There are broadly two kinds of pension plans. In defined benefit plans, the employer guarantees a fixed (defined) pension benefit to the employee upon retirement. The risk associated with investing the pension corpus is borne by the employer. In defined contribution plans, the contributions made by the employee are defined but the retirement benefits are not fixed and, instead, depend on the return generated by investing the corpus. The investment risk is, therefore, borne by the employee.
India’s two major pension plans–EPF (Employee Pension Fund) and NPS (National Pension Scheme)–are defined contribution plans. The return in the EPF plan is fixed annually by a board of trustees while the NPS return is driven by the market.
Recently, the EPF board raised the annual return in the plan from 8.55 percent to 8.65 percent, a move that surprised many observers given that the returns offered in the EPF plan were already quite attractive compared to other alternatives. Since the pension benefits in EPF are not taxed, a return of 8.65 percent is equivalent to a taxable return of 10.9 percent for someone earning between Rs 5 lakh and Rs 10 lakh a year and 12.6 percent for those earning between Rs 10 lakh and Rs 50 lakh. In comparison, a five-year deposit at SBI currently fetches only 6.8 percent.
Since the EPF is under the administrative control of the government, the obvious question is whether this increase in returns is a reflection of better investment returns earned by the fund or a SOP for the salaried middle class before the elections.
EPF, with an active subscriber base of six crore people and a corpus of over Rs 11 trillion, is mandated by the government to invest this money as follows: 45-50 percent in government bonds (read as a minimum of 45 percent and up to 50 percent), 20-45 percent in debt securities like corporate bonds and term deposits of banks, 5-15 percent in equity markets, up to 5 percent money market instruments (short-term liquid instruments like treasury bills and certificates of deposits) and up to 5 percent in asset-backed securities (home and auto loans).
It is hard to see how the board of trustees came up with an investment return of 8.65 percent given that the vast majority of its investments are in government bonds, currently yielding around 7.4 percent, and non-banking financial companies like IL&FS which are underwater. Its equity component, which is invested in a broad-market index, is up only about 3 percent in 2018 and struggling this year. For a pension plan to pay out more than it earns is fiscally imprudent. In 2017-18, EPFO’s surplus was Rs 586 crore, and this year after an 8.65 percent payout, its surplus will drop to ₹151 crore—far below the level maintained in earlier years.
That EPFO raised its offered return (for the first time in four years) soon after the Reserve Bank of India lowered interest rates is indeed puzzling. Raising the offered rate on EPF will force banks to increase their rates which in turn will increase the cost of borrowing capital. Some of the trustees on the EPFO’s central board have complained that the board’s finance committee did not endorse the decision to raise rates and that detailed calculations on the derivation of 8.65 percent were kept hidden from all members. Elections in India do bring out confounding and often conflicting SOP’s—the not-too-independent RBI lowers rates, and the country’s largest pension plan raises returns. Go figure.
The other government pension scheme offered in India, the National Pension Scheme (NPS), was launched in 2004 primarily as a retirement scheme for new government employees but was subsequently offered to the general public in 2009. While the EPF provides a guaranteed annual return, the NPS gives market linked returns. The vast majority of the EPF corpus is invested in government bonds, and investment in the equity market is limited to a maximum of 15 percent. But NPS is allowed to invest up to 50 percent of its corpus in the equity markets, which, over the long term, has the potential to earn higher returns.
There are some other differences between the two pension plans. Firstly, EPF is open only for salaried employees of private sector firms. It is compulsory in companies with ten employees or more. NPS, while mandatory for government employees who joined after April 2004, is also open to the general public, including the self-employed and people in the unorganised sector.
Secondly, in EPF, the employee’s contribution is fixed at 12 percent of his basic salary (with an equal amount added by the employer), but in NPS, the employee can put any amount over the minimum contribution of Rs 6,000 per year–there is no upper limit.
Thirdly, under NPS, the employee can choose how his money is invested between debt and equity. This flexibility is missing in the EPF scheme. Everyone gets the same return dictated not by the market but by the board of trustees (which is controlled by the Ministry of Labour). The higher allocation to equity could potentially offer NPS subscribers additional returns of 2 to 3 percent per year for long tenure plans.
Fourthly, the entire accumulation in the EPF can be withdrawn at the time of retirement (age 60), while in case of NPS only 60 percent can be withdrawn as a lump sum and the remaining 40 percent must be compulsorily invested in an annuity that provides annual pension payments every year.
Finally, there are differences in how the pension benefits in the plans are taxed. While both plans allow the monthly contribution to be deducted from current income for tax purposes (up to a maximum of Rs 1.5 lakh), withdrawals at retirement in the EPF plan are completely tax-free while only 40 percent of the amount withdrawn under the NPS scheme is tax-free. Also, the annuity pension payments under the NPS scheme are taxable. The 7th Pay Commission recommended that withdrawals under NPS should also be tax-exempt to place it on par with EPF.
So which retirement system is better—NPS where the returns are market driven but withdrawals are not tax-free or EPF where the returns are dictated by a government-controlled board but the withdrawals are tax-free? NPS does offer the potential for higher returns over the long term and should be the preferred alternative for young subscribers under the age of 40. Since inception, the 50 percent equity option under NPS has given a return of 11.8 percent, but after taxes, the return falls to around 8.7 percent which is equivalent to the 8.65 percent offered by EPF. The tax exemption gives EPF a significant advantage over other plans.
There are multiple other pension plans offered by private companies such as HDFC, Bajaj, Reliance, and government organisations like LIC, SBI, etc. Most are based on the notion of a fixed monthly premium paid during the working life of a person, which is invested to provide a cumulative amount or annuity at retirement. Individuals who want greater control over their investment can also construct their own retirement plan by investing a fixed amount in a portfolio of their choosing –systematic investment plans (SIP) in mutual funds are an example. The significant disadvantage of self-designed pension plans is that the premiums are not tax deductible.
Saving for the day when one can’t generate regular income is a must for everyone. The government should make all plans, including private offerings, tax neutral to provide individuals with a wide range of retirement options. Younger workers would have the flexibility to choose plans that have a higher equity component to deliver better returns, while older workers may prefer the guaranteed return of EPF.
Retirement plans play an important role in economic growth because they help channel savings into capital markets. Plans like EPF, which are forced to invest a majority of their corpus in government bonds, crowd out capital available for the private sector. This affects business productivity.
The fact that EPF withdrawals are tax-free gives it a significant advantage over other plans. The government can fix this anomaly by making all pension plans tax-neutral as suggested by the 7th Pay Commission. Providing the same tax treatment for all qualified retirement plans will force the plans to compete on the basis of returns. This will increase the retirement options available to citizens and provide the private sector with greater access to capital.
This article was published in India Legal, March 3, 2019