India is poised to launch an innovative pension system on an unprecedented scale. After many years of languishing in bureaucratic limbo, the so-called New Pension System (NPS) is now set to go live on April 1, having just completed an eight-week flurry of activity to establish operational procedures and select fund managers.
The NPS is aimed at catering to the nearly 400 million people in India's 'unorganised' sector of small- to medium-sized enterprises and cottage industries.
It originated as a scheme for central government employees, with the intention of expanding to the private unorganised sector. Last year the Pension Fund and Retirement Development Authority (PFRDA), the system's regulator, handed out three mandates for this role, to three government-owned fund managers, LIC Mutual Fund, State Bank of India Asset Management and UTI, based on recommendations forwarded by Crisil, a local ratings agency. These mandates are mainly fixed income; they allow the managers to invest up to 15% in equities but so far none has come close to that cap.
Because the NPS is only mandatory for newly joining civil servants, the size outsourced to these three managers is modest, and they will be paid 3-5bps on managed assets.
September saw another opening of the pensions world, when the Employee Provident Funds Office, which manages around $25 billion on behalf of the organised sector (the larger corporations), for the first time outsourced assets to four fund houses: HSBC Asset Management, ICICI Prudential Asset Management, Reliance Capital and SBI. Collectively these houses will receive $2-3 billion annually to run domestic bond portfolios.
But the biggest, most anticipated move has been the extension of the NPS from just covering new civil servants to the entirety of the unorganised sector. This had been held up for years because the Marxist parties that had provided the ruling Congress Party with support in parliament had opposed this. But in September the Marxists broke the alliance over India's nuclear deal with the United States, and Congress was able to reassemble a new ruling coalition with other parties.
With a general election scheduled for this spring, the PFRDA's chairman D. Swarup realised he had a short window of opportunity to get the NPS expansion through parliament and into action. The PFRDA appointed Mercer to assist it with designing the plan for the unorganised sector in December and unveiled the results this month.
The designers appear to have come up with a truly innovative design that is intended to maximise benefits to members, rather than enrich product providers. The 'new' NPS is structured around three tiers. First is the Central Recordkeeping Agency (CRA), which manages the system and is responsible for collecting contributions and disbursing benefits.
Beneath this is a myriad of Points of Presence (PoPs), in other words, distributors. Although entities such as the post office were considered, the designers for now have opted to stick with commercial banks and life insurance companies. An additional level of independent financial advisors has likewise been scrapped over concerns about their ability to understand or sell the NPS. So for now, the PoPs -- mainly the state-owned banks -- will serve as the front line.
The CRA is now in the process of finalising its choice of external fund managers who will handle all assets for members from the unorganised sector. It has made offers to six providers for three-year contracts, and it is assumed these six will accept, although negotiations are not over. The six include three government-owned entities (ICICI Life Insurance, SBI and UTI) and three private players (IDFC Asset Management, Kotak Asset Management and Reliance Capital). By law managers to the system cannot have more than 26% foreign ownership, which has automatically excluded foreign players such as Franklin Templeton and HSBC Asset Management, and most joint ventures as well.
These will manage two portfolios of indexed equities, two of fixed income, and two of corporate bonds and other credit instruments -- all domestic, for now. These will serve as building blocks to which members can allocate any mix of assets. (Government employees in NPS will also be able to choose from among these six managers, in addition to the three balanced mandates already chosen for them; but not vice versa, i.e. private-sector workers will not have access to portfolios chosen explicitly for civil servants.)
One of the most progressive features of the NPS is its default option for anyone who doesn't want to pick among funds, which is a lifecycle option. The CRA will allocate on member's behalf among the six funds, with an equities component ranging from 80% to 10%, adjusting accounts each year by the member's age.
If the scale of the unorganised sector is vast, consider the flip side: the razor-thin fees on offer. UTI put in the lowest bid, at 0.09 basis points -- yes, that's nine-hundredths of a basis point, and it includes transaction and custody costs. The CRA is now locking down the same fee among the other five managers. (In the cash market, an equity index fund sells for 100bps, and an actively managed fund for 200bps.)
"This cost structure is as close to a true index as you can get," says Hansi Mehrotra, Mumbai-based principal and business leader for investment consulting at Mercer.
For these fund managers, the eventual promise of servicing the vast unorganised sector is worth writing off the next three years. They already charge tiny fees for regular saving plans to their mutual funds. They have the existing IT, management and other resources already in place. Because the equity funds are passive, there is little call on portfolio managers.
And the biggest expense in asset management, the marketing, has been taken out of fund managers' hands. The PFRDA insisted on the CRA being responsible for all marketing efforts, in order to defend against mis-selling.
The PFRDA is also concerned about mis-selling at the PoP level. There is nothing to prevent an adviser at, say, State Bank of India from suggesting a member put all of their contributions into the fund run by SBI Asset Management. But at least it must obtain a signature from each member.
The biggest challenge will be making people aware of the NPS, and convincing them to contribute. Although mandatory for new civil servants, it is voluntary for private-sector workers. The CRA will begin marketing on April 1, once the system goes live, but it lacks a mechanism to reach the hundreds of millions who are eligible. The banks that will serve as PoPs don't have incentives to push the system, when it comes at the expense of their own deposit bases -- and besides, some 20% of these workers don't even have a bank account.
One big weakness in the system is the lack of tax incentives. Although plenty of workers in the unorganised sector pay no taxes, there could be rebates on things like excise taxes or custom duties, as well as corporate and income-tax breaks for those who qualify.
A second flaw is the requirement that nearly half the accumulated assets are to be used to buy an annuity from life insurance companies upon retirement. Although the annuity concept is good, doing so in this manner will subject members to the high prices of the cash market, undermining the benefits of ultra-low cost that the NPS's scale is meant to deliver.
There is now a bill in parliament that would address the tax issues, separate to the launch of the system, but fund management executives in Mumbai are sceptical it will be passed before the elections -- which means it is unlikely to be passed. Getting the NPS off the ground at all is a success and a coup for D. Swarup, but the system will require plenty of further reform.
The PFRDA says the system will attract only $2 billion per annum as a result of these problems -- a disappointment to fund executives, who had previously expected five or six times that amount. It will take fund houses 10 years or more to break even, says one funds exec, although the cutthroat fee schedules may be renegotiated in three years.