Pension reforms 2.0: Why we need to think beyond defined benefits and contribution

Why we need to think beyond defined benefits and defined contribution

Pension reforms, PFRDA, defined benefit, PAYG, Atal Pension Yojana, EPS,  unorganised sector
The organisation of pension system can also take two forms—the pay-as-you-go (PAYG) unfunded-type financed by tax revenues (directly through budgets or through a special trust) and fully-funded type financed through individual contributions.

Saket Hishikar

The first-generation financial sector reforms completed 25 years in 2018. In contrast, pension reforms, which began with OASIS Report of 1999 and fructified after a Cabinet decision to create PFRDA in 2003, are recent reforms. The state, under Article 41, Directive Principles of State Policy, is bound to facilitate provision of old-age income within the limits of economic capacity. This makes pension reforms very important, requiring long-term planning and periodic evaluation to minimise moral hazard. But Article 41 does not specify how the provisions for old-age income support should be organised, i.e. the pension system design and financial engineering, is a matter of policy choice.

Drawing from the theory of actuarial science, a pension fund can take two financial forms—defined benefit (DB) wherein final income drawn after a certain age is defined, and defined contribution (DC) wherein the amount contributed is specified but not how much can be drawn after a certain age. Both methods of pension funding have their pro and cons. While DB offers cover for longevity, DC offers more choices and flexibility under high labour mobility.

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The organisation of pension system can also take two forms—the pay-as-you-go (PAYG) unfunded-type financed by tax revenues (directly through budgets or through a special trust) and fully-funded type financed through individual contributions. Depending upon the choices made, there are four possible ways a pension system can be organised.

At times, a pension fund can also have both DB-DC characteristics. The DB-DC type pension funds have both PAYG and individual contributions features. The Atal Pension Yojana (APY) and the new Pradhan Mantri Shram-Yogi Maandhan (PMSYM) fall in this category. Even the EPS 1995, managed by EPFO, is a DB-DC scheme. The exempted PFs are also treated as DC funds with DB characteristics under AS15. India’s experiment with DB-DC is quite old. EPS was formed in 1995 by merging the Family Pension Scheme of 1971, much before adoption of NPS. But once PFRDA was formed, the conventional policy thinking of the time agreed that PAYG-DB was unviable and individually-funded DC was the best choice. As a matter of principle, pension policy accepted a separation between ‘savings objective’ and ‘redistribution objective’ of the government.

But two successive experiments in DB-DC type pension somehow suggest a departure from this principle, blurring the lines between the two. Although these experiments are justified and within the scope of Article 41, they fail on long-term viability. The ‘limits of economic capacity’ have both short and long-term tradeoffs. In state-sponsored DB-DC pension, these tradeoffs will spread across generations. Take EPS. The finances of EPS became unsustainable after five years of operation. Long-term simulation of funds using World Bank’s software indicated unsustainable finances. Srivastava Committee 2009 suggested parametric reforms to balance the fund. The EPS example shows that DB-DC arrangements are difficult to manage over time.

More recent cases are interesting. APY was launched in 2015-16 as a universal pension scheme to address longevity risks among workers in unorganised sector. Now, PMSYM also covers the unorganised sector workers with monthly income up to Rs 15,000. What is the rationale to carve out a new category of individuals in the unorganised sector when a universal scheme is already in operation in the same sector? How will this segment be identified because those earning up to Rs 15,000 need not file income tax returns.

For the exact fund position of APY, one has to wait for actuarial valuation report, for which expression of interest was invited in July 2018. However, under APY, for an individual aged 30, to draw Rs 3,000 monthly pension, the actuarially determined contribution is Rs 347, which is three times what is promised under PMSYM for a similar benefit.

As India approaches 20 years of first-generation pension reforms, one has to ask how to evaluate the progress? On what basis should future policy be formulated? The trajectory of pension policy in India had very different conditions precedent in 1947. Neither had we the war-torn generation like the in Europe, which justified creating PAYG-DB plans, nor we had large-scale industrialisation that led to Anglo-Saxon model of employee-sponsored DC pension funds. Pension reform 2.0 must explore solutions that meet our needs.

The author is an economist in the banking sector. Views are personal

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