EPFO's pension mirage

Updated: Dec 13 2013, 14:51pm hrs
The appeal to the Congress leadership by the ministry of labour to overrule the prudent and valid objections by the ministry of finance on proposed tweaks to the Employee Pension Scheme (EPS) reinforces two things(1) any pension reform debate involves people not only coming with their own opinions but also their own facts; (2) these tweaks are short-term, politically-driven rather than greater good motivated. Wed like to make the case that EPSstarted by the Employees Provident Fund Organisation (EPFO) in 1995 despite employer objections and continued because of a Supreme Court Judgementshould be scrapped because (a) its design has birth defects that make it unviable without huge and continuous government infusion, (b) it is slowly reducing benefits despite a commitment to the Supreme Court that it would not need to, and (c) employees would be better off in reverting to individual defined contribution accounts that existed before this tinkering by EPFO.

The EPS saga has not villains but it does have victims. The noble original motivation of providing a monthly income linked to salary and working years has been negated by various design deficiencies, a one-size-fits-all structure and unrealistic assumption around investment returns, life expectancy and EPFOs administrative capabilities. Most importantly, the benefits as originally envisaged are actuarially unsustainablethe deficit in 2009 was pegged at R54,000 crore. Since introduction, a number of modifications to the scheme have broken the connection between contributions and benefits. In 2008, the factor adjustment used for early pension was increased from 3% to 4% and the option for return of capital and commutation was deleted. In the same year, the factor for benefit payment of those who moved from the early scheme to EPS was adjusted to reduce benefits by 1% to 40% and the factor for resignation payments before 10 years was reduced by 3-6%. In 2010, the cap on wages for international workers was removed, essentially creating another subsidy for the scheme since most of them do not claim benefits. Recently, EPFO proposed to increase the ceiling for contribution and benefits that, in effect, will be negative for most participants. Even without the last change, the poor value for money of EPS is demonstrated by the accompanying table that contrasts the payments between EPS Pension, LIC annuity, and the interest on the lump-sum that would have accumulated had the EPS never been started (the calculation assumes the current wage cap of Rs 6,500 for benefits and contributions).

Over a 20-year career, the table shows that employees would be better off than contributing to EPS (option 1) if they had paid their contributions to LIC and bought a deferred annuity (option 2). But what is shameful is that they would even have been better off if they had paid their contributions to EPFO in the defined contribution account and used the lump-sum of PF at retirement to live off a fixed deposit in a bank (option 3). While acknowledging the interest rate risk in third option, it must be noted that in this case the principal amount is not lost and available to the pension to will to his or her successor. An expert committee appointed in 2010 to review EPS made a similar case that EPS should revert to the original defined contribution structure because it is unsustainable without impossible contribution increases. It also expressed horror that only 5% of the data used for valuation is accurate and complete, i.e. only 2.4 million of the 44.5 million members had complete date and everything else was assumption based. The committee also noted that is EPS increased wages applicable to contributions and benefits from R6,500 to R10,000 per month and promised a minimum pension of R1,000 per month sustainability will need an increase in EPS contributions from the current 9.49% (8.33 employer plus 1.16 government) to 14.75% and a number of benefit reductions (pensionable salary to be calculated on last three years wages, delete withdrawal and nominee pension option, disallow 2-year bonus option, raise early pension age from 50 to 55 and retirement age to 60).

EPS is on the wrong side of history; civil servants and most private sector employees have moved away from defined benefits pensions during the same period that the sustainable EPFO carved out an unsustainable defined benefit programme. The only reason the Supreme Court did not accept the employers plea that it was unsustainable because EPFO made the case that it was a fantastic solution. But now it is clear that the only sustainable and fair long-term solution to EPS is to end it.

From April 1, 2014, no new subscribers should be brought into the scheme. From that date all employees will indicate to their employer if they wish to pay their entire monthly provident fund contributions (24%) to EPFO or open individual accounts with NPS. EPS should purchase annuities from LIC for all existing members and after that money is transferred, it should be liquidated.

Otherwise the government will have two bad choices: use taxes to fill a hole larger than UTI to pay unappreciated pensions for a small minority of the labour force or force EPFO to continuously reduce benefits by subtly defaulting on its obligations to employees and the Supreme Court. Neither option is fair or desirable to the very people that EPFO is pretending to benefit. Better to scrap EPS and revert to the what EPFO was before this silly adventure began.

Amit Gopal & Manish Sabharwal

Manish Sabharwal is with Teamlease Services and Amit Gopal represents India Life Capital