When the gates are all down and the signals are flashin’
The whistle is screamin’ in vain
And you stay on the tracks, ignoring the facts
Well, you can’t blame the wreck on the train.
The internet is a place where everyone has an opinion on everything. So when a friend posted this Don McLean song in the context of the US presidential election results, I could be forgiven for thinking that he was talking about investments by the Employees’ Provident Fund Organisation (EPFO) in equities. After all, both seem headed towards an abyss unless serious corrective action is taken.
Here is why. Our Employees’ Provident Fund (EPF) money was invested by the EPFO and the trusts in government and government-owned company bonds for many years. This fixed-income-based asset allocation was appropriate for an era of non-existent retirement planning, under-developed capital markets and low employee expectations.
It was also apt for the EPF, given that returns from the fund are credited to members’ accounts annually. Bonds give fixed rates of return, which are earned by the EPFO’s fund and credited to member accounts—an uncomplicated method to keep assets and liabilities in the balance.
But if you run a pension fund in India for a population whose average age is around 30, you have to think long term and cannot ignore equities.
Returns from bonds do not beat inflation in the long run; returns from equities do.
Hence, the advent of equities into the asset allocation of the EPFO, in the form of a 5-15% allocation. Anyone who begrudges this decision with the usual ‘speculative’ rhetoric, should not be taken seriously.
At 15% of incremental surpluses, and with funds being deployed solely in an index, one would think that the EPFO got the equities bit right.
Why then the morbid prescience? Because the EPFO has not changed the liability accounting of its fund. Equities, unlike bonds, do not provide fixed returns. They are prone to fluctuations, often significant in quantum, and may deliver negative returns too. Basic portfolio theory, therefore, suggests that it is not possible to provide a fixed return to an investor in a portfolio that consists of equities, unless someone is willing to underwrite the risk. Further, prudent accounting requires returns from equities to be recognised only when they are realised. Realisation can be achieved in the form of redemption of funds or dividends, both of which have not occurred. This is, therefore, a piquant situation.
The EPFO’s fund invested in equities last year and continues to do so this year, indeed at a higher allocation than the previous year. However, the return credited to member accounts either does not consider equity returns or considers notional equity returns. As the proportion of equity in the portfolio of the EPFO mounts, we could face a situation where the liability (contribution and interest) exceeds the asset (because of underperformance of equities). A scary thought considering that this means an insolvent provident fund.
The EPFO did attempt to use innovative accounting to resolve this issue. This revolved around recognising income on a notional basis, setting up of a risk mitigating reserve and credit of equity earnings to members.
However, these were entirely based on notional earnings and not realised earnings of equities, and lack credibility from an accounting standards perspective. Alternatives to this accounting jugglery, which I have heard, of range from those that are inefficient (investing in dividend schemes, redeeming the funds once a year, and others) to those that are bad administrative ideas (unitising only the equity component).
To my mind, the solution lies solely in liability reforms. It is time the EPFO unitises the liability. For long, the EPF has been viewed as a fixed-return product. This makes it singularly attractive to employees, but thwarts progress in asset allocation and reduces the EPF from a pension fund to a government security mutual fund.
Unitising the EPF will ring in the real benefits of the changed investment guidelines and deliver value to the members in the form of better long-term returns. We do not need to look far for peers.
For long, Indians, albeit a smaller number, have invested in unitised mutual funds, insurance products and more recently, in the National Pension System. The flaws of these products revolve around mis-selling, something that will not affect a statutory scheme like EPF.
Unitisation has a few imperatives though. It will require that employees gives up the guaranteed, yet low, returns of the current avatar for the potential of higher returns. More significantly, it will require changes to the way the EPFO functions.
Unitised products need fund accounting systems, controls, stringent turnaround times for transactions, service-level governance, detailed beneficiary communication programmes and, most importantly, a customer centricity by the administrators of the plans. Sadly, the EPFO lacks these and will need to evaluate whether it should build these or exit its benefits administrator role.
Investing in equities has brought the EPFO to a point of inflexion.
The government can choose to ‘ignore the facts’ and send it towards the ‘train’. Or it can fix it. An interesting call option for the government.
Amit Gopal is senior vice-president, India Life Capital Pvt. Ltd.