Pension Reforms in IndiaPension reforms are yet to benefit a large section of the Indian population. Significant changes on the policy and regulatory fronts, better marketing and better pricing of products can give this sector a much-needed boost.

Executive SummaryLife expectancy has shot up in recent decades. When public pension systems were first estab-lished, people could typically look forward to only a few years of retirement if any. Today, globally, the probability of a newborn boy surviving until age 65 is over 80%; the figure is over 90% for a girl child. Aging populations are “a high-class” problem, said U.S. President Bill Clinton in his 1999 State of the Union address. He continued: “It’s the result of something wonderful: the fact that we are living a lot longer.” Nevertheless, there is no denying that aging populations pose significant challenges for economic, social and health policies in general and pension systems in particular.

India is no exception to this global trend. Demographic projections indicate that the share of the aged will rise to 9% of the total popula-tion by 2016 and to 13.3% by 2026. Life expec-tancy has increased significantly in India, thanks to economic development and better access to medical care. This also means that a significant percentage of the population is expected to live beyond 75 years of age. Therefore, it is essential that a formal mechanism of benefits to reach a large section of the aged population is in place

and cost-effective products are available to the population for creating a retirement corpus.

Background of Pension ReformsIndia does not have a universal social security sys-tem. A large number of India’s elderly are not cov-ered by any pension scheme. Pension reforms and a pension system with greater reach will not only ensure citizens’ welfare in their golden years but will also help the central and state governments cut their future liabilities. With these broad objec-tives in mind, the government of India set up an expert committee in 1998 to devise a new pension system for India. Project Oasis, which was chaired by S.A. Dave, submitted its report in 2000.1

The report recommended setting up a new pension system in India. It recommended creating a pension system based on individual retirement accounts (IRAs). An individual would save and accumulate assets through his entire working life. Upon retirement, the individual would be able to use his pension assets to buy annuities from annuity providers and obtain a monthly pension. The pension amount would be governed by what the employees’ pension fund account could earn from market investments.

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This was a paradigm shift, from the existing defined returns philosophy to a defined contribu-tions philosophy.

The committee suggested creating a profession-ally managed system with a large base of pension account holders across all sectors of the economy and centralized record-keeping. The proposed system would ensure fair competition among professional fund managers so as to provide a wide range of choices to employers and fair market-linked returns to the account holders.

In line with the above recommendations, the government set up its New Pension System (NPS), India's answer to the U.S.'s 401(k) plans.2 The NPS was launched in 2004 for central and state government employees, who had to subscribe mandatorily. In 2009, it was thrown open to all Indian citizens in the 18-60 age group. However, it has failed to take off in the voluntary segment given the anemic subscriptions from the private sector (see Figure 1).

Challenges in ImplementationThe scheme’s lack of popularity has been attributed to several factors, such as weak incen-tives to intermediaries, a lack of awareness among the general population, insufficient mar-keting and promotion of the product and lower returns compared to other investment options. The scheme has delivered 5% to 12% returns in the past three years. Compare this to a return of 8.5% for Employees Provident Fund for the financial year 2012-13, 8.7 % for Public Provident Fund and 8.5% and 8.8% from National Savings Certificate for five and 10 years, respectively.4

A closer look at the finer elements of the scheme reveals that there are other issues that need to be addressed to improve investor sentiment for this product.

One of the most important issues is the tax treatment. There is no clarity on the taxation of funds at withdrawal. In India, returns from annuity insurance plans are not exempt from taxation. Another significant impediment is the compulsory annuity feature of the scheme. Even on maturity, the account holder can withdraw only up to 60% of the accumulated sum. The remaining amount has to be used to buy annui-ties, the returns from which are not tax-exempt. Also, the annuity can be bought only from one of the six PFRDA-approved insurers. This restricts the investor’s choices.

The fact that the scheme caps equity exposure at 50% is a dampener for younger investors, who usually have a higher appetite for risk and would prefer a larger equity allocation.

Also, the scheme faces stiff competition from the mandatory Employees’ Provident Fund (EPF), which remains the main retirement savings instrument for a majority of Indian employees. Given the mandatory retirement contribution to EPF, employees are reluctant to put in additional money in NPS.

Another challenge is to popularize this scheme in the unorganized sector where financial literacy is poor and workers rarely have surplus money to invest. NPS has come up with a scheme, Swalam-ban Yojana,5 which seeks to target this sector. Under the scheme, the government contributes 1,000 rupees per year for three years for each NPS account opened in the past three financial years. However, this is not a sustainable model in the long run. For this scheme to survive with-out government funding, awareness campaigns and marketing targeted to this segment of the working population are essential.

Sector-wise NPS Status as of March 2, 20133

Figure 1

Sl. No. Employer/Sector Number of SubscribersCorpus Under NPS (in billion rupees)

1 Central Government 11,25,871 170.47

2 State Government 15,85,349 97.80

3 Private Sector 2,02,679 12.54

4 NPS-Lite 15,79,690 4.12

Total 44,93,589 284.93

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Managing the ShiftIn defined contributions models, the burden of changes in life expectancy is borne by individual retirees in the form of lower pensions. When people retire in a defined-contribution plan, the accumulated contributions and investment returns is converted from a lump sum into a regular pension payment, known as an “annuity.” The calculation of the annuity is based on projected life expectancy of retirees at the time of retirement. Pension replacement rates — the percentage of a worker’s pre-retirement income that is paid out by a pension program upon the worker’s retirement — will therefore be automatically lower as people live longer.

In India’s pension system, the shift from a defined benefits model to a defined contribu-tions model will impact pensioners. The defined benefits model has some advantages such as a stable income replacement rate with market and longevity risk borne by the employers. In contrast, in defined contribution plans the amount of retirement income cannot be known in advance. The move to a defined contribu-tion plan would require employees to carry out complex financial calculations in both the asset accumulation and retirement phases. Policy mak-ers would need to design simple default solutions that do not require complex calculations. They would also need to assume the responsibility of creating greater awareness among pensioners

Chile

United Kingdom

Netherlands

France

Sweden

China

Australia

India

Singapore

Japan

KoreaSwitzerland

Germany

PolandCanada

Brazil

United States

Denmark

Global Grades for Pension System

Source: Melbourne Mercer Global Pension Index October 2012Figure 2

GradeIndex Value Countries Description

A >80 DenmarkA first class and robust retirement income system that delivers good benefits, is sustainable and has a high level of integrity.

B+ 75–80Netherlands & Australia A system that has a sound structure, with many good features,

but has some areas for improvement that differentiates it from an A-grade system.B 65–75

Sweden, Switzerland & Canada

C+ 60–65 UK & Chilie A system that has some good features, but also has major risks and/or shortcomings that should be addressed. Without these improvements, its efficacy and/or long-term sustainability can be questioned.

C 50–60USA, Poland, Brazil, Germany, Singapore & France

D 35–50China, Korea (South), Japan & India

A system that has some desirable features, but also has major weaknesses and/or omissions that need to be addressed. Without these improvements, its efficacy and sustainability are in doubt.

E < 35 NilA poor system that may be in the early stages of development or a nonexistent system.

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who have shifted to the defined contributions model and educate them on the intricacies of the risks and returns from each type of plan. Treat-ment of the corpus in line with the Employees’ Provident Fund or the Public Provident Fund (no tax is levied at the investment, accumulation or withdrawal stages) would certainly help increase the popularity and acceptance of the defined contributions system.

As life expectancy continues to increase, annuity providers will be expected to provide regular monthly benefits to retirees for longer periods. This should not impact annuity providers’ commercial viability. Innovative products such as index-linked funds and international diversifi-cation to equities or equity-based products and new tax treatment methods are needed so that longer life expectancy does not become a burden for annuity providers.

Global ComparisonThe Melbourne Mercer Global Pension Index, which measures countries’ retirement income scheme against more than 40 indicators, places India at an overall index value of 42.4 for 2012. The index is based on a study of retirement

systems in 18 countries. The table below (in Figure 3) shows the overall index value for each country, together with the index value for each of the three sub-indices: adequacy, sustainability and integrity. Each index value represents a score between zero and 100.

The index value for India indicates that some sound features exist but there are some signifi-cant omissions or weaknesses. The score also indicates that the country is in the early stage of development of a retirement income system.

According to the Melbourne Mercer Global Pension Index report, India’s overall index value could be increased by:

• Introducing a minimum level of support for the poorest among the elderly.

• Introducing a minimum access age so that it is clear that benefits are preserved for retirement.

• Improving the regulatory requirements for the private pension system.

• Continuing to improve the required level of communication to members from pension arrangements.

Overall Index for Each Country

Figure 3

Source: Melbourne Mercer Global Pension Index October 2012

Sub-index Values

Country Overall Index Value Adequacy (40%) Sustainability (35%) Integrity (25%)

Australia 75.7 73.5 73 83.2

Brazil 56.7 71.5 26.9 74.8

Canada 69.2 74.2 56.3 79.3

Chile 63.3 50.1 67.7 78.4

China 45.4 55.7 30.5 49.7

Denmark 82.9 78.1 86 86.4

France 54.7 74.3 32 55.2

Germany 55.3 65.2 35.9 66.7

India 42.4 37.4 40.7 52.8

Japan 44.4 46.1 28.9 63.3

Korea (South) 44.7 45.1 42.3 47.5

Netherlands 78.9 77 73 90.3

Poland 58.2 63.6 43.4 70.1

Singapore 54.8 42 54.2 76.2

Sweden 73.4 68 73.3 82.5

Switzerland 73.3 71.3 67.9 84.1

UK 64.8 68.1 46.2 85

USA 59 58.3 58.4 61.1

Average 61 62.2 52.1 71.5

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• Increasing the pension age as life expectancy continues to increase.

• Increasing the level of contributions in statutory pension schemes.

The Road AheadThe NPS scheme has several advantages over other schemes in terms of cost and equity exposure. Mutual funds can charge up to 2.25% and ULIP Pension plans from life insurers can charge up to 1.35% as fund management fees. NPS charges just 0.25%, making it one of the cheapest pension products in the world.6 The difference in fees/charges affects the total corpus significantly over longer periods of investment. NPS also instills a sense of disciplined savings and offers tax benefits.

Policy initiatives are also required to encourage voluntary subscription to this scheme. These initiatives could include establishing a compre-hensive national pension policy, improvements in the security and returns from NPS investments, setting up distribution channels and increas-ing the incentives for them and increasing the channels’ regional coverage. Designing custom-ized marketing strategies for different market segments will also be effective; marketing through SMS or street events/road shows could be one option. Telecommunication companies’ support can be sought to build a database of prospective customers.

Also, the virtues of this scheme need to be com-municated to the investing public. One of its biggest pluses is that the cost of administration remains the cheapest in the world.7 Also, the scheme is portable anywhere within the country – i.e., employees can “carry” their accounts with them when they change jobs. The scheme offers a choice of investment mix and pension fund managers. All transactions can be tracked online through the central record keeping system, and there is an efficient grievance management sys-tem in place. The scheme offers an auto choice (default) option for subscribers who do not have sufficient knowledge about these instruments.

A concerted effort by the regulators, pension fund administrators and the service provider is needed to make this laudable social initiative a true success.

A study of the retirement income system in G20 countries indicates that in a country of India’s

size and complexity, a defined contributions model is the model for the future. There are a few provisions which need to be incorporated from other pension models to make the system more beneficial: provision of minimum pension under social security, provision for early and late retirement and benefits calculation modeling in line with price increases.

For Indian pension reforms to truly succeed and be an example for emerging economies, it is not just essential to move to a defined contribution model; it needs to create a basic pension from public finances. A formal old-age income support especially for financially impoverished senior citizens is needed urgently.

In its influential report “Averting the Old Age Crisis,” the World Bank (1994) recommended a multi-pillar system for the provision of old-age income security comprising:

• Pillar 1: A mandatory publicly managed tax-financed public pension.

• Pillar 2: Mandatory privately managed, fully funded benefits.

• Pillar 3: Voluntary privately managed, fully funded personal savings.

Subsequently, Holzmann and Hinz (2005) of the World Bank extended this three-pillar system to the following five-pillar approach:

• Pillar 0: A basic pension from public finances that may be universal or means-tested.

• Pillar 1: A mandated public pension plan that is publicly managed with contributions and, in some cases, financial reserves.

• Pillar 2: Mandated and fully funded occupa-tional or personal pension plans with financial assets.

• Pillar 3: Voluntary and fully funded occupa-tional or personal pension plans with financial assets.

• The fifth pillar is a nonfinancial pillar that includes the broader context of social policy such as family support, access to healthcare and housing, etc.

The key challenge in India is to continue the pension reforms while addressing the needs for Pillar 0 and create a universal security net for the most needy.

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Footnotes1 http://pfrda.org.in/writereaddata/linkimages/oasisreport6305547711.pdf.

2 http://www.financialinfohub.com/index.php?pr=Investing-advantagesdisadvantges_of_401k_plans.

3 http://pfrda.org.in/writereaddata/linkimages/NPS%20status%20March2013651445507.pdf.

4 http://www.indiapost.gov.in/posb.aspx.

5 https://www.npscra.nsdl.co.in/news_detail.php?id=12.

6 http://articles.timesofindia.indiatimes.com/2013-02-04/personal-finance/36742174_1_nps-trust-nps-account-national-pension-system.

7 http://www.thehindubusinessline.com/industry-and-economy/banking/scope-to-offer-annuity-ser-vices-in-new-pension-scheme/article3734945.ece.

References

• www.Pfrda.org.in.

• http://www.actuariesindia.org/.

• https://www.npscra.nsdl.co.in/.

• http://www.globalpensionindex.com/.

• www.forbes.com.

• www.iief.com.

• http://www.oecd.org/.

• www.statestreet.com.

• www.actuaries.org.

• http://www.ccsindia.org.

• http://financialservices.gov.in/PensionReforms_india_index.asp.

• http://financialservices.gov.in/pensionreforms/Pension%20Reforms%20in%20India.pdf.

• Ramdev Gowswami, “Indian Pension System: Problems and Prognosis.”

• S.A.Dave, Robert Palacios, Gautam Bhardwaj, “Rethinking Pension Provision for India.”

• The Project Oasis report (Old Age Social and Income Security Project), January 2000.

• Ajay Shah, “Issues in Pension System Reform in India.”

• “Pensions at a Glance 2011: Retirement-Income Systems in OECD and G20 Countries,” OECD 2011.

• Final Report of the ACA’s 2011 Pension Trends Survey, conducted by the Association of Consulting Actuaries.

• Robert Holzmann, Global Pension Systems and Their Reform Worldwide Drivers, Trends, and Chal-lenges.

• Dr. Ramesh Gupta, Pension Reforms in India: Myth, Reality and Policy Choices.

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• Hertie School of Goverance, working paper, “Extending Coverage of the New Pension System in India – Analysis of Market Forces and Policy Options.”

• http://www.aca.org.uk/files/2011_Pension_trends_report-3_January_2012-20111222162316.pdf.

• http://www.thehindubusinessline.com/opinion/columns/aarati-krishnan/same-old-story-on-pension-reforms/article3539828.ece.

• http://www.financialexpress.com/news/india-needs-a-pension-culture/1056520/0.

• http://www.livemint.com/Home-Page/E7OCcGDCbC2DVmU2NlwFtO/IMF-Working-Paper--Financial-market-implications-of-Indias.html.

About the AuthorRajdeep Bhaduri is a Manager with Cognizant’s Banking and Financial Services’ Product Solutions and Applications Group. Rajdeep has more than 14 years of experience in leading business and IT engagements, mainly in the private banking and capital markets domains. He can be reached at Rajdeep.Bhaduri@cognizant.com.