Pension schemes: professional advice helps

This is the second and concluding part on Pensions market. The first part was published on August 9.

AT PRESENT in India employees eligible for a comprehensive retirement package have the benefits of provident fund, gratuity and pension. While provident fund schemes are predominantly of the defined contribution (DC) type, gratuity schemes are of the defined benefit (DB) type. Most private corporate superannuation schemes are of the DC type while government employees are eligible for a DB scheme. As both DB and DC schemes co-exist, the legislative and regulatory framework governing occupational pensions should take care of both types. Pension and provident funds form about 20 per cent of total household financial sector savings in India, with some year-to-year variations.

In the case of government organisations, both Central and State, pensions are paid to retirees on DB basis. The pension payable is based on the last pay drawn and the number of years of completed service. A portion of the basic pension can be commuted and this is tax-free. In addition to this are gratuity and the accumulated amount in the general provident fund account. Government employees are therefore eligible for an attractive retirement benefit package, which is the envy of other citizens in the country. Some public sector organisations such as banks and insurance companies also provide pension schemes to employees, in line with those available to government employees. Employees Provident Funds (EPFs) for organised sector employees are broadly divided into two categories, exempted and non-exempted. Companies forming EPFs under the exempt category are free to manage their funds subject to government regulations. A board of trustees set up by the government manages the EPFs of non-exempted category companies. The corpus available under the EPF scheme is about Rs. 80,000 crores.

The scenario in private sector organisations has undergone a change in recent years. With the enactment of the Employees Pension Scheme, 1995, employees of factories and other establishments, who were eligible for the benefits of the Employees Provident Funds and Miscellaneous Provisions Act, 1952, have become eligible for the benefits of the new scheme. This applies to an estimated 2.75 lakh establishments employing around 20 million employees. Under the Employees Pension Scheme, 1995, the employer contribution is 8.33 per cent and Government contribution is 1.16 per cent of wages, not exceeding Rs. 5,000 a month.

The pension business in India is treated as being part of life insurance business. Till recently, the Life Insurance Corporation (LIC) was the sole provider of life insurance, and hence, in the normal course, would have been the sole provider of pensions. Private sector employers have a choice between LIC and a self- administered trust at the funding or accumulation stage. Once the employee retires, an annuity is taken out with LIC. The LIC also provides an option of annuity for life with return of corpus to the beneficiary on the death of the annuitant.In the above scheme of things, most of the working population, including the self- employed, farmers, professionals, small businessmen and traders, are left to fend for themselves. It is estimated that only about 11 per cent of the working population in India enjoy old age security benefits. Others make do with the Public Provident Fund (PPF) Scheme, some avail of LIC schemes like Jeevan Suraksha, Jeevan Dhara and Jeevan Akshaya. The Unit Trust of India and Kothari Pioneer Mutual Fund also run pension plans. The PPF scheme has an estimated corpus of Rs. 12,000 crores while the individual pension plans have a total corpus of Rs. 200 crores. It will thus be seen that the unorganised sector is left high and dry in the pension arena.

Designing a pension scheme

The Government constituted the Old Age Social and Income Security (OASIS) committee to recommend a pension system for India. The basic recommendation is for the setting up of fully funded Individual Retirement Accounts (IRAs) of the DC type for the non- salaried population which is not covered through other schemes in India. The OASIS committee suggested three types of schemes depending on the investment pattern and managed by six pension fund managers. Once the OASIS recommendations were received, the Government sought other opinions. The Association of Mutual Funds of India recommended the highly successful 401 Retirement Formula of the U.S. The Insurance Regulatory and Development Authority (IRDA) has now been given the task of formulating a retirement scheme for the non-salaried population.

Designing such a scheme, given the size of the country, is not an easy task. First, it will be difficult to make any such scheme a compulsory one. Second, the criteria for pension fund managers will have to be decided. The OASIS committee has recommended six providers offering three schemes each, that is, a total of 18 schemes. The three types are expected to have varying degrees of investment in debt and equity markets. However, the suggested number of pension fund managers is arbitrary. Life insurance companies, asset management companies and banks are interested in becoming pension fund managers at the accumulation stage, while only life insurance companies would be involved at the pay-out stage. Capital adequacy and solvency margins would have to be laid down for pension fund managers.

There are other important aspects like cost of the scheme, minimum amount of contribution, points of collection, transfer of funds to the pension fund manager, transfer from one scheme to another, fees payable to the pension fund manager and the like. There is also the aspect of discouraging borrowings against the accumulated pension assets. The administrative aspects of such a scheme can be mind-boggling. However, the rapid progress achieved in recent times in computerisation and the telecom revolution give hope that such schemes can be run efficiently.

Type of investment

There is then the issue of type of investments allowed for pension funds. Historically, in the Indian scenario, pension funds have been discouraged from investing in the equity market and most investments have been mandated in government securities. However, there is a view that in the long term, equity instruments outperform debt securities, and hence in order to protect pensioners from inflation, pension funds should be allowed to invest in equities also. The problem is that it is difficult for even experts to time entry or exit in equity markets and the bulk of investors are in no position to make such difficult decisions. There is also the view that past performance of equity markets is no guarantee that equity markets will continue to outperform debt markets over the medium and long term. Already a few pension providers in countries like the U.K. are facing problems on account of the downturn in equity markets after the long bull run witnessed in major capital markets.

As it is envisaged that there will be a DC type scheme that will maintain IRAs, the risk will be borne by the account holder. This means that the retirement income of the member is at risk. It is difficult for an ordinary member of a scheme to judge the level of contributions required to secure an adequate retirement income. Overall investment strategies have to be consistent with the nature, term and cash flow profile of the member's requirements. This brings us to the important role that professional advice plays in pension schemes. This advice has to be both financial and actuarial in nature. Perhaps it needs to be made mandatory for such schemes to provide professional advice to new entrants so that they become aware that different objectives can be met through suitably structured investment vehicles. Further, review of schemes will have to be done on an on-going basis in the light of the changing economic circumstances and demographic profile.

As in the case of life insurance companies, the regulator can make the actuary or auditor accountable to the Pension Funds Authority. In designing and implementing the new IRA type pension scheme, we should hasten slowly. The US-64 disaster has highlighted the pitfalls in our financial system. The pension system cannot afford such disasters if we have to retain the faith of pensioners.

Tax issues

The tax treatment for various pension plans is of course critical. At present, at the accumulation stage, occupational pension plans are eligible for relief under Rules 87 and 88 of Income Tax Rules, while personal pensions offered by life insurers and eligible mutual funds are eligible under Section 88 and Section 80 CCC(1) of the Income-tax Act. Under the OASIS recommended type of IRAs, it is expected that relief would be granted under Sec. 88 of the Income-tax Act. At present, during the accumulation stage, incomes of certain funds are taxed while other funds are tax exempt.

At the pay-out stage, occupational and personal pensions offered by life insurers are taxed at standard rates. In the case of personal pensions offered by mutual funds, the funds are taxed at 20 per cent if the equity component is less than 50 per cent, while the income is tax exempt in the hands of the pensioners.

Pension for the poor

We should not forget in all the discussions about people funding pensions on their own that people living below the poverty line still need financial support, especially when they become old. Hence old age pension for the poor as well as provision for free medical aid for such persons should form an organic part of the pension planning process.

Abhijit Roy

(Concluded)

Send this article to Friends by E-Mail

Section  : Business
Previous : Restructuring customs and Central Excise
           departments
Next     : Highest safety rating for Rane TRW's CP programme