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ABSTRACT
The paper offers an empirical study on the Pension system in India. The paper has discussed about the

current condition of pension system. It studies the segment of population covered under proper pension

system and the segment which is not covered under a proper pension system. Currently India has the

highest percentage of youth workforce but majority of them are not covered under a proper pension system.

Only those working I government sector are assure about their old age income, the rest are covered under a

faulty pension scheme. It also studies the employees provident fund scheme, employee’s pension scheme,

employees’ deposit link insurance scheme and other schemes like civil servants pension

scheme. Research was conducted through questionnaire survey as a tool to collect

primary data. Also secondary data has been collected through various journals and

reports. The result showed that only the government employees’ are covered under a

proper pension scheme.


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TABLE OF CONTENTS

S.No Chapter Page no


1. Introduction 2-5
1.1 Introduction 2-4
1.2 Role of pension fund in the economy 5
2. Review of Literature 6-54
2.1 Structure of Indian pension system 7
2.2 Pension under EPF & MP Act, 1952 7-23
2.3 Other Pension Schemes 23
2.4 Central Government Pension 24-36
2.5 State Government Pension 36-38
2.6 Bank Pension 39-47
2.7 Mutual Fund Pension Plan 48
2.8 Insurance Firm Pension Plan 48-51
2.9 Present Situation of Government Finances 52
2.10 Impact of Fifth Central Pay Commission 53-54
3. Finding & Analysis 55-94
3.1 Need For Reform 56-61
3.2 Aims for the Reform 61-62
3.3 Recent Trend in Pension Reforms 62-67
3.4 Proposed Reform 68-70
3.5 Major Issues for Reform 70-71
4. Recommendations 72-73
4.1 Recommendations for Indian Pension System 73-74
4.2 Proposed Structure 74-94
5. Conclusion 95-99
5.1 Conclusion 96-99
6. Bibliography 100-102
7. Appendices 103-109
7.1 Response Sheet – 1 104
7.2 Response Sheet – 2 105
7.3 Response Sheet – 3 106
7.4 Response Sheet – 4 107
7.5 Response Sheet – 5 108
7.6 Response Sheet – 6 109
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“Will I have enough to live on when I retire?” This question of old age

financial security is being asked across the world with growing


apprehensions. India is no exception.

An economy, apart from everything else, is a highly fluid transmission mechanism. Its
beauty lies in how the smallest of changes have the most complex trickle down
effects. A paradigmatic example of how seemingly minor policy changes can
jumpstart the economy can be illustrated by examining the effects of a reform in the
pension system.

A reform in the pension system tackles the primary problem of the financial sector in the
dual manner. On the one hand introduction of private pension funds managers will
ensure the large scale mobilization of savings which would lead to increase in rate of
savings, which would further lead to higher rate of capital accumulation, crucial for
a developing country like India. It has been proved statistically that private managers
are in a position to earn greater returns from their sources. So in effect privatizing
the pension system would place a larger pool of fund in the hands of efficient
managers, specializing in this form of activity.

But that answers only half the question. At this point it may be prudent to ask, so where
these funds would be diverted in the absence of adequate channels? This is where the
overall commitment comes into the picture. Admittedly pension reform is only a small
part of a larger program of allowing private initiative in the economy.
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Introduction
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1.1Introduction

The debate on the pension system reforms is intensifying in India. The ongoing financial
sector reforms have made significant progress in the spheres of banking, capital and
currency markets and now provide an opportunity to revamp the hitherto untouched
sectors like insurance and pension. While insurance sector reform is already underway,
the effect of which to a certain extent is expected to percolate to the private pension
market - a comprehensive policy for pension system restructuring is yet to be undertaken.

A variety of problems plague the pension system in India. The gradual collapse of the
traditional old age support mechanism and the rise in elderly population highlights the
need for strengthening the formal channels of retirement savings. The imperative, more
proximate reasons for pension reforms are also well known – skewed coverage of the
existing benefit schemes favoring organized workforce while informal employment is on
the rise, worsening financial situation of government pension schemes against a
background of rising system expenditure, unfair treatment of private sector workers vis–
a vis public sector employees, an underdeveloped private annuity market, and finally the
need to increase the domestic rate of savings through higher contractual saving.

Major retirement saving schemes like provident and pension funds predominantly cover
workers in the organized sector, constituting only about 10% of the aggregate workforce.
The majority of workers around 90% of the working population is engaged in the
unorganized sector and has no access to any formal system of old age economic security.
This skewed coverage is further shrinking as informal workforce is growing while the
size of formal workforce has remained more or less stagnant.

The diverse and often conflicting set of problems faced by the Indian pension system
requires a more serious and coherent approach. For example, on one hand, there is an
urgent need to contain the escalating expenditure on public pension programs while there
is also an urgency to extend the coverage to the unorganized sector. The government
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initiatives in recent years like advancement of retirement age for its employees, partial
conversion of provident funds into pension schemes for private workers and introduction
of new means-tested social assistance schemes for the poor have met with limited
success, further underlining the need for an early and lasting reform of the current
system.

Additional impetus for pension reform comes from the fragmented nature of the existing
Benefit schemes. In spite of its limited scope and size, the Indian pension system in its
current form, can at best be described as an extremely complicated and fractured one
inducing distortion in the labor market. A large number of occupation based retirement
schemes with wide diversity in plan characteristics and benefit provisions are in
existence, and have created a wedge of disparity between public and private sector
workers. While private sector workers are aggrieved with low returns from their benefit
schemes, public employees are privileged with generous pension provisions.
In recent years, there have been attempts to address these problems. These efforts,
however, have largely been piecemeal. The diverse and often conflicting set of problems
faced by the Indian pension system requires a more serious and coherent approach. For
example, on one hand, there is an urgent need to contain the escalating expenditure on
public pension programs while there is also an urgency to extend the coverage to the
unorganized sector. The government1 initiatives in recent years like advancement of
retirement age for its employees, partial conversion of provident funds into pension
schemes for private workers and introduction of new means-tested social assistance
schemes for the poor have met with limited success, further underlining the need for an
early and lasting reform of the current system.

1.2Role of Pension Funds in the Economy

Importance for the Financial Sector

Fully funded pension systems do not provide benefits to the pensioners alone, but they
may also exert strong externalities that may benefit the overall economy. The most
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widely acclaimed externality that fully funded pension schemes are held to generate is
their stimulus for financial development. It is often claimed that fully-funded pension
systems help (a) raise the supply of long-term funds, (b) strengthen the efficiency of fund
allocation, and (c) stimulate the financial infrastructure of a country. Moreover, it is often
asserted that a funded pension system would also help stimulate the level of national
savings.

In a country’s social security system Pensions play an imperative part. The development
of the pension funds market is necessary for ensuring the future needs of the country’s
population and developing depth in the equity and bond markets. In fact, liberalization of
Insurance and Pension has been cornerstone of every developing country’s embracing of
free market economy. For instance, after Korean and Taiwanese insurance sectors were
liberalized, the Korean retirement cover market has grown three times faster than GDP
and in Taiwan; the rate of growth has been almost 4 times that of its GDP. Philippines
followed the trend in 1992. As a case in point, over the past half-century, the U.S.
financial sector has undergone a transformation as household savings shifted from banks
to pension funds and other institutional investment pools. Between 1953 and 2003, the
assets of all depository institutions – banks, savings institutions and credit unions –
dropped from 60.1 percent of total financial-sector assets to 23.0 percent. Meanwhile, the
assets of pension funds and mutual funds grew from 9.6 to 33.5 percent of the total. At
yearend 2003, these institutional investment pools provided the dominant channels for
households’ saving and investment flows with combined assets of $14.4 trillion. By
contrast, the total assets of depository institutions amounted to $9.9 trillion.

Seen from the global economic scenario the pension industry is a key component of the
financial infrastructure of an economy, in the sense that it is one of the few sources of
long term funds which have null or least risk associated with maturity of assets and
liabilities, and its viability and strengths have far reaching consequences for not only its
money and capital markets, but also for each and every facet of the economy.
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Review of Literature
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2.1Structure of Indian Pension System


Inspite of its limited scope and size, the Indian pension system in its current form, can at
best be described as an extremely complicated and fractured one inducing distortion in
the labor market. A large number of occupation based retirement schemes with wide
diversity in plan characteristics and benefit provisions are in existence, and have created
a wedge of disparity between public and private sector workers. While private sector
workers are aggrieved with low returns from their benefit schemes, public employees are
privileged with generous pension provisions.

As per 1991 census, approximately 75% of India’s population lives in rural areas. The
per capita income of the populace stood at Rs.13193 (at 1997-98 price levels). The 1991
census estimated the Indian labor force to comprise of 314 million workers. Of these,
15.2% were regular salaried employees, 53% were self-employed and another 31% were
casual /contract labor. The Central Government departments (including P&T, Defence
and Railways), States and UT Governments employed a total work force of
approximately 11.13 million thus accounting for 23% of the total salaried employees in
India. They are eligible for the full range of government’s pensionary benefits including
a non-contributory, indexed, defined benefit pension scheme. Another 49% of the total
salaried workers are covered by a mandatory Employees’ Provident Fund (EPF) and
Employees’ Pension Scheme (EPS).

2.2Pension under EPF & MP act 1952


Employees' Provident Fund (EPF)

The EPF program, established in 1952, is a contributory provident fund providing


benefits upon retirement, resignation or death, based on the accumulated contributions
plus interest, from employers and employees. Subscribers to the EPF have the option to
make partial withdrawals for specified purposes such as house construction, higher
education for children, marriage, and medical expenses associated with illness.
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Establishments covered by the EPF can either have the EPFO manage the provident fund,
or can undertake processes to qualify as an exempt establishment, whereby they manage
the provident fund themselves. In general, exempted establishments are large companies.
(Private Provident Funds)

Statistics about EPF:

Workers covered 24 million

Contribution rate 12 % employers’ share and 12 %

employees’ share

Total contribution 24 per cent

Diverted as under • Provident Fund - 15.67 per cent

• Pension Fund - 8.33 per cent

Government contribution in 1.16 per cent


pension fund

The Employees Provident Fund (EPF) is the first of the three schemes designed under the
EPF&MP Act 1952. It is primarily a defined contribution scheme, which pays a lump
sum benefit to its members.

Applicability

The EPF&MP Act, 1952 is applicable to all establishments engaged in the 182 specified
industries employing twenty or more people earning up to Rs.6500 p.m. The Act does
not apply to co-operative societies employing less than 50 persons. The rule under EPFO
is that only those institutes that are hitherto being provided pension either by the State or
the Central Government are not under the aegis of the EPFO. However this Act applies
only to members earning up to Rs.6500. Those members above that wage are exempt
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from the PF rules of contributions. The coverage of the EPF has been steadily increasing
over the years. The regional distribution of the EPF is not uniform and found to be
skewed towards the more prosperous states.

Operational framework
Contributions

The EPF requires the employers and employees to contribute an amount equal to 12% of
the employees' salary (consisting of basic wage, with dearness allowances, retaining
allowance and cash value of food concessions). In some cases the rate of contributions
for both the employers and the employees have been fixed at an lower level equaling
10% of the employees' salary, these are namely,

1. An establishment that has been declared as a sick unit by the Board of Industrial
and Financial Re-construction.

2. An establishment that has accumulated financial losses exceeding its net worth
for the given financial year.

3. Any establishment in the a) Jute industry b) Beedi industry c) Brick industry d)


Coir industry other than spinning sector and Guar gum factories.

If an employee so desires he can contribute at a rate higher than 12% (10% where
applicable) of his salary. However in such a case the employer is not obliged to
contribute at such higher rates.

During 2004-05, the EPF received Rs. 9613.11 cr as contributions.

Benefits

The primary benefit of the EPF is a lump sum withdrawal of the accumulations at the
time of retirement. The accumulation of a member's balance is facilitated by the statutory
rate of interest declared by the government every year. The interest rate for the past ten
years had varied from 12% to 9.5%. In January 2006, the government further reduced the
interest rate to 8.5% for the current fiscal year.
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The EPF&MP Act, 1952 allows for withdrawals and advances prior to retirement in
certain circumstances that are different for withdrawals and advances. The EPF has
witnessed large amounts of withdrawals, which lead to very small balances at the time of
retirement. The policy of early withdrawals defeats the purpose of the provident fund as a
means of old age income security.

The full accumulations are paid in the following circumstances

1. On retirement from service after attaining 55 years of age.

2. On retirement on account of permanent and total incapacity for work due to


bodily or mental infirmity.

3. Migration from India and permanent settlement abroad.

4. Termination of service in the case of mass or individual retirement.

In the case of death of a member before the amount standing to his credit in the fund has
become payable, the amount is paid to the person nominated by the member. If the
member has a family at the time of making the nomination, the nomination has to be in
favor of one or more members of the family. If the member does not have a family at the
time of nomination, he can nominate one or more person. However if he subsequently
acquires a family, he will be required to make a fresh nomination in favor of one or more
family members.

The EPF settled 2408797 claims in 2004-05.

Investment

The funds have to be invested as per the directions given by the Central Government in
the securities listed in Section 20 of the Indian Trusts Act, 1882. The investment pattern
is prescribed by the Ministry of Finance and is then approved by the Ministry of Labor.
(See EPF investments)

Administration

The scheme is administered by the Employees' Provident Fund Organization and is


governed by the EPF&MP Act, 1952. The EPF&MP Act, 1952 provides for the
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administration of the scheme by a Board of trustees referred to as the Central Board. The
Central Board consists of the following members:

1. A Chairman and a Vice Chairman appointed by the Central Government.

2. Central Provident Fund Commissioner.

3. Up to 5 members appointed by the Central Government from amongst its


officials.

4. Up to 15 members representing State Governments appointed by the Central


Government.

5. 10 persons representing employers of the covered establishments, appointed by


the Central Government after consultations with organizations of employers.

6. 10 persons representing employees of covered establishments, appointed by


Central Government after consultation with employees' organizations.

The Central Government also appoints an executive committee and a regional committee
to assist the Central Board in its operations.

The EPFO covers the administrative expenses by levying administrative charges on the
employers of the covered establishments. As of 2002-03 every employer has to pay
administrative charges at the rate of 1.10% of emoluments towards the provident fund.

Exemptions

An establishment can be exempt from the EPF if the employees of the establishment are
covered by a provident fund scheme that provides benefits at least at par with those
provided under the EPF. The exempted establishments run their own schemes, typically
called exempt funds but they remain covered under the EPF&MP Act, 1952 and are
subject to a number of terms and conditions mentioned in the Act. One important
condition here is that the contribution rates under the provident fund rules of any
establishment should not be less than those under the EPF. There are other conditions in
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respect of maintenance of accounts, submission of reports that the exempted


establishments are expected to follow.

Defaults

The EPF&MP Act, 1952 has several provisions which give the EPFO the authority to
deal with employers who default in making payments (either contributions or charges)
due to the EPFO. For example, if an employer defaults in complying with the rules of the
EPFO, he is liable to pay a simple interest at the rate of 12% on the amount due for the
period between the date when the amount was due and the date when the payment was
actually made. Apart from this he has to pay damages at the following rates

Period of default Rate of damages as a percent of arrears


Less than two months 17
Above two months but less than four months 22

In India the EPF, has been used more as medium of tax evasion by the salaried classes as
the entire amount deposited in EPF is deductible for income-tax estimation purposes.
This negates the purpose for which it was originally set up for i.e. as a fund that would
cover expenditure during the lifetime after retirement.

Employees' Pension Scheme (EPS)


The EPS, established in 1995, provides for the payment of a member’s pension upon the
member’s superannuation/retirement, disability, and widow/widower pension, and
children's pension upon the member’s death. The EPS program has replaced the erstwhile
Family Pension Scheme (FPS). Employers that are not mandated to be covered may
voluntarily apply for coverage. The new scheme, known, as the Employees’ Pension
Scheme (EPS), is essentially a defined-benefit program providing earnings related
pension on superannuation, disability or death. Thus, EPF members are now eligible for
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two benefit streams on superannuation – a lump sum EPF accumulation upon retirement
and a monthly pension from the EPS.

The amount of the pension benefit is based on the employee's average salary during the
final year of employment and the total number of years of employment. Under the EPS,
members must have completed a minimum of ten years of service and must be at least 58
years old. However, if an employee has completed twenty years of service, he/she may
obtain an early pension from age 50. Under this provision, the amount of pension benefit
is reduced by 3 per cent for every year falling short of 58. Exemption from the EPS is
allowed, but in this event, the employer will have to cover the government's contribution.

However, participation to the EPS program was voluntary for the existing workers as on
1995 but mandatory for the new workers whose monthly pensionable earnings did not
exceed Rs. 5000. Aggrieved workers alleged that the pension from the EPS was
substantially inferior compared to the public pension schemes and that the return from
the scheme was even lower than the provident fund arrangement. The debate surrounding
the EPS continues unabated till today, with many trade unions filing litigations against
the scheme.

This new system along with the recommendations of the Fifth Pay Commission Report
has only added to the liabilities of the government.

Employee Pension Scheme is a defined benefit scheme where monthly pensions are paid
to the members after they retire In case of the death of the member the pension is paid to
the widow and children. The scheme commenced on November 1995 and replaced the
Family Pension Scheme, 1971.

Applicability

The scheme currently applies to all establishments engaged in 182 specified industries,
employing at least 20 people. Once an establishment is covered, it remains covered even
if the number of employees falls below 20. The scheme is mandatory only for employees
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earning a monthly salary up to Rs. 6,500, where salary includes basic wage, with
dearness allowances, retaining allowance and cash value of food concessions. However
employers usually extend it to all employees. The EPS coverage has been steadily
increasing, with a membership of 31149049 people as on March 2005.

Operational Framework
Contributions

No additional contributions are required by the employer or employees under the


Employees pension scheme. Out of the contribution towards Provident Fund, employer's
contribution equal to 8.33% of the employees' wages is diverted towards the Employees
Pension Fund. The Government also contributes at the rate of 1.16% of the employees'
salary. The total contributions collected by the EPS stood at Rs.6511.85 cry as of 2004-
05.

Benefits

The number of beneficiaries under the EPS has been increasing at a fairly rapid pace. The
total number of pensioners as well as the number of pensioners in each category has
shown a consistent increase over the years. This indicates an ever increasing
responsibility of the EPS to meet the pension requirements of an increasing number of
people.

Monthly Pension

A member is eligible to receive pension after retirement if he has rendered 10 years of


service. The kind of pension a member gets under the scheme depends upon the age at
which he retires and the number of years of eligible services he has rendered. If a
member has rendered twenty years of service and retires after attaining the age of fifty
eight he is entitled to Superannuation Pension. If he has rendered twenty years of service
but retires before attaining the age of fifty eight he gets a retirement pension. Lastly a
member is entitled to Short Service Pension if he has rendered services for any number of
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years ranging between ten and twenty. The period of eligible service is calculated as
follows

• For employees joining the EPF after 16th November 1995, the period of service is
calculated as the number of years of service rendered after November 16th 1995.
For those who were members of the Family Pension Scheme' 71, the period of
service is calculated as the total of services rendered before and after November
1995.

• The member is entitled to receive pension as soon as he attains the age of 58


years. This applies even if the member has retired before attaining the age of 58
years.

However in case a member desires to draw a monthly pension before attaining the age of
58 years, he is allowed to do so provided he has already attained the age of 50. In this
case the pension would accrue to the member at a reduced rate. The pension accruing to
the member would be reduced at the rate of 3% for every year the age falls short of 58
years.

Disability benefits

In case of total and permanent disability, a member is entitled to receive pension


provided he has contributed to the fund for at least one month. Pension is calculated in
the same manner as for any other retiree. The pension paid is subject to a minimum of
Rs.250.

Widowers pension

In case of death of a member, his widow is entitled to receive pension till her death or
remarriage. In case there are more than one widows pension would be paid to the eldest
surviving widow where the term eldest implies senior-most with respect to marriage. On
the death of the senior-most widow, pension will be paid to the next surviving widow.
The widow's pension is subject to a minimum of Rs.450.
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Children's pension

If there are surviving children of a deceased member they are entitled to receive pension
provided they are below 25 years of age. This is in addition to the monthly widow's
pension the monthly pension admissible to children is equal to 25% of pension received
by the deceased member's widow subject to a minimum of Rs.115 per child per month.
Starting from the eldest, maximum of two children can receive pension at a time. In
addition to the above, if there is a totally and permanently disabled child in the deceased
member's family he is entitled to receive children's pension irrespective of his age. If the
deceased member is survived only by his children, then the children will be entitled to
receive a monthly Orphan's Pension. This pension will be paid at the rate of 75% of the
amount of monthly widow's pension payable subject to a minimum of Rs.250 per month
per child. Even if a widow dies or remarries after her pension has been sanctioned, the
children would be entitled to receive Orphan's Pension in lieu of Children's Pension. The
Orphan's Pension is payable to a maximum of two children at a time, starting from the
eldest.

Benefits to nominees

In case a member is unmarried or has no living spouse or children, he can nominate a


person who would receive pension benefits on the death of the member. The nominee
would receive pension benefits equal to the monthly widow's pension. The nomination
would remain valid only till the member acquires a family. Thus if the member
subsequently acquires a family the nomination would stand void. In case the member
dies without any nomination, the widow's pension will be paid to dependent father or
dependent mother. If the father dies after his pension is sanctioned, the dependent mother
receives pension lifelong. The beneficiaries are entitled to receive pension from the date
of death of the member.

Commutation

A member is allowed to take a maximum of 1/3rd of his monthly pension as lump sum.
The value of commutation would be hundred times the amount of monthly pension the
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member desires to take away. Thus if a member's monthly pension is Rs.600 the
maximum amount he can take as commutation is 1/3x600x100. In this case the balance
of pension payable on a monthly basis is Rs.400.

Return of capital

A member can also opt for drawing a reduced pension and avail the facility of return of
capital. In this case the member gets less than the full amount of pension admissible to
him and after his death a given lump sum is returned to his nominee. There are three
alternatives available to him in this case.

Benefits if a member leaves service before being eligible for monthly pension

If a member leaves his job or attains the age of 58 before rendering at least 10 years of
service, he will be entitled to a withdrawal benefit. The amount he can withdraw is a
proportion of his monthly salary on the date of exit from employment. The proportion
depends on the number of years of eligible service he has rendered.

If a member leaves a job before attaining the age of 58, he also has the option to receive
the Scheme Certificate. The certificate indicates the pensionable salary and the amount of
pension due on the date of his exit from employment. In case he subsequently gets
employment in an establishment covered under the EPF Act, this certificate will be taken
into account to calculate his full pensionable service.

The number of non pensionable exits has been quite high. In fact the number of non
pensionable exits has been higher than pensionable exits. For the year 2000, the numbers
of non pensionable exits were 1717619 as compared to 212531 pensionable exits. This is
not a good sign as it can defeat the very purpose of the scheme.

If an employee was a member of the erstwhile Family Pension Scheme, he would receive
additional withdrawal benefits.
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Investment

The funds have to be invested as per the directions given by the Central Government in
the securities listed in Section 20 of the Indian Trusts Act, 1882. The current investment
pattern has been prescribed by the Government with effect from 1st April 2003. The
contribution by the Government is kept in the Public Accounts and earns an interest rate
of 8.5% as of 2004. An observation of the profile of EPS investments shows that over the
years there has been a sharp rise in investment in Central Government, State Government
and Government guaranteed securities. The investment in special deposits has remained
more or less constant while the investment in public sector financial institutions has
actually declined. The funds in Public Accounts have also shown an increase.
Investments are made each year out of the contributions received after setting aside the
required amount for meeting that year's liabilities. Thus even though EPS is a funded
scheme, it tends to behave like a pay as you go DB scheme.

An actuarial valuation of the Pension Fund is carried out on an annual basis to examine
the relative positions of the assets and liabilities and assess the viability of the scheme.
The pension rates may be revised based on such valuation.

Administration

The scheme is administered by the Employees' Provident Fund Organization and is


governed by the EPF&MP Act 1952. Since the inception of EPS, the working setup of
EPFO has been modified in order to ensure proper implementation of the new scheme
and to provide prompt and trouble free service to the Pension Fund members and
pensioners. A Pension Wing has been constituted in all the field offices of EPFO. This
wing comprises of Pension (Monitoring) Section, Pension (Audit) Section, Pension
(Disbursement and Reconciliation) Section and a Database Creation Cell to look into the
different work areas related to pensions. The offices have been equipped with application
software programs to assist in monitoring, maintenance of accounts and record keeping.

The Employees Pension Fund Account records all contributions into and disbursements
made out of the fund the scheme provides for the maintenance of a separate account for
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recording administrative expenses. However only one account is maintained which, is the
Pension Fund Account. An amount equal to 16% of administrative expenses can be met
out of the Employees Pension Fund. This includes costs of remittance of pension which
is to be charged exclusively from the Pension Fund. The balance of administrative
expenses is met out of administration accounts set up under the Employees Provident
Fund Scheme.

Taxation

The employers' contribution towards provident fund is treated as a deductible business


expense as per Section 36(1)(iv) of the Income Tax Act 1962. The fund income is tax
exempt. However the monthly pensions are taxable.

Exemption

Under Section 17 of the EPF&MP Act, exemption can be granted to an establishment


from the scheme provided the members of such an establishment are or propose to be
members of a pension scheme that provides benefits at least at par with those in the EPS.
The EPFO has been very strict in this matter and only three establishments have received
exemption so far. They are;

• M/s TELCO (Maharashtra).

• M/s Malaysian Airlines(Tamil Nadu).

• M/s Oil India (Assam).

Employees' Deposit Linked Insurance Scheme (EDLI)


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The EDLI program was established in 1976. This program provides lump sum benefits
upon the death of the member equal to the average balance in the member’s EPF account
for the 12 months preceding death, up to Rs. 25,000 plus 25 per cent of the amount in
excess of Rs. 25,000 up to a maximum of Rs. 60,000. Contributions received are kept in
the Public Account and earn an interest of 8.5 per cent. Health care and insurance are
covered through Employees’ State Insurance Corporation.

Insured persons 8.8 million

Beneficiaries 34.2 million

Contribution rate 4.75 per cent employers’ share and 1.75 per cent employees’
share

Total contribution 6.5 per cent

The EPF&MP Act, 1952 provided for a provident fund and a family pension scheme for
employees from 1971 onwards. However it was felt that problems arising out of early
death of the employee were left unaddressed. In view of this, the Act was amended to
incorporate an insurance scheme, called the Employees' Deposit Linked Insurance
Scheme (EDLIS) in 1976. The objective of the scheme was to put in place a mechanism
to provide employees' families with income security after the death of the member. It was
funded through contributions by the employer and the Central Government with no
contribution by the employee himself. The scheme has undergone several changes since
its introduction. The Government no longer contributes to the scheme and the rates of
benefits have also been changed many times. The contributions thus come only from the
employers. A comprehensive administrative framework was set-up to ensure smooth
functioning of the scheme.
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Applicability

EDLIS is applicable to all the factories and establishments to which the EPF&MA Act,
1952 applies. This includes both the exempt and non-exempt establishments covered by
the Act. All employees who join the Employees' Provident Fund are covered by the
EDLIS.

Operational Framework of the EDLIS


Contributions

At the time of inception of EDLIS, contributions were made by both employer and the
Central Government. The Act specified that the employer shall contribute not more than
1% of the aggregate of basic wages, dearness allowance including cash value of food
concession and retaining allowance. In 1977 it was decided that the employer would
contribute 0.5% of the above mentioned aggregate pay, subject to a ceiling of Rs.6500.
The Central Government contributed 0.25% of the pay in respect of the covered
employees. In 1996, an amendment was passed which ended the Government's
contributions with respect to covered employees. The Government stopped contributing
in 1998. The employers continued to contribute at the rate of 0.5% of pay. The time limit
for the employer to remit his contributions to the Deposit-Linked Insurance Fund is
within fifteen days of the close of every month. The Central Government must credit its
contributions to the Fund as soon as possible after the close of every financial year. As of
2004-05, the total contributions received under the EDLI were Rs.191.62 cr.

Benefits

On the death of an employee who is a member of the Provident Fund, the selected
nominee will get the existent accumulations in the PF account of the employee as well as
an additional amount. This additional amount is equal to the average balance in the
account of the deceased during the preceding twelve months or during the period of
membership, whichever is less. Where the average balance exceeds Rs.35,000, the
amount payable is Rs.35,000 plus 25% of the amount in excess of this figure. This total
amount is subject to a ceiling of Rs.60,000. The lump sum is tax free.
24

Investments

Before 1997, the corpus of the Deposit-Linked Insurance Fund was deposited with the
Central government in the public account. It earned an interest of 7.5% before 1989. In
1989 the interest rate was increased to 8.5%. After 1997, the corpus already in the Fund
was left in the public account, and new contributions were invested according to a
specified pattern described below.

Investment category Percentage invested


Central Government Securities Not less than 25%
State government securities and guaranteed securities Not less than 25%
7-Year National Savings Certificates or Post Office Time
Not exceeding 30%
Deposits
Special Deposits Not exceeding 20%
The EDLIS portfolio stands at Rs.4375 cry as of 2004-05. The exposure of the EDLIS
portfolio to various State Governments has been quite substantial.

Administration

The contributions towards administration and inspection charges have changed over the
years through reforms. At the time of inception, the employer paid 0.1% while the
Government contributed 0.05% of pay. In 1980 a proposal was passed which put in place
inspection charges for employers of exempt establishments. This charge was 0.02% of
pay. In 1988, administration charges were reduced from 0.1% to 0.01% for employers,
and from 0.05% to 0.005% for the Government. These charges were then subject to a
minimum of Rs.2 per month for the employer, and Rs.1 per month for the Government.
The scheme is currently following this pattern of charges but the Government stopped
contributing towards administration charges after 1998. As of the year 2000, employers
of exempt establishments must pay inspection charges of 0.005% instead of the earlier
rate of 0.02%. These payments are deposited in the Insurance Fund Central
25

Administration Account and are used to fund the expenditures involved in the running of
the scheme. The EPFO collected Rs.8.66 cry on account of charges in 2004-05.

Exemption

Provisions for exemption from the EDLIS are listed under Section 17 of the EPF&MP
Act 1952 along with Section 28(1) of EDLIS. An exemption from EDLIS is granted
where the employees receive an insurance benefit without making any separate
contribution or paying premium. It is necessary that this insurance benefit be greater than
the insurance benefit provided under the EDLIS. An establishment exempted from the
operation of the EDLIS is required to submit a monthly return to the RPFC. The
establishment is also liable to pay inspection charges at the rate of 0.005% of the basic
wages and dearness allowance, subject to a minimum of Re.1 per month. It does not have
to pay any administration charges.

Defaults

Where an employer makes a default in the payment of any contribution or charges, the
Central Provident Fund Commissioner may recover penalty from the employer at varying
rates depending on the period of default. The penalty rates are as follows

Less than 2 months default period 17%


Between 2 to 4 months default period 22%
Between 4 to 6 months default period 27%
6 months and above default period 37%

These damages may be waived or reduced in certain cases. If the management changes,
or there is a merger or amalgamation, the damages may be waived completely. If the
Board for Industrial and Financial Reconstruction recommends a waiver, a waiver up to
100% may be granted. In other cases, depending on the merit of the claims for waiver, up
to 50% of damages may be reduced. If an employer deducts or attempts to deduct
contributions from the employees' remuneration, fails to submit a return, obstructs an
official in the discharge of duty or fails to produce records for inspection, he is
punishable with imprisonment up to one year, or a fine of up to Rs.4000, or both. In
26

2005, of a total of 14,748 prosecution cases, only 774 cases were disposed while the
remaining 13,974 cases were still pending. The top five states as of 2004-05 in terms of
prosecution cases lunched were Madhya Pradesh, Bihar, Maharashtra, Karnataka and
Gujarat.

2.3Other Pension Schemes

Government Pensions

Government pensions in India are defined under the Directive Principles of State policy
and are therefore not under a Statute. The Government amended the regulations to put in
place the new pension system. The old scheme continues for the existing employees (i.e.
those who joined service prior to January 1, 2004). Pensions for government employees
would include employees of the central as well as the state governments.

2.4Central Government Pensions

Civil Servants pension

Civil servants pensions in India underwent reform starting January 2004, with the
introduction of the new pension system, a defined contribution scheme for new entrants
to the Central Government. This was introduced in response to the growing pension bill
of the Central Government and with a view to integrate pension provisions for the formal
and informal sectors in India.

In the past, civil servants pensions have known to be the most generous of occupational
pensions in India. The pension scheme is primarily a wage indexed defined benefit
scheme which offers a 50% replacement rate. This scheme continues for the old
employees. As of 2004 there were about 14 lakh employees in the civil services.
27

Legislation

Matters relating to social security are listed in the Directive Principles of State Policy and
are subjects in the Concurrent List. The retirement benefits for Central civil service
employees are administered by the provisions of the following Acts/rules:

• General Provident Fund (Central Service) Rules, 1960

• Contributory Provident Fund Rules (India), 1962

• Central Civil Service Pension Rules, 1972

• Central Civil Service (Commutation of Pension) Rules, 1981

Operational Framework
Benefits

The retirement benefits for the Central civil service employees can be broadly classified
into

• Non contributory benefits.

• Contributory benefits.

• Other benefits.

Non contributory benefits

The non contributory retirement benefits for the Central civil service employees are
pensions and gratuity. These are a function of the following two factors:

• The length of the qualifying service.

• The manner of termination of the service.


28

Contributory benefits

The contributory benefits for a Central civil service employee are provided through one
of the two provident funds run by the Central Government. These are

• Contributory Provident Fund (CPF).

• General Provident Fund (GPF) .

The option of participating in the Central Provident Fund (CPF) was however removed
since 1986. Central civil service employees, after a qualifying service of 1 year are
eligible to become a subscriber to the General Provident Fund. Subscribers to the GPF
have to subscribe a fixed portion of their emoluments on a monthly basis. At the end of
their service, they get the accumulated amount with the interest thereon. Subscribers to
the GPF are also eligible to get the non-contributory benefits mentioned above.
Subscribers to the CPF are not eligible for pension benefits.

Other benefits

These are like non-contributory benefits. However they have some special characteristics
that make them a little different from non-contributory benefits. There are two main
kinds of benefits

• Extraordinary pension rules.

• Leave encashment.

Taxation

The monthly pension an employee receives after retirement is taxable.

The following components of the retirement benefits are exempted from taxes:

1. Death-cum-retirement gratuity or any other gratuity. This is exempt to the extent


specified, from inclusion in computing the total income under clause (10) of
section 10 of the IT Act.
29

2. Any payment in commutation of pensions received under the civil pension rules
or under any similar scheme which is applicable to Central civil service
employees. The exemption is subject to the condition that (a) in case where the
employees receives any gratuity, the commuted value does not exceed one third
of the pension which he is normally entitled to receive and (b) in any other case,
the commuted value should not exceed half of such pension.

3. Cash-equivalent of the leave salary in respect of the period of earned leave to his
credit at the time of his retirement on superannuation or otherwise.

4. Compensation received at the time of voluntary retirement. This is subject to the


fulfillment of the following conditions:

a. The employee availing voluntary retirement should have completed


ten years of service or completed forty years of age.

b. The voluntary retirement scheme should apply to all employees


including workers and executives, except the director of a company.
The scheme of voluntary retirement should aim at reducing the
strength of employees.

c. The vacancy created by voluntary retirement is not filled up and the


retiring employee is not employed in another company or concern
belonging to the same management.

d. The amount of compensation received by the employee should not


exceed the amount equivalent to three months' salary for each
completed year of service or the value of monthly emoluments at the
time of retirement weighed by the reciprocal of balance months of
services left at the time of retirement.
30

Defense Pensions

The defense services employ one of the largest numbers of people in the Central
Government and simultaneously have the largest number of pensioners. There were 21
lakh pensioners as of March 2004. The pension scheme for defense employees is a
defined benefit scheme that pays a pension as per a particular formula. The pensions are
paid out of the Consolidated Fund of India. The defense services have one of the highest
expenditure on pensions among the various departments in the Central Government.
They have been kept out of the purview of the new pension scheme for the time being.
However civil employees within the defense services will be a part of the NPS as the
civilian employees were paid pensions under the Central Civil Service Rules, 1972.

Legislation

The pension benefits in defense are determined as per the provisions of the following
rules

1. Pension Regulations for the Army, 1961 (Parts I and II);

2. Pension Regulations for the Air Force, 1961 (Parts I and II);

3. Navy (Pension) Regulations, 1964; and

4. Entitlement Rules for Casualty Pension Awards to the Armed Forces Personnel,
1982.

Applicability

There are two categories of employees within the armed forces- commissioned officers
and persons below officer rank (PBOR). The pension eligibility rules differ for both these
categories. Typically, the criterion in determining the eligibility and quantum of pensions
is the number of years in service. In the case of armed forces an adjustment is done to the
number of years in service, due to the fact that personnel in the defense services are
31

subject to early retirement. This concept is called weightage. In the case of commissioned
officers of the army, navy and air force, the minimum period of qualifying service
(without weightage) required for earning retiring pension is 20 years (15 years in the case
of late entrants). In the case of PBOR it is 15 years (20 years in the case of Non-
Combatants Enrolled (NCsE)).

Operational framework
Pensioners Benefits

The pensioner’s benefits are a function of the mode of termination of service. This can
happen in four ways

1. Normal retirement. This is retiring out of the service at the retirement age.

2. Retirement on account of a disability that causes invalidation. The benefit here


depends on whether the person is retained in service after the disability or not.
There are three cases of disability

1. Disability on account of service conditions.

2. Disability outside the purview of service conditions

3. Disability due to war or warlike situations

3. Death in service. There are three cases here

1. Death on account of service conditions

2. Death outside the purview of service conditions

3. Death due to war or warlike situations

Normal retirement pension

This is calculated at 50% of the average emoluments drawn during the last ten months. In
the case of Personnel Below Officers Rank (PBOR), it is calculated at 50% of the
maximum pay scale of the pay for the rank and group, held for 10 months preceding
32

retirement. Retiring pension cannot be less than Rs.1275/- per month or more than 50%
of the highest pay. In the case of past pensioners, with effect from January 1, 1996,
pension should not be less than 50% of the minimum pay in the revised scale of the pay
introduced w.e.f. January 1, 1996 for the rank, rank and group (in the case of PBOR) held
by the pensioner.

Disability benefits

Disability related to service: A person, who is released/retired from service, on account


of a disease/injury/wound attributable to or aggravated by military service gets disability
pension which consists of service element (retiring pension on the basis of period of his
service) and disability element (compensation for disablement depending upon the
magnitude of disability). The retiring pension in this case is applicable even if the service
period is less than the minimum service required for retiring pension.

Disability not related to service: In this case invalid pension is granted if the service
actually rendered is 10 years or more. If the service is less than 10 years, such service
personnel are paid Invalid Gratuity depending upon the length of service.

War injury pension: War Injury Pension is sanctioned to an individual, who sustains
injury/disability in war or war like operations such as terrorist attacks and are invalided
out of service. War Injury Pension consists of service element and war injury element.
Service element is calculated equal to retiring/service pension to which he/she would
have been entitled on the basis of his/her pay on the date of becoming invalid but
counting service up to the date on which he/she would have retired in that rank in normal
course including weightage as admissible. War Injury Element is payable equal to
reckonable emoluments last drawn for 100% disablement. However, in no case, the
aggregate of service element and war injury element will exceed last pay drawn.

Benefits if the person is retained despite disability: If an individual is found to have a


disability which is assessed at 20% or more for life but is retained in service despite such
disability, he/she is paid a compensation in lump sum (in lieu of disability element) equal
to the capitalized value of disability element on the basis of disability actually assessed.
33

Once compensation has been paid in lieu of the disability element, there is no further
entitlement to the disability element for the same disability.

Pensioners benefits on account of death

Death outside the purview of service conditions: Families of Armed Forces Personnel
who die during service or after retirement with pension, are granted family pension at a
uniform rate of 30% of the relevant value of the emoluments. The amount of minimum
family pension is Rs.1275, If the deceased personnel had rendered 7 years or more
service, the family is given family pension at enhanced rate (50%) for the first 7 years or
up to the time the deceased would have reached the age of 67 years, whichever is earlier.

Death on account of service conditions: If the death of a service personnel has occurred
on account of causes attributable to or aggravated by Service the family is paid “Special
Family Pension”. There is no condition of minimum service on the date of death for grant
of Special Family Pension. With effect from January 1, 1996, Special Family Pension is
calculated at the uniform rate of 60% of reckonable emoluments drawn by the deceased,
subject to a minimum of Rs.2,550/-p.m. There is no maximum ceiling on Special Family
Pension.

Death due to war or war-like situation: In the event of death of Armed Forces Personnel
in war or war like operations, counter insurgency operations or in an encounter with or in
an incident involving armed hostilities, terrorists/extremists, anti-social elements etc. ,
their families are granted liberalized family pension equal to the reckonable emoluments
last drawn by the deceased personnel at the time of their death.

Railways Pensions: The Indian Railways is a commercial department under the Central
Government i.e. a department that functions on its own revenues. The Railways employ a
total of 1381584 permanent employees and have a wage bill of Rs.14135.19 cr. The
railways run their own pension scheme for their employees. In recent years, railways
have been increasingly feeling the burden of pension payments which have been rising
continuously. For example, the railways had 1191564 pensioners as of 2003-03 and a
34

total of 51641 people retired in the same year. Realizing the burden of pensions, the
railways too were brought under the pension reform which commenced from January 1,
2004. New entrants to the railways are now a part of the new pension system. The
employees are covered by two kinds of benefits:

• State railway provident fund. The Government does not contribute to provident
fund for new employees

• Railway pension.

State railway provident fund

The state railway provident fund (SRPF) is a defined contribution scheme that pays a
lump sum on retirement. It is governed by the State Railway Provident Fund Rules. The
scheme initially involved contributions from the employees as well as the employers.
However, after 1957, all new employees were a part of the pension scheme. Such
employees are called pensionable employees. Those who had joined prior to 1957 and
chose not to be a part of the pension scheme are called non-pensionable employees. The
employer ceased to contribute towards the provident fund, for the pensionable
employees. The employee however is still required to contribute towards the provident
fund.

Applicability

All railway servants except those who are re-employed after final retirement from
railway service are required to subscribe to the provident fund after completing one year
of service or after obtaining confirmation of service, whichever is earlier. A probationer
to railway services Group A and B have to subscribe from the date of appointment. In
case of a person who has been transferred from the Central Government or State
Government or a body corporate which is owned or controlled by the Government or an
autonomous organization, his previous provident fund accumulations (if any) shall be
35

transferred to the Railway Provident Fund and he shall subscribe to the fund from the
date of joining the railway service. A temporary railway servant who is borne on
establishment or factory to which provisions of EPF&MP Act 1952 (19 of 1952) apply is
eligible to subscribe to the SRPF if he has completed 6 months or less in such an
establishment. Re-employed persons are also allowed to subscribe on re-employment.

Contributions

The amount of subscription payable for any month is 1/12th of monthly emoluments in
the case of pensionable employees and 10% of the emoluments in the case of non
pensionable employees. In addition to compulsory subscription, the employees may
contribute voluntarily to SRPF at any time during the financial year. The rate of
contribution should not exceed 100% of the basic pay of the employee.

The employer i.e. the Railways makes a contribution at the end of each half year i.e. on
31st March and 30th September (This subscription is valid only for the non-pensionable
employee). The employer also makes a special contribution towards the non-pensionable
employees' accounts. The rate of contribution depends on the number of years of service.

• More than 15 years of service. In this case the contribution is calculated as one
fourth of a month's pay for each completed six monthly period of service but not
exceeding 16½ months pay or Rs.100,000 whichever is less.

• Less than 15 years of service. In this case the contribution is calculated at one
fourth of a month's pay for each completed six months period of service but not
exceeding six months pay. In the case of Group C & D staff, the controlling
officer may, in certain special circumstances, allow contribution of half a month's
pay for each completed six months period of service subject to a maximum of six
months' pay.

Interest rate

The interest credited on members' balances is determined by the government from time
to time. However no interest is paid on the special contributions to the fund.
36

Railways pension

The railways pension scheme was introduced on 16.11.1957 effective from 1.4.1957 vide
Railway Boards letter No. F(E)50/RTI/6 dated 16.11.1957. All railway employees who
entered service on and after 16.11.1957 are governed by the said pension scheme. This is
essentially a defined benefit scheme funded by the railways out of their own revenues.
These are recorded under operating expenses in the railway financial statement.

Applicability

At the time of introduction of the pension scheme, the option to join the scheme was also
given to all those non-pensionable railway servants who were in service on 01.04.1957 or
had joined railway service between 01.04.1957 and 16.11.1957. This option was open till
30.09.1959.

As a result of various improvements in the service conditions and implementation of the


Pay Commission's recommendations etc. fresh options were again allowed to the staff to
join the pension scheme as these improvements had bearing on the pensioner’s benefits.
In all,12 such options were allowed.

As per the last pension option order issued under Boards letter No. PC-IV/87/ Imp/ PN1
dated 08.05.1987 (RBE 115/1987), PF beneficiaries who were in service on 1.1.1986 and
those who continued to be in service on the date of issue of the said order were, however,
automatically deemed to have come over to the Pension scheme unless they specifically
opted to continue under the provident fund scheme. The last date for such option was
30.9.1987.

All pension option orders issued from time to time were made applicable retrospectively
from the specified dates as mentioned in each order. The staffs that had retired in the
intervening period but were otherwise eligible to opt for the pension scheme were,
therefore, also given the option to join the pension scheme by refunding the payment of
settlement dues that they had received under the provident fund scheme. Similarly, the
37

families of the deceased employees who were eligible for these options were also
allowed the option to join the pension scheme by refunding the payments they had
received under the provident fund scheme.

Benefits

1. Pension: Pension becomes admissible to a railway employee (temporary or


permanent), with not less than 10 years of qualifying service on his quitting
services on account of either abolition of post or medical invalidation or
retirement on completion of 30 years qualifying service or superannuation. The
amount of pension is calculated at 50% of average emoluments in all cases and is
subject to a minimum of Rs.1,275 p.m. and maximum up to 50% of the highest
pay in the Government i.e., Rs.30,000

2. Retirement Gratuity: It is payable to a railway servant on his retirement if he


has completed five years of qualifying service. The gratuity is paid at the scale of
one fourth of the emoluments for each completed six months period of qualifying
service. This is subject to a maximum of 33/2 times the emoluments, provided
that the amount of retirement gratuity payable shall in no case exceed Rs.1 lakh.

3. Death Gratuity: It is payable to the family of a railway servant in the event of his
death in harness. The amount of gratuity is defined as per the salary scales. For
those quitting with less than 10 years qualifying service, gratuity at a uniform rate
of half month's emoluments for every completed six-month period of service is
paid.

4. Pension for temporary employees. Temporary employees who retire on


superannuation or on being declared permanently incapacitated for further
railway service by the appropriate medical authority after having rendered not
less than 10 years of service are eligible for grant of superannuation or invalid
pension as the case may be. Retirement gratuity and family pension in accordance
with the rules is also provided to them.
38

5. Family pension: Family pension is admissible to the widow/widower of the


deceased railway employee at the rates specified from time to time. If the
employee is not survived by his widow, his children receive the pension. Family
pension benefits are available to the family of an employees in the following
cases:

1. If the employee dies while in service, provided they have rendered at least
one year of service.

2. If the employee dies before rendering one year of service, provided the
employee was examined and declared medically fit at the time of joining
the service.

3. If an employee had retired and was receiving pension or compassionate


allowance at the time of death.

2.5State Government Pensions

Pension rules in states typically vary from state to state. Each state has its own set of
rules, barring a few like Himachal Pradesh and Tripura, which follow the Central Civil
Service Pension Rules, 1972. The pension scheme of most states is a defined benefit
scheme paid out of the State Government revenues. The State Governments have been
increasingly unable to keep up with pension payments. For example, the pension
payments of all states put together were 17.1% of their own revenue receipts as of 2001-
02. This number is only likely to increase in the future. Keeping the increasing liability in
mind, many State Governments have initiated reform of their pension systems. Till now,
sixteen Indian states have issued orders to join the new pension system for the new
entrants to the State Government services. The old schemes continue for the existing
employees.
39

Applicability

Pension schemes typically cover all the State Government employees. There is however,
a slight difference in the way employees of grant in aid institutions, local bodies and
panchayats are covered under State pensions. There is also considerable variation in the
way employees of State Electricity Boards (SEBs) and State Road Transport
Corporations (SRTCs) are covered. In most cases the pension burden of employees of
these organizations is borne by the State Governments. There are, however, a few states
where the burden is also met by the concerned institutions themselves.

Calculation of pension

The basic pension amount is calculated with reference to average basic pay drawn by the
State Government employee during the last 10 months of service. However, in a few
states like Orissa, the basic pension is computed on the basis of the last pay drawn by the
employee. The full pension amount is 50% of the average pay, payable to employees
who have completed 33 years of qualifying service. For those employees who have not
completed 33 years of service, the basic pension is calculated on a proportionate basis. In
most of the states, there is a provision for adding 5 years to the total qualifying service
while working out the basic pension pay in the case of employees seeking early
retirement, provided they are left with 5 years of service. However, the total number of
years shall not exceed 33 years for the purpose of calculation of pension. The minimum
eligibility period for receipt of pension on retirement, other than voluntary retirement, is
10 years of service. In case of voluntary retirement, minimum service period is 20 years.
The minimum pension/family pension payable is Rs.1275 p.m. The maximum limit on
pension is Rs.12250 per month and on family pension it is restricted to Rs.7350 per
month. There are, however, instances of minor variations. For example, in Tripura, the
minimum pension is Rs.1300 per month, while the maximum pension is Rs.11200 per
month. States normally follow full wage indexation for the pensioners. The exception is
Kerala, where the government has not adopted full wage indexation.
40

Commutation of pension

A pensioner has the option to take away a portion of his/her pension, not exceeding 40
per cent of basic pension, as a lump sum payment. Some State Governments, however,
limit the commutation amount to one-third of the basic pension. The lump sum amount
payable is calculated with reference to the commutation table constructed on an actuarial
basis. The monthly pension is reduced by the portion commuted and the commuted
portion is restored on the expiry of 15 years from the date of receipt of the commuted
value of pension. In Orissa, restoration of the commuted portion is allowed after 12
years. In Rajasthan and Assam, restoration of the commuted portion is allowed after 14
years. Dearness relief on pension, however, continues to be calculated on the basis of the
original pension, i.e. without reduction of commuted portion.

Gratuity

There are three types of gratuity available to State Government employees:

1. Retirement gratuity: A minimum of 5 years qualifying service and eligibility to


receive service gratuity/pension is essential to get this one time lump sum benefit.
Retirement gratuity is calculated at the rate of one fourth of the last basic pay for
each completed six monthly period of qualifying service.

2. Death gratuity: This is one time lump sum benefit payable to the nominee of the
deceased employee.

3. Service gratuity: An employee is entitled to receive gratuity (and not pension), if


total-qualifying services is less than 10 years. Admissible amount is half-month
basic pay for each completed six monthly period of qualifying service. There is
no maximum or minimum monetary limit on the quantum. This one time lump
sum payment is paid over and above the retirement gratuity. |
41

Non-pensioners benefit

On retirement, the State Government employees are entitled to certain additional non-
pensioners benefits such as leave encashment, government employees insurance
schemes, etc. It is mandatory for the government servant to contribute a certain (6 per
cent) portion of his/ her emoluments towards the General Provident Fund.

2.6Bank pension

Pension in RBI

The pension scheme in RBI was introduced before it was introduced in the public sector
banks. The scheme came into force on 1st November, 1990. It is primarily a defined
benefit scheme that pays pension at a replacement rate of 50%.

Applicability

The pension scheme in RBI covers three classes of employees:

• Employees who were recruited or who joined the bank on or after 1.11.1990.

• Employees who were on the rolls on 1.11.1990 and who had opted for the pension scheme.

• Employees who retired from the bank after 1.1.1986.

The employees who retired between 1.1.1986 and 1.11.1990 were allowed to join the
scheme provided they returned the Bank's contribution to provident fund and interest
accrued on it along with a simple interest at the rate of 6%. The interest was payable for
the period between the date of retirement and the date of repayment. These employees
started receiving pension from 1.11.1990. The employees were allowed to commute their
pension after due medical examination.
42

Operational framework
Benefits

There are several classes of pensions and the pension an employee receives depends on
the manner in which he retires.

The full rate of pension for the retirees of the Reserve Bank is fifty percent of the average
emoluments subject to a minimum of Rs.375/- per month in the case of a full time
employee. In case of a part time employee the minimum pension is a proportionate
amount which depends on the rate of wages applicable. An employee who has put in 33
years of qualifying service is eligible to receive full pension. In case of members with
less than 33 years of qualifying service, the pension is a proportionate depending on
qualifying service.

The scheme also provides for a family pension after the death of the member. The
ordinary rate of family pension is calculated as:

Family pension

Pay Range Rate of Family Pension per month

Up to Rs.1500 30% of pay, subject to a minimum of Rs.375

Rs.1500 to Rs.3000 20% of pay, subject to a minimum of Rs.450

15% of pay, subject to a minimum of Rs. 600 p.m. and maximum


Above Rs.3000
of Rs.1250

Public Sector Bank Pensions

For a long time banks in India were covered only by the Contributory Provident Fund
and Gratuity. A defined benefit pension scheme existed only in the State Bank Of India.
The fact that some employees received pension benefits (for example employees in the
State Bank of India) and the rest of the employees could never avail this facility became
a major topic of concern. There ensued a series of negotiations and settlements between
the Indian Banks Association and the Workmen’s' Union (which comprised mainly of All
43

India Bank Employees Association), which resulted in the introduction of a pension


scheme for all banks.

Eligibility

Pension scheme in public sector banks cover both full time employees and part time
employees. (Part time employees are those who work for thirteen hours or more per week
and have served for at least ten years). The following classes of employees are covered.

• Employees joining the bank on or after 1st November, 1993.

• Employees serving in the banks as on 31st October, 1993. These employees had the option of
joining the scheme. In case an employee decided to do so, he had to transfer the bank's total
contributions to the provident fund and the interest accrued thereon, to the pension fund.

• Employees retiring between 1st January, 1986 and 1st November, 1993. These employees could
join the pension scheme by paying back the bank's total contributions to the provident fund and
the interest accrued thereon, along with a simple interest of 6% per annum.

Operational Framework
Contributions

Old age income security in banks consists of a contributory provident fund and a defined
benefit pension scheme. In case of the contributory provident fund, the bank contributes
the same amount as the employee does towards the provident fund. This is 10% of the
employee's pay. Pay includes the basic pay including stagnation increments, if any and
all allowances counted for the purpose of making contributions to the provident fund and
for the dearness allowance.

If an employee opted for the pension scheme, the ten percent contribution of the bank
which was earlier made to his provident fund was transferred to the pension fund. This
applied to all employees working in the banks in 1993 and was compulsory for all new
employees recruited after 1993.
44

Benefits

There are two kinds of pension benefits- pension available to the employees and family
pension for family members after the death of the employee. An employee needs to fulfill
certain conditions to be eligible to receive pension. The formula for calculating pension
is (half of the average emoluments X number of years of qualifying service)/33. The
minimum amount of pension received is Rs.375 per month in case of a member who
retired before 1st November, 1993.and Rs.720 per month for those retiring after 1st
November, 1993.

A dearness relief is granted over and above the basic pension to allow for inflation.
Dearness relief is granted on member's pension or family pension or invalid pension or
on compassionate allowance. It is allowed on full basic pension even after commutation
(withdrawal of one third of money from the basic pension).

Commutation of pension

The scheme allows a member to take a fraction of monthly pension as a lump-sum after
retirement. This is known as commutation of pension. The maximum amount a member
can take as a lump sum is 1/3rd of the basic pension admissible to him. A pensioner who
has commuted a part of pension, shall receive only the balance of the pension on monthly
basis. However the full value of the pension is restored after a period of 15 years from
the date of commutation. The commutation is admissible in respect of superannuation
pension, voluntary retirement pension, premature retirement pension, invalid pension and
compassionate allowance. If a pensioner dies after the commutation has become payable,
without receiving the commuted value, it will be paid to his/her nominees.

The maximum amount that can be taken as a lump sum is equal to basic pension X 1/3 X
12 X factor as per commutation Table. The factor in the commutation table that is
applicable depends on the age of the member on the next birthday.

Commutation after one year from the date of retirement can only be sought after medical
examination. If the application for commutation is made within one year after the date of
45

retirement, no medical examination is required in cases of superannuation pension,


premature retirement pension and pension on voluntary retirement. If application is made
after one year of retirement, then it becomes essential to undergo medical examination.
However in case of those who are granted invalid pension or compassionate allowance, a
medical examination is essential even if one applies for commutation within one year of
retirement.

Forfeiture of pension

The cases of dismissal, termination or resignation by an employee from the service


would disentitle him from any pension benefit or payment. There could be exception
only under the condition where the Service regulations or Service Rules or Settlements
entitle such an employee to receive superannuation benefits.

An employee who is deemed to have retired voluntarily from the bank's service under the
provisions for voluntary cessation of employment contained in Bipartite Settlement dated
10th April, 1989, shall entail forfeiture of past service and would not qualify for pension.

Tax benefits

The pension that an employee receives after his retirement is subject to tax. However, the
commuted amount up to one third of the pension is tax free.

Investment

Every bank has provision for the payment of pension or family pension to the employees
or his family. In order to have such a provision, each bank constitutes its own fund,
known as the Bank (Employees) Pension Fund. To ensure proper management, this fund
is kept under a trust. This Trust has to be constituted within one hundred and twenty days
from the notified date. It is important to have sufficient amount in the fund so that the
trustees managing the Fund are able to meet the due payments and interests of the
pensioners and beneficiaries. The Bank here, plays a vital role in contributing to the
Fund. Each Fund (Trust) has books of accounts containing details of all the financial
46

transactions relating to the Fund. The Trust also prepares the financial statements which
specify the assets and liabilities. An account of the Financial statement is sent to the
Bank on a periodic basis. For investigating into the financial condition of the Fund an
actuarial valuation of the fund is carried out every financial year. All money contributed
to the Fund has to be deposited in a Post Office Savings Bank Account in India or in a
current account with any bank. The contributions are invested as per the notified
investment pattern. These investment guidelines are meant for and followed by not only
the pension scheme but also by the provident fund scheme. The investment pattern as
envisaged in the above categories is achieved by the end of a financial year (that is,31st
March of each year)30.

Administration

Every Fund is constituted in the form of a Trust. Every Bank is vested with the
responsibility of appointing the Trustees who shall comply with the directions of the
Bank for the proper administration and functioning of the Fund. One of the Trustees is
the Chairman of the Board Of Trustees and in case the Chairman of the Trust is absent
then the acting Chairman - another Trustee acting as an alternate Chairman takes the
responsibility for Fund management. The pension fund in State Bank Of India, is
administered by the Pension, Provident fund and Gratuity Department. The cost of the
management of pension fund is borne by the bank itself and not by the trustees.

Grievances

The pension is paid to the retiree on a monthly basis. There may crop up a situation
where the pension is not received in time. In such a case, the retiree can go to the senior
authorities of the bank to complain about such a delay. In the State Bank Of India, the
retiree(s) can go to the Trustees or Pension, Provident fund and Gratuity Department.

Transfer of job

There might arouse a situation where an employee resigns from a bank before rendering
or completing minimum number of years of service and joins another bank/service. In
such a case, the employee would not be entitled to receive any pension from the former
bank as this leads to the forfeiture of this service and hence pension. On the contrary, if
47

he leaves the bank after completing the minimum years of service required for receiving
pension and joins another bank or service, he would be entitled to receive the pension
benefits from the former bank. In situation where an employee joins any other bank or
service then, based on the number of years of service rendered in the bank / service he
joins, he would be entitled to the pension. The services rendered in the past or previous
bank is not taken into account unless there is a case of merger of the banks.

NABARD Pensions

The pension scheme in National Bank for Agriculture and Rural Development was
introduced in 1993. The scheme came into force on 1st November, 1993 under Section
60 (1 (j)) of the National Bank for Agriculture and Rural Development Act, 1981.

Eligibility

Three classes of employees are eligible to receive pension under the scheme;

• Employees joining the bank on or after 1st November, 1993

• Employees serving in banks as on 31st October, 1993.

• Employees who were in service as on 1st January 1986 and had retired before 1st
November, 1993.These employees could opt to join the pension scheme by
paying back the bank's contribution to PF along with the interest received from
the bank, together with a simple interest at the rate of 6% per annum. The interest
has to be paid for the period between the date of withdrawal of the provident fund
amount and the date of refund.
48

Operational framework
Benefits
Monthly pension

A member has to render a minimum of ten years of service in order to qualify for
monthly pension. The qualifying service of an employee commences the day he takes the
charge of his post on a permanent basis. Qualifying service of an employee also include
the following;

• The service on training or probation immediately prior to the appointment in the


bank.

• Broken period of service provided it is less than six months.

• The period on leave for which salary is payable.

• The period of suspension of an employee is counted as qualifying service


provided the suspension is proved unjustified.

The full rate of pension is payable to an employee who renders thirty three years of
qualifying service. If the number of years of service is less than thirty three years, then
pension payable is calculated in proportion to the number of years of qualifying service.

The rate of basic pension is fifty percent of monthly emoluments for a full time
employee. For a part time employee the rate of basic pension is in a certain proportion to
the rate of wages.

Family Pension

n the case of death of the employee, the survivor of the deceased is granted a family
pension. Family pension is granted to the dependents or survivors of an employee if he
dies after completion of one year of continuous service. If the employee dies before
completion of one year of continuous service, family pension benefits are paid to the
survivors provided that the deceased employee was declared fit by the bank immediately
prior to his appointment. Family pension is also payable to the dependents of an
49

employee who had retired and was receiving pension or a compassionate allowance on
the date of death.

The family pension is not payable to more than one member of the family at the same
time. In case the deceased employee is survived by a widow / widower, the family
pension would be granted to her / him failing which it is granted to the eligible child.

The eligible child would receive the family pension till the time he or she attains the age
of twenty five years or start earning or get married (in case of daughter) whichever is
earlier. If the child is a minor then the family pension would be received by his or her
legal guardian till the time he or she has attained majority. If the child is handicapped he
receives the family pension throughout his life provided that he is incapable of earning
his livelihood. Family pension is granted on the basis of age of the children.

Commutation
An employee can commute up to two-fifth of his pension. Commuted portion of the
pension is restored after a period of fifteen years from the date of commutation. If the
commutation is sought after one year of the retirement, it will be granted only after
medical examination by the National Bank's Medical Officer.

Forfeiture of pension

The cases of dismissal, termination or resignation by an employee from the service


would disentitle him from the past service and hence from any pension benefit or
payment.
50

2.7Mutual Fund Pension plans

There are primarily two pension plans that mutual funds in India offer:

• Templeton India pension plan.

• UTI retirement benefit plan.

Pension funds are typically hybrid schemes with an orientation towards debt schemes.
They generally maintain 60-40 debt-equity allocation. Investments in pension plans of
mutual funds are eligible to tax benefit under Section 88 of the Income Tax Act, 1961 up
to a total limit of Rs.70000 p.a.

2.8Insurance Firms Pension Plan

Insurance firms in India typically sell two types of pension plans:

• Unit linked pension plans

• Annuities

Unit linked pension plans

Unit linked pension plans are fund management products sold by the insurance firms.
These schemes typically provide the investor with a choice of funds for investment in
accordance with the policyholders' risk appetite.

Premiums

An individual needs to pay the premium to be eligible to avail the benefits of a Unit
linked pension plan. The premium is the amount that is paid regularly, throughout the
term of the policy or a single premium in the initial period of the policy. In case of
51

payment of a regular premium, the minimum amount is Rs.10,000 p.a. and in single
premium it is Rs.25,000.

Investments

The premiums are invested in the units of an investment fund. This is done according to
an individual's will and is based on the prevailing unit prices. There are different kinds of
Investment funds like, liquid funds, secure managed funds, defensive managed funds and
balanced funds. The illustrations of these funds are briefly represented in the table below:

Funds Area to be invested in Level of risk


Bank deposits and short term money
Liquid Fund Very low level
market instruments
Government Securities and bonds Low level of risk, though
Secure Managed
issued by companies unit price may vary
Defensive Managed High quality Indian equities Moderate level of risk.
High quality Indian equity and
Balanced Managed High Level of risk
government securities and bonds

The investment in the aforementioned areas is portable, that is, an individual can switch
his existing investments from one to another unit linked pension plan.

Benefits

The benefits available to the members are pension benefits and cash lump sum benefit.
The maximum limit for any cash lump sum is one third of the unitized fund value
standing to the credit of a member. The rest of the amount is used to provide an annuity.
These benefits are paid in cherub. In case of the death of the member, the beneficiary
receives unuitilized fund value plus cash lump sum of Rs.1000.
52

Tax benefits

The premiums offered under the plans are subject to tax benefit under Section 80ccc of
the Income Tax Act, 1961. At the time of vesting, the lump sum (1/3rd of accumulation)
is tax free, whereas the annuity is treated as income and taxed accordingly.

Charges

For every premium that is paid, a percentage from that is invested in buying units. This is
called Investment Content rate. There is also the charge for fund management which is
included in the unit price each day. Changes can be made to these charges only after
getting approval from the Insurance Regulatory and Development Authority. However,
the maximum limit on the fund management charge is 2% per annum.

Annuities

The annuity market in India is very small. Most insurance companies in India sell
deferred annuities. The only company to sell an immediate annuity is the Life Insurance
Corporation of India (LIC), the biggest public sector insurance company in India.
Typically, the following options are available to the customers of annuity products:

• Life annuity

• Joint life annuity

• Annuity for certain (5/10/15) years

• Annuity with return of capital on death.

At the time of vesting, only 1/3 of the accumulated balance can be withdrawn as a lump
sum, whereas 2/3rd of the balance has to be necessarily annuitized. All the insurance
companies offer a free market option. As per this option, at the time of vesting, the
customer can buy an immediate annuity from any service provider and is not bound to
the insurance company from where he bought the deferred policy.

The following table shows the policies sold by the Life Insurance Corporation:

Number of policies sold by the LIC (in lakh)


53

Year New business Business in force

1993 0.15 5.06

1994 0.09 4.65

1995 0.11 4.61

1996 0.11 4.58

1997 1.82 6.22

1998 0.66 6.71

1999 1.05 7.58

2000 2.23 9.59

2001 3.44 12.88

2002 7.76 20.63

2003 2.40 22.86


54

2.9Present Situation of Government Finances


An important point to note is that the government pension system in India is not a true
Pay-As-You-Go (PAYG) system, as conventionally defined. In a true PAYG system,
benefits to retirees are (at least partially) funded through contributions by existing
employees and/or payroll taxes on those working. Government employees in India do not
contribute to the fund of their basic pension benefits, which are met solely from
government’s current revenues, even for Railways and Telecom, which are commercial
enterprises.

Over 50 per cent of pension payments of central government pertain to Defence an


employee, which represents the single most important sub-category. Being commercial
departments, Railways and Telecom are required to establish their own dedicated
Pension Funds for meeting their respective liabilities.

To illustrate the magnitude of pension payments of Central Government, it would be


pertinent to mention that as at the end of March, 1998, the total number of Central
Government employees was 5.2 million while the number of pensioners was 3.54 million
thus giving us an overall dependency ratio of approximately 67%. Central Government
pension payments for the financial year 2000-01 (excluding Railways and Telecom) were
Rs.15375 crores (0.70% of GDP), compared to expenditure of Rs.66387 crores on
economic, general and social services. If the allocation for the Railways and Department
of Telecom were also taken into account, total budgeted pension liability of the GOI for
2000-01 would increase to Rs.21117 crores or 0.96% of GDP (See Figure 2 below). As
would be apparent, these pension outgoes are an enormous drain on Central Government
revenues and will only keep increasing over a period of time, as these are indexed not
only to inflation but also to revision of salary structure of serving employees. Increases
in longevity of the general population will further compound the problem in years to
come.
55

2.10Impact of Fifth Central Pay Commission (FCPC)


Generous recommendations of the FCPC have significantly contributed to the sharp rise
in pension payments. The increases were implemented retrospective from 1996-97, and
the effects became manifest from 1997-98 onwards. The FCPC recommendations
changed the pension structure of the civil service. It was a wide ranging restructuring,
much more radical than the recommendations of the Fourth CPC. The following were the
major changes:
a. Pension levels were linked to salaries of serving employees thus, in effect, ushering
in a ‘one-rank, one-pension’ regime.
b. These linkages were extended to all existing pensioners, irrespective of date of
retirement.
c. The basic pension amounts were given full indexation to inflation.
d. Commutable amounts were increased from the existing 33 percent to 40 percent.

As a result of these changes, the Central Government’s budgetary expenditure on


pensions for all the departments has increased from Rs. 11,375 crores in the FY 1997-98
to Rs. 21,117 crores (RE) in FY 2000-01, i.e., an increase of almost 86 percent over three
years. The arrears arising from implementation of the FCPC recommendations are still
being paid in FY 2000-01.

It would be instructive to note that the FCPC had assessed the financial implication of its
recommendations on pension and family pension to be of the order of Rs. 1,170 crores
per annum, which corresponds to an increase of Rs 3,510 crores over the three years FY
1997-98 to 2000-01. Pension outlays over this period actually increased from Rs 11,375
crores to Rs 21,117 crores (RE FY 2000-01). The increase in Dearness Relief over the
corresponding years has been of the order of only 22 percent. Factoring this increase on
the 1997-98 pension outlay level, the presumed actual payment of arrears is of the order
of Rs 7,239 crores. The point of this exercise, imprecise as the estimates may be, is to
highlight the sheer uncertainty about estimates, even by a body as august as the FCPC.
56

Post- FCPC recommendation implementation, if the income flows to a pensioner from


various sources such as General Provident Fund, Gratuity and pensions are combined
together, it is estimated that the Replacement Rate (ratio of pre-retirement income to post
retirement income) for Government employees may be close to or even over 100 percent,
a high figure even by international standards. It is estimated that the pensionary liability
of the GOI would rise to Rs.29, 891 crores (for all departments, including Telecom and
Railways) in the FY 2009-10 given an annual inflation rate of 6% and subject to the other
assumptions outlined above. At an inflation rate of 10% p.a. the liability would increase
to Rs.33,558 crores.

As evident from the projections for financial years 2000-01 to 2009- 10, this would go up
further primarily on account of:
a. Increased life expectancy
b. Indexation of pension to the wage of serving employees
c. Full neutralization of inflation linked to cost of living index.
d. Higher rate of retirement in the next 10 years because of a fifty-seven percent
increase in employment over the period 1957-71
e. Decrease in spread of salaries by successive Pay Commissions resulting in increase in
average pension
f. Increase in promotional avenues leading to increase in final salaries and hence in
pensions
g. Revision of pension of past pensioners in line with successive Pay Commission
recommendations.

Of all the factors enumerated above, the one factor that would possibly impact hardest on
future increases in the pensionary liability of the Union Government, and consequently
on the validity of these projections, would be the constitution of a fresh Pay Commission.
57

Finding and Analysis


58

3.1Need for Reform


The steadily worsening demographic and labor market trends provide the strongest
impetus for restructuring the pension system in India. Additional motivation for reform
comes from the fractured nature of the existing pension schemes, creating a sharp
dichotomy between public and private sector labor force. The precarious financial
position of public pension programs, against a background of rising generosity and
falling proportions of workers to pensioners, and inadequate benefit levels for private
sector workforce are among the major factors necessitating reform of the old age pension
system in India.
1. Population aging:
Improvement in life expectancy and decline in fertility rate are leading to a
significant change in the population age structure. The old age population (aged
60 years or more) has risen from about 19.8 million in 1951 to 56.7 million in
1991, resulting in an increase of the proportion of the elderly in the total
population from 5.5 to 6.9 percent. According to the World Bank (1994a)
estimates, the percentage of old people are expected to rise further to 10.3% by
2020. In absolute terms, the number of elderly citizens is anticipated to nearly
double between 1996 and 2016, from 62.3 million to 112.9 million. Given the
continuing trend of erosion of the informal support channels for the elderly, the
population aging underlines the need for appropriate formal mechanisms for old
age economic security.
2. Skewed coverage - focus on the organized sector:
Existing pension schemes in India predominantly cover the organized sector
workers, constituting about 10 percent of the aggregate workforce. Exclusion of
the majority of the workers engaged in the unorganized sector is therefore a
serious limitation of the current system. In the private organized sector, the
Employees’ Provident Fund (EPF), the largest retirement support scheme, covers
around 23.12 million workers. The other smaller provident fund schemes for
coalminers and tea plantation workers cover another 1.25 million workers. In the
public sector, there are 11.14 million covered employees working in central, state
and union territories. Together, the covered workforce is therefore only about
59

35.51 million representing just 9.54 percent of the aggregate labor force of 372
million as on March 1997. In contrast, the number of covered workers in the
unorganized sector is merely 2 million - less than 10 percent of the covered
organized sector workers and just 1 percent of the total unorganized sector
working population. The proportion of self-employed persons alone accounts for
56 percent of the aggregate labor force as on 1991. The near absence of statutory
benefit provisions for the unorganized sector workers thus poses a serious
challenge. The recent labor market trend suggests further shrinkage in coverage,
given the low growth in organized labor force while unorganized employment is
on the rise. The absence of a formal system for retirement income support for the
unorganized and informal workers has resulted in high incidence of elderly
participation in the labor force. As per the 1991 census, 39 percent of the people
aged 60 years or more continue to be in the labor force. Of the total working
population, about 5.26 percent are aged 60 or above. An overwhelming majority
of these elderly workers are either self-employed or engaged in casual work. The
elderly participation rate is significantly higher in the rural areas where the
incidence of poverty is greater compared to the urban areas.

3. Dichotomy in formal pension schemes - inequity within the organized


sector: Further fragmentation of the current pension system has occurred due to
the disparate benefit levels within the organized sector where public sector
employees are treated rather generously vis-à-vis the private organized workers.
A striking characteristic of the current system is the varying range and level of
benefits within the organized sector. Besides a self contributory provident fund, a
lavish defined-benefit pension rights offering superior protection against
longevity and inflation risks cover public workers. In contrast, pension benefits
for the private sector employees have been financed primarily through mandatory,
defined-contribution provident fund schemes. The accumulated balances are paid
in lump sum, and thus do not cover for inflation and longevity risks. The recent
enactment of the Employees’ Pension Scheme (EPS) in 1995, partially converting
60

the Employees’ Provident Fund Scheme (EPF) scheme, has however granted
pension rights to private workers. Interestingly, there are allegations that the new
pension scheme has increased the dichotomy between public and private workers.
In comparison to the public pension schemes, the EPS provides a significantly
lower level of replacement income due to a variety of factors like ceiling on
maximum pension, lack of indexation, etc.

4. Problems with provident funds:


The Indian provident fund system has many shortcomings - some of which are
inherent to the schemes while others have emerged due to poor plan
administration. According to Vittas and Skully (1991), in a provident fund
system, the income replacement, investment and inflation risks are borne by the
plan participants. According to the principles of social insurance, provident fund
is not an ideal substitute for pension. The ILO (1997) argues that provident funds
have serious limitations in alleviating old age poverty because it does not provide
protection against the whole length of the contingency. The experience of
provident fund schemes in India also suggests some practical limitations of a pure
provident fund arrangement. First, the inability to ensure that lump sum payments
are used to provide old age protection is a serious drawback of the current system.
Majority of the workers being low wage earners has little additional savings and
much of the lump sum amount is spent in meeting essential needs after
retirement. Second, the provision of liberal non-refundable withdrawal facility
from provident funds to meet various contingencies during the employment
period significantly reduces the quantum of benefit at retirement. For example,
the EPFO distributed average terminal accumulations of less than Rs. 25,000 per
member during 1997-98. In the same year, the EPFO allowed an average
premature withdrawal of Rs. 17,000 per member (OASIS, 2000). Low investment
yields from provident funds, due to conservative investment norms, further
complicate the problem.7 According to World Bank (1994a) estimates, the
average real rate of return from the EPF scheme was below 1 percent in the
1980s. The annual returns from EPF for more recent period are shown in Figure
61

2. The average annual real rate of return between 1985 and 1997 is only about
2.63 percent. These returns are too low to generate a sizeable terminal
accumulation of pension assets, and they further encourage premature withdrawal
of funds allowed under certain defined circumstances as mentioned earlier.

5. Rising financial burden of public pension schemes:


The rising number of retirees and the increasing generosity of the public pension
programs are rapidly jeopardizing their long-term financial sustainability. Pension
schemes of the central as well as various state governments are facing acute
financial crisis due to lavish benefit provisions. Figure 3 shows the trend in yearly
expenditure by central and state governments. Between 1995 and 1999, the
pension expenditure by the central government has increased at an annual rate of
18 percent. The annual growth rate in pension expenditure for different states has
varied between 22 and 34 percent in the corresponding period. Asher (2000)
observes that unless the current system is adjusted, the public pension schemes
will be financially unsustainable in the near future. The Railways Pension
Scheme can best illustrate the seriousness of the risk of the looming financial
insolvency awaiting the public pension programs. In absolute terms, there has
been a fourfold increase in the number of pensioners from 0.27 million in 1984 to
1.05 million in 1999-2000. As a result, pension payment by the Indian Railways
has increased 50-fold from Rs.1060 million in 1980-81 to Rs. 53120 million in
1999-2000. With deceleration in recruitment of fresh employees, the dependency
ratio i.e. the ratio of pensioners to workers for the railways has increased sharply
from 0.17 in 1980-81 to 0.66 in 1999-2000. As a result, the share of pensions in
the working expenses of the railways has risen from 4.65 percent in 1981 to 13.3
percent in 1998. If the current system remains unchanged, the pension
expenditure will put further pressure on railways accounts, given the likely
scenario of further rise in number of retirees in the future. The other public
pension programs too show similar experience of rapidly rising pension burden as
witnessed by the Indian Railways. The annual expenditure incurred by major
central government administered pension programs is reported in the combined
62

expenditure of central and state run pension programs is already significantly high
(about 1-1.5 percent of GDP) and accounts for almost a quarter of the fiscal
deficit. There are several reasons for such escalation in the pension bill. First,
with increase in longevity, retirees are living longer and collecting more benefits
than ever before. Second, generous wage settlement by Pay Commissions in
recent times with retrospective adjustment in benefits have further increased the
pension burden.9 Third, decline in fresh recruitment and increase in the number
of retirees is pushing up the system dependency ratios. For example, in case of
the defense pension scheme - the largest pension expenditure program, the
dependency ratio is already greater than unity (OASIS, 2000). Such high
dependency ratio, coupled with generous benefit provisions, is resulting in
closing the gap between aggregate wage payment and pension expenditure. If the
trend continues, yearly benefit disbursement by public pension programs may
soon surpass the annual wage bill.

6. Government control:
The current pension system is heavily regulated by government agencies. State
control and interference in administration and supervision has only hindered the
growth of the pension system. The government virtually controls all aspects of
major retirement saving schemes like participation criteria, benefit entitlements,
investment guidelines, etc. The conservative regulatory environment, leading to
lack of transparency and public accountability, characterizes the present system.
In recent years, there has been widespread recognition that the current regulations
are impeding the growth of the pension system. Many claim that greater
autonomy for the provident and pension funds, supported by an environment of
prudential regulations, are essential for pension reform in India.10 Such a
regulatory regime should enhance transparency and public accountability, enforce
internationally comparable accounting and disclosure standards and develop
superior record keeping facility. There is also a need to remove the monopoly
status of the Life Insurance Corporation (LIC) of India in the private pension
business. The total hegemony of the LIC in the annuity market has further
63

undermined the efficacy of the provident fund system. Upon retirement,


subscribers to the fund, face the problem of investing their accumulations due to
lack of suitable annuity products.11 Malhotra (1994) and more recently OASIS
(2000) therefore suggest liberalizing the private pension market to bring in
greater efficiency.

7. Problems with public assistance schemes:


Finally, lack of formal old age income support for the financially impoverished
classes, is another serious deficiency of the current system. For some time, the
social assistance programs, administered at the state level, has remained the main
apparatus for alleviating poverty among India’s elderly population. In recent
years, however, the central government has significantly increased its
involvement with these schemes. Still, the efficacy of these means-tested state
pension programs is highly doubtful because of low coverage and meager benefit
levels. The inefficiency in administration, as witnessed in a number of states, has
further hampered these programs. Wadhawan (1989) therefore observes that these
measures of support through public assistance schemes have been somewhat
restrictive, minimal or cosmetic in their impact and approach, circumscribed as
they are by a variety of limitations and constraints.

3.2Aims for the Pension Reform


In light of these circumstances, the central goal of the private pension system should be
to
Encourage or provide adequate and secure retirement income in a cost-efficient and
equitable manner. To meet this goal, pensions must achieve several intermediate
objectives.
First, they should increase households’ saving for retirement. The central motivation for
using the tax system to encourage pensions is the belief that without incentives, people
would save too little to provide themselves with adequate retirement income. Saving
64

incentives succeed in any meaningful sense only if they increase the saving of those who
would have saved too little in their absence.
Second, pensions should boost national saving—the sum of public and private saving.
National saving contributes to economic growth, and increased growth would make
Social Security and Medicare easier to finance. Pensions increase national saving,
however, only to the extent that the contributions represent saving that would not have
occurred anyway and only to the extent that the increase in private saving exceeds the
reduction in tax revenues resulting from the tax incentives.
Third, pensions should induce efficient handling of risk. Long-term financial
commitments, such as those represented by pensions, are inescapably risky. The recent
stock market collapse and corporate scandals underscore those risks. While people are
working and accumulating pensions, the risks include the possibility of unemployment,
slowed growth of wages, a decline in asset values, unanticipated inflation, and
disappointing yields.
Fourth, the increasing burdens on workers to support a growing retired population
suggest that pensions should not promote early retirement and, in fact, should encourage
continued work. Extended working lives are now feasible because of increasing
longevity and improved health.
Finally, the pension system must be sufficiently simple and otherwise attractive enough
to induce employers to offer pension plans and workers to participate in them. This is a
considerable task because of inherent conflicts in the design of pension policy.

3.3Recent trends in pension reform


The last decade has been a witness to sweeping reforms in the financial sector in India.
Coinciding with reforms in the other spheres of the financial system, there have also been
some reform initiatives in the pension sector. However, unlike comprehensive reforms
undertaken in banking, capital and currency markets or more recently in the insurance
sector, a significant degree of inconsistency and elements of ad-hock mark pension
reform during the past ten years. The low priority that is accorded to pension system is
65

perhaps intentional and reflects the sequencing of the overall financial sector reform
process. Such sequencing is however not surprising given the complex nature of pension
reform. The linkages of pension system with fiscal and tax policy, labor markets, health
and insurance sectors, and financial markets in general reflect the multi-dimensional
character of pension reform. The pension reform process can therefore be painstaking
and long drawn, with potential to jeopardize or slacken the pace of the overall reform
procedure. Hence, in recent times, the limited initiative to restructure the pension system
is marked by a lack of sustained commitment or application of prudence. With the
exception of partial conversion of some of the provident funds into pension schemes,
most of these reforms are practically minor adjustments of the current system.
Incidentally, such minor adjustments are most frequent in case of provident funds. From
time to time, provident funds have been subjected to changes in eligibility criteria,
contribution and benefit structures or revision in investment norms. By the early eighties,
there was a growing perception about the limitations of a pure provident fund
arrangement among the organized private sector workers. In 1986, labor bodies formally
approached the Central Board of Trustees (CBT) of the Employees’ Provident Fund
(EPF) scheme for partial conversion of the scheme in favor of a pension arrangement.
Following some further persuasion, the CBT appointed a committee with the mandate to
restructure the EPF scheme in 1990. While the committee was developing the framework
for a new pension scheme within the EPF, in a related development in November 1993,
the government introduced pension schemes for nationalized banks and insurance
employees. There has been a long-standing demand for pension benefits from labor
bodies representing these institutions. That the government acceded to the demand in
1993 is significant as it coincided with the banking sector reform - giving rise to some
speculation that the move was to appease the agitating employees. The two schemes,
known as the Bank Employees’ Pension Scheme (BEPS) and the Insurance Employees’
Pension Scheme (IEPS) were created by diverting the accumulated employers’
contribution to the provident funds. The schemes are financed by the employers’
contribution to the provident fund contribution, which is equivalent to 10 percent of the
basic wage. Separate pension trusts were created to administer pension schemes for each
institution. The benefit structure of these schemes replicated the existing pension
66

schemes for the government employees offering defined-benefit tension on


superannuation, death or disability. The main superannuation pension provides a
replacement income of 50 percent of the final earnings. The pension is indexed to
inflation. Participation is mandatory for the new workers but optional for the existing
workers. Meanwhile, the recommendations of the expert committee on EPF were out for
public scrutiny. In a stark contrast to the smooth transition of provident funds into
pension schemes for bank and insurance employees, the draft legislation for EPF stirred a
hornets’ nest among the workers. The controversy surrounding the draft bill soon
snowballed into an intense debate, both inside and outside the Parliament. Consequently,
the government made some concessions and the original draft legislation was amended.
Most of these labor bargains were aimed at retaining the provident fund nature of the
scheme like liberal withdrawal facilities, commutation provisions, Even then, it failed to
mollify every labor group. Finally, in August 1996, the Parliament, amidst some
opposition, approved the legislation creating the new pension scheme with retrospective
effect from November 1995. The new scheme, known as the Employees’ Pension
Scheme (EPS), is essentially a defined-benefit program providing earnings related
pension on superannuation, disability or death. Thus, EPF members are now eligible for
two benefit streams on superannuation – a lump sum EPF accumulation upon retirement
and a monthly pension from the EPS. The EPS program has replaced the erstwhile
Family Pension Scheme (FPS). The balance amount of about Rs. 90,000 million in the
FPS was transferred to the EPS as the initial corpus. It is financed by diverting 8.33
percent of employer’s monthly contribution from the EPF and government's contribution
of 1.17 percent of the worker’s monthly wages. However, participation to the EPS
program is voluntary for the existing workers as on 1995 but mandatory for the new
workers whose monthly pensionable earnings do not exceed Rs. 5000. The debate
surrounding the EPS however continued unabated with many trade unions filing
litigations against the scheme. Aggrieved workers alleged that the pension from the EPS
was substantially inferior compared to the public pension schemes and that the return
from the scheme was even lowering than the provident fund arrangement it replaced. The
ceiling on the benefit level and absence of indexation further depressed the return from
EPS. Chatterjee (1996), the principal actuary behind the EPS program, however observed
67

that index linking of pension is not feasible in case of EPS since there is a high level of
pooling of private employers. In 1997, in an effort to placate the workers, the
contribution rate for the EPF scheme was enhanced to 12/10 percent replacing the earlier
rates of 10/8.33 percent of monthly wages. The total contribution rate for EPF scheme
thus rose significantly and is estimated to be anywhere between 21.92 and 25.92 percent.
As already discussed, the EPF scheme is often criticized for inadequate rates of return.
Recognizing the need for increasing the yield from the EPF scheme, the investment
norms have been progressively liberalized in recent years, especially after 1993. Table 6
reports the periodic changes in the investment norms for the EPF. A distinct trend has
emerged which permits investments in debt instruments of public sector undertakings and
public financial institutions. This percentage has since then been progressively raised and
has reached 40 percent in 1997-98. In practice however, there has been very little
application of discretion and the bulk of the funds, between 80 and 92 percent, has been
invested in special deposits with the government, which has provided a yield of 12
percent since 1986. In recent times, however, the interest rates on provident funds have
attracted a fair deal of attention. Over the years, the annual interest rate on provident
funds has been progressively increased. The last revision, made in 1989-90, set the
interest rates for various provident funds at 12%. However, with a general drop in
interest rates in recent times, it was increasingly becoming difficult to maintain such a
high rate, thereby initiating some contemplation over reduction in the provident fund
interest rate. As a first step, the government reduced the interest rate on the Public
Provident Fund (PPF) scheme from 12 to 11 percent in January 2000. Soon, a similar cut
was affected in the interest credited to government employees on their General Provident
Fund Deposits (GPF), triggering speculation on a similar cut in the EPF interest rate. The
Central Board of Trustees (CBT) of the EPF, however, opposed such a cut and requested
the government to keep the interest rate unchanged. In April 2000, the government
slashed the interest on the Special Deposit Scheme (SDS) from 12 to 11 percent.
Considering,
that over 81 percent of the outstanding EPF holdings of Rs. 4,75,630 million (for
unexempted establishments) as on March 31, 2000 was invested in the SDS account, it
was expected that this would force the CBT to reduce the EPF interest rate
68

correspondingly. The CBT, however, decided to dip into the EPFO's reserves to maintain
an interest rate of 12 percent during 2000-01. The unfolding drama finally came to an
end in June 2000 when the Government reduced the interest rate on EPF deposits from
12 to 11 percent with effect from April 1, overruling the recommendation of the Central
Board of Trustees (CBT) of the EPFO. Meanwhile, the most sweeping reform took place
in the private pension market. Private pension business is a part of insurance business in
India. After nationalization of the insurance sector in 1956, the Life Insurance
Corporation (LIC) of India became the only player. The monopoly of the LIC seriously
hampered the development and growth of the private annuity market. The Malhotra
Committee (1994), the expert group which studied the insurance sector, suggested
opening up of the insurance industry. Following the committee’s recommendations, the
government liberalized the insurance sector in the year 2000. As a result, private
corporations including foreign entities are now permitted to enter the private pension
market. The IRDA, the newly formed apex regulatory body overseeing the insurance
sector, has recently released investment norms for insurance firms intending to enter the
private pension market. All these reforms were centered on the EPF scheme. Although,
mounting pension expenditure was straining government finances, there was no effort to
control it due to political compulsions. Finally, in 1998-99, faced with an escalating
pension burden, the central government took the most politically favorable step of
increasing the retirement age from 58 to 60 for its employees. The attempt to contain
pension expenses has however failed due to upward revision of benefits awarded by the
Fifth Central Pay Commission. Recently, the Ministry of Finance has set up a working
group to examine pension reform options for the government employees. The expert
group is reviewing the extent of coverage and liabilities under the existing pension
schemes and is also examining the merits of switching over to a funded pension
arrangement [Asher (2000)]. Learning from the experience of these disjointed efforts to
reform the pension system, the government is increasingly realizing the need to
undertake a comprehensive reform policy. However, there is still a lack of cohesion and
coordination among different ministries which have stakes in social security for the aged,
and each one is formulating its own blue-print for pension reform. In August 1998, the
Ministry of Social Justice and Empowerment, commissioned a national project titled
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"OASIS" (an acronym for "Old Age Social and Income Security") by appointing an
expert committee. In its directive to the committee, the Ministry expressed concern
About the whole package of welfare to the elderly, the committee was given the task to
prepare a reform plan for the pension system with a special emphasis for the hitherto
uncovered unorganized sector. The committee submitted two reports, an interim one in
February 1999 and the final one in January 2000, outlining comprehensive reform
policies for the pension system. Central to the reform proposal was creation of a separate
regulatory body (Indian Pensions Authority) to control the pension system. The new
pension system should be fully funded, defined-contribution and based on portable
individual retirement accounts. The existing schemes like EPF and EPS should either be
merged or restructured in line with the new scheme. The most radical suggestions were
made in case of investment management, including appointment of professional fund
managers, permission to invest in equity stocks, subscriber’s right to choose portfolio
composition and freedom to select fund manager based on performance. Further, to
protect the retirees against unfavorable circumstances, the committee suggested offering
contribution protection insurance and relative returns guarantee. It was also suggested
that the retirees be given a real annuity, although the modalities of which were not
discussed in details. In a parallel initiative, the Ministry of Labor also set up a taskforce
to examine various social security schemes. The report of the committee (Wadhawan
Committee), submitted in May 2000, has called for replacement of the existing social
security schemes with a single integrated comprehensive scheme. The committee
recommended the unification of the Employees’ Provident Fund (EPFO), Employees’
State Insurance (ESIC) and the Employees’ Pension Scheme (EPS) under the
administration of a single agency.
70

3.4Proposed Reforms
To reform the pensions system, the government appointed the Bhattacharya and IRDA
committees to make suggestions for government employees and the non-governmental
sector respectively. They made the following recommendations.
Bhattacharya Committee Recommendation for Government Employees
1. An unfunded defined benefit, pay-as-you-go scheme (PAYG), or a pure defined
contribution scheme is not suitable for government employees; instead a hybrid defined
benefit/defined contribution scheme is recommended. This is a two-tier scheme. In the
first tier, there is a mandatory contribution of 10 per cent each by employer and
employee. The accumulated funds would be used to pay pension in annuity form. The
second tier is to promote personal savings and there is no limit for employee’s
contribution but employer’s contribution would be matching and limited to 5 per cent.
Accumulated funds can be withdrawn in lump sum or converted into annuity at the time
of retirement. These payments would be tax exempt and portable if an employee changes
job before retirement.

2. Funds collected in the first tier would be deposited in a separate fund and would be
invested in both debt and equity. Some funds can be earmarked for active fund
management including for short term trading for better returns. However, irrespective of
fund performance, government would remain liable for pension to its employees based
on predetermined benefit formula.

3. Contribution obtained in the second tier will have a separate institutional structure and
the employee would have a choice of funds (income, balanced, and growth) to invest in.
Employees may decide to continue, quit, or swap among funds while in service.
Government will not guarantee any specific rate of return.

4. The new schemes would be applicable to new employees only


71

IRDA Committee Recommendations for Non-Governmental Sector


The IRDA Committee’s recommendations for reforms in the non-governmental sector
are largely based on the OASIS report. The recommendations are as follows:
• Establish a system based on privately managed, individual funded defined-contribution
accounts. Lump sum payments and/or annuity on retirement would be actuarially
determined based on funds available.
• Privatize assets management functions of EPFO and exempt funds and allow private
insurance firms to provide annuities. Increase coverage by covering more firms and by
eliminating the present salary ceiling of Rs. 6500. Phase out the government subsidy of
1.16 per cent.
• For persons not covered by any scheme, allow a limited number of private asset
managers to operate, each offering three investment portfolio options. Participants would
have choice among fund managers selected through a competitive bidding process by
regulatory authorities.
• Employers’ and fund managers’ responsibility to participants would be that of
‘principal and agent’ and fiduciary in nature. Fund managers would work for a fee with
no performance guarantee. However, it is hoped that with expert managerial skill and
wider investment choice, participants would be better off than presently available
through publicly managed funds.

5
• Government would need to provide tax subsidy to encourage acceptance of privately
managed funds. The suggested tax measures are increasing entitlement of contributions
towards pension for tax rebate up to Rs. 80,000; and providing for tax exemption on the
income earned by pension funds, commuted value, and annuity amount received as
pension. Existing deduction under Section 80 CCC of Rs.10,000 should be withdrawn as
it only defers the tax, since annuities received from these funds are taxable.
72

• Government should allow facilitated access to the system through its postal and
banking network throughout the country to keep the administrative cost low.
• To supervise and regulate the system, an independent regulatory authority called the
Indian Pensions Authority should be set up.

3.5Major issues for reform

The preceding discussion highlights the limitations of the current structure of the pension
system and brings some critical issues pertaining to reform into focus. Growing
perception about the deficiencies of existing pension schemes has prompted the
government to initiate some reformatory steps in recent years. However, as described,
these reforms were mostly initiated in an ad-hoc manner and therefore met with limited
success. In some cases, like the Employees’ Pension Scheme, the reform has probably
caused further deprivation. The failure of these limited reform initiatives therefore
underlines the need for a lasting reform, adequately supported by a systematic approach.
The question is how to structure the reform and what are the critical issues that need to be
addressed. Three key issues emerge from the preceding discussion. First, the immediate
challenge for India is to design and implement a pension reform strategy capable of
restoring the long-run financial viability for public schemes. Equally important is to
provide better returns to private workers through relaxation of investment norms. And
finally, the exclusion of the vast majority of unorganized and informal workers under the
current system is a serious drawback. The escalating trend in the expenditure pattern of
the defined-benefit, non-contributory, pay as- you-go, and public pension programs needs
to be checked. Generous pension benefits together with health benefits provided to the
retirees are threatening the financial sustainability y of these schemes. Re-examination of
the contribution and benefit structures including switching to advanced-funding and/or
rationalization of benefits could ensure actuarial and fiscal sustainability of public
pension programs. Secondly, it is also evident that without reforms in investment policies
and performance of provident and pension funds, it will be difficult to provide adequate
replacement rate in a sustainable manner for the current and future retirees. Also, there is
73

a need to review policies concerning withdrawal of accumulated balances. Present


system of liberal non-returnable lump sum withdrawal often results in inadequate
provision during the old age. Thus, limiting withdrawal facilities and some form of
mandatory annuities needs to be given serious consideration. Outside the scope of the
current system, a larger issue of extension, of coverage to alleviate poverty among the
elderly remains to be addressed. The pertinent question here is that can we move towards
a universal publicly managed social security system covering all citizens attaining
seniority. The answer is probably no. There are several reasons. First, public pension
schemes are already under great financial pressure due to lavish benefit patterns. Second,
problems of persistent poverty, unemployment, low tax base and tax evasion imply that
ability and willingness to contribute in a collective system may have limited appeal.
Together, the argument suggests that the prospect of extending the publicly managed first
pillar of pension system is bleak. Hence, there is a need for a pragmatic approach to
expand pension coverage. Such approach essentially requires appropriate strategy to
strengthen the second and third pillars of the pension system. Indeed, coverage can be
spread through institution of mandatory individual account based and defined-
contribution pension schemes and/or voluntary retirement saving schemes to supplement
retirement income. The government alone is unlikely to deliver such income support
programs. Hence, there is a need to encourage the participation of private institutions.
The recent opening up of the private pension business suggests that India is moving in
that direction.
74

Recommendations
75

4.1Recommendations for Indian Pension System

Government Pension Liabilities: PAYG vs. Creating a Separate Fund


The government as employer in its wisdom decided to have a ‘pay as you go system’
(PAYG) rather than create a separate fund for its employees. The policy decision may not
be as disastrous as it has been made out to be. Since government regularly borrows a
large amount of funds from the market, the practice of first paying out to privately
managed pension funds and then borrowing them back from the very same agencies does
not seem to be cost effective. The present problem has arisen when government did not
exercise enough discipline in managing its own wage costs and associated pension costs.
As a populist measure, successive governments made the benefit formula more and more
generous which has resulted in considerable increase in pension payments. The problem
has nothing to do with accounting or financial system. Since government is finding it
politically impossible to reduce the promised pensions benefits and/or provide funds
from current revenues the Bhattacharya report has come up with a hybrid system for
new employees. For new employees, benefits would not be reduced considerably;
however, employees would be asked to contribute equally along with government to
build up a separate fund to be managed by expert fund managers under the supervision of
a board of trustees. Further, to enhance the returns, equity investment including short-
term trading would be permitted. However, government would remain liable for payment
of pension. New pension promises would also include social insurance like disability and
survivor’s benefits.

For a long-term perspective, a more stable and visional approach has to be taken. In
economies worldwide, generally post-retirement payments rest on the “three pillars”.
These three pillars are:
1. A mandatory, publicly managed, tax-financed pillar for social insurance
2. A mandatory, privately managed, fully funded pillar for old age savings
3. A voluntary pillar for those who want more protection in their old age
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The first pillar resembles public pension plans, providing a social security net for the old
and poor, particularly for those whose lifetime income was low or who cannot afford to
pay for building a reasonable retirement income. These are based on the principles of
social insurance and are wholly financed by the state either out of general tax revenue or
by some kind of special tax or cess. The United States, for example, levies a social
security tax on all working people to finance this pillar. This pillar is totally non-existent
in India and its need has been felt time and time again. The second pillar requires that
people save mandatorily for old age and benefits are actuarially linked to contributions. It
should preferably be privately managed, fully funded, and managed competitively. In
India, the limited saving avenues for this pillar are managed by the State with strict
control. The third pillar, voluntary savings and annuities, is meant to provide
supplemental retirement income for people who want more generous old age pensions.
The success of this pillar rests on a number of factors like awareness of need for saving
for future, financial prudence and awareness, saving induced tax and fiscal policies etc.
The World Bank suggests that the first pillar providing basic security needs must be
publicly managed, and only the second and third pillars are to be privately managed.

4.2Proposed Structure
After studying the various developments, both within and outside the country, following
recommendations are made for the structure post reform period. Since, the issue has to be
tackled both for public pension (whose burden is faced by the Government) as well as
private pension plans for private sector, hence recommendations are made for them
separately.

For Government employees:


An unfunded defined benefit, pay-as-you-go scheme (PAYG), or a pure defined
contribution scheme is not suitable for government employees; instead a hybrid defined
benefit/defined contribution scheme is recommended. This is a two-tier scheme. In the
first tier, there is a mandatory contribution of 10 per cent each by employer and
employee. The accumulated funds would be used to pay pension in annuity form. The
second tier is to promote personal savings and there is no limit for employee’s
77

contribution but employer’s contribution would be matching and limited to 5 per cent.
Accumulated funds can be withdrawn in lump sum or converted into annuity at the time
of retirement. These payments would be tax exempt and portable if an employee changes
job before retirement.
Funds collected in the first tier would be deposited in a separate fund and would be
invested in both debt and equity. Some funds can be earmarked for active fund
management including for short term trading for better returns. However, irrespective of
fund performance, government would remain liable for pension to its employees based
on predetermined benefit formula. Contribution obtained in the second tier will have a
separate institutional structure and the employee would have a choice of funds (income,
balanced, and growth) to invest in. Employees may decide to continue, quit, or swap
among funds while in service. Government will not guarantee any specific rate of return.
The new schemes would be applicable to new employees only

For Non-government employees


• Establish a system based on privately managed individual funded defined-
contribution accounts. Lump sum payments and/or annuity on retirement would be
actuarially determined based on funds available.
• Privatize assets management functions of EPFO and exempt funds and allow private
insurance firms to provide annuities. Increase coverage by covering more firms and
by eliminating the present salary ceiling of Rs. 6500.
• For persons not covered by any scheme, allow a limited number of private asset
managers to operate, each offering three investment portfolio options. Participants
would have choice among fund managers selected through a competitive bidding
process by regulatory authorities.
• Employers’ and fund managers’ responsibility to participants would be that of
‘principal and agent’ and fiduciary in nature. Fund managers would work for a fee
with no performance guarantee.
• Government would need to provide tax subsidy to encourage acceptance of privately
managed funds. The suggested tax measures are increasing entitlement of
contributions towards pension for tax rebate up to Rs. 80,000; and providing for tax
78

exemption on the income earned by pension funds, commuted value, and annuity
amount received as pension. Existing deduction under Section 80 CCC of Rs.10,000
should be withdrawn as it only defers the tax, since annuities received from these
funds are taxable.
• Government should allow facilitated access to the system through its postal and
banking network throughout the country to keep the administrative cost low.
• To supervise and regulate the system, an independent regulatory authority called the
Indian Pensions Authority should be set up.

Private participation
If individual accounts are adopted, should the reformed system move toward private and
decentralized collection of contribution, record keeping of individual accounts,
management of investments, and payment of annuities, or should these functions be
administered by a government agency (EPFO) and employer-managed exempt funds?
Related issues need to be considered are:

Economics of Accumulation- Intermediaries Spread and Other Costs: Intermediation


spread is the expense (explicit-implicit, direct-indirect) charged by intermediaries who
take responsibility to manage funds. The economic magnitude of the spread is found to
significantly reduce the net periodic returns made available to participants, particularly in
defined contribution pension funds. To reduce the financial intermediation spread and
related costs, the IRDA and OASIS reports have suggested that instead of open entry, the
government might auction off operating rights to a limited number of investment
companies and employees can choose among them. The contract could specify the
maximum risk, offer a reward for high returns, and choose the winners based on who
charges the lowest administrative fees.

Agency Risk: Principal-agent fiduciary relationship

Employers’ Costs to Administer Plan: If EPFO schemes were to be privatized, employers


would face far more formidable administrative problems if employees were free to select
79

among several mutual funds and insurance companies. Further, if employees would be
free to change plans periodically, a typical employer would have to remit small sums
regularly to a very lengthy and constantly changing list of financial institutions. In fact,
the whole process would be so cumbersome, costly, and difficult that honest mistakes
would proliferate and abuses would be inevitable. It would be difficult to monitor if
employers default on payment or hang on to payment for a few days to earn some
interest. Direct deposits by employers or employees would require substantial regulatory
and enforcement costs for the government to ensure that accounts are established and
maintained and funds are deposited in a timely manner. Further, most of the privately
managed funds require a minimum amount per deposit and balance in the account.
The regulatory agency will have to ensure that
a) The same charge in percentage terms irrespective of its size is applied for all accounts
b) All employees who wish to use a particular fund are accepted regardless of the size of
these accounts.

Functioning of employees provident fund organization (EPFO)


i) EPFO may be technically as efficient as the private sector in providing
administrative services to its members; however, this deficiency arises from delay
in technology up gradation of its offices and training of its officers and has
nothing to do with being publicly or privately managed.
ii) Even if it is true that EPFO is technically not efficient in providing administrative
services to its members, it is economically efficient. The contribution rate for
services EPFO provides is not very high. For new government employees, the
Bhattacharya report based on recent estimates has proposed a combined
contribution of 20 per cent of wages to provide the same level of benefits, which
is currently being provided by EPFO. High rates of contribution are partly the
result of forced savings for reasons that go beyond old age pension.
iii) EPFO provides employees what they are looking for: assured return with
disability and survivor’ benefits at a reasonable rate of contribution. EPFO may
not be earning as good a return as privately owned funds. However, since
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pensions are assured, funds are usually and understandably invested


conservatively.
iv) Some feel that the EPS 1995 scheme’s aggressive actuarial and benefit
assumptions make the scheme unviable. EPFO fund trustees believe that this is
not true. Annual actuarial valuations have certified the sustainability of the
scheme.
v) Is the private sector willing to provide the services currently offered by EPFO?
So far no package has been offered. Only vague promises with no underwritten
liability have been put forward. Would employees prefer private sector lofty
promises or government-backed guarantees for their pension benefits? Probably a
demand survey of employees is required before making major policy decisions
regarding privatization, which does not provide return guarantee. None of the two
reports has done any demand survey.

Role of State/Regulator
As with any type of financial institution, the regulation of pension funds originates with
the identification and assessment of risks. Although fund members are subject to a great
variety of risks, these risks can be grouped as follows:
(i) Portfolio Risk: It contains unsystematic of diversifiable risk and systematic of
market risk. Proper portfolio diversification eliminates the unsystematic risk,
leaving only the market. One of the main objectives of regulation is to ensure that
portfolios are well diversified, while also eliminating some very risky and illiquid
assets from the range of investment opportunities. Plan members are still subject
to the risk of fluctuations in the market, even after proper diversification. This
could be due to a variety of factors, such as normal fluctuations in asset prices,
episodes of bubbles and crashes, and unexpected jumps in inflation.
(ii) Agency Risk: It arises when the interest of fund administrators and asset managers
are not fully aligned with the interest of fund members. The complex portfolio
strategies associated with long-term investment horizons, the informational
asymmetries between fund managers and members, and the low levels of legal
81

and financial sophistication of many fund members create room for


incompetence, inefficiencies, and abuse. The types of agency risks depend in
good part on the legal and governance structure of pension funds, but all these
types of funds are exposed to agency risks.
(iii) Systemic Risks: It arises from the links between the pension industry and other
areas of financial system. Although pension funds have minimum liquidity
constraints relating to “run on the bank”, they may be affected by banking crises
that can result in a sharp collapse in asset prices, negatively affecting some
cohorts and leading to the insolvency of several banks. To the extent that fund
managers are subsidiaries of the banks, there is overall erosion of capital
protection in the pension industry.

It is possible to identify the main components of regulation found in most countries,


which generally include the following:
(i) Licensing Criteria: They are adopted in most every country, although conditions
for licensing can differ substantially across countries and institutional models.
(ii) Governance Rules: In occupational funds, the boards usually play a number of
important functions: setting broad investment strategies, delegating responsibility
of the management funds to a range of service providers, and monitoring
performance. Clear rules on board composition, voting rights, and duties and
responsibilities of board members can help improve fund governance and
minimize agency risks.
(iii) Asset Segregation Rules: It aims at separating the pool of fund asset from the
asset of the sponsor/management company in order to protect members’ balances
and vested rights and limit systemic and agency risks.
(iv) External custodian Rules: They are essential to limit agency risks. Under
adequate custodian arrangements, the administration of the fund and/or asset
managers never directly hold legal title to the assets of the pension fund, limiting
the opportunities for fraud and theft by requiring a separate party with defined
responsibilities to execute all transactions.
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(v) Disclosure Requirements: They involve a number of important rules, such as


asset variation rules, the frequency of asset valuation, and the distribution of
relevant information to fund members and the general public.
(vi) External Audits: Audits of Pension Funds accounts are required in every country,
although the scope and quality may vary substantially. In underdeveloped legal
and institutional environments, the external audits do not provide an independent
and objective assessment of the fund’s situation, and the legal responsibilities of
auditors are not clear/or enforceable. In other countries, external audits not only
provide an accurate and independent assessment but also constitute the most
important tool of supervision.
(vii) Investment Regulations: The regulations typically involve ceilings on holdings by
issuer, type of instrument, risk, concentration of ownership, and asset class. The
literature on pension fund regulation generally concludes that investment
restrictions may initially be justified in emerging countries introducing private
pension schemes, particularly those introducing a mandatory second pillar.
However, there is also a consensus on the need for the countries to relax the
restrictions over time in accordance with the development of institutions and
instruments and improvements in the depth and liquidity of securities markets and
overall legal framework.
(viii) Guarantees: The minimum return guarantees have been defined relative to the
average return of all pension funds, to a broader market benchmark, or to a
combination of both. They can also be expressed in nominal or real terms.
(ix) Capital/Reserve Requirements: The notion of capital does not have meanings in
funds constituted as trusts, foundations, and mutual, since these legal entities do
not have shareholders, although the liability assigned to the sponsors of these
arrangements often serves as proxy.
(x) Restriction of Fees: They are a common feature in Latin American and Eastern
European systems. Chile, for example, permits only certain categories of fees,
prohibiting exit charges, asset based management fees, and performance fees. In
contrast, commissions for selling agents and annuity conversions are held to a
prescribed level.
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Despite the importance of supervisory institutions and programs to the security of private
pension system, at present there is little literature on the various arrangements and
supervisory agencies. The methods in use are as follows:
1. Licensing of Funds: The range of methods for approval of funds to operate is one of
the more widely varied areas of supervision. In most Latin American and Central
European countries, with system based on a small number of open funds, licensing
constitutes one of the primary activities of the supervisory agencies. Prior to granting
of licenses, funds are required to provide extensive documentation regarding their
compliance with minimum capital levels, reserves, or other financial criteria.
2. Monitoring and Inspection: The core of most supervisory programs is the monitoring
of the activities of funds. This involves two main components: the review of reports
on the financial status of pension funds (off-site surveillance) and the conduct of on-
site reviews.
3. Problem Resolution: The application of sanctions for remedial and punitive purposes
is usually the most difficult part of any supervisory program. In countries employing
more proactive systems, there is a heavy emphasis on preemptively addressing
compliance issues, by providing supervisory agencies the authority to direct funds to
make changes in their operations.

A financial crisis can affect pension funds in two fundamental ways. First, the pension
funds may experience a major decline in the value of their portfolios. Second, they may
be subject to negative spill-over effects from other areas of the financial and real sectors.
The spillover effects are potentially more severe in cases where there is no clear asset
segregation, that is, where the pool of pension assets is not separated from the assets of
financial intermediaries and companies.

In addition, the regulator should prescribe certain standardized, broadly described types
of investments that would receive a measure of fiduciary safe harbor treatment, i.e.,
would be immune from certain challenges for imprudence and lack of diversification
under ERISA. In addition to stable value investments, these would include balanced,
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prudently diversified, low-cost funds with a range of permissible allocations representing


a mix of equities and bonds

Coping with Market Risk


The exposure of the average retiring worker to market risk depends in the first place on
the relative size of private pillars of retirement provisions, particularly the size of the
second pillar. Multipillar systems already contain an element of risk diversification, since
the implicit returns on the first pillar of contributions are weakly correlated with the
second pillar returns.
There are five possible ways to deal with market risk:
• Introducing DB Schemes: DB Schemes deal with market risk by introducing an
element of intergenerational risk pooling.
• Guarantees on Second-Pillar Benefits: A central guarantee fund, to which all funds
must contribute, backs both guarantees.
• Multiple Portfolios: the introduction of more portfolio choices to workers provides an
alternative mechanism to deal with market risk. The assumption underlying this
solution is that worker will make informed portfolio choices and will hold
progressively lower shares of equity as they approach retirement.
• Deferral of Annuities: It allows retiring workers to postpone the conversion of their
accumulated balance into an annuity, thus, preventing an unfavorable year to give
rise to lower annuities.
• Variable Annuities or Sequenced Purchase of Fixed Annuities: Variable annuities
could allow workers to diversify market risk to a significant extent. Workers retiring
in a bad year could experience a sharp recovery in real value of their pensions during
the retirement period, when markets would be expected to recover.
• Portfolio Diversification: Pension funds that are restricted to a narrow range of
investment may find themselves with excessive holdings of a few asset categories
and greater vulnerability to real and financial shocks
• Valuation and Auditing: Even Pension systems involving relatively few institution
and proactive supervision must ultimately depend on reliable valuation methods and
an efficient auditing function. This issue is potentially of even greater concern for
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countries envisaging hybrid systems, combining a larger number of employers based


and open funds.
• Regulation of Fees: there is a debate on whether regulation of level and/or the
structure of fees may have a significant impact on marketing activities and the
switching across funds. Reducing the intensity of marketing activities and the large
marketing costs may require a more fundamental change in the industry’s structure.
In a pension system, this could be accomplished through mixed or hybrid approaches,
incorporating voluntary private alternatives and facilitating the entry of occupational
schemes in second pillar as well.
• Building Supervision Capacity: Proactive supervision in banking has emerged as a
result of banking crisis and failures and attempts to identify and correct problems at
an early stage before they become too costly to solve.
• Independence of Regulators: When faced with a crisis in the financial sector,
policymakers have often brought pressure on bank regulators to engage in policies of
forbearance or to delay interventions. The result has often been to ultimately make
problems deeper or more costly when they finally are addressed. While this has
clearly been an issue with banking regulators for some time, it is also of concern for
the regulation of pension funds. Insulating the regulator from these pressures is of
paramount importance, and in many cases requires establishing an independent
institution with clear board responsibilities and terms independent of political cycle.

Management of Pension Reserves


The creation and management of reserves created for the purpose of well functioning of
pension funds is of crucial importance for making the structure a success. It has been
found that in poorly managed reserves, the value of reserve has shrunk to drastic extent.
This had resulted in considerable drain on the national resources as well as distortions in
the financial market within the economy. Hence, following issues are involved with
management of reserves:
1. Governance structure
Provident funds and social insurance agencies typically have boards that set
investment policy. These boards are almost always tripartite, with representatives
86

from labor unions, employers, and the government. While the board may determine
overall investment policy, an investment committee often holds responsibility for
more detailed decisions and monitoring as well as evaluating the investments of the
fund, trading, valuation, and so on. Further, the composition of boards reflects
domestic political circumstances.
2. Restrictions and Mandates
Typically, a set of rules explicitly limits the governing boards’ investment options.
Restrictions on investment choices and mandates to invest in certain projects
comprise the most common way that their discretion is curtailed. In India, the EPF
must make 90 percent of investments in government or government guaranteed debt,
leaving only 10 percent to invest in private corporate bonds with investment grade
rating. Economic o development objectives give rise to “economically- targeted
investments” or ETIs. Some proponents of this type of investment claim that
inefficiencies in the capital markets leave worthwhile projects without financing and
that there are externalities to some projects that can produce quantifiable benefits for
members. There are examples of ETIs involving pension funds in every region with
every income level. Infrastructure projects and state enterprises often benefit from
pension fund investment. The government can also use restrictions and mandates to
force pension funds to lend it money. Governments prefer to borrow from public
pension funds for at least three reasons:
(i) The flow of pension fund surplus is usually predictable, making it easier to
finance anticipated deficits in comparison to issuing bonds in the market
(ii) By forcing the pension funds to purchase non-tradable bonds with no
transparent market pricing mechanism, the government may be able to reduce
its borrowing costs
(iii) Fiscal accounting practices may reward this form of borrowing, since
purchase of government securities by a public pension fund reduces net
government debt.
3. Limited Domestic Investment Options
In addition to the constraints imposed by governments, underdeveloped capital
markets and shallow financial sectors can be major obstacles for pension funds
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managers, whether they are public or private. While allowing for investment abroad
would ease this constraint, it is often not an option because of exchange controls,
high transaction costs, perhaps most importantly, political pressure to keep scarce
investment funds at home. In countries where domestic capital markets do provide
potential investment outlets for large pension funds, three problems emerge:
(i) Ownership of a large proportion of the shares by the government would
effectively nationalize the industries involved. At least, it would raise
important questions about corporate governance.
(ii) The Government may be tempted to use the pension fund to support the stock
market or specific firms with political influence.
(iii) The Government may find itself in the awkward position of regulator and
owner of certain industries, creating other possible conflict of interest.

4. Investment Returns and Volatility


The rate of return perhaps represents the most important single indicator of how
public pension reserves are being managed. This measure provides an important
signal as to whether investment decisions allocate capital efficiently in the economy.
It also measures the extent to which pre funding is actually offsetting defined benefit
liabilities or generating retirement wealth in defined contribution accounts. The
causes for under performance of publicly managed schemes are government
interference in investment, ranging from the imposition of social or development
objectives on the pension fund to forcing pension funds to finance deficits or state
enterprise losses, often at interest rates lower than what is available on the market.
The common prohibition on investment abroad posed another major challenge to
public pension fund managers trying to diversify their specific risk.

Government Fiscal Policy


Tax treatment of pension is a critical policy choice. A generous tax treatment may
promote saving but may be costly in terms of revenue forgone. Apparently, an exercise in
balancing is necessary. This brings us to the question of what should be the rational tax
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policy, which would promote a healthy and widespread pension market for everybody in
the country. A few suggestions are offered below in this connection:
1. Allow Section 80 CCC benefits up to Rs. 20,000. Pension benefits should remain
taxable.
2. Abolish and/or alter Section 88. Restrict Section 88 to provide tax rebate to
induce/direct/channel savings in a desired sector like infrastructure. Remove the
rebate on all small savings schemes of short duration. It distorts the interest rate
structure and flows of funds in the economy and is the most inefficient way of raising
funds for government.
3. Create another section for accumulation of funds for old age (PPF equivalent). Allow
for each participant tax deductible contribution of 20 per cent (combined employer
and employee) of salary. These contributions would be sufficient to accumulate funds
for old age. Accumulated funds assuming 9 per cent interest after 30 years of service
would total Rs. 32.71 lakh. The commuted amount and/or annuity bought from this
amount should be tax-free.

These provisions would ensure that government liability on account of providing old age
security for its citizens would be rationally determined and appropriately distributed
among all income groups. High-end income groups would not corner major part of the
tax subsidy. Tax forgone is a form of indirect tax subsidy, which must be recognized in
framing tax policies. Retirement benefits available from accumulated funds under
sections 80 CCC and 88 would be more than what would be required for an average
citizen to lead a dignified life. However, people with high resources can build their own
third pillar by accumulating funds on their own private account, but government need not
provide any tax subsidy here. When the government cannot provide the first pillar for
want of resources, it should also not squander money (lose tax revenue) on building the
third pillar for a select few.
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Investment and asset allocation


As a component of managing of reserves, the investment priorities have to be distinctly
reviewed. The following discussion shows the comparison between investment returns
from government bonds and equity returns.

Investment using government bonds


The long {run historical rate of return on government bonds in India have been around
4% per annum (corresponding to a nominal interest rate of 12% and an inflation rate of
8%). It is likely that in the future, the real rate of return on government bonds will be
lower than has been observed in the past. Hence we additional analyze a scenario where
the real rate of return on government bonds proves to be 2% in real terms. If we assume
that an inflation indexed annuity for a person at age 60 pays around 7% per annum, then
this accumulation yields an inflation indexed annuity of between Rs.887 and Rs.1254 per
month.

Investment using equity index


The motivation for long term investment into equity is based on what financial
economists call \the equity premium", i.e. the higher returns which equities have to pay
(on average) in order to justify the volatility of stock prices. The difference between
long-run average rates of return on riskless investments and on equities is termed \the
equity premium". Empirically, it has been established that the equity premium exists in
every country of the world, and that the size of the premium itself varies from country to
country. Empirical estimates for the size of the equity premium are most robust from
countries where the stock market index has been recorded over longer time periods. In
the US, where the data quality is strong, the long-run real rate of return on equities has
proved to be 6% while government bonds are at 0.5%.

Equity exposure could be obtained using either active management or using passive
management. Active management adds value when fund managers are able to exploit
market inefficiencies adequately, and pay for transaction costs and management fees.
Active management subtracts value in the absence of such abilities. In addition, active
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management introduces risk in terms of the variability of performance of a manager or of


an AMC subject to manpower turnover. Active management introduces substantially
greater regulatory complexities, since regulators have to deal with a much greater range
of trading strategies adopted by active managers. In a country like India, where
regulation and enforcement is weak, this generates significant risks. In contrast, passive
management (index funds) reliably harnesses the equity premium. Index funds are not
vulnerable to the volatility of performance of active managers. Index funds are easier to
regulate. The long-run average rate of return on the stock market index in India, inclusive
of dividends, is 23.5% per annum. This is based on evidence over the twenty year period
from 1979 to 1999. If we assume that the riskless rate of return is around 12% (four
percent in real terms), this gives us an equity premium of 12 percent per year. In the
future, the equity premium could prove to be lower for a variety of reasons: enhanced
wealth in India leading to an enhanced supply of risk capital, the onset of capital account
convertibility, the fact that an episode like the reforms of the early 1990s is unlikely to be
repeated, etc. Hence, we show two scenarios: using an equity premium of 10 or 12
percentage points. In all cases, the volatility of the NSE-50 index is set to its long-run
historical average, i.e. 1.8 percent per day.

Investment strategy of 100% investment in government bonds:


Rate of return GOI bonds
Terminal Wealth 2% 4%
Rs. 152,000 Rs. 215,00
Source: OASIS Report

Investment strategy of 100% investment in a NSE-50 Index Fund:


Real rate of return in GOI bonds
Equity Premium 2% 4%
10% 507,254 737,654
20% 775,761 1,165,611
Source: OASIS Report
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Investment risk borne by participants


Equity investment involves investment risk. The variability of terminal wealth is also a
useful way of measuring the investment risk of being in equities. Investing in equities
exposes the individual to the returns on the stock market over the 35 years that he is
invested in equities. Each cohort which embarks on equity investment at age 25 faces a
different 35 years of returns on the equity market. Further, equity exposure can be phased
out as the retirement date approaches.

International diversification
One of the most effective tools for reducing the risk of equity investment is to diversify
internationally. This dramatically brings down volatility. Index funds give an excellent
Sharpe's ratio (reward to risk ratio) among funds, which invest in one country. When
investment barriers are dropped to allow for funds to be invested the world over, the
Sharpe's ratio can further increase (which is equivalent to either higher returns or lower
risk, both of which imply lower shortfall probabilities). The diversification across
countries allow for a much lower risk, while the expected rate of return taken as an
average across different countries only drops slightly

While international diversification sharply reduces risk, it also reduces the rates of return
accessible for unleveraged investments, since the equity premium internationally is lower
than that found in India (where risk capital is scarce). In addition, an environment with
capital account convertibility is also likely to go along with a reduced interest rate on
government bonds. Hence, the scenario that we assume is (a) a riskless rate of return of
2%, (b) an equity premium of 8%, and (c) a daily standard deviation of the world market
index of 0.8% (in contrast with the value of 1.8 for the NSE-50 index).
This gives the following results. The median value of the terminal wealth This is a highly
attractive set of outcomes, the main driver for which is the lower volatility of the world
stock market index when compared with the much less diversified NSE-50 index. The
median accumulation is lower (owing to the lower rates of return that are prevalent
internationally). Individuals who desired higher rates of return in such a world could do
so by leveraging using index futures.
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Median Inter-
Terminal Shortfall quartile
Strategies Wealth Probability Range

A: All Bonds (4%) 0.215 0 0


B: All equity (4%, 12%) 1.166 7.5 2.312
C: Phaseout after age 50 (4%, 12%) 0.785 7.8 1.307
D: Intl. Diversified equities (2%, 8%) 0.617 0.2 0.884

Investment Options and Prudential regulations for PFMs


Each Pension Fund Manager should offer at least 3 different types of investment
alternatives:
a) safe income b) balanced income and c) growing income styles.
Regulations need to be laid down to harness the rate of return of the asset class and
prevent malpractice and defrauding. In addition assurances also need to be made for
ensuring the safety of returns.

Investment Guidelines Safe Income Balanced Income Growth


Government Paper >50% >30% >25%
Corporate Bonds >30% >30% >25%
Domestic Equity <10% <30% <50%
Of which, International <10% <10%
Equity
Source: OASIS Report

An increase in the rate of interest by 1 percentage point over a lifetime of accumulations


increases the terminal wealth of a pension program by 20%. In India, the funds deposited
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into pension accounts are invested mostly in government securities and securities under
the special deposit scheme. The returns on these are highly limited.

Equity investment is risky but also yields greater return. Hence the strategy to reduce risk
and earn maximum return would be to:
1) Phase out equity exposure after age 50,
2) International diversification would greatly reduce risk and volatility. Expected rate of
return taken as an average varies only slightly across different countries

This however seems to be just a half-hearted attempt to the whole privatisation approach.
Undeniably, index funds have the following advantages:
1. If markets are fairly efficient then it is difficult for active fund managers to obtain
excess returns after considering extra fees and costs. Active fund management is a
method of trying to earn excess returns. In this process, active fund managers expend
resources on fund management and incur trading costs. Index funds lower
expenditure by avoiding information collection and processing.
2. There is great difficulty in monitoring the activities of an agent. If a layer of
intermediaries in the form of a pension committee is introduced then incentive
schemes need to be devised to make both the committee and the PFM to act in the
best interests of workers, which is a highly difficult task in itself.
3. In the case of quasi-nationalisation of pension accounts, when the bulk of the
investment is done in equities there may be a large political risk where the
government can use this control for meeting its political ends.
4. A naive comparison of returns across alternative funds is an inefficient way to
measure, fund manager ability especially when there are significant differences in the
levels of risk adopted by different funds.

However, the advantages of index funds do not necessarily mean that active fund
management is in any way disadvantageous. Index funds themselves impose certain
negative externalities:
1) Distorted cost of capital for index stocks
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2) Inferior corporate governance


3) Diminished market efficiency
4) Enhanced concentration in the fund industry

In India, market inefficiencies may still arise on account of:


1) Poor information access: inferior disclosure laws
2) Inferior human capital
3) Higher transaction costs

But this does not mean that the individuals should not be given a choice to try their hand
at active fund management. Even though the argument of increased transaction costs may
hold, active fund management in itself has a high educative value and one should not
discount the existence of certain enterprising individuals who would be able to use these
inefficiencies and earn a higher rate of return on their deposits.
Moreover, individuals themselves should be given a choice of whether they would like to
adopt passive or active fund management for their accretions along with the freedom to
choose their fund managers. However there could be an argument that the "moral hazard"
problem enters into the picture. That is, in case individuals are backed by too many
government-guarantees then they would be prompted to take more risks than they would
ordinarily have taken and hence would opt for the riskier strategy of Active fund
Management. But this problem can easily be avoided. The individuals who are ready to
take the chance with active fund management should be allowed to do so – at their own
risk.

To sum up, each of the investment strategies, be it active fund management, passive fund
management or investment in indexed equities abroad, each has its pros and cons in
terms of risks and return. Ultimately it is the individual who should be given the
opportunities to translate his preferences to reality. On the other hand, as far as PFMs are
concerned, efforts should be made to give up the closed approach and allow them
freedom to function within a broad regulatory framework.
95

Another approach to improving asset allocation is through diversified “life cycle” mutual
funds. Several companies worldwide offer such funds, which vary by the year of one’s
expected retirement. Each fund has a specific asset allocation that changes over time so
that an individual’s portfolio will automatically move away from equities and toward
bonds as the individual ages. These funds are already widely available and have proven
increasingly popular among investors.

Involving the unorganized sector


The absence of a unique social security number in India along with the high costs
associated with implementation make it impossible to have a mandatory pension scheme
for all. Specifically with regards to the unorganised sector, the PPF Scheme has clearly
failed in attaining its objective of inducing savings. Even the Life Insurance Corporation
(LIC) has neglected annuities and pension schemes, which have considerable potential
among the self-employed and only 100 million people are covered by provident fund or
pensions. LIC has no low premium policies like term or whole life insurance. Instead, it
concentrates on expensive endowment policies.

One of the biggest problems of most of the countries that have the experience of a private
social security system is the inherent failure of involving the unorganised sector. In the
case of workers in the organised sector, the employer contributes part of the contribution.
However, this is only implicit and it is the worker who actually bears the entire burden of
the contribution. In the light of this matter, it ought not to make a difference to the self-
employed. There may be many reasons behind the lack of participation from the self-
employed such as:
a. By participating in the private pension system, a self-employed worker would be
revealing information that he may want to keep private for income-tax reasons.
b. Wealthy self-employed workers would have other means of providing for their own
retirement including self-insurance and access to financial instruments that would
provide a better combination of risk and return.
c. It could be more profitable for them to rely on government guarantees. This is
another area where the ‘moral hazard’ problem could come into play and hence,
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schemes need to be devised to make it more profitable for the self-employed to enter
the formal pension system.

RBI view
In pursuance of the objective of multiple types of financial intermediaries providing
larger choice and competition, RBI would seek reductions in pre-emptions of banks
resources and level playing field among the intermediaries, and such a level playing field
would necessitate appropriate equitable tax treatment, as explained separately, and more
importantly appropriate equitable regulatory induced financial burden such as
differentiated reserve requirements. Thus, a comprehensive review of the regulatory
induced financial burdens, including on the savings schemes, may be needed as part of
medium term actions, that would clearly set apart pension funds and contractual savings
on the one hand and all other market based financial intermediation with level play on the
other. While contractual savings could have preferred-status in tax-treatment, all others
ought to have an assured level playing field.
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Conclusion
98

5.1Conclusion

Indian pension system is passing through a crisis of confidence. The economic,


demographic and labor market trends of the current system are moving in troublesome
directions. The problems that the system is confronting now are quite well known:
Demographic
 aging: The age structure of the population is changing drastically with
increasing life expectancy and declining birth rates. The result of such demographic
transition will be a larger proportion of older people.
Changing
 social mores: Collapse of joint family system coupled with pressures of
urbanization and migration are also leading to deterioration in traditional means of
support for the elderly.
Skewed
 coverage: Existing schemes predominantly cover the organized workers
leaving the bulk of the workforce with little access to any formal system of old age
income security. The coverage is further diminishing due to stronger growth in
unorganized employment.
Inequity
 in benefits: Within the organized labor force having access to some kind of
formal retirement income system, generous treatment of the public workers vis-à-vis the
private workers is resulting further fragmentation of the pension system.
Pressure
 on public finances: The spiraling expenditure pattern of the non-contributory,
unfunded public pension programs are putting increasing pressure on governments
Budgetary allocations. Unless this trend is arrested, these schemes will be financially
Unsustainable in near future.
Low
 returns from provident funds: Conservative investment norms for provident
funds,
ostensibly to safeguard the workers’ interest, have resulted in inadequate rates of return
from these schemes.
Under
 developed private annuity market: Lack of pension annuities and health
insurance cover further complicates the old age economic security. In recent years,
growing realization about these deficiencies has prompted the government to take
reformatory steps to overcome these problems. However, most of these reforms are
initiated in a piecemeal manner. The failure of such ad-hoc initiatives suggests that
99

there are no shortcuts to address these problems. The policy makers, therefore, need to
take a fresh view and develop new mechanisms to rejuvenate the pension system. A mix
of policies like austerity on benefit promises, reliance on greater funding, relaxation of
investment norms, encouraging private participation, enhancing system efficiency and
developing regulatory capacity could help avert the looming pension crisis and promote
better economic security for the aged. The benefit of such a pension regime is also likely
to foster aggregate rate of savings and accelerate capital market development.

To conclude, the performance of Employee Provident Fund Scheme as well as the


government Pension Policy does not go well with the overall financial performance of
the economy. It is highly recommended that new policy initiatives be adopted in this
regard as this matter is of crucial importance. For the Central, State and local
Governments, precarious position is held as far as pensionary outlay is concerned. Huge
deficits on account of such expenditure have brought funds for other developmental
projects to a standstill. Moreover, with the situation expected to worsen, it has put the
future of such provisions as passe.

As is evident from the discussion above, for the long-term perspective, three-pillar
approach needs to be looked into as a viable and welfare provision to take care of the
retirement of the people. As far as the second pillar of pension is concerned, to which this
project deals to, two pronged approach needs to be followed for Government and non-
government sector employees.

Other areas to be looked into while reforming the pension sector are summarized as
follows:
• Leverage the power of information technology and related emerging technology and
create a compelling and forceful compliance environment that is entirely information-
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driven. Improve the capacity to identify, collect and process information from third
party sources. These will include such sources as departments and agencies in
government, public sector and private sectors in relation to any economic transaction
that involves employment and workers.
• Create an environment whereby it is cheaper to comply and more expensive not to
report or under-report employees and contributions in a timely manner. Design and
put in place a separate collection programme that will address the issue of unpaid
arrears.
• Enhance the knowledge and skill levels of existing officers and staff to help them
adjust to and absorb changes in work methods. The objective in the creation of such a
system is to register geometric growth in the membership/corpus of the Employees'
Provident Fund’s improved customer/client services. Changes in the Act and Scheme
With the envisaged radical changes in the business processes as well as the design to
make the schemes more efficient, reduce costs and optimize yields, it was necessary
to bring the law in harmony with these changes.
• To address the high level of labor mobility resulting from the economic restructuring
programme, the proposals include a system of deductions at source in the nature of a
withholding tax from payments made to contractors appointed by public or private
sector employers.
• Appointment of an investment consultant: An investment consultant will be
appointed in the near future to ensure that the EPFO is able to get better returns on its
investments by utilizing best available investment avenues.
• Formulation of a road map for investment with radical changes in the investment
pattern: To identify emerging trends in the investment management of social security
funds. To establish a road map for the next ten to fifteen years in respect of
investment of social security funds by identifying national/international best practices
and also to establish a benchmark for investments of the EPFO. To establish
benchmarks for the investment pattern, investment management, investment
guidelines and investment processes after studying national/international best
practices.
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• Finally, in developing pension initiatives to meet global demographic challenges we


must consider activities to encourage personal retirement savings. Workers should be
encouraged to put aside a set amount each month or pay period for their retirement.
As more nations create private pension arrangements, there is a growing need for
consumers to receive timely, objective and useful guidance and information on their
retirement savings investments.
102

BIBLIOGRAPHY
103

1. Wikipedia – www.wikipedia.com

2. Invest India Economic Foundation – www.iief.com

3. Agarwala R. and Sharma R.K. (1999) “India’s Pension System Reform:


Challenges and Opportunities”, paper presented at the International Conference
on Social Security Policy: Challenges before India and South Asia, New Delhi,
November.

4. Bhatt, Gita (1996), “Reforming Pension Systems: An Idea Whose Time Has
Come?” Economic and Political Weekly, June 22, 1570-1571.

5. Chatterjee, Bhudev (1996), Journey From My Provident Fund To Our Pension


Scheme,

6. Employees’ Provident Fund Organisation, New Delhi.

7. Jain, Shashi (1997), “Social Security for the Informal Sector in India: Feasibility
Study on Area-Based Pilot Projects in Anand (Gujarat) and Nizamabad (Andhra
Pradesh)” in Wouter van Ginneken (ed.), Social security for the Informal Sector:
Investigating the Feasibility of Pilot Projects in Benin, El Salvador, India and
Tanzania, Issues in Social Protection, Discussion paper 5, ILO, Geneva.

8. OASIS (1999), The Project OASIS Report Part I, Ministry of Social Justice and
Empowerment, Government of India, New Delhi.

9. OASIS (2000), The Project OASIS Report Part II, Ministry of Social Justice and
Empowerment, Government of India, New Delhi.

10. Dave, S.A. (1999), Restructuring Pensions for the Twenty-First Century”, in
James A. Hanson and Sanjay Kathuria (ed.), India A Financial Sector For The
Twenty-First Century, Oxford University Press, New Delhi, pp.305-333.

11. International Social Security Association; Twelfth Regional Conference for Asia
and the Pacific; Bangkok, Thailand, 20-23 November 2000. "Challenges to
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Providing Social Security to the Informal Sector in India", Ajai Singh, Central
Provident Fund Commissioner, Employees’ Provident Fund Organisation, India;
ISSA/ASIPAC/RC/THAILAND/2000/2-INDIA

12. Insurance Regulatory and Development Authority (IRDA) Report on ‘pensions


reforms in the unorganized sector’ (October 2001)

13. ) Government of India High Level Group on New Pensions System


(Bhattacharya) Report (February 2002).

14. PENSION FUND REGULATORY AUTHORITY - http://pd.cpim.org


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