| Pension Plans for India - 401(K) Style |
Under this plan an employee can authorize his employer to deduct a certain amount of payback before taxes are calculated. The monies so deducted are then invested in investment options chosen by the employees from the ones offered through the company’s plan. The proposal has been justified on the grounds that it would only imply a tax deferment and not a tax deduction. These investment options may include mutual funds, guaranteed investment contracts, and so on. As per the proposal, the employee need not pay tax when the investment grows, but only when the amount is drawn at the time of retirement.
What has prompted the need for these 401(K) type of investments is an alarming piece of statistics: while India's total population is expected to rise by 49 per cent by 2016, the number of senior citizens aged 60 and above is expected to soar by 107 per cent to 113 million. A majority of them will need retirement security. Pension funds such as the 401(K) have immense potential to succeed in India, where a large section of the population is outside the social security net.
In a bid to provide social security cover for the aged and allow pension funds to manage retirement assets, the ministry of social justice and empowerment commissioned Dr S A Dave to delve into the issue. The expert committee submitted its final report styled Old Age Income and Social Security (Oasis) -Project Oasis report which recommended allowing pension funds and alongside reforming the existing employees' provident fund (EPF) and employees' pension system (EPS). Not surprising that Dave has attempted to separate pension liability from the government. His Oasis report is a total emphasis on thrift and self-help, planning for your old age yourself which could be on an average 17 years after retirement. Alongside, he has recommended that public provident fund account should be renamed as Individual Retirement Account (IRA) and provident fund should be renamed as Employee Retirement Account (ERA).
Currently, only employees of the government and the corporate sector are covered under the EPF. There is the public provident fund (PPF) for the self-employed. These are under government control and they suffer from poor asset management, in a State-controlled pension fund regime the individual saver has no control over his savings, will have no participation and the incidences of political risks are greater. The State has been known to use the pooled up retirement savings for developmental purposes and for financing budgetary deficit. The project Oasis report by Dr.Dave suggests that if the government wants to handle pension and provident funds, it should resist the temptation of using these funds to finance fiscal deficit and should treat these funds as fiduciary funds and create wealth for the poorest of the poor. In order to promote accountability and professionalism the report also suggests that EPF and EPS managers begin marking their investments to market and declare net asset values on a daily basis. If net asset values are to be declared on a daily basis, EPF and EPS managers will turn accountable and professionalised.
Also -- 401(k) plans are primarily equity-oriented. And over such a long-term horizon, there is a 99 per cent chance that equities outperform bonds. As per the Project-Oasis report currently, the State earns just 2.5 per cent real rate of return net of inflation, on its provident fund assets. This provides for a good case for leaving pension planning to the private sector, where professional pension fund managers invest in equity after intensive research. The long-run average rate of return on the equity index in India is 18.5 per cent, which has the potential to revolutionize wealth accumulation over a worker's lifetime. To compare this return to the 11% tax free return offered by PPFs etc., is not a valid argument as this rate is not sacrosanct and can be reduced by the government as and when it wants to. Also with India moving towards integration with the global economy, it is but natural that sooner or later these small savings rates will be lowered or even freed. Infact, in the latest pre budget proposals, removal of tax incentives for these schemes has been suggested as a way of lowering their return.
With regard to portfolio composition of pension funds, countries such as the United Kingdom and the USA follow the prudent man concept, where the pension fund manager has investment freedom and can decide prudently where to invest. Mutual fund industry experts are of the opinion that the same practice should be followed here in India - Once the fund manager is selected, choice of assets should be left to him and true, investment quality, investment merit and returns should be the considerations for designing a pension funds portfolio.
The financial experts also claim that for, the number of players can be best left to the market forces. Just define capital adequacy, transparency, disclosure and delivery standards and have a powerful regulator in place. That is macro management, leaving all the rest to the market forces. Let the players sweat it out in the marketplace and let the fittest survive.
Pension funds also play that balancing role in the equity markets. In the US, 401(K)s control over 36% of all financial assets. The financial bigwigs estimate Indian pension funds, if and when introduced, to be to the tune of over Rs 4 lakh crores. With this kind of financial muscle they will be able to operate shoulder to shoulder with the other domestic financial institutions as well as FIIs. Balancing role apart, pension funds can pool in sizable savings to create socio-economic impact and enable efficient utilisation of funds collected. Their reach will extend to the daily labourer, the self employed and the corporate earner too.
Also, pension funds are agents which ensure maximisation of utility of capital - they make individuals save, they provide incentives to save for long-term and provide disincentives for dissaving. Under the 401(k) plan of the USA, savings are taxed only when there is a withdrawal. Dave has also recommended in his interim Oasis report, a 10 per cent tax on premature withdrawals from the retirement account.
So, with the winds of change blowing over the financial landscape, 401(k)s may be just the thing the investor needs for long term savings, where there is greater transparency, higher accountability and of course better returns.
Aru Srivastava
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