Hui-chen Chou looks at the impact India's New Pension System, which may soon announce it will open the door to foreign managers, will have on the country's economy and retirement landscape
The Pension Fund Regulatory and Development Authority (PFRDA) Bill was introduced by finance minister P. Chidambaram back in 2005 to establish the PFRDA as a statutory regulator for the New Pension System, or NPS, India's unprecedented pension scheme aiming to eventually cover up to 87% of the entire workforce. The Bill, once passed in Parliament, will break the monopoly of the existing Employees' Provident Fund Organisation (EPFO), which is facing a deficit of over Rs220bn (US$4.8bn) in handling pension funds by allowing new public and private players.
The passage of the Bill, already tabled in the upcoming combined monsoon and winter sessions in the Parliament convening on 17 October, will allow the participation of private asset mangers in NPS. Alongside the PFRDA Bill are banking and insurance Bills that look to remove a 10% cap on the voting rights of foreign investors in non-state banks and raise the foreign investment ceiling for insurers to 49% from 26%. The PFRDA Bill will also open the private pensions business under NPS to overseas pension fund managers.
All the above market liberalisation initiatives have been opposed by India's leftwing parties. In August 2008, the Indian government delegated necessary executive powers to the PFRDA to move forward with implementation of the NPS pending passage of the PFRDA Bill by the Parliament.
The NPS is a defined contribution scheme currently available for government employees, both state and central, who joined service after 1 January 2004. It involves a mandatory employee contribution of 10% of income with a matching contribution from the central and state governments as employers. Workers from the unorganised sector will need to contribute entirely based on their own money.
Life Insurance Corporation, State Bank of India and UTI Mutual Fund are currently the only three public sector fund managers running NPS. The NPS fund already has about Rs40bn (US$871m), while the government's decision to merge its employees' Contributory Provident Fund (CPF), currently underfunded, with it will bring in an additional Rs1bn to Rs120bn (US$2.2bn to US$2.6bn). The merger of CPF with NPS may happen in the next two months with the PFRDA supporting the government's proposal.
Upon passage of the PFRDA Bill, the regulator shall select more fund managers, including private ones, to co-manage the NPS funds. So far, the central government staff and employees of 20 state governments -- except Left-ruled Kerala, West Bengal and Tripura and a few others in the northeast -- have joined the NPS. The New Pension System for employees in the unorganised sector could be available as early as the beginning of 2009.
Over the next four to five months, the regulator will formulate a new investment norm for non-government provident funds, allowing individual subscribers to opt for four to five schemes varying in levels of equity exposure (0% to 50%), the contribution amount, the age subscribers can withdraw their entire funds, etc. and a default option. Contributions from a subscriber who fails to make an active choice of fund manager and scheme will be routed to this default option.
Under the new scheme, subscribers will be able to receive 40% of the amount in hand once they retire. The remaining 60% will be used for buying an annuity from life insurance companies -- this will provide subscribers with a monthly income after retirement. PFRDA chairman Dhirendra Swarup has urged that benefits under the NPS should be brought under EEE (exempt exempt exempt) tax treatment, in step with competing pension schemes, such as the Public Provident Fund (PPF).
The NPS investments in the initial stage get an EET tax treatment, which means that though members' contributions and earnings thereon would be tax-free, the accumulated amount would be taxed at the time of withdrawal. This may prove to be a disincentive to subscribers who can opt for PPF and the Employees' Provident Fund (EPF), which both enjoy EEE tax exemption.
"Tax incentive is one crucial factor for spurring subscription of NPS. Without it, its subscribers will therefore be placed in a disadvantageous position," said Swarup.
Unlike pensions elsewhere in the world aggressively emerging in high-risk, high-return alternative investment classes like hedge funds, private equity, infrastructure, real estate or commodities, the NPS will have to take it slow.
The investment universe can likely be extended to offshore financial instruments, such as US treasury bonds, only beyond three to five years.
"A pension plan with low transaction costs and charges, coupled with a limited number of simple product options, particularly in the initial stage, is crucial in the context of financial illiteracy among the NPS target subscriber population," said Gautam Bhardwaj, director of Delhi-based pension policy think tank Invest India Economic Foundation (IIEF).
One advantage India wields to reduce the fees and charges under NPS lies in the fact securities transaction costs are among the lowest in the world. Under the centralised, tech-driven trading platform with no physical trading at all, one single transaction only costs Rs4, or 10 cents, Bhardwaj illustrated.
The sheer size of the Indian population translates into a lucrative pension market both local and foreign banks, insurance companies and asset managers can tap into. The pension market opportunity will be potentially worth Rs12trn (US$280bn) by 2020, according to the Invest India Dataworks Income and Savings Survey of 2007 issued by Indian research firm IIMS Dataworks -- four times the number of those now saving for their retirement in life insurance and other financial products.
If latent demand for pensions from these groups were fully harnessed, Indian workers would contribute an estimated Rs570bn (US$12.4bn) to the NPS in the first full year of operations based on differential capacity to pay by different income groups, said the report.
Yet brand awareness, talent retention and education are challenges foreign players need to tackle in expanding their business landscape in India.
"Indian people tend to opt for local brands they are familiar with and trust [rather] than for prominent global brands. Hence foreign pension service providers need to rely on their local partners to enhance brand visibility, attune to the diversified dialects used in various parts of the country. Also, they have to come up with novel ideas to educate a large illiterate population, particularly in rural areas," Kulin Patel, India head of Watson Wyatt pointed out.
Impact of NPS on the wider economy
Doubtlessly, NPS will yield benefits to India on social and economic fronts, as PFRDA officials and economists believe.
The dependence on the government for old-age security could come down from 300 million people to 100 million in 30 years with the right steps, helping to reduce the fiscal strain.
Meanwhile, the NPS will facilitate the strengthening of India's financial depth, particularly its capital markets.
"India's pension sector is small relative to more advanced Asian economies and other emerging countries. While demographic trends and rising income should contribute to rising demand for retirement services in the next two decades, pension assets currently amount to only 5.75% of GDP, much below its Asian peers like Hong Kong SAR and Singapore," said Helene Poirson, economist at the International Monetary Fund.
Poirson also anticipated that NPS would facilitate development of the country's inactive bond market -- inactive mainly due to the stringent disclosure requirements and high level of interest that ward off potential corporate debt issuers. At the end of 2006, Indian bond markets accounted for just 3.5% of the country's GDP, compared with 140% and 189% in the UK and US, or 200% and 35% of Asian peers Japan and China, according to Watson Wyatt.
"A large part of the Indian financial sector is still mainly involved in deposit and loan services. Pension sector reforms and the accompanying introduction of new players, especially institutional investors, could help increase the relative importance of equity and corporate bond markets," Poirson illustrated.
"A diversified investor base is especially critical for the development of the local corporate bond market as it helps ensure a stable demand for fixed income securities. Broadening and deepening of the corporate bond market in turn would help enhance the supply of long term funds," she added.
Given that NPS is the first retirement saving scheme targeting an enormous untapped pension demand, IIEF's Bhardwaj stated understanding consumer preferences and financial behavior would be essential in encouraging disciplined voluntary pension contributions over multiple decades by India's vast informal sector workforce.
"The sheer population size and rising incomes mean that India is destined to become a major global pension market," Bhardwaj agued. "With the correct incentives for commercial service providers tasked with mobilising this market, it can happen more quickly than most people would expect."
The Indian pension landscape
The Indian population is rapidly ageing. Census Bureau of India estimates suggest that the percentage of people aged over 55 will increase from 11% to 26% between 2005 and 2050, translating to approximately 423 million people. The population over 60 is growing at a rate of 3.8% and is estimated to reach from 115 million to 330 million between 2010 and 2050.
On the surface, such a demographic trend does not seem to pose imminent challenges for young countries like India with an average age of 26, one of the world's youngest. Both the presence of 15 youngsters for every old person and a low dependency ratio would suggest there is not much need to worry.
Yet only about 13% of India's 321 million paid workers is covered by some formal pension provision. The luckier 22 million working for the public sector can take home state-funded pensions, with the civil servants being able to get inflation-indexed benefits that replace up to half their last-drawn salaries.
However, the 369 million "unorganised" sector workers comprising 87% of the paid workforce, be they farmers, vendors, casual construction labour or self-employed in micro-enterprises, have little or no access to formal pension or provident fund schemes to sustain them after retirement.
India's implicit pension debt (IPD) on account of tax financed retirement benefits to the civil service (which is less than 7% of India's paid workforce) is estimated at 65% of GDP. The annual pension expenditure for federal and local government employees has been growing at a compound annual growth rate (CAGR) of over 20% for the last few years.
Also, India's joint family system, which has been the traditional source of income security for the elderly is crumbling. "Two in every three families in India are nuclear today and most of them are single earner households. With increasing labour mobility, children are no longer a reliable retirement portfolio. The only option for most Indians therefore is to aim to achieve old age income security through thrift and self-help," said Gautam Bhardwaj, director of Delhi-based pension policy think tank Invest India Economic Foundation (IIEF).
The uncovered population of 284 million can be broken down into smaller groups for specific targeting:
- 100 million are lifetime poor with no savings. They need government subsidy and direct delivery;
- 40 million are in their 50s, so they have little time to build pensions. They rely on rent from homes they own;
- 84 million can afford to save, but they are waiting for PFRDA Bill to access pensions;
- 60 million want to save but they have no adequate earnings and they need government co-contributions.
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