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Business News/ Opinion / Unlock our pension potential
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Unlock our pension potential

Unlock our pension potential

Illustration: Jayachandran / Mint Premium

Illustration: Jayachandran / Mint

The New Pension System (NPS) had been extended to all citizens from 1 May, yet it is progressing rather slowly. The Pension Fund Regulatory and Development Authority (PFRDA) has argued that one of the major causes for this is the differential tax treatment of NPS. But the regulator itself can do much to promote NPS’ growth even within the available tax dispensation.

Illustration: Jayachandran / Mint

To be sure, NPS is treated differently from other pension funds as far as taxation goes. NPS is under the exempt-exempt-tax (EET) regime: The first two stages of investing—contribution and accumulation—are tax-exempt; but the last stage—withdrawal—is not. However, the public provident fund (PPF) and the Employees’ Provident Fund Organisation (EPFO) is under the exempt-exempt-exempt (EEE) regime; all three stages are tax-exempt. The government aims to change this; the draft direct tax code proposes several changes in the tax regime which, once enacted, would bring the EET regime into effect not only for EPF and PPF, but also for payments such as gratuity and leave encashment. However, at this stage it is far from clear as to what shape the final enactment will take.

What is clear, though, is what PFRDA can do.

In a pension scheme, the investor buys a mix of securities over time to build a corpus, which is then drawn down to provide income in retirement. Equities as an asset class provide higher returns over the long run due to the risk premium attached to the variability of their returns. But the variability of annualized equity returns declines over time. Therefore, higher equity exposure will reward younger investors.

An efficient pension fund investment policy would then provide a higher contribution to equity for younger investors. The thumb rule in the developed financial markets is 100 less investor’s age in years equals the percentage point allocation to equity. Yet, the investment guidelines issued by PFRDA cap the equity allocation at 50%. This rigidity costs younger investors up to 2% in annual returns. It is interesting to note that the 2007 Deepak Parekh committee set up to suggest investment guidelines for pension funds had recommended a choice of up to 100% equity allocation. With this mandate and some ingenuity, the regulator could provide investors an option that would be almost equivalent to achieving an EEE regime for pensions. For this, it could offer hybrid funds with a minimum allocation to equities of 65%; the investment in the hybrid fund makes them eligible for exemption from long-term capital gains tax. For achieving overall asset allocation, either an investor could be allowed a second pension account with a pure debt-based scheme or it could be left to the investor to do so outside the pension system through the much-envied PPF.

And the investment universe isn’t restricted to the Bombay Stock Exchange (BSE) Sensex and the National Stock Exchange (NSE) Nifty. Both these indices comprise large-cap stocks, of companies with large capitalizations, and account for only 50-60% of total market capitalization. The University of Chicago’s Eugene Fama, among others, has shown that for the long-term investor, there is some extra juice of returns in investing in small-caps and value stocks. Therefore, the regulator should at least allow pension fund managers (PFMs) an option at this stage to offer funds benchmarked on or mirroring broader market indices such as the S&P CNX 500—later this could be made mandatory. The restriction on the use of derivatives should go, as these are valid risk management tools and can be used to structure relatively safer pension plans, as Boston University’s Zvi Bodie, author of Worry-Free Investing (2008), has shown.

Once these regulatory issues are addressed, NPS would become an intelligent and efficient system of old-age income security. However, to build a large base of funds for PFMs to manage to ensure sustainability, PFRDA should try to keep NPS open to as large a body of investors as possible for the purpose of long-term savings. These savings include, besides pensions, savings for house, children’s education and one’s will or estate. In doing that, it would be following the example of the growth of mutual fund industry in India which, while meant to serve small investors, has grown with the contributions of high net worth investors and corporate treasuries.

To illustrate, under NPS it is mandatory for the investor to purchase an annuity for 40% of the corpus. An annuity guarantees a monthly payment for life but the corpus is lost to the investor or his or her heirs in case of death. This is a specific and restrictive feature of pure pension savings. Instead, it should be possible to offer an alternative as an option with a cap on the percentage of corpus that can be withdrawn in a year. This would meet the requirement of old-age income security while catering to other long-term savings goals. Also, the asset basket may be expanded to include alternative asset classes such as gold and real estate which hold special attractions and relevance for Indian investors.

With these initiatives, PFRDA can, by itself, unlock the full potential of NPS, without waiting for a new tax code.

Asha Ram Sihag is a civil servant. Views expressed here are personal. Comments are welcome at

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Updated: 30 Aug 2009, 09:08 PM IST
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