Fund management that you buy

Business Standard, 7 February 2022

The New Pension System (NPS) was imagined in the late 1990s. Many elements of that thinking were forward-looking. A key element of this was the ideas about fund management.

An insight that shaped the early work was that on multi-decade horizons, there is a lot to gain, on average, by diversified equity exposure. This inevitably introduces greater risk for the worker. Equity returns are higher only because of equity risk: The higher return is the compensation for the risks taken. Young people should load up on diversified equity exposure, while recognising that there are irreducible risks about the future that are commensurately being taken. Over multi-decade horizons, with the power of compounding, small changes in the average return add up.

What can be controlled is fees and expenses. Every customer incurs fees paid to financial firms. In the late 1990s, equity fund management in India was all active management, and the customer was suffering a total drag of about 150 basis points (bps) per year for the privilege of obtaining diversified equity exposure.

A big idea of the NPS is that the stock market is reasonably efficient, that fund managers add limited value, and that there is a lot to gain by non-discretionary "index fund" management, where the fund manager merely reproduces the returns on an index such as Nifty. For the stocks with derivatives trading, ample algorithmic trading, and thus high liquidity, the price becomes efficient. Index fund investors free ride on this price efficiency that is produced by the active traders.

Index fund management is a fixed cost operation. As the assets under management (AUMs) goes up, the percentage costs come down. As a thumb rule, in the wholesale market in the US, a billion dollars of index fund management can be purchased for 1 bps per year (where the fund manager additionally gets the proceeds from stock lending).

There is no difference between the index funds run by different managers, so we should buy the one with the lowest fees and expenses. The NPS envisaged an auction to buy the services of the index fund manager.

The NPS replaced the traditional civil servants pension system for all new recruits from January 1, 2004. In the early years, the AUMs were inevitably small. At that time, many concepts of the NPS appeared theoretical. It speaks well for the leadership teams of the NDA-1 and UPA-1 period that they introduced this difficult reform and stayed the course.

It is in the nature of pension assets that they grow slowly but inexorably. NPS assets have now reached about ~7 trillion or $100 billion. At this point, we can reap the economies of scale.

We are now at the point where every 1 bps charged to the worker represents ~0.7 billion or ~70 crore. It is now looking feasible for NPS to pay for a comprehensive system cost of perhaps 5 bps, where the producers in the NPS ecosystem earn ~3.5 billion or ~350 crore. This pot of expenses, for total NPS expenditure, is a plausible total payment to all the organisations who make up the NPS (the Central Recordkeeping Agency (CRA), the Points of Presence (POPs), and the Pension Fund Managers (PFMs)). Such a price point is an excellent deal for the end-user.

Looking forward, the AUM is likely to double every five years. In this case, the envelope for total expenditure goes from ~350 crore (~3.5 billion) to ~700 crore (~7 billion) from 2022 to 2027, at which point it would become possible for the price to go down, e.g. to 4 basis points.

The conventional mutual fund or hedge fund industries are not able to deliver such cost efficiency. A full 24 years after the design work that led to the NPS, the numbers are now in place, and it can become highly attractive for everyone's financial planning.

Weary consumer marketing staffers in finance say "financial products are sold, not bought", to convey the idea that products have to be pushed down the throat of an uninterested customer. This justifies the high sales expenditures, that are ultimately paid for by the customer. NPS, and index funds, are a different vision, one where financial products are bought, and not sold. The essence of these products is virality. Equity index funds at 5 bps: it's a good deal. Once the idea sinks into the mind of one person, it would spread to two others.

In its early years, the NPS was in an uncomfortable position where there was a promise, there was a clean theoretical idea, but the AUMs were not big enough to generate compelling economics. It was easy for practical people to dismiss the NPS as theoretical. The Ministry of Finance and Pension Fund Regulatory and Development Authority (PFRDA) have played a difficult balancing act through these years, between the need for low expenses charged to the worker versus the fixed costs for the various service providers that are doing the work. Now, for the first time, the sheer AUM of NPS makes it feasible to have a total cost of about 5 bps, for the best portfolio for the young: a 100 per cent equity index portfolio that is globally diversified.

The NPS Trust and PFRDA need to move in a few directions in order for NPS to step up to these possibilities. A clean organising principle for the NPS is a number for total system cost for the next five years. The customer should be able to get 100 per cent equity exposure if she so desires. Asset management needs to graduate beyond India into mature democracies. This is a free lunch in terms of reduced risk, and these index funds have low fees. Avenues for premature withdrawal need to be closed: The essence of a pension system is carrying assets through into old age.

Once these things are done, every sophisticated person in India would want to get substantial assets into the NPS, without requiring a sales force or state coercion. With these reforms, NPS as the implementation engine is the answer to the long-standing difficulties of the Employees' Provident Fund Organisation.

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