MACRO ECONOMICS AND GLOBAL BUSINESS ENVIRONMENT

A Term Paper on

LIBERALIZATION OF PENSION
SECTOR IN INDIA

Submitted by:

Chaitanya 09211

Chaya 09213

Gaurav 09215

Harshitha 09217

Hitendar. M 09219

Submitted to:

Prof. Dr. Rajesh Gangakhedkar

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Contents

Objective...............................................................................................................................................3
Introduction...........................................................................................................................................4
Initial conditions....................................................................................................................................6
Present conditions...............................................................................................................................10
Reforms that are needed.....................................................................................................................14
Conclusion...........................................................................................................................................17
References...........................................................................................................................................19

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 Objective
To discuss about the existing pension sector in India and list out possible reforms for the same

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Introduction

An economy, apart from everything else, is a highly fluid transmission mechanism.

India treaded on the path of Liberalization in the early 1990s under Dr. P. V. Narsimha Rao
government and the then Union Finance Minister Dr Manmohan Singh, prior to which India’s
monetary position was in a precarious situation. Before the process of reform began in 1991,
the government attempted to close the Indian economy to the outside world. The Indian
currency, the rupee, was inconvertible and high tariffs and import licensing prevented foreign
goods reaching the market. India also operated a system of central planning for the economy,
in which firms required licenses to invest and develop. The labyrinthine bureaucracy often
led to absurd restrictions — up to 80 agencies had to be satisfied before a firm could be
granted a licence to produce and the state would decide what was produced, how much, at
what price and what sources of capital were used. The government also prevented firms from
laying off workers or closing factories. Liberalisation led to the dismantling of the licensing
system which was built over the previous four decades. Thus in order to facilitate
liberalisation and to establish a positive rapport with World Bank, Banking and Financial
sector reforms were initiated along with many trade reforms. Private sector Banks including
foreign Banks were encouraged to operate in India. The impact of these reforms may be
gauged from the fact that total foreign investment in India grew from a minuscule US $132
million in 1991-92 to $5.3 billion in 1995-96. Like all the other sectors, pension sector also
got affected. This paper tries to present specifically the reforms in the Pension sector and
major issues related with it.

The OASIS Report first brought out the possibility of pension reform in India. The OASIS
reports about the various data regarding pension sector, its schemes etc. In December 1997, a
financial sector policy conference was to take place in Goa the result of whose discussions
resulted in a ‘Project OASIS’ being initiated by the Ministry of Welfare in July 1998. OASIS
was an acronym for ‘Old Age Social and Income Security’. The quest of the project was to
find implementable policy directions through which the great mass of India’s uncovered
sector could be assisted by a formal pension system, and thus reduce the burden coming upon

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government systems such as the NOAP, which (in any case) were pitifully small when
compared with the scale of expenditure required for a decent existence in old age.

Thus a reform in the pension system tackles the primary problem of the financial sector in a
dual manner. On the one hand introduction of private pension fund managers will ensure the
large-scale mobilisation of savings. This would increase the rate of savings, which would
lead to a higher rate of capital accumulation, crucial for a developing country like India. It
has been proved statistically that private managers are in a position to earn greater returns
from their sources. So in effect privatising the pension system would place a large pool of
fund in the hands of efficient managers, specialising in this form of activity.

But that answers only half the question. At this point it may be sensible to ask, so where
would these funds be diverted in the absence of adequate channels? This is where the overall
commitment comes into the picture. Admittedly pension reform is only a small part of a
larger programme of allowing private initiative in the economy. The pension reforms largely
determine the source of funds for aged (>60years of age), though there are other minute
sources of funds as follows

Sources of income for Indians over age 60, 2001

Source: Bank staff calculations ., Challenge of Pension Reforms in India, 2002

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Initial conditions

The broad facts about Indian pensions are well known. There are three main components:

1. The Employee Provident Fund Organisation (EPFO) - which is mandatory for private firms
with over 20 employees. This is a blend of a defined contribution (DC) system called the
Employee Provident Fund (EPF), and a defined benefit (DB) system called the Employee
Pension Scheme (EPS).

In detail

There are two major programs which are run by the EPFO: they are the Employee Provident
Fund, based on legislation enacted in 1952, and the Employee Pension Scheme (EPS), based
on legislation enacted in 1995. They are mandatory for establishments with more than twenty
employees. Most of India’s labour force is in establishments with less than twenty
employees. The fraction of the labour force in these programs has steadily risen from 1% of
the labour force in 1953 to 5% in 1995. The contribution rates for the two programs are
summarised in the following Table.

Sources of contributions into EPF and EPS

All contributions are expressed as percent of “basic wage”. Over recent decades, the labour
market has steadily reduced the size of basic wage expressed as a fraction of the total wage.
Hence, these values overstate the true contribution rates as percent of the overall wage bill.
The values shown pertain to the rules that apply for 172 industries. There are five industries
where slighly different rules apply.

Source: Issues in Pension System Reform in India, Aug 2000, Ajay Shah, IGIDR

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The EPF is a DC program; the participant receives a lump-sum upon retirement. The EPS is a
DB program. It yields a benefit rate of 50% of the terminal wage, for individuals who have
contributed for above ten years. The EPFO outsources fund management to a single fund
manager. The rules under which this fund manager operates under are highly restrictive. The
following table shows the required asset allocation.

Regulation of investments for EPF

Source: Issues in Pension System Reform in India, Aug 2000, Ajay Shah IGIDR

2. The civil servants pension - which applies for employees of the government. This is an
unfunded DB scheme.

3. The uncovered sector, which makes up 87% of the workforce. The first and foremost goal
of pension reforms, is to increase the size of the covered sector. India is at a unique moment
in the demographic transition, where large numbers of young people are coming into the
labour force. If these individuals can be placed into a modern pension system, they will be
able to accumulate pension assets for their old age, and India would then be able to avoid the
crises associated with an ageing population that have been seen in myriad other countries.
But in addition, there were structural problems with the EPFO and with the civil servants
pension which needed to be addressed. The EPS is supposed to be based on contributions and
assets, but is actually underfunded. The expenditure on the civil servants pension was
growing at double digit rates, and a recent paper found that the implied pension debt of the
GOI on account of civil servants alone is probably above 64% of GDP.

Thus, the EPFO and the civil servants pension, both imposed insuperable costs upon the
exchequer. In addition, owing to flawed policies in many respects, EPFO typically leaves

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participants without significant income in old age. In other words, participation in EPFO for
an entire lifetime generally fails to leave a retired person with income security.

The above pensions schemes were considerably changed, during the dawn of Atal Bihari
Vajpayee in 1998 from which the Indian pension saga begun. The policy thinking on perhaps
the most important second generation economic reform for India originated in a tiny, and
perhaps unlikely part of the Government – the Ministry of Welfare (which was later renamed
Ministry of Social Justice and Empowerment, abbreviated as MoSJE). The diversified and
vast workforce structure asks for more effective pension reforms.

Workforce structure by employment status (million)

Source: CMIE basic statistics for Indian economy (1993)

One of the many responsibilites of this ministry was the care and welfare of destitute old.
Given the breakdown of intra-family support structures such as the ‘joint family’
(cohabitation across generations), income in old age was rapidly becoming a major problem
for the Ministry of Welfare. A program named the National Old Age Pension (NOAP)
Scheme, which paid a tiny means-tested pension of Rs.200 (US$4) per month to a destitute

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person above age 65 had been setup. However, this scheme is plagued by administrative
difficulties in means-testing and ineffective delivery.

While India’s elderly population had been growing, the ratio of elderly to the overall
population of aged persons had been rising at much faster pace.

Age structure of Indian Population

Source: Indian Pension System: Problems and Prognosis(2001), Ranadev Goswami, IIM B

Data for the 1991 census, which was released in 1995-96, induced considerable concern for
the then Minister of State for Welfare, Maneka Gandhi, when it estimated that the population
of persons over age 60 was at roughly 70 million. Demographic projections also suggested
that life expectancy was rising rapidly, and that a person at age 60 in 1998 could be expected
to live for another 15 years. Projections showed that India would have an elderly population
of 113 million by 2016 and 179 million persons by 2026.

After some years of trying to tackle this situation through traditional approaches, the then
Joint Secretary of Welfare had started thinking out of the box, and had started noticing that in
other countries, the backbone of handling this problem lay in a system of pension funds with

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defined contributions. Gradual changes in the pension schemes hav thus led to present system
of pension schemes.

Present conditions

The last decade has been a witness to sweeping reforms in the financial sector in India.
Coinciding with reforms in the other spheres of the financial system, there have also been
some reform initiatives in the pension sector. However, unlike comprehensive reforms
undertaken in banking, capital and currency markets or more recently in the insurance sector,
a significant degree of inconsistency mark pension reform during the past ten years. The low
priority that is accorded to pension system is perhaps intentional and reflects the sequencing
of the overall financial sector reform process. Such sequencing is however not surprising
given the complex nature of pension reform. Government-sponsored many schemes for old
age income security as follows

Government-sponsored schemes for old age income security in India

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 The linkages of pension system with fiscal and tax policy, labour markets, health and
insurance sectors, and financial markets in general reflect the multi-dimensional character of
pension reform. The pension reform process can therefore be painstaking and long drawn,
with potential to jeopardize or slacken the pace of the overall reform procedure. Hence, in
recent times, the limited initiative to restructure the pension system is marked by a lack of
sustained commitment or application of prudence. With the exception of partial conversion of
some of the provident funds into pension schemes, most of these reforms are practically
minor adjustments of the current system. Incidentally, such minor adjustments are most
frequent in case of provident funds. From time to time, provident funds have been subjected
to changes in eligibility criteria, contribution and benefit structures or revision in investment
norms.

By the early eighties, there was a growing perception about the limitations of a pure
provident fund arrangement among the organized private sector workers. In 1986, labor
bodies formally approached the Central Board of Trustees (CBT) of the Employees’
Provident Fund (EPF) scheme for partial conversion of the scheme in favor of a pension
arrangement. Following some further persuasion, the CBT appointed a committee with the
mandate to restructure the EPF scheme in 1990.

While the committee was developing the framework for a new pension scheme within the
EPF, in a related development in November 1993, the government introduced pension

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schemes for nationalized banks and insurance employees. There has been a long-standing
demand for pension benefits from labor bodies representing these institutions. That the
government acceded to the demand in 1993 is significant as it coincided with the banking
sector reform - giving rise to some speculation that the move was to appease the agitating
employees. The two schemes, known as the Bank Employees’ Pension Scheme (BEPS) and
the Insurance Employees’ Pension Scheme (IEPS) were created by diverting the accumulated
employers’ contribution to the provident funds. The schemes are financed by the employers’
contribution to the provident fund contribution, which is equivalent to 10 percent of the basic
wage. Separate pension trusts were created to administer pension schemes for each
institution.

The benefit structure of these schemes replicated the existing pension schemes for the
government employees offering defined-benefit pension on superannuation, death or
disability. The main superannuation pension provides a replacement income of 50 percent of
the final earnings. The pension is indexed to inflation. Participation is mandatory for the new
workers but optional for the existing workers. Meanwhile, the recommendations of the
expert committee on EPF were out for public scrutiny. In a stark contrast to the smooth
transition of provident funds into pension schemes for bank and insurance employees, the
draft legislation for EPF stirred a hornets’ nest among the workers. The controversy
surrounding the draft bill soon snowballed into an intense debate, both inside and outside the
Parliament. Consequently, the government made some concessions and the original draft
legislation was amended. Most of these labor bargains were aimed at retaining the provident
fund nature of the scheme like liberal withdrawal facilities, commutation provisions, etc.

Even then, it failed to mollify every labor group. Finally, in August 1996, the Parliament,
amidst some opposition, approved the legislation creating the new pension scheme with
retrospective effect from November 1995. 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 EPS program has replaced the erstwhile Family Pension
Scheme (FPS). The balance amount of about Rs. 90,000 million in the FPS was transferred to
the EPS as the initial corpus. It is financed by diverting 8.33 percent of employer’s monthly
contribution from the EPF and government's contribution of 1.17 percent of the worker’s
monthly wages. However, participation to the EPS program is voluntary for the existing

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Different retirement benefits carry different pension schemes

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Source: Indian Pension System: Problems and Prognosis, Ranadev Goswami, IIM B

workers, but mandatory for the new workers whose monthly pensionable earnings do not
exceed Rs. 5000.

The debate surrounding the EPS however continued unabated with many trade unions filing
litigations against the scheme. 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 it replaced. The ceiling on the
benefit level and absence of indexation further depressed the return from EPS. Chatterjee
(1996), the principal actuary behind the EPS program, however observed that index linking
of pension is not feasible in case of EPS since there is a high level of pooling of private
employers.

In a parallel initiative to the OASIS, the Ministry of Labor also set up a taskforce to examine
various social security schemes. The report of the committee (Wadhawan Committee),
submitted in May 2000, has called for replacement of the existing social security schemes
with a single integrated comprehensive scheme. The committee recommended the unification
of the Employees’ Provident Fund (EPFO), Employees’ State Insurance (ESIC) and the
Employees’ Pension Scheme (EPS) under the administration of a single agency.

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Reforms that are needed

The deficiencies of the current pension system in India are as follows:

 low coverage

 under performance of Provident Fund schemes

 investment restrictions

 administrative difficulties

 underdeveloped private annuity market

 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 differences in pensions between public and private sector employees as compared
to the public sector are wide.

There is an urgent need to:

 Reduce government burden: In India the number of elderly (persons aged 60 and
above) is expected to increase by 107%, to 113.0 million by 2016.

 Involve unorganised sector: Barely 34 million (or less than 11%) of the estimated
working population in India is eligible to participate in formal provisions meant to
provide old age income security. Therefore, almost 90% of India’s workforce is not
eligible to participate in any scheme that enables them to save for economic security
during their old age.

 At present the pension Social Security system is based on employer and employee
contributions, which largely excludes the unorganised sector.

Pension savings accounts represent real and visible property rights—they are the primary
sources of security for retirement. A clear definition of property rights is a reaffirmation of
the rights of people to their accretions.

The reform in the Pension system and the adoption of a system based on funded defined-
contribution Individual Retirement Accounts will have a multi-pronged advantageous effect
on the Indian Economy.

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  The government’s burden of administering pensions will certainly decrease.

 With the entry of private Pension fund managers, pension assets will be invested
wisely thus providing a larger amount to individuals at the time of retirement.

 Pensions, as an issue will be de-politicised and will become more of an economic

 The development of the pension sector will create a symbiotic relationship with the
Insurance sector.

 The element of forced saving inbuilt into the system of mandatory contributions will
go a long way in increasing the rate of savings of the household sector which
constitutes the largest part of savers in India. The effective mobilisation of these will
go a long way to aid capital formation and economic growth.

Changes to the investment rules and increased competition are a necessary but not sufficient
condition for raising long run returns and improving service. The second requirement is good
regulation and supervision. The current system places few demands on the supervisor.
Portfolios are highly restricted and the main task of the EPFO is to ensure that the employers
in the exempt funds actually make the required contributions. In this context, the relatively
light supervision of exempt funds would not be adequate.

In the reformed system described here, supervision will become more complicated. Valuation
will have to be checked frequently, reporting standards will be higher and a series of
safeguards will have to be monitored, including compliance with the new portfolio limits.
Currently, the EPFO functions as both administrator and supervisor. It manages the
individual accounts and investments of three-quarters of EPF members while at the same
time supervising the employers that run exempt funds. The new system will not only require
more resources, but also a staff with a different set of skills from that currently available at
the EPFO.

Systemic reform illustration

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Source: Pension Reforms in India(2002) , Robert Palacious

Many of the issues facing the regulator of the reformed EPF will require experience and
training in finance and insurance. They will need to work very closely with the securities
market regulator and the new insurance regulator. And they will have to be paid comparable
salaries. All of this argues for the separation of private pension supervision from the other
functions of the EPFO.

This model assumes a new pensions regulator, a new set of participants in the asset
accumulation process and an annuity stage that would also have multiple providers. Most
importantly perhaps, it is a system wherein workers in small or large firms, self-employed
individuals and public and private sector workers can participate in a seamless system with a
unified infrastructure of recordkeeping, regulation and supervision. Larger employers that
currently fall into the category of ‘exempt funds’ would contract directly with one of the
licensed asset managers (LAMs). These defined contribution accounts would be tracked by
the EPFO and would be completely portable from one employer to another. The change
would affect roughly one quarter of the employees covered by the EPFO today and a
significantly higher share of total system assets.

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Conclusion

Indian pension system is passing through a crisis of confidence. The economic, demographic
and labor market trends of the current system are moving in troublesome directions. The
problems that the system is confronting now are quite well known:

• Demographic aging: The age structure of the population is changing drastically with
increasing life expectancy and declining birth rates. The result of such demographic transition
will be a larger proportion of older people.

• Changing social mores: Collapse of joint family system coupled with pressures of
urbanization and migration are also leading to deterioration in traditional means of support
for the elderly.

• Skewed coverage: Existing schemes predominantly cover the organized workers leaving
the bulk of the workforce with little access to any formal system of old age income security.
The coverage is further diminishing due to stronger growth in unorganized employment.

• Inequity in benefits: Within the organized labor force having access to some kind of formal
retirement income system, generous treatment of the public workers vis-à-vis the private
workers is resulting further fragmentation of the pension system.

• Pressure on public finances: The spiraling expenditure pattern of the non-contributory,

Thus we can say that the pension system in India is in its infancy. There are generally three
forms of plans: provident funds, gratuities and pension funds. Most of the pension schemes
are confined to government employees (and some large companies). The vast majority of
workers are in the informal sector. As a result, most workers do not have any retirement
benefits to fall back on after retirement. Total assets of all the pension plans in India amount
to less than USD 40 billion. Therefore, there is a huge scope for the development of pension
funds in India.

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The nature of the system that has been proposed involves new institutions, in particular
regulators, recordkeeping 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 India’s vast population. 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. This volume is a modest attempt to contribute to this process.

References

Agarwala R. and Sharma R.K. (1999) “India’s Pension System Reform: Challenges and
Opportunities”

“Does Not india Need a Default Option in the New pension system” by H. Sadhak ,
Economic and Political Weekly , Nov ’09.

Sinha Tapen, Privatization of insurance market in India: from British Raj to Monopoly Raj to
Swaraj, CRIS Discussion Paper series.

Bank staff calculations, Challenge of Pension Reforms in India, 2002

Pension Reforms in India (2002) , Robert Palacious

Indian Pension System: Problems and Prognosis, Ranadev Goswami, IIM B

Issues in Pension System Reform in India, Aug 2000, Ajay Shah, IGIDR

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