Public Pension Fund  Management in India Conference on Public Pension Fund Management September 24-26, 2001
Outline <ul><li>Framework of Old Age Income Security in India </li></ul><ul><li>Mandatory Retirement Plans in India </li><...
Framework of Old Age Income Security in India
Public Pillar – Poverty Alleviation Programmes <ul><li>India does not have Social Security Programmes of OECD Countries </...
Mandatory Pillar – Covers Formal Employment <ul><li>Government employees are covered under provident fund and pension fund...
Voluntary Pillar – Main Stay of Income Security <ul><li>India has well-developed financial markets to provide savings oppo...
Mandatory Retirement  Plans in India
Mandatory Plans in India <ul><li>All covered employees mandatorily become members of three EPF plans </li></ul><ul><ul><li...
Employees’ Provident Fund Scheme, 1952 <ul><li>Defined Contribution Plan </li></ul><ul><li>Contributions </li></ul><ul><ul...
Employees’ Pension Scheme, 1995  <ul><li>Defined Benefit Plan </li></ul><ul><li>Contributions </li></ul><ul><ul><li>8.33% ...
Deposit Linked Insurance Plan, 1971 <ul><li>Life Insurance Plan </li></ul><ul><li>Contributions </li></ul><ul><ul><li>0.5%...
Governance Structure
Governance Structure <ul><li>The three mandatory plans are administered by Employees’ Provident Fund Organisation </li></u...
Administrative Structure <ul><li>EPFO carries out Benefit Administration and Record keeping </li></ul><ul><ul><li>Set up a...
Exempted Funds <ul><li>Employers can opt out of the Government Schemes by setting up their own Provident Fund and Pension ...
Funding Levels and Coverage
Funded Schemes <ul><li>Provident Funds </li></ul><ul><ul><li>Both Employees Provident Fund and Exempted Funds are fully fu...
Growth in Coverage of EPF <ul><li>177 industries and classes of establishments covered today </li></ul><ul><ul><li>Started...
Total Pension Assets <ul><li>Asset Growth Rates </li></ul><ul><li>EPF </li></ul><ul><ul><li>1998-99: 16% </li></ul></ul><u...
Reasons for low asset base <ul><li>Total GDP (2000-01) – Rs 1,972,700 crore (US$ 420 billion) </li></ul><ul><li>Gross Dome...
Investment Guidelines for  Provident and Pension Funds
Investment Guidelines Prescription <ul><li>Funds are required to follow Investment Pattern prescribed by the Government </...
Asset Class Prescription <ul><li>Investment Guidelines define permitted Asset Classes </li></ul><ul><ul><li>Almost entirel...
Investment Pattern since inception Federal Govt Bonds Federal Govt Deposits State Govt Bonds Bonds of Public Enterprises P...
Investment Pattern in the past 10 years <ul><li>Almost entirely channeled to Government or Government Enterprises </li></u...
One Investment Pattern fits all <ul><li>No distinction between Provident Fund and Pension Fund in the Investment Pattern <...
Returns on Provident and  Pension Funds
EPF Interest Rate in the past 12 years <ul><li>EPF Interest Rate remained fixed at 12% from 1991-92 to 1999-2000 </li></ul...
Deposit Account Concept <ul><li>Provident Fund works like a Deposit Account </li></ul><ul><ul><li>Unlike a Mutual Fund, NA...
No Active Management <ul><li>Funds are required to hold all investments until maturity </li></ul><ul><ul><li>Sale before m...
Special Deposit Rate determines EPF Rate <ul><li>Special Deposit Scheme started by the Government as a convenience to Prov...
Portfolio Composition of Funds <ul><li>Portfolio Composition of Funds depends on their age </li></ul><ul><ul><li>Older fun...
Confidence in the System <ul><li>Public Confidence maintained in PF System </li></ul><ul><ul><li>Unquestioned confidence i...
Real Rates of Return Consumer Price Inflation is sharply down in the last 3 years Despite fall in nominal rates, Real rate...
How do the Returns compare
Where do public savings flow? <ul><li>Total Financial Savings of Households (1999-2000): Rs 2,05,898 crore (US$ 43.8 bn) <...
PF Returns compared to Bank Deposits <ul><li>Most of the time, Bank Deposit rates are lower than PF Interest Rate </li></u...
Returns on Underlying Assets –Government Bonds <ul><li>Since 1993, yields on Federal Government Bonds are market-driven </...
PF Rate compared to Mutual Funds <ul><li>Mutual Funds is a nascent industry in India </li></ul><ul><ul><li>Experience for ...
Returns on Stocks <ul><li>Average Returns over long periods </li></ul><ul><ul><li>14.7% over 9 years from 1992-93 to 1999-...
Tax Benefits <ul><li>Tax benefits for contributions </li></ul><ul><ul><li>Employees get tax rebate on their contribution t...
Can PF Returns be increased? <ul><li>Without disturbing Deposit Account Concept </li></ul><ul><ul><li>Private Sector Bonds...
Public v. Private Management
Exempted Funds <ul><li>Employers can contract out of EPF and set up privately managed funds </li></ul><ul><ul><li>Only 3,0...
No Minimum Rating Stipulation <ul><li>Guidelines do not stipulate minimum rating for investment </li></ul><ul><ul><li>Only...
Benchmarking of Returns
Benchmarking <ul><li>Exempted Funds are benchmarked against EPF Rate for interest declared </li></ul><ul><ul><li>Performan...
Role of Funds in Allocation of Capital
Government Bonds and Special Deposits support fiscal deficit <ul><li>Government Bonds are used for deficit financing </li>...
Private Sector funded through Public Financial Institutions <ul><li>Financial Institutions are biggest issuers of bonds </...
Corporate Governance
Corporate Governance <ul><li>Provident and Pension Funds play no role in corporate governance </li></ul><ul><ul><li>No inv...
The Future
Future Pension Reforms <ul><li>OASIS Project initiated by Ministry of Social Justice to identify pension reforms required ...
Possible Future Direction <ul><li>Introduction of Retirement Funds </li></ul><ul><ul><li>NAV based funds </li></ul></ul><u...
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Public Pension Fund Management in India

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  • In the last couple of days, we have heard presentations from very many countries on their experiences in public pension fund management. It is good for me to come later in the programme because it gives an opportunity to contrast the Indian system with what prevails in other countries. India represents a very different paradigm in pension asset management and we will see how in the next 40 minutes and then we can discuss the merits and demerits of the system.
  • I would like to start with a brief introduction to mandatory pension plans in India and their governance structure and then delve deeper into fund management issues, returns, economic impact and corporate governance. Finally, we will also discuss where India could possibly go from here.
  • Let’s see where India stands with respect to old age income security in World Bank’s three pillar framework.
  • India is the second most populous nation and racing to be the first. It has more than a billion people and is 3.65 times the population of the United States which is the next and third most populous nation. The population is still growing at about 2% every year. More Indians babies are borne every year than of any other nationality. Every year, India adds the equivalent population of Australia and every 10 years, it adds the equivalent population of Brazil which is itself the fifth most populous nation in the world. Providing for food, clothing and shelter to these growing numbers is a challenge for the country whether in the young age or old age. Therefore, the country does not have and cannot afford an OECD-type social security programme with almost universal coverage. Government’s taxation revenues are used to fund targeted programmes. Poverty alleviation, employment generation programmes and food subsidy targeted at poor families. A good portion of the government’s budget is spent on these programmes. According to official estimates, 26% of the population is below poverty line. These people have no savings. For old age income security, one of the important programmes is a means-tested old age pension scheme for the poor. The benefit is only Rs 75 per month, but there are 5.3 million beneficiaries. There are a variety of insurance, retirement and employment programmes operated by the central and state governments for low income workers. This constitutes the Public Pillar in India.
  • As part of the second pillar, there are mandatory provident fund and pension fund plans covering most of the regular salaried employees. Government is the largest employer in India and operates railways, postal system, telecommunications and a host of public services. All employees of the central and state governments are covered under a pay go system for a provident fund and pensions. The provident fund is contributed by employees but is not funded. The pensions are paid by the government. Like most other pay go systems, the pension liabilities of the government are growing and there is a large implicit pension debt which is not quantified. This is just beginning to attract government attention and a committee has recently been set up to review the pension liabilities. All employers other than the government, both private sector and public sector enterprises, are required mandatorily to join three funded plans set up under the EPF Act of 1952. This Act is applied to all establishments with more than 20 employees in specified industries and services. Presently, the Act applies to 177 industries and services and the coverage is very wide. The employer is made responsible to ensure that his establishment complies with the requirement. EPF Act is the main statute which applies generally to all types of employers. But there are also other funded plans under other statutes for some classes of employees like the armed forces, coal mine workers, tea plantation workers etc. But this distinction is only in terms of operating statute but the plans and their operation is similar. These plans have a high coverage among the salaried class, more than 70%. But the problem is salaried employment constitutes only 15% of India’s working population. More than 50% is self-employed and more than 30% do not have regular permanent employment. These people are not covered and they depend entirely on the third pillar.
  • Despite high poverty levels, India has a large economy. It is the 12 th largest economy in the world by absolute dollar GDP and the fourth largest economy in terms of GDP by purchasing power parity as per IMF database. It is also one of the fastest growing economies. Among the 11 economies which are larger than India, only China and Mexico had higher growth rates in year 2000. Over the last 54 years since Independence, the country has built up well-developed financial markets to help people save money for the future. India also has a high savings rate at about 23%. The voluntary pillar is supported by a large banking system with a vast reach in a country which is of the size of a subcontinent. 65,000 branches with deposits of almost Rs 10 trillion. There is a large post office network of 133,000 offices which distributes savings certificates of the government. There is also a large stock market but it has been beset with regular market crises and investor confidence is low at the moment. The market cap which I indicated there as of March is now down to half of that. Government bond market is big since the Indian government runs a large fiscal deficit and there is a growing corporate bond market. India also has had a fairly stable macro-economic environment which encourages savings. There has been no run away inflation or a major currency crisis. And finally, cultural factors play a very important role in old age security. Even the Bollywood movies promote caring for the old as an important virtue.
  • As I said there are three EPF Plans which are mandatory for every covered employee.
  • India has a combination benefit structure. There is a defined contribution plan called the provident fund as also a defined benefit plan which is the pension fund. There is also a deposit linked insurance plan. The contribution rates are quite high. There is a deduction of 12% from employee’s contribution and an equal amount contributed by the employer making a total of 24%. In five out of the 177 covered industries, the contributions are slightly lower at 10% each. Some companies have retirement plans over and above these like the company I work for. There is an additional income tax deduction up to 15% which some companies use. In such cases, as much as 39% of the salary goes into retirement plans. There is, however, a little loophole on how the salary is computed for the purpose of contribution. It does not include bonus and some special allowances. But generally there is no major attempt to structure compensation in a way to avoid on PF contributions.
  • Out of the total 24% contribution, 15.67% goes into the DC plan called the provident fund. There is no annuitisation and the accumulation is paid out on retirement. The plan also permits withdrawals for specific purposes like housing, major medical expenses, children’s education and marriage. A lot of people use these withdrawals. So the plan works like a savings plan rather than a purely retirement plan. Being a DC plan, it is easily portable and the investment risk is borne by the employee.
  • The DB plan called the Pension Scheme has a lower contribution at 8.33%. As part of a settlement with the unions, the government contributes 1.16% of salary for all employees in the country subject to a maximum salary of Rs 5000 per month. This scheme has a replacement rate of 50% based on final salary of the last twelve months for a full service of 33 years. If the service is shorter, the pension amount is proportionate. There are options to commute up to a third of the pension and options to take a lower pension and get a lump sum amount on death. In the event of disablement, one gets full pension without any minimum service requirement. On death of the member, there is survivor pension at about 50% of normal pension for spouse and 25% for each dependent child. But there is no cost of living increase. What the EPF does is to carry out actuarial valuations every two years and announce an increase in pension based on valuation. In the last two such valuations, there was increase in pension by 4% and 5.5% respectively. The government also has the right to increase contributions or reduce benefits in the event of actuarial deficit. Since the plan is run by the government, it is portable even if the employee shifts jobs.
  • The Deposit Linked Insurance Plan pays an amount equal to the accumulation in the provident fund, in effect doubling it, in the event of death of an employee while in service subject to a limit of Rs 60,000 per employee. There is a 0.5% contribution to this plan which the employer is required to pay.
  • All three mandatory plans are administered by EPFO (Employees’ Provident Fund Organisation), a government body set up under the EPF Act. There is a Central Board of Trustees which supervises EPFO. All the funds are vested in this Central Board. The Minister of Labour is the Chairman and there are a total of 40 central and state government representatives, employer organisation representatives and employee union representatives. All the trustees are appointed by the Central Government after a consultation process. A civil servant is appointed as the Central Provident Fund Commissioner who acts as the CEO of the EPFO.
  • The EPFO has a network of 281 offices all over the country and they do record keeping and benefit administration. There is not much computerisation and there are complaints about service levels. But fund management is contracted out to a bank. State Bank of India has been the fund manager for the past several years.
  • While it is mandatory for covered employers to establish retirement plans for their employees, they need not necessarily join the government’s EPFO. They can set up their own plans by getting an exemption under the EPF Act and also an authorisation under the Income Tax Act. Employers have to draw up their own plans and they are granted exemption if the contribution and benefit structure are not inferior to EPF. In practice, the exempted plans are very similar to the EPF plans in all respects. The exempted plans are required to be fully funded, even the EPF is fully funded. The only difference is that in the case of exempted plans, the benefit administration, record keeping and funds management are done by the independent trust set up for the purpose. All the funds are vested in this trust. The trustees are employee and employer representatives. Other than this, all the guidelines are common for EPF and exempted plans including the statutorily prescribed investment guidelines. EPF plays a supervisory role in respect of the exempted plans. We should also note that exempted plans are employer specific. An employer can have only one exempted plan. Multiple employers cannot set up a common fund. The trustees of exempted plans have the freedom to contract out benefit administration or funds management to a third party. But very few funds do it. They are managed in-house normally by employees of that employer. About 3000 employers have used this provision and set up exempted funds. This is only 1% of total covered establishments of about 300,000. But these are larger employers and they cover more than 18% of total subscribers.
  • Let us look at the coverage levels and asset base.
  • As we saw earlier, excepting for plans for government employees, all other plans are funded. Provident funds are fully funded in any case. Exempted pension funds are also fully funded based on actuarial valuation. We do not know if the Employees Pension Scheme is fully funded because their actuarial valuations are not made public. But as we saw earlier, the Central Board declares ad hoc increases in pension to cover cost of living increase after biennial actuarial valuations. There was an increase of 4% in 1996 and 5.5% in 1998.
  • There has been a sharp increase in coverage of the mandatory plans. From just 6 industries in 1952, 177 industries and services are covered today. There are more than 330,000 establishments covered under the EPF Act with about 24 million subscribers. If you factor in more than 2.5 million workers covered under special statutes, total coverage under mandatory funded plans is nearly 27 million. If you include 11 million government employees, nearly 38 million workers are covered under mandatory plans. But this is only about 10% of total working population in India. The reason is regular salaried employment constitutes only 15.2% of the labour force. 53.6% is self-employed and 31.2% is casual employment both of which are not covered under mandatory plans.
  • EPF has total assets of about Rs 65,000 crore (650 billion) in its three plans with 24 million subscribers. The exempted funds have more than Rs 28,000 (280 billion) crore in provident fund. There are very few exempted pension funds. The other funds under special statutes have about Rs 40,000 crore (400 billion). Total pension assets, therefore, are at about Rs 134,000 crore (1.3 trillion). In US Dollars, it about 28.5 billion which is about 7% of GDP. The assets are also growing rapidly. EPF has been growing at 14-16% in the past two years as new establishments get covered and the old subscribers add contributions. The exempted funds are growing at about 7.5-8%.
  • Let us see why, despite high contribution rates, the assets as a percentage of GDP are low. India’s GDP in 2000-01 was about US$ 420 billion. Savings rate in the economy is quite high at 22.3%, of which households constitute the largest component at 19.8%. The households divide their savings between financial and physical assets roughly equally. Of the financial savings, 23% goes into provident and pension funds. We will see a little later where rest of the savings go. So every year, 2.1% of GDP goes into retirement plans. Yet the asset base is only 7% of GDP. I think there are two main reasons for the low asset base. Firstly, there is no annuitisation in the provident fund and the accumulation is paid out to subscribers on retirement. Secondly, the provident fund permits early withdrawals for specified purposes, mainly housing. And these withdrawals constitute as much as 60% of new contributions. PF, therefore, works like a regular savings plan as much as a retirement plan.
  • Let us now see the Investment Guidelines which apply to provident and pension funds.
  • The funds are required to comply with asset allocation pattern which is prescribed by the government. The investment pattern is the same for EPF as also the exempted funds. The investment pattern is prescribed under two different statutes. Firstly, by the Ministry of Labour under the EPF Act. If any fund does not comply, EPFO may withdraw exemption status and take over the funds and subscribers of the exempted fund. Secondly, by the Ministry of Finance under the Income Tax Act. Failure to comply could result in withdrawal of tax exemption for the fund and it will have to pay tax on its income. Generally, the same guidelines are issued under both statutes. There is no explicit definition of the objectives of these guidelines. They appear to be three-fold. First, ensure complete safety of the subscribers’ moneys and maintain confidence in the provident fund system. Second, to channel funds to the government and government enterprises. And third, to pay a reasonable or in fact an attractive return to the employees.
  • The investment guidelines define what the permitted asset classes are and what percentage is required to be invested in each asset class. We will see what asset classes are permitted in the next slide. But no investments are allowed in international securities, unlike most other countries which have made presentations here. There are capital account controls in India which do not permit any overseas investment by an Indian citizen or corporate. Investments are allowed only in debt, and therefore, no stocks. Only financial assets are permitted, so no real estate or gold. The funds are allowed to invest only in marketable securities, that is, bonds. No bank deposits or corporate deposits are allowed. The only deposits allowed are Central Government Special Deposits. No loans are permitted either to individuals or corporates.
  • This is a time line chart of how the investment pattern changed since inception of the system in 1952. The reds and browns are government bonds. The blues are bonds of public enterprises and green is private sector enterprises. As you can see, from 1953 till 1975, 100% of the investments had to be made in Central Government Bonds. Even after that there was only choice between Central Government Bonds and Central Government Special Deposits which were introduced specially for provident funds. It was only in 1993 that bonds of government enterprises were added and bonds of state governments in 1995. Only in 1998, private sector bonds were permitted to the extent of just 10%. In fact, we should look closely at the investment pattern in the last ten years because bonds purchased in the last ten years is what is likely to be in the investment portfolio today. Bonds bought earlier would have matured.
  • This is the same chart but only for the past ten years. You can see that the orange representing Central Government Bonds is not so big now. The chocolate brown representing Central Government Special Deposits looks big in the earlier years and the blue representing bonds of public sector enterprises looks big in later years. The pattern applicable today for the financial year 2001-02 is given on the right side axis. 25% in Central Government Bonds, 15% in State Government Bonds, 40% in Bonds of Public Sector Enterprises. 10% can be invested by the trustees in any of the three public categories. Most of them have decided to invest the 10% in Bonds of Public Sector Enterprises because they yield higher returns. 10% can be invested in private sector enterprises. You can see that the funds are almost entirely channeled to government sector. In the past few years, the share of government enterprises has gone up at the cost of direct government investments. Though private sector bonds are permitted since 1998 to the extent of 10%, it is at the discretion of the trustees. If they decide not to invest in private sector they can invest it in any of the public categories. In fact, EPF trustees have decided not to invest in private sector. Many exempted funds have also followed the same and do not invest in private sector.
  • There is no distinction in investment pattern between pension and provident funds irrespective of who bears the risk. Advocates of relaxation in investment pattern are today focussing on pension funds since the employee does not bear the risk. There is also no choice of alternate investment plans based on risk preferences of either employers or employees.
  • What are the historical returns on provident and pension funds?
  • For 10 years from 1990-91 to 1999-2000, the provident fund interest rate remained fixed at 12%. Note that this is an interest rate, not NAV returns. PF in India functions like a fixed income instrument. This is the biggest difference between India and other countries we have seen here. Due to a sharp fall in market interest rates, the rate was reduced to 11% for 2000-01. This is being further reduced to 9.5% for 2001-02 again due to fall in market interest rates. You can see the yields on 10-year government bonds in the past five years. They were in 12-13% range for three years and then fell to 10.5% and 9.5% range in the next two years.
  • The Provident Fund works like a deposit, not like a mutual fund where NAV is computed based on value of the portfolio. There is no loss of principal. Interest is credited every year based on a rate which is declared from year to year. The rate is declared based on the income of the fund. Every year, an employee gets a statement showing contributions and interest credited and the accumulated balance. The interest rate historically has been fairly stable. All interest rates were administered in India till liberalisation started in 1991. But even after most interest rates became market driven, the provident fund rate functions almost like an adminsitered interest rate. It is stable and chaged only when there are substantial changes in market interest rates. The funds, both EPF and exempted funds, are not required to disclose their portfolio or their actual returns or income. How does it work like a fixed income instrument despite having a portfolio of securities? It happens because of two reasons.
  • First reason is that the funds are required to hold all investments until maturity. Any sale before maturity requires approval of the PF Commissioner and it is granted only for reasons of liquidity where the fund has more payouts than new contributions. Therefore, funds account for investments as long term investments. There is no valuation of investments or marking to market. Since the fund are not allowed to sell, fund managers cannot make profits based on interest rate views. They cannot even sell securities when they expect downgrades of the issuers. But the funds are protected from any kind of market risk. So no profits or losses from trading. The investment pattern we saw earlier actually applies to fresh accretions to the funds. When the pattern changes, the fund is not expected to restructure existing portfolio. Also, interest received in any category is reinvested in the same category. The result of this system is stability in the interest rate. Changes in market rates of interest affect the provident funds with a lag. For example, if the interest rates are falling as they are now, the provident fund will be affected only over a time since they already carry a portfolio of securities issued earlier at higher rates.
  • The second reason is the Central Government’s special deposits. While all other bonds invested by the provident funds have market driven yields and are traded, the interest rates on special deposits are determined by the Central Government. The Special Deposit Scheme was introduced in 1975 by the Central Government specially for provident funds as an alternative to Central Government Bonds. At that time, provident funds were required to invest 100% of their funds in Central Government Bonds and they had difficulty in sourcing these bonds since the secondary market liquidity was poor and new issuances were infrequent. So a deposit plan available round the year was a big convenience. When it came to determining the interest rate on the special deposits, the government equalised it with savings certificates which it sold to individual investors through the post offices. These rates did not change very frequently, but they were changed if the government was not getting adequate funds from individual investors through the post office channel or if the savings certificate rates were out of line with the market interest rates. The special deposit interest rate was market driven only to that extent. The government also fixed the same interest rate for the provident fund of government employees. Since it is not a funded scheme, government has to announce an interest rate to be credited to the provident fund accounts of the government employees. The same rate is also fixed for the voluntary public provident fund available for any citizen. That is how all these rates are equalised by the government. Special Deposit Scheme was discontinued in 1998 as the liquidity in Government Bond markets improved. But the existing deposits which were to mature in 1998 were unilaterally extended till 2003.
  • Since special deposits are the only asset class that does not trade and has a government determined interest rate, the impact of such a administered rate on the provident fund depends on the portfolio composition of the fund. If you remember how the investment pattern changed over the years, the share of bonds of government enterprises increased at the cost of share of bonds of the government itself. So the portfolio composition depends on the age of the fund. Older funds are heavily weighted towards special deposits and government bonds. The first pie here shows the composition of a large but old fund we manage established in 1948. It has more than 75% in special deposits. EPF’s portfolio is very much similar. So the special deposit rate is the provident fund rate. That is how the government can determine what the EPF rate will be. A newer fund is more weighted towards bonds of public enterprises. The second pie is the portfolio of a fund established in 1998. There are no special deposits. The largest component is bonds of public enterprises. Such a fund will have higher returns which are market-driven. Once the special deposits fully mature, the returns of all funds would be entirely market-driven.
  • What is the positive outcome of this system? There is unquestioned confidence in the system from the employees. Even a newly joined employee contributes to the provident fund with the confidence that he will get the money back when he retires 30 or 35 years later. They know that their capital is not lost and that they will get a reasonable return. Employees do not know where their provident fund invests money, but they consider it the safest investment. They think that the government is somehow behind the system and that they will not lose money.
  • We have seen that the PF returns are almost fixed. But you cannot fix inflation, so what are the real returns? The orange in the graph represents the nominal PF rate. The consumer price inflation which is the green line graph has been falling especially in the last three years. So the real rates have gone up despite lower nominal rates. The real rates today are almost near the income or GDP growth rates. But prior to 1999, this was not the case and real rates were lower than GDP growth rates. But can an employee get any better returns by investing himself?
  • First, let us see where Indian investors invest their savings. Total financial savings of the households in India in 1999-2000 was more than Rs 2 trillion, that is, about US$ 44 billion. If we look at the top 5 investments: Bank deposits is the top investment which absorbs 33.6% of all financial savings. Provident and pension funds is the second most important savings vehicle which constitutes 23.1% of all financial savings. This is despite the low coverage of the provident fund system in the total work force. It is because the system covers a fairly substantial portion of people who have the capacity to save. We saw that India has a large network of post offices which distribute government’s savings schemes. This is the third largest savings vehicle with a market share of 12.2%. Life Insurance comes next with a share of 12.1%. Finally currency accounts for 8.9%. We should note that stocks, bonds and mutual funds together account for only 6.7%. Their share has actually fallen from about 13.5% in 1993-94. Investors have lost money in Indian stock market partly due to the meltdown in global markets and partly due to scams and market crises. This has resulted in loss of investor confidence. Now, how do returns on PFs compare with these savings vehicles? We saw that PF rate and the post office savings rate are the same. Insurance is a different product and we cannot directly compare returns. Currency obviously has no return. So the only real comparison we need to do is with bank deposits.
  • The top graph shows the 3-year bank deposit rate as the blue line superimposed on the orange provident fund rate. The bottom graph shows the differential between 3-year bank deposit rates and the provident fund rate. You can see that out of the last 12 years, bank deposits earned more than the PF in three years, by about 1%. In all other years, bank deposit rates are lower than PF rate by 0.5% to 1%. At present, bank deposit rate with the largest banks is about 9% while PF rate is 9.5%, though some smaller banks pay higher rates. Bank deposit rates are lower primarily because of several statutory compulsions such as cash reserve and liquidity ratio stipulation, directed lending to priority sectors and high administrative costs.
  • Let us also look at the returns on other investments. First, the bond market. Government bonds constitute the biggest component of bond market in India. It is basically an institutional market which is why it did not figure in the distribution graph of household savings we saw earlier. Since 1993, yields on government bonds are market-driven determined by auctions to market participants. Banks, provident and pension funds and insurance companies are required by law to invest a minimum percentage of assets in government bonds. But the requirements of government deficit are much larger than these mandatory investments, so the government has to pay market rates to get subscriptions. In the last 12 years, government bonds have yielded more than the PF in five years. In other years, the rates are fairly close to each other. The situation today is that government bonds yield a little higher than the PF. But generally, the rates are only marginally higher than the PF.
  • There are more than 40 fund families in India which offer over 200 mutual funds. Many international names are in India. But all this has happened only in the last 3 – 4 years. So we cannot look at their performance over a long period. In the past one year, as you can see in the table, there has been blood on the street with red splashed all over. Only gilt funds have done well with returns of over 18%. Surprisingly, other debt funds have not done too well. But mutual funds could potentially be a good investment option for provident and pension funds in future.
  • Over long periods, stocks have performed well. In the nine years from 1992-93 to 1999-2000, the average annual returns on Bombay Sensex was 14.7%. But it is not much higher than PF rate if you take into account the risk. During the previous decade, the market did better with annual returns of 22.3%. But the Indian stock market hasn’t had a long bull run. It always did yo-yo with regular scams and crises. Most individuals have turned away from stocks today and many would not feel comfortable if their provident funds invest in stocks.
  • So the bottomline is that individual investors haven’t done badly by putting their savings in their provident funds. They have actually got higher returns compared to what they would have got if they invested these funds themselves. Besides, fairly good returns, the provident and pension funds also carry tax benefits. Contributions get tax benefits. There is a tax rebate on the amount of contributions an employee makes. The employer’s contributions are completely tax free. Interest paid on the PF is also tax free. If you take into account the tax benefits, the returns on PF are unmatched. In fact, the government limits the amount you can contribute to PF for this reason. Only other reason why people do not invest more in PF is because it is a long term investment which you cannot easily withdraw until retirement.
  • Though the returns on provident and pension funds are quite attractive, can they be increased further? First decision we need to make is whether to preserve the deposit account concept or fixed income nature of the PF. If we keep it that way, there is opportunity to increase returns by permitting funds to invest a larger amount in private sector bonds. There are a large number of private sector companies issuing bonds and the funds will need to develop the ability to evaluate these bonds. Another way to increase returns is for the government to repay special deposits which can be invested in private or public sector bonds or even government bonds. The other option is to shift to the NAV concept like other countries. But the fund will be exposed to risk and may lose even capital. If we shift to NAV concept, active management and trading of portfolio can be permitted. Secondly, investments can be permitted in stocks and mutual funds.
  • Is there any evidence that private management is better than public management? Let us see.
  • As we know, employers can contract out of EPF and set up their own funds. About 3,000 funds have set up such exempted funds. Most of these funds are managed in-house by the employers. They do not engage a professional fund manager. This is despite the fact that exempted funds have an obligation to declare at least the EPF rate and bear the shortfall, if any. Financial markets in India are not as complex as in developed countries and the finance departments of these companies generally believe that they can do as well as a professional manager. On the other hand, EPF engages a professional manager. Most of the exempted funds are actually at a disadvantage compared to EPF because EPF invests large amounts and can strike better deals with issuers of bonds. Though some exempted funds generate higher returns and declare interest rate higher than EPF, it is mainly because of the age of the fund since newer funds do not have the burden of special deposits. Some funds generate higher returns by taking more risk and investing in lower rated bonds. Exempted funds may be right in not engaging a professional manager because it is guidelines which drive returns than the manager. A professional manager can increase returns, but only marginally.
  • More than returns, the issue today in India is risk. The investment guidelines do not specify any minimum rating. Investment guidelines implicitly assume that investments in public sector are safe. Large funds like EPF have minimum rating criteria which are set by the trustees. Not many exempted funds have set such criteria and they also do not have the capability to evaluate investments. So many exempted funds have invested in low rated public sector bonds. In the last couple of years, the assumption that public sector is safe is being increasingly challenged with performance of many public enterprises deteriorating and government refusing to bail them out. Though there aren’t any major defaults at the moment, if there is a crisis as is expected, privately managed exempted funds are likely to suffer more than publicly managed EPF.
  • Exempted funds are benchmarked against EPF. But there are no risk parameters available for comparing the risk of the exempted fund with the risk of EPF. Returns also depends on age of the fund, hence benchmarking becomes more difficult. Apart from this, no benchmarking is possible since the actual returns are not disclosed by the funds and they do not value their portfolio. The only way to evolve a benchmark is to define a benchmark portfolio without active management but such benchmarks have not evolved as there was no market requirement. In fact, there are no satisfactory bond indices available in India. A couple of providers, one of them being JP Morgan, publish bond indices but they are not followed by the market because there is no liquidity across all securities. There are, of course, well established equity indices but since the PFs are not allowed to invest in equities, these are not relevant.
  • What role have the funds played in allocation of capital in the economy?
  • Both Central and State Governments in India run large fiscal deficits. The actual fiscal deficit has been sharply rising as you can see from the bars in the graph. Though the fiscal deficit as a percentage of GDP has been coming down as shown by the maroon line in the graph, fiscal deficit is considered the No 1 macro economic problem in India. Moreover, the government runs a large revenue deficit meaning that the borrowings are actually used to finance government’s consumption expenditure. In old funds like EPF, almost 90% of the funds are invested with the government either in the form of bonds or special deposits. In substance, therefore, these funds are as good as pay go systems. Because the government will have to either increase taxes or borrow more when the time comes to repay. Do the investment guidelines encourage government’s profligacy? Perhaps. The only thing one can say is that provident funds are not the biggest buyers of government bonds. It is banks and insurance companies which invest the largest amounts in government bonds.
  • But that applies only to government bonds and not bonds of public enterprises. And as we know the share of bonds of PSEs has been rising. Biggest issuers of bonds in India are the public financial institutions. Of about Rs 524 billion raised in privately placed bonds in 2000-01, 46% is accounted by public financial institutions and banks. These institutions also constitute the biggest investments of provident funds. The institutions mainly finance private sector projects. Therefore, though PFs are required to invest only in public enterprises, today 60% of their funds flow mainly to financial intermediaries who finance private industry. Non financial intermediaries among the PSEs also create productive infrastructure in the country. Particularly in the past few years, state government guaranteed bonds, akin to municipal bonds in the US have helped to create investments in irrigation, power and road projects in the states.
  • Provident and pension funds do not play any role in corporate governance since they do not invest in stocks. Even mutual funds do not play an active role in corporate governance. In fact, it is only recently that corporate governance has started to receive attention in India and stock exchanges have issued guidelines for disclosure related to corporate governance.
  • Public Pension Fund Management in India

    1. 1. Public Pension Fund Management in India Conference on Public Pension Fund Management September 24-26, 2001
    2. 2. Outline <ul><li>Framework of Old Age Income Security in India </li></ul><ul><li>Mandatory Retirement Plans in India </li></ul><ul><li>Governance Structure for the Plans </li></ul><ul><li>Funding Levels and Coverage </li></ul><ul><li>Investment Guidelines </li></ul><ul><li>Historical Returns </li></ul><ul><li>How do the returns compare </li></ul><ul><li>Public v. Private Management </li></ul><ul><li>Benchmarking of Returns </li></ul><ul><li>Role of Funds in allocation of capital </li></ul><ul><li>Corporate Governance </li></ul><ul><li>Future Direction </li></ul>
    3. 3. Framework of Old Age Income Security in India
    4. 4. Public Pillar – Poverty Alleviation Programmes <ul><li>India does not have Social Security Programmes of OECD Countries </li></ul><ul><li>Government’s taxation power is used to fund Poverty Alleviation Programmes </li></ul><ul><ul><ul><li>26% of population below poverty line (1999-2000) </li></ul></ul></ul><ul><ul><ul><li>Employment Generation, Food for Work, Food Subsidy, Subsidised Education and Health Care Programmes </li></ul></ul></ul><ul><ul><ul><li>Public Investments in a big way in industry and infrastructure during 1950-90 </li></ul></ul></ul><ul><li>National Old Age Pension Scheme </li></ul><ul><ul><li>Monthly Pension for the poor of above 65 years old </li></ul></ul><ul><ul><li>5.3 million beneficiaries </li></ul></ul><ul><li>Several welfare programmes covering agricultural workers, construction workers and home workers </li></ul>
    5. 5. Mandatory Pillar – Covers Formal Employment <ul><li>Government employees are covered under provident fund and pension fund with a pay as you go system </li></ul><ul><li>Mandatory Provident and Pension Funds exist for the workers in organised sector </li></ul><ul><ul><li>Employees’ Provident Fund and Miscellaneous Provisions Act, 1952 governs mandatory plans </li></ul></ul><ul><ul><li>All employees of notified industries and establishments with more than 20 employees mandatorily covered by three EPF Plans </li></ul></ul><ul><ul><li>Compliance responsibility with the employer </li></ul></ul><ul><li>Special enactments for certain groups with funded plans </li></ul><ul><ul><li>Armed forces, Coal Mine Workers, Tea Plantation Workers, Jammu & Kashmir, Merchant Navy, Banking Sector </li></ul></ul><ul><li>High coverage of occupational plans among organised workers </li></ul><ul><ul><li>Only 15.2% of total work force in Regular Salaried Employment </li></ul></ul><ul><ul><li>Self-employed is 53.6%. Casual employment is 31.2%. </li></ul></ul>
    6. 6. Voluntary Pillar – Main Stay of Income Security <ul><li>India has well-developed financial markets to provide savings opportunities </li></ul><ul><ul><li>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) </li></ul></ul><ul><ul><li>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) </li></ul></ul><ul><ul><li>Market Capitalisation of Stock Market – Rs 9,12,000 crore (US$ 194 billion – 42% of GDP) </li></ul></ul><ul><ul><li>Large market of Government Bonds – Outstanding of Rs 8,95,000 crore (US$ 190 billion – 41% of GDP). Growing Corporate Bond market. </li></ul></ul><ul><ul><li>Fairly stable macro-economic environment </li></ul></ul><ul><li>Informal Arrangements are important sources of security for the old </li></ul><ul><ul><li>Cultural factors emphasise caring for the old </li></ul></ul>
    7. 7. Mandatory Retirement Plans in India
    8. 8. Mandatory Plans in India <ul><li>All covered employees mandatorily become members of three EPF plans </li></ul><ul><ul><li>Provident Fund Scheme (DC Plan) – Accumulation paid out on retirement. Early withdrawals allowed for specified purposes. </li></ul></ul><ul><ul><li>Pension Scheme (DB Plan) – Monthly Life Pension after retirement with Survivor and Disability Benefits. </li></ul></ul><ul><ul><li>Deposit Linked Insurance Plan – Additional payment based on accumulation amount in case of death while in service </li></ul></ul><ul><li>Combination Benefit Structure of DC and DB Plans </li></ul><ul><li>High Contribution Rates </li></ul><ul><ul><li>12% Employee Contribution + 12% Employer Contribution = 24% </li></ul></ul><ul><ul><li>In five specified industries, contribution is 10% + 10% = 20% </li></ul></ul><ul><ul><li>Some companies have additional superannuation schemes with up to 15% employer contribution </li></ul></ul><ul><ul><li>Bonus and Special Allowances not included for computation of contribution </li></ul></ul>
    9. 9. Employees’ Provident Fund Scheme, 1952 <ul><li>Defined Contribution Plan </li></ul><ul><li>Contributions </li></ul><ul><ul><li>12% Employee Contribution + 3.67% Employer Contribution = 15.67% </li></ul></ul><ul><ul><li>10% + 1.67% = 11.67% in five industries </li></ul></ul><ul><li>Benefit Structure </li></ul><ul><ul><li>Accumulated Balance paid out on retirement. Balance = Employee and Employer Contributions + Interest credited – Non-refundable Loans </li></ul></ul><ul><ul><li>No annuitisation </li></ul></ul><ul><ul><li>Non-Refundable Loans allowed for for housing, major illness, marriage or education of children and special circumstances </li></ul></ul><ul><li>Portable between employers </li></ul><ul><li>Investment Risk is Borne by the Employee </li></ul>
    10. 10. Employees’ Pension Scheme, 1995 <ul><li>Defined Benefit Plan </li></ul><ul><li>Contributions </li></ul><ul><ul><li>8.33% Employer Contribution + 1.16% Government Contribution (subject to limit) </li></ul></ul><ul><li>Benefits </li></ul><ul><ul><li>Monthly Superannuation Pension for life at 50% of Average of last 12 months’ Salary (for 33 years of service) </li></ul></ul><ul><ul><li>One-third pension can be commuted. Reduced pension with return of capital possible </li></ul></ul><ul><ul><li>Disablement Pension – Full Superannuation pension without minimum service </li></ul></ul><ul><ul><li>Survivor Pension – to surviving spouse and children (50% of pension for spouse and 25% for each dependent child) </li></ul></ul><ul><ul><li>No cost of living increases </li></ul></ul><ul><li>Portable at EPF </li></ul><ul><li>Investment Risk borne by the Fund </li></ul><ul><ul><li>Government has the power to increase contribution or reduce benefits </li></ul></ul><ul><ul><li>Pension increased by 4% & 5.5 % after the last two biennial actuarial valuations </li></ul></ul>
    11. 11. Deposit Linked Insurance Plan, 1971 <ul><li>Life Insurance Plan </li></ul><ul><li>Contributions </li></ul><ul><ul><li>0.5% Employer contribution </li></ul></ul><ul><li>Benefits </li></ul><ul><ul><li>Additional payment made to employee in case of death while in service </li></ul></ul><ul><ul><li>Amount equal to accumulated balance in the Provident Fund </li></ul></ul><ul><ul><li>Subject to a limit of Rs 60,000 </li></ul></ul><ul><li>Investment Risk borne by the Fund </li></ul>
    12. 12. Governance Structure
    13. 13. Governance Structure <ul><li>The three mandatory plans are administered by Employees’ Provident Fund Organisation </li></ul><ul><ul><li>Set up under the EPF Act </li></ul></ul><ul><ul><li>Central Provident Fund Commissioner appointed by the Federal Government is CEO. Usually a civil service bureaucrat. </li></ul></ul><ul><ul><li>Supported by Assistant and Regional Provident Fund Commissioners </li></ul></ul><ul><li>Central Board of Trustees is the supervisory authority </li></ul><ul><ul><li>Minister of Labour is the Chairman </li></ul></ul><ul><ul><li>Central Provident Fund Commissioner </li></ul></ul><ul><ul><li>Five Federal Government Representatives </li></ul></ul><ul><ul><li>Fifteen State Government Representatives </li></ul></ul><ul><ul><li>Ten Employer Representatives </li></ul></ul><ul><ul><li>Ten Employee Representatives </li></ul></ul><ul><li>All trustees are appointed by Federal Government after consultation </li></ul>
    14. 14. Administrative Structure <ul><li>EPFO carries out Benefit Administration and Record keeping </li></ul><ul><ul><li>Set up an extensive administration network with offices all over the country </li></ul></ul><ul><ul><li>Headquartered at New Delhi. 281 offices throughout the country. </li></ul></ul><ul><ul><li>Employers pay contributions at designated banks </li></ul></ul><ul><li>Fund Management is contracted out to a professional fund manager </li></ul><ul><ul><li>State Bank of India is presently the fund manager </li></ul></ul><ul><ul><li>No change in fund manager for several years </li></ul></ul>
    15. 15. Exempted Funds <ul><li>Employers can opt out of the Government Schemes by setting up their own Provident Fund and Pension Fund </li></ul><ul><ul><li>Need to get an exemption from the Government under EPF Act </li></ul></ul><ul><ul><li>Need to get an authorisation under Income Tax Act for tax exemption </li></ul></ul><ul><li>Employers allowed to set up Exempted Funds when: </li></ul><ul><ul><li>Contributions and Benefits under the Employer’s Scheme are not inferior to that of the Government Scheme </li></ul></ul><ul><ul><li>Agree to follow all guidelines including Investment Pattern </li></ul></ul><ul><li>Employers can set up own trust </li></ul><ul><ul><li>Full funding required </li></ul></ul><ul><ul><li>Trustees are representatives of Employer and Employees </li></ul></ul><ul><ul><li>Benefit Administration, Record-keeping and Funds Management done in-house </li></ul></ul><ul><li>2970 Exempted Funds with 4.5 million subscribers (18.8% of total subscribers) </li></ul>
    16. 16. Funding Levels and Coverage
    17. 17. Funded Schemes <ul><li>Provident Funds </li></ul><ul><ul><li>Both Employees Provident Fund and Exempted Funds are fully funded </li></ul></ul><ul><ul><li>Assets of the Funds are represented by portfolios of securities </li></ul></ul><ul><li>Pension Funds </li></ul><ul><ul><li>Employees Pension Fund is funded by contributions of Employer and Government </li></ul></ul><ul><ul><li>Actuarial deficits, if any, of EPS not known </li></ul></ul><ul><ul><li>Pension Funds managed by Employers in Banking Sector and Public Sector are fully funded with regular actuarial valuations </li></ul></ul><ul><li>All Funded Schemes are required to follow prescribed Investment Pattern </li></ul>
    18. 18. Growth in Coverage of EPF <ul><li>177 industries and classes of establishments covered today </li></ul><ul><ul><li>Started with 6 industries in 1952 </li></ul></ul><ul><ul><li>All establishments with more than 20 employees covered within specified industries </li></ul></ul><ul><li>24 million subscribers covered </li></ul><ul><li>Approximately 9.7% of labour force covered </li></ul><ul><ul><li>53.6% is Self Employed </li></ul></ul><ul><ul><li>31.2% is in Casual Employment </li></ul></ul>
    19. 19. Total Pension Assets <ul><li>Asset Growth Rates </li></ul><ul><li>EPF </li></ul><ul><ul><li>1998-99: 16% </li></ul></ul><ul><ul><li>1997-98: 14% </li></ul></ul><ul><li>Exempted Funds </li></ul><ul><ul><li>1998-99: 7.5% </li></ul></ul><ul><ul><li>1997-98: 8.1% </li></ul></ul>On 31-3-1999
    20. 20. Reasons for low asset base <ul><li>Total GDP (2000-01) – Rs 1,972,700 crore (US$ 420 billion) </li></ul><ul><li>Gross Domestic Savings – 22.3% ( of which Total Household Savings – 19.8%) </li></ul><ul><ul><li>Financial Savings – 10.5% (53%) </li></ul></ul><ul><ul><li>Physical Savings – 9.2% (47%) </li></ul></ul><ul><li>Provident and Pension Funds form 23% of total household financial savings </li></ul><ul><ul><li>2.1% of GDP every year goes into Provident and Pension Funds </li></ul></ul><ul><li>Reasons for low asset base </li></ul><ul><ul><li>No annuitisation in provident fund </li></ul></ul><ul><ul><li>High Premature Withdrawals: Rs 2715 crore in EPF and Rs 1437 crore in Exempted Funds (in 1998) </li></ul></ul><ul><ul><ul><li>60.8% of New Contributions </li></ul></ul></ul><ul><li>New Contributions in 1998 </li></ul><ul><ul><li>EPF – Rs 3643 crore. Exempted Funds – Rs 3175 crore. Total– Rs 6818 crore </li></ul></ul>
    21. 21. Investment Guidelines for Provident and Pension Funds
    22. 22. Investment Guidelines Prescription <ul><li>Funds are required to follow Investment Pattern prescribed by the Government </li></ul><ul><ul><li>Both Employees Provident Fund and the Exempted Funds follow the same pattern </li></ul></ul><ul><ul><li>Investment Pattern prescription comes from two sources: </li></ul></ul><ul><ul><ul><li>Ministry of Labour under EPF Act – Failure to comply could result in withdrawal of Exempted Fund status and imprisonment up to 6 months </li></ul></ul></ul><ul><ul><ul><li>Ministry of Finance under Income Tax Act – Failure to comply could result in withdrawal of tax exemption for the Fund </li></ul></ul></ul><ul><li>Objectives not explicitly defined. Appear to be: </li></ul><ul><ul><li>Ensuring complete safety of employees’ funds and confidence in the system. </li></ul></ul><ul><ul><li>Channel funds to Government sector </li></ul></ul><ul><ul><li>Pay a reasonable return to the employee </li></ul></ul>
    23. 23. Asset Class Prescription <ul><li>Investment Guidelines define permitted Asset Classes </li></ul><ul><ul><li>Almost entirely channeled to Government or Government Enterprises </li></ul></ul><ul><ul><li>Percentage to be invested in each asset class specified </li></ul></ul><ul><li>No investments allowed in </li></ul><ul><ul><li>International Securities – Strict Capital Account Controls exist in India. No Indian citizen or corporate can invest overseas. </li></ul></ul><ul><ul><li>Stocks – India has a large stock market </li></ul></ul><ul><ul><li>Real Estate – Only Financial Assets allowed </li></ul></ul><ul><ul><li>Gold – Only Financial Assets allowed </li></ul></ul><ul><li>No investments permitted in Bank or Corporate Deposits </li></ul><ul><ul><li>Investment allowed only in marketable securities </li></ul></ul><ul><ul><li>No loans to individuals or Corporates </li></ul></ul><ul><ul><li>Only exception is Federal Government’s Special Deposits </li></ul></ul>
    24. 24. Investment Pattern since inception Federal Govt Bonds Federal Govt Deposits State Govt Bonds Bonds of Public Enterprises Private Sector Bonds Any Public Category
    25. 25. Investment Pattern in the past 10 years <ul><li>Almost entirely channeled to Government or Government Enterprises </li></ul><ul><ul><li>Divided among Federal Govt, State Govts and Public Enterprises </li></ul></ul><ul><li>Share of Government Enterprises has gone up at the cost of direct Government flows </li></ul><ul><li>Private Sector Bonds allowed up to 10% since 1998 </li></ul><ul><ul><li>Not Mandatory; Can be invested at the option of Trustees </li></ul></ul><ul><ul><li>EPF Trustees decided against investment in Private Sector </li></ul></ul><ul><ul><li>Many Exempted Funds also do not invest in Private Sector </li></ul></ul>Federal Govt Special Deposits Federal Govt Bonds State Govt Bonds Bonds of Public Enterprises Any Public Category Pvt Sector Bonds 25% 15% 40% 10% 10%
    26. 26. One Investment Pattern fits all <ul><li>No distinction between Provident Fund and Pension Fund in the Investment Pattern </li></ul><ul><ul><li>Risk lies with Employee in a Provident Fund </li></ul></ul><ul><ul><li>Risk lies with Employer in a Pension Fund </li></ul></ul><ul><ul><li>Today, advocates of relaxation in Investment Pattern are focusing on Pension Funds </li></ul></ul><ul><li>No choice to the Employer or the Employee </li></ul><ul><ul><li>Only choice is for the Employer to opt out by setting up an Exempted Fund </li></ul></ul><ul><ul><li>No choice of alternate investment patterns based on risk preferences of Employees and Empoyers </li></ul></ul>
    27. 27. Returns on Provident and Pension Funds
    28. 28. EPF Interest Rate in the past 12 years <ul><li>EPF Interest Rate remained fixed at 12% from 1991-92 to 1999-2000 </li></ul><ul><li>Slashed to 11% in 2000-01 consequent to fall in market interest rates </li></ul><ul><li>Being further reduced to 9.5% in 2001-02 due to sharp fall in interest rates </li></ul>12% 11% 9.5%
    29. 29. Deposit Account Concept <ul><li>Provident Fund works like a Deposit Account </li></ul><ul><ul><li>Unlike a Mutual Fund, NAV of underlying portfolio not computed </li></ul></ul><ul><ul><li>Members’ Accounts are credited annually with an interest rate declared based on current income of the Fund </li></ul></ul><ul><ul><li>Members get annual Statements of Account </li></ul></ul><ul><li>No loss of principal amount. Interest credited every year. </li></ul><ul><li>Fairly Stable Interest Rate. Changed in the event of substantial changes in market interest rates </li></ul><ul><li>No Disclosure of Portfolio or Actual Returns </li></ul>
    30. 30. No Active Management <ul><li>Funds are required to hold all investments until maturity </li></ul><ul><ul><li>Sale before maturity requires approval of Provident Fund Commissioner </li></ul></ul><ul><ul><li>No Valuation of investments. No marking to market. </li></ul></ul><ul><ul><li>Accounted like long term investments. </li></ul></ul><ul><li>No permission to Fund Managers to churn portfolio </li></ul><ul><ul><li>Cannot generate profits based on market views </li></ul></ul><ul><ul><li>Cannot sell a security when issuer’s financials deteriorate </li></ul></ul><ul><ul><li>But funds are protected from market risk </li></ul></ul><ul><li>Specified Pattern applies to fresh accretion only </li></ul><ul><ul><li>New contributions and redemption proceeds are required to be invested according to the pattern </li></ul></ul><ul><ul><li>Interest in any asset category is required to be reinvested in the same category </li></ul></ul><ul><li>Changes in interest rates affect Provident Funds with a lag effect </li></ul>
    31. 31. Special Deposit Rate determines EPF Rate <ul><li>Special Deposit Scheme started by the Government as a convenience to Provident Funds </li></ul><ul><ul><li>Available round the year - A big help when Government Bond issuances are infrequent and secondary market liquidity is poor </li></ul></ul><ul><ul><li>Withdrawals permitted without any loss of interest </li></ul></ul><ul><li>Interest Rate on Special Deposits determined by Federal Government </li></ul><ul><ul><li>Broadly tracks government bond yields </li></ul></ul><ul><ul><li>Government equalises the EPF rate with </li></ul></ul><ul><ul><ul><li>Government Provident Fund Rate </li></ul></ul></ul><ul><ul><ul><li>Public Provident Fund Rate </li></ul></ul></ul><ul><ul><ul><li>Small Savings Schemes distributed through Post Offices </li></ul></ul></ul><ul><ul><ul><li>Special Deposit Scheme Rate </li></ul></ul></ul><ul><ul><li>These are few of the administered interest rates in the country </li></ul></ul><ul><li>Special Deposits were to mature in 1998 </li></ul><ul><ul><li>Federal Government unilaterally extended the maturity to 2003 </li></ul></ul>
    32. 32. Portfolio Composition of Funds <ul><li>Portfolio Composition of Funds depends on their age </li></ul><ul><ul><li>Older funds are weighted towards Federal Government Special Deposits and Government Bonds </li></ul></ul><ul><ul><li>Newer funds are weighted towards Bonds of Public Financial Institutions and Public Enterprises </li></ul></ul>Typical Old Fund (set up in 1948) Typical New Fund (set up in 1998)
    33. 33. Confidence in the System <ul><li>Public Confidence maintained in PF System </li></ul><ul><ul><li>Unquestioned confidence in the system from employees </li></ul></ul><ul><ul><li>PF considered the safest investment </li></ul></ul><ul><ul><li>Government thought to be behind the system </li></ul></ul><ul><li>PF interest rate works like an administered rate despite full funding and separate portfolio </li></ul>
    34. 34. Real Rates of Return Consumer Price Inflation is sharply down in the last 3 years Despite fall in nominal rates, Real rate of interest has risen
    35. 35. How do the Returns compare
    36. 36. Where do public savings flow? <ul><li>Total Financial Savings of Households (1999-2000): Rs 2,05,898 crore (US$ 43.8 bn) </li></ul><ul><li>Top 5 Investments </li></ul><ul><ul><li>Bank Deposits (33.6%) </li></ul></ul><ul><ul><li>Provident and Pension Funds (23.1%) </li></ul></ul><ul><ul><li>Post Office Savings (12.2%) </li></ul></ul><ul><ul><li>Insurance (12.1%) </li></ul></ul><ul><ul><li>Currency (8.9%) </li></ul></ul><ul><li>Stocks, Bonds and Mutual Funds form a small part </li></ul>Distribution of Financial Savings Of Households in 1999-2000
    37. 37. PF Returns compared to Bank Deposits <ul><li>Most of the time, Bank Deposit rates are lower than PF Interest Rate </li></ul><ul><ul><li>Banks have higher administrative costs </li></ul></ul><ul><ul><li>Banks have to follow Cash Reserve, Liquidity Ratio stipulations </li></ul></ul>Bank Deposits over PF Rate
    38. 38. Returns on Underlying Assets –Government Bonds <ul><li>Since 1993, yields on Federal Government Bonds are market-driven </li></ul><ul><ul><li>Bonds issued in auctions </li></ul></ul><ul><ul><li>Banks, PFs, LIC required to invest in Govt Bonds up to specified percentage </li></ul></ul><ul><ul><li>Banks hold Govt Bonds much in excess of requirement </li></ul></ul><ul><li>State Govt Bonds yield 15-20 bp over Federal Govt </li></ul><ul><li>Govt Bond yields have fallen sharply in the past four years </li></ul>EPF Rate
    39. 39. PF Rate compared to Mutual Funds <ul><li>Mutual Funds is a nascent industry in India </li></ul><ul><ul><li>Experience for only 2-3 years </li></ul></ul><ul><li>Equity Funds have made big losses due to market conditions </li></ul><ul><li>Gilt Funds are the only exception with 18% return during last one year </li></ul>
    40. 40. Returns on Stocks <ul><li>Average Returns over long periods </li></ul><ul><ul><li>14.7% over 9 years from 1992-93 to 1999-2000 </li></ul></ul><ul><ul><li>22.3% over 10 years from 1980-81 to 1989-90 </li></ul></ul><ul><li>Regular crises on Indian stock markets have affected confidence of retail investor </li></ul><ul><li>Substantial volatility has resulted in individual investor turning away </li></ul>Returns on BSE Sensex In the last five years
    41. 41. Tax Benefits <ul><li>Tax benefits for contributions </li></ul><ul><ul><li>Employees get tax rebate on their contribution to Provident Fund </li></ul></ul><ul><ul><li>Employer’s contribution is tax free </li></ul></ul><ul><li>Interest is tax free </li></ul><ul><li>Taking tax benefits into account, returns are unmatched </li></ul>
    42. 42. Can PF Returns be increased? <ul><li>Without disturbing Deposit Account Concept </li></ul><ul><ul><li>Private Sector Bonds can give a higher return </li></ul></ul><ul><ul><ul><li>Will increase risk. PF managers need to have skills to evaluate risk. </li></ul></ul></ul><ul><ul><li>Government Securities give higher return compared to Special Deposits </li></ul></ul><ul><li>By Shifting to NAV Concept </li></ul><ul><ul><li>Investment in Stocks will sharply increase risk and give higher return potential </li></ul></ul><ul><ul><li>International Diversification can increase yield </li></ul></ul><ul><ul><li>Active management of portfolio </li></ul></ul>
    43. 43. Public v. Private Management
    44. 44. Exempted Funds <ul><li>Employers can contract out of EPF and set up privately managed funds </li></ul><ul><ul><li>Only 3,000 companies have opted to set up Exempted Funds </li></ul></ul><ul><li>Most Exempted Funds manage funds in-house. Few engage a professional fund manager </li></ul><ul><li>Exempted Funds have obligation to declare at least the EPF Rate </li></ul><ul><ul><li>Employer to bear the cost in case of shortfall </li></ul></ul><ul><li>Little evidence of Private Management producing better returns </li></ul><ul><ul><li>Some Exempted Funds declare more than EPF Rate </li></ul></ul><ul><ul><li>This is related to age of the fund </li></ul></ul><ul><ul><li>Higher return by taking higher risk </li></ul></ul><ul><ul><li>Small privately managed funds are at disadvantage compared to EPF </li></ul></ul><ul><li>Professional management can increase returns marginally </li></ul><ul><ul><li>Guidelines drive the returns </li></ul></ul>
    45. 45. No Minimum Rating Stipulation <ul><li>Guidelines do not stipulate minimum rating for investment </li></ul><ul><ul><li>Only for Private Sector Bonds are required to be rated at investment grade (BBB and above) by two rating agencies </li></ul></ul><ul><ul><li>Implicit assumption that public enterprises are safe </li></ul></ul><ul><li>Many trustees have internal guidelines stipulating minimum rating </li></ul><ul><ul><li>EPF and CMPF Trustees have minimum rating criteria </li></ul></ul><ul><ul><li>Some Exempted Funds also have such criteria </li></ul></ul><ul><li>Most Exempted Funds do not have capability to evaluate investments </li></ul><ul><ul><li>Very few Exempted Funds engage a professional fund manager </li></ul></ul><ul><ul><li>Often consider all eligible securities as equal </li></ul></ul><ul><ul><li>Assume that market interest rates represent risk-adjusted return </li></ul></ul><ul><ul><li>Implicit assumption that public enterprises are safe is coming increasingly under challenge </li></ul></ul>
    46. 46. Benchmarking of Returns
    47. 47. Benchmarking <ul><li>Exempted Funds are benchmarked against EPF Rate for interest declared </li></ul><ul><ul><li>Performance can be evaluated by outperformance over EPF </li></ul></ul><ul><ul><li>No risk parameters available </li></ul></ul><ul><ul><li>Age of the fund becomes critical </li></ul></ul><ul><li>Actual Returns are not disclosed </li></ul><ul><ul><li>NAV not computed </li></ul></ul><ul><ul><li>Hence no benchmarking is possible </li></ul></ul><ul><li>No satisfactory benchmarks even for debt funds </li></ul><ul><ul><li>Couple of Govt Bonds benchmarks available in the market </li></ul></ul><ul><ul><li>Not followed by the market </li></ul></ul><ul><li>Equity Indices are well-established </li></ul><ul><ul><li>Not relevant since PFs do not invest in equities </li></ul></ul>
    48. 48. Role of Funds in Allocation of Capital
    49. 49. Government Bonds and Special Deposits support fiscal deficit <ul><li>Government Bonds are used for deficit financing </li></ul><ul><ul><li>Central and State Governments run large deficits </li></ul></ul><ul><ul><li>Government has been running revenue deficit with high consumption expenditure financed by borrowing </li></ul></ul><ul><ul><li>In old funds, almost 90% of funds are with government </li></ul></ul><ul><li>Pay as you go system in substance </li></ul><ul><li>Does Investment Pattern encourage government deficit? </li></ul><ul><ul><li>Banks and LIC are biggest subscribers of Government Bonds </li></ul></ul><ul><ul><li>Banks invest more than SLR requirements in Government Bonds </li></ul></ul>
    50. 50. Private Sector funded through Public Financial Institutions <ul><li>Financial Institutions are biggest issuers of bonds </li></ul><ul><ul><li>Make loans to private enterprises for setting up new projects </li></ul></ul><ul><li>PSE Bonds has created productive infrastructure in the country </li></ul><ul><ul><li>State Govt enterprises have set up projects in irrigation, road development, power projects </li></ul></ul>Total Privately Placed Bond issuances in 2000-01 (Rs 52,433 crore – US$ 11.2 bn)
    51. 51. Corporate Governance
    52. 52. Corporate Governance <ul><li>Provident and Pension Funds play no role in corporate governance </li></ul><ul><ul><li>No investment in equities </li></ul></ul><ul><li>Even mutual funds are yet to play an active role </li></ul><ul><li>Recently, stock exchanges have issued guidelines for disclosure towards corporate governance </li></ul>
    53. 53. The Future
    54. 54. Future Pension Reforms <ul><li>OASIS Project initiated by Ministry of Social Justice to identify pension reforms required </li></ul><ul><li>Key recommendations </li></ul><ul><ul><li>Establishment of a Pensions Authority </li></ul></ul><ul><ul><li>Introduction of Individual Retirement Accounts </li></ul></ul><ul><ul><li>To be managed by approved Pension Managers (committee recommended six) </li></ul></ul><ul><ul><li>A common servicing and record-keeping infrastructure </li></ul></ul><ul><ul><li>Three funds from each company representing conservative, balanced and aggressive investment styles </li></ul></ul><ul><li>Group of Ministers constituted by Government to examine suggested reforms </li></ul>
    55. 55. Possible Future Direction <ul><li>Introduction of Retirement Funds </li></ul><ul><ul><li>NAV based funds </li></ul></ul><ul><ul><li>Different investment objectives and management styles </li></ul></ul><ul><ul><li>Capital preservation funds </li></ul></ul><ul><li>Option to Employees to shift fully or partially to Retirement Funds managed by approved pension companies </li></ul><ul><ul><li>Employees may take time to get used to variable returns </li></ul></ul><ul><ul><li>Marketing and administration costs will increase </li></ul></ul><ul><ul><li>Strict Regulation and Disclosures required </li></ul></ul><ul><li>Requires distribution and servicing infrastructure to be set up </li></ul><ul><ul><li>Common infrastructure as suggested by OASIS may be a good option </li></ul></ul>
    56. 56. Thank you for your attention
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