India’s Pension Reform: NPS and Beyond

8th January 2005

U.K. SinhaJoint Secretary (CM)

Department of Economic AffairsMinistry of Finance

Contours of the Presentation

• Present Status of New Pension System• Imperative for reforms in Pension• Pension systems - Indian profile• Architecture of New Pension System- CRA,

POPs, PFs• Role of Regulation in Pension Sector- PFRDA• Road ahead- challenges and opportunities

Status of Implementation of New Pension System

• Ordinance establishing the statutory PFRDA has been issued on 29th December 2004.

• Statutory Authority is being constituted with 3 whole time Members and a Chairperson.

• CRA & PFs to be selected by the Authority.• POPs to be registered by the Authority• Full system to be in place in about 12 months.

Background/status of pension systems in India

Status of Pension System Mandatory Provisions

Government– Civil Services Pension Schemes ( 12 mn. Covered under both central and

state Governments)– Civil Services Provident Fund ( same as above)– Gratuity to Civil Servants ( Same as above)Organised Sector– Employee Provident Fund ( 21 mn. Covered)– Employee Pension Scheme (19 mn. Covered)– Gratuity to employees ( Same as above)– Special Provident Funds such as Coal Miners Provident Fund, Assam Tea

Plantation Provident Fund, Jammu & Kashmir Provident Fund and Seaman's Fund ( 1.8 mn covered)

Status of Pension System

Voluntary Provisions– Public Provident Fund ( 2.9 mn participants)– Superannuation Plans ( 0.7 mn participants)– Personal pension plans from annuity providers ( 0.7 mn participants)

Other Provisions– National Social Assistance Programme for Poor and Elderly - need-

cum-merit based – Pilot scheme for unorganised workers in 50 districts- based on matching

employer-employee contributions providing for old age pension of Rs. 500 p.m (USD 10 approx.) with insurance cover.

Status of Pension SystemCivil Services Pension Schemes (pre-1.1. 2004)- Defined benefit , PAYG, Unfunded - Tax benefits – Pension benefits are taxable as this would form a

part of the gross annual income• Rate of return – an accrual rate of slightly more than 1.5% per year

of service is multiplied by the wage during the final ten months before retirement. This applies for the case of a full pension, which requires a minimum of 20 years of service. Partial pensions are paid upon completion of 10 years of service and maximum number of years taken into account is 33 years. Commutation of pension is also possible and the Fifth pay Commission increased the portion of commutation from 33 % to 40%.

Status of Pension SystemEmployees’ Provident Fund

Defined contribution. The system mandatorily covers those employees with salary below Rs. 6500/-( w.e.f. 1.6.2001) Workers whose wages exceed this threshold are required to contribute on the first Rs. 6500/- but may voluntarily contribute more.Tax benefits – Employees’ contributions receive tax rebates/credits/ relief up to 20% of the amount contributed subject to a maximum of Rs. 70,000 per annum. Lump sum withdrawals are tax free.Rate of return – Announced annually by the Board of Trustees. It was 12% up to June, 2000 , 11% up to 28.2.2001 and 9.5% thereafter. Now proposed to be 8. 5% p.a

Status of Pension SystemEmployees' Pension Scheme (EPS)

• DC with guaranteed DB. • Financing – Out of 12% contribution made by the employers for EPF

8.33% remitted to EPS. Central government contributes at the rate of 1.16% of the pay of the members. In case the pay of a member exceeds Rs. 6500/- ( w.e.f. 1.6.2001) p.m., the contribution made by the employer and the central government shall be limited to the amount payable on a pay of Rs. 6500/-.

• Rate of return – At the rate of 1/70 of final pay per year of service with maximum of 50% of the last pay drawn

Status of Pension SystemEPFO

Administrative charges are payable separately by the employer to the EPFO to cover costs. Administrative charges are 1.10 % of salary, which translates to 4.58 % of new contributions taking the contribution rate as 24 %.Corpus ( as on 31st March 2004)

EPF Rs. 71,838 cr.EPS Rs. 52,293 cr.EDLI* Rs. 3,904 cr.Total Rs. 1,28,036 cr. (USD 28 bn. approx)

*Employees’ Deposit Linked Insurance

Status of Pension SystemSpecial Provident Funds

Financing – Employer and employee contributions. Defined benefit / Defined contribution (DB/DC) – DC

Public Provident FundDefined contribution - long term saving schemeFinancing – Voluntary contributions. There is a limit of one account per person with minimum deposit of Rs. 100 and a maximum deposit of Rs. 60,000 per annum.Tax benefits – Tax rebate of 15% is provided on the contribution upto Rs. 60,000 per annum ; withdrawals are tax free.Rate of return – 8% p.a

Status of Pension SystemSuperannuation Plans

• Defined contribution • Tax benefits – Employer contributions are tax deductible upto a limit of 27%

of a worker’s salary. Employee contributions attract tax credit of 15% of the contribution, upto a maximum of Rs. 60,000 under Section 88 of I.T. Act. Annuity payments are taxable as income and commuted value up to 1/3rd or half (depending upon whether gratuity is payable or not) is tax free.

• Administration of scheme – Until the annuity begins to pay out, the funds (approved by Income Tax authorities) can be managed either by LIC or a trustee. The provisions of Insurance Act, 1938 and the LIC Act 1956 make LIC the only entity allowed to provide annuity schemes to the Indian public

Status of Pension SystemNational Social Assistance Programme (NSAP)

• Legal Coverage – Elderly persons (over 65 years) who are destitutes in the sense of having no regular means of subsistence from their own source of income or through financial support from family members or other sources.

• Effective coverage - Varies by state, about 13 percent of population over age 65 years

Government’s Initiatives

• Two parallel sets of initiatives have been undertaken during the last 3-4 years.– Budget 2001-02 announced pension scheme based on defined contribution

basis for the new entrants in the Government service. A High Level Expert Group (HLEG) was set up that suggested a new hybrid scheme combining contributions from employees and the Union Government on matching basis, on the one hand, while committing to the employees a defined benefit as pension.

– The second initiative was for the unorganised sector. OASIS (Old Age Social and Income Security) project was commissioned by the Ministry of Social Justice and Empowerment under the Chairmanship of Shri S.A.Dave which submitted its report in January, 2000.

New Pension System (NPS)

New Pension System (NPS)Guiding Principles of NPS– Define upfront liability of Government on pension

payment– Give choice to customers– Facilitate portability of labour force– To ensure transparency and fair-play in the

industry– To build a model which is small in the beginning

but is capable of replication and in handling large numbers.

Architecture of the New Pension System

• Central Recordkeeping Agency- CRA• Pension Funds - PFs• Point of Presence- POPs/PAOs• Independent Regulator - PFRDA

Architecture

Employer

New Pension System (NPS)

Uniqueness of NPS– System available to both Government servants and to

unorganized sector with one regulator. The system is scalable to accommodate State Governments, if they decide.

– Choice of fund managers and schemes to be exercised independent of the fund managers through mechanism of central record keeping agency (CRA)

New Pension System (NPS)The NPS unbundled the overall problem of pensions into three parts:

• Contributions into Individual Retirement Accounts (IRA) during working years

• Accumulation- asset management using NAV based system

• Pay-outs upon retirement - subscribers to use part or all of their accumulated pension assets to purchase annuities from IRDA -regulated life insurance companies which will pay monthly pension until death.

Contours of the New Pension System

• Based on defined contribution.• Concept of first tier (non-withdrawable) and a

second tier (withdrawable account).• Use of existing network of bank branches and post

offices etc. to collect contributions• Central record keeping infrastructure.• Several pension funds (PFs) to offer three basic

schemes: at least one PF to be in Public Sector.

Contours of the NPS

• Applicable (mandatory ) for new entrants into the Central civil service, Railways and Posts (excluding Defence) initially.

• Government to make a matching contribution. • Contributions to be 10%+10% of the salary ( basic

+DA). • The existing provisions of GPF withdrawn for new

entrants. • Schemes under EPFO are not covered under NPS

Contours……….

• At age 60, the individual would be mandatorily required to purchase an annuity (from an IRDA-regulated life insurance company) out of al least 40% of accumulated pension wealth so as to achieve a decent replacement rate.

• Beyond that, the individual would receive a lumpsum ( 60% of accumulated pension wealth), which he would be free to utilize in any manner.

Contours …..• Pension contributions and accumulations would be tax-

exempt upto a certain limit, but benefits would be taxed as normal income ( tax preference only in non-withdrawable A/C)

• Assets under both A/Cs would be managed through exactly same procedures.

• The employee would be free to withdraw his money anytime from withdrawable A/C.

• This withdrawable account does not constitute pension investment, and would attract no special tax preference

Investment Options

Options Govt. Bonds Corp Bonds Equity

A at least 60% at least 30% upto 10%

B at least 40% at least 40% upto 20%

B at least 25% at least 25% upto 50%

Investment Norms

Mutual Funds IRDA (pension) EPFO

Rated debt: not more than 15% G-sec: at least 20% Central G-sec: 25%Unrated: not more than 25% Approved securitiesState G-sec:15%

including g-sec>40% PFI+pvt. bonds:30% In any of the above:

Listed equity: not more than 10% Other approved invts<60% 30%in one companyUnlisted equity: not more than 5%Overseas investment in equity & debtpermitted with an industry ceiling=USD 1bn.

CRA- Why?

Central facility for holding records of all individuals in the new pension system

– single statement on account balance– benefit of netting, lower costs especially for

small value transactions– facilitates portability

PFs

• Each PF to offer a range of different schemes - number of schemes to be limited initially- A, B and C. Scheme –A to be the default option.

• At least one PF to be a Public Sector entity Individuals to be free to allocate his pension assets across schemes.

• PFRDA to select PFs• Role of PFs- interaction between PFs and

subscribers, access to information

PFs

• Number of PFs to be limited in initial stages and to grow based on increase in number of participants- international experience supports this approach.

• Stringent technical standards for entry of PFs - cost and fees to be the second stage selection criteria.

• PFs to exclusively provide pension fund management services as is the practice in newly reformed pension systems e.g Poland, Mexico etc.

New Pension System vs. Old Benefits Old Pension system NPS

Pension DB-50% of last 10 DC- 10% each months months’ salary salary by employees and

employer ( tier-I)

GPF Employee contribution only Tier-II- same Return fixed by GOI architecture as

tier-I (employee contribution

only )Gratuity maximum of Rs. 3.5 lakh No

CGEIS Yes Yes

Capital Market Perspective of Pension Sector Development

• Capital market in India provides comfort for NPS– Capital market offers varied instruments- debt, ,equity, futures and

options on equity and indices– 400 cities and towns with brokers’ terminals and electronically

connected– 10,000 listed companies and brokers with average daily transaction of

Rs 7,000 cr.– Daily transaction of 2.5 million - only next to New York Stock

Exchange and NASDAQ– Risk management , margining and settlements systems are robust– 50% of bank business through computerized branches- RTGS from

1st April 2004.– Record keepers in capital and stock market like NSDL, CDSL, UTI

Investor’s services etc. already handling millions of accounts and transaction every day.

Regulation in Pension Sector- PFRDA

• A separate regulatory agency will regulate and develop pension market in India.

• PFRDA’s activities include contracting for CRA, choice of pension funds, setting up regulatory requirement for fund management, establishing linkages between CRA and government etc.

Features of Reformed Pension SystemsWhy specialized supervision?• Unique system, private fund managers, long term

perspective, specific standards different from other financial entities, promotional & developmental roles, conflict of interest - short term considerations affecting the solvency of banks and insurance companies are at odds with the long term objectives of the pension system.Examples: Columbia, Ecuador, Uruguay, India

Regulation in Pension Sector- PFRDA

• PFRDA to play a synergistic role , coordinating with SEBI, RBI and IRDA in effecting a new leap for India’s pension sector.

• PFRDA will also have an active system of redressal of customer grievances.

• World wide pension sector reform has created large institutional investors and help develop their capital markets- effective and efficient regulation is very much needed.

Road ahead- challenges and opportunities

Road ahead- challenges and opportunities

• The NPS envisages harnessing many strengths of India’s financial system. – bank branches and post offices expected to offer access

services, so as to avoid cost of building up new branch network,

– PFs to be users of existing asset market including those of govt. bonds, corporate bonds, equity, derivatives etc.,

– existing life insurance industry would produce annuities.

Road ahead- challenges and opportunities

• Provision of population –wide mandatory and sustainable pension system/social security system is the ultimate goal

• Building a reliable and comprehensive data-base on pension- Central Government, State Government, Unorganized sector.

• NPS could be replicated to other Government Departments, State Governments etc.

• Address parametric and systemic reforms in other existing pension schemes.

THANK YOU