The combined expenditure of Central and State-run pension programmes is already significantly high (about 1.5 per cent of GDP) and accounts for a quarter of the fiscal deficit, which is about $53 billion (or nearly 11 per cent of GDP) (source: CMIE).

Central government pension spending alone accounts for 10 per cent of the central fiscal deficit (source: http://indiabudget.nic.in).

Switching to a privately funded scheme, therefore, would directly reduce the cost of government employees' pension schemes and indirectly it would reduce the interest cost of market borrowing to finance those schemes by issuing government debt securities.

The EPF schemes pay at the current fixed rate of interest, pegged at 9.5 per cent, but they earn less from investing in government bonds.

The real rate of return on government bonds is barely 3 per cent a year. Ideally, the EPF rate should move in line with the central bank's key benchmark `bank rate', which currently stands at 6 per cent, the lowest since 1971.

The fact that the EPF rate is pegged higher than the bank rate costs the government more in terms of interest payments, which justifies the need for privately run pension schemes. Given the urgent need for fiscal discipline, the reform process could be accelerated.

Investment rules have been designed to create a pool of funds for use by the public sector, as most funds must be invested The provident fund schemes — India's largest retirement income scheme — under-perform owing to investment restrictions such as administered rates and investments restricted to government bonds and restrictions on sales, and have had little bearing on the capital market.

The financial difficulties in administering unfunded public pension programmes appear to have rendered the current system ineffective and unsustainable, further emphasising the need for a structural and lasting change. Pension funds such as insurance funds play an important role for the development of capital market, especially the long-term debt market.

Whether the new system will channel any additional money into pension funds will depend on the growth of employment in the formal organised sector, as the private pension funds are unlikely to enter the informal sector. The foreign investors interested in coming into the formal market could gain, as the market open to private fund managers will be bigger.

Estimating the size of the new market

There are estimates that the market size of India's pension system could be as large as Rs 3.5 lakh crore.

Following the currently proposed reforms, the likely market size of the new pension system can be estimated.

Assuming a 4 per cent increase in new employees in the formal organised sector and given the size of the pension market of 37.2 million people, 4 per cent employment growth could add about 1.5 million new employees, who will have to join privately funded schemes following the reform.

Assuming an average wage of Rs 48,000 a year, about Rs 12,000 will go into pension schemes, with contributions by both the employee (12 per cent) and the employer (a matching 12.5 per cent).

For 1.5 million new employees, this will amount to Rs 1,750 crore (nearly $400 million) annually. If we assume wage growth of, say, 3 per cent in line with current inflation, this amount will be higher in the next period.

Risk management for pension investments

Pension privatisation is, however, no magic bullet. Long-term savings exposed to bad market conditions can lead to a deterioration in savings, whether they are invested in stocks or in debt instruments.

But a strategy of diversification or a mixed portfolio of equities and government bonds (both domestic and overseas) can have a higher expected return than a 100 per cent bond or an all-equity portfolio.

To reduce risks in long-term investments, a balanced portfolio (with low volatility) is inevitable; this will have the potential to keep the investment risk low by minimising portfolio volatility, particularly at a time of heightened risk and domestic uncertainty.

It is also a prudent investment strategy to diversify the sources of credit risk, as holding a portfolio of fiscally strapped government bonds could pose credit risks for long-term investors.

Supervisory and regulatory issues

The Government has decided in principle to allow pension funds to invest in overseas markets, but is yet to formulate guidelines for the entry of foreign pension funds into the sector.

Traditionally, private pensions were part of the insurance business in India, which was liberalised in 2000; consequently private entities, including foreign players, entered the private pension market.

On October 10, the Government announced the setting up of an interim pension funds regulator, the Pension Fund Regulatory and Development Authority (PFRDA), which will prescribe the minimum capitalisation norms.

This will be similar to the Insurance Regulatory and Development Authority (IRDA) specifying a minimum capital of Rs 100 crore and allowing a foreign player to hold up to 26 per cent of the equity in a new insurance company.

The pension regulator will announce guidelines by January for the operation of the new funds including the existing mutual funds and insurance companies.

Given that all the proposals will need approval of the Union Cabinet, the final decision has been scheduled for early next year. There are two things to watch out for.

First, will there be any restriction on private fund managers maintaining an internationally diversified portfolio?

In general, an internationally diversified portfolio is safer than any portfolio held in only one country.

Second, will there be any rate of return guarantees by the fund managers to their clients on a safe investment option?

To conclude, India's high fiscal deficit is already a serious challenge. The fiscal unsustainability has been partly due to the unfunded pension provision for the civil service sector.

Shifting to funding pensions could help improve the long-term sustainability of India's public finances and also help channel long-term savings into investment in the capital market.

Funded pension schemes are the trend of the future. India is, in some ways, ahead of the curve. The operation of pension funds could help a boom in the capital market in the years ahead.

But the challenge for the Government is to modernise the system (record-keeping) and operations (contribution inflows and benefit payouts), and to benchmark its governance and investment policies (money management) to minimise investment risk.

(The author is Lecturer, Department of Economics, Loughborough University, UK.)

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