Two civil servants write: New pension reform must reduce burden on future generations

The contributory NPS was adopted in 2004 by the central and state governments in India following the global trend, across public and private sectors. Thanks to a combination of ageing populations and fiscal strains, a pay-as-you-go (PAYG) DB pension was becoming unsustainable. The latest examples are France and Spain, where efforts to address fiscal unsustainability by raising retirement age and increasing contributions from younger workers respectively have sparked massive public protests.

Under the NPS, the employee contributes 10 per cent and the government 10-14 per cent of the salary to a pension fund. The fund invests in securities, therefore its returns are market-linked. At retirement, pensioners must buy a fixed annuity from the market, whose value depends on the accumulated corpus and expected future returns.

The NPS has shown impressive annual returns above 9 per cent since its inception. In contrast, pension funds in the Organisation of Economic Cooperation and Development (OECD) economies have grown at 3-5 per cent over the last 15 years. But since long-term global trends point to low-interest rates, corpus growth, and therefore annuity payouts, might be lower than currently expected. Therefore, pensioners under NPS bear market risk and also face a lower likely pension annuity. This is the substantive case for NPS reform.

But a return to OPS is fraught with problems. The OPS suffers from the twin problem of being unfunded and fiscally unsustainable. In the absence of any employer and employee contributions, it’s a pure PAYG system where present workers finance the retired. This becomes a problem as birth rates decline and people start to live longer.

The UN’s population pyramid indicates that for India, the ratio of 25-64 year-olds to above 64-year-olds will decline from 7.3 to 1.5 from 2020 to 2100, a near five-fold increase in dependency ratio. The World Health Organisation’s life expectancy simulations show that for people aged 60, life expectancy would increase from 18 to 27.9 years over the same period. Hence the typical pension support period will increase by 55 per cent just this century.
Then there is the issue of fiscal sustainability. At retirement, the OPS employees currently get pension at 50 per cent of their last drawn salary. This pension increases twice every year with a dearness allowance (DA) to account for inflation. It’s also rebased with the cumulative DA and the fitment awarded in Pay Revision Commissions which happen every five years or so (10 years in the central government).

To illustrate the problem, consider the following scenarios over a 25-year post-retirement life. Assuming a DA of 4 per cent without compounding, the pension doubles. It rises by 148 per cent if DA is rebased every five years. However, if the base is revised with 4 per cent DA and fitment of 10 per cent, the pension rises by 243 per cent, and with 5 per cent and 15 per cent, the rise is 411 per cent. The numbers go up exponentially with higher DA and fitment rates. This is the fundamental problem with OPS.

The OPS is more generous on several other counts. For example, the pension replacement rate, a measure of how much pensions replace salaries, is much lower for higher-paid employees in the OECD economies compared to 50 per cent of the last drawn salary for all OPS employees. The retirement age and the minimum period of service for full pension are far lower, the base for determining the pension is the highest drawn salary instead of some average of earnings over the career followed globally, and OPS covers the family too.

Then there is the accumulated stress. Pensions as a share of states’ revenue receipts and own revenues are already 13.2 per cent, and 29.7 per cent respectively. Alarmingly, pension liabilities of states have risen annually by 15-20 per cent in the last decade. The high average of 31.2 per cent debt to gross state domestic product ratio conceals higher debts among several states and excludes significant off-balance sheet borrowings and guarantees. As pension bills rise faster than revenue growth, it will lower development expenditure and necessitate further borrowing, thereby causing a debt trap.

Therefore, any NPS reform must reconcile the often-conflicting interests of the present generation of employees with those of the future. It should provide reasonable pension security without burdening future generations, thus promoting inter-generational equity.

If NPS is inadequate and OPS is fiscally unsustainable, what’s the alternative?
For a start, any sustainable pension reform should retain the contributions and the NPS fund management. It should avoid periodic increases in the annuity. The government could then guarantee a certain percentage of the last drawn salary as a fixed annuity pension.

The pensioner would purchase the annuity at retirement, and the government could bridge the gap, if any, between the guaranteed pension and the purchased annuity. The gap could be met by direct budget transfers to the pension. The guaranteed annuity would reduce in proportion to any lump sum withdrawal from the corpus.

But this guarantee should reflect the declining trend in global interest rates and India’s stage of economic development, both of which would likely lower the nominal returns on the pension corpus. As reference points, just over this century, the returns on Public Provident Fund have declined from 12 per cent to 7.1 per cent. On one-year bank deposits, they have halved to 5 per cent. This suggests that even a contributory DB pension scheme will be difficult to sustain if the guarantee is too generous. However, the guaranteed pension could be topped with additional benefits, currently unavailable to NPS pensioners. They include extending pension to the spouse, albeit with a lower annuity, health and life insurance benefits, and a minimum pension to cover for those with lower service tenures. This too will strain the budget. But it may be the best that can be offered without irreparably burdening future generations.

The writers are civil servants. Views are personal