Unified Pension Scheme: Is good psychology also sound economics?

Two decades of investments in market instruments failed to impress people, apparently, even though it was faring alright in spite of contributions being made only bit-by-bit to its kitty. 

If contributors were pining for a re-adoption of the Old Pension Scheme (OPS), which offered assured benefits, an explanation may lie in human behaviour. Prospect Theory, as laid out by Daniel Kahneman and Amos Tversky, posits that people generally prefer an assured sum of money over a potentially larger sum that’s uncertain. 

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This is so even if the laws of probability dictate that the expected value of the unsure option is higher. The duo’s psychology experiments showed that people tend to be risk-averse in their approach to potential gains.

This behavioural insight may explain people’s anxiety over the NPS despite seeing their contribution pool swell in line with India’s stock market. That corpus, however, exists on paper and may shrink by the time they retire if the country’s equity upsurge fizzles out. 

We have seen significant asset-price inflation in recent years, after all, and unlike the cost of living, stocks can undergo long phases of deflation. 

So, now that the UPS is offering an assured pension of half one’s basic average salary over 12 months till retirement if one puts in 25 years of service (with smaller proportions for fewer years), and that too with other sweeteners thrown in, we can expect most employees to grab the new option with both hands. 

The big question, then, is whether the UPS is fiscally sustainable. The OPS, remember, was unsound because it had no funding device. Thankfully, the UPS is a clever hybrid. While it offers OPS-like assured payouts, what it shares with the NPS is its preset contribution characteristic. 

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Would-be UPS pensioners must keep putting in 10% of their basic pay while they earn, as with the NPS, while the government will chip in 18.5%, a bit more than the NPS’s 14%. 

The Centre has estimated an extra ₹6,250 crore needed in the next budget for this hike, plus a one-time ₹800 crore outlay to switch NPS users to this scheme.

What cannot be reliably forecast, however, is the fiscal burden in the decades ahead if UPS investments fail to generate sufficient funds for promised payouts. 

Overall, while the hybrid scheme will satisfy a psychological need and thereby shield the government from political accusations of being stingy, any shortfalls that need to be filled would call for future budget allocations. 

To keep such gaps small and the risk of draining India’s exchequer low, the market value of UPS-invested assets will need to follow a steady upward path. In other words, the state now has a greater interest in ensuring an orderly rise in long-term asset values, given how costly a prolonged market slump could prove. 

As retail investors have stormed into the stock market, too much money chasing too few stocks has led equity valuations to outpace company earnings, by and large. The instability that such froth might spell could conceivably become a big public concern. 

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Tighter corporate governance and market oversight, thus, would seem appropriate. Only if asset markets resist bubbles will the UPS succeed over the long haul—both fiscally and politically.