Policy Proposals and Actions for providing sustainable retirement outcomes under legislated pension and PF provisions

1. Policy Proposals and Actions for providing sustainable retirement outcomes under legislated pension and PF provisions By Mukul Asher, Professor National University of Singapore sppasher@nus.edu.sg Presented at The 7th annual Indian Pension Policy Conference September 27-28,2005, New Delhi.

2. Organization Introduction EPFO Key challenge overview Governance Structure Scheme design Non-investment related core functions. Investment policies and management Concluding Remarks

3. Introduction/1 Figure 1 provides an overview of India's social security system. It has 6 components and each component has several elements. Currently these components are not integrated in a systemic manner. Professionalism in design and management in each of the components and systemic perspective integrating them requires substantial improvement

4. INTRODUCTION/2 There is thus considerable scope for improvement in the current system. This presentation focuses on reforming EPFO and occupational pension plans (superannuation)

6. EPFO/1 Key challenge to provide quality of service and retirement income security commensurate the costs imposed on the economy. Time to ask : can India afford the EPFO in its current form?

7. EPFO/2 OVERVIEW Largest provider of retirement income in the non-government organized sector EPFO administers three schemes: Employees Provident Fund (EPF), Employees’ Pension Scheme (EPS) and Employees’ Deposit Linked Insurance (EDLI) – TABLE 1 Total contributions are 25.66% of basic salary plus DA plus certain allowances. The administrative costs are charged separately. The EPFO thus imposes large costs on the members, as its rates are higher than the international norms of between 10-20%.

9. EPFO/3 firms with twenty or more employees in 181 designated industries are required to be registered with the EPFO Those beginning their work careers at wages above Rs. 6500 per month are not required to join the EPFO. Companies can be exempt from participating in EPFO’s schemes if it is proven that the employees of these establishments enjoy the benefits of provident funds set up through an independent trust. Such ‘exempt’ trusts are privately managed, but are under the overall supervision of the EPFO.

10. EPFO/4 As at end-March 2003, after more than 50 years of operations , EPFO covered Only 344,508 establishments, less than Malaysia with a population of only 22 million. The EPFO has not focused on enhancing its organizational capacities to cover beyond 181 industries specified( such specifications reflect a static mindset inconsistent with India's current vision of becoming a major economic power), and covering establishments employing less than 20 workers.

11. EPFO/5 The provident fund scheme and the pension fund scheme in 2003 had 39.5 million and 27.5 million members respectively. The active contributors however are less than half for the EPF scheme. The active membership represents only about 5% of India's labour force. This figure alone demonstrates the extent to which EPFO has become marginal in providing retirement income security to India's labour force. Its claims for representing India's work force are therefore unwarranted.

12. EPFO/6 The outcome of the EPFO policies and practices is reflected in the balances of the members shown in table 2. The balance of the member is not only low, but 16% members account for 84% of the balances. This suggests that any interest subsidy to EPFO members accrues to those in the higher wage groups. Characteristically the EPFO does not publish such data on a regular basis. It should be required to do so.

14. EPFO/7 GOVERNANCE STRUCTURE. EPFO is governed by a Board of Trustees, headed by the Union Minister of Labour Administrative and policy matters are under the control of the Central Provident Fund Commissioner, who is the Chief Executive Officer of EPFO. Thus, while the Board has a bureaucrat at its head, a political appointment has the final authority on all critical policy decisions.

15. EPFO/8 The current structure of the Board is tripartite with representatives from the government, employers and employees The Central government appoints 20 members (5 from the Central government and 15 from the state governments) 10 persons each representing the employers and employees respectively appointed by the Central government Chairman (Minister of Labor) and Vice-Chairman are also appointed by the Central government. The Central Provident Fund Commissioner as ex-officio member

16. EPFO/9 The Board consists of 45 members, which is an unwieldy size All members are appointed by the Central Government There is no provision for inducting independent experts, even on a temporary or rotating basis Unlike SEBI or IRDA, there are no committees with specialized professionals to advise on policies, investments, and administration. The current EPFO board structure is ill-equipped to deal with complexities of core Provident and Pension funds tasks in both investment and non- investment areas.

17. EPFO/10 Board can improve the diversity of views and hence quality of decision-making by ensuring that not all members are centrally appointed. The international trend is towards to appointing professionals as chair persons of the national provident fund rather than a politician. India should seriously consider its practice of the Minster of labour being the chairperson of EPFO. Short run time horizon of political decision making is inconsistent with the long term financial contact in administering retirement security schemes By including independent experts, the Board can gain access to new developments and ideas in the retirement financing industry

18. EPFO/11 EPFO is both a service provider and a regulator of the provident and pension funds market. This dual function in one organization is contrary to good governance practices. This not only creates conflict of interest , as EPFO a service provider should not be involved in deciding who is exempt and how such funds should be run. It has no regulatory capacity and yet the administrative cost at 4.4% of the contributions, it levies on exempt funds are high.

19. EPFO/12 SCHEME DESIGN Modernize laws and regulations. The EPFO act, 1952 and its subsequent amendments are not in conformity with the complexity of India's economy, and dynamics of its labour market. India’s overwhelming task is to create more jobs to take advantage of the demographic “ gift” phase, but EPFO’s mindset is traditional , long term employee-employer relationships, which are becoming less of a norm.

20. EPFO/13 There are many examples where current regulations and their administration are counter- productive. Because of organizational inefficiencies , there are large suspense accounts, funds i.e. where contributions have not been credited to any individuals’ accounts. The transaction processing efficiency is particularly low. EPFO has large number for withdrawal schemes for healthcare and housing purposes, which has made it almost like a bank, increasing staff load and reducing the retirement benefits which can be obtained. ( table 3)

21. EPFO/14 This is exasperated by the requirements that the exempt funds must pay at least the same interest rate as the EPFO. EPFO is unable to administer efficiently when there is significant labour mobility , particularly with respect to temporary and contract workers whose role has been growing. some individuals are able to withdraw full amounts when they change jobs, defeating the purpose of retirement savings; others lose their balances due to inefficiencies of the EPFO when they change jobs. Job creation, among the highest Indian priority, is hampered when temporary workers and other accounts are not efficiently administered.

22. EPFO/15 The EPS scheme is badly designed , as It defines both the benefits and the contributions . This is mathematically impossible. Given nearly Rs.20,000 crore actuarial deficit in the EPS and given that the scheme requires a 70 year time horizon of financial sustainability, it should be drastically overhauled with benefits brought in line , with assets ( Asset liability matching over a 70 year period should be practiced). The alternative would be to close the scheme and pay the accrued benefits.

24. EPFO/16 NON- INVESTMENT RELATED CORE FUNCTIONS These are the four non-investment related core functions of Pension and Provident fund organizations. 1) Reliable collection of contribution/taxes, and other receipts. 2) Payment of benefits for each of the schemes in a correct way without any side-payments. In case of pre-retirement loans, ensuring their timely repayment 3)Maintaining an effective communication network, including development of accurate data and record keeping mechanisms to support collection, payment and financial activities. 4) Production of timely and policy relevant financial statements and reports. The importance of this function cannot be over emphasized As on March 31, 2003, the activities of EPFO were carried out through a network of 21regional offices, 87 sub-regional offices, and 163 district-level offices. Collectively, staff strength of EPFO amounted to 19329 persons on that date.

25. EPFO/17 Key areas for improvement Accounting system – move accrual and double entry system. Providing unique Identification number to members. Connectivity among its officers across the country. Treasury management expertise.

26. EPFO/18 Human resource development policies (staff must have requisite computer literacy, management must have skills for generating and implementing financial management systems ; and the organization must have mindset which accepts the goal of EPFO as a world-class service provider). EPFO’s annual report is neither widely accessible nor sufficiently informative. It should be benchmarked against such reports by countries like Malaysia. EPFO should have an interactive website that reflects India's skills in the IT sector. All circulars and forms should be online.

27. EPFO/19 Table 4 provides operational indicators of EPFO , while table 5 provides administrative efficiency indicators for 2 national provident funds i.e. of Malaysia and Singapore which are regarded as reaching a high degree of administrative and compliance efficiency.

30. EPFO/20 On March 31, 2003, the EPFO held investments worth Rs.1,51,278 crore under its three schemes, equivalent to 6% of India’s Gross Domestic Product. Almost two-thirds of this corpus (64%) was directly under EPFO’s management, and the remaining was managed by private exempt provident funds. Investment management is outsourced by the EPFO to the State Bank of India Funds available with the EPFO are invested in accordance with guidelines prescribed by the Government of India. Exempt establishments are also required to follow the prescribed investment pattern

31. EPFO/21 There are two sets of guidelines , one by ministry of labour 2003 and the other by ministry of finance, 2005. The IRDA also has investment guidelines for the pension corpus of the life insurance companies that it regulates. The IRDA guidelines are consistent with modern financial principles and practices. Ministry of finance has allowed a small percentage to be invested in equities through mutual funds, while ministry of labour guidelines permit primarily public sector debt, with no equities. It is therefore the list in tune with India’ sophistication of financial and capital markets.

32. EPFO/22 Moreover the ministry of labour and EPFO do not even permit the exempt funds to follow internationally accepted investment policies , permitting asset diversification, but with strong regulation. (table 6) This hampers the vision of India becoming an important regional financial center and using its relatively more developed financial and capital markets as a competitive tool against other countries such as China.

33. EPFO/23 Table 6 Investment Guidelines for Provident Funds ,

34. EPFO/24 Actual investment by EPFO: At end-March 2003, 80% of the EPFO’s Provident Fund corpus was invested in Special Deposit Schemes of the government and the remaining locked into central and state government securities and bonds of public financial institutions and PSUs Interest rate paid by the EPFO is administered, and has no link with return earned on its investments, or market rates Figure 2 shows the gap between yield on government securities and interest rate paid by the EPFO. The shortfall is funded from reserves or subsidized by the government

35. EPFO/25

36. EPFO/26 Investment Strategy is Passive: Investments are made on a buy and hold basis Re-investment risk: EPFO liabilities are very long-term; its assets are relatively short-term. This mismatch is managed by repeatedly rolling over investment; thus exposing the fund to the risk that re-invested proceeds might earn a lower interest rate. As Fig 1 shows, interest rates have fallen continuously in the last decade, exposing EPFO to a high degree of re-investment risk No Transparency: Investments are valued at cost. Since there is no mark-to-market valuation, opportunity losses and gains cannot be measured by contributors

37. EPFO/27 Lost opportunities of booking capital gains By imposing total restrictions on sales, EPFO has lost the opportunity to make capital gains on its portfolio of government bonds in a falling interest rate scenario (rates on government borrowing have fallen by over 500 basis points in the last few years)

38. EPFO/28 Loss of profits from equity premium By holding an all-debt portfolio, EPFO has lost the benefit of higher returns from equity Using a simple numerical simulation, it can be shown that terminal wealth in a portfolio consisting of 80% debt and 20% equity, will be twice the wealth accumulated under an all-government debt portfolio (Table 7); even if no trading is permitted

39. EPFO/29 Table 7: Terminal wealth for annual PF contribution of Rs.15.67 (Rs.12 from employee, Rs.3.67 from employer)

40. EPFO/30 Exempt Funds potentially more efficient ( with some exceptions) In 2002-03, over 10% of exempt provident funds paid a higher interest rate than the minimum administered rate prescribed by the EPFO Simply assuming that these funds consistently pay 0.5% over the funds directly managed by EPFO, terminal wealth would increase substantially (Table 8)

41. EPFO/31 Table 8: Terminal wealth for annual PF contribution of Rs.15.67 (Rs.12 from employee, Rs.3.67 from employer)

42. EPFO/32 The EPFO has almost 20,000 staff, but no treasury department, or investment professionals. Who will be held accountable for its fund mismanagement? Poor disclosure and valuation at cost implies that inefficiencies are not widely known and taken note of. As custodian of savings of the public, is it not EPFO’s responsibility to make its operations more transparent? Is EPFO not accountable to its contributors?

43. Concluding Remarks A Mindset change is needed with appropriate leadership to transform EPFO from an employer focused to employee focused organization. The EPFO should aim to become a world class service provider for its members and acquire investment management capabilities. Its time to begin taking advantage of India's demographic “ gift” phase, reflected in increasing share of working age population in total population till 2045.