Indian Express , 17th December 2012

Towards a secure retirement

Increasing provident fund contributions within a faulty system is not the answer

The Employees Provident Fund Organisation (EPFO) is moving towards increasing the mandatory contributions made towards an individual's provident fund (PF). Contributions to the PF are 24 per cent of basic wages. Earlier, employers would exclude allowances such as the housing allowance (HRA) to make the basic wage look smaller, and pay lower amounts. If the EPFO has its way, all sub-components of wages, except specific exclusions, will now be used to calculate the value of contributions, making the total greater.

In theory, this is a welcome step. Individuals are usually myopic about saving for old age, and mandatory contributions help build up a retirement corpus. In practice, even if there was complete clarity about which sub-components of the wage get excluded and which do not, there is one problem: the EPFO itself. Increasing contributions would not be as big a concern if the system worked well. Today, it does not.

First, there is the problem of choice. Not only is the EPFO locking 24 per cent of an individual's wage into a provident fund when a part of it could have been invested in instruments of her choice, but also not providing her with a choice of avenues within the provident fund set-up. The EPFO is required to invest its corpus into a set of specific instruments, mostly government securities and corporate bonds, and individual members have no say on where their own money should get invested. Larger contributions would only mean greater funds for the government, and not necessarily a greater corpus for members. Younger members of the EPFO may actually have the risk-appetite for equities, and may want to benefit from the upside till such time as they can. The EPFO could have been the avenue through which a large number of people are given the option to access the stock market, but it is not.

A contribution rate as high as 24 per cent of the entire wage may also end up crowding out private savings. If increasing contributions implies that members have lower private savings, they may resort to withdrawing from their provident fund accounts to finance events in their working life. Early withdrawals are already a problem, and may get exacerbated as more money gets deposited with the new rule change. If most members withdraw from their retirement corpus for reasons that have very little to do with old age, the point of a provident fund system, and increase in contributions, is defeated.

The EPFO suffers from poor record-keeping and portability. In today'ss economy, members frequently change jobs, or move across locations, and frequently lose track of accounts opened at previous workplaces. Accounts need to be closed at older workplaces, and opened at new ones. Pouring down contributions into a system without centralised record-keeping and portability seems to not be the most efficient method of providing old-age income security.

Finally, the EPFO diverts 8.33 per cent of the contributions towards a defined-benefit scheme called the Employees Pension Scheme (EPS). Much has been written about the deficit of the EPS, and some part of the increased contributions will no doubt go towards bridging the funding gap. This will at best make the deficit go down temporarily, but does not solve the deeper design issues of the scheme, or make members any less vulnerable to the possibility of the EPFO reneging on its EPS obligations.

If the EPFO is keen on encouraging individuals to build a retirement corpus, then it should look towards the New Pension System (NPS) regulated by the Pension Fund Regulatory Development Authority (PFRDA). While the NPS also falls short of its initial design principles, it does slightly better in offering members choice of investments (though limited), larger equity exposure, and full portability of accounts. The EPFO could provide its members the option to invest their money in the funds offered by the NPS, thus serving as a point-of-presence, like the accounting departments of Central and state governments, that direct their employee contributions to the NPS.

Ultimately, the goal of policy should be to encourage and enable individuals to save for old age. This is best done with a system that is easily accessible, provides investment choice, is low-cost, and allows portability across occupations and locations. In a country like India, which has a large informal sector, mandating contributions, or providing tax-breaks, can only affect the formal-sector workforce. To encourage the informal sector to save would require a very different combination of products, infrastructure and intermediaries. One initiative is the NPS-Swavalamban scheme that provides a matched contribution by the government, and uses a network of financial services firms and NGOs to reach out to those usually excluded from formal finance. Little is known, however, about the success of the Swavalamban scheme.

Increasing mandatory contributions towards an inefficient system like the EPFO is not the way to prepare a country for providing old-age income security. The EPFO will provide a greater service by being the channel through which its members can connect to a more modern pension system. The finance ministry and the PFRDA will provide a greater service by strengthening the original design principles of the NPS and plugging loopholes that make the NPS Swavalamban more efficient, such that the NPS becomes the one-stop pension shop for Indians from all walks of life.

The writer is a research economist at the Indira Gandhi Institute of Development Research. Views are personal.

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