Pension Reforms in India

• Cognizant 20-20 Insights Pension Reforms in India Pension reforms are yet to benefit a large section of the Indian population. Significant changes on the policy and regulatory fronts, better marketing and better pricing of products can give this sector a much-needed boost. Executive Summary and cost-effective products are available to the population for creating a retirement corpus. Life expectancy has shot up in recent decades. When public pension systems were first estab- lished, people could typically look forward to only Background of Pension Reforms a few years of retirement if any. Today, globally, India does not have a universal social security sys- the probability of a newborn boy surviving until tem. A large number of India’s elderly are not cov- age 65 is over 80%; the figure is over 90% for ered by any pension scheme. Pension reforms and a girl child. Aging populations are “a high-class” a pension system with greater reach will not only problem, said U.S. President Bill Clinton in his ensure citizens’ welfare in their golden years but 1999 State of the Union address. He continued: will also help the central and state governments “It’s the result of something wonderful: the fact cut their future liabilities. With these broad objec- that we are living a lot longer.” Nevertheless, tives in mind, the government of India set up an there is no denying that aging populations pose expert committee in 1998 to devise a new pension significant challenges for economic, social and system for India. Project Oasis, which was chaired health policies in general and pension systems in by S.A. Dave, submitted its report in 2000.1 particular. The report recommended setting up a new India is no exception to this global trend. pension system in India. It recommended Demographic projections indicate that the share creating a pension system based on individual of the aged will rise to 9% of the total popula- retirement accounts (IRAs). An individual would tion by 2016 and to 13.3% by 2026. Life expec- save and accumulate assets through his entire tancy has increased significantly in India, thanks working life. Upon retirement, the individual to economic development and better access to would be able to use his pension assets to buy medical care. This also means that a significant annuities from annuity providers and obtain a percentage of the population is expected to live monthly pension. The pension amount would be beyond 75 years of age. Therefore, it is essential governed by what the employees’ pension fund that a formal mechanism of benefits to reach a account could earn from market investments. large section of the aged population is in place cognizant 20-20 insights | june 2013 This was a paradigm shift, from the existing One of the most important issues is the tax defined returns philosophy to a defined contribu- treatment. There is no clarity on the taxation tions philosophy. of funds at withdrawal. In India, returns from annuity insurance plans are not exempt from The committee suggested creating a profession- taxation. Another significant impediment is the ally managed system with a large base of pension compulsory annuity feature of the scheme. Even account holders across all sectors of the economy on maturity, the account holder can withdraw and centralized record-keeping. The proposed only up to 60% of the accumulated sum. The system would ensure fair competition among remaining amount has to be used to buy annui- professional fund managers so as to provide ties, the returns from which are not tax-exempt. a wide range of choices to employers and fair Also, the annuity can be bought only from one of market-linked returns to the account holders. the six PFRDA-approved insurers. This restricts the investor’s choices. In line with the above recommendations, the government set up its New Pension System The fact that the scheme caps equity exposure at (NPS), India's answer to the U.S.'s 401(k) plans.2 50% is a dampener for younger investors, who The NPS was launched in 2004 for central usually have a higher appetite for risk and would and state government employees, who had to prefer a larger equity allocation. subscribe mandatorily. In 2009, it was thrown open to all Indian citizens in the 18-60 age group. Also, the scheme faces stiff competition from However, it has failed to take off in the voluntary the mandatory Employees’ Provident Fund (EPF), segment given the anemic subscriptions from the which remains the main retirement savings private sector (see Figure 1). instrument for a majority of Indian employees. Given the mandatory retirement contribution to Challenges in Implementation EPF, employees are reluctant to put in additional The scheme’s lack of popularity has been money in NPS. attributed to several factors, such as weak incen- tives to intermediaries, a lack of awareness Another challenge is to popularize this scheme in among the general population, insufficient mar- the unorganized sector where financial literacy is keting and promotion of the product and lower poor and workers rarely have surplus money to returns compared to other investment options. invest. NPS has come up with a scheme, Swalam- 5 The scheme has delivered 5% to 12% returns in ban Yojana, which seeks to target this sector. the past three years. Compare this to a return Under the scheme, the government contributes of 8.5% for Employees Provident Fund for the 1,000 rupees per year for three years for each financial year 2012-13, 8.7 % for Public Provident NPS account opened in the past three financial Fund and 8.5% and 8.8% from National Savings years. However, this is not a sustainable model Certificate for five and 10 years, respectively.4 in the long run. For this scheme to survive without government funding, awareness campaigns A closer look at the finer elements of the scheme and marketing targeted to this segment of the reveals that there are other issues that need to working population are essential. be addressed to improve investor sentiment for this product. Sector-wise NPS Status as of March 2, 20133 Corpus Under NPS Sl. No. Employer/Sector Number of Subscribers (in billion rupees) 1 Central Government 11,25,871 170.47 2 State Government 15,85,349 97.80 3 Private Sector 2,02,679 12.54 4 NPS-Lite 15,79,690 4.12 Total 44,93,589 284.93 Figure 1 cognizant 20-20 insights 2 Managing the Shift In India’s pension system, the shift from a In defined contributions models, the burden of defined benefits model to a defined contribu- changes in life expectancy is borne by individual tions model will impact pensioners. The defined retirees in the form of lower pensions. When benefits model has some advantages such as a people retire in a defined-contribution plan, stable income replacement rate with market and the accumulated contributions and investment longevity risk borne by the employers. In returns is converted from a lump sum into a contrast, in defined contribution plans the regular pension payment, known as an amount of retirement income cannot be known “annuity.” The calculation of the annuity is based in advance. The move to a defined contribu- on projected life expectancy of retirees at the tion plan would require employees to carry out time of retirement. Pension replacement rates complex financial calculations in both the asset — the percentage of a worker’s pre-retirement accumulation and retirement phases. Policy mak- income that is paid out by a pension program ers would need to design simple default solutions upon the worker’s retirement — will therefore be that do not require complex calculations. They automatically lower as people live longer. would also need to assume the responsibility of creating greater awareness among pensioners Global Grades for Pension System Denmark Sweden Canada United Kingdom Poland United States Netherlands Germany China Japan France Switzerland India Korea Brazil Singapore Australia Chile Index Grade Value Countries Description A first class and robust retirement income system that delivers A >80 Denmark good benefits, is sustainable and has a high level of integrity. Netherlands & B+ 75–80 Australia A system that has a sound structure, with many good features, but has some areas for improvement that differentiates it from Sweden, Switzerland B 65–75 an A-grade system. & Canada C+ 60–65 UK & Chilie A system that has some good features, but also has major risks USA, Poland, Brazil, and/or shortcomings that should be addressed. Without these C 50–60 Germany, Singapore improvements, its efficacy and/or long-term sustainability can be & France questioned. A system that has some desirable features, but also has major China, Korea (South), D 35–50 weaknesses and/or omissions that need to be addressed. Without Japan & India these improvements, its efficacy and sustainability are in doubt. A poor system that may be in the early stages of development or E < 35 Nil a nonexistent system. Source: Melbourne Mercer Global Pension Index October 2012 Figure 2 cognizant 20-20 insights 3 who have shifted to the defined contributions systems in 18 countries. The table below (in model and educate them on the intricacies of the Figure 3) shows the overall index value for each risks and returns from each type of plan. Treat- country, together with the index value for each ment of the corpus in line with the Employees’ of the three sub-indices: adequacy, sustainability Provident Fund or the Public Provident Fund (no and integrity. Each index value represents a score tax is levied at the investment, accumulation or between zero and 100.

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