View on Pension Reforms

 

                                         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.