A PROJECT ON

THE EMERGING PENSION SCENARIO IN INDIA

Submitted to

Director General, Prof. P.V. NARSIMHAM

By:

MS. AYESHA B. GAGRAT M.M.S. FINANCE ROLL NO. 15

IN PARTIAL FULFILLMENT OF THE REQUIREMENTS OF THE MASTER OF MANAGEMENT STUDIES (M.M.S.) DEGREE COURSE 2003-2005

UNIVERSITY OF MUMBAI

CERTIFICATE
This is to certify that the project titled The Emerging Pension Scenario In India, been submitted by Ms. Ayesha B. Gagrat, Roll No. 15, towards partial fulfillment of the requirements of the Master of Management Studies (M.M.S.) degree course 2003-2005, has been carried out by her under the guidance of Prof. P.V. Narsimham at the K.J. Somaiya Institute of Management Studies and Research, Mumbai 400 077, affiliated to the University of Mumbai. The matter presented in this report has not been submitted for any other purpose in this institute.

Prof. P.V. Narsimham, Project Guide & Director General, K.J. Somaiya Institute of Management Studies and Research, Mumbai. 15th of March 2005

Acknowledgements
I would sincerely like to thank my project guide, Director General, Prof. P.V. Narsimham, for his valuable support, guidance and encouragement given to me during the course of this project. I am grateful to the library staff of the institute for their timely co-operation. I also thank the

administrative staff members for providing help at various stages. I extend my heartfelt gratitude to my colleagues and other good wishers who contributed towards the successful completion of my project work

Dated March 15 2005 Ayesha B. Gagrat

Old age is the most unexpected of all things that happen to man.
- Leon Trotsky

Preface

Preface
As science and medicine become more advanced, all over the world the population of old people is growing rapidly. Supporting oneself at that age requires considerable savings that have been got through good intelligent investment practices through the early years. In India the joint family concept with the Patriarch as the pivot, traditionally provided Old Age Security. This was adequate in a agrarian & rural society But as time passed by industrialization and urbanization undermined the traditional concept. Today, in India, old age seems to be most unanticipated and unfortunately the groundwork for meeting the financial demand that old age entails is quite inadequate.

This report studies the pension sector in India along with the various reforms undertaken. It starts by explaining what pensions are along with their characteristics. It throws light on the current retirement benefit scenario in India, leading to the deficiencies in this sector, thus the need for reforms. The recent reforms as well as the challenges ahead have been highlighted in the report at the end.

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Table of Contents

Table Of Contents
1 2 3 3.1 3.2 4 4.1 4.2 4.3 4.4 4.5 5 Executive Summary.. Introduction... Pension Defined.. What is Pension Pension System Characteristics... Current Retirement Benefit Scenario & Historical Background. Current Schemes: For Government and Public Sector Employees. For the Organised Sector Employees.. For the Unorganised Sector. Tax Treatment of Provident Funds, Pension & Regulation of their Funds.. Latest Investment Guidelines .. 1 4 6 6 6 10 11 12 16 18 19

Need for Pension Reforms.. 21

6 6.1 6.2 6.3

Project O.A.S.I.S. 28 Introduction... 28 Goals before the OASIS Committee in framing the New Pension System.. 33

Features of the Report... 38

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Table of Contents

7 8 9 10 11 12

The Indian Pension Reform of 2003.. 46 Pension Fund Regulator and Development Authority Ordinance. 56 Challenges Ahead 70 Conclusion... Appendix- A Case Study.... References... 73 75 86

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Executive Summary

Chapter 1

Executive Summary
In India, retirement benefits consist of three different systems. There is the system of Provident Fund, Gratuity and Pensions. Pension is a mechanism for saving for the old age by building a fund during the earning years of individuals, which, if managed properly, can provide them adequate income in their twilight years.

Everywhere old age is unanticipated but in India the groundwork for it is not enough. The hangover of the welfare state ideology has resulted in government sponsorship of a large part of pensions, which are a major part of government expenditure. As of now, payment of pensions constitutes a large part of the governments expenditure. This is expected to increase more so in the future as the improvements in health have resulted in an increased life span of the elderly.

Indias Pension System has a low coverage and there is an under performance of Provident Fund schemes. Investment restrictions exist along with administrative difficulties. The private annuity market is underdeveloped and an increase in the informal workforce is further widening the skew ness in the existing structure of pensions, which in turn introduces distortions into the labour market. The Social Security system is based on employer and employee contributions, which largely excludes the unorganised sector. Project Report 1 By: Ayesha Gagrat

Executive Summary Also the differences in pensions between public and private sector employees as compared to the public sector are wide. Thus there is an urgent need to reduce government burden and involve the unorganised sector as at present the pension.

The reason that led to reforms was that the existing retirement benefit schemes suffered from various drawbacks. Government worried over the ever-increasing cost of the inflation linked Defined Benefit scheme, which was on a pay as you go basis. Reforms were also triggered by estimates of the burgeoning pension liabilities of the Government. Given Indias demographic forecast, life expectancy is increasing while birth rates are on the decline, that is the share of population above the age of 60 is growing at a rapid rate.

Thus in the last few years, a number of important developments and studies have led the Government of India to reexamine the various public programs meant to ensure old age income security for its workforce and consider reform strategies which include an increased role for privately managed, defined contribution schemes. The OASIS Report first brought out the possibility of pension reform in India. The Committee presented its report in January 2000 recommending a system for private-sector management of pension funds to generate market-linked returns, based on individual retirement accounts, with product choices, accessible through points of presence, contributions being flexible. There would be professional funds management, as well as portability through centralized record-keeping, central depository and administration.

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Executive Summary While presenting the Union Budget for 2003-04, the Finance Minister announced the Governments intent to introduce the above, pension system Also the government proposed to set up a new agency called the Pension Fund Regulatory and Development Authority (PFRDA) to supervise and regulate the functioning of this new pension system.

This initiative would enable the government to gradually transit to a fully funded pension scheme for all its employees over the next few decades. It would also, for the first time, provide a vehicle for informal sector workers to save for their retirement during their working lives. This will in turn contribute to greater income security in old age for our workforce as India enters its demographic transition. By reducing fiscal pressures caused by unfounded or inadequately funded pensions and by channeling long-term savings effectively, the new pension system will benefit a much wider population in the decades to come.

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Introduction

Chapter 2

Introduction
It is surprising how the mathematics of compounding can manifest a relatively small saving today into a sufficiently large pool of resources tomorrow. A countrys pension system is an attempt at capturing this mathematical phenomenon into its policy initiatives to ensure that the contributors to the Gross Domestic Product today are not left wanting tomorrow. The relevance of an efficient pension system is further accentuated in a developing economy where the smallest of policy changes can have the most complex trickle down effect.

A formal old age security system has been neglected in India largely because a major part of the nations population placed reliance on the next generation as an old age support mechanism. But with the growing westernisation of the country, nuclear families appear to be the order of tomorrow. With the age-old joint family system undergoing dilution, it was about time that India formulated a robust pension system to provide adequate income, to the aged in their twilight years.

Pension systems should be conceived as long-term financial contracts under which pensioners contributions today are exchanged for benefits tomorrow. Monetary payments on or after one has ceased to work, can be made in a number of ways, say lump Project Report 4 By: Ayesha Gagrat

Introduction sum on retirement or regular series of payments for a certain number of years or lump sum on death or series of payments to dependents etc. These can be in combination of two or more or on stand-alone basis. All these benefits are known as Pension or Retirement benefits or Superannuation benefits and exact nomenclature for the same type of benefits varies form country to country.

In India, as of now, there is no unique definition of pension. What is commonly understood by pension is the stream of regular monthly payments made till death, commencing from retirement.

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Pensions Defined

Chapter 3

Pensions Defined
What Is Pension? Pension is a mechanism for saving for the old age by building a fund during the earning years of individuals, which, if efficiently and profitably managed by competent people, can provide them adequate income in their twilight years. Pension systems should be conceived as long-term financial contracts under which pensioners contributions today are exchanged for benefits tomorrow.

A countrys pension system is an attempt at capturing this mathematical phenomenon and when managed by competent people, can provide them adequate income to support themselves in the latter years of their lives.

Pension System Characteristics Pension products either individually or in group are placed in two types : the ones which define or prescribe benefits which are delivered when due but assets are not created to deliver the same prior to occurrence of the benefits. Necessary resources are arranged as and when benefits fall due. In the other, assets are created to generate benefits to be delivered when due, whether benefits are defined / prescribed in advance or not. The former pension plans are called Un-funded or Pay-as-you-go (PAYGO) system and the Project Report 6 By: Ayesha Gagrat

Pensions Defined later is called Funded. In either case, the benefits can be pre-defined in which case the plan is called Defined Benefits (DB) type and in case where the plan is funded and benefits are not pre defined or prescribed, the same is called Defined Contribution (DC) type.

The following matrix explains the relationship. Type Funded Un-funded DC DB

The pension products need to incorporate various characteristics so as to capture varying circumstances. The following matrix attempts to capture the relationship of plan types with various characteristics.

Characteristics Financial System

Pay-as-you-go or Un-funded A method of

Funded accumulation reserves 100% value of of of that the all

financing The

whereby current outlays on pension pension benefits are paid out of satisfy current revenues. present

pension liabilities owed to current members.

Contributions

Non Defined

Defined

They are neither fixed nor A pension plan in which Project Report 7 By: Ayesha Gagrat

Pensions Defined uniform. At the beginning, the periodical pension is

when there are few pensioners, prescribed and the benefit the contribution is small but, as depends the pension system matures contribution on plus the the

and the population ages, the investment return. Benefits contribution must be raised. Defined Benefit is regulated by law/ pension scheme, which Non-Defined / Defined 1. Non-defined : the

insured gets the pension resulting from his / her contributions contribution). 2. Defined : Defined (defined

establishes its minimum and maximum, provides a formula to calculate the pension

according to the years of service and amount of income.

Benefits Plan where the present values of all

obligations to date are funded.

It has to be noted that under the DC scheme, the liability of the provider of the pension scheme is fixed and has to be provided from year to year. Once the defined contribution is made for the year, the providers liability ceases. Under a DB scheme, since the ultimate pension payments are linked to the final salary, the liability is very much

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Pensions Defined dependant on inflation as also the interest earned by the pension fund. If the DB scheme is inflation linked, then the liability goes on increasing throughout the retired lifetime of the pensioner.

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Current Scenario & Historical Background

Chapter 4

Current Retirement Benefit Scenario & Historical Background

To understand the current Retirement Benefit scene a little historical background would help. The current scene is substantially employee oriented. Also the Indian Pension market is ring fenced by legislative provisions including taxation.

It has to be noted that in India, retirement benefits consist of three different systems. There is the system of Provident Fund where the employee contributes a percentage of his salary to a fund with a matching contribution from the employer. The accumulated amount is given to the employee on his retirement. The second system is known as Gratuity. This is a lumpsum payment by the employer on the employee ceasing to be in service. The lumpsum will be a product of the final salary, the number of years of service and the rate of payment of gratuity. The third system is the Pensions, a series of payments made after retirement from service till the end of life.

The system of Pensions in India is a legacy of the British rule. The Civil Service in our country have always had the Pension System of retirement benefits. In the corporate

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Current Scenario & Historical Background world, in the early days of independence, this system was hardly in existence. It existed only in some of the multinationals. The Provident Fund system has been in vogue in India for a very long time. Some corporates also started giving gratuity over and above the provident fund. With the two benefits in vogue and later on legislation making these two benefits mandatory, the Pension system had no chance to grow. However, the first signs of change did come with the passing of the Payment of Bonus Act, which places a cap on the payment of bonus. Officers and executives were at the receiving end of this legislation. To overcome this drawback many corporates started providing pensions as a third benefit to their officers and executives. With this background, discussed below is the current retirement system existing in India.

Current Schemes
1. For Government and Public Sector Employees The Government of India and State Governments administer separate pension programs for civil employees, defence staff and workers in railways, post, and telecommunications departments. This is called the Civil Servants Pension Scheme (CSPS). These benefit programs are typically run on a pay-as-you-go, and are index linked defined-benefit schemes. The schemes are non-contributory i.e. the workers do not contribute during their working lives. The entire pension expenditure is charged in the annual revenue expenditure account of the government. The Government also operates Provident Funds to which only the employees contribute. The employees are also entitled to gratuity to the extent of death in service, which is very generous, and also on retirement from service.

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Current Scenario & Historical Background The basic pension payable to an employee with service of 33 years and above is 50% of 10 months average of final salary, with proportionate amount for service less than 33 years. Basic pension attracts Dearness pension, which is revised form time to time in line with the revision of D.A. of employees in service. There is also provision for widows/orphans, pension in case of death of employee and disability pension.

Certain Quasi-Government organizations like Reserve Bank of India and Public Sector Financial Institutions like banks and insurance companies also have inflation linked defined benefit pension plans and employee contribution to provident funds.

2. For Organised Sector Employees Employees' Provident Fund (EPF) The EPF programme, established through the Employees Provident and Miscellaneous Provisions Act 1952, is a contributory provident fund providing benefits upon retirement, resignation or death, based on the accumulated contributions plus interest, from employers and employees. The Act applies to specific industries and establishments, employing more than 20 employees. The specified contribution is10-12% of salary from the employee with a matching contribution from the employer.

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. Establishments covered by the EPF can either

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Current Scenario & Historical Background 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)

In India since withdrawals are permitted from Provident Funds, it 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.

There are similar enactments of Provident Funds applicable to specified vocations like Seamens Provident Fund Act, Coal Mines Provident Fund Act, etc., which operate more or less on similar lines as Employees Provident Fund and Miscellaneous Provisions Act.

Employees' Pension Scheme (EPS) The EPS, established in 1995, provides for the payment of a members pension upon the members superannuation/retirement, disability, and widow/widower pension, and children's pension upon the members 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 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

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Current Scenario & Historical Background 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 atleast 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, now Rs. 6500. 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 programme is funded by utilizing a part of the employers contribution to EPF (namely 8 1/3% of the salary, with a cap on salary of Rs. 6500) The Government also contributes 1.16% of the salary, the amount that they were contributing to the erstwhile Family Pension Scheme. In a way this is defined benefit pension scheme with a defined contribution. The E.P.F.O, which manages the scheme, gets an actuarial valuation

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Current Scenario & Historical Background conducted form time to time. The latest actuarial report reveals a deficit in the fund of Rs. 17,000 crores as revealed in the newspapers.

Employees' Deposit Linked Insurance Scheme (EDLI) The EDLI programme was established in 1976. This programme provides lump sum benefits upon the death of the member equal to the average balance in the members 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. This programme is funded by contributions from the employer at the rate of 0.51% of salary.

Payment of Gratuity Act, 1972 In addition to the provident fund, workers in both public and private sectors receive a second tier of lump sum retirement benefit known as gratuity. It is paid to the workers who fulfill certain eligibility conditions like a minimum qualifying service period of five years. It is equivalent to 15 days of final earnings for each years of service-completed subject to a maximum of Rs. 350,000. The cost of gratuity is entirely borne by the employer.

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Current Scenario & Historical Background Pensions For a very small minority of employed population, there are pension schemes also. MNCs and large Indian industrial houses have designed a voluntary pension scheme for the benefit of their staff (in most cases management staff). Most of these schemes are non-contributory.

3. The Unorganised Sector The Public Provident Fund (PPF) scheme, introduced about three decades ago, is meant to provide unorganised sector workers with the facility to accumulate savings for old age income security. Under the scheme, amounts between Rs 100 to Rs 60,000 per annum, now RS. 70,000 can be deposited into the PPF account. These investments are eligible for tax rebate under Sec 88 of the Income Tax Act and the interest is fully tax-exempt under Sec 10.

The scheme has poor coverage because of ineffective marketing and the service delivery is grossly inadequate. Being largely urban centric, the scheme is used more as a tax planning vehicle by high-income savers than an old age income security plan.

In an effort to widen the reach of the social safety net for the aged poor, the central government, in 1995, introduced a more comprehensive old age poverty alleviation program called the National Old Age Pension (NOAP) under the aegis of the National Social Assistance Programme (NSAP). The scheme aims to provide monthly pension to

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Current Scenario & Historical Background thirty percent of the poorest elderly. This programme provides benefits for poor people above the age of 75 years. Under the programme a pension of Rs. 75/- per month is provided to eligible persons.

Besides the above there are many pension products of insurance companies and mutual funds, which are essentially, tax centric. Tax benefits are available for investment in such plans. Sec 10(23AAB) read with 80CCC of the Income Tax Act 1961 and Sec 10(23D) along with Sec. 88 (2)xiii(c) provide tax relief for such schemes. To name a few schemes: Jeevan Suraksha of LIC ICICI Pru Forever Life of ICICI Prudential Life Insurance Co Ltd. Retirement benefit plan form UTI Kothari Pioneer Pension Plan from Kothari Mutual Fund

The formal old age income security system in India can thus be classified into three categories: The upper tier consists of statutory pension schemes and provident funds for the organised sector employees. The middle tier is comprised of voluntary retirement saving schemes for the selfemployed and unorganised sector workers. The lower tier consists of targeted social assistance schemes and welfare funds for the poor.

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Current Scenario & Historical Background

Tax

Treatment

of

Provident

Funds,

Pensions

&

Regulation

of their Funds:
Under the present system, a beneficiary is entitled to a limited relief on the contributions that he makes to Provident Fund and Superannauation Fund. Contributions made by the employer are not taxable in the hands of the employee. Interest credited to the account of the beneficiary is not taxed .On cessation of employment, accumulations from Provident Funds are completely tax free (subject to a five year vesting).

In case of superannaution funds, the accumulations are permitted to be utilized to pay a monthly/periodical income, which is taxable as salary. A part of this monthly income is permitted to be commuted for a tax-free lump sum. The above mentioned position exists for both the private funds as well as the statutory funds.

Private Pension/ Gratuity/ Provident Funds in order to qualify for tax benefits have to obtain approval of their scheme form the Income Tax Department. The IT department when granting recognition to the scheme imposes many conditions. The most important is the imposition of the pattern of investments, which must be followed by the funds. There is also a ceiling to the contribution that can be made. One provision for approval of pension schemes is that on cessation of service, the fund must purchase the annuity from LIC. This has been one of the factors, which has hampered the growth of Pension Schemes in India.

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Current Scenario & Historical Background The Government from time to time alters the guidelines on investment. The bias in investment is more on Government Securities. Recently on revising the guidelines, the Government has allowed investment in corporate equities for the first time.

Latest Investment Guidelines:

The latest guidelines to be followed from 1 st April 2005 for investment announced by the government which are to be followed by non-Government, Superannuation Funds and Gratuity Funds are as given below: % amt to be invested (i) Certain defined Central Government securities and /or units of such mutual funds which have been set up as dedicated funds for investment in Government securities regulated by the Securities (ii) and Exchange Board of India (a) Government securities as defined by any State Governments and /or units of such mutual funds which have been set up as dedicated funds for investment in Government securities regulated by the Securities and Exchange Board of India and/or (b) Any other negotiable securities where the principal and interest is fully guaranteed by the Central Government or specified State Governments. 15% 25%

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Current Scenario & Historical Background The exposure of a trust to any individual mutual fund, which ahs been set up as a dedicated fund for investment in Government securities should not be more than 5% of its portfolio at any point of time. (iii) (a) Bonds/Securities of Public Financial Institutions, Public Sector Companies and Public Sector Banks; and/or (b) Term Deposit Receipts upto 3 years issued by public sector banks (iv) (c) Collateral Borrowing and Lending (a) To be invested in any of the above three categories as decided by their Trustees (v) (vi) (b) Shares of companies that have an investment grade debt rating from at least two credit rating agencies The trustees, may invest upto 1/3rd of (iv) above, in private sector debt instruments and/or in equity-linked schemes of mutual funds regulated by the Securites and Exchange Board of India. 5% 30% 25%

Any money received on the maturity of earlier investments reduced by obligatory outgoing has to be invested in accordance with the investment pattern prescribed in the notification In case the rating of any of the instruments mentioned above falls below the investment grade, confirmed by two credit rating agencies, the exit option can be exercised.

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Need for Pension Reform

Chapter 5

Need For Pension Reform

India A Demographic Analysis
Necessity is the mother of invention; this may be true of policy reforms also. The necessity for pension reforms was triggered by estimates of the burgeoning pension liabilities of the Government, given Indias demographic forecast. India is in the phase of a rapid

demographic transition. Life expectancy is increasing while birth rates are on the decline.

As per the report submitted by the Old Age social and Income Security Committee (OASIS), global demographics suggest that the population of the world is ageing with about one-eighth of the worlds elderly living in India. The share of population above the age of 60 is growing at

a rapid rate. Those who cross the age of 60 are expected to live till or beyond the age of 75. This has not sufficiently dawned in the minds of our people. They tend to be myopic and are not saving sufficiently for old age, a period of 15 to 17 years beyond the age of retirement. There is a serious threat that persons who were not below the poverty line, might sink below the poverty line in their old age, since not enough savings have been made by them. On the other hand, they have to incur heavy expenditure on health, neglect of which will only worsen their quality of life. Destitution and ill health could lead to rampant devastation of life of aged people under such circumstances.

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Need for Pension Reform

Populations, worldwide, are ageing. In India, while the total population is expected to rise by 49% (from 846.2 million in 1991 to 1263.5 million in 2016), the number of aged (persons aged 60 and above) is expected to increase by 107%, from 54.7 million to 113.0 million, in the corresponding 25 year period. In other words, the share of the aged in the total population will rise to 8.9% in 2016 (from 6.4% in 1991). Population estimates further suggest that the number of the aged will rise even more rapidly to 179 million by 2026 - or to 13.3% of the total Indian population of 1331 million.

Today, males and females in India at age 60 are expected to live beyond 75 years of age. Thus, on an average, an Indian worker must have adequate resources to support himself for approximately 15 years (and his wife for an even longer duration) after his retirement.

Traditionally, governments and societies provide economic security during old age through pension provisions. Sound pension systems form a social safety net for reducing poverty during old age. However, a rise in the number of older persons often causes a corresponding increase in government expenditure on non-contributory pensions and health services - since health and pension spending rise together. Higher government spending on old age security has often been at the cost of expenditure on other important public goods and services and has increasingly been a serious drain on government

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Need for Pension Reform finances.

As per the 1991 Census data, it is seen that India has an estimated 314 million workers (9.4% employed in the organised sector and the balance 90.6% employed in the unorganised sector). Of the working population, 15.2% (47 million) are regular salaried employees while over 53% (166 million) are self-employed and 31% (97 million) are casual/contract workers.

Of the salaried employees, approximately 23% (11.1 million) are presently employed by the Central, State and UT Governments and Departments (including post & telegraph, armed forces and railways) and are eligible to a non-contributory, defined benefit pension, funded entirely by the State. Government spending on non-contributory pensions is an enormous strain on revenues and will only increase over time with an ongoing increase in benefits as well as increasing life expectancy of the population (including current and potential pensioners).

Approximately 49% (23.18 million) of the salaried (non-Government) workers in the formal sector are covered by Provident Funds. These mandatory, employer centric, defined contribution plans (including EPFO, Coal Miners Fund, Seamen Fund, et al) cover only 177 industries and classes of establishments notified by the Government. In addition, within these specified industries, only establishments employing 20 or more persons need to provide provident fund benefits to employees. Further, employees

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Need for Pension Reform drawing a monthly salary of 6500 or more have the option to opt out from contributions to Provident Fund. Over 28% (13 million) of the salaried employees and approximately 89.2% (280 million) of the workers (including self-employed and farmers) are not covered by any pension scheme that enables them to save for economic security during old age. Though the Public Provident Fund (PPF) was introduced in 1968-69 to provide a facility to self employed persons to save for old age, it today serves only as a medium term savings instrument with liberal withdrawal facilities and tax benefits. Thus, the present formal provisions for old age income security in India cover less than 11% of the estimated working population.

However, even for these individuals, incomes generally fall below poverty line during old age despite the high levels of contribution (over 24% - among the highest in the world) prevailing in India. This is primarily due to low real returns and generous withdrawals. For instance, in 1996-97, Rs.2047 crores was prematurely withdrawn by 1.20 million provident fund members to fund marriages, illness, housing and purchase of insurance policies. In the same period, a total of Rs.3306.15 crores was paid out to 1.32 million outgoing provident fund members on account of retirement, death or leaving service indicating an average lump-sum accumulation of Rs.25,000 per member.

Over the last decade, provident funds in India have earned a return of little over 2.5% over inflation for their members (as against 11% in Chile). On the other hand, the long-

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Need for Pension Reform run average rate of return on the equity index in India is 18.5%, which has the potential to revolutionize the wealth accumulation over a worker's lifetime. The average wealth that is obtained by investing Rs.5 per working day into the equity index, from age 25 to age 60, works out to Rs.36,00,865. Over such a long term horizon, there is a 99% chance that equities outperform bonds.

While we witness an increase in the number of aged, and insufficient accumulations for old age, the traditional, informal methods for income security, such as the joint family system in India, are increasingly unable to cope with the enhanced life span and medical costs during old age.

There is growing stress in the family system and there is an immediate need for introduction of formal, contributory pension arrangements, which can supplement informal systems. This problem is particularly important in India, which will enter its demographic transition into increasing number of aged persons at lower income levels than those seen in other countries which have since long introduced systems to cope with the problems of an ageing population.

India has been among the enlightened nations, which recognised the need for social security during old age quite early. The Provident Fund Act was introduced way back in 1925 for select public enterprises. We have the Employees Provident Fund and Miscellaneous Provisions Act (EPFMP) of 1952 which covers 177 industries today. From

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Need for Pension Reform 1995, workers covered under the EPFMP Act, 1952 are also covered by the Employees Pension Scheme. While these have been laudable steps, and are serving the working class well, their coverage is woefully small, with only 11 percent of the working population in India covered by them.

There is also the Public Provident Fund (PPF) scheme for self employed and those not covered by the EPFMP Act. Though good in intention, the PPF has not been well publicised, and as a consequence, its clientele is basically confined to large cities. It is not easily accessible either.

The final reason as to why India needs reforms in its pension sector is that formal systems of retirement income provision suffer from three major weaknesses problems of funding, problems of investment restrictions and administered rates, and problems of mismanagement of funds. Each of these problems is present to varying degrees in many of the pension and provident funds in India. The ultimate impact of these problems will be to place greater demands for taxpayer-financed bailouts of these funds a solution that is not sustainable in an already difficult fiscal situation. This point has been illustrated in the Seamans Provident Fund case attached in the appendix.

Thus to conclude, projections suggest that the number of aged will rise more rapidly to 176 million by 2026; i.e. by 2025, it is anticipated that about 13.3 percent of Indias population will be above 60 years of age. This in monetary terms would mean that where

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Need for Pension Reform the Government has to provide a lowly amount of Rs 100 per month as pension to the projected 175 million elderly, it would translate into a whooping annual outflow of over Rs 210 billion (about USD 4.7 billion). This figure may increase further if the increasing average life expectancy is factored in the years to come. The proposed pension reforms suggested to address this change in Indias demographics should be viewed in the context of the existing pension system in India and its deficiencies.

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Project O.A.S.I.S.

Chapter 6

Project O.A.S.I.S. (Old Age Social And Income Security)

Introduction
The least noticed of the destitute in India are the elderly. Millions of elderly in India are trapped in misery through a combination of low income and poor health. The traditional support structure of the family is increasingly unable to cope with the problem. In a world where the joint family is breaking down, and children are unable to take care of their parents, millions of elderly face destitution. The emerging demographic profile and socio-economic scenario of the country indicate that matters will worsen dramatically in the years to come.

While there is a need to initiate poverty alleviation programs designed to support the elderly, the gigantic dimensions of the problem defy an easy solution. The steady elongation of life expectancy and declining birth rates are inexorably taking us towards an India where there will be such a large number of aged persons, that a poverty alleviation programme, which aims to pay even a modest subsidy would require a staggering expenditure much beyond the capacity of the government.

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Project O.A.S.I.S. In this situation, the Government realises that poverty alleviation programmes directed at the aged alone cannot provide a complete solution to the problem. Faced with such large numbers, it is apparent that the problem will have to be addressed through thrift and selfhelp, where people prepare for old age by savings accumulating through their decades in the labour force. The role that the Government can play in this enterprise is to create an institutional infrastructure to enable and encourage each citizen to undertake this task.

Project OASIS, the first comprehensive examination of policy questions connected with old age income security, took birth in this background. The basic mandate of the Project is to make concrete recommendations for actions, which the Government of India can take today, so that every young person can genuinely build up a stock of wealth through his or her working life, which would serve as a shield against poverty in old age.

It is interesting to note that India already has a high contribution rate to the provident fund system from amongst salaried employees in large establishments. The challenge therefore is not so much to ask workers to save more but to convert high saving rates into old age security.

The inefficiencies of the pension system and Indias precarious pension liability was first recognised by the Government in 1998. Consequently, the Government commissioned a national project titled OASIS and nominated an eight member expert committee that constituted of representatives from the Ministries of Finance, Labour and Social Justice

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Project O.A.S.I.S. chaired by Mr. S.A. Dave to suggest policy changes to the existing pension framework. Thus the OASIS Project was commissioned as the first comprehensive study of Indias pension sector by the Ministry of Social Justice and Empowerment, Government of India, to Invest India Economic Foundation (IIEF) in August 1998. The OASIS Committee commissioned over 25 research papers and studies to domestic and overseas experts and conducted several technical consultations to elicit opinions and create policy awareness and consensus on the core principals of pension system design. During the process, the OASIS Committee also received inputs from a team of experts from The World Bank. The final OASIS report was submitted to Indias Prime Minister on January 14, 2000 at New Delhi.

While the original mandate and focus of the Project OASIS Expert Committees report was on the ninety-percent of workers that are not covered by any pension scheme in India, it eventually raised awareness regarding the overall state of the pension system. Its proposals are now seen as an option to be considered beyond the informal sector. Specifically, as the pressure on government finances due to an aging civil service grew, the paradigm shift advocated by the OASIS report gained support.

Part of the awareness that was created by the OASIS Project and other efforts was recognition of the deficiencies of the existing system that provided strong rationale for reform. Low coverage, flaws in the benefit formula and indexation procedures that produce inequities between and within generations, and most notably, the risk that

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Project O.A.S.I.S. promises could not be kept in light of projected pay-as-you-go deficits were found to undermine the social objectives of the existing system. In fact, it was not clear that those social objectives had ever been clearly defined and in this way, the OASIS Project helped raise fundamental questions as to the objectives of the system itself.

Importantly, the OASIS Project brought the debate on pension system design and reform into the public domain. However, even from the outset, the policy discussion was not limited to the internal workings of the pension system. The fact that fewer than one in ten workers are covered by a pension system in a country with high levels of absolute poverty makes the indirect impact of the pension system on the economy more important than usual. Such indirect effects could be positive for example, when a pool of long term savings is created and is effectively channeled into projects that increase economic growth, or when pension funds contribute to greater liquidity and depth in domestic capital markets. However, these indirect effects can also be negative, as is the case when governments use the savings to increase wasteful public consumption or when high contribution rates add to the incentives for small firms to remain in the informal sector. In the case of civil service pensions, the program may also begin to crowd out other social programs as the pension bill eats up a rising share of tax revenues.

As the national dialogue on pension policy progressed, it was also important to recognize the opportunities and constraints for pension reform created by changes in other parts of the economy. There were important developments in the financial sector that improved

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Project O.A.S.I.S. the prospects of a funded pension system including the end of the 50 year monopoly of the Life Insurance Corporation of India and the introduction of modern technology in Indias securities markets. The growth of the private mutual fund industry, including partnerships with foreign firms, is especially relevant to the proposed reform. Meanwhile, the presence of new, voluntary private pension products provided additional rationale for the creation of a specialized pension regulator. These developments made it more likely that a defined contribution scheme of the type advocated by OASIS could succeed. The Ministry of Social Justice and Empowerment is entrusted with the nodal responsibility for care of older persons. The Ministry has been increasingly concerned with the issues of ageing, health and income security during old age as well as its close links to mental and emotional well-being. As a culmination of this growing concern, and coincidentally with 1999 being declared the "International Year of Older Persons", the Ministry commissioned the national Project titled "OASIS" (an acronym for Old Age Social and Income Security) and nominated an 8-member Expert Committee to examine policy questions connected with old age income security in India. The Project OASIS Expert Committee was mandated to make concrete recommendations for actions that the Government of India can take today, so that every young worker can build up a stock of wealth through his or her working life, which would serve as a shield against poverty in their old age.

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Project O.A.S.I.S. The research and recommendations under Project OASIS have a twin focus: that of further improving existing provisions, and, to devise a new pension provision for excluded workers who are capable of saving even modest amounts and converting this saving into an old age income security provision. The Report on reforms to the existing provisions was submitted to the Ministry of Social Justice and Empowerment in February 1999. The objective of this Report is to recommend a pension system which can be used by individuals spread all over India, which enables them to attain old age security at the price of modest contribution rates through their working career. It is simple and convenient to use and has the capability for converting modest contributions into reasonably large and comfortable sums in an almost risk-free manner for old age security.

Goals before the OASIS Committee in framing the New Pension System
(a) Today, we in India face severe problems in the form of poverty amongst the elderly. In addition, three powerful forces are at work which ensure that the problem will worsen in the years to come: Improvements in health are increasing longevity, which means that more people are living to ever-longer life spans. Present demographics suggest that a person who survives to age 60 has, on average, 17 years ahead of him. This number may rise to 25 years in the

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Project O.A.S.I.S. coming decade. This would mean that a person who retires at the age of 60 has to plan to live for a quarter century without a wage income. Families are becoming smaller as people have fewer children. Geographical labour mobility implies that children are increasingly likely to be geographically separated from their parents. Individual and social values are changing so that the joint family is increasingly considered unattractive. All these factors are leading to a situation where the young are increasingly unable or unwilling to have parents living with them. Improvements in education and health are generating new expectations on the part of the elderly for the minimal level of consumption that is considered acceptable. (b) In the face of this problem, it is clear that anti-poverty programs will simply not suffice in addressing the problem. The sheer number of the elderly is too large, and the resources with the State are too small, to make anti-poverty programs the central plank in thinking about the elderly. International experiences, and common sense, suggest that Government dole is not sustainable on a significant scale, that economic security during old age should necessarily result from sustained preparation through lifelong contributions and the central values that a pension system should emphasise are self-help and thrift. (c) Hence, the need to establish an institutional infrastructure through which individuals can prepare for old age while they are in the labour force, i.e. an efficient pension system.

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Project O.A.S.I.S. The role of the pension system is to encourage and enable old age preparation on the part of a large fraction of individuals presently working in India. (d) Most individuals in India are outside the organised sector. Thus the concept of a "regular monthly salary" is alien to most of India, and hence the concept of a "monthly pension contribution" is equally alien. The large number of workers who are agricultural labourers or construction workers falls in this category. Unorganised sector workers may change jobs, opt for spells of self-employment, move from one location to another and also face temporary unemployment during their working lives. A pension system for India should thus be flexible and useful to this mass of individuals; not just to the small fraction of people in India who work in the organised sector, have a "regular monthly salary", and undergo very little job mobility. (e) Tax incentives are more or less synonymous with old age income security savings in India. However, most individuals in India are not taxpayers, hence an exclusive focus on tax incentives as a vehicle to encourage pension savings is misplaced. Indeed, in a situation where the rich in India pay taxes while most do not, tax incentives which benefit the rich may often prove to be regressive, as the revenue forgone may be made good by some other form of commodity taxation. (f) From a financial perspective, sound pension planning can be achieved by two factors: (i) by obtaining continuous, uninterrupted accumulations and (ii) by using sound fund management to achieve the highest possible rates of return. Once these two ingredients are in place, the arithmetic of compound interest over multiple decades generates

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Project O.A.S.I.S. remarkable income security from even modest flow of savings. A rupee saved at age 25 turns into Rs 7.68 at the end of 35 years with a real rate of return of 6%. When either of these two features are absent, old age income security is lost. If the accumulation is broken by withdrawal, or if low interest rates are obtained through weak fund management, then a much higher savings rate is required in order to avoid poverty in old age. (g) The terminal wealth at age 60 is highly sensitive to the rate of return. An improvement of one percentage point in the rate of return -- i.e. from 12% to 13% - has the potential to yield a 20% higher corpus at age 60. If the interest rate goes up from 12% to around 15%, it can double the terminal accumulations. Improving the rate of return by such percentage points, without sacrificing long-term safety of funds, is possible by appropriate modifications in investment guidelines, and by entrusting funds to professional managers. (h) From a political economy perspective, a large stock of pension assets is a dangerous thing. Pension programs face large political risk. Pension systems in all countries have faced pressures from a host of special interest groups who seek to obtain "minor" alterations of pension-related policies in order to benefit themselves. This has ranged from buying shares of public sector companies, financing the Government debt, transferring resources to states, financing infrastructure, subsidising inefficient financial sector entities all the way to directed credit to "priority" sectors. Regardless of the merits of any of these claims, the only goal that the pension system should serve is the well

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Project O.A.S.I.S. being of individuals who are the contributors and hence preparing themselves for old age. This requires sound governance and sound pension system design. Individuals participating in the pension system should have incentives to take interest in the functioning of the system and block appropriation of their retirement savings by such special interest groups. (i) The challenge in building a pension system also lies in obtaining low administrative costs, nation-wide collection, and adequate simplicity for participation by millions of people with highly limited financial sophistication. The challenge also lies in obtaining freedom from fraud, and in resisting the pressures which seek to apply pension assets to further any agenda other than that of old age income security of members. (j) Research commissioned by Project OASIS shows that regular savings at the rate of between Rs 3 and Rs 5 per day through the entire working life easily suffice in escaping the poverty line in old age provided the pension assets are invested wisely. This is an extremely heartening feature of pension system design in India, since we can visualise an extremely large number of people in India today who can save between Rs 3 and Rs 5 per day and thus prepare themselves for old age income security. These numbers also remind us that low contribution rates are not the essence of the problem. (k) Systemic distortions and preferential treatment to certain provisions is undesirable and we need to strive towards creating an equitable environment and simplified provisions to encourage universal coverage both for salaried employees as well as selfemployed persons.

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Project O.A.S.I.S. (l) The pension system recommended in this Report can make an enormous difference in the form of removing millions of people from the ranks of the destitute elderly in the years to come. Each additional person who is able to plan for old age income security is one less from the ranks that require the minimum support safety net in old age. This powerful motivation is the central inspiration for the Report of the O.A.S.I.S. Committee.

Features of the Report

The Committee presented its report in January 2000 recommending a system for privatesector management of pension funds to generate market-linked returns with, inter-alia, the following features given in brief as below: The pension system would be based on individual retirement accounts with full portability across geographical locations and job changes. The account would be accessible on a nationwide basis through points of presence such as post-offices, bank branches, depository participants, etc. Contributions to the pension account would be flexible; though pre-mature withdrawals will not be permissible, micro-credit facility would be available against the pension account. Six pension fund managers would be appointed to manage the pension funds based on the lowest fee bids.

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Project O.A.S.I.S. Each pension manager would offer three schemes, viz safe income, balanced income and growth plans of which the pension account holder could select any one; further the pension account holder would be free to switch between pension schemes. Records of the pension accounts would be centralised with a central depository to minimise overheads. A separate Pensions Regulatory Authority would be set-up to regulate the pension system. Funds accumulated by the pension provider would be handed over to an annuity provider on the pension account holder attaining retirement age.

A detailed explanation of the main points covered by the report is as under: The new pension system should be based on individual retirement accounts. An individual should create this account; have a passbook where he can see a balance that is his notional wealth at that point in time; he should control how this wealth is managed; this account should stay with him regardless of where he is or how he works. He would make contributions towards his pension into this account through his working life (whether employed in the organised sector or not), and obtain benefits from it after retirement for the rest of his life. A heuristic sketch of the operations of this system may be offered here. (a) A person will open a single Individual Retirement Account (IRA) with the pension system at as early a point in his life as possible. The account will provide the individual with a unique IRA number that will stay with the individual through life. The individual

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Project O.A.S.I.S. would save and accumulate assets into this account in his working life, subject to a minimum of Rs 100 per contribution and Rs 500 in total accretions per year. Individuals would be free to decide the frequency of accretions into their accounts; there will be no pressure to make a fixed monthly contribution. The account would stay with the individual across job changes, spells of unemployment, and can be accessed at any location in India. The individual would always have access to an account balance statement showing his assets. All through, the individual would be empowered in having control of how his pension assets should be managed. Finally, upon retirement, the individual would be able to use his pension assets to buy annuities from annuity providers, and obtain a monthly pension. (b) In this entire process, a sound regulatory framework would give individuals an umbrella of safety with respect to problems of risk management and prevention of fraud. c) A key feature of the system described ahead is a high ease of access to the pension system through myriad Points of Presence (POPs) which would be located all over India and will include post offices, bank branches, etc. The individual would be able to visit any POP in India (not just the POP where he had opened the IRA) and conduct transactions on his individual retirement account. Every POP would exhibit identical features, processes and procedures. These transactions would be extremely simple and convenient, so as to require minimal knowledge about the financial sector. (d) Individual accounts imply full portability: i.e. the individual would hold on to a single account across job changes across geographical locations. Individual accounts will also

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Project O.A.S.I.S. give individuals the opportunity to alter their risk profile in the life cycle in an optimal fashion (from high-risk, high-return investments at a young age to a low-risk, low-return portfolio when approaching retirement) if they so desire, while allowing them full freedom and flexibility in making their own choices. Individual accounts also interpret individual accumulations as individual wealth; they eliminate the free-rider problem of collectivist programs. The accumulation of retirement assets, in a form which is manifestly visible as individual wealth, helps reduce the political risks that many pension systems have suffered from. Service delivery (a) Individuals should be able to access and operate their retirement accounts from "Points of Presence" (or POPs) located all over India. Any individual would be able to obtain identical services from any POP located anywhere in India. The facilities that individuals should be able to access are extremely simple : Open an individual retirement account and obtain a permanent and unique IRA number Submit contributions into this account Obtain an account balance statement, and Submit instructions governing pension fund management

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Project O.A.S.I.S. (b) The committee proposed a two-tier system where POPs with good information technology and telecommunications facilities would offer better services than other technologically constrained POPs. At a POP that has IT and telecommunications facilities, all these transactions would be satisfactorily completed instantaneously. At other POPs, there would be delayed responsivity: for example, when the individual asks for an account balance statement, he would get it a few days later. (c) The committee emphasized a need to harness the largest number of POPs possible, while preferring POPs that have IT and telecommunications facilities. The universe of POPs would include: Bank branches, Post offices, Depository participant offices. Any other location from which electronic connectivity into a central computer system is possible . Centralisation of record-keeping and individual access (a) The committee recommended that the Government should obtain centralisation of record-keeping and individual transactions through a centralised depository. The depository would be connected to the myriad POPs spread across the country. An individual would be able to access any POP and conduct all transactions. Individuals would be able to submit instructions with any POP which would transmit these to the depository, which would in turn implement them with the relevant Pension Fund Managers (PFMs). The accent on modern IT and communications, with a modern depository, would yield superior services and a reduced risk of fraud, at a lower cost.

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Project O.A.S.I.S. (b) The basic architecture of the system is hence one where individuals deal with POPs, which carry these instructions to the depository. The depository would maintain the database of all individual accounts as well as the instructions given by each individual. The depository would consolidate individual instructions into blocks of funds, which will be handed over to PFMs. In this system, PFMs would be able to focus purely on what they do best -- i.e. Fund Management. They would only obtain a single instruction from the depository everyday, which will drive the assets under their management. This would make it possible to sharply drop the fees and expenses in fund management. (c) PFMs would be provided the database of individuals who have chosen them. This would make it possible for PFMs to understand their user profiles, optimise sales strategies, and offer improved services directly. (d) The Depository will provide an IRA balance statement to each individual once every six months. This statement will be forwarded at no cost to the individual through the POP located closest to the individuals contact address. The role for IT in lowering transactions costs Technology-intensive solutions are often conceived to be expensive. However, an essential insight into the problem of transactions costs is that the deployment of computers and telecommunications is the essence of lowering transactions costs.

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Project O.A.S.I.S. The OASIS report was followed up by the World Bank report on pension reforms in April 2001. The World Bank report critically reviewed the OASIS report and endorsed that privatisation of pension sector was the need of the hour.

While the OASIS report suggested a pension framework for the organised sector, the Finance Minister in his Budget speech for 2001 acknowledged that the Central Governments pension liability had reached unsustainable proportions and announced that a high level committee would be formulated to design a contribution based pension scheme for new Government recruits. Further, the Finance Minister required the Insurance Regulatory and Development Authority (IRDA), the Indian insurance industry regulator, to devise an implementation plan for the OASIS report so as to formulate a pension scheme for the unorganized sector.

As requested, the IRDA submitted its report in October 2001 in which it examined various aspects of the OASIS report and suggested, inter-alia, the following: Pension fund managers should constitute a separate legal entity to conduct pension business. The IRDA should regulate the pension sector since international experience suggests that pension and life insurance industry is regulated by a common regulator due to similarities in the sector. There should be no ceiling on the number of pension fund managers.

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Project O.A.S.I.S. The pension fund managers should be vertically integrated to offer the full lifetime process of fund management and annuities, though the pension account holder would have the option of choosing an annuity provider of his choice. Fund management would be on a passive basis so as to minimise transaction costs.

For about a year and a half after the IRDA submitted its report, no announcement was made as regards either the policy on pension reform or the mechanism to implement the suggested reforms.

Finally, the Finance Minister in his Budget speech for 2003 announced that the restructured pension scheme in respect of new entrants to Government service was being finalised and would soon be introduced. The Finance Minister also indicatedthat the scheme would be available to all employers for their employees and to the self-employed on a voluntary basis.

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Indian Pension Reform 2003

Chapter 7

The Indian Pension Reform of 2003

Change in Government Pension Scheme from Defined Benefit to Defined Contribution for new entrants: Despite the inherently long time horizon of pension systems, changes to these important programs are observed to be quite frequent over the course of the last century. In some sense, this should be expected given the difficulties of predicting what the world will look like when a young worker today joins the ranks of the elderly tomorrow. Changing demographic structures, income levels, technology and even cultural changes can and have forced policy makers throughout the world to reconsider the intergenerational equation.

It should not come as a surprise then, that India is among a growing number of countries considering important changes to the institutions and policies that aim to provide their workers with a measure of income security in old age. Rather, what is surprising is how little the two main pension schemes currently operating have changed since Independence. For the private sector, the basic structure outlined in the Employees Provident Fund Act of 1952 remained unquestioned for almost four decades while the inherited British pension scheme for civil servants still operates essentially as it did under colonial rule. Project Report 46 By:Ayesha Gagrat

Indian Pension Reform 2003

A major change did occur in 1995 however, with the conversion of part of the definedcontribution, EPF scheme to a defined benefit scheme in the form of the Employees Pension Scheme. This was an important break with previous policy in two ways. First, it extended the concept of a mandated annuity to the private sector for the first time. Second, it added a new pension liability to the one that already existed with regard to civil servants. In doing so, India became one of the last countries to join the century-long march to dependence on publicly-managed, defined benefits schemes that are financed on a pay-as-you-go basis.

India, however, can exhibit stark contrasts at times. Satellites and firms producing the cutting edge of information technology are juxtaposed with brown-outs in the capital and hugely inefficient state enterprises. While reforms open the insurance sector for the first time in five decades to competition and set up a new insurance regulator, the government is forced to bail out a quasi-public sector mutual fund. The introduction of a new, public DB pension scheme in 1995 is followed a few years later by proposals for introducing the first privately-managed, defined contribution pension provision in South Asia. The latter pension reform was first proposed in 1998 by a special commission known as the Old Age Security and Income Security (OASIS) Project.

In his annual budget speech in February 2003, Indias Union Finance Minister, Mr. Jaswant Singh, announced a bold and progressive pension reform initiative with the core elements of a privately-managed, defined contribution scheme that would eventually Project Report 47 By:Ayesha Gagrat

Indian Pension Reform 2003 replace the non-contributory, defined benefit scheme of the civil service. In his Budget speech, the Finance Minister said :

My predecessor in office had, in 2001, announced a road map for a restructured pension scheme for new Central Government employees, and a scheme for the general public. This scheme is now ready. It will apply only to new entrants to Government service, except to the armed forces, and upon finalization, offer a basket of pension choices. It will also be available, on a voluntary basis, to all employers for their employees, as well as to the self-employed. This new pension system, when introduced, will be based on defined contribution, shared equally in the case of Government employees between the Government and the employees. There will, of course, be no contribution from the Government in respect of individuals who are not Government employees. The new pension scheme will be portable, allowing transfer of the benefits in case of change of employment, and will go into individual pension accounts with Pension Funds. The Ministry of Finance will oversee and supervise the Pension Funds through a new and independent Pension Fund Regulatory and Development Authority.

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Indian Pension Reform 2003 The key feature of this new system is the individual, defined contribution account. This is a fundamental change and the first system of its kind in South Asia. The details of the proposal began to emerge in the following months and included the following: Reliance on private asset managers to be selected through a bidding process. Centralized record-keeping and administration of individual retirement accounts. Limited choice among investment portfolios. Contribution rates set with the intention of providing roughly the same replacement rate as current levels to a central government worker with a full contribution history.

Also important is the population targeted for coverage by this new pension system. To start with, only new entrants to central government service would be obliged to join the new DC scheme while other workers would be allowed to do so on a voluntary basis, but without contributions from the state. While this strategy avoids difficult issues related to those civil servants that already have acquired pension rights in the old system, it also prolongs the transition period and results in relatively small numbers of contributors in the early years of the scheme.

Another significant element in the new system is the new pension fund supervision agency. The first of its kind in the region, the Pension Fund Regulatory and

Development Authority (PFRDA) would be responsible for enforcing a set of regulations which have yet to be issued. Presumably, the rapidly growing voluntary private pension

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Indian Pension Reform 2003 sector as well as the enterprise-based schemes that operate in parallel, such as the electricity board pension plans, would also fall under the new regulatory framework. Finally, following recommendations by The World Bank and the Asian Development Bank in two major studies, this new agency may eventually be charged with oversight of the schemes currently supervised by the EPFO. In short, the PFRDA could bring the entire pension sector under one supervisory umbrella for the first time in Indias history.

While the broad policy framework of the reformed civil service scheme has been described, a plethora of design and implementation questions remain. Among the most pressing are the following : How soon can the appropriate information technology for collection and recordkeeping be constructed ? What is the required size and budget of the new supervisory agency ? What regulations must be issued and how are these to be coordinated with those falling under the securities and insurance sectors (SEBI and IRDA, respectively). How will the fund managers be selected and on the basis of what criteria ?

These are only a few of the several challenging issues facing public officials responsible for implementing the reform, and the list of policy decisions to be made is much longer. For example, the rules regarding the payout period have yet to be defined. Each of these questions requires discussion about policy objectives as well as analytical work to spell out the possible solutions.

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Indian Pension Reform 2003 While a daunting task, there is ample international experience that shows systemic reform is possible. Roughly a dozen Latin American countries have already introduced

individual account schemes and have managed (some better than others) the transition from an unfounded, DB scheme to a funded, DC scheme. With regard to civil service schemes in particular, most of the Latin American reformers have integrated their civil service pension schemes with those of the private sector. In Eastern Europe, special schemes for civil servants had already been eliminated during the socialist period.

While India will become the first South Asian country to introduce a privately-managed, defined contribution scheme for its civil servants, there is some precedent elsewhere. A similar arrangement to the one proposed, known as the Thrift Savings Plan (TSP), was introduced for federal government workers in the United States after 1984 and has been deemed a success after almost two decades. More recently in 2000, HongKong required new civil servants to join the Mandatory Provident Fund system, a privately-managed, employer-based, DC scheme that covers the entire labour force. Interestingly, the

pension scheme being replaced is essentially the same type of scheme as that found today in India having been inherited from the colonial period.

In short, while this is a bold reform with far-reaching implications, it is a reform that is demonstrably feasible. However, the task is huge and will take some time to implement even under the best of circumstances.

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Indian Pension Reform 2003

The New Pension Scheme

As promised by the Finance Minister in his Budget speech, the Government on August 23, 2003 approved contours of the radical transformation of Indias pension sector; the pension scheme would initially be available to central Government employees. The service delivery features of the new pension scheme are broadly based on the recommendations of the OASIS report complemented by certain suggestions made in the IRDA report, as illustrated in the following diagram.

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Indian Pension Reform 2003

PFM I N D I V I D U A L W O R K E R S POPs

Indian Pensions Authority

PFM POPs

PFM

POPs

Depository
POPs

Annuity Providers

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Indian Pension Reform 2003

The scheme is based on individual retirement accounts linked to a central depository with defined points of presence from which these accounts may be accessed. Certain other features of the scheme are as follows: It would be mandatory for new entrants into the Union Government employment (excluding defense personnel) to join the scheme. The monthly contributions would be 10 percent of the salary and the dearness allowance by both, the employee and the government. There will be no cap on the number of fund managers and they would have the leeway to make investments in the international markets subject to regulatory restrictions. Fund managers will offer three schemes, the investment pattern of which would be broadly on the following lines. Type of Type of Instrument Government Paper Corporate Paper Equity Safe Income >60 >30 <20 Balanced Income >40 >40 <20 Growth >25 >25 <50

ed

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Indian Pension Reform 2003 While exiting at the age of 60 years or above, the individual would have to mandatorily invest atleast 40 percent of the pension money to purchase annuity from an IRDA regulated life An interim Pension Fund Development and Regulatory Authority (PFRDA) will be set up to regulate the pension industry. The Government has constituted the PFRDA on October 11, 2003 and proposed to put in place the central registry and other necessary legislation/regulations, such that the new pension scheme could be launched effective January 1, 2004.

On the other hand, the short-term fiscal pressures partly due to pension payments made it more difficult to move quickly from an unfunded to a funded pension scheme. The Union government as well as state governments have grown dependent on an automatic source of deficit finance by way of the EPFO schemes, and the introduction of an employer contribution to the new civil servants scheme would require additional resources.

After several years, the rationale for pension reform, the cost of inaction and the constraints to be taken into account, have percolated to the higher levels of government and public awareness has increased. Even so, the reform announced by the Minister of Finance in March 2003 represents but the first step in the proverbial thousand mile journey.

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Pension Fund Regulator & Ordinance

Chapter 8

Pension Fund Regulator & Development Authority Ordinance 2004

As the Government decided to have a defined contribution pension scheme for all their recruits, steps had to be taken to implement the scheme. The Government has passed an Ordinance titled The Pension Fund Regulator and Development Authority Ordinance 2004. this Ordinance lays down the framework for the operation of the defined contribution scheme for the civil service recruits as also for any other pension scheme which is not regulated by any other enactment. The salient features of this Ordinance are reproduced below:

Objects: An Ordinance to provide for the establishment of an Authority to promote old age income security by establishing, developing and regulating pension funds, to protect the interests of subscribers to schemes of pension funds and for matters connected therewith or incidental thereto.

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Pension Fund Regulator & Ordinance

Short title, extent and commencement: (1) This Ordinance may be called the Pension Fund Regulatory and Development Authority Ordinance, 2004. (2) It extends to the whole of India. (3) It shall come into force at once.

Definitions: (1) In this Ordinance, unless the context otherwise requires, (a) Authority means the Pension Fund Regulatory and Development Authority established under sub-section (1) of section 3; (b) central record keeping agency means an agency registered under section 24 to perform the functions of record keeping, accounting, administration and customer service for subscribers to schemes; (c) Chairperson means the Chairperson of the Authority; (d) individual pension account means an account of a subscriber, executed by a contract setting out the terms and conditions under the New Pension System; (e) intermediary includes pension fund, central record keeping agency, pension fund adviser, retirement advisor, point of presence and such other person or entity connected with collection, management, record keeping and distribution of accumulations; (f) member means a member of the Authority and includes its Chairperson; (g) New Pension System means an the contributory pension system

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Pension Fund Regulator & Ordinance referred to in section 20 whereby contributions from a subscriber are collected in an individual pension account using points of presence and central record keeping agency and accumulated by pension funds for pay offs as specified by regulations; (h) notification means a notification published in the Official Gazette; (i) pension fund means an entity registered with the Authority under subsection (3) of section 24 as a pension fund for receiving contributions, accumulating them and making payments to the subscriber in the manner specified by regulations; (j) Pension Regulatory and Development Fund means the fund constituted under subsection (1) section 37; (k) point of presence means an entity registered with the Authority under sub-section (3) of section 24 as a point of presence and capable of electronic connectivity with the central record keeping agency for the purposes of receiving and transmitting funds and instructions and pay out of funds; (l) prescribed means prescribed by rules made under this Ordinance; (m) regulated assets means the assets and properties, both tangible and intangible, owned, leased or developed by and other rights belonging to, the central record keeping agency; (n) regulations means regulations made by the Authority under this Ordinance; (o) scheme means a scheme of pension fund approved by the Authority under this Ordinance;

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Pension Fund Regulator & Ordinance (p) Securities Appellate Tribunal means a Securities Appellate Tribunal established under sub-section (1) of section 15K of the Securities and Exchange Board of India Act, 1992; (q) subscriber includes a person who subscribes to a scheme of a pension fund; (r) Subscriber Education and Protection Fund means the fund constituted under subsection (1) of section 38;

Establishment and incorporation of Authority: (1) With effect from such date as the Central Government may, by notification, appoint, there shall be established, for the purposes of this Ordinance, an Authority to be called the Pension Fund Regulatory and Development Authority. (2) The Authority shall be a body corporate by the name aforesaid, having perpetual succession and a common seal with power, subject to the provisions of this Ordinance, to acquire, hold and dispose of property, both movable and immovable, and to contract and shall, by the said name, sue or be sued.

Composition of Authority: The Authority shall consist of a Chairperson and not more than five members, of whom at least three shall be whole-time members, to be appointed by the Central Government from amongst persons of ability, integrity and standing and having experience and knowledge in economics, finance, law or administrative matters with at least one person from each discipline.

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Pension Fund Regulator & Ordinance Extent and Application (1) This Ordinance shall apply to (a) the New Pension System; (b) any other pension scheme not regulated by any other enactment. (2) Every pension scheme referred to in clause (b) shall conform to the regulations made by the Authority within such time as may be specified in the regulations. (3) Notwithstanding anything contained in sub-section (1), the provisions of this Ordinance shall not apply to (a) the schemes or funds under (i) the Employees Provident Funds and Miscellaneous Provisions Act, 1952; (ii) the Coal Mines Provident Fund and Miscellaneous Provisions Act, 1948; (iii) the Assam Tea Plantations Provident Fund and Pension Fund Scheme Act, 1955; (iv) the Jammu and Kashmir Employees Provident Funds Act, 1961; and (v) the Seamens Provident Fund Act, 1966; (b) contracts referred to in sub-section (11) of section 2 of the Insurance Act, 1938; (c) any other pension scheme, which the Central Government may, by notification, exempt from the application of this Ordinance; (d) persons appointed before the 1st day of January, 2004 to public services in connection with the affairs of the Union or to All-India Services constituted under section 2A of the All-India Services act, 1951; (e) persons appointed to public services in connection with the affairs of any State or Union territory.

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Pension Fund Regulator & Ordinance (4) Notwithstanding anything contained in sub-section (3), any State Government may, by notification, extend the New Pension System to its employees. (5) Any person governed under any of the schemes or funds referred to in subsection (3) may, at his option, join the New Pension System.

Duties, Powers and Functions of Authority: (1) Subject to the provisions of this Ordinance and any other law for the time being in force, the Authority shall have the duty to regulate, promote and ensure orderly growth of the New Pension System and pension schemes to which this Ordinance applies and to protect the interests of subscribers of such System and schemes.

(2) Without prejudice to the generality of the provisions contained in sub-section (1), the powers and functions of the Authority shall include (a) regulating the New Pension System and the pension schemes to which this Ordinance applies; (b) approving schemes, the terms and conditions thereof and laying down norms for the management of the corpus of the pension funds, including investment guidelines under such schemes; (c) registering and regulating intermediaries; (d) issuing to an intermediary, on application, a certificate of registration and renewing, modifying, withdrawing, suspending or cancelling such registration; (e) protecting the interests of subscribers to the pension funds;

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Pension Fund Regulator & Ordinance (f) establishing mechanism for redressing grievances of subscribers to be determined by regulations; (g) promoting professional organisations connected with the pension system; (h) adjudication of disputes between intermediaries and between intermediaries and subscribers; (i) collecting data and requiring the intermediaries to collect such data and undertaking and commissioning studies, research and projects; (j) undertaking steps for educating subscribers and the general public on issues relating to pension, retirement savings and related issues and training of intermediaries; (k) standardising dissemination of information about performance of pension funds and performance bench marks; (l) regulating the regulated assets; (m) levying fees or other charges for carrying out the purposes of this Ordinance; (n) specifying by regulations the form and manner in which books of account shall be maintained and statement of accounts shall be rendered by intermediaries; (o) calling for information from, undertaking inspection of, conducting inquiries and investigations including audit of, intermediaries and other entities or organisations connected with pension funds; (p) exercising such other powers and functions as may be prescribed.

(3) Notwithstanding anything contained in any other law for the time being in force, while exercising the powers under clause (o) of sub-section (2), the Authority shall have

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Pension Fund Regulator & Ordinance the same powers as are vested in a civil court under the Code of Civil Procedure, 1908 while trying a suit, in respect of the following matters, namely: (i) the discovery and production of books of account and other documents, at such place and at such time as may be specified by the Authority; (ii) summoning and enforcing the attendance of persons and examining them on oath; (iii) inspection of any books, registers and other documents of any person or entity referred to in section 24, at any place; (iv) issuing commissions for the examination of witnesses or documents; (v) any other matter which may be prescribed.

New Pension System

The contributory pension system notified by the Government of India in the Ministry of Finance vide notification number F. No. 5/7/2003-ECB & PR dated the 22nd December, 2003, as amended from time to time, and having the following basic features, shall, from the New Pension System under this Ordinance, namely: (a) every subscriber shall have an individual pension account; (b) the functions of recordkeeping, accounting and switching of options by the subscriber shall be effected by the central recordkeeping agency; (c) there shall be a choice of multiple pension fund managers and multiple schemes; (d) there shall be portability of individual pension accounts in case of change of employment;

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Pension Fund Regulator & Ordinance (e) collection and transmission of contributions and instructions shall be through points of presence to the central record keeping agency; (f) there shall not be any implicit or explicit assurance of benefits except market based guarantee mechanism to be purchased by the subscriber; (g) a subscriber shall not exit from the New Pension System except as specified by the Central Government by, notification; (h) at exit, the subscriber shall purchase an annuity from a life insurance company as specified under the New Pension System.

Central record keeping agency: (1) The Authority shall, by granting a certificate of registration under subsection (3) of section 24, appoint a central record keeping agency: Provided that the Authority may, in public interest, appoint more than one central record keeping agency. (2) The central record keeping agency shall be responsible for receiving funds and instructions from subscribers through the points of presence, transmitting such instructions and transferring such funds to pension funds, effecting switching instructions received from subscribers and discharging such other duties and functions, as may be assigned to it under the certificate of registration or as may be determined by regulations. (3) All the assets and properties owned, leased or developed by the central record keeping agency, shall constitute regulated assets and upon expiry of certificate of registration or earlier revocation thereof, the Authority shall be entitled to appropriate and take over the

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Pension Fund Regulator & Ordinance regulated assets, either by itself or through an administrator or a person nominated by it in this behalf:

Provided that the central record keeping agency shall be entitled to be compensated the fair value, to be ascertained by the Authority, of such regulated assets as determined by regulations:

Provided further that where the earlier revocation of the certificate of registration is based on violation of the conditions in the certificate of registration or the provisions of this Ordinance or regulations, unless otherwise determined by the Authority, the central record keeping agency shall not be entitled to claim any compensation in respect of such regulated assets.

Point of Presence: (1) The Authority may, by granting a certificate of registration under subsection (3) of section 24, permit one or more persons to act as a point of presence or points of presence for the purpose of receiving contributions and instructions, transmitting them to the central record keeping agency and paying out benefits to subscribers in accordance with the regulations made by the Authority from time to time in this regard. (2) A point of presence shall function in accordance with the terms of its certificate of registration and the regulations made under this Ordinance.

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Pension Fund Regulator & Ordinance Pension Funds: (1) The Authority may, by granting a certificate of registration under subsection (3) of section 24, permit one or more persons to act as a pension fund for the purpose of receiving contributions, accumulating them and making payments to the subscriber in such manner as may be specified by regulations. (2) The number of pension funds shall be determined by regulations and the Authority may, in public interest, vary the number of pension funds. (3) The pension fund shall function in accordance with the terms of its certificate of registration and the regulations made under this Ordinance. (4) The pension fund shall manage the schemes in accordance with the regulations.

Registration of central record keeping agency, pension fund, point of presence: (1) No intermediary, including a pension fund or a point of presence to the extent regulated under this Ordinance, shall commence any activity relating to a pension fund except under and in accordance with the conditions of a certificate of registration granted by the Authority in accordance with provisions of this Ordinance and the regulations:

Exemption from tax on wealth, income, profits and gains. Notwithstanding anything contained in (i) the Wealth Tax Act, 1957; (ii) the Income Tax Act, 1961, or

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Pension Fund Regulator & Ordinance (iii) any other enactment for the time being in force relating to tax on wealth, income, profits or gains, the Authority shall not be liable to pay wealth-tax, income-tax or any other tax in respect of its wealth, income, profits or gains derived.

Power to make Regulations: (1) The Authority may, by notification, make regulations consistent with this Ordinance and the rules made thereunder to carry out the provision of this Ordinance. (2) In particular, and without prejudice to the generality of the foregoing power, such regulations may provide for all or any of the following matters, namely: (a) the times and places of meetings of the Authority and the procedure to be followed at such meetings (including the quorum at such meetings) under subsection (1) of section 10; (b) the transactions of business at the meetings of the Authority under subsection (5) of section 10; (c) the terms and other conditions of service of the officers and other employees of the Authority under sub-section (2) of section 12; (d) the regulations to be made by the Authority in respect of pension schemes referred to in clause (b) of sub-section (1) of section 13 and the time within which such schemes should conform to the regulations, made under sub-section (2) of that section; (e) the establishing of mechanisms for redressing grievances of subscribers under clause (f) of sub-section (2) of section 14;

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Pension Fund Regulator & Ordinance (f) the form and manner in which books of account shall be maintained and statement of accounts shall be rendered by intermediaries under clause (n) of sub-section (2) of section14; (g) the duties and functions of central record keeping agency under subsection (2) of section 21; (h) the determination of compensation of fair value of the regulated assets payable to central record keeping agency under proviso to sub-section (3) of section 21; (i) the manner of receiving contributions and instructions and transmitting them to the central record keeping agency and paying out the benefits to the subscribers, under subsection (1) and the regulations governing functioning of points of presence under subsection (2) of section 22; (j) the manner in which a pension may receive contributions, accumulate them and make payments to the subscriber under sub-section (1), the number of pension funds under subsection (2), the functioning of the pension fund under sub-section (3), and the manner of managing the schemes by the pension fund under sub-section (4), of section 23; (k) the form and manner in which an application for grant of certificate of registration shall be made and the fee which shall accompany such application (l) the conditions subject to which a certificate of registration may be granted to an intermediary under sub-section (3) of section 24; (m) the procedure and manner of suspension or cancellation of certificate of registration of intermediaries under sub-section (4) of section 24;

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Pension Fund Regulator & Ordinance (n) the procedure for holding inquiry by an adjudicating officer under subsection (1) of section 27; (o) the supersession of the governing board or board of directors of the intermediary under sub-section (2) of section 28; (p) the manner of administering and utilising the Subscribers Education and Protection Fund under sub-section (3) of section 38; (q) delegation of powers and functions of the Authority to Committees under subsection(2) of section 50; (r) any other matter which is required to be or may be specified by regulations or in respect of which provision is to be or may be made by regulations.

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Challenges Ahead

Chapter 9

Challenges Ahead
The pension framework outlined by the Government though inspired by existing models successfully being implemented in other countries, may be prone to challenges in the Indian scenario given the rural demography of India. Earlier, concerns were expressed on whether the pension system would be able to generate enough critical mass to ensure its sustainability. However, this fear has been mitigated to a certain extent with state Governments of seven states already showing keen interest in enrolling their employees into the Central Government Pension Scheme.

The long-term sustainability of the proposed pension framework would largely be influenced by the marketing effort that is put into giving large scale publicity to the concept of pension as a whole and to the benefits available under the reformed pension scheme in particular. This is seen as one of the greatest challenges since contribution into the pension system would depend upon both the willingness and the ability of rural India to postpone current consumption to the future.

It is necessary that the appropriate information technology for collection and record keeping has to be constructed.

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Challenges Ahead

The proposed pension framework would need to factor in ways and means to keep in check the transaction processing time and cost to ensure that the pension system is selfsufficient and needs minimal funding by way of deficit financing.

The Government also needs to lay out a framework for operationalising the new pension scheme, which has already been delayed with the proposed launch date of January 1, 2004 not being met. Further, the Government would also need to ascertain the role of the EPFO in the reformed pension environment and whether funds with the EPFO would ultimately merge into the new pension system or whether there would be a separate initiative to reform the EPFO.

The Government also has to prepare rules and regulations governing the POPs. Pension fund managers require to be appointed and rules and regulations that govern these pension fund managers need to come into existence.

The Pension fund managers maybe required to bring in a large amount of capital. As the current scheme is offered to only the new recruits of the Central Government, the number of subscribers to the scheme would be very few. Thus not many parties would be interested in participating as it would be unviable. All the State Governments should be requested to join in and also, the scheme should be extended to the employees in the organised and unorganized sectors.

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Challenges Ahead The Government has to undertake the task of educating the employees and others who participate in the scheme in the matter of selection of the Pension Fund Manager and the schemes which they offer.

The Government has to take on the challenge of attracting individual and self employed people to participate in the new scheme so that the number of participant increase.

Also, though the Government has indicated that foreign direct investment would be permissible in the pension sector, a policy announcement to this effect and the percentage of foreign direct investment that would be permissible is yet to be announced. Clarity on such key matters is necessary to prompt competent fund managers to commit themselves to the pension cause.

Due to the large potential in this area, huge interest is expected from foreign majors (players present in mutual fund, pension fund and insurance sectors). It is estimated that the amounts involved would far exceed the current asset management market in India. Foreign major interest has already been witnessed in the insurance space wherein they have preferred partnering with major local financial conglomerate, which is also likely to be seen in the pension fund business.

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Conclusion

Chapter 10

Conclusion
Pension reform is squarely on the agenda in India and the stakes are high. Paramount of course are the dual objectives of consumption smoothing and alleviation of poverty in old age. By providing a safe vehicle for long term savings, a well-designed pension system can improve the lives of millions of Indian citizens in the decades to come. As such, it is a key area of social policy for the Government of India.

The nature of the system that has been proposed involves new institutions, in particular regulators, record-keeping agencies and of course, pension fund managers. Setting them up properly is a great challenge. But a well-regulated and efficient pension system can achieve two important things under the right conditions: First, it can effectively channel resources from savers to the increasingly dynamic private sector firms that can promote economic growth. Second, it will result in demand for longer term instruments including government and even mortgage-backed bonds. Together, the impact on government finances and capital market liquidity can generate indirect benefits for the rest of Indias vast population.

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Conclusion In order to reap these rewards, the system must be based on a sound design and be well implemented. Both will require a concerted effort and support from stakeholders. In the coming months, the new Pension Regulatory and Development Authority will begin to operate, policy-makers will finalize the design of the new system and the administrative apparatus will be constructed.

Pension reforms in other countries reveal that it is a long drawn process that requires consistent commitment from the Government. For a country of Indias size and population, flexibility in pension opportunities will play a significant role in its success. While it is necessary that rules and regulations be laid down to regulate the pension system, the number and stringency of these rules should keep in mind the overall objective of the pension system. With the formulation of the new pension scheme, the Governments job has just begun; the bigger objective is to change the ideology of Indias population and to engrave in them the importance of saving the best for the last.

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Appendix

Appendix
A Case Study Seamens Provident Fund - A Crises of Governance
The Seamens Provident Fund Organisation (SPFO) was set up by an Act in 1966, with the mandate to provide social security to seamen upon retirement, either at superannuation age or due to work related stress or injury. The scheme was also extended to cover their families upon the death of the seamen. The scheme itself was deemed to have come into existence in 1964.

The Structure of the SPF It is a mandatory, defined contribution scheme: all employers who were eligible under the Merchant Shipping Act, 1958, have had to contribute to the SPFO, where the total contribution on their part had to match the contribution of their employees. When the Act was first set up, it fixed the rate of contribution to 8 percent. It was later amended to 10 percent and then to 12 percent, or any higher rate that the employer deemed appropriate. This allowed the employer the flexibility to put aside a higher amount for the retirement benefit of the seamen. The contribution was deposited with the SPFO at the termination of every voyage. At the time of this amendment, the Merchant Navy

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Appendix Association was also brought under this scheme. As of year-end of 1999, SPFO covered 33,708 accounts with a total accumulation of Rs.3.05 billion.

Like all pension funds in India, fund investments have to follow a defined pattern that is set by the Ministry of Finance. The pattern for the SPFO is as follows:

1.

The largest amount of 55 percent is to be invested in a Special Deposit Scheme introduced by the Ministry of Finance in 1975.

2. 3.

15 percent could be invested in Central or State Government securities. 30 percent could be invested in PSU bonds or equities.

It was initially set up so that the collection and the investment of funds could be done at a single bank (the State Bank of India, SBI). This was later amended to allow for the funds to be deposited at any nationalized bank to allow for a wider distribution channel that would be available to seamen.

Aspects of Governance and Regulation The SPF is vested in and administered by a Board of Trustees. The membership of this board consists of four members, a Chairman and a representative each of the Government, the Ship owners and the Seamen. The ex-officio chairman is typically the Director General of Shipping. The Commissioner of the SPFO acts as Secretary to the Trust.

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Appendix All the appointments of the top levels of management at the SPFO is done by the Government of India. The Chairman of the Board of Trustees is also a Government appointee. Thus, there is a strong state control on the management of the SPFO. The original Act awarded the state control on appointments of even lower level positions in the SPFO. However, this was changed in the amendment of 1996, where control of the fund management was shifted to be the responsibility of the Chairman of the SPFO.

Lastly, the Act also defines the upper bound on the fines that are to be imposed in case the management indulges in fraudulent practices. The original Act specified an amount of Rs.1000 in case such instances were uncovered. It has been amended to Rs.50,000.

All of these point to the regulation of the SPFO being defined vigorously down to the level of specific amounts of wages and fines. However, a rigid structure of regulation and governance often precludes the fact that criminal offences undergo innovations, and that governing the SPF under a very rigid set of rules and regulation leaves it vulnerable to offences that the Act has not covered.

The Problem of Poor Governance in the Management of Funds In April 2002, it was discovered that a sum of nearly Rs.930 million had been placed with a debt market broker (Home Trade) to purchase Govt. of India bonds for the SPF. The broker defaulted on delivering the bonds. The trade showed up several disparities

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Appendix between the manner in which the SPF carried out its investments and gilt bond investments practices that are the norm in the country today.

The Reserve Bank of India (RBI) had announced in an announcement in November 2001 that all fresh purchases of bonds should be dematerialized. The SPF transaction was to purchase physical units of the bonds.

Almost all gilt securities transactions are bilateral transactions, settled by the end of the day. The transaction is supposed to be done only after the funds and the securities are verified to be in the accounts of the counter parties.

In this case, the funds were transferred but the securities were not delivered. This almost certainly points to some attempt to deliberately defraud the SPF of funds.

This implied that of a total asset base of about Rs.3 billion, SPF had lost about Rs.930 million almost a third of its fund. Thus far, appeals of the SPF for a bailout by the government have not been received favorably. It is unclear how the SPF will honour its obligations to its contributors.

What is most troubling about this story is that the default to the SPF was not reported immediately. It was only after Home Trade defaulted on delivering gilt securities to a cooperative bank (Nagpur Co-operative Bank) that this problem of a similar default at the

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Appendix SPF was uncovered. This points to either problems of deliberate non-disclosure on the part of SPF management, or a lack of awareness at the management of the status of its investment portfolio.

Principles for Management and Regulation of Pension Funds Even with tightly defined rules of investment, pension funds are vulnerable to gaps in regulation and problems of governance. This can be clearly seen from the example of Indias SPF. Since pension funds in India, are typically locked into the same

management for long periods of time, the management ahs to be especially careful and alert to poor decision making or any misconduct by employees.

For example, a common problem with financial investment management is the temptation to throw good money after bad investments in the hope that the bad investment will eventually turn around. This has been a vulnerability with asset management is all financial sectors: the common practice of ever-greening of bad loans at banks, the cascading of losses in equity markets, etc. These problems are even more pervasive if the investment horizon is long; i.e., returns have only to be delivered at a point far away from the funds being received.

The optimal governance structure would be one that makes the attempt to tie in management incentives with that of the goals of pension funds. The best performance of securities industries professionals are typically seen in competitive market structures,

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Appendix where the clientele has the freedom to move from one service provider to another with as small a transaction cost as possible. Such as market structure was followed in the case of the Chilean pension system with multiple pension fund managers, who had to be authorized by the Chilean pension supervisory authority. The supervisor also established norms of transparency in fund management that the funds were obligated to follow.

This is very much like the structure that is followed by any well-regulated mutual fund industry. For instance, the Indian mutual fund industry is one of the most transparent and well-regulated of the financial service providers in India today. The same supervisory and fund management principles, and, arguably, providers also can be used to provide pension fund management services at marginal cost.

Therefore, the principles based on which pension fund investment regulation can be structured can be as follows:

Define the principles and goals of the investment. Define the processes through which the investment should be done and monitored.

Mandate full disclosure of the investment portfolio. While the government has a role in the regulation and supervision of these schemes, care should be taken to clearly highlight the risks investors take while investing in these funds. Clear statements that the government does not guarantee

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Appendix financial returns should assist in removing the implicit belief that investors may have that an industry regulated by the government will also be bailed out the government. It is important to build walls between the government and the pension funds to ensure that the government is not tempted to misuse these funds in times of crisis or need.

There are two paths to implementing the above system:

1.

The first is to build an independent institution that acts as the pension fund industry regulator, with powers to quickly take quick action once fraud is detected. This could involve setting up special courts to try cases that concern the regulatory aspects of pension fund investments and/or management.

2.

The second is to simulate the structure of the mutual fund management industry, and allow full disclosure and competitive forces to take care of the majority of misconduct episodes.

Possible Solutions for the SPF The case of the SPF shows the lack of regulatory control and transparency in pension fund investment. This stands out in stark contrast to the recent improvements in the mutual fund industry. It is interesting to note that no mutual fund was found to be a victim to Home Trade, whereas co-operative banks and the SPF were. Over the last

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Appendix decade, there have been a series of reforms to the regulation of the mutual fund industry. A lot of the changes and improvements in the mutual fund regulations were sparked off by episodes of misconduct. However, at the end of this period, the mutual fund industry is much more transparent and better regulated compared to the situation in 1994.

Improving governance at SPF would call for increasing the role of private asset managers under a system of sound regulation. The SPFO has no comparative advantage in asset management, although it may be good at collecting contributions and distributing benefits. Therefore, it should exist the fund management business. The SPFO could set out the broad objectives of the provident fund and outsource the management of the funds to a group of professional fund managers who will most likely be from the mutual fund industry. The SPFO could then supervise and monitor these fund managers to ensure that their performance is in line with the objectives established by the SPFO. Requiring full disclosure from the private fund managers on their investments and making this information public would significantly improve transparency of the SPF. The SPFO should reevaluate the performance of the fund, both in terms of absolute and relative returns as well as costs. The SPFO should have the right to allocate funds among managers on the basis of their performance.

The SPFO should also be required to hire professionals who are knowledgeable about the industry to advise the Board of Trustees regarding investment decisions. Making

transparent the technical recommendations to the Board as well as decisions taken by the

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Appendix Board to the contributors of SPF would go a long way towards improving the governance of the SPF.

The Board should also be held legally accountable for its fiduciary responsibilities towards its contributors. Trustees of provident funds are agents of the contributors and are making investment decisions on behalf of the contributors. They should therefore ensure that the decisions that they make are in the best interests of the contributors; and they should be held to high standards of care and loyalty towards contributors. One model for such standards is that of the Employees Retirement Income Security Act (ERISA) of the United States. ERISA requires trustees of pension plans to use the prudent investor standard in managing a plan and in making investment decisions. Under this standard, a fiduciary of a pension plan is require to exercise the judgment and care, under the circumstances then prevailing, which men of prudence, discretion and intelligence exercise in the management of their own funds, considering the probable outcome as well as safety of their capital Logue & Rader (1998).

Conclusion Formal systems of retirement income provision in India suffer from three major weaknesses problems of funding, problems of investment restrictions and administered rates, and problems of mismanagement of funds. Each of these problems are present to varying degrees in many of the pension and provident funds in India. The ultimate

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Appendix impact of these problems will be to place greater demands for taxpayer-financed bailouts of these funds a solution that is not sustainable in an already difficult fiscal situation.

For those plans that are of a defined benefit type, the problem is one of lack of adequate funding. Pension liabilities are placing increasing stress on the financial conditions of the entities that have promised pension benefits. Unless solutions are found soon, these liabilities will threaten the viability of entities involved.

For defined contribution plans such as the EPF a poorly structured investment regime imposes costs on contributors in terms of lost returns. Small increases in returns will significantly enhance total asset accumulations of contributors and will improve the security of their retirement income.

Finally, irrespective of the type of plan, good governance is critical. As the case of the SPF demonstrates, passive regulation, such as defining the class of investments that pension funds can invest in to the extent of defining what fraction of the funds can be invested in which class, is not a sufficient condition to ensure that the fund is invulnerable to theft and fraud. Close supervision, monitoring, and accountability has to be built into the very processes of investment.

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References

References
Books and Reports:
Rethinking Pension Provision For India 2003 -by Anand Bordia and Gautam Bhardwaj A Consolidated Model of Pensions for India - by Nandita Markandan Ernst and Youngs EYinfi- Volume 4, Issue 2, 26th February 2004 Pension Products Designing, presented to Sixth International Conference on Insurance, FICCI by Liyaquat Khan Report on Pensions- by Insurance Committee of Confederation of Indian Industry Report on the Task Force on Pension Sector Reforms from the Federation of Indian Chambers of Commerce and Industry Pension Reforms in India - presented at the 4th Global Conference of Actuaries PFRDA Ordinance, 2004 The Project OASIS (Old age social and income security) Report Savings Scheme Notification, 24th January 2005

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References

Websites:
http://www.financialexpress.com/fe/daily http://www.ficci.com/ficci/index.htm http://www.etinvest.com/ettax/news http://www.ey.com/global/download.nsf/India http://www.seniorindian.com/oasis__.htm taxindiaonline.com http://www1.iinvestor.com/retirementplanning/statichtml/templatepro1.asp

Project Report 86

By: Ayesha Gagrat