A significantly larger chunk of India’s pension money appears headed for the equities market because of a new default investment option that the regulator plans to offer as part of its proposed new pension system.
This new default choice will let those participating in the pension scheme to allow the manager of the funds to decide how much of their money goes into equities, according to a person familiar with the plan.
Until now, the new pension system was to offer just four options, three of which cap the amount of money that can be put into equities—up to 50% of contributions—and the fourth, which was earlier to be the default, that puts all the money into government securities such as long-term bonds.
The latest default option, which mimics what are known as “life cycle funds” in many countries, links the investment choices with the age of the person contributing to the pension plan. Typically, a younger contributor will have a much larger share of his or her pension contribution put into equities. As the contributor grows older, the mix of investment starts shifting to more conservative instruments. Closer to retirement, the entire amount typically shifts to government securities.
Those who don’t choose any option will have their money automatically put into the new default option.
It is unclear what the cap on equities would end up to be under the default option. Even if it is capped at 50%, the current maximum under the most aggressive equity option, it is likely that a significant amount of money will flow into the country’s stock market.
That’s because typically more than half of those signing up for a pension plan—often 60% to 70% in various countries where such plans exist—end up not choosing specific investment options and instead end up with a “default” option when asked to make a choice of investments, said this official who did not want to be named.
Based on such surveys, the government is expecting a majority of people coming into the new pension plan to end up in the default option, thus making a lot more money available for investment in equities.
Irrespective of the option chosen, the new plan won’t allow fund managers to invest directly in individual shares. Instead, they are only allowed to buy index mutual funds.
An index fund is a passively managed fund that tries to mimic the movement of a selected index, such as the Bombay Stock Exchange’s Sensex, which is an index of 30 companies traded on the exchange that are chosen by a committee of the exchange.
Still, because the index fund itself buys individual company shares, the pension money will indirectly flow into shares of companies.
While it is impossible to predict how many people will opt for the default choice or pick other equity options available once the pension system is put in place, the move is sure to increase the flow of pension money into stocks, given India’s soaring markets that are generating double-digit annual returns to investors.
At the very least, Rs1,500 crore worth of government employee pension contributions will immediately flow into the new system.
That is because all employees who joined government service—both at the Centre and in states—after 31 December 2003 and their pension contributions will automatically fall into the new system. Most of them are young, increasing the chances that they will seek higher risk pension plans anyway even if they don’t come into the default option category.
The pension reforms bill, which will allow the pension regulator to offer the investment options , including the new default option, is expected to be introduced in this month’s budget session of Parliament. While the bill itself remains controversial and is being opposed by some political parties, especially the Left, the government is keen to move forward on it as it faces major problems in sustaining current pension plans that promise certain fixed payments to its employees, irrespective of the actual returns on the amounts collected from employees.
In return for moving to a flexible returns system, contributors will get the option to invest their contributions in riskier investment avenues that could offer better returns.
Under the new pension system, the government plans to entrust the money to private pension fund managers as well as one state-owned company.
Since the government is expecting the default option to be the most preferred—thus with the most amount of pension money to invest—it plans to entrust those funds to the management company that will charge the lowest fees, said an official familiar with the government’s thinking. This decision will be reviewed annually, he added.