NPS is a good product that lives in a bad market

It is a pattern now. Whether it is at a committee meeting or a conference where retail financial products are being discussed, the example of the National Pension System (NPS) keeps coming up to substantiate the argument that lobbyists make in favour of front-end incentives in retail financial products. Their argument goes like this: you can have the best product but unless there is an upfront commission, it will remain on the shelf. Look at the NPS, it has the best product structure, but retail participation is not there; it has failed. I’m always amazed by this argument. Because this is not the failure of the NPS, but of the market place. The ‘fault’ of the NPS is this: it is a good product in a bad market. I made this argument at the Second Pension Conclave organised by the pension regulator last week in Delhi.

Let’s unpack this argument, but before we can get to the ‘good’ part, we need to understand why a financial product cannot be measured by the metrics used on products such as cars, colas, telephone services and such like. The fact that there is a commission that sits in the price of bread does not make it mandatory for a commission model to work in financial services. This is because a financial product is invisible; it is created in the minds of the consumer when the seller describes it and the moment of truth is far away—30-40 years away in some cases—which is why a market place that puts the financial well being of the customer at the heart of the market structure is the only way to prevent market failure. A market where consumers are systematically cheated, is a market that has failed because people lose trust and rush to real assets like gold.

Next, what are the attributes of a ‘good’ financial product? One, a good financial product is transparent—costs and benefits are easy to identify and understand. Hiding costs and mis-representing benefits (what does 105% of sum assured as a return illustration even mean?) makes for an opaque product structure. Two, a good product has low costs. Mukul Asher, a professor at the National University of Singapore, also speaking on the panel I was on, quoted a study that calculated the loss in the final corpus of a 40-year product. An upfront cost of 20% on the invested amount cut the final corpus value by 20%. Add on-going annual costs of just 1% and the corpus loses another 19.6% of its value. In other words, the final corpus value of 1 crore, post these costs will be about 60 lakh. Costs matter. No matter how hard the financial sector tries to hide this fact, a growing body of work in household finance shows just how much wealth is transferred from households to the financial sector by costs, explicit and hidden. Three, a good financial product is portable. If the fund manager is not doing well, I should be able to exit at minimal cost to another fund in the system. Four, a good product has good benchmarks. Unless a market-linked product has a benchmark, there is nothing to compare the return with. Five, a good product is comparable. There is no true consumer choice unless the product can be easily seen in comparison to others in the market. Six, a good product can be exited from at a low cost. NPS does well on all the features excepting exit. And that is by design. A pension product is a long-term commitment and must be seen as a long-term closed-end product.

Why do I call the market ‘bad’? India’s retail finance market is a commission-driven sales-push market that has replicated the lessons from the packaged consumer goods industry with disastrous results. And Indians’ rush towards gold and real estate must be seen in the context of investors losing trust in the financial products sold to them in this market place. Worse, the market is fragmented by pension products that are being regulated by different regulators with very different rules of the game.

The Pension Fund Regulatory and Development Authority (PFRDA) must stop trying to copy models of products that have failed investors—it is a race to the bottom. You cannot compete with 70% commissions, so don’t even try. There is an urgent need to rethink the annuity part of NPS. Open it up, allow an annuity as an option rather than the only choice. The clunk factor associated with NPS must be removed. The government must consolidate all pension products under the PFRDA umbrella. Investors find it difficult to shop for regulators rather than pension products. It must make it a level playing field by removing the tax arbitrage. Let not a bad market place make a great product toxic.

Monika Halan works in the area of financial literacy and financial intermediation policy and is a certified financial planner. She is editor, Mint Money, Yale World Fellow 2011 and on the board of FPSB India. She can be reached at expenseaccount@livemint.com