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How the Old Pension Scheme can be cruel to the Future Generations - Analysis

Updated: Nov 21, 2022

Every now and then there are elections in India and rallies are the favorite things that TV media love to cover that gather them TRP's, but how is that benefitting (Not the TRP's but the rallies and frequent elections) the nation?



Thousands of crores of tax payers money is flown out and humongous working hours of the people are wasted just for electing few people who in return are supporting terrible policies such as the old pension scheme and freebies. This Article does not intend to support or criticize any political party but this topic matters to the future of our Nation.

Giving populous schemes just to please the masses is a kind of parenting that raises a rebel child who will not learn to stand on its own feet in life.

Let's analyze how old pension scheme as explained in SBI Research Ecowrap document, can be a terrible move going forward in simplest words. This blog has two parts.

  • First part is the crux and simplified version to understand from a layman perspective.

  • Second part is the original text of SBI Research ECOWRAP document.

 

What is the New Pension Scheme and how it differs from Old Pension Scheme.

  • First, the Government makes a 14% matching contribution against the 10% monthly contribution of employees.

  • Second, the Government also will adequately compensated for any non-deposit or delayed deposit of contributions during 2004-12.

  • The employee has the exclusive right to choose the fund manager and his investment pie.

  • Additional yearly tax rebate of Rs 50,000 and 60% of the corpus is tax free and the entry age is also raised to 70 years.

Basically, it is also called the defined pension scheme where as the old pension scheme is the scheme that had no accumulated funds and or stock of savings for pension obligations and hence it is a clear fiscal burden.

The current old aged people benefit from the scheme even though they may not have contributed to the pension kitty while they were working.


The Old Pension scheme also involved a direct transfer of resources from the current generation of tax payers to the fund of pensioners. In other words, we the current generation is working for the pension of old age people.


The Old Pension Scheme was discontinued in 2004 due to explicit burden on future generations and also the incentive for early retirement was done away with (as the pension is fixed at the last drawn salary).


India now is undergoing change in its demography with the current generations producing less babies resulting in low fertility and also the increasing longevity of living, that is people are dying late as compared to previous generations.

So, the burden of pensions will be on the generation that will work for free to pay for pension of old government employees in 2030s and onwards.


One should ask, How is this beneficial to the nation whose population projected to be 164 Crore by 2050? But sad petty politics has played. The sudden reversion to old pension scheme that too with retrospective effect is bound to increase the current expenditure of the state governments.


The SBI Report said, "The actual affect of the decision will be felt from 2035, although this may differ for different states when actual retirements will happen".
 

This is the Second part and original Text from SBI Research ECOWRAP Document. (Full document link: here ).


Recently, state governments of Rajasthan & Chhattisgarh have reverted back to the old pension scheme commonly known as PAYG (pay as you go) scheme. PAYG scheme is commonly defined as an unfunded pension scheme where current revenues fund pension benefits. India had a PAYG scheme prior to 2004. Under such a PAYG scheme, the contributions of the current generation of workers was explicitly used to pay the pensions of current pensioners. Hence a PAYG scheme involved a direct transfer of resources from the current generation of tax payers to fund the pensioners.

The PAYG scheme was in vogue in most countries prior to 1990’s , but was discontinued given the problem of pension debt sustainability, an ageing population, explicit burden on future generation and the incentive for early retirement (as the pension is fixed at the last drawn salary). The PAYG scheme thus had no accumulated funds and or stock of savings for pension obligations and hence was a clear fiscal burden. Interestingly, the PAYG scheme is always an attractive dispensation for political parties as the current aged people can benefit from PAYG even though they may not have contributed to the pension kitty. Is the PAYG scheme fiscally viable? First, the trends in the pension liability of the state governments over the long run shows a very sharp increase.

The CAGR in pension liabilities for the 12 year period ended FY22 was at 34% for all the state governments. As on FY21, the pension outgo as percent of revenue receipts is around 13.2% for all states combined and 29.7% of own tax revenue. In fact 56% of expenditure of the states that is committed (interest payments, salary and pension payments) is met out of state revenue receipts. In FY21, the total committed expenditures of states as a percentage of state own revenue receipts was at a staggering 125%. For larger states like Punjab, the committed expenditure is as high at 80%, followed by Kerala (73.9%) West Bengal (73.7%) and Andhra Pradesh (72.2%) as a % of state revenue receipts. If we take the committed expenditure as a percentage of state own tax revenue, these numbers are higher by 149% -191% for these 4 states.

Second, PAYG financing often masks the long-run cost of promised pension obligations. One way to estimate it is to quantify the present value of this future stream of expected benefits known as the “implicit public pension debt.” This implicit debt is a complicated function of the number of workers and retirees, entry age of workers, the expected life spans, the size of the average benefit, the retirement age & the discount rate used to calculate the present value. We endeavoured to quantify the implicit pension debt in the Indian context through the following methodology. In respect of National Pension Scheme (NPS), data on the state-level participants is not available. Consolidated data given by NPS Trust informs us that there are 55.44 lakh contributing state-level employees as of Feb 2022. If we assume that all states migrate to the old scheme, and assuming an entry level age of 28 years, with a 5% inflation indexation, the current present value of the implicit pension liabilities is around 13% of GDP, discounted by the current G-sec yield on 40 years. This is the implicit pension debt that will be unfunded as per the PAYG scheme.


The above fact clearly underlies World Bank’s warning that PAYG schemes are illusory. Specifically, when the population is young it induces the government to offer generous benefits as the costs are low. But the implicit pension debt will explode rapidly as population ages. Third, India’s demographic profile is currently undergoing a structural change with declining fertility, increasing longevity and an ageing Southern States coupled with young Northern States. As per India’s demographic profile, the Ageing Index (adapted from Rakesh Mohan, 2004) for India defined as the number of persons 60 years old or over per hundred persons under age of 15 years is likely to reach 76 by 2036 from the current value of 40. The old-age dependency ratio defined as the number of persons 60 years and over per one hundred persons 15 to 59 years is to touch 23% by 2036 from current 16%.

By 2050, India’s population will be 164 crores, out of which 32 crore will be of age 60 years and above. An increase in the old-age dependency ratio imposes significant demands on the working-age population to maintain the intergenerational flow of benefits to the pensioners and to that extent PAYG scheme is unfair to the younger generation. Taking all these factors into account, the Government had moved to a system of defined contributory pension benefit scheme, NPS in 2004. All states have migrated to NPS, with the exception of West Bengal and Tamil Nadu.

The current government has taken many steps to make the NPS scheme attractive. The Government now makes a 14% matching contribution against the 10% monthly contribution of employees. Secondly, the Government has also notified that subscriber would be adequately compensated for any non-deposit or delayed deposit of contributions during 2004-12.

Thirdly, the employee has now the exclusive right to choose the fund manager and his investment pie. There is an additional yearly tax rebate of Rs 50,000, 60% of the corpus is tax free and the entry age has now been raised to 70 years. Going forward, the NPS scheme can be made further attractive, by incentivizing SME/MSME sector covering its employees to be covered under NPS. Secondly, it is mandatory for any company with more than 20 employees to file EPFO employee contributions. This can be made more flexible by introducing NPS and allowing the corporates to select between EPF & NPS. Thirdly, the Govt. may increase tax benefit on Employer’s Contribution for Tier- I account holders from existing 10% of Basic + DA to 14% of Basic + DA (at par with Central Govt. Employees). Finally, the Govt. may further extend the benefit of Tier- II Tax Saving Schemes to all citizens of India. We should not commit fiscal hara-kiri in the quest for populism. Otherwise it will be disastrous for the country’s growth potential and at the same time place higher burden on our younger generation!


 

Disclaimer to Article: The write-up on Economic & Financial Developments is based on information & data procured from various sources and no responsibility is accepted for the accuracy of facts and figures.



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