How PFRDA Bill proposals change NPS structure

While the recommendation of the parliamentary standing committee reviewing the Pension Fund Regulatory and Development Authority Bill, 2011, (PFRDA Bill, 2011) to cap the foreign direct investment limit to 26% has been the most discussed, other recommendations that evaluate the structure of the New Pension System (NPS), too, need some attention.

These recommendations are aimed at driving growth, finding more takers for NPS and making it more investor friendly. In the two years of its existence, NPS has found only around 53,954 investors. But in doing so, the recommendations have tinkered with the spirit of NPS. And this has become a matter of concern for the experts who worked on the NPS structure initially. Here are key recommendations relating to NPS and how they would affect the product.

Minimum guarantee

The standing committee has proposed a minimum guaranteed return on the contributions made by the members of the NPS. This is to ensure that the returns are not subject to the vagaries of the market and are on par with other pension products that provide a defined benefit; for instance, Employees’ Provident Fund Scheme (EPF). The committee states: “The government must devise a mechanism to enable subscribers of NPS to be ensured of a minimum assured/guaranteed returns for their pensions so that they are not put to any disadvantage vis a vis other pensioners.”

For this purpose, the committee has proposed to peg the minimum rate of return on EPF’s rate of return. EPF gave 9.5% for FY11 due to a windfall gain; it had been giving 8.5% for about four previous years. EPF invests only in debt products and the rate of return once declared is guaranteed for the year. However, the structure of NPS is different from that of EPF.

Under NPS, investors from the unorganized sector can choose among three fund options: equity (E), fixed-income instruments other than government securities (C) and government securities (G). However, you can invest only up to 50% of the funds in the equity option.

You can either allocate the percentage of investment in the three investments yourself (active choice) or let the fund allocate it for you in accordance to your age (auto choice). It automatically begins with a maximum exposure to equity at 50% till the age of 35 years and reduces it to 10% by age 55 in order to lend stability to your investment as you near maturity. However, for government employees, who have switched to NPS, the cap on equity exposure is 15%, on government securities 55% and on other fixed instruments 40%.

The present structure of NPS is such that it allows an investor to enjoy market-linked returns while limiting equity exposure. Having a minimum guarantee on returns will affect the fabric of NPS and will increase the burden on the government that promises to meet any shortfall if the fund managers are not able to meet the minimum return criteria.

Says Dhirendra Swarup, chairman of Financial Planning Standards Board India and former chairman of PFRDA: “The provision for a guaranteed return which should not be less than the interest paid on EPF alters the basic structure of the NPS. It tantamounts to a partial return to a defined benefit pension as against the original intention of a pure defined contribution scheme.

The government will have to fill in the funding gap if the returns are below the minimum guaranteed amount. The funding gap in EPS runs into thousands of crores. In the final analysis, the burden will fall on the taxpayers.”

Withdrawal facility

The other key recommendation, which takes NPS’ structure closer to that of EPF, is to allow partial withdrawals. But the committee has suggested that these withdrawals be repayable. The report says: “The committee desires that the facility of repayable advance should also be provided to subscribers to enable them to meet important commitments. For this purpose, the subscribers may be allowed to take a repayable advance from their accounts, say after 10-15 years of service.”

The withdrawal facility defeats the purpose of having a strict lock-in to help investors save for their sunset years. Says Gautam Bhardwaj, director, Invest India Economic Foundation, a consultancy specializing in pension reforms: “Tier-I structure of NPS is meant strictly for accumulation. However, it was realized that for government servants who moved to NPS, the withdrawal facility under the government provident fund was not there. In order to allow for partial withdrawals in case of emergencies, Tier-II of NPS was formulated. It is a flexible account that allows for withdrawals. So in the presence of Tier-II account any partial withdrawals from Tier-I account does not make sense.”

Under the Tier-I account, the subscriber needs to invest every year till he turns 60 years of age. At 60, the investor can take up to 60% of the maturity corpus as lump sum, but mandatorily needs to buy an annuity—a pension product that gives periodic stream of income—with the remainder. The system discourages early withdrawals—before age 60, only 20% of the corpus can be withdrawn as lump sum and the remaining buys an annuity. The Tier-II account, however, works like a savings account and allows unlimited withdrawals. Tier-II can be opened by investors of Tier-I account.

Other recommendations

The committee is also concerned about returns from NPS, particularly with respect to the unorganized sector and has pointed out to the uneven performance of fund managers. The returns published by PFRDA as on 31 March indicate that in the equity scheme of the Tier-I structure, only two fund managers had outperformed its benchmark index, S&P CNX Nifty, in the last one year. Even in the debt schemes—C and G—the returns varied between fund managers. The committee has recommended that the pension regulator exercise stringent monitoring and review the guidelines/instruction issued to the fund managers periodically and strictly evaluate the performance with a view to ensure stability of returns to the subscribers. The fund managers’ defence: volatility is a short-term phenomenon, while saving for retirement is a long-term goal. Says V.R. Narasimhan, CEO, Kotak Pension Fund Ltd: “The volatility in performance is due to the fact that the reported returns on debt scheme are marked to market. Hence, in the short-term, these rates may be uneven, but in the long term, the returns will mirror the actual returns of the underlying securities.”

While the PFRDA Bill may go in for further deliberations, NPS remains a good investment vehicle for retirement savings if you are a conservative or a medium risk investor.