Pension System in India

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Pension System

India operates a fragmented and complex pension system with a wide variety of schemes. The basic structure is the following: in the realm of public pensions, there is a limited social safety net for the elderly poor. The old-age provision for civil servants is the most developed part of the system; they are covered by several schemes. Workers in the organised portion of the private sector are covered by mandatory plans operated by the Employees' Provident Fund Organisation, which runs two pension schemes. Employers can decide to opt out of these schemes and establish Exempted Funds. There are also voluntary pension schemes in the organised sector called superannuation funds. Voluntary private pensions are available for the self-employed and for workers in the organised and unorganised sectors. 

India will witness remarkably different and much more positive demographic developments than most of the other Asian countries. The current fertility rate stands at 2.8 children per woman, significantly above the natural reproduction rate of 2.1. With a median age of roughly 24 years, the current population is very young. A shrinking population is not an issue in India, as the country's population is expected to grow from 1.16 billion today to 1.66 billion in 2050. Still, India's population will age, albeit at a moderate pace. The old-age dependency ratio will increase from 8 today to 21 in 2050.

Assets in the Employee Provident Fund system currently amount to EUR 40.1 billion, and we expect a yearly growth of at least 14.9% until 2050. For the New Pension System, our projection foresees a rapid asset built-up, with an asset volume between EUR 17.6 billion and EUR 22.9 billion by 2015.

Public Pensions

Public pensions comprise a limited safety net for the needy elderly population, two pension schemes for civil servants and the New Pension System, which replaces the civil servants' schemes for new entrants. In addition, employees in the public and private sectors with more than five years of tenure receive a gratuity upon retirement or if they leave the company before retirement. This gratuity is paid by the employer. It is equivalent to 15 days of final salary for each year of service; the maximum amount is EUR 6,013 (INR 350,000). There are also two major ongoing pilot projects in the realm of pensions. One focuses on better coverage for workers from the unorganised sector, and the other provides "micro-pensions" to unorganised workers and the rural population.

Social security

The National Old Age Pension scheme was introduced in 1995 and is part of the National Social Assistance Programme. It aims to expand the social safety net for the poor. Needy persons over 65 below the poverty line are eligible for this scheme, which provides monthly benefits of EUR 3.4 (INR 200), an increase from EUR 1.3 (INR 75) in 2006. It is estimated that around 16 million people are entitled to benefits under this scheme.

Central Civil Service Pension Scheme/Civil Service Provident Fund

The Central Civil Service Pension Scheme and the Civil Service Provident Fund are mandatory schemes for civil servants that were established in 1972 and 1981, respectively. Both schemes are now only available to existing central government employees. The Civil Service Pension Scheme is an unfunded defined benefit, pay-as-you-go scheme. Employees do not contribute, while the respective employer pays 8.3% and the government adds 1.16%. To qualify for a pension, ten years of service are necessary, and the pensionable age is 58. The maximum benefit is 50% of the final salary, and one-third of the pension value may be withdrawn as a lump sum. Pension schemes for the civil servants of state governments generally have a similar structure.

The Civil Service Provident Fund is run for employees of the Central Government. While it is designed as a provident fund on a defined contribution basis, it actually operates on a pay-as-you-go basis; current contributions are used for financing the pension benefits of current pensioners. Members have to contribute monthly and can freely decide which amount they would like to contribute between 6% and 100%. The employer does not pay contributions, and benefits are paid as a lump sum after at least 20 years of service. The government credits the accounts with an interest rate that is determined each year; currently the rate is 8.5%.

The pension system for civil servants delivers a high replacement rate. However, it has been exposed to rapidly rising financial burdens for the government and seems unsustainable in the long run. For this reason, access to the old schemes was closed for new entrants and replaced by a different system.

New Pension System

The New Pension System, a defined contribution scheme, was introduced in 2004 and has since covered new entrants to the central government's civil service. An exception is armed forces personnel, which is not in the scope of the New Pension System. Public service employees who worked for the government prior to 2004 have remained in the old system. Employers and employees contribute 10% of salary each and contributions are placed in individual accounts. The minimum retirement age in the new system is 60 years and taxation is based on the EET principle, with mandatory annuitisation of 40% of accumulated capital. While the scheme is designed for central government employees, 26 of the 29 state governments have indicated that they plan to join the scheme. The New Pension System has a targeted replacement rate of 50% of final wage.

The Pension Law, which will establish the details of the new system, has not yet been passed. Hence, implementation has only begun for central government employees, for which parliamentary approval is not necessary. For the time being, contributions are held by the central government and awarded a rate of return of 8%. The scheme will be mandatory for civil servants, but open to every Indian citizen, meaning that employees from the organised and unorganised sectors as well as the self-employed will be able to participate. Their participation will be voluntary, and employers will not be obliged to contribute. It is not clear when the voluntary component of the New Pension System will become effective.

Once the system is running, members will be able to choose between three funds with different investment strategies and risk-return profiles. If they fail to make a choice, their contributions will be transferred to a default fund, which is the safe fund. Assets in the three funds will be allocated as follows:

To provide funds to the system, asset managers will need to be licensed. The administrative framework for the New Pension System foresees that contributors can access Points of Presence, such as post office and bank branches, to ensure nationwide distribution.

The Points of Presence will be service providers for all sorts of New Pension System issues, such as opening accounts or collecting contributions. Contributions will then be directed to the Central Recordkeeping Agency, which forwards the capital to the various fund managers, who then put it in the chosen fund. Recordkeeping is centralised to keep fees low.

The NPS will have tier-I and tier-II accounts. Tier-I accounts are the mandatory pension accounts for civil servants without the possibility of premature withdrawal. Tier-II accounts are voluntary. They will consist of savings that can be withdrawn, are subject to minimum contributions to the tier-I account and will not enjoy tax advantages.

Occupational Pensions

Employees' Provident Fund Organisation
The mandatory pension scheme for the private sector is managed by the Employees' Provident Fund Organisation (EPFO). It was set up in 1952 and covers employees in 181 specified economic sectors at firms with more than 20 employees. It is part of the central government's Labour Ministry and administers and regulates all employee benefits, while outsourcing the management of the scheme's assets to fund managers. Traditionally, assets have been managed by state-owned banks. Employers can be exempted from participation if their pension plans provide at least the same level of benefits.

The EPFO operates three major schemes: the Employees' Pension Scheme, the Employees' Deposit Linked Insurance Scheme and the Employees' Provident Fund Scheme. All three are mandatory for employees. While the Employees' Deposit Linked Insurance Scheme is a life insurance scheme to which only the employer contributes 0.5% of wages, and which is intended to provide benefits to the family in case of the breadwinner's death, the other two schemes are directly pension-related.

The Employees' Pension Scheme is a defined-benefit plan to which employers and the government contribute 8.33% and 1.16% of salary, respectively. The assessment ceiling is EUR 112 (INR 6,500). Retirement under this scheme is possible at age 58, while early retirement with reduced benefits is possible from age 50 onwards. One-third of the capital can be withdrawn as a lump sum. The Employees' Pension Scheme follows the EET taxation principle and covers 32 million members.

The Employees' Provident Fund Scheme is a defined contribution scheme with an administered rate of return that provides lump-sum benefits at the time of retirement. Members can make partial withdrawals for specific purposes, such as buying a house or covering medical expenses. Employers and employees each contribute 3.67% of wages. Also in the Employees' Provident Fund, the assessment limit is EUR 112 (INR 6,500), voluntary employee contributions of up to 100% of basic salary are possible. The taxation principle is EEE, meaning that contributions, investment returns and benefits are tax-exempt. The stated rate of return, which is fixed by the government, is currently 8.5%. Employers must make up for shortfalls in investment income. The Employees' Provident Fund covers 43 million employees.

Apart from these schemes, there are special mandatory provident funds for certain occupational groups, such as the Coal Miners' Provident Fund, the Assam Tea Plantation Provident Fund, the Jammu and Kashmir Provident Fund and the Seamen's Fund. Although managed by different trusts and fund managers, these funds follow the same investment and return rules as those regulated by EPFO, and cover around 2 million members.

Exempted Funds
Exempted Funds can be established as a substitute for the EPFO plans, provided that benefits at least match the ones of the EPFO plans and that the EPFO agrees.

If employers set up Exempted Funds to substitute the EPFO, employees must participate in the scheme. They are established as independent trusts and governed by employer and employee representatives as trustees. Contribution levels are the same as in the EPFO system and must provide the same rate of return; the retirement age ranges between 58 and 60 years. Employer and employee contributions are tax-deductible, investment income is tax-exempt and benefits are taxed.

There are strict investment regulations for the Exempted Funds that specify minimum investment limits. The regulations are as follows:

- 25% of assets must be invested in central government bonds
- 15% of assets must be invested in state government bonds or bonds of public sector enterprises guaranteed by central or state governments
- 30% are required to be invested in bonds of public financial institutions or public sector enterprises

The remaining assets can be invested in the same asset categories. Since 1998, trustees have had the option of investing a maximum of 10% in private sector bonds.

Voluntary occupational schemes
Voluntary occupational schemes, called superannuation funds, target organised sector employees and provide additional pension benefits, mainly in the form of defined contribution plans. A main reason to set up voluntary funds is the low income limit in the Employees' Provident Fund, which means that group pension plans often only cover senior executives. Superannuation funds can either be run internally as a trust fund, or externally in cooperation with life insurance companies.

The upper limit for employer contributions to the superannuation funds is 15% of salary; the same limit applies to employees. Contributions are tax-deductible, as is investment income, but benefits are taxed. Tax-exemption for employer contributions applies up to EUR 1,718 (INR 100,000) per employee. The same limit is valid for all employee contributions to pension and life insurance schemes.

Superannuation funds are required to annuitise the accumulated capital by buying an annuity from a life insurance company. However, 30% to 50% of the capital can be taken as a lump sum. Investment regulation of superannuation funds is the same as for Exempted Funds if they are managed in-house by trustees. In contrast, externally managed funds increasingly offer investment choices for members. Current discussions on this issue focus on whether superannuation funds should have the possibility to invest in approved funds of the New Pension System in the medium term, which would make guidelines for internal and external superannuation consistent.

India's pension policy challenges differ from those of other Asian countries. While most other countries face a severe demographic challenge, Indian demographics will develop more favourably. However, like the other countries, India is in the process of restructuring its pension system, especially to increase the coverage of formal pension systems.
There is currently a wide and complex variety of existing schemes, which predominantly target civil servants and employees in the organised sectors. The New Pension System has the potential to modernise pensions for civil servants, but also to provide unorganised sector workers with access to a formal pension system on a voluntary basis. The architecture of the NPS is quite innovative in terms of distribution and investment choice, and has the potential to provide higher workforce coverage once it finally comes into effect. The establishment of a pension regulator will also support the modernisation of India's financial system. Nevertheless, the success of the New Pension System will depend on the acceptance of unorganised sector workers. The issue of how to cover unorganised sector employees is therefore likely to remain high on the agenda in years to come.
Compiled by Allianz Global Investors