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In 1983, the excitement was palpable as Kapil Dev hoisted the Prudential trophy after the limited-overs World Cup held in England. The 1987 event, initially set for England, was moved to India and Pakistan due to the financial woes experienced by the United Kingdom’s (UK) pension providers, including Prudential, the World Cup’s sponsor then.
The pension industry was struggling because pensioners were living longer, investment returns were lower than estimated, and pension payments were fixed and payable for the pensioner’s lifetime. Ultimately, the UK government took over the liability. Some individuals, who were eligible for a higher pension, experienced losses as the government capped the maximum pension amount.
A similar situation unfolded in the wake of the 2008 Great Financial Crisis, when General Motors (GM) faced bankruptcy due in part to high pension liabilities towards former employees. The US government nationalised GM, took over the pension liability, again capping the maximum pension amount. Pensioners eligible for a higher pension again suffered.
These events show that reckless pension schemes eventually fail. Another lesson is that when the government steps in, it focuses on protecting those who need the pension the most. Those receiving higher pension amounts often suffer.
This leads to the current debate among executives about whether they should opt for a higher future pension by diverting a portion of their existing Employees’ Provident Fund (EPF) corpus.
Let’s say an employee, whose salary is Rs 1 lakh per month, contributes 12 per cent (Rs 12,000) to his EPF account. The employer contributes an equivalent amount (12 per cent of salary or Rs 12,000) over and above the salary. Of this 8.33 per cent, subject to a maximum salary limit of Rs 15,000 (or Rs 1,250 per month) has to be contributed to the Employees’ Pension Scheme (EPS).
The balance Rs 10,750 (Rs 12,000 less Rs 1,250) is transferred to the EPF account. The employee’s EPF account receives a total of Rs 22,750 per month (Rs 12,000 from the employee and Rs 10,750 from the employer). The accumulated balance in the EPF account is tax-free, and can be withdrawn fully on retirement.
The EPS fund receives Rs 1,250 per month from the employee. Additionally, the central government tops up with a proportional contribution to enable EPS to meet its pension liability. This contribution is Rs 174 per month (1.16 per cent of salary, with a maximum salary cap of Rs 15,000).
The pension on retirement is based on the number of years of contribution and the salary at retirement. The maximum salary assumed on retirement remains Rs 15,000 per month and the maximum pension is Rs 7,500 per month (for those who have contributed for 35 years or more).
The retirement pension is available only if the employee completes 10 years in the scheme. Those who don’t can withdraw their EPS contributions. Many employees don’t withdraw this EPS amount even though they are eligible to do so. This unclaimed amount is exceptionally large and is likely to be never claimed back. The interest earned on this “surplus” powers many of the unsustainable pension promises, like a minimum pension of Rs 1,000 per month.
A Supreme Court decision has allowed some EPF subscribers to receive a higher retirement pension without the constraint of a cap on maximum salary of Rs 15,000 per month. To be eligible, however, they would need to transfer significant amounts from their EPF accounts to EPS, sparking a debate on the advisability of such an action.
A valuer assesses whether the resources can meet the liabilities. The latest valuation for the year ended March 31, 2017, revealed a deficit of Rs 15,000 crore. The deficit is expected to grow even larger with the removal of the cap on retirement pensions and growing life expectancies of Indians.
Truth be told, employees hoping for a larger pension in the future by contributing more from their EPF corpus are betting on the government stepping in to cover the deficit. However, history has shown that when a government intervenes, those receiving higher pensions often suffer losses. Employees with higher salaries would be better off investing their tax-free EPF corpus in suitable financial instruments upon retirement rather than trusting that money to an uncertain future pension.
All data taken from EPFO annual accounts of 2021-22
The writer heads Fee-Only Investment Advisors LLP, a Sebi-registered investment advisor
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
(A slightly different version of this column first appeared in the Business Standard on May 08, 2023)