PENSION FUNDS AND SOCIAL SECURITY

PENSION FUNDS AND SOCIAL SECURITY India does not have a comprehensive old-age income security system. The vast majority of Indians continue to rely on support from their children as their main income in old age. Two important mandatory, albeit narrow, pension systems exist, however: the civil servants' defined benefit pension and the organized sector system run by the Employee Provident Fund Organisation (EPFO), which is an arm of the Ministry of Labour.

Traditional Civil Servants' Pension

The phrase "traditional civil servants pension" (TCSP) connotes the pension program that existed for employees of the central government who were recruited prior to January 2004. With small variations, the TCSP applies to most employees of state governments as well. The TCSP for central government employees is administered by the Department of Pensions and Personnel Welfare. The TCSP is a defined benefit pension. It was an integral part of the employment contract for government employees. There is a minimum requirement of ten years of service before a worker is entitled to this pension. There is no attempt at having contributions or building up pension assets—in other words, it is unfunded. The benefit promised by the TCSP is a pension that is roughly half of the wage level of the last ten months of employment. The benefit rate is computed as 1/60 for each year of service, subject to a cap of a 50 percent benefit rate. In case of death after retirement, the spouse gets the full pension for seven years, after which the benefit rate drops to 30 percent until the death of the spouse.

There is a commutation provision, under which the pensioner can choose to forgo up to 40 percent of the pension payout for fifteen years, taking instead a lump sum. The TCSP is indexed to wages. There is a "one rank, one wage" principle, whereby all retired persons of a certain rank get the same pension, steadily revised to reflect growth in wages. Hence, the growth in pension payout in old age is typically higher than inflation.

The standard information released as part of the budgeting process only reveals information for the flow of annual pension payouts by both the central government and the states. Estimates of unfunded liabilities, that is, the implied pension debt, associated with workers and pensions under the TCSP are not computed or disseminated by the government. Over the period from 1987–1988 to 2003–2004, while nominal gross domestic product (GDP) grew by a compound rate of 14.5 percent, central pension payments grew at a compound rate of 17.8 percent and state pension payments grew at a compound rate of 21 percent. These magnitudes—with a fast-growing expense that is already at 1.64 percent of GDP—highlight the fiscal ramifications of pension reforms.

The Employee Provident Fund Organisation

The EPFO runs two programs: the Employee Provident Fund (EPF) and the Employee Pension Scheme (EPS). Both plans are mandatory for workers earning below 6,500 rupees a month, in establishments with over 20 workers in 177 defined industries. As of 31 March 2003, there were 344,508 such establishments, and 39.5 million members.

The EPF is an individual account contribution system, using a contribution rate of 16 percent. The flow of contributions in 2002–2003 was 114 billion rupees, and the stock of assets was 1.03 trillion rupees. There are several provisions for premature withdrawal of balances under EPF, which are routinely exploited by most members, leading to small balances at the time of retirement and consequently limited old-age income security.

The EPS is a defined benefit system, based on a contribution rate of 8.33 percent. The government contributes an additional 1.16 percent. EPS was created in 1995, and it applies only to workers who entered the labor force after 1995. In 2002–2003, the flow of contributions that came into EPS was 48 billion rupees, and the stock of assets was 450 billion rupees. The EPS provides a defined benefit at a rate of 1/70 of the salary drawn in the last twelve months preceding the date of exit, for each year of service, subject to a maximum of 50 percent. Upon death, the EPS provides a pension to the spouse for life or until remarriage.

Establishments covered under the EPF can seek an exemption from the EPFO for fund management and set up their own self-administered fund. These "exempt funds" are required to use identical investment regulations to those of the EPFO. There were 341,944 establishments with exempt funds as of March 2003, covering 3.75 million members.

Other Elements of the Pension System

"Gratuity" is a mandatory lump sum benefit, up to a maximum limit of 350,000 rupees, paid to the employee at the time of exit, under the Payment of Gratuity Act 1972. It is applicable to establishments with 10 or more people. The National Old Age Pension Scheme is a part of the National Social Assistance Program, which came into effect 15 August 1995. It is funded by the central government but administered by the state governments. It pays a benefit of 75 rupees per month to "destitutes" above the age of 65.

The most basic problem of India's pension plans is that of coverage. Two systems, the TCSP and the EPFO, cover just 11 percent of the workforce. Hence, the majority of the workforce has no formal pension system. In the case of the TCSP, the major problem has been that of fiscal stress. The pension payout of the central government and states has risen at a compound average annual growth rate of 20 percent over the period from 1987 to 2004. The TCSP was designed in a world where most workers who retired at age sixty were likely to be dead by seventy. The value of the annuity embedded in the TCSP has gone up dramatically, owing to the elongation of mortality in recent decades. The fiscal stress has been particularly acute at the state level. Some states are reported to have delayed pension payments. In 2003 the state of Tamil Nadu chose to cut pension benefits by reversing recent increases in pensions that followed as a consequence of wage hikes to existing employees.

The EPFO has several shortcomings that undermine its service provision, financial stability, and hence effectiveness as a pension system. Its accounting systems and policies have certain weaknesses. The lack of computerized databases spanning information from the entire country has led to difficulties in reconciliation. More importantly, the valuation framework used is one in which all bonds are valued at 100 rupees, regardless of market price. The "interest rate" on EPF that is announced every year is the average coupon rate on the bond portfolio. It is announced at the start of the year, which necessitates a difficult effort in forecasting interest rates during the year. There is an explicit subsidy in the form of assets of roughly 0.5 trillion rupees, which have been deposited with the government at an above-market rate of return.

A difficulty that runs across both the TCSP and the programs of the EPFO is that of taxation. Fiscal subsidies underlie EPFO, and these subsidies constitute a regressive transfer from the exchequer to the members of the EPFO, who are likely to fall into the top quartile by income. Further, even among EPFO customers, recently released distributional data has shown that only 7 percent of the accounts have an account balance of above 50,000 rupees, so that the bulk of the subsidy that EPFO members are enjoying is being captured by the richest among them.

Recent Initiatives in Reforms

Meeting the challenges of old-age poverty requires fresh efforts in many areas. Modern information technology needs to be implemented across the country, in order to deliver high quality customer service with low administrative costs. Members need portability that enables migration across multiple geographical locations, across different employers, and across multiple fund managers. Modern investment regulation needs to be in place, so that professional pension fund managers can produce the best risk/reward combinations for their members, using globally diversified portfolios and giving members the choice of exposing themselves to systematic risk factors. Clear separation is required between policy making, regulation, and service provision.

In recent years, EPFO has embarked on efforts to introduce computer technology and improve customer service. At the same time, there has been no progress in terms of the deeper policy problems. While there has been considerable public criticism and awareness of the deficiencies, significant progress in terms of EPFO reforms is likely to be infeasible without broad-based support in Parliament.

On the other hand, major progress has been made in recent years in civil servants' pensions and the problem of extending coverage into the unorganized sector. This progress flowed mainly from the recommendations of the Old Age Social and Income Security Committee, chaired by S. A. Dave, which was constituted by the Ministry of Social Justice in 1999. Through a multiyear process of debate and discussion, decisions have been made on the introduction of a New Pension System (NPS). The key elements of the NPS include the following: it will be an individual account system with defined contributions; there will be competition between multiple pension fund managers; and each pension fund manager will offer roughly three standardized products. The three product types will differ in their exposure to equity. Individuals will be free to spread their pension wealth among all the available products. The selection of pension fund managers is likely to be based on an auction, focusing on the sum of fees and expenses.

There will be a centralized record-keeping agency, which will give customers a single account balance statement covering all products in the system. The agency will also reduce transactions costs. As befits a pension system, withdrawals prior to age sixty will be disallowed. There will be a network of banks, post offices, and other "points of presence" across the country, where consumers will be able to access the pension system. The focus of the NPS is on building pension wealth. Upon retirement, it is expected that there will be a minimum mandatory annuitization of 40 percent of terminal pension assets.

All new recruits into the central government (excluding the armed forces) who joined after 1 January 2004 have been placed in the NPS, using a contribution rate of 20 percent. Many states have also chosen to join the NPS. Once the institutional structure stabilizes, it will be opened to voluntary participation by anyone in the country. A new regulatory agency, the Pension Fund Regulatory and Development Agency (PFRDA), is expected to come into existence once suitable legislation is passed by Parliament. PFRDA will closely coordinate its activities with other modern Indian financial regulators.

Ajay ShahUrjit R. Patel

See alsoEconomic Development, Importance of Institutions in and Social Aspects of ; Economy since the 1991 Economic Reforms

BIBLIOGRAPHY

Asher, Mukul G. "Case for a Provident and Pension Funds Authority." Economic and Political Weekly 37, no. 8 (2002): 688–689.

Bordia, Anand, and Gautam Bhardwaj, eds. "Rethinking Pension Provision for India." New Delhi: Tata McGraw Hill, 2003.

Patel, Urjit R. "Aspects of Pension Fund Reform: Lessons for India." Economic and Political Weekly 32, no. 38 (1997): 2395–2402.

Srinivas, P. S., and Susan Thomas. "Institutional Mechanisms in Pension Fund Management: Lessons from Three Indian Case Studies." Economic and Political Weekly 38, no. 8 (2003): 706–719.