Pension Reforms in India
(article written in 2003)
Broadly pension reform proposals in India aim
at creation of an independent pension regulatory authority to control the
pension system, making it mandatory beyond a level of employment, limiting
withdrawal option before retirement, facilitating increase in rate of return on
funds contributed by liberalising investment rules for such funds, and
professionalising pension funds management.
In short, there is a proposed shift from defined benefit system to defined
contribution system as well as a choice of three different investment patterns:
growth, balanced income and safe income.
It is assumed that with higher levels of corpus and with better
financial management, higher income replacement levels at the time of
retirement can be anticipated. The focus
of the reforms at present seems to encourage the working population to take
more interest in their post retirement income levels.
There is a general perception that in a society
faced with demographic features like an ageing society and higher pensionary
outflows on a retiring work force and delicate state of public finances, a
switch from public unfunded pensions to private funded pension systems will
increase growth through savings, especially the flow of savings to capital
markets and augment the overall well being of the pensioners by giving them the
responsibility of managing their pensionary finances.
Can
funded pension system face the challenges of demographic transition?
Demographic transition is indicated by an ageing population and higher
healthcare costs associated with it.
There is also the question of declining proportion of working population
and higher dependency levels on earning members.
The
most compelling reason for pension reforms seems to be the increasing pension
burden in the future. One of the key
aspects of such reforms is seen to be the replacement of Pay As You Go (PAYG)
system with funded pension systems.
Funding is seen as a solution for two basic reasons: a) funded systems
will increase levels of savings and investment and thus income b) funding is
expected to lead to faster economic growth and generally enable coping with
demographic challenges. Both these can
however, be challenged. Assuming that
funded systems lead to accumulation of financial assets such as equity and
debt, enhanced role for capital markets is envisaged and increased savings can
be expected to flow through capital markets.
The logic largely follows the Feldstein theory that PAYG pension system
curbs national savings and a switch to funded systems will increase savings and
investment. This can however be subject
to critical analysis. Savings largely
depend on life cycle considerations, with society’s age structure determining
the level and time profile of savings.
If that be so, savings should be unaffected by how the society takes
care of the elderly. There are several
reasons why savings of the society are expected to remain unchanged. In a transitional phase, Governments would
still need to fund existing pension liabilities. This can be done by borrowing, raising taxes
or cutting (non-pension) expenditure.
Raising taxes does not effect savings as it directly affects social security
contributions, leaving workers’ disposable income and saving unchanged. Government borrowing is usually in the form
of issue of bonds to finance pension
obligations, and in fact Government borrowing can be seen as dissaving. By cutting manpower expenditure, Government
saving is not effected and in fact may adversely impact economic activity. If Governments can cut expenditure, they
would do so irrespective of the pension system prevalent. In sum, the hope of a higher level of savings
may not be well founded.
In
an assumption of a complete switchover from PAYG to funded pension system, it
appears as if more forced contributions would lead to greater savings. Having the possibility of savings does not
mean savings will take place. Even if these
are made mandatory, it has to be remembered that higher savings by workers may
not imply higher national savings as pensioners may be forced to dissave by
selling other financial assets.
Often
it is argued that privately funded pension systems would ensure that
demographic challenges are met more effectively. The demographic challenges are often meant to
denote a declining proportion of workforce and an ageing population. It is also assumed that pensioners have no
saving capability and consume whatever output they are used to in their active
years. Furthermore, they have no wage or
other income and claim today’s goods and services based on their past
contributions.
Under
Indian conditions many of these assumptions can be put to test. While the demographic challenge for mature
countries like those in Europe is understood, Indian working population is set
to increase in the years to come.
Furthermore, any growth in public or private sector is expected to
create employment opportunities leading to more than proportionate growth of
workers vis a vis non workers or pensioners. It may be added that the present pension
system has not fully saturated the working population for various reasons. Only about 23% in the Government sector are
beneficiaries of defined benefit pension system and only about 49% employed in
the private sector are covered by mandatory Employee Provident Fund. Many organisations blatantly violate labour
laws and try to avoid any type of benefit to their employees including
pensionary benefits or provident fund.
The present pension scheme assures a transfer
payment from Government in a fixed proportion to their present wage level and
even this is indexed broadly to cost of living. Under
funded pension systems, workers accumulate no assurances of income replacement
but financial assets. Inflation is a
cruel reality that bites into financial assets even as they are being built
up. Even if investments are made in
bonds, equities and real estate, their value is likely to depreciate as in an
ageing society, there may be few takers for these assets and hence lower
realisation or even a capital loss.
Two
other compelling arguments for funded pension systems are often cited: growth
and globalisation. But as shown
earlier, higher savings may only be misnomer and may not translate into growth. Growth can however result from more efficient
mobilisation and allocation of savings.
Under funded pension systems, funds may flow more through capital
markets than through banks. The hidden
assumption however is that market based financial systems are more efficient
than bank based financial systems, or score in allocational efficiency. However, one cannot at the present juncture
compare the two as banks have been overregulated and our capital markets are
yet to inspire confidence, after repeated scams have scarred investors’
memories. Growth in a reforming economy
like ours presumes that expanding investment opportunities would be available
for private sector and high levels will be sustained.
The
other argument—globalisation—presumes that free flows of capital or financial
assets are possible; in other words, financial assets can acquire claims on
output of other countries, and pension funds can be invested in foreign
countries freely without any let or restriction. This is helpful if marginal returns on
capital in other countries are expected to be more than realisable
domestically. The investments have to be
moreover, in countries with a different demographic profile and faster growth
prospects, and those capable of exporting goods and non factor services when
the investing countries is ready to sell its assets. Last of all, the credit worthiness issue is
paramount in international investments and debt repayment of external finance
depends equally on willingness and capacity to repay. Moral hazard argument has often been used
while discussing reverse financial flows.
This logic would however hold goods in both pension systems.
The
question of overall welfare of the pensioners still remains. The power to select the fund manager
according to the risk profile of the employee remains with the employee instead
of depending on a designated public fund manager. But with it also shifts the responsibility of
taking the risks associated with the investment pattern. There is also the uncertainty that extraneous
factors such as inflation, depreciation of currency, the state of the stock markets as well as
international monetary flows might put paid to the value of realisation of the
financial assets which are being created.
The emerging demographic profile will also have a great bearing on the
value of capital assets created.
It
can be therefore concluded that there are no strong reasons to believe that a
shift in pension systems would impact growth of economies substantially and
that the blow on pensioners would be softened compared to the present
levels. However, with the good
intentions and objectives such as risk sharing, corpus creation, and passing on
part of decision making to the working population, the new scheme deserves to
be given a chance and modifications if any can be considered looking to the
lessons learnt in implementation of the same.
