There's hole in the bucket

Indian Express, 8 September 2004

While the Employees Provident Fund Office (EPFO) has been haggling with labour unions on the interest rate on provident fund, the biggest impending crisis in EPFO has gone unnoticed. The Indian Express has learnt that the latest actuarial report for the “Employees Pension Scheme” (EPS), shows an unfunded gap of Rs 17,500 crore. This is “bigger than UTI” in that when the bad news on UTI surfaced, US-64 had a gap of Rs 14,500 crore. The tax-payer paid for roughly half of the hole and the other half was borne by the holders of US-64. The 2.75 crore EPS members face these same risks.

EPS is a “defined benefit” (DB) scheme run by EPFO and guaranteed by the government. This means that the employee is guaranteed a certain pension — regardless of whether there is enough money to pay for it or not. EPS is mandatory for employees earning less than Rs 6500 a month in all establishments covered by EPFO (roughly speaking, companies with more than 20 workers).

The EPFO is required to invest this money in government bonds and other highly rated bonds. When a member retires, EPFO is obligated to give him a pension till he dies and then to his widow till she dies. This means that a member who joins EPS when he starts working, stays with EPFO for about 70 years.

EPS can work if on retirement date, the assets in hand for a person are enough to pay for the flow of pensions that must ensue. At every point of time the value of the pension liabilities can be measured by adding up the promises. The value of the assets can be measured by summing up the securities in hand and the expected future contributions. The two sides — the sum of assets and sum of promises — must match.

But the arithmetic does not tally. The contributions are small, and the promised pension is big. Since the freedom of EPFO to do any “asset management” is limited as its hands and feet are tied in terms of portfolio management, higher returns cannot be obtained by better fund management. In addition, defined benefit (DB) schemes have a constraint where investments can only be in fixed-return government bonds since the promises are fixed.

These problems are innate to DB schemes, and have popped up with such schemes all over the world. It is all too easy for a government to make rosy promises about the future, and then renege on these promises after a decade or two because the assets are not there. Reneging on promises is not just a hypothetical possibility. This has happened in numerous countries such as Italy and Sweden, which had introduced DB schemes, but then had to back away when reality set in.

Basic forces of economics are against EPS. When EPS was launched in 1995, interest rates were very high. These have fallen by more than 10 percentage points. The returns on assets has fallen. Further, the death rate has dropped. This makes pensions costlier. As a result the unfunded gap has risen. The inherent mistakes of EPS were perhaps tolerable when there were fewer people in the scheme. But every year as more people are joining the scheme, the gap is increasing.

One way to meet the fixed promises is to enforce higher contributions. But the total contributions being made by workers to EPFO are already enormous — EPF and EPS together eat up 25 per cent of the wage of the worker, one of the highest contribution rates in the world. If the contribution rate cannot be increased, then the promised benefits must be cut. Fixing benefits requires making projections about parameters like interest rates and life expectancy way into the deep future. The uncertainty involved is huge and even the most conservative estimates of what may be the pension payment can go wrong. If the assets being invested do not turn out to be enough to give the promised returns then members putting in money are simply hoping that the government will be paying for the shortfall. This faith in the credibility of a future government is naive. India is already on an explosive debt-GDP path. It is not difficult to imagine that 25 years from now, a government under severe pressure to contain its spending may say that it cannot pay the high pensions promised under the EPS.

Moreover, even if there is no debt crisis, is it fair that tax payer money should be used for paying pensions to one section of the population, while the rest of the population (other than government employees) has no access to pensions? Already, the scheme blatantly dips into taxpayer resources. The scheme requires that the government must add a contribution of 1.16 per cent to the contribution of 8.33 per cent of salary that is made for each employee. The government does not put Rs 140 into the savings account of a farmer every time he puts Rs 1000 in the bank!

In the case of EPF, the trade unions are demanding 9.5 per cent interest rate. However, here the law is on the side of sensible accounting. The Act says that EPF cannot pay out more interest than it earns. In the case of EPS, there is no sensible accounting. The promises to pay high pensions are being made even though life expectancy is increasing, interest rates are falling and contributions are not enough to pay for the promises. Unless this flaw in the scheme is urgently addressed, the EPS problem will get bigger and bigger. Will EPS be able to convert itself into a simpler and defined contribution system? Or will the unfunded gap be allowed to grow till it reaches such large proportions that the easiest option for the government is to renege? Both UTI and EPFO were unregulated financial service providers in the period where they ran up large problems with US-64 and EPS. EPFO is like the pre-SEBI UTI in not having a regulator. To understand EPS, to criticise how EPS has been run, and to try to solve the problems of EPS inexorably leads to questions of the legal framework, competence and incentives of EPFO. Is EPFO the right agency to think about policy problems on India’s pension sector?

Ila Patnaik