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Asia-PacificMarch 3 2004

Tortuous path to pensions reform

Kala Rao reports on India’s timid yet nevertheless genuine attempts to overhaul its pension system – and on the global players licking their lips in anticipation.
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Last February, Indian Finance Minister Jaswant Singh’s announcement in his budget speech that India was ready to allow private management of pension funds stirred hope among foreign investors of gaining access to India’s vast pool of savings. In January this year India’s first privately-managed pension scheme came into existence.

However, the new scheme is a characteristically modest, some might say, timid beginning towards pension reform. New recruits into government employment will move to a defined contribution pension scheme from this year as opposed to the defined benefit pension that their predecessors enjoy.

An interim Pension Fund Regulatory and Development Authority (PFRDA) has also been set up and it will frame the rules for licensing private pension fund managers.

Although only a modest estimated 50,000 national government employees will have to mandatorily join the new scheme this year, it is open to individuals employed in the informal sector who can join it voluntarily.

U K Sinha, joint secretary at the Ministry of Finance, and the government’s chief spokesperson on pension fund reforms, points out the reasons why the new scheme is an important departure from the past: “It will be privately managed, under independent regulation, and it can invest its funds abroad.”

Reducing liabilities

The new pension scheme will cut the government’s future pension liabilities to some extent. Nageshwar Rao, managing director of IDBI Bank, reckons the national government spends just under a tenth of its revenues on pensions, while pensions account for around 8% of the expenses of state governments. Burdened by growing budget deficits every year, the government is finding it hard to meet the current pension liabilities of 7.3 million pensioners, leave aside the future pension liabilities of another 12 million government employees.

According to a government-appointed panel report on pension reform called the Oasis report, just around a tenth of India’s workers are covered by some form of pension.

Mukul Asher, a professor at the National University of Singapore, says India’s existing pension system is poorly managed and administered, is skewed towards civil servants and has no single agency responsible for regulation.

Government employees are covered by a defined benefit system, private employees by a defined benefit system one that allows for generous premature withdrawals, and others that invest in voluntary tax-free savings schemes.

Most of them are managed by the government or its agencies, are invested primarily in government bonds and are guaranteed a return by the government that is higher than what they earn. There is practically no investment in equities, even in the domestic market.

As interest rates on these bonds have fallen sharply in recent years, the extent of government subsidy has grown.

The present reforms do not touch the existing structure. In fact, Professor Asher points out that the new pension scheme is likely to increase the government’s cash immediate outlay because it will have to contribute its share towards the pensions of new recruits.

The case for pension reform is urgent. India’s high savings rate and relatively young population makes the pension fund market an exciting one for foreign fund managers. Several foreign banks, asset managers and insurers are examining the prospects. Foreign insurers such as Standard Life, Prudential, American Insurance Group, Allianz and Aviva set up joint ventures with Indian partners around two years ago, in line with the rulelimiting foreign investment in insurance to 26%.

Standard Charted Bank, Deutsche, HSBC, ING and ABN Amro, among the foreign banks set up asset management companies in the last two to three years in anticipation that India’s market for retirement savings would be opened up. US fund manager Templeton recently acquired Pioneer’s assets in India to put it in the top league among mutual fund managers.

Another US fund manager Principal struck a strategic alliance recently with Punjab National Bank, India’s second biggest commercial bank, and Vijaya Bank that, according to Sanjay Sachdev who heads Principal’s business in India, says “we’ll enable it to build a distribution network to sell pension and mutual funds.”

Rocky path to reform

The progress of pension reform is likely to be slow and protracted. Legal hurdles could stall reform. It took three contentious years of debate and delay before the Indian parliament cleared legislation that enabled insurance reform. The present pension fund authority is an interim one set up by an executive order. New legislation must be approved by parliament to give it statutory authority.

National elections are likely to be held ahead of schedule in April or May, and assuming that the current coalition led by the ruling Bharatiya Janata Party is voted back to power, passing the new legislation on pension reform is likely to take at least a year.

Important amendments to recruitment and pension rules of government employees have “mercifully been done”, says Mr Sinha, seemingly relieved at the absence of litigation so far by employee unions.

Vinod Rai, a former Ministry of Finance official who was recently appointed the head of the PRFDA, is expected to announce the regulations for private fund managers. One of the challenges he will face is the number of pension fund managers it should license. A suggestion in the Oasis report on pension reform that just six private fund managers be picked on the basis of lowest fees quoted received a lot of adverse comment, prompting the government to concede that it would not restrict the number of licenses on offer.

IDBI Bank’s Mr Rao points out that Chile and Poland licensed a large number of private pension managers and the market eventually consolidated.

However, given that the funds available for private management is likely to be small, around Rs1.2bn ($27m) reckons Ashwin Parekh, executive director at consulting firm Deloitte, he questions if there will be enough to go around.

Already, a turf war of sorts has emerged. Insurers argue against licensing asset managers as pension fund managers. R Krishnamurthy, managing director of SBI Life, which has Cardiff as a joint venture partner, says such pension companies will merely accumulate pensions and would have to eventually buy annuities from insurers.

Foreign interests

Another challenge for the regulator will be setting the limit for foreign direct investment in pension fund management.

Mr Sinha says this will be done “keeping in mind the level of foreign investment in other financial sectors.” Foreign investment in insurance is capped at 26%, in commercial banks it was recently raised to 49%, and foreigners can own 100% of asset management companies in India. However, a decision on this politically sensitive issue can be expected only after the national elections are held.

Foreign investors are also eager to know the capital required to set up a pension fund company and its relation to their existing businesses in insurance or banking.

The minimum capital for commercial banks and insurance companies is Rs2bn while a majority stake in asset management costs just Rs100m. Dutch bank ING has invested over $150m in capital in acquiring a local bank (the first foreign bank to do so), setting up an insurance and an asset management company.

Yvo Metzelar, who heads ING Vysya Life Insurance, told a television channel that the bank is waiting for the new regulations to know if it must allocate new capital in a separate company for pension fund management.

The roadmap for liberalisation

India has 314 million workers, according to the Oasis report on pension reform, of which 53% are self-employed, 31% are employed on casual or contract work and 15% are salaried employees. Just a tenth of these workers participate in some sort of pension system.

Nageshwar Rao, managing director of IDBI Bank, reckons the national government spends just under a tenth of its revenues on pensions, while 8% of the state governments’ expenditure currently goes to pay pensions.

Most of this is spent on government employees who enjoy a defined benefit, indexed pension. Those employed in the private sector contribute to a provident fund with matching contributions by their employers and managed by the Employees Provident Fund Organisation (EPFO), a government agency.

The EPFO had 24.5 million members and managed assets of Rs1,127bn in March 2001, around 5.8% of GDP. Managed by state banks, the money is mostly invested in public sector bonds with no equity investment. The EPFO declares a fixed annual rate of return, currently 9%, higher than the return earned by the fund.

Around 3,500 private companies have been allowed to run pension schemes for their employees, and these funds are under pressure to pay out the same return as the EPFO, for which employers may have to fork out the shortfall. The government also manages various savings schemes such as the Public Provident Fund for self-employed individuals.

Mukul Asher, a professor at the National University of Singapore, says that India’s existing pension system is poorly managed, skewed towards civil servants and has no single agency responsible for regulation.

The current pension reform affects fresh pension liabilities for new government employees; it does not reduce the government’s pension liabilities before January 2004.

In fact, Professor Asher points out that the move to a defined contribution pension system will increase the government’s cash outlay initially because it will have to contribute towards the pensions of the new recruits as well as pay out pensions under the old scheme.

The EPFO has launched a plan of administrative reform that should make it a more professional service provider but at the moment there is no plan to outsource management of its funds. U K Sinha, joint secretary, pensions and capital market in the Ministry of Finance, says any move to do this will require a legal amendment because the EPFO was set up in 1952 by an act ofparliament.

The roadmap for pension reform is laid out in the Oasis report written by a government-appointed panel. It suggests that the new pay-as-you-go pension system should be based on individual retirement accounts that offers contributors the freedom and flexibility to make allocations in line with their risk-return profile.

Three options will be offered – safe, balanced and growth – with equity investment varying from 10% to 50% of the corpus, including 10% in overseas equity investment. Individuals will be free to choose their fund manager, and option, and be able to switch both.

The most controversial suggestion in the report is that six licenses should be auctioned out to private fund managers on the basis of the lowest management fees.

For the new system to work, interest rates must be fully deregulated. Existing administered interest rates, subsidised by the government, tend to distort returns. The yield on

10-year government paper is around 5.3% but the EPFO pays out 9% to its members.

Interest rates have fallen by over 5 percentage points in the last three years, but guaranteed returns on government savings schemes only fell by around 3 percentage points.

The subsidy on government-managed funds goes into the government’s deficit, but private companies, who must pay the same high rate into their employees pension accounts, are hurting, and are eager to hand their funds over to the government to manage.

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