In India, is a guaranteed funded pension feasible?

For most of India, pensions are illusory, available only to formal, permanent, largely government, employees. Before 2004, it was their privilege, baked into the social compact with the State, making government jobs almost the sole source of long-term social security. This is why pensions are at the heart of the current contestations.

The Old Pension Scheme (OPS) is guaranteed, but not funded.

The guaranteed defined benefit (50% of last salary drawn) is funded out of current revenue collections. This works as long as productivity and the worker-to-pensioner ratio is favourable, and there are limited claims on general taxes. Once this balance tilts, can the guarantee hold?

Policy cynics point out that OPS engenders irresponsible promises, especially since future pension liabilities are that of a different government. It may also be why it’s politically attractive. Unlike OPS, the New Pension Scheme (NPS), is funded, but not guaranteed.

As former civil servant and colleague KP Krishnan noted in a recent article, the Union pension bill in 2002 consumed 5.7% of revenue expenditure, a quantum jump from 2.4% in 1980-81. In a rare moment of fiscal rectitude and wise political resolve, State capacity, including a pensions’ regulator, was built to implement NPS, a defined contribution scheme. At retirement, the accumulated contributions — hopefully wisely and profitably invested — form a wealth corpus, which is drawn down as annuities during the post-retirement life of the pensioner.

The value of the annuity is not guaranteed or inflation-adjusted; it depends on the accrued corpus and annuity options available when the pension is needed. NPS transfers all these uncertainties to the pensioner, who is singularly ill-equipped to evaluate these complex risks, and limited by the unavailability of necessary financial instruments. This is not an Indian problem, it is a global issue with all defined contribution pension systems.

This reality — that NPS has changed the established social security compact of government jobs — fuels the current anxiety over pensions. Along with the shifting sands of federalism and intensifying state level political competition, this is tempting states to unravel the prevailing consensus, and revert to OPS, with one notable exception. In this maelstrom, India’s federal system remains a fecund laboratory.

The response of Andhra Pradesh offers an interesting and innovative alternative — the guaranteed pension scheme (GPS) — both (substantially) funded and guaranteed. Employees continue to contribute, as in NPS, but if the annuity from their wealth corpus at the time of retirement is less than 30% of their last salary, the state government guarantees to make up the difference. This guarantee too, as in OPS, is funded from current revenues, but since it is only making up the difference, and that too at a more conservative level, the feasibility and hence credibility of the guarantee is higher.

Indeed, with favourable market conditions, the guarantee may never be needed. GPS, in addition, limits downside risks further by providing health insurance, a key concern of pensioners. But, another gap needs filling.

In this maze of OPS, NPS and GPS, it is possible to overlook that a key reason for the concern around defined contribution pensions is that there is almost no financial instrument that provides an inflation-protected, predictable post-retirement income stream. The RendA+, launched this January in Brazil, is an exception. Building on work by Arun Muralidhar and Nobel laureate Robert Merton on retirement security bonds, Brazil’s treasury offers an inflation adjusted monthly payout (coupon of 6.48% plus inflation) for 20 years, from a defined future date (pension funds can absorb actuarial risk, so lifetime payout products can also be offered).

Individuals just need to know their retirement date and target retirement income (at today’s value). In this example, a person who wishes to have an inflation-adjusted pension of (say) INR25,000 a month after retirement, would have to accumulate about INR46 lakhs worth of such bonds during their (say) 30-year working life. These bonds could sell at a discount, so their purchase value, ie, needed investment, may be less.

Brazil’s RendA+ has an additional attractiveness — one can invest in morsel-sized chunks on a smartphone app, a feature that would be replicable in India, given our digital infrastructure. This means it can benefit workers beyond the formal permanent labour market. Given that India has long had inflation indexed bonds — such as the Reserve Bank of India’s inflation-indexed national saving securities — many basic components for such a system are already in place in India.

The unravelling of an important federal fiscal reform is a serious concern. It is important to move the OPS-NPS debate away from political posturing, and the move by the Union government to establish the committee is a necessary and welcome step. Striking a balance between three key needs — fiscal sustainability, clarity of needed contributions and certainty of benefits for the pensioner, and fostering innovative market instruments — will not be easy, but GPS and RendA+ offer promising points of departure.

Let’s hope wisdom prevails.

Yamini Aiyar and Partha Mukhopadhyay are with the Centre for Policy Research

The views expressed are personal