Parametric reforms of NPS merit consideration
The mandatory New Pension System (NPS) has been applicable for the Central government employees since 2004. It mandates a contribution of 10% each from the covered civil servants and from the government, as an employer. The contribution base is the full salary. The interim PFRDA (Pension Fund Regulatory and Development Authority) set up in 2003, has instituted a well-designed NPS architecture. The 13th Finance Commission, which submitted its report on February 25, 2010, reported that 23 states have adopted the NPS for their civil servants. The total amount currently at Rs 12500 million is expected to increase rapidly. While voluntary NPS for all Indian citizens with a minimum annual contribution of Rs 6,000 was made operational from May 2009, Swavlamban with a top-up of Rs 1,000 for members from the unorganised sector, is set to take off anytime now. Both the mandatory and voluntary NPS require accumulations till age 60, with no pre-retirement withdrawals, enabling compounding effect to benefit members. Recently, the interim PFRDA has raised the age of joining the NPS to 60 years from the previous 55 years. The NPS charges and fees for services of the points of presence (PoP) and for the central recordkeeping agency (CRA) are flat and fixed. Therefore, they adversely impact members with short period of accumulations. As an example, a member joining at the age of 59 contributing the minimum depositof Rs 500 pm and retiring at 60 would end up obtaining a negative 15.20% (annualised) return despite an assumed positive 10% growth by the pension fund due to a fixed cost of Rs780 in year one. However, as the balances grow, these charges become relatively less important. Thus, for the NPS members who are contributing only minimum amount required, raising the age of joining to 60, but leaving other design parameters unchanged,(and ignoringSwavlamban contributions), is likely to result in negligible returns under plausible assumptions. For those in the same age cohort contributing relatively large amounts annually to NPS (e.g. 2 lakh), it is the EET (Exempt at Investment, Exempt at Growth, and Taxed at withdrawals) which could result in negligible returns if the membership period is short. This is because whatever a member contributes between aged 57 - 59, is paid back at 60 as own taxable income. Raising the age for joining the NPS by the PFRDA provides an opportunity to seriously consider the following parametric reform for the pay-out phase for both the mandatory and voluntary NPS. It should be emphasised that these reforms should be considered as a package and not separately, though not all of them need to be introduced at the same time. First, the mandatory annuity requirement may be reconsidered. A phased-withdrawal program, under which a member does not join an insurance pool, but retains the annuity component (40%) of accumulated balances in a special interest-bearing account, or senior- citizen- bond may be a possibility. A member may be given options to withdraw principal plus interest every quarter for a period ranging from 10 to 20 years until the amount is exhausted. The bond could receive treatment similar to interest paid to senior citizens for fixed deposits. All members may choose this option up to a prescribed amount (e.g. Rs 10 lakh in 2010 prices). This would enable disciplined and stable withdrawal of funds over the period chosen.Alternatively, a member can opt to receive only interest / return as quarterly withdrawal in the initial period and withdraw accumulated balances in a phased manner at a later stage e.g. beginning at age 70. Under the phased withdrawal, there is no insurance pool, so a member retains the ownership of balances and therefore nominees benefit in the event of member’s death. PFRDA should encourage research and policy dialogue on phased withdrawal options appropriate for the NPS. This can also benefit micro-pension, and occupational pension plans.Second, the age of ‘retirement’ from NPS could be made more flexible. Thus a member may chose to partially withdraw the accumulated balances as lump-sum (60%); purchase mandatory annuity and, as proposed above, invest in a phased withdrawal plan, at any time between the age of 60 and 70. This will have several advantages. - It will permit individuals to enter NPS even between ages of 55 and 60, and still have sufficient time to accumulate retirement funds. - It will provide flexibility to individuals to choose the macroeconomic conditions, particularly the interest rate conditions, under which to purchase annuities, and participate in the proposed phased withdrawal program. For greater flexibility the age of withdrawal of lumpsum, and the purchase on annuity (and phased withdrawal program) could be separated. Thus, a person could withdraw lump-sum at age 60, but purchase the annuity anytime between 60 and 70 years. - Flexibility in timing of annuity purchases will better enable suppliers of annuities and bonds, such as life insurance companies, to match their assets and liabilities; and help manage uncertainties in longevity trends. - Third, the current EET treatment of NPS is disadvantageous to its growth compared with other instruments that are subject to EEE treatment. Thus, there is a strong case for exempting from income tax a reasonable proportion of accumulated NPS balances.As there is already a higher exemption level for senior citizens of Rs 240,000 currently, the two combined should enable even the middle class income earners to be exempt from income tax during old age. Simultaneously, the reported plans to harmonise EET treatment for other pension and provident fund plans in April 2011 should be implemented to minimise tax arbitrage. The above three parametric reforms in the mandatory and voluntary NPS will further strengthen the NPS design, and contribute to better retirement income security. They could also help in increasing NPS membership, which, to date, has been very disappointing with around 5,000 members, and meager balances of Rs 100 million. India’s current elderly population of about 105 million is projected to increase to 330 million by 2050. India’s demographic challenges arising from rapid ageing, and its need for fiscal consolidation (the current Greek crisis has lent greater urgency to this issue globally), strongly suggests that the PFRDA Bill be considered by the Parliament expeditiously; and parametric reforms of NPS suggested above be given urgent consideration.
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