The spirit of the NPS

Economic Times, 14 November 2013

We have been through a long detour on the NPS. In the decade that elapsed until the law was passed in Parliament, many things have been done which were expedient. Now that this phase is behind us, it is time to go back to the spirit of the NPS. This involves one single simple system, harnessing economies of scale, using auction-based procurement, and waging war against fees and expenses.

The draft Indian Financial Code, built by Justice Srikrishna's group in 2013, shows a full blown legal foundation for financial regulation aiming at consumer protection. But in 1999, the OASIS Committee, led by Surendra Dave, attacked this same problem in a different manner (link, link). The OASIS committee understood that conventional mutual fund / insurance products are a bad deal for consumers. If a pension system was constructed in that fashion, between 30% and 40% of lifetime savings would be transferred from workers to financial firms, which is not nice. The heart and soul of the NPS is a particular strategy for combating this market failure.

The defining question is: How to reduce the payments, over life, from workers to financial firms? The first insight is to obtain economies of scale. It is useful to unbundle the overall problem of pensions into three parts: the front-end, the record-keeping and the fund management. Of these three parts, there are strong economies of scale in the record-keeping and the fund management.

By having one centralised recordkeeping agency (CRA), we reap economies of scale and can cut costs of recordkeeping with scale, as has been done by NSDL in the depository business.

With fund management, the evidence shows that the path to higher returns to customers lies in spending less on fees and expenses. Index funds yield good returns, and index funds have profound economies of scale. The ideal structure, then, consists of 3 fund managers producing 3 index funds: one in government bonds, one in corporate bonds and one in equities. This gives 9 choices. A `default option' should start a person into a high-equity allocation when young, and gradually shift away towards fixed income as she gets older.

Auction-based procurement for fund management and recordkeeping ensures that the costs are kept wafer thin. The OASIS report envisaged outlandish low costs which could be obtained, and was much criticised for this. The events have proved that outlandish low costs can indeed be obtained.

All this was understood in December 2002, when the NDA government decided to build the NPS. However, for a decade, it lay in an uncomfortable state with PFRDA being non-statutory. In this period, numerous flaws have crept in. Many decisions were made, in response to political considerations at the time, which now need to be reversed.

Today there is not one but two NPS systems. This damages economies of scale. In addition, it generates greater complexity. The average household finds it very difficult to understand financial products, and we should always fight to make a pension system as simple as product. It is now time to merge the two systems into one.

That unified system needs to be far simpler than it is. There should be just three managers and three asset-class index funds. Today, there is far too much complexity in the NPS. Some decisions of PFRDA run against the spirit of the NPS. As an example, PFRDA banned pension fund managers from investing in exchange-traded funds (ETFs). This is the wrong way to think about it. First and foremost, fund managers should have to compete in auctions and bid low numbers for fees and expenses to get into the NPS. Once this is done, we do not care about whether they implement index funds through ETFs or not. In practice, there is much merit in ETFs as they have some of the lowest costs amongst all funds in India today.

Some participants of NPS have started reaching the age of retirement and exiting. Their lumpsums have to now be converted into annuities. PFRDA has brought in insurance companies to sell annuities. But the heart of the NPS lies in auction-based procurement. There is an opportunity for obtaining remarkable low prices for annuities -- exactly as with index fund management -- by doing auction-based procurement of annuities.

It is not fair to criticise decisions made in the past, as there was complex political maneuvering that led up to the PFRDA Act. We should respect and applaud the persistence and political skill that has brought us here. But now that we have the PFRDA Act, it is time to go back to the spirit of the NPS. The NPS is not a conventional mutual fund or insurance system. It consists of using public procurement and economies of scale to give consumers a great deal.

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