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Pension Issue and Challenges Facing India

The success in pension reform will depend on a greater degree of professionalism in the design and governance of provident and pension fund organisations such as the Employee Provident Fund Organisation, as well as requiring that all components of social security are reviewed to assess their suitability, scalability, and sustainability. Greater financial literacy so that pensions are not considered a welfare measure without due regard for financial and fiscal analysis is also essential.

HT Parakh financa forum

Pension Issue and Challenges Facing India

The success in pension reform will depend on a greater degree of professionalism in the design and governance of provident and pension fund organisations such as the Employee Provident Fund Organisation, as well as requiring that all components of social security are reviewed to assess their suitability, scalability, and sustainability. Greater financial literacy so that pensions are not considered a welfare measure without due regard for financial and fiscal analysis is also essential.


ince independence in 1947, India has constructed a fairly complex set of social security laws, implementing regulations, and organisations (see the figure). The policy-makers have however essentially approached social security issues from a purely welfare perspective and have underemphasised the need for professionalism, long-term sustainability, robustness, and system-wide perspective.

There are several reasons why social security (or pension) reforms need to be pursued with greater urgency.

First, the existing provident and pension fund schemes, laws and regulations, and organisational governance structures need to be modernised and made consistent with India’s open-economy, open-society paradigm.

Second, India’s labour market comprising 450 million people has been undergoing significant transformation. The so-called organised sector employment, i e, those falling under labour laws, has been essentially constant at between 30 and 40 million persons (between 7 and 9 per cent of labour force). Employment in the so-called informal or unorganised sector, which is heterogeneous (ranging from shopkeepers to self-employed professionals to daily labourers), thus has been the main absorber of labour. In the organised sector, the public sector is generating little or no net job growth.

Higher labour mobility between and within sectors has increased the importance of portability in the retirement benefit systems.

Third, globalisation has made effective social safety nets essential to cushion the adverse impact on those most adversely affected; to help maintain the legitimacy of essential economic, social, and governance reforms; and to encourage risktaking by providing a minimum floor in the event of a failure.

The fourth reason concerns India’s demographic trends. India’s favourable demographic phase is reflected in the share of working-age population in total population increasing from 60 per cent in 2005 to 63.5 per cent in 2040. This could lead to a higher national savings rate from the current rate of around 30 per cent to 35 per cent of GDP. If these savings are invested in a growth-enhancing manner, higher growth rates could be achieved.

The above will require creation of large number of productive and sustainable jobs in the economy. So the balance between job creation on the one hand and preservation of existing jobs must shift to the former. Labour market reforms are therefore urgently needed.

India’s demographic advantage notwithstanding, India’s social security system will face huge challenges due to the level and the speed of ageing. The life expectancy at age 60 (16 years for male and 17 years for female in 2001) is expected to rise rapidly, requiring a longer period of retirement support for each elderly. As consumption of healthcare resources increases disproportionately with age, retirement financing will need to factor in the healthcare needs. By 2030, the population over 60 years of age (which is the current retirement age) will approach 200 million.

Fifth, the need for fiscal consolidation and fiscal flexibility has necessitated reforming the current non-contributory defined benefit, generously priced and wage-indexed pension schemes for civil servants. India has been experiencing a consolidated public sector deficit of about 9 per cent of GDP for several years. This has severely constrained growth-inducing and social cohesion-enhancing government expenditure, including social assistance to the elderly.

Sixth, due to a variety of sociological and demographic reasons, the role of the family in providing retirement financing is likely to be less prominent in the future.

Key Reform Factors

The success in pension reform will depend on three major factors. The first concerns substantially greater degree of professionalism in the design and governance of each of the provident and pension fund organisations. Each such organisation must perform the following core functions in an efficient manner. These are: reliable collection of contribution/taxes, and other receipts; payment of benefits for each of the schemes in a correct way and in case of pre-retirement loans, its timely repayment; secure financial management and productive investment of provident and pension assets; maintaining an effective communication network, including development of accurate data and record keeping mechanisms to support collection, payment and financial activities; and production of financial statements and reports that are tied to providing effective and reliable governance, fiduciary responsibility, transparency, and accountability [Ross 2000].

The H T Parekh Finance Forum is edited and managed by Errol D’Souza, Shubhashis Gangopadhyay, Subir Gokarn, Ajay Shah and Praveen Mohanty.

Economic and Political Weekly November 11, 2006

Figure: India’s Social Security System: An Overview


India’s Social Security System

,,--------, , --------EPFO Schemes Civil Service Schemes Public Sector Enterprises(Usually DB Schemes) OccupationalPension Schemes (traditionallyDB but significantshift to DC) Voluntary Tax-AdvantagedSchemes Schemes for UnorganisedSector EPF-DCEPS-DBEDLICentral GovernmentState GovernmentLocal Bodies Small savings schemesPension products of Life Insurance CompaniesNational Assistance SchemesState Assistance SchemesWelfare BodiesNGOs, Family and CommunityGroup Insurance CSPS-DB GS CSPS-DBEPS-DCGPF-DC GS CSPS-DBGPF-DC GS

The second factor concerns systemic perspective. It requires that all components of social security system are wellintegrated in meeting the retirement needs of the population. This is consistent with obtaining retirement income security from multiple sources. The role of each component, and the schemes within each component should be periodically reviewed to assess their suitability, scalability, and sustainability.

The third factor concerns managing political risk. Low level of financial literacy, particularly concerning pensions, is endemic among India’s policy-makers, elites, and the general public. The prevailing tendency of regarding pensions as a welfare measure without due regard for empirical evidence and rigorous economic, financial and fiscal analysis represents a formidable constraint in social security reform. This mindset change in the broad political system is essential if requisite progress is to be made in attaining greater professionalism and system-wide perspective.

India’s Social Security System

India’s social security system has six components – the Employee Provident Fund Organisation (EPFO) schemes, the civil service schemes, the schemes of public enterprises, superannuation plans of the corporate sector, voluntary tax advantaged schemes, and social assistance schemes in the figure.

Each requires much greater degree of professionalism and management of political and other risks. Moreover, these components have not been integrated with each other to provide a system-wide perspective. Illustrative examples are provided below.


Established in 1952, it is an unusual national provident fund in combining a Defined Benefit (DB) (Employees Pension Scheme, EPS, introduced in 1995) and a Defined Contribution (DC) (Employee Provident Fund, EPF) scheme for its members. Operational for over half a century, membership is confined to 181 designated industries, in firms employing more than 20 workers. It is governed by an unwieldy board of 45 members, with the union minister of labour as the chairperson. The board has shown no inclination to access the requisite expertise as indicated by the absence of any independent experts on the board or by setting up of advisory committees.

The total membership is about 41 million workers (9.1 per cent of the workforce), though the workers actually contributing in any given month are estimated to be at most 20 million (4.4 per cent of the workforce). It is therefore essential not to regard the EPFO’s membership as being representative of India’s total labour force. EPFO’s insistence that its membership reflects India’s workers is therefore unconvincing.

As EPFO contributions, interest, and withdrawals are all tax exempt, and as current regulations permit those earning above Rs 6,500 per month to contribute without limit, the EPFO has essentially become the tax-shelter for some highincome individuals.

The total contribution for the EPFO schemes amounts to 25.6 per cent of the wages. The administrative charges, amounting to 4.4 per cent of the contributions, are levied separately. The investment guidelines of the EPFO provide for only debt instruments, and even these are almost fully of the public sector organisations. Its investment guidelines therefore differ from the insurance regulator’s guidelines for the pension products of life insurance companies. These permit investment in domestic equities up to 40 per cent of the total investment funds. They also differ from the proposed guidelines for the New Pension Scheme (NPS) as discussed below. The investment guidelines for occupational pension plans primarily governed under the income tax laws are also different from those of the EPFO. These divergent investment guidelines reflect a lack of coherence.

The EPFO has not learned how to earn income from investments through acquiring expertise in managing investments. It also does not appear to want to declare the interest rate on the balances which reflect its earnings and the long-term nature of its liabilities. It is astonishing that an organisation with assets of over Rs 1,70,000 crore insists on declaring the interest rate on the balances before the financial year is over.

The EPFO’s insistence on declaring a higher rate of interest than its earnings disproportionately benefits only a tiny minority of its members. In 2004, 85 per cent of the total members accounted for 17 per cent of the total balances, with an average balance of Rs 3,133. Higher interest rate therefore only marginally benefits the preponderant majority of the workers. In contrast, those with balances above Rs 1 lakh constituted 3.4 per cent of the total members, but 45 per cent of the total balances.

Economic and Political Weekly November 11, 2006

The EPFO’s implementing regulations permit substantial pre-retirement withdrawals for housing, meeting social obligations and other purposes. This design feature negates among the main advantages of mandating savings, which is to take advantage of the power of compound interest. It is therefore not surprising that the average balance at retirement is only about Rs 30,000, an amount too small for retirement income security. There are also indications that EPFO members are not able to access pre-retirement benefits and funds at retirement without side-payments. This constitutes indignity to labour. Unconcern of the EPFO trustees to this indignity also makes their often proclaimed statements about looking after workers’ welfare unconvincing and hypocritical.

According to the latest actuarial report available, there are large unfunded liabilities in the EPS which are likely to grow over time in the absence of substantive reforms. The ultimate contingent liability is on the fiscal system. Yet, EPFO board annually goes through the spectacle of wanting to pay higher interest than what they have earned.

To professionalise the EPFO, it must learn to earn and pay what is earned; match assets with liabilities; and must provide services and benefits commensurate with the costs it imposes on the society.

Its “Reinventing EPFO” programme focusing on improving administrative and compliance efficiency, and lowering transaction costs deserves support. But it must be held accountable for the outcomes.

Civil Service Schemes

The key reason for reforming these schemes is illustrated by the fact that while civil servants at all levels of government constitute only about 3 per cent of the total labour force, their retirement benefits are already equivalent to nearly 2 per cent of GDP. There is also high level of longevity and inflation risk protection as the benefits are indexed to prices and to wages. There are also generous survivors’ and disability benefits.

The civil servants are the beneficiaries of the schemes but they also are the key actors in formulating and in implementing the civil service pensions. There is no independent regulator which oversees these schemes. This is contrary to good governance practices.

The economic and fiscal unsustainability of the schemes, and need for labour mobility led the central government to introduce the NPS for the civil servants entering the government service since January 1, 2004.1 The NPS is designed to be a scalable and sustainable pension scheme [Shah 2005].

The NPS is a DC scheme, with no preretirement withdrawals until age 60. Each employee has an individual account which is portable, thus facilitating labour mobility. The contribution rate is 10 per cent (of gross salary) each by the government as an employer and by the employee. A member may allocate the balances among a limited number of investment schemes. At age 60, the accumulated amounts will be divided into a compulsory annuity component and a lump sum withdrawal component.

Addressing the longevity risk (accumulated balances may prove to be inadequate during the lifetime of the retiree), and inflation risk (maintaining real value of the annuity throughout the retirement period) will however be a challenge. Some riskpooling arrangements will be needed.

While the NPS is mandatory for the central government employees, it has potentially a much wider reach. There are 16 states which have decided to introduce similar schemes. Some states are likely to implement the NPS in full without waiting for the political deadlock at the centre (resulting in the PFRDA Bill not being passed by Parliament) being resolved.

Various public enterprises and statutory boards and aided institutions can also join NPS. The individuals, particularly thosewho do not enjoy formal employeremployee relationship may also find NPS a useful vehicle for retirement savings provided some of the current schemes such as Public Provident Fund (PPF) are either phased out or made more market-consistent.

The estimates for potential membership of the NPS vary widely. A 2004 survey commissioned for the ministry of finance suggest that roughly 54 million persons in the unorganised sector have both the interest and the financial capacity to participate in the NPS. A study by Cashmore et al (2005) puts the estimate at 80 million. Over next three decades, about 20 million civil servants and public sector workers will mandatorily join the NPS. The total potential membership therefore is between 75 and 100 million.

With rising trend of wages in India, pension assets will also grow rapidly. Cashmore et al (2005) estimates that

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Economic and Political Weekly November 11, 2006

by 2015, pension assets under the NPS will be US $ 175 billion. These will need to be intermediated through the financial and capital markets.

Thus, reforms of these markets and continuing improvements in corporate governance will be the key in translating increased savings into economically productive and growth-enhancing investments.

The NPS is more consistent with India’s basic strengths and competitive advantage than large-scale and ambitious social insurance type schemes as proposed by the National Commission for Enterprises in the Unorganised Sector. Such large inflexible schemes not only ignore the administrative, technical, and fiscal constraints, but also do not take into account the heterogeneity of the unorganised sector and the high transaction costs in delivering relatively small benefits.

Micro-pension schemes which are based on decentralised basis with a degree of competition among providers, and regulated by the Provident Fund Regulatory and Development Authority (PFRDA), can be one of the avenues for expanding coverage to the low income persons. The pay-out phase however will require broader risk-sharing arrangements to address longevity and inflation risks.

Targeted social assistance programmes, based on improved public finances and service delivery systems, are a more effective way of ensuring a degree of social security for the lifetime poor. This will require fiscal consolidation and flexibility.

The NPS will be supervised by a regulatory body, called the Provident Fund Regulatory and Development Authority. The regulatory function is currently performed by different agencies. The EPFO acts both as service provider and regulator (as well as approving authority) for funds which seek exemption from the EPFO. This dual role represents a fundamental conflict of interests and should be ended. Permission for superannuation funds and for the excluded funds is under the jurisdiction of the Central Board of Direct Taxes (CBDT). It also, in principle, regulates these funds, though it has no capacity to undertake effective supervision. Since there is no centralised database for firms that have received permission from the CBDT for pension plans, the overall assessment of the effectiveness of current policies is also hampered.

The PFRDA can help in achieving greater professionalism and system-wide perspective by bringing these funds under its purview.

The annuities will continue to be provided by the life insurance companies which are regulated by the Insurance Regulatory and Development Authority. Since the NPS will involve exposure to financial and capital markets, regulated by Securities and Exchange Board of India, close coordination among the three regulators, the ministry of finance, and the Reserve Bank of India (RBI) will be needed.

The Indian government is to implement the exempt-exempt-taxable system of taxation for pension savings under which contributions and the investment income in the accumulation phase will be exempt from income tax, but the withdrawals in the payout phase will be taxed. The tax system therefore is being aligned with international practices. The transition phase however will have to be carefully negotiated.


The corporate sector has important stakes in pension reform as well. A better governed and managed mandatory systems will permit corporates to better structure their occupational pension plans, and align them with globalisation of their operations. Accounting Rule 15 will gradually require unfunded retirement and healthcare costs to be reflected on the profit and loss statements and on the balance sheet. A strong regulatory regime can provide the requisite discipline to the corporates. This will be particularly important for many listed public enterprises and financial institutions.

India’s income tax rates are now internationally competitive. The Fringe Benefits Tax has been rationalised in the 2006-07 budget, thus substantially minimising a major impediment to occupational pension plans.

A novel development is to regard human capital as largely bond-like in nature which provides a stream of income, hopefully stable and growing. The implication is that the Indian corporates need to be proactive in not only equipping their employees with human capital but also teaching them how to use it during retirement, so that bond-like features can be realised. This is essential to cope with increased life expectancy and has the potential to partially mitigate for reduced family support. State support for providing enabling environment for the elderly to participate in paid work also needs to be considered.

Concluding Remarks

The analysis suggests high potential for efficiency and equity gains from relatively simple changes in laws, regulations, and administrative and governing practices of India’s provident and pension funds. In particular, there should be greater urgency in inducing greater professionalism in governance and operations of the EPFO. There is also an urgent need to reach consensus among the stakeholders on the passage of the PFRDA Bill. A strong pension regulator in the form of PFRDA, and greater coordination between it and other financial sector regulators can bring about greater professionalism and systemwide perspective. Fiscal reforms and greater effectiveness in delivering public services are essential if the poor elderly are to benefit from social assistance, financed from general budgetary revenue.

There is a strong case for greater financial education; and for encouraging establishment of pension research centres so that empirical evidence-based public policies in this area can be pursued. India’s economy and current administrative, fiscal, institutional and other capacities are more suited for decentralised rather than inflexible centralised approaches.

As India’s demographic advantage phase will be over by 2040, any undue delay can only have adverse impact on all stakeholders, particularly for India’s 450 million labour force. It is time that India’s pension system reflects its economic dynamism and aspirations.




1 From January 1, 2004, all newly recruited civilservants at the Centre (except for armed forces)are on a DC scheme. Sixteen states have also issued notification for a shift to a DC scheme, but their starting dates vary.


Cashmore, N, S Leckie and Y Pai (2005): ‘Moving

On Up: Pension Funds in Asian Markets’,

CLSA, Hong Kong.Ross, S G (2000): ‘Building Pension Institutions:

Administrative Issues’ in Proceedings of the

Third APEC Regional Forum on Pension Fund

Reform, Bangkok, pp 120-32.Shah, A (2005): ‘A Sustainable and Scalable

Approach in Indian Pension Reform’, available

electronically at

ajayshah/pensions.html, Last Accessed:

November 1, 2006.

Economic and Political Weekly November 11, 2006

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