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The ticking pension time-bomb

Alok Ray

A major crisis is brewing on the pension front with various mismatches, of funds generated and paid out and interest rates. Alok Ray looks at the cause and effect of the situation that will impact the government and the people alike.

DARK clouds are gathering over the heads of retirees all over the world. Grave doubts arise whether governments will be able to deliver the promised benefits to those who will be retiring. The looming pension crisis is being widely described as a "ticking time bomb". Pension riots have happened in China and Latin America. What of India? How serious is the situation?

Over the six-year period, 1995-96 to 2001-02, the consolidated pension liabilities of the 29 major States rose three-and-a-half times. The situation is particularly grave for some States. For example, in Bihar the pension bill as percentage of the State's revenue expenditure has shot up from 6.57 per cent in 1995-96 to 13.78 per cent in 2001-02. For Jammu and Kashmir it has increased from 2.69 per cent to 9.79 per cent, Haryana from 3.1 per cent to 6.62 per cent, West Bengal from 5.4 per cent to 7.15 per cent, and Orissa from 4.14 per cent to 9.7 per cent. No wonder many government employees are not getting their salaries and pensions on time. There was the talk of freezing the DA instalments for government employees, but the government had to quickly back down as a result of strong political pressures.

What has led to this crisis? The universal global factor is rising longevity of people. In most countries, including India, the pension system runs on "pay as you go basis". The pension received by a retired person does not come from his own individual contribution made over his working life. The contributions of current employees go to a common pool from which pensions are paid to all the retirees. The problem is that the ratio of current employees to retirees has been steadily going down as retired people are living longer and the number of people on current payroll is increasing at a much slower rate.

The proverbial last straw, as far as India is concerned, came from the implementation of the Fifth Pay Commission recommendations. The salary scales of existing employees (after merging of DA with the basic pay) went up by a minimum of 20 per cent. The hike in salaries was to be accompanied by a reduction in posts and a cut in holidays. While the salary hike part was implemented, for obviously populist motive, the unpopular part of "voluntary" retirement of redundant employees and reduction of holidays was shelved. In addition, monthly pension payment — which is broadly determined as 50 per cent of the last pay drawn — automatically went up with the salary scales. Further, the introduction of "one rank one pay" formula for all retired people implied that whenever the salaries of the current employees went up or were revised, the pension payment to people in the same rank would go up automatically. Finally, the rate of family pension — paid to dependents after the death of the retiree — was revised upwards.

The salaries and pensions were also protected in full against any rise in prices. The 100 per cent adjustment of dearness allowance to price rise was accepted even before the Fifth Pay Commission. However, justified some of these changes may appear on equity grounds, together all these broke the back of government finances.

The hardest hit were the State governments whose ability to raise additional revenue is restricted for various reasons. But they had to raise the salaries and pensions in line with the Central government. The State governments are taking loans to meet the increasing expenses and many of them are already in the "debt trap" where they have to borrow just to meet the interest cost on past loans.

There are several reasons why the crisis would become much more serious in a few years. Basically three problems are involved here. One, is the under-funding problem, that is, the growing gap between the inflows from current contributions of existing employees and the outflows in the form of pension payments to all the retirees, past and present. This uncovered gap is estimated to be around Rs 60,000 crore. Two, the interest rate gap. Provident funds are assuring a tax-free 9 per cent return whereas the interest rate on current investments is around 7 per cent. A situation analogous to UTI is developing here. A 2 per cent gap in earnings on PFs would mean a loss of about Rs 2,000 crore each year. If this gap is allowed to persist despite a falling interest rate regime, a massive government bailout will be needed — as in the case of the UTI — fairly soon. The problem would become more critical once the bonds in which the PF funds invested earlier and hence earning higher interest rates mature within a few years. The funds will have to be reinvested in lower return bonds.

Three relates to the quality of assets in which the PF monies are invested. A large part is it is held in the form of State government-guaranteed bonds issued by various State undertakings and development projects such as State electricity boards and river valley projects. There is a grave risk of default associated with these near-bankrupt State undertakings. The guarantee by the equally bankrupt State governments merely means that the States will have to borrow more from the market, tightening the noose of the debt trap around their necks. One estimate puts the value of these state government guaranteed bonds in the range of Rs 50,000-60,000 crore. The time-bomb is really ticking.

It is not that the Centre is oblivious of the crisis. A committee under the former UTI Chairman, Mr S. A. Dave, was appointed which submitted its Old Age Social and Income Security (OASIS) report in 1997. It is being debated and no consensus has emerged so far.

All over the world it is recognised now that the "pay-as-you-go" system will have to be given up. Basically, an individual's pension will have to be financed from the earnings of his own savings and will go down (up) if the return on his savings goes down (up). This is unlike the present system where a retiree gets an assured pension linked to his last salary drawn, irrespective of his own contribution over his working life or the interest rate on the money invested.

The Dave Committee has suggested several things: The pay-as-you-go system should be gradually given up, perhaps starting with new employees. Applying a new less favourable system to existing employees may appear as a breach of contract. In future, each worker will have an individual PF account built with his own contribution plus some contribution from the employer. His pension will be financed from the return on this individual accumulated fund. The PFs should be professionally managed and a part of the money can be invested in the private equity market. Finally, individuals may be given the choice of taking alternative pension schemes sold by private companies. The final solution would be some combination of these various options. This is broadly the way the pension crisis is being sought to be tackled all over the globe. The Dave Committee recommendations were basically in line with prevailing international thinking. But the problem is that subsequently a great deal of apprehension has developed in the US, Germany, the UK, Japan and Argentina about the move towards `privatisation' of pensions.

This is the result of the unfolding of numerous unscrupulous business practices of fund managers and top corporate executives, concealment of information from small investors, wiping out of employees' savings invested in the stock market (example: Enron), and the general fear about the dangers of unregulated financial liberalisation. So, the final consensus on pension reforms in India may again change with changes in the international mood.

Meanwhile, the government finances are continuing to bleed. But who is going to take the unpalatable political decision, specially when the swelling ranks of retired people are already reeling under the squeeze on interest income on their past savings?

(The author is Professor of Economics, IIM Calcutta. He can be contacted at: alokr@iimcal.ac.in)

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