According to a working paper published by Asian Development Bank (Ageing Asia’s Looming Pension Crisis): “A young continent reaping the demographic dividend of a large youthful workforce is giving way to a greying continent where the ratio of retirees to workers is on the rise. In contrast to industrialized countries, most Asian countries do not yet have mature, well-functioning pension systems”. This makes the task of pension reforms in India rather compelling in nature and a dire social necessity that cannot be forestalled for far too long. The Indian economy is currently basking in the glow of the so-called “demographic dividend”, a fortuitous consequence of what was earlier considered a millstone for the economy – the country’s burgeoning population. But, this dividend can also turn into what has been termed as a “demographic echo”. Over time, this huge bulge in the working force – which is being considered as an economic windfall -- is expected to retire. At the same time, the lower dependency ratio will see fewer younger people joining the workforce, resulting in a graying of the economy. A larger number of older and retired people, in the absence of a dependable pension system, will pose a danger to the old age income security in the country and put enormous pressure on the government of the day to re-route expenditure earmarked for public goods and services towards providing for health and pension spending. This causes a drain on the state of the fiscal and, subsequently, on the economy.
The proportion of those aged 60 and above is expected to climb from 4.6% in 2000 to 9% in 2030. In absolute numbers, the number of people above the age of 60 will increase from 87.5 million in 2005 to 100.8 million in 2010 and this is expected to jump to 200 million by 2030. By 2050, it is expected to be over 320 million (Source -- World Population Ageing: 1950-2050, United Nations). What makes this data-point chilling is the fact that improved economic development is bound to lead to a higher life span. The inability to implement a properly functioning pension system now is likely to affect a larger number of people in the future
What further complicates matters is that only about 12% of the working population participates – and is eligible to participate -- in the mandatory, formal programmes designed for providing income security during the non-earning years. These employees are largely part of the formal sector (private sector and the government). The rest is either part of the informal sector (which goes unreported in the broader economic scheme) or does not enjoy adequate income streams that can be accommodated in the existing pension schemes.
Any pension system in the world can be said to broadly conform to any one, or a combination, of three basic pillars.
Pillar-I: This pillar essentially comprises all the state-funded pension plans, which in theory should ideally cater to every citizen in the country. This is also the pillar under which the government launches some of its poverty alleviation programmes aimed specifically at the aged. Under this pillar, the system is publicly managed, the liabilities are not actuarially funded and the scheme works on what is termed as Pay-As-You-Go. This means that current revenues are used to meet current expenditures. But, in fiscal terms, the consequences need a slightly more detailed look – the current generation’s tax payments are used to pay the pension liabilities of an earlier generation. The World Bank’s now famous report on pensions, called Averting The Old Age Crisis (1994), defines Pillar-I thus: “…a publicly managed system with mandatory participation and the limited goal of reducing poverty among the old…”. In India, the defined benefit pension system in vogue for the civil services at both the Centre and the state level – including in the railways, defence and telecommunication services – fall under Pillar-I, where the system is essentially non-contributory in nature and any particular year’s pension liabilities are met from the government’s annual revenue expenditure account for that year.
Pillar-II: This typically comprises a mandatory savings programme at the employment level which is either privately or publicly managed. In simple terms, it is a forced savings pillar that provides benefits only to contributors, and, in general, incorporates a direct linkage between the volume of contribution and the extent of benefits received. In India, the Employees Provident Fund, which is India’s largest defined contribution and publicly managed plan, is an example of this. In addition, there is the Employees Pension Scheme, a publicly managed scheme carved out of the EPF scheme with the objective of paying a monthly pension to workers after their retirement.
Pillar-III: This pillar includes all kinds of voluntary savings, available to everyone including those looking to supplement their Pillars I & II pension provisions. In India, the Public Provident Fund scheme fits the definition.
The Journey from Defined Benefit to Defined Contribution
The government began to take note of the looming pension crises necessitated by an existing anachronism in the civil service pension scheme – a defined benefit scheme inherited from the British administration, which was showing all signs of being fiscally unsustainable and, secondly, by an important event in the mid-nineties in which a part of the age-old defined contribution scheme, the Employees Provident Fund Scheme, was converted into a defined benefit scheme in the form of the Employees’ Pension Scheme, 1995. This marked a curious move by the Indian government, particularly at a time when the rest of the world was moving away from DB to DC. However, the introduction of NPS a few years later might be seen as an attempt to make course corrections.
The Ministry of Social Justice and Empowerment (earlier called the Ministry of Welfare), in 1998, commissioned the first comprehensive study of India’s pension sector under the chairmanship of former UTI Chairman Dr S A Dave, under the name of Oasis Project – Old Age Social and Income Security Project. While the original remit of the Oasis Committee was to provide a pension solution for the 90% of the informal sector workers, the committee ended up providing a prescription for overall pension reforms. As part of its overall recommendations, the Oasis committee (which submitted its final report in January 2000) suggested a completely new and radically different architecture through portable individual retirement accounts, across-the-counter service delivery platforms, centralized record keeping, competing pension fund managers, extensive use of information technology, freedom to choose investment menus, among other things. While observing that there was a separate working group looking into the aspect of government pensions, the Oasis committee expressed its view on the issue rather succinctly: “…measures should be taken so that Government Pension liabilities become fully funded out of contributions made by government employees. This goal can be achieved over a period of the next ten years.”
The turning point came on February 28, 2001, when former Finance Minister, Mr. Yashwant Sinha, announced this in his Budget speech for 2001-2002: “The Central Government pension liability has reached unsustainable proportions: as a percentage of GDP, it has risen from about 0.5 per cent in 1993-94 to 1 per cent in 2000-2001. As such it is envisaged that those who enter central government services after October 1, 2001 would receive pension through a new pension programme based on defined contributions. In order to review the existing pension system and to provide a roadmap for the next steps to be taken by the Government, I propose to constitute a High Level Expert Group, which would give its recommendations within 3 months.”The Finance Minister Jaswant Singh announced in his Budget speech of February 2003: “My predecessor in office had, in 2001, announced a road map for a restructured pension scheme for new Central Government employees, and a scheme for the general public. This scheme is now ready. It will apply only to new entrants to Government service, except to the armed forces, and upon finalisation, offer a basket of pension choices. It will also be available, on a voluntary basis, to all employers for their employees, as well as to the self-employed. This new pension system, when introduced, will be based on defined contribution, shared equally in the case of Government employees between the Government and the employees. There will, of course, be no contribution from the Government in respect of individuals who are not Government employees. The new pension scheme will be portable, allowing transfer of the benefits in case of change of employment, and will go into ‘individual pension accounts’ with Pension Funds. The Ministry of Finance will oversee and supervise the Pension Funds through a new and independent Pension Fund Regulatory and Development Authority.”Thus began the transition from the age-old defined benefit scheme to the fiscally prudent defined contribution scheme as part of the National Pension System. In December 2003, the Interim Pension Fund Regulatory and Development Authority was created as the watchdog and promoter for the pension sector. Simultaneously, all government employees joining service on or after January 1, 2004, were compulsorily brought under the coverage of the New Pension System (NPS)—a defined contribution scheme replacing the defined benefit scheme available to the Government employees until then. Most of the states have also migrated to the DC system under NPS, except three states. Only one category of government employees has been exempted from mandatorily moving to NPS: personnel from Armed Services. NPS was introduced for all citizens from May 2009.
Each government employee contributes 10% of his salary (basic+DA+DP) to the pension account, which is then matched by a government contribution of an equal amount. However, non-government employees do not get the benefit of a matching government contribution. In both the cases, investors are free to contribute higher than what has been mandated. All these contributions are accrued in a pension account called Tier-I from which funds cannot be withdrawn. Once the account-holder reaches the proper exit age (60 years, relaxed to 50 years for Swavalamban beneficiaries in Budget 2011-12, see below), he/she can withdraw only up to 60% from the accrued savings corpus. The balance 40% in the savings corpus has to be used to compulsorily purchase annuities sold by any life insurance company. This annuity then provides for regular pension streams over the non-working life of the investor. In addition, there is a tax issue at work here as well. The contributions to this account and the savings accrued are exempt from income tax, as per Section 80CCD. However, when the investor withdraws the amount on maturity, it is taxable. The Direct Tax Code is proposing to convert retirement savings from the current Exempt-Exempt-Taxable regime (which exempts contributions and the accumulated sums from income tax but levies tax on the final corpus) to a completely Exempt-Exempt-Exempt regime.
Over 12 lakh government employees are currently registered with NPS. However, when weighed against the fact that it has been more than six years since NPS was first made mandatory for government employees, the enrolments at 12 lakh do seem to be on the lower side. In May 2009, NPS was thrown open to the general public. The subscription levels so far have remained rather tepid and do not seem to reflect any investor interest in the product. The scheme has managed to draw less than 55,000 subscribers so far (October 2011). This is a rather low number, given that the scheme architecture was designed to make it attractive to the general public. In terms of money managed by the PFMs, as of March 31, 2011, the total assets under management by all PFMs amounted to Rs 8,585 crore. Of this, the contribution from the nongovernment sector does not exceed Rs 100 crore. This reflects the sluggish growth of NPS.
While the transition from DB to DC is a financially prudent and viable in terms of long term sustainability, the progress under NPS scheme has been sluggish, staggered and far below the potential. We need to look into what ails NPS and what can be done to popularise the scheme.