyone benefits when there is more competition.

Why do we need pension investment in private companies? To obtain higher returns. From 1979 till 2005, investment in the BSE Sensex index fund gave a compound return of roughly 18% - there is no other asset class which has matched this return. Yes, equity returns fluctuate from year to year, but over long periods, equities have outperformed bonds in every country of the world. The NPS seeks to give participants the choice of holding equity.

Why should the government get out of underwriting defined benefits? Because government does not have the financial strength to give out guarantees for crores of people. A mentality of feeding on the government works for trade union leaders, since trade unions are a tiny part of the country. But it does not work for the great masses. If a pension system has to go beyond trade union members to the larger population, then the participant has to build up his own pension wealth, without recourse to the government.

There are four parts of Indian finance: banking, securities, insurance and pensions. In three of the four, there is a clear separation of a statutory regulator dealing with a competitive industry. Pensions is the last piece of Indian finance which now needs to be put into such a format.

Given the peculiar influence of the 5.66% fringe, how can progress be achieved? The key point is to see that the NPS is distinct from PFRDA. The NPS has already come about at a legal level. It is feasible to implement the NPS without the PFRDA. Contracting with the recordkeeping agency does not require law (as has been done with the Tax Information Network). SEBI can regulate fund managers as a transitory measure. The NPS can and should be running.

What we should avoid is a bad PFRDA Act. If we start with a compromised system, it may become inherently difficult to amend it in the future (as has happened with the EPS). Even if the PFRDA Act can be amended in the future, this will induce substantial costs of modifying the institutional infrastructure, and of having all participants go through unlearning.

India has been blessed with four outstanding finance ministers from 1991 onwards. There is every likelihood that this peculiar situation with the CPI(M) in Parliament will end with the next elections. There is every likelihood that the next finance minister will be of the same calibre as Sinha, Singh, Chidambaram and Singh. Hence, it makes sense to build NPS now, avoid a compromised PFRDA Act, and wait for the next elections.

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