NPS vs EPFO: Demystifying the pension debate

Posted online: Friday, Sep 13, 2013 at 0000 hrs
The Parliament nod to the PFRDA Bill has triggered a heated debate on the performance of the National Pension System (NPS) offered under the PFRDA and EPS run by the Employees Provident Fund Organisation (EPFO). Debates are healthy and important tools in a democracy to weigh the worth of ideas and should be welcomed but they must be informed and bring out all aspects of the topic under consideration.

Citing reams of statistics on returns, projections and some recent media reports comparing the two have drawn conclusion that EPS of EPFO is inefficient when compared with ‘promising’ NPS, hailed as a panacea to the problem of providing old age social security for the working population. But before pronouncing the verdict, can we spare a thought on whether it is a case of their apples are sweeter than my oranges!

To start with, EPFO manages three separate schemes namely Employees Provident Fund Scheme 1952 (EPF), Employees Pension Scheme 1995 (EPS) and Employees Deposit Linked Insurance Scheme 1971 (EDLI). Of the three, only one, the EPF scheme, is comparable to NPS’s scheme. The EPF scheme is an individual account scheme where the member’s contribution (12% of wages) and 3.67% of the wages comprising of the employer’s contribution is received and the funds are invested to earn interest which is distributed as annual dividend. Also, the returns flow to the members’ account and are not subject to change with fluctuations in market yields.

NPS is also an individual account scheme where a member’s contributions are received and are invested in the securities. The final accumulation of the fund is partly utilised to purchase annuity as monthly pension. EPS, on the other hand, is a pooled account, defined contribution and defined benefit scheme. The employer contribution of 8.33% of the wages and the government’s contribution of 1.16% of the wages (limited to a wage ceiling of R6,500) go to EPS pooled fund. The benefits are in the form of member pension, widow pension, children pension, dependent parent pension, orphan pension and disability pension. These benefits are carved out from one single pool of fund.

Comparing NPS with EPS, to use an often used cliché, is like comparing an apple to an orange. However, NPS can be compared with EPF as both are defined contribution individual member accounting schemes. The funds for both the schemes are invested in the market, albeit EPFO has not ventured into the equity market till date and returns are accumulated in the members’ account. The basic difference here is: (1) in the manner of fund accumulation and (2) in the manner the accumulated funds are paid out.

In case of NPS the fresh investments are used to purchase units as per the existing NAV, while in case of EPF the entire sum is invested and the portfolio is held-to-maturity (HTM), and the interests actually received is credited to the members’ account. As such, the returns on EPF are actual returns which remain unaffected by market fluctuations, while in case of NPS the mark-to-market portfolio valuations (MTM) make net asset value (NAV) fluctuate both ways.

The returns are only notional; nothing tangible is getting credited to the members’ account. This means that in the year when the financial markets do not perform and that being your retirement year, NAV could be substantially low, possibly eroding most of your lifetime savings.

This is important as ‘security’, by definition, means something a person can bank on. Can you in a social security scheme brush under the carpet a possibility when a lifetime of earnings can be eroded if markets turn bearish the very year your retirement is due?

In NPS a minimum of 40% of the final pot on retirement is utilised to purchase annuity, while the rest is returned as a lump sum. In case of EPF, on retirement the entire corpus is returned to the member. EPF, however, also allows partial withdrawals during the service period for meeting social obligations as well as for certain exigencies during rainy days.

Benefits under EPS spread far beyond what the member has contributed. Under EPS, lifelong pension is available to the widow and children up to the age of 25 years even if the member has only contributed only for a single month. It is unlikely that the range of benefits offered under EPS is available under any other scheme and EPS with such kind of benefits cannot be compared with pure market-linked annuity scheme.

There is a prevailing notion in the media that the returns in EPF/EPS are low compared to NPS and other market-oriented SIP schemes. This, no doubt, stems from the conventional wisdom that investment in equity market outperforms other investment avenues in the long run. However, a dispassionate analysis of the returns actually achieved by EPFO would show that it fares rather competitively with the returns under NPS and even outscores most of the offering in the NPS basket. It would be essential for comparative purposes to convert the interest earnings of the EPF scheme into an NAV. When this NAV is compared with the declared NAV of various NPS schemes under tier-1 account, it emerges that only the three corporate schemes of NPS has performed better than EPF since May 2009 to September 6, 2013.

In NPS, life cycle approach has been adopted as default during the investment phase. This means that for a member who is below the age of 35 years and does not choose to actively manage his funds, the investments in his case would be governed by the default scheme. This default scheme mandates investment of 50% in equity (E) scheme, 30% in corporate (C) scheme and the balance 20% in government (G) scheme for a person below 35 years of age. The returns when calculated for a member who is below 35, under default scheme of NPS commencing from May 2009 and EPF/EPS for the same period, it is seen that the performance of EPF is better than all the other schemes run by different NPS fund managers. EPF has provided annual returns of 10.05% in comparison to 9.78% of the best performing ICICI Pension Fund Management Company among NPS fund managers.

There is another prevailing notion that the management charges of EPS are high. This is far from the truth, for while EPFO charges 1.10% of the wage from the employer for managing the EPF scheme, there is no charge on the member for managing the EPS scheme and also for disbursing pension to the pensioner.

In respect of NPS, there is a need to demystify the management charges which are actually borne by the subscribers.

NPS has adopted three different methods of charging its members. Points of presence (POP) charges are collected upfront from the member. Central record keeping agency (CRA) charges are through cancellation of units of the members. Portfolio management charges (PFM) and custodian charges are taken through NAV deduction. All these charges are only for the accumulation phase of the scheme. During payout, annuity service providers’ give returns on the corpus which is much lower than the market earnings.

The fixed cost of the NPS adds to a minimum of R500 only on account for POP and CRA charges which is more than 8% of the contribution for someone contributing R6,000 annually in NPS. Thus, it is not a cost-effective product particularly for low wage earners. Further, the PFM charges on AUM basis are going to eat into a substantial chunk of the corpus over the long period. A simple calculation suggests that PFM charges on investment of a fixed sum monthly/annually for 30 years would wipe out 3.88% of the corpus. The actual charges could be significantly higher as the AUM would increase annually on account of fund earnings and also annual increase in wages. Thus, the NPS scheme is far from being the cheapest pension scheme as it is made out to be.

It has been suggested by the finance ministry to migrate the members under EPS to NPS on the grounds that they would get a decent return as well as adequate pension wealth, while the government would be free from any financially unsustainable liability of EPS. These views have been taken on the basis of the continuously rising actuarial deficit of EPS over 2001-08. The underlying concern of the ministry here is on the continued viability of EPS. But an evaluation of EPS carried out at the suggestion of the finance ministry using the PROST model of the World Bank in 2011 brought out that there would a continuous positive cash flow up to the year 2075 (last year for which the model could predict). Further, the actuarial valuations of the fund till date had been based on 5-10% members’ data and as such the actuarial report outcomes have not proved to be very reliable. This shortcoming has been addressed by the EPFO and 60-70% members’ data collected through special drive has been provided for the current actuarial study for which the results are expected soon.

As is evident from the facts presented, EPS remains a stable, viable and competitive pension scheme with returns not yet matched by NPS and a bouquet of benefits that are unmatched by any other pension scheme offerings in the market today.

Chandramauli Chakraborty & Ajay Kumar

Chandramauli Chakraborty is regional PF commissioner I (pension). Ajay Kumar is regional PF commissioner II (IMC). Views are personal