The New Pension Scheme: New wine in completely new bottleThe new pension scheme has some innovative features. It is a long- term investment vehicle that will deepen our capital markets and make a much needed provision for self-funded old age social security net.
08 Jun 2009
The new pension scheme has just been opened to the general public from May 1, 2009. It has been written about extensively in the news media due to some of its really innovative features. I am not writing about the detailed features since these have already been covered by the media. Instead I will highlight some of the more innovative features of this scheme.
The cost structure is very low which means that the individual investors will be able to fully reap the benefit of their long-term investments. When investments are for long terms such as 20-40 years, even a 0.25% drop in fund management costs can make a substantial difference in value accumulated. An example here will illustrate this *: If you save Rs. 24,000 per annum for 40 years at an compounded return of 10% p.a., the corpus accumulated at the end of 40 years is Rs. 117 lacs at the fund management charges of 0.0009% (negotiated by the PFRDA on your behalf). For comparison even at an otherwise very reasonable fund management charge of 0.50% p.a.: your accumulated value at the end of 40 years would have been only Rs. 102 lacs or a difference of around Rs. 15 lacs. In other words it makes a difference of around 13% in the accumulated corpus where the difference in fund management charges is 0.50% p.a.
*The transaction charges have been ignored for the purpose of this example.
It takes on the role of a default financial advisor by providing for an automatic asset allocation (based on your age) between safe fixed income investments and riskier equity investments. Again this is an excellent feature as most lay investors rarely give a thought to asset allocation and in the absence of a conscious choice made by the investor the default asset allocation based on age ensures that equity investments also form a part of the investment pool as it should for any long- term investment period.
As far as the equity investments are concerned, the risk of fund manager judgment going wrong has been eliminated and market-linked returns have been ensured by requiring equity investments to be made only in Index funds. This also brings down the fund management costs as the money is allocated among stocks in the same proportion as the underlying index which function can be automated easily.
Withdrawal before the age of 60 years has been made difficult by making it compulsory to buy an annuity for 80% of the amount withdrawn thus guarding against the possibility of your immediate consumption needs eating into your future pension. Thus even if you withdraw the amount before you reach the age of 60 years, you will only get access to 20% of the withdrawn amount. The balance amount will only come to you by way of a periodic payment on an annuity that you will have to buy from any Insurance company.
Each investor's account will be separately maintained and can be monitored by the concerned investor including changing his fund manager once every year. Thus it is similar to a ULIP account or a mutual fund account. Given that there is individual ownership of the accounts and returns and control over who manages the account, the politicians/bureaucrats will not be able to get their hands on it in any way. The temptation is likely to be huge given that it is estimated that the scheme is likely to have a very large corpus by the end of the next decade.
Despite these and some other innovative features it will be a while before this scheme takes off in a big way.
The major reasons are:
Clarity on tax treatment: Currently there is no clarity on the tax treatment of the contributions made and the amounts withdrawn. (Already written about) It will suffice to say that this lack of clarity is expected to be addressed in the current budget to be presented by the new UPA government. It is widely expected that this will follow an EET model (namely contributions will be tax deductible, accumulated income will be exempt and any withdrawal will be fully taxable).
Existing small saving schemes such as PPF and NSCs: PPF provides an EEE taxation model and the current rate of 8% return is very attractive. Given political pressures, it is unlikely that the return will be bought down significantly or the scheme will be scrapped. NSC also provide a government guaranteed fixed return for 6 years at 8% (Compounded half-yearly) which is fairly attractive.
No push: At the best of times government savings schemes are pull products i.e. the customers look to buy these products rather than being sold these products by investment/financial advisors. However, these advisors are provided a small consideration for servicing these requirements to ensure that payments are picked up, certificates/passbooks delivered, reminders made where periodic payments are involved, etc. Given that electronic transactions are still a very small proportion of the overall transactions, the services of these intermediaries are absolutely essential for consumers to navigate the transaction logistics of such investments. The new pension scheme has no such inducement for any service provider. The intentions are obviously very good i.e. to keep the costs low so that the investor can benefit. But ironically such low costs (combined with the fact that returns are not guaranteed) will almost make sure that this scheme is actively de-marketed by these influential advisors/consultants. Already newspapers have reported how some banks (which are nominated as Points of Presence for the new pension scheme) tried to sell the pension product of the insurance companies that they represent when consumers went in to enquire about the new pension scheme. Multiply this scenario manifold and you will see why this scheme will take a while before it takes off.
Minimum 4 contributions every year: This one is perhaps an oversight. Even if the investor makes the minimum annual contribution of Rs. 6000 in a single installment he will still need to make at least 3 more contributions of Rs. 500 each. Given that there is no systemic push to ensure that the investors meet their obligations (see point 3 above), this will make for a large number of defaults.
This is not to pick holes in what is truly a path breaking initiative by the PFRDA. Hopefully, the initial teething problems will get sorted out and we will soon have a robust long- term investment vehicle that will deepen our capital markets as well as make a much needed provision for self- funded old age social security net.