Policy Proposals and Actions for providing sustainable retirement outcomes under legislated pension

1
Policy Proposals and Actions for providing
sustainable retirement outcomes under legislated
pension and PF provisions

• By
• Mukul Asher, Professor
• National University of Singapore
• sppasher_at_nus.edu.sg
• Presented at
• The 7th annual Indian Pension Policy Conference
• September 27-28,2005, New Delhi.

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Organization

• Introduction
• EPFO
• Key challenge
• overview
• Governance Structure
• Scheme design
• Non-investment related core functions.
• Investment policies and management
• Concluding Remarks

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Introduction/1

• Figure 1 provides an overview of India's social
  security system. It has 6 components and each
  component has several elements.
• Currently these components are not integrated in
  a systemic manner.
• Professionalism in design and management in each
  of the components and systemic perspective
  integrating them requires substantial improvement

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INTRODUCTION/2

• There is thus considerable scope for improvement
  in the current system.
• This presentation focuses on reforming EPFO and
  occupational pension plans (superannuation)

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(No Transcript)
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EPFO/1

• Key challenge
• to provide quality of service and retirement
  income security commensurate the costs imposed on
  the economy.
• Time to ask can India afford the EPFO in its
  current form?

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EPFO/2

• OVERVIEW
• Largest provider of retirement income in the
  non-government organized sector
• EPFO administers three schemes Employees
  Provident Fund (EPF), Employees Pension Scheme
  (EPS) and Employees Deposit Linked Insurance
  (EDLI) TABLE 1
• Total contributions are 25.66 of basic salary
  plus DA plus certain allowances. The
  administrative costs are charged separately.
• The EPFO thus imposes large costs on the
  members, as its rates are higher than the
  international norms of between 10-20.

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Table 1 Overview of Schemes under the EPFO
Source- Asher and Vasudevan (2006) forthcoming
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EPFO/3

• firms with twenty or more employees in 181
  designated industries are required to be
  registered with the EPFO
• Those beginning their work careers at wages above
  Rs. 6500 per month are not required to join the
  EPFO.
• Companies can be exempt from participating in
  EPFOs schemes if it is proven that the employees
  of these establishments enjoy the benefits of
  provident funds set up through an independent
  trust. Such exempt trusts are privately
  managed, but are under the overall supervision of
  the EPFO.

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EPFO/4

• As at end-March 2003, after more than 50 years of
  operations , EPFO covered Only 344,508
  establishments, less than Malaysia with a
  population of only 22 million.
• The EPFO has not focused on enhancing its
  organizational capacities to cover beyond 181
  industries specified( such specifications reflect
  a static mindset inconsistent with India's
  current vision of becoming a major economic
  power), and covering establishments employing
  less than 20 workers.

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EPFO/5

• The provident fund scheme and the pension fund
  scheme in 2003 had 39.5 million and 27.5 million
  members respectively.
• The active contributors however are less than
  half for the EPF scheme. The active membership
  represents only about 5 of India's labour force.
• This figure alone demonstrates the extent to
  which EPFO has become marginal in providing
  retirement income security to India's labour
  force. Its claims for representing India's work
  force are therefore unwarranted.

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EPFO/6

• The outcome of the EPFO policies and practices is
  reflected in the balances of the members shown in
  table 2.
• The balance of the member is not only low, but
  16 members account for 84 of the balances.
• This suggests that any interest subsidy to EPFO
  members accrues to those in the higher wage
  groups.
• Characteristically the EPFO does not publish such
  data on a regular basis. It should be required to
  do so.

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Table 2 Members Balances in the EPF
Source EPFO, Computed from Sridhar(2004)
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EPFO/7

• GOVERNANCE STRUCTURE.
• EPFO is governed by a Board of Trustees, headed
  by the Union Minister of Labour
• Administrative and policy matters are under the
  control of the Central Provident Fund
  Commissioner, who is the Chief Executive Officer
  of EPFO.
• Thus, while the Board has a bureaucrat at its
  head, a political appointment has the final
  authority on all critical policy decisions.

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EPFO/8

• The current structure of the Board is tripartite
  with representatives from the government,
  employers and employees
• The Central government appoints 20 members (5
  from the Central government and 15 from the state
  governments)
• 10 persons each representing the employers and
  employees respectively appointed by the Central
  government
• Chairman (Minister of Labor) and Vice-Chairman
  are also appointed by the Central government.
• The Central Provident Fund Commissioner as
  ex-officio member

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EPFO/9
Governance issues in existing system

• The Board consists of 45 members, which is an
  unwieldy size
• All members are appointed by the Central
  Government
• There is no provision for inducting independent
  experts, even on a temporary or rotating basis
• Unlike SEBI or IRDA, there are no committees with
  specialized professionals to advise on policies,
  investments, and administration.
• The current EPFO board structure is ill-equipped
  to deal with complexities of core Provident and
  Pension funds tasks in both investment and non-
  investment areas.

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EPFO/10
SUGGESTIONS

• Board can improve the diversity of views and
  hence quality of decision-making by ensuring that
  not all members are centrally appointed.
• The international trend is towards to appointing
  professionals as chair persons of the national
  provident fund rather than a politician. India
  should seriously consider its practice of the
  Minster of labour being the chairperson of EPFO.
• Short run time horizon of political decision
  making is inconsistent with the long term
  financial contact in administering retirement
  security schemes
• By including independent experts, the Board can
  gain access to new developments and ideas in the
  retirement financing industry

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EPFO/11

• EPFO is both a service provider and a regulator
  of the provident and pension funds market. This
  dual function in one organization is contrary to
  good governance practices.
• This not only creates conflict of interest , as
  EPFO a service provider should not be involved in
  deciding who is exempt and how such funds should
  be run. It has no regulatory capacity and yet the
  administrative cost at 4.4 of the contributions,
  it levies on exempt funds are high.

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EPFO/12

• SCHEME DESIGN
• Modernize laws and regulations.
• The EPFO act, 1952 and its subsequent amendments
  are not in conformity with the complexity of
  India's economy, and dynamics of its labour
  market. Indias overwhelming task is to create
  more jobs to take advantage of the demographic
  gift phase, but EPFOs mindset is traditional ,
  long term employee-employer relationships, which
  are becoming less of a norm.

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EPFO/13

• There are many examples where current regulations
  and their administration are counter- productive.
  
• Because of organizational inefficiencies , there
  are large suspense accounts, funds i.e. where
  contributions have not been credited to any
  individuals accounts.
• The transaction processing efficiency is
  particularly low.
• EPFO has large number for withdrawal schemes for
  healthcare and housing purposes, which has made
  it almost like a bank, increasing staff load and
  reducing the retirement benefits which can be
  obtained. ( table 3)

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EPFO/14

• This is exasperated by the requirements that the
  exempt funds must pay at least the same interest
  rate as the EPFO.
• EPFO is unable to administer efficiently when
  there is significant labour mobility ,
  particularly with respect to temporary and
  contract workers whose role has been growing.
• some individuals are able to withdraw full
  amounts when they change jobs, defeating the
  purpose of retirement savings others lose their
  balances due to inefficiencies of the EPFO when
  they change jobs.
• Job creation, among the highest Indian priority,
  is hampered when temporary workers and other
  accounts are not efficiently administered.

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EPFO/15

• The EPS scheme is badly designed , as It defines
  both the benefits and the contributions . This is
  mathematically impossible.
• Given nearly Rs.20,000 crore actuarial deficit in
  the EPS and given that the scheme requires a 70
  year time horizon of financial sustainability, it
  should be drastically overhauled with benefits
  brought in line , with assets ( Asset liability
  matching over a 70 year period should be
  practiced).
• The alternative would be to close the scheme and
  pay the accrued benefits.

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Table 3 Withdrawals from the EPF
Source- Asher and Vasudevan (2006) forthcoming
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EPFO/16

• NON- INVESTMENT RELATED CORE FUNCTIONS
• These are the four non-investment related core
  functions of Pension and Provident fund
  organizations.
• 1) Reliable collection of contribution/taxes, and
  other receipts.
• 2) Payment of benefits for each of the schemes in
  a correct way without any side-payments. In case
  of pre-retirement loans, ensuring their timely
  repayment
• 3)Maintaining an effective communication network,
  including development of accurate data and record
  keeping mechanisms to support collection, payment
  and financial activities.
• 4) Production of timely and policy relevant
  financial statements and reports.
• The importance of this function cannot be over
  emphasized
• As on March 31, 2003, the activities of EPFO were
  carried out through a network of 21regional
  offices, 87 sub-regional offices, and 163
  district-level offices. Collectively, staff
  strength of EPFO amounted to 19329 persons on
  that date.

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EPFO/17

• Key areas for improvement
• Accounting system move accrual and double entry
  system.
• Providing unique Identification number to
  members.
• Connectivity among its officers across the
  country.
• Treasury management expertise.

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EPFO/18

• Human resource development policies (staff
  must have requisite computer literacy, management
  must have skills for generating and implementing
  financial management systems and the
  organization must have mindset which accepts the
  goal of EPFO as a world-class service provider).
• EPFOs annual report is neither widely accessible
  nor sufficiently informative. It should be
  benchmarked against such reports by countries
  like Malaysia.
• EPFO should have an interactive website that
  reflects India's skills in the IT sector. All
  circulars and forms should be online.

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EPFO/19

• Table 4 provides operational indicators of EPFO ,
  while table 5 provides administrative efficiency
  indicators for 2 national provident funds i.e. of
  Malaysia and Singapore which are regarded as
  reaching a high degree of administrative and
  compliance efficiency.

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Table 4 EPFO Operational Statistics
Source- Asher and Vasudevan (2006) forthcoming
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Table 5 indicators of Administrative Efficiency
in Malaysia and Singapore, 2004
Source- Asher and Vasudevan (2006) forthcoming
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EPFO/20
Investment policies and management

• On March 31, 2003, the EPFO held investments
  worth Rs.1,51,278 crore under its three schemes,
  equivalent to 6 of Indias Gross Domestic
  Product.
• Almost two-thirds of this corpus (64) was
  directly under EPFOs management, and the
  remaining was managed by private exempt provident
  funds.
• Investment management is outsourced by the EPFO
  to the State Bank of India
• Funds available with the EPFO are invested in
  accordance with guidelines prescribed by the
  Government of India. Exempt establishments are
  also required to follow the prescribed investment
  pattern

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EPFO/21

• There are two sets of guidelines , one by
  ministry of labour 2003 and the other by ministry
  of finance, 2005. The IRDA also has investment
  guidelines for the pension corpus of the life
  insurance companies that it regulates.
• The IRDA guidelines are consistent with modern
  financial principles and practices.
• Ministry of finance has allowed a small
  percentage to be invested in equities through
  mutual funds, while ministry of labour guidelines
  permit primarily public sector debt, with no
  equities. It is therefore the list in tune with
  India sophistication of financial and capital
  markets.

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EPFO/22

• Moreover the ministry of labour and EPFO do not
  even permit the exempt funds to follow
  internationally accepted investment policies ,
  permitting asset diversification, but with strong
  regulation. (table 6)
• This hampers the vision of India becoming an
  important regional financial center and using its
  relatively more developed financial and capital
  markets as a competitive tool against other
  countries such as China.

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EPFO/23

• Table 6 Investment Guidelines for Provident Funds
  ,

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EPFO/24

• Actual investment by EPFO At end-March 2003, 80
  of the EPFOs Provident Fund corpus was invested
  in Special Deposit Schemes of the government and
  the remaining locked into central and state
  government securities and bonds of public
  financial institutions and PSUs
• Interest rate paid by the EPFO is administered,
  and has no link with return earned on its
  investments, or market rates
• Figure 2 shows the gap between yield on
  government securities and interest rate paid by
  the EPFO. The shortfall is funded from reserves
  or subsidized by the government

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EPFO/25
Source- Asher and Vasudevan (2006) forthcoming
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EPFO/26
Investment Strategies

• Investment Strategy is Passive Investments are
  made on a buy and hold basis
• Re-investment risk
• EPFO liabilities are very long-term its assets
  are relatively short-term. This mismatch is
  managed by repeatedly rolling over investment
  thus exposing the fund to the risk that
  re-invested proceeds might earn a lower interest
  rate. As Fig 1 shows, interest rates have fallen
  continuously in the last decade, exposing EPFO to
  a high degree of re-investment risk
• No Transparency
• Investments are valued at cost. Since there is
  no mark-to-market valuation, opportunity losses
  and gains cannot be measured by contributors

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EPFO/27

• Lost opportunities of booking capital gains
• By imposing total restrictions on sales, EPFO has
  lost the opportunity to make capital gains on its
  portfolio of government bonds in a falling
  interest rate scenario (rates on government
  borrowing have fallen by over 500 basis points in
  the last few years)

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EPFO/28

• Loss of profits from equity premium
• By holding an all-debt portfolio, EPFO has lost
  the benefit of higher returns from equity
• Using a simple numerical simulation, it can be
  shown that terminal wealth in a portfolio
  consisting of 80 debt and 20 equity, will be
  twice the wealth accumulated under an
  all-government debt portfolio (Table 7) even if
  no trading is permitted

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EPFO/29

• Table 7
• Terminal wealth for annual PF contribution of
  Rs.15.67
• (Rs.12 from employee, Rs.3.67 from employer)

Assumptions 30 year working life real wage
growth of 3 per year equity premium of 7
following Shah(2003)
Note Table 1 refers to wealth accumulated in a
contributors account, assuming contribution
rates and interest rates. It does NOT refer to
actual amounts paid at retirement, because that
is computed on the basis of a higher administered
nominal rate
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EPFO/30

• Exempt Funds potentially more efficient
  ( with some exceptions)
• In 2002-03, over 10 of exempt provident funds
  paid a higher interest rate than the minimum
  administered rate prescribed by the EPFO
• Simply assuming that these funds consistently pay
  0.5 over the funds directly managed by EPFO,
  terminal wealth would increase substantially
  (Table 8)

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EPFO/31

• Table 8
• Terminal wealth for annual PF contribution of
  Rs.15.67
• (Rs.12 from employee, Rs.3.67 from employer)

Assumptions 30 year working life real wage
growth of 3 per year
Note Table 7 refers to wealth accumulated in a
contributors account, assuming contribution
rates and interest rates. It does NOT refer to
actual amounts paid at retirement, because that
is computed on the basis of a higher administered
nominal rate
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EPFO/32
Accountability

• The EPFO has almost 20,000 staff, but no treasury
  department, or investment professionals. Who
  will be held accountable for its fund
  mismanagement?
• Poor disclosure and valuation at cost implies
  that inefficiencies are not widely known and
  taken note of. As custodian of savings of the
  public, is it not EPFOs responsibility to make
  its operations more transparent? Is EPFO not
  accountable to its contributors?

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Concluding Remarks

• A Mindset change is needed with appropriate
  leadership to transform EPFO from an employer
  focused to employee focused organization.
• The EPFO should aim to become a world class
  service provider for its members and acquire
  investment management capabilities.
• Its time to begin taking advantage of India's
  demographic gift phase, reflected in
  increasing share of working age population in
  total population till 2045.