Globalization, Demographic Transition and Reform of Social Safety Nets in India By: Mukul G. Asher, Professor and Deepa Vasudevan, Research Assistant LKY

Globalization, Demographic Transition and Reform of Social

Safety Nets in India

By:

Mukul G. Asher, Professorand

Deepa Vasudevan, Research Assistant LKY School of Public Policy

National University of Singapore.

To be presented at the 2nd Global Labor Forum, India Habitat Centre, December 13-14, 2005.

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Organization

I. Introduction

II. Objectives of Social Security System

III. A Framework

IV. Demographic Trends

V. Overview of India’s Social Security System

VI. Reforming EPFO

VII. Reforming Civil Service Pension

VIII. Concluding Remarks

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I. Introduction/1• Globalization is multi-faceted – economic, political, social,

and cultural.

• It is not a new phenomenon.

• It does not have a standard definition. In economic terms globalization may be broadly defined as the shrinkage of economic distances (i.e. ease with which each element of production-distribution-information-communication of the production and trade flows can be located over large geographical distances).

• Vastly increased financial and capital flows across borders.

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Introduction/2

• Three broad factors constitute the current phase of globalization, which nearly all countries must manage reasonable well to sustain their standards of living.

– Advances in transportation, information and communication technologies, including the internet.

– Strong trend towards global/ regional/bilateral/unilateral economic liberalization.

– Rebalancing of state-market mix towards the market; and greater recognition of complementary roles each plays.

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Introduction/3

• Another major characteristic of the current phase is that most countries have concluded that they need to manage globalization, and try to be net gainers from the process.

• Globalization has made safety nets essential for cushioning the burden of restructuring, increasing legitimacy of reforms, and for risk taking by individuals and firms by providing a floor level income in case of failure.

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II. Objectives of Social Security System/1

• The core objectives of any social security system for both individuals and government is smoothing consumption over lifetime, insurance (particularly against longevity and inflation risks), income redistribution, and poverty relief.

These have to be traded off against economic growth and labor market efficiency and flexibility.

• Individual, fiscal and societal affordability should be kept in mind in reforming social security system. This implies that benefits promised must evolve overtime as affordability grows.

• Expenditure on social security needs should be balanced against other needs, e.g. Health, education, infrastructure, etc.

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Objectives of Social Security System/2

• Each country needs to think carefully about the system it wants based on its political economy, initial conditions, objectives and organizational, institutional, technical and financial capacities.

• From a systemic perspective, the system should be

• Adequate (both in terms of coverage and level of protection against various risks).

• Affordable (from individual, business, fiscal and macroeconomic perspectives)

• Sustainable ( should have tight strategy, but flexible

implementation to financially sustain the system over a period of 70 years or more).

• Robust ( must be able to withstand macroeconomic and other shocks)

• Secondary Goals (actually consequences): lower distortion of labor force; positive impact on financial capital markets.

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Objectives of Social Security System/3

• As social security reform is a process which spans over a decade or more, sequencing is also important.

• Social security systems however must be sustainable for 60-70 years. So long term is particularly relevant.

• There has been considerable debate and experience with social security reform but no single idea, system or model has emerged even among Asian countries.

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III. A Framework/1

• The World Bank’s five pillar model could be used to think about designing, implementing and reforming social security system which is applicable to the conditions and the context of a given country (Table 1).

– Different target groups will require different combinations of pillars;

– Private management, investment allocation among wide variety of physical and financial assets, and international diversification may not be suitable for all countries;

– Contextual aspects of each country are important in design and governance.

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Table 1: Multi-Pillar Pension Taxonomy of the World Bank

Pillar Target Groups Main Criteria

Lifetime

poor

Informal sector

Formal

sector

Characteristics Participation Groups

0 X x x “Basic or “Social pension,” at least social assistance, universal or means-tested

Universal or Residual

Budget/general revenues

1 X Public pension plan, publicly managed, defined-benefit or notional defined-contribution

Mandated Contributions, perhaps with financial reserves

2 X Occupational or personal pension plans, funded defined-benefit or funded, defined-contribution

Mandated Financial assets

3 x x, X X Occupational or personal pension plans, funded defined-benefit or funded, defined contribution

Voluntary Financial assets

4 x X X Personal savings, homeownership, and other individual financial and non-financial assets

Voluntary Financial assets

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Table 1: Multi-Pillar Pension Taxonomy of the World Bank

• Note: The size of x or X characterizes the importance of each pillar for each target group.

• Source: Holzmann R. et al. “Old age income support in the 21st century: the World Bank’s perspective on pension systems and reform”, Washington DC: The World Bank, May 2004 Draft (Processed).

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A Framework/2

• Pillar 0 and 4 are new pillars as compared to 1994 World Bank report.

• More importance is now given to family support and to physical assets (Pillar 4); and to tax financed redistributive pillar for lifetime poor (Pillar 0)

• There is also less insistence on private management of pension assets and recognition that accumulation of large assets is not always optimal.

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A Framework/3

• It is however pertinent to point out that in many developing countries and transition economies, there will be lifetime poor and those who had served in armed forces and suffered disability who will require social assistance type of support (0 pillar in the WB framework)

• The above group may be as large as 30% of the elderly population.

• This is one of the ways in which the social security needs and the need for fiscal consolidation and flexibility are inter-related.

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A Framework/4

• In any funded system there is an accumulation phase and a payout phase (Figure 1).

• Usually, the accumulation phase receives the most attention. Many policymakers believe that once the notional retirement age at which withdrawals (usually lump sum) can be made is attained, their responsibility is complete.

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Figure 1Accumulation and decumulation phases of DC schemes

CumulativeBalances$

Accumulation Phase Decumulation phase

Working-phase Withdrawal Age Retirement Period

Cumulative Balances = Net contributions (contributions minus withdrawals), plus interest credited on accumulated balances.Decumulation phase: the funds accumulated can be spent rapidly or slowly. Death may occur before the funds are exhausted or reverse is also a possibility. So need to protect against longevity risk. As it is the purchasing power of the funds that is relevant, protection against the inflation risk is also desirable. Source: Author

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IV. Demographic Trends/1Three major demographic trends are apparent

1. Fertility Rates are dropping nearly everywhere

2. Life Expectancy is rising in many, though not all parts of the world(in some sub-groups such as professionals in Shanghai, life expectancy is actually falling and is below national average. This has important implications for actuarial projections and pricing of pension products. It would be interesting to do a similar study of IT professionals in Vietnam)

3. Developed countries are well advanced with respect to the above two trends, reflected in their declining share in world population. The non-developed countries are farther behind, though variation among them is large.

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Demographic Trends/2

• 59% of world’s elderly (249 million) lived in developing countries in 2000; this will increase to 71 % (686 million) by 2030.

• Most of the growth will take place in developing countries, over half of it in Asia and more than a quarter in China alone.

• The problem in the developing countries will not be just the level of elderly population but the rapid pace of ageing.

• Many developing countries will have an `old’ demographic profile at much lower level of per capita income than the industrial countries.

Ageing Factoids

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Table 2: Population Aging in Selected Countries

Population(In Millions)

% of Population Over 65

Population over 65 (Numbers in million)

2000 2030 2000 2030 2000 2030

China 1262 1483 7.0 16.0 88 237

India 1014 1437 4.6 9.0 47 129

USA 276 351 12.6 20.0 35 70

Vietnama 76 N.A. 5.8 N.A. 4.4b N.A.

Indonesia 225 313 4.5 10.9 10 34

Brazil 173 203 5.3 13.2 9 27

Russia 146 133 12.6 20.5 18 27

Japan 127 117 17.0 28.3 22 33

France 59 62 16.0 24.0 9 15

UK 60 61 15.7 23.5 9 14

S.Korea 47 54 7.0 19.5 3 11

Malaysia 22 35 4.1 9.4 1 3

Australia 19 23 12.4 21.1 2 5

Singapore 4 9 6.8 14.8 0 1

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Table 2: Population Aging in Selected Countries

• a data for 1999

• b 2.63 million or 60% were females. So gender issue will need to be addressed. Early retirement age for women will mean larger need for retirement resources.

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Fig 2: Proportion of Elderly in Population

28.325.8

24

23.521.1

20.520

19.516.4

1614.8

13.210.9

9.49

7.7

0 5 10 15 20 25 30

JapanGermany

FranceUK

AustraliaRussia

USAS.Korea

ThailandChina

SingaporeBrazil

IndonesiaMalaysia

IndiaPhilippine

2000 2030

Source: An Aging World, 2001, US Census Bureau

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Fig 3: Life Expectancy at age 60: Selected Asian Countries

21

19

18

16

17

16

16

16

25

22

21

19

19

18

17

17

0 5 10 15 20 25 30

Japan

Singapore

Thailand

China

Malaysia

Philippines

India

Indonesia

Male Female

Source: Adapted from Chakraborty (2004)

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• In 2030, 9% of India’s population, or nearly 130 million people, will be over 65 years of age. The population over 60 years of age will approach 200 million in that period

• By 2030, 237 million people, or 16% of China’s population will be over 65 years of age

• The vast numbers of elderly adds a human dimension and imposes a significant responsibility on the part of those who are involved in managing retirement funds and systems

• How Asia addresses the challenge will largely determine how the world will cope with ageing

Implications for India

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Fig 4: Life Expectancy at age 60: Selected Asian Countries

21

19

18

16

17

16

16

16

25

22

21

19

19

18

17

17

0 5 10 15 20 25 30

Japan

Singapore

Thailand

China

Malaysia

Philippines

India

Indonesia

Male Female

Source: Adapted from Chakraborty (2004)

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• Share of working age population will decline in Asia in the future. This will mean that the demographic “gift” that southeast Asia and China has enjoyed, will become a demographic “burden” within the next two decades.

• Figure 5 shows the turning point in working age population for selected countries

• As Figure 5 shows, India is entering demographic gift phase. The challenge will be to actually translate this “gift” into competitive advantage as Southeast Asia and China have done

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Figure 5

Source: World Economic Outlook, IMF, September 2004

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V. Overview of India’s Social Security System/1

- Figure 6 provides an overview of India's social security system. It has 6 components and each component has several elements.

- Two key requirements:- Professionalism in design and management of provident and

pension funds in each of the components; much more progress is needed in this area to benefit all the stakeholders;

- Systemic perspective: Currently each component is functioning separately. There is a need to adopt a systemic perspective.

- This presentation focuses on reforming EPFO and Civil service pensions.

Figure 6: India’s Social Security System

EPFO Schemes

Civil Service Schemes

Public Sector Enterprises (Usually DB Schemes)

Schemes for Unorganized Sector

NG

Os,

Fam

ily, a

nd C

omm

unity

Wel

fare

Bod

ies

Stat

e A

ssis

tanc

e Sc

hem

es

Nat

iona

l Ass

ista

nce

Sche

mes

Pens

ion

prod

ucts

of L

ife In

sura

nce

Com

pani

es

Loca

l Bod

ies

Stat

e G

over

nmen

t

Cen

tral G

over

nmen

t

EDLI

EPS

-DB

EPF

-DC

Smal

l sav

ing

s sc

hem

es

India’s Social Security System

NC

PS-D

B

GPF

-DC

GS

GS

GS

NC

PS-D

B

NC

PS- D

B

GPF

- DC

GPF

- DC

Voluntary Tax-Advantaged Schemes

Occupational Pension Schemes (traditionally DB but significant shift to DC)

Gro

up In

sura

nce

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VI. Reforming 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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Reforming 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 3

- 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 3 : Overview of Schemes under the EPFO

Contribution[% of wages]

EPF (1952)

EPS (1995)

EDLI(1976)

Total contributions

Employer 3.67 8.33 0.50 12.50

Employee 12.00 nil nil 12.00

Government nil 1.16 nil 1.16

Total Contributions 15.67 9.49 0.5 25.66

Administrative charges paid by employer [unexempted sector only]

1.10 Paid out of EPS Fund

0.01

Inspection Charges paid by employer [exempted sector only]

0.18 n.a 0.005

Benefits

Accumulation plus interest on retirement, resignation, death. Partial withdrawals permitted for specific purposes

Monthly pension on

superannuation, retirement, disability, survivor,

widow(er), children. no automatic inflation

indexation

Lumpsum benefit on

death while in service.

Source- Asher and Vasudevan (2006) forthcoming

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Reforming 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 EPFO’s 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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Reforming 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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Reforming 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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Reforming EPFO/6

• The outcome of the EPFO policies and practices is reflected in the balances of the members shown in table 4.

• 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 4: Members’ Balances in the EPF

Balance(in Rs.)

No. of members

% of total members

% of total accumulation

Average Balance (in Rs.)

Up to 20,000 293.4 lakh

84.58 16.98 3133

20,000 - 49,999 28.77 lakh

8.30 21.52 40,468

50,000 - 99,000 12.77 lakh

3.68 16.67 70,663

1 lakh – 1.99 lakh 7.91 lakh 2.28 20.25 1,38,414

2 lakh – 2.99 lakh 2.33 lakh 0.67 10.37 2,40,616

3 lakh – 3.99 lakh 82,629 0.24 5.23 3,41,959

4 lakh – 4.99 lakh 34,593 0.10 2.83 4,42,575

5 lakh – 9.99 lakh 36,297 0.10 4.29 6,40,229

10 lakh – 24.99 lakh 5973 0.02 1.45 13,16,782

25 lakh – 49.99 lakh 5973 0.0001 0.31 25,06,620

Above 50 lakh 86 0.00001 0.90 54,48,660

Source: EPFO, Computed from Sridhar(2004)

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Reforming 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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Reforming 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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Reforming EPFO/9

• 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.

Governance issues in existing system

39

Reforming EPFO/10

• 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

SUGGESTIONS

40

Reforming 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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Reforming 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. India’s overwhelming task is to create more jobs to take advantage of the demographic “ gift” phase, but EPFO’s mindset is traditional , long term employee-employer relationships, which are becoming less of a norm.

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Reforming 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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Reforming 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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Reforming 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 5 Withdrawals from the EPF

Year Total number of claims settled

Amount of settlement (Rs.million)

Number of claims settled on superannuation

% of superannuation claims to total claims

Average amount of settlement (Approx.)

1997-98 1,265,811 20,630.8 55,194 4.36 16,290

1998-99 1,437,749 27,799.5 61,421 4.27 19,330

1999-00 1,629,786 35,771.0 62,764 3.85 21,940

2000-01 1,750,360 41,862.5 67,716 3.87 23,910

2001-02 2,029,193 50,900.1 69,741 3.44 25,080


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Reforming EPFO/16NON- 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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Reforming 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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Reforming 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).

• EPFO’s 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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Reforming EPFO/19

• Table 6 provides operational indicators of EPFO , while table 7 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 6: EPFO: Operational Statistics

2000-01 2001-02 2002-03

Establishments Covered 340013 357747 344508

Establishment Covered per Staff 17.4 18.5 17.8

Members enrolled (in thousands) 26301 27418 39498

Members per staff 1344 1419 2043

Staff Strength 19574 19327 19329

Contributions Collected (Rs.Crore)

Provident Fund 10728.44 11188.26 11388.14

Exempted 4328.89 4278.13 3859.37

Unexempted 6399.55 6910.13 7528.77

Pension Fund 4222.61 4449.04 4787.84

Deposit Linked Insurance Fund 139.36 153.47 158.62


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Table 7: indicators of Administrative Efficiency in Malaysia and Singapore, 2004

Variable Central Provident Fund (CPF), Singapore

Employees Provident Fund

(EPF), Malaysia

Operating cost as % of income

3.52 3.11

Operating cost as % of Funds Under Management

(FUM)

0.11 0.15

Operating cost as % of contributions

0.88 1.68

Number of employers registered per employee

55.7 78.4

Number of members registered per employee

2,156 2,124

Number of active contributors per employee

946 1,067


52

Reforming EPFO/20

• On March 31, 2003, the EPFO held investments worth Rs.1,51,278 crore under its three schemes, equivalent to 6% of India’s Gross Domestic Product.

• Almost two-thirds of this corpus (64%) was directly under EPFO’s 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

Investment policies and management

53

Reforming 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.

54

Reforming 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 8)

• 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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Reforming EPFO/23Table 8 Investment Guidelines for Provident Funds

Investments in % of totalCentral Govt. Securities 25

State Government securities and negotiable instruments guaranteed by the Government

15

Bonds of Public financial institutions and PSUs

30

In any category as may be decided by the trustees

30

Private sector bonds/securities 10% out of the 20% above

56

Reforming EPFO/24

• Actual investment by EPFO: At end-March 2003, 80% of the EPFO’s 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 7 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

57

Reforming EPFO/25

Fig 7 Interest rates: EPF Payouts Vs. Earned

5

6

7

8

9

10

11

12

13

14

1989

-90

1990

-91

1991

-92

1992

-93

1993

-94

1994

-95

1995

-96

1996

-97

1997

-98

1998

-99

1999

-00

2000

-01

2001

-02

2002

-03

2003

-04

2004

-05

EPF interest rate

G-sec yield medium term

G-sec yield long term


58

Reforming EPFO/26

• 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

Investment Strategies

59

Reforming 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)

60

Reforming 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 9); even if no trading is permitted

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EPFO/29Table 9: Terminal wealth for annual PF contribution of Rs.15.67 (Rs.12 from employee, Rs.3.67 from employer)

Real rate of return scenarios 2% debt, 9% equity

4% debt,

11% equity

100% Government debt 964.93 1278.64

80% Government debt

20% Equity

1338.07 1824.48

Assumptions:

30 year working life; real wage growth of 3% per year; equity premium of 7% [following Shah(2003)]

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Reforming 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 10)

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Reforming EPFO/31Table 10: Terminal wealth for annual PF contribution of Rs.15.67 (Rs.12 from employee, Rs.3.67 from employer)

Real rate of return scenarios 2.0% /2.5%

4.0% /4.5%

Unexempt Fund 964.93 1278.64

Exempt Fund 1033.07 1376.67

Percentage Difference in wealth 7.1 7.7Assumptions:

30 year working life; real wage growth of 3% per year

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Reforming EPFO/32

• 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 EPFO’s responsibility to make its operations more transparent? Is EPFO not accountable to its contributors?

Accountability

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EPFO Summary

• 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.

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VII. Reforming Civil Service Pensions/1

• Traditionally, Central Government has provided the lead in social security system management.

• As shown in Figure 6, the civil servants are provided with non-contributory, defined benefit, price (and wage) indexed pensions, with generous commutation benefits linked to earlier mortality tables, and family pensions.

• Increasingly the fiscal burden of these pensions is being felt by specially the state governments, and also by the Centre.

• Political economy has prevented reforms in design and other aspects of the current pension system.

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Reforming Civil Service Pensions/2

• In January 2004, the government decided on a long period of slow transition to a mandatory New Pension Scheme (NPS) for new entrants to civil service. So far 14 states have indicated their willingness to introduce similar reforms.

• The NPS has provisions for voluntary membership by others. Even those that are mandated can voluntarily contribute additional amounts.

• This has made reform politically more acceptable, but the trade-off was that full impact will not be evident for at least three decades

• An interim Pension Fund Regulatory and Development Agency (PFRDA) was also set up

• The PFRDA Bill is proposed to be introduced in the winter 2005 session of the Parliament.

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Main Features of NPS

• A shift from DB to DC method (10% by employer-employee each, with no wage ceiling)

• No pre-retirement withdrawals to realize the power of compound interest;

• So long-term contractual savings expected to increase rapidly (some estimates suggest that pension assets could be around 50% of GDP by 2025, from current levels of about 25%)

• Mandatory annuatization at retirement for part of the accumulated balances

• Focus on minimizing transaction costs

• FDI in pensions sector to be permitted but its extent is yet to be decided.

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• Lack of survivors’ and disability insurance (PFRDA can add them at their discretion)

• Limited investment choices to individuals; but possibility of asset class diversification.

• Lessening of duality in pension arrangement between public and private sectors

• Considerable knowledge-base is being used (and created) in implementing NPS and PFRDA. This may assist wider adoption of evidence-based and more flexible policies

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• Longevity risk addressed through annuities, though inflation risk not addressed

• Fiscal savings will be a slow process encompassing at least three decades.

• Urgent efforts needed to have more states adopt such a system, albeit after careful planning and preparation

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Other Reform Trends

• Private sector superannuation funds have been pro-active and are now benchmarking their Human Resources Management (HRM) practices against international norms. This is in response to Indian firms themselves aspiring to have regional/global presence

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• The annuity market is also expected to develop in a more professional manner as there are now number of life insurance companies in this market

• Supply of investment quality assets, both debt and equity, is increasing. International investments of pension assets will enhance risk diversification, and give impetus to financial and capital market development (India’s current market capitalization is around US$400 billion)

• Increased competition, and other aspects noted above, will impact positively on the dynamics of pension reform

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Concluding Remarks

• India has a combination of demographic advantage and rapid ageing of the population.

• Social Security Reform should be a high priority for India

• Professionalism and systemic perspective are needed.

• Strong regulation and supervision are essential and these can only be provided by the government.

Documents

Globalization, Demographic Transition and Reform of Social Safety Nets in India By: Mukul G. Asher, Professor and Deepa Vasudevan, Research Assistant LKY