India’s old pension scheme was simply not sustainable

With increasing longevity, it often meant that persons were collecting pension for a duration longer than their active service.
With increasing longevity, it often meant that persons were collecting pension for a duration longer than their active service.


Reframe the debate on the old versus new scheme as one of defined benefit versus contribution

India prides itself on its young demography. The median age of the population is 27 years. The subset of working-age people out of the total population is growing 1% faster than the total set. On a base of 1.4 billion people, that translates to a bigger bulge every year. This is the basis for our growth optimism, and the potential virtuous cycle of a young workforce that is working, earning, consuming, investing and paying taxes. The other implication is that the dependency ratio of working age-to-retired persons is favourable for India. The word ‘favourable’ is meant in a fiscal sense. If working people pay taxes, which support social security for retired folk, then the low per-capita taxpayer burden depends on the favourable dependency ratio. This is actually relevant to most OECD economies, where every person upon reaching the age of 65 is eligible for old-age benefits. That is an entitlement guarantee from their respective social contracts. Such universal coverage for the elderly is a distant dream for India. For OECD economies, the dependency ratio is a significant matter because social security is essentially a pay-as-you go system. The working young pay for the retired old. In India, only about 11% of the elderly draw a pension as former workers of the government (be it at the Centre or state level). The rest have a pension scheme that is minuscule by comparison. The pension paid to the elderly was on a pay-as-you go principle in India too, being paid by current revenues of governments.

It was realized back in the 1990s that a pension scheme that guarantees benefits was simply not sustainable. Government employees were guaranteed 50% of their last drawn salary, with periodic upward adjustments as dearness allowance, as pension upon retirement. This is the guaranteed or Defined Benefit (DB) scheme. With increasing longevity, it often meant that persons were collecting pension for a duration longer than their active service. Indeed, it is true that in sheer numbers, the government, including the railways and armed forces, have more pensioners than working people on its payroll. This is not sustainable if this pension remains a DB scheme paid out of current revenues, as the share of pension payments out of total revenue expenditure will keep mounting. This in turn will increase the fiscal deficit and public debt. To keep the fiscal situation somewhat manageable, the government will be forced to cut other spending, especially on health, education and capital items. Hence, the DB system needed to be reformed. India opted to move away from defined benefits to be paid from government coffers to a system where the employee and employer together build a nest egg on a monthly basis throughout the former’s working career.

Much like the systematic investment plans (SIPs) pushed and made popular by the mutual fund industry, this nest egg accumulates and has a fairly handsome corpus at the time of retirement. That corpus can then be partly encashed (up to 60%) and the rest is converted into a monthly pension via annuity. The returns depend on stock markets, but only partially. This is the Defined Contribution (DC) scheme adopted by India in 2004 for all government employees. This does not entail any fiscal burden on the government after the employee retires. It is a totally different paradigm and is sustainable.

The problem is with the transition period. Governments are currently making payouts both to pensioners who enjoy DB (the old pension scheme) and a tiny fraction of those who are retiring under a DC system. And the difference in their take-home pay (as pension) is rather stark. That is why the DC gang is upset and agitating. Since the shift from DB to DC through the pension reform of 2004 did not put in a sweetener for the transition batch (say, in a decreasing sliding scale), they are all up in arms. Some states have already reverted to DB (calling it the old pension scheme) and others want to follow suit. A recent report by the Reserve Bank of India shows how fiscally disastrous it will be if everyone went back to DB. And during election season, this is snowballing into a huge political hot potato. There is competitive populism, with opposition parties stridently promising to go back to the old pension scheme for all government servants. Never mind that the pension reform of 2004 was a culmination of almost a decade-long discussion and debate, and had bipartisan consensus. And not to forget that nearly 85% of the country’s present workforce has neither pension plan, old or new. If India has to meaningfully widen old age income security for a large proportion of its elderly, it has to adopt a DC scheme, wherein the retirement kitty is built jointly by the employer and employee, and grows along with our capital markets over a long period of time. This frees up fiscal resources for research, innovation, infrastructure, healthcare and national security. Since DC has to be the endgame in this debate, the way to get there is through a hybrid version (which has been initiated at least in one state, Andhra Pradesh), and slowly wean the successive batches of new recruits completely away from DB.

In any debate, a winning strategy is to impose your framework and lingo. In the present context too, the debate should not be framed as old-versus-new pension, but rather as defined benefit (with huge and uncertain fiscal costs) versus defined contribution (with zero post-retirement cost to the government and a reasonably well predicted steady pension income).



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