TeaPension Fund Regulatory and Development Authority of India recently announced Minimum Assured Return Scheme The exact rate of guaranteed return under the National Pension Scheme is still to be decided. MARS will be offered to all government employees after approval from the central government. Assured returns may give some comfort and perhaps instill confidence in NPS. However, the guarantee comes at a cost. The price we pay for security is huge.
A defined contribution pension fund is a pass-through intermediary. It invests the contribution based on the choice of the member of the scheme. For withdrawals, it redeems the units at the prevailing rate and returns the money to the member. There is no solvency risk in this setup. But that all changes with guarantees. Pension funds will now have to manage contributions in such a way that if returns fall below the guarantee, it makes up for the shortfall. This has two effects.
Firstly, the plans it offers will have to be more conservative, as it does not want to risk losing money in a downturn. This will limit the upside. The member may no longer get returns less than a certain limit, but they are not likely to get more than that either. There is a trade-off between the value of the pension at retirement versus how much protection is needed. The more we protect the downside, the lower the final value of the pension. If India’s growth story plays out, letting go will be a big price to pay.
Second, pension funds have to maintain some reserves so that they don’t sink. In fact, the introduction of the guarantee has been delayed as the Pension Fund Regulatory and Development Authority (PFRDA) is yet to come out with the revised capital requirements for pension funds. Higher capital requirements will lead to an increase in fees charged from members. This further reduces the possible returns. Solvency risk is a serious concern with funds that offer guaranteed returns. The guarantee actually introduces a risk that did not exist before.
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NPS Implementation
It is useful to step back and understand how certain choices relating to NPS may have given rise to the demand for guaranteed returns. This was the basic idea behind NPS: The pension fund would offer three broad schemes with varying degrees of equity exposure. Members will select the scheme and how much to allocate to each. An individual who does not mind the market risk will choose a scheme with higher equity exposure. Someone who does not appreciate risk would choose a scheme that invests largely in government bonds. This design helps keep costs down, which translates into higher returns. But it also means that people retiring in similar positions can get very different pension results depending on the investment choices they make.
This simple structure of NPS was gradually diluted over the years. Government employees were not given a choice of schemes, perhaps because officials feared equity, members could be financially illiterate, or that the various pension outcomes were considered unacceptable. His contribution was invested in three public sector fund managers with 85 per cent allocation to bonds and 15 per cent to equity. Even though the returns offered by NPS have been higher as compared to other similar funds, they could have been higher if there was more exposure to equity. It is important for us to evaluate the impact of these conservative investment options on the performance of the scheme for government employees and how this may play a role in the demand for guaranteed returns.
The guarantee also poses other challenges to the NPS design. How are the guarantees being paid – through upfront costs, deductions on surpluses over the guaranteed amount, or something else? Will members be allowed to switch between schemes of different fund managers on choosing a Guaranteed Return product? We will have to wait for more clarity on the design of the scheme before addressing these.
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want guaranteed returns
PFRDA should know the cost of providing the guarantee. And yet, the PFRDA Act 2021 mandates the authority to require pension funds to introduce one. This brings us to the larger question of demanding guaranteed returns.
When there is too much background risk in life – whether it is labor income or health – people become risk-averse about their finances. When customers lose money through fraud by unregulated or regulated market products, it becomes difficult to differentiate between fraud risk and market risk. Consumers in India have become accustomed to guaranteed returns through old pension schemes, small savings schemes, public provident funds, or even government-run schemes starting with the Employees’ Provident Fund.
Higher guaranteed returns are only possible when all taxpayers finance a small portion of the workforce, as was the case with the old pension scheme. When the number of beneficiaries is large – as is the case with small savings schemes or public provident funds – the guarantee lowers the effective rates of return. As NPS subscribers will soon realize, there is no free lunch.
Renuka Sane is Director of Research at TrustBridge, which works on improving the rule of law for better economic outcomes for India. Thoughts are personal.
(Edited by Hamra Like)