Public Pension Fund Management in India

I D B IC A P I T A L

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Public Pension Fund Management in India

Conference on Public Pension Fund ManagementSeptember 24-26, 2001


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Outline Framework of Old Age Income Security in India Mandatory Retirement Plans in India Governance Structure for the Plans Funding Levels and Coverage Investment Guidelines Historical Returns How do the returns compare Public v. Private Management Benchmarking of Returns Role of Funds in allocation of capital Corporate Governance Future Direction


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Framework of Old Age Income Security in India


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Public Pillar – Poverty Alleviation Programmes

India does not have Social Security Programmes of OECD Countries Government’s taxation power is used to fund Poverty Alleviation

Programmes• 26% of population below poverty line (1999-2000)

• Employment Generation, Food for Work, Food Subsidy, Subsidised Education and Health Care Programmes

• Public Investments in a big way in industry and infrastructure during 1950-90

National Old Age Pension Scheme Monthly Pension for the poor of above 65 years old 5.3 million beneficiaries

Several welfare programmes covering agricultural workers, construction workers and home workers


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Mandatory Pillar – Covers Formal Employment

Government employees are covered under provident fund and pension fund with a pay as you go system

Mandatory Provident and Pension Funds exist for the workers in organised sector

Employees’ Provident Fund and Miscellaneous Provisions Act, 1952 governs mandatory plans

All employees of notified industries and establishments with more than 20 employees mandatorily covered by three EPF Plans

Compliance responsibility with the employer Special enactments for certain groups with funded plans

Armed forces, Coal Mine Workers, Tea Plantation Workers, Jammu & Kashmir, Merchant Navy, Banking Sector

High coverage of occupational plans among organised workers Only 15.2% of total work force in Regular Salaried Employment Self-employed is 53.6%. Casual employment is 31.2%.


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Voluntary Pillar – Main Stay of Income Security

India has well-developed financial markets to provide savings opportunities

Established banking system with a vast reach – 65,000 branches with deposits of over Rs 9,62,000 crore (US$ 205 billion – 44% of GDP)

Post Office Savings products cover the whole country – 133,000 post offices with outstanding deposits of Rs 1,55,000 crore (US$ 33 billion – 7% of GDP)

Market Capitalisation of Stock Market – Rs 9,12,000 crore (US$ 194 billion – 42% of GDP)

Large market of Government Bonds – Outstanding of Rs 8,95,000 crore (US$ 190 billion – 41% of GDP). Growing Corporate Bond market.

Fairly stable macro-economic environment

Informal Arrangements are important sources of security for the old Cultural factors emphasise caring for the old


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Mandatory Retirement Plans in India


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Mandatory Plans in India All covered employees mandatorily become members of three EPF plans

Provident Fund Scheme (DC Plan) – Accumulation paid out on retirement. Early withdrawals allowed for specified purposes.

Pension Scheme (DB Plan) – Monthly Life Pension after retirement with Survivor and Disability Benefits.

Deposit Linked Insurance Plan – Additional payment based on accumulation amount in case of death while in service

Combination Benefit Structure of DC and DB Plans High Contribution Rates

12% Employee Contribution + 12% Employer Contribution = 24% In five specified industries, contribution is 10% + 10% = 20% Some companies have additional superannuation schemes with up to 15%

employer contribution Bonus and Special Allowances not included for computation of contribution


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Employees’ Provident Fund Scheme, 1952

Defined Contribution Plan Contributions

12% Employee Contribution + 3.67% Employer Contribution = 15.67% 10% + 1.67% = 11.67% in five industries

Benefit Structure Accumulated Balance paid out on retirement. Balance = Employee and Employer

Contributions + Interest credited – Non-refundable Loans No annuitisation Non-Refundable Loans allowed for for housing, major illness, marriage or

education of children and special circumstances

Portable between employers Investment Risk is Borne by the Employee


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Employees’ Pension Scheme, 1995

Defined Benefit Plan Contributions

8.33% Employer Contribution + 1.16% Government Contribution (subject to limit) Benefits

Monthly Superannuation Pension for life at 50% of Average of last 12 months’ Salary (for 33 years of service)

One-third pension can be commuted. Reduced pension with return of capital possible Disablement Pension – Full Superannuation pension without minimum service Survivor Pension – to surviving spouse and children (50% of pension for spouse and

25% for each dependent child) No cost of living increases

Portable at EPF Investment Risk borne by the Fund

Government has the power to increase contribution or reduce benefits Pension increased by 4% & 5.5 % after the last two biennial actuarial valuations


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Deposit Linked Insurance Plan, 1971

Life Insurance Plan Contributions

0.5% Employer contribution

Benefits Additional payment made to employee in case of death while in service Amount equal to accumulated balance in the Provident Fund Subject to a limit of Rs 60,000

Investment Risk borne by the Fund


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Governance Structure


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Governance Structure The three mandatory plans are administered by Employees’ Provident

Fund Organisation Set up under the EPF Act Central Provident Fund Commissioner appointed by the Federal Government is

CEO. Usually a civil service bureaucrat. Supported by Assistant and Regional Provident Fund Commissioners

Central Board of Trustees is the supervisory authority Minister of Labour is the Chairman Central Provident Fund Commissioner Five Federal Government Representatives Fifteen State Government Representatives Ten Employer Representatives Ten Employee Representatives

All trustees are appointed by Federal Government after consultation


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Administrative Structure EPFO carries out Benefit Administration and Record keeping

Set up an extensive administration network with offices all over the country Headquartered at New Delhi. 281 offices throughout the country. Employers pay contributions at designated banks

Fund Management is contracted out to a professional fund manager State Bank of India is presently the fund manager No change in fund manager for several years


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Exempted Funds Employers can opt out of the Government Schemes by setting up their

own Provident Fund and Pension Fund Need to get an exemption from the Government under EPF Act Need to get an authorisation under Income Tax Act for tax exemption

Employers allowed to set up Exempted Funds when: Contributions and Benefits under the Employer’s Scheme are not inferior to that

of the Government Scheme Agree to follow all guidelines including Investment Pattern

Employers can set up own trust Full funding required Trustees are representatives of Employer and Employees Benefit Administration, Record-keeping and Funds Management done in-house

2970 Exempted Funds with 4.5 million subscribers (18.8% of total subscribers)


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Funding Levels and Coverage


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Funded Schemes Provident Funds

Both Employees Provident Fund and Exempted Funds are fully funded Assets of the Funds are represented by portfolios of securities

Pension Funds Employees Pension Fund is funded by contributions of Employer and

Government Actuarial deficits, if any, of EPS not known Pension Funds managed by Employers in Banking Sector and Public Sector are

fully funded with regular actuarial valuations

All Funded Schemes are required to follow prescribed Investment Pattern


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Growth in Coverage of EPF

177 industries and classes of establishments covered today

Started with 6 industries in 1952 All establishments with more than 20

employees covered within specified industries

24 million subscribers covered

Approximately 9.7% of labour force covered

53.6% is Self Employed 31.2% is in Casual Employment

Year Covered Establish-ments

Covered Employees (Million)

1952-53 1,400 1.201959-60 7,373 2.701969-70 46,504 5.601979-80 93,094 10.461989-90 194,961 14.661999-2000 331,504 23.96

(Million)EPF Act 23.96Coal Mine Workers 0.80Assam Tea Plantation Workers

0.76

Seamen's PF 0.03J & K PF 0.15Banking Sector 1.00

26.70Govt Employees 11.14Total Coverage 37.84

Total Covered Employees


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Total Pension Assets

(Rs Crore)Provident Fund

EPF 41,310Exempted Funds 28,691

Pension FundEPF 22,016

DLI FundEPF 2,188

Other FundsCoal Mines 22,000Assam Tea Plantation (est) 10,000Banks (est) 8,000

Total Assets 134,205US$ 28.5 billion7% of GDP

Total Pension Assets Asset Growth Rates EPF

1998-99: 16% 1997-98: 14%

Exempted Funds 1998-99: 7.5% 1997-98: 8.1%

On 31-3-1999


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Reasons for low asset base Total GDP (2000-01) – Rs 1,972,700 crore (US$ 420 billion) Gross Domestic Savings – 22.3% ( of which Total Household Savings –

19.8%) Financial Savings – 10.5% (53%) Physical Savings – 9.2% (47%)

Provident and Pension Funds form 23% of total household financial savings

2.1% of GDP every year goes into Provident and Pension Funds Reasons for low asset base

No annuitisation in provident fund High Premature Withdrawals: Rs 2715 crore in EPF and Rs 1437 crore in

Exempted Funds (in 1998)• 60.8% of New Contributions

New Contributions in 1998 EPF – Rs 3643 crore. Exempted Funds – Rs 3175 crore. Total– Rs 6818 crore


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Investment Guidelines for Provident and Pension Funds


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Investment Guidelines Prescription

Funds are required to follow Investment Pattern prescribed by the Government

Both Employees Provident Fund and the Exempted Funds follow the same pattern

Investment Pattern prescription comes from two sources:

• Ministry of Labour under EPF Act – Failure to comply could result in withdrawal of Exempted Fund status and imprisonment up to 6 months

• Ministry of Finance under Income Tax Act – Failure to comply could result in withdrawal of tax exemption for the Fund

Objectives not explicitly defined. Appear to be: Ensuring complete safety of employees’ funds and confidence in the system. Channel funds to Government sector Pay a reasonable return to the employee


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Asset Class Prescription Investment Guidelines define permitted Asset Classes

Almost entirely channeled to Government or Government Enterprises Percentage to be invested in each asset class specified

No investments allowed in International Securities – Strict Capital Account Controls exist in India. No

Indian citizen or corporate can invest overseas. Stocks – India has a large stock market Real Estate – Only Financial Assets allowed Gold – Only Financial Assets allowed

No investments permitted in Bank or Corporate Deposits Investment allowed only in marketable securities No loans to individuals or Corporates Only exception is Federal Government’s Special Deposits


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Investment Pattern since inception

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Pvt Sector Bonds Any Public Category Public Enterprises Bonds

State Govt Bonds Fed Govt SDS Fed Govt Bonds

Federal Govt Bonds

FederalGovtDeposits

State Govt Bonds

Bonds of PublicEnterprises

Private Sector Bonds

Any Public Category


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Investment Pattern in the past 10 years

Almost entirely channeled to Government or Government Enterprises

Divided among Federal Govt, State Govts and Public Enterprises

Share of Government Enterprises has gone up at the cost of direct Government flows

Private Sector Bonds allowed up to 10% since 1998

Not Mandatory; Can be invested at the option of Trustees

EPF Trustees decided against investment in Private Sector

Many Exempted Funds also do not invest in Private Sector

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

Federal GovtSpecialDeposits

Federal Govt Bonds

State Govt Bonds

Bonds ofPublicEnterprises

Any Public Category

Pvt Sector Bonds

25%

15%

40%

10%

10%


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One Investment Pattern fits all No distinction between Provident Fund and Pension Fund in the

Investment Pattern Risk lies with Employee in a Provident Fund Risk lies with Employer in a Pension Fund Today, advocates of relaxation in Investment Pattern are focusing on Pension

Funds

No choice to the Employer or the Employee Only choice is for the Employer to opt out by setting up an Exempted Fund No choice of alternate investment patterns based on risk preferences of

Employees and Empoyers


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Returns on Provident and Pension Funds


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EPF Interest Rate in the past 12 years

EPF Interest Rate remained fixed at 12% from 1991-92 to 1999-2000

Slashed to 11% in 2000-01 consequent to fall in market interest rates

Being further reduced to 9.5% in 2001-02 due to sharp fall in interest rates

6%

7%

8%

9%

10%

11%

12%

13%

14%

15%

16%

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

12%11%

9.5%

1997 12.9%1998 11.9%1999 11.9%2000 10.4%2001 9.2%

10 year Govt Bond Yield


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Deposit Account Concept Provident Fund works like a Deposit Account

Unlike a Mutual Fund, NAV of underlying portfolio not computed Members’ Accounts are credited annually with an interest rate declared based on

current income of the Fund Members get annual Statements of Account

No loss of principal amount. Interest credited every year. Fairly Stable Interest Rate. Changed in the event of substantial changes

in market interest rates No Disclosure of Portfolio or Actual Returns


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No Active Management Funds are required to hold all investments until maturity

Sale before maturity requires approval of Provident Fund Commissioner No Valuation of investments. No marking to market. Accounted like long term investments.

No permission to Fund Managers to churn portfolio Cannot generate profits based on market views Cannot sell a security when issuer’s financials deteriorate But funds are protected from market risk

Specified Pattern applies to fresh accretion only New contributions and redemption proceeds are required to be invested

according to the pattern Interest in any asset category is required to be reinvested in the same category

Changes in interest rates affect Provident Funds with a lag effect


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Special Deposit Rate determines EPF Rate

Special Deposit Scheme started by the Government as a convenience to Provident Funds

Available round the year - A big help when Government Bond issuances are infrequent and secondary market liquidity is poor

Withdrawals permitted without any loss of interest

Interest Rate on Special Deposits determined by Federal Government

Broadly tracks government bond yields Government equalises the EPF rate with

• Government Provident Fund Rate

• Public Provident Fund Rate

• Small Savings Schemes distributed through Post Offices

• Special Deposit Scheme Rate These are few of the administered interest rates in the country

Special Deposits were to mature in 1998 Federal Government unilaterally extended the maturity to 2003


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Portfolio Composition of Funds Portfolio Composition of Funds depends on their age

Older funds are weighted towards Federal Government Special Deposits and Government Bonds

Newer funds are weighted towards Bonds of Public Financial Institutions and Public Enterprises

Federal GovtBonds

State Govt Bonds

Bonds of PSEs

Special Deposits

Typical Old Fund (set up in 1948) Typical New Fund (set up in 1998)


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Confidence in the System Public Confidence maintained in PF System

Unquestioned confidence in the system from employees PF considered the safest investment Government thought to be behind the system

PF interest rate works like an administered rate despite full funding and separate portfolio


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Real Rates of Return

-4%-2%0%2%4%6%8%

10%12%14%16%

PF Rate Real Rate CPI

Consumer Price Inflationis sharply down in the last3 years

Despite fall in nominal rates,Real rate of interest has risen


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How do the Returns compare


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Where do public savings flow? Total Financial Savings of

Households (1999-2000): Rs 2,05,898 crore (US$ 43.8 bn)

Top 5 Investments Bank Deposits (33.6%) Provident and Pension Funds (23.1%) Post Office Savings (12.2%) Insurance (12.1%) Currency (8.9%)

Stocks, Bonds and Mutual Funds form a small part

Distribution of Financial SavingsOf Households in 1999-2000

Currency Bank DepositsStocks Mutual FundsGovt Schemes InsuranceProvident and Pension Funds Others


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PF Returns compared to Bank Deposits

Most of the time, Bank Deposit rates are lower than PF Interest Rate

Banks have higher administrative costs

Banks have to follow Cash Reserve, Liquidity Ratio stipulations

0%

2%

4%

6%

8%

10%

12%

14%

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

PF Rate Bank Deposits

-3%

-2%

-2%

-1%

-1%

0%

1%

1%

2%

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Bank Deposits over PF Rate


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Returns on Underlying Assets –Government Bonds

Since 1993, yields on Federal Government Bonds are market-driven

Bonds issued in auctions Banks, PFs, LIC required to invest in

Govt Bonds up to specified percentage Banks hold Govt Bonds much in excess

of requirement

State Govt Bonds yield 15-20 bp over Federal Govt

Govt Bond yields have fallen sharply in the past four years

6%

7%

8%

9%

10%

11%

12%

13%

14%

15%

16%

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

PF Rate State Govt Central Govt

Central Govt Bonds over PF Rate

-1.00%

-0.50%

0.00%

0.50%

1.00%

1.50%

2.00%

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

EPF Rate


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PF Rate compared to Mutual Funds

Mutual Funds is a nascent industry in India Experience for only 2-3 years

Equity Funds have made big losses due to market conditions

Gilt Funds are the only exception with 18% return during last one year

CategoryAnnual Return

%

Equity-Diversified -33.82Equity-ELSS -32.72Equity-Index -27.17Sectoral-Basic -6.01Sectoral-FMCG -22.7Sectoral-MNC -23.9Sectoral-Pharma -12.59Sectoral-TMT -58.27Gilt 18Income 5.59Liquid 9.01MIP -6.66Balanced -16.89

How are mutual funds doing?


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Returns on Stocks Average Returns over long periods

14.7% over 9 years from 1992-93 to 1999-2000

22.3% over 10 years from 1980-81 to 1989-90

Regular crises on Indian stock markets have affected confidence of retail investor

Substantial volatility has resulted in individual investor turning away

-40.00%

-30.00%

-20.00%

-10.00%

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

1997 1998 1999 2000 2001

Returns on BSE SensexIn the last five years


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Tax Benefits Tax benefits for contributions

Employees get tax rebate on their contribution to Provident Fund Employer’s contribution is tax free

Interest is tax free Taking tax benefits into account, returns are unmatched


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Can PF Returns be increased? Without disturbing Deposit Account Concept

Private Sector Bonds can give a higher return

• Will increase risk. PF managers need to have skills to evaluate risk. Government Securities give higher return compared to Special Deposits

By Shifting to NAV Concept Investment in Stocks will sharply increase risk and give higher return potential International Diversification can increase yield Active management of portfolio


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Public v. Private Management


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Exempted Funds Employers can contract out of EPF and set up privately managed funds

Only 3,000 companies have opted to set up Exempted Funds Most Exempted Funds manage funds in-house. Few engage a

professional fund manager Exempted Funds have obligation to declare at least the EPF Rate

Employer to bear the cost in case of shortfall Little evidence of Private Management producing better returns

Some Exempted Funds declare more than EPF Rate This is related to age of the fund Higher return by taking higher risk Small privately managed funds are at disadvantage compared to EPF

Professional management can increase returns marginally Guidelines drive the returns


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No Minimum Rating Stipulation Guidelines do not stipulate minimum rating for investment

Only for Private Sector Bonds are required to be rated at investment grade (BBB and above) by two rating agencies

Implicit assumption that public enterprises are safe

Many trustees have internal guidelines stipulating minimum rating EPF and CMPF Trustees have minimum rating criteria Some Exempted Funds also have such criteria

Most Exempted Funds do not have capability to evaluate investments Very few Exempted Funds engage a professional fund manager Often consider all eligible securities as equal Assume that market interest rates represent risk-adjusted return Implicit assumption that public enterprises are safe is coming increasingly under

challenge


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Benchmarking of Returns


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Benchmarking Exempted Funds are benchmarked against EPF Rate for interest

declared Performance can be evaluated by outperformance over EPF No risk parameters available Age of the fund becomes critical

Actual Returns are not disclosed NAV not computed Hence no benchmarking is possible

No satisfactory benchmarks even for debt funds Couple of Govt Bonds benchmarks available in the market Not followed by the market

Equity Indices are well-established Not relevant since PFs do not invest in equities


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Role of Funds in Allocation of Capital


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Government Bonds and Special Deposits support fiscal deficit

0

20000

40000

60000

80000

100000

120000

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Rs

Cr

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

Revenue Defict Fiscal Deficit % of Fiscal Deficit to GDP

Government Bonds are used for deficit financing

Central and State Governments run large deficits

Government has been running revenue deficit with high consumption expenditure financed by borrowing

In old funds, almost 90% of funds are with government

Pay as you go system in substance Does Investment Pattern encourage

government deficit? Banks and LIC are biggest

subscribers of Government Bonds Banks invest more than SLR

requirements in Government Bonds


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Private Sector funded through Public Financial Institutions

Financial Institutions are biggest issuers of bonds

Make loans to private enterprises for setting up new projects

PSE Bonds has created productive infrastructure in the country

State Govt enterprises have set up projects in irrigation, road development, power projects

Central PSEs15%

State PSEs22%

Private Sector

17%FIs and Banks

46%

Total Privately Placed Bondissuances in 2000-01

(Rs 52,433 crore – US$ 11.2 bn)


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Corporate Governance


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Corporate Governance Provident and Pension Funds play no role in corporate governance

No investment in equities

Even mutual funds are yet to play an active role Recently, stock exchanges have issued guidelines for disclosure

towards corporate governance


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The Future


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Future Pension Reforms OASIS Project initiated by Ministry of Social Justice to identify pension

reforms required Key recommendations

Establishment of a Pensions Authority Introduction of Individual Retirement Accounts To be managed by approved Pension Managers (committee recommended six) A common servicing and record-keeping infrastructure Three funds from each company representing conservative, balanced and

aggressive investment styles

Group of Ministers constituted by Government to examine suggested reforms


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Possible Future Direction Introduction of Retirement Funds

NAV based funds Different investment objectives and management styles Capital preservation funds

Option to Employees to shift fully or partially to Retirement Funds managed by approved pension companies

Employees may take time to get used to variable returns Marketing and administration costs will increase Strict Regulation and Disclosures required

Requires distribution and servicing infrastructure to be set up Common infrastructure as suggested by OASIS may be a good option


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Thank you for your attention

Business

Public Pension Fund Management in India