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Contacts Details

CRISIL

Jiju Vidyadharan

Director – Funds & Fixed Income Research

Email: jiju.vidyadharan@crisil.com

Sandhya Dhar

ET Edge

Sector Head – TCL – BCCL

Email: sandhya.dhar@timesgroup.com

Piyush Gupta

Associate Director – Funds & Fixed Income Research

Email: piyush.gupta1@crisil.com

Sowmia Gopinathan

Manager, Sponsorship Sales – TCL – BCCL Email: sowmia.gopinathan@timesgroup.com

Prahlad Salian

Manager – Funds & Fixed Income Research

Email: prahlad.salian@crisil.com

Saloni Singh

Associate – Funds & Fixed Income Research

Email: saloni.singh1@crisil.com

Table of Contents

Table of Contents RESEARCH State of the pension industry 4 Scope of the pension industry -
RESEARCH
RESEARCH

State of the pension industry

4

Scope of the pension industry - past, present and future

5

  • - EPFO – a behemoth

5

  • - NPS – the new plan on the block

6

  • - Potential for NPS

8

  • - Defined Benefit-Contribution mix – a move to create a universal pension

system

9

  • - Accumulation-annuity model – Need a long-term system for assetliability

management

10

Reinventing the regulatory wheel

11

  • - Need to set the NPS design right

..............................................................

11

  • - Need for pension and insurance coordination

11

Key takeaways from the report

12

3 3
3
3

State of the pension industry

The $36 trillion 1 global pension industry has grown at an average 6.0% annually over the past ten years,

led predictably by developed economies, which realise the importance of retirement planning and have

developed financial structures for it.

The industry follows the World Bank’s three-pillar framework, formed in the late 1990s, which segregates the

major objectives of pension plans as:

Pillar 1: Comprises universal/ standardised social security coverage, covering even the lowest strata

of society. This is the base on which other schemes are developed. Here, the governments of the

respective economies fund the schemes from their exchequer – for instance, the US’ OASDI (Old

Age, Survivors and Disability Insurance) programme, which has nearly universal coverage.

Pillar 2: Comprises occupational pension schemes, where both recipients and employers contribute.

These are mandated pension plans for employees in an organisation; for instance, the 401K plan in

the US.

Pillar 3: This comprises personal savings and investments, such as private pension funds created

by asset management companies.

State of the pension industry The $36 trillion global pension industry has grown at an average

India presents a unique case. The joint family structure, which traditionally provided a social security net, is

fast giving way to nuclear families. From over 5 people per household in 2001, there were 4.3 per household

in 2011. Within the private sector, only about 8% of retirees receive pension 2 , while pure pension corpus is

about 2% of the GDP currently 3 . (Source: CRISIL report)

1 Global Pension Assets Study 2015, Towers Watson 2 Pensioner base in the Employees’ Provident Fund Organisation, Coal Mines Provident Fund Organisation, Assam Tea Plantations Provident Fund and Pension Fund as per latest available data 3 Assets under Employees’ Pension Scheme of Employees’ Provident Fund Organisation data as of March 2013, National Pension System data as of March 2014 and pension assets of Assam Tea Plantations Provident Fund and Pension Fund data as of March 2012

RESEARCH Table 1 – Indian pension industry vis-à-vis the World Bank’s pillar model Pillar 1 The
RESEARCH
RESEARCH

Table 1 – Indian pension industry vis-à-vis the World Bank’s pillar model

Pillar 1

The Swalambhan Scheme, which was started under the National Pension System (NPS) to cover the lower strata, has met with limited success. The recently launched Atal Pension Yojana aims to renew this model.

Pillar 2

The Employees’ Provident Fund Organisation (EPFO), Coal Mines Provident Fund Organisation (CMPFO) and NPS (for Central and State government employees) fall under this category. EPFO,

with 8 crore subscribers, is the largest. Even so, a significant mass of population is not covered.

Pillar 3

This category, which includes NPS for the private sector, retirement plans by mutual funds, and insur- ance, too, has met with limited success.

The Indian pension industry seems to be a victim of low awareness of the importance of retirement planning

and lack of distributor focus for NPS schemes (due to low incentivisation). Further, people tend to have a

myopic view on pension; they focus on the short term and expect the government to cover their future social

security. The pension industry needs to deepen its penetration in a holistic manner.

Scope of the pension industry - past, present and future

EPFO – a behemoth

The pension industry in India is led by the 60-year-old EPFO. Beneficial taxation policies, mandatory saving

under the plan for eligible citizens, and the country’s affinity to invest in ‘safe’ fixed income instruments have

grown its corpus to Rs 8 lakh crore and subscriber base to 8 crore individuals.

In a high-inflation economy such as India, provident funds, or PFs, are not exactly the most appropriate

pension product. Being fixed income-oriented, PFs give marginal real returns (returns – inflation)

(see Chart 1).

Chart 1 – EPFO declared interest rate vs retail inflation rate

1990 EPF Declared Interest Rate Retail Inflation Rate 2014 2010 2006 2002 1998 1994 14.00% 0.00%
1990
EPF Declared Interest Rate
Retail Inflation Rate
2014
2010
2006
2002
1998
1994
14.00%
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%

Source: EPFO, RBI

5 5
5
5

Realising the need for higher returns to build a better retirement corpus, the Ministry of Labour & Employment

(MoLE) has introduced equity and other investment schemes. In a country where the median age falls

between 25 and 30, equities can easily provide a windfall for a long-term goal such as pension.

Table 2 - Change in investment structure for provident funds

Investment product

Old investment pattern (%)

New investment pattern (%)

Government securities

Up to 55

45-50

Debt securities and bank term deposits

Up to 55

35-45

Money market instruments

Up to 5

Up to 5

Equity and equity-related instruments

Nil

5-15

(includes Exchange Traded Fund, or ETF)

Asset-backed securities, units of real estate/

Nil

Up to 5

infrastructure investment trusts

MoLE has also revised the aspects of the investment policy. It has introduced concepts of cost management,

fiduciary responsibility, established investment safeguards and allowed trading to an extent rather than

holding the portfolio until maturity. Such reforms display a shift from regulated management of assets to a

prudent management system, and are progressive steps for the industry at large.

NPS – the new plan on the block

The Government of India launched NPS in 2004 to enhance pension coverage in the country and bring in the

informal sector into the pension fold. Initially launched for government employees, it was opened to all Indian

citizens from May 1, 2009.

NPS marked the government’s shift from the Defined Benefit (DB) model to the Defined Contribution (DC)

model of pension management with the aim of reducing the fiscal pressure on the country. For instance, if

private coverage stays chronically low at its current level of 8% even by 2030, the government will have to

formulate a pension scheme to support the old-age population, raising its fiscal burden to as high as 4.1%

of GDP. For the record, the Central government today spends 3-3.4% of GDP on education and just over

1% of GDP on medical and public health, water supply and sanitation (source: CRISIL Report). Greece, with

pension provision 4 accounting for 16% of its GDP, is the freshest example of a fiscally imbalanced liability.

Currently, the bulk of household savings in the country is in bank Fixed Deposits (FDs) and physical savings

(real estate, gold, etc). (Source: RBI report 2013-14). In comparison, NPS allows investments in fixed income

instruments as well as in equity and newer investment options such as equity mutual fund, Infrastructure Debt

Funds (IDFs), Asset-Backed Securities (ABS) and Credit Default Swaps (CDS).

NPS offers a variety of asset allocation patterns for contributors, including one with a moderate exposure to

equities. Contributors can choose the pattern that best suits their risk profile. It offers two strategy options:

active and default.

  • 4 http://blog-imfdirect.imf.org/2015/06/14/greece-a-credible-deal-will-require-difficult-decisions-by-all-sides/

RESEARCH Chart 2 – Break-up of household savings Components of financial savings Currency 9% Deposits 59%
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RESEARCH
Chart 2 – Break-up of household savings Components of financial savings Currency 9% Deposits 59% 32%
Chart 2 – Break-up of household savings
Components of financial savings
Currency
9%
Deposits
59%
32%
68%
Shares, debentures (private companies, banks,
PSUs and mutual funds)
3%
Life funds of LIC and private insurance companies
Provident and pension funds
17%
12%
Financial savings
Physical savings

Source: RBI

Active choice: Subscriber has the option to decide how to invest his/her NPS pension in the following three

options:

Asset Class E - investments in predominantly equity market instruments

Asset Class C - investments in fixed income instruments other than government securities (G-sec)

Asset Class G - investments in G-sec

Subscribers can choose to invest their entire pension wealth in C or G asset classes and up to a maximum

of 50% in E.

Default choice is lifecycle fund: If subscribers are unable/ unwilling to exercise any choice on asset

allocation, their funds will be invested in accordance with the auto choice option. Here, investments will be

made in a life-cycle fund. The fraction of funds invested across three asset classes will be determined by a

pre-defined portfolio based on the age of the investor.

7 7
7
7

Chart 3 – Growth of NPS assets

AUM in Rs Cr NPS Swavalamban Unorganized Sector State Government Corporate Sector Central Government 2011-12 2013-14
AUM in Rs Cr
NPS Swavalamban
Unorganized Sector
State Government
Corporate Sector
Central Government
2011-12
2013-14
2012-13
2014-15
0
10,000
20,000
30,000
40,000
50,000
60,000
70,000
80,000
90,000

Source: NPS Trust

The pace of coverage under NPS has been increasing, but the absolute figure still has a long way to go. Here

are the challenges:

NPS is voluntary: There is no successful social security scheme dependent on voluntary

contributions. A strong, mandatory basis is required to ensure schemes such as NPS succeed.

Taxation: A consistent, equitable taxation policy is required across pension products. Tax arbitrage

distorts markets as people invest as per post-tax calculations.

Lack of clarity regarding regulation: There is a need to align frameworks across insurance, asset

management, EPFO and PFRDA. The Financial Sector Legislative Reforms Commission (FSLRC)

mechanism may help to resolve the issue by introducing a standard regulatory structure and code

across regulators.

Trust: The level of trust in products is weak in emerging economies such as India. This is largely

reflective of the quality of intermediation, which is crucial for the sustainability of the pension industry.

Long-term contribution schemes are yet to garner enough trust.

Lack of awareness: There is a need for financial literacy. The general mindset should favour long-

term investing.

Potential for NPS

It would be wrong to write off NPS based on modest growth over the past 11 years. We just need to direct

the demographic dividend of the country into apt investment avenues and leverage the optimistic phase of

growth.

The infrastructure required for distribution is in place. There are more than 60 points of presence (PoPs)

with a network of more than 36,000 branches, and more than 70 aggregators across the country 5 . National

Securities Depository Limited or NSDL, the Central Recordkeeping Agency (CRA) for NPS, updates NPS

subscribers on the status of their investments. The distribution channel, however, has to be adequately

incentivised to sustain the industry's growth potential.

RESEARCH The recently launched Atal Pension Yojana (APY), a universal target-linked pension plan, aims to renew
RESEARCH
RESEARCH

The recently launched Atal Pension Yojana (APY), a universal target-linked pension plan, aims to renew the

Swavalambhan scheme, and is a good augury for the domestic pension industry.

Defined Benefit-Contribution mix - a move to create a universal

pension system

Though DB pension schemes are laudable, they are a huge long-term liability. On the other hand, DC

schemes free the provider of the liability, shifting the onus of retirement planning to the investor. They are two

extremes of pension planning, and either one would be unsustainable from a universal pension perspective.

Thus, a mix of both seems a good solution for social security.

Countries around the world are adopting various ratios of DB-DC. Australia has an 85% DC-based system,

while the Netherlands has 95%+ DB component. DB-DC schemes do need sufficient government funding

along with adequate equity and alternatives exposure.

Table 3 - Relative shares of DB and DC pension fund assets in select OECD countries, 2013

Country

Defined Benefit / Hybrid-mixed

Defined Contribution

Chile

0.0%

100.0%

Czech Republic

0.0%

100.0%

Estonia

0.0%

100.0%

France

0.0%

100.0%

Greece

0.0%

100.0%

Hungary

0.0%

100.0%

Poland

0.0%

100.0%

Slovak Republic

0.0%

100.0%

Slovenia

0.0%

100.0%

Denmark

6.6%

93.4%

Italy

6.8%

93.2%

Australia

9.8%

90.2%

Mexico

13.3%

86.7%

New Zealand

20.1%

79.9%

Iceland

24.9%

75.1%

Spain

27.7%

72.3%

United States

57.4%

42.6%

Turkey

60.7%

39.3%

Israel

70.4%

29.6%

Korea

72.5%

27.5%

Luxembourg

79.7%

20.3%

Portugal

84.8%

15.2%

Canada

97.2%

2.8%

9 9
9
9

Country

Defined Benefit / Hybrid-mixed

Defined Contribution

Finland

100.0%

0.0%

Germany

100.0%

0.0%

Switzerland

100.0%

0.0%

Source: OECD Global Pension Statistics

Going back to the World Bank’s three pillars of pension planning, though the Indian government has initiated

measures to strengthen pillars 2 and 3 viz., organisational and personal retirement plans, pillar one – social

security net for the lower strata of the population – is still weak or rather non-existent.

Though APY provides the vast population an avenue to save a small amount for retirement, the highest

possible vesting age pension is currently restricted to Rs 5,000 per month. If we consider the long gestation

period of 30 years, this money would be paltry and would not meet the subscribers’ needs. The government

needs to step up and support these plans. It is also important that the government start creating a corpus,

which can be fiscally sustainable over the long term.

Accumulation-annuity model – Need a long-term system for asset- liability management

Currently, the pension industry in India largely focuses on the accumulation phase of retirement planning.

While this stage is important, it is equally necessary to plan for disbursement of the corpus on retirement. Do

not ignore the annuity phase. Thanks to NPS, there is at least a new awareness about annuities and their

importance.

At present, under NPS, it is mandatory to use at least 40% of the corpus amount on maturity to purchase an

annuity. However, NPS has limited investors’ options by appointing only seven annuity providers. Investors

should be allowed to choose: 1) the amount for annuity, and 2) annuity providers from a pool of more than

seven. There is no fixed template for income required at retirement; the math varies from person to person.

Hence, annuity providers need to be flexible.

However, with distributor commissions very low in annuities, significant incentive is required for new players

to enter the market. A vibrant annuities market is essential for the pension industry to grow. Further, longevity

is a universal issue of annuities as insurers are unwilling to commit to a situation where it is unclear as to how

long a person would live.

Pure play annuity providers would be a boon to the pension industry. If foreign players are allowed to enter,

their expertise could help to lower costs by improving efficiency and promote innovation in annuity plans.

Asset management companies could also be given the option to design annuity plans. However, in the end,

the choice should be left to the investor. By putting in place a long-term system for managing assets and

liabilities, the accumulation-annuity model could be a success in India.

RESEARCH Reinventing the regulatory wheel Need to set the NPS design right From a regulatory perspective,
RESEARCH
RESEARCH

Reinventing the regulatory wheel

Need to set the NPS design right

From a regulatory perspective, NPS has certain design limitations, which need to be addressed to ensure

universal social security. These include:

Distribution: Operational barriers between regulators are preventing effective use of the distribution

network. Depository participants can be directed to combine distribution, marketing and servicing

roles to tap economies of scale.

Competition: With one CRA monopolising the system, efficiency is limited. Introducing some

competition here can help.

Product and process innovation: Factors such as imposing a penalty for non-contribution, no

direct accounts and imposition of service charges make NPS inflexible for the informal sector, which

often lacks funds to make regular, sizeable contributions.

Need for pension and insurance coordination

In the NPS context, fund managers are responsible for the accumulation phase and have to be mindful of the

mortality element. For an insurer, the annuities phase is the focus and longevity element cannot be ignored.

Allowing pension fund managers to offer annuities can help them raise economies of scale and thus provide

better return to investors. Cross-pooling of expertise among insurers and fund managers could increase

efficiency. For e.g. in Australia, several pension fund managers are from insurance companies.

Further, a separate healthcare account could be explored as a part of NPS’s current unbundled structure

once a universal pension system is in place.

  • 11 11

Key takeaways from the report

Social security provisions in India remain inadequate

For NPS to succeed, a mandatory basis should be introduced

A uniform tax code and regulatory structure for the pension industry are required

Financial literacy and awareness are key challenges

Incentive for distribution and quality of intermediation are crucial for expanding reach

■ Asset allocation should be more flexible

Need for a vibrant annuities market

Government funding is necessary along with variations in DB-DC mix

Cross-pooling of expertise across mutual funds and insurance could increase efficiency significantly

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