• 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 with- out 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 asa 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. withdrawal stages) would certainly help increase the popularity and acceptance of the defined The index value for India indicates that some contributions system. sound features exist but there are some signifi- cant omissions or weaknesses. The score also As life expectancy continues to increase, indicates that the country is in the early stage of annuity providers will be expected to provide development of a retirement income system. regular monthly benefits to retirees for longer periods. This should not impact annuity providers’ According to the Melbourne Mercer Global commercial viability. Innovative products such Pension Index report, India’s overall index value as index-linked funds and international diversifi- could be increased by: cation to equities or equity-based products and new tax treatment methods are needed so that • Introducing a minimum level of support for the longer life expectancy does not become a burden poorest among the elderly. for annuity providers. • Introducing a minimum access age so that it is clear that benefits are preserved for Global Comparison retirement. The Melbourne Mercer Global Pension Index, • Improving the regulatory requirements for the which measures countries’ retirement income private pension system. scheme against more than 40 indicators, places • Continuing to improve the required level of India at an overall index value of 42.4 for 2012. communication to members from pension The index is based on a study of retirement arrangements.

Overall Index for Each Country

Sub-index Values Country Overall Index Value Adequacy (40%) Sustainability (35%) Integrity (25%) Australia 75.7 73.5 73 83.2 Brazil 56.7 71.5 26.9 74. 8 Canada 69.2 74. 2 56.3 79.3 Chile 63.3 50.1 67.7 78.4 China 45.4 55.7 30.5 49.7 Denmark 82.9 78.1 86 86.4 France 54.7 74. 3 32 55.2 Germany 55.3 65.2 35.9 66.7 India 42.4 37.4 40.7 52.8 Japan 44.4 46.1 28.9 63.3 Korea (South) 44.7 45.1 42.3 47.5 Netherlands 78.9 77 73 90.3 Poland 58.2 63.6 43.4 70.1 Singapore 54.8 42 54.2 76.2 Sweden 73.4 68 73.3 82.5 Switzerland 73.3 71.3 67.9 84.1 UK 64.8 68.1 46.2 85 USA 59 58.3 58.4 61.1 Average 61 62.2 52.1 71.5

Source: Melbourne Mercer Global Pension Index October 2012 Figure 3

cognizant 20-20 insights 4 • Increasing the pension age as life expectancy size and complexity, a defined contributions continues to increase. model is the model for the future. There are a few • Increasing the level of contributions in provisions which need to be incorporated from statutory pension schemes. other pension models to make the system more beneficial: provision of minimum pension under The Road Ahead social security, provision for early and late retirement and benefits calculation modeling in The NPS scheme has several advantages line with price increases. over other schemes in terms of cost and equity exposure. Mutual funds can charge up to 2.25% For Indian pension reforms to truly succeed and and ULIP Pension plans from life insurers can be an example for emerging economies, it is not charge up to 1.35% as fund management fees. just essential to move to a defined contribution NPS charges just 0.25%, making it one of the model; it needs to create a basic pension from 6 cheapest pension products in the world. The public finances. A formal old-age income support difference in fees/charges affects the total especially for financially impoverished senior corpus significantly over longer periods of citizens is needed urgently. investment. NPS also instills a sense of disciplined savings and offers tax benefits. In its influential report “Averting the Old Age Crisis,” the World Bank (1994) recommended a Policy initiatives are also required to encourage multi-pillar system for the provision of old-age voluntary subscription to this scheme. These income security comprising: initiatives could include establishing a compre- hensive national pension policy, improvements in • Pillar 1: A mandatory publicly managed tax- the security and returns from NPS investments, financed public pension. setting up distribution channels and increas- • Pillar 2: Mandatory privately managed, fully ing the incentives for them and increasing the funded benefits. channels’ regional coverage. Designing custom- • Pillar 3: Voluntary privately managed, fully ized marketing strategies for different market funded personal savings. segments will also be effective; marketing through SMS or street events/road shows could Subsequently, Holzmann and Hinz (2005) of the be one option. Telecommunication companies’ World Bank extended this three-pillar system to support can be sought to build a database of the following five-pillar approach: prospective customers. • Pillar 0: A basic pension from public finances Also, the virtues of this scheme need to be com- that may be universal or means-tested. municated to the investing public. One of its • Pillar 1: A mandated public pension plan that biggest pluses is that the cost of administration is publicly managed with contributions and, in 7 remains the cheapest in the world. Also, the some cases, financial reserves. scheme is portable anywhere within the country • Pillar 2: Mandated and fully funded occupa- – i.e., employees can “carry” their accounts with tional or personal pension plans with financial them when they change jobs. The scheme offers assets. a choice of investment mix and pension fund • Pillar 3: Voluntary and fully funded occupa- managers. All transactions can be tracked online tional or personal pension plans with financial through the central record keeping system, and assets. there is an efficient grievance management sys- • The fifth pillar is a nonfinancial pillar that tem in place. The scheme offers an auto choice includes the broader context of social policy (default) option for subscribers who do not have such as family support, access to healthcare sufficient knowledge about these instruments. and housing, etc.

A concerted effort by the regulators, pension The key challenge in India is to continue the fund administrators and the service provider is pension reforms while addressing the needs for needed to make this laudable social initiative a Pillar 0 and create a universal security net for the true success. most needy.

A study of the retirement income system in G20 countries indicates that in a country of India’s

cognizant 20-20 insights 5 Footnotes 1 http://pfrda.org.in/writereaddata/linkimages/oasisreport6305547711.pdf.

2 http://www.financialinfohub.com/index.php?pr=Investing-advantagesdisadvantges_of_401k_plans.

3 http://pfrda.org.in/writereaddata/linkimages/NPS%20status%20March2013651445507.pdf.

4 http://www.indiapost.gov.in/posb.aspx.

5 https://www.npscra.nsdl.co.in/news_detail.php?id=12.

6 http://articles.timesofindia.indiatimes.com/2013-02-04/personal-finance/36742174_1_nps-trust-nps- account-national-pension-system.

7 http://www.thehindubusinessline.com/industry-and-economy/banking/scope-to-offer-annuity-ser- vices-in-new-pension-scheme/article3734945.ece.

References • www.Pfrda.org.in. • http://www.actuariesindia.org/. • https://www.npscra.nsdl.co.in/. • http://www.globalpensionindex.com/. • www.forbes.com. • www.iief.com. • http://www.oecd.org/. • www.statestreet.com. • www.actuaries.org. • http://www.ccsindia.org. • http://financialservices.gov.in/PensionReforms_india_index.asp. • http://financialservices.gov.in/pensionreforms/Pension%20Reforms%20in%20India.pdf. • Ramdev Gowswami, “Indian Pension System: Problems and Prognosis.” • S.A.Dave, Robert Palacios, Gautam Bhardwaj, “Rethinking Pension Provision for India.” • The Project Oasis report (Old Age Social and Income Security Project), January 2000. • Ajay Shah, “Issues in Pension System Reform in India.” • “Pensions at a Glance 2011: Retirement-Income Systems in OECD and G20 Countries,” OECD 2011. • Final Report of the ACA’s 2011 Pension Trends Survey, conducted by the Association of Consulting Actuaries. • Robert Holzmann, Global Pension Systems and Their Reform Worldwide Drivers, Trends, and Chal- lenges. • Dr. Ramesh Gupta, Pension Reforms in India: Myth, Reality and Policy Choices.

cognizant 20-20 insights 6 • Hertie School of Goverance, working paper, “Extending Coverage of the New Pension System in India – Analysis of Market Forces and Policy Options.” • http://www.aca.org.uk/files/2011_Pension_trends_report-3_January_2012-20111222162316.pdf. • http://www.thehindubusinessline.com/opinion/columns/aarati-krishnan/same-old-story-on-pension- reforms/article3539828.ece. • http://www.financialexpress.com/news/india-needs-a-pension-culture/1056520/0. • http://www.livemint.com/Home-Page/E7OCcGDCbC2DVmU2NlwFtO/IMF-Working-Paper--Financial- market-implications-of-Indias.html.

About the Author Rajdeep Bhaduri is a Manager with Cognizant’s Banking and Financial Services’ Product Solutions and Applications Group. Rajdeep has more than 14 years of experience in leading business and IT engagements, mainly in the private banking and capital markets domains. He can be reached at [email protected].

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