While equities have been uncertain, bigger risks have emerged in fixed income
Pension conclaves that were organised at the turn of the decade were instructional affairs for people like me. This was the pre-National Pension System (NPS) era. Participants, typically policymakers, think-tanks, fund managers and annuity providers, brainstormed about pension design, regulation, ecosystem and global best practices. Time was allocated to discussions on organised sector occupational pensions. During the sessions everyone turned to EPFO bashing. Focus was not on delivery and outcomes but on asset allocation of EPFO and its funds. Speaker after speaker lamented the absence of choice in asset allocation. This was a period when retirement plans invested solely in government securities and bonds of PSUs. Everyone was thinking of liberalising the asset allocation (read: introducing equities). There were hints of dissent with the occasional speaker citing the speculative nature of equity and suggesting EPFO remain fixed income-centric.
Some of the suggested changes did make their way into policy many years later. Three years ago, the government liberalised investment guidelines of retirement fund trusts. While the highlight of the change was introduction of equities as a mandatory investment class, other notable changes included greater choice in fixed income, more corporate bonds and wider array of instruments to choose from. These changes generated some euphoria among retirement fund managers. Retirement funds affected by post-demonetisation fall in interest rates flocked towards NBFC debt for varied reasons—diversification and returns.
But the fears of nay-sayers have not been unfounded. While the journey with equities has been fraught with uncertainties, bigger risks have surprisingly emerged in fixed income. This year’s singularly largest event in the retirement funds space has been the IL&FS default and the resultant strain on NBFCs. The focus has been impact on other asset aggregators such as mutual funds, banks and insurers, but while such institutions have shock absorber mechanisms (reserves, shareholder infusion, investor acceptability) to handle stress, PFs will face greater challenges due to resistance from beneficiaries and sponsors alike to bear the impact of the haircut and archaic regulation that lays the incidence of such haircuts on employers. It may also be more difficult to assess the impact on PFs since MTM (mark-to-market) is not the prevalent accounting norm. While the immediate impact plays out on employees, employers and the government, long-term consequences of IL&FS and NBFC crises are more consequential.
Consolidation in retirement landscape: It is expected that many small and medium sized pension funds with limited risk-taking capabilities and limited focus on governance will consolidate into larger pools such as EPFO and LIC. Such consolidation is good from a policy and regulator standpoint since it improves oversight and cuts costs for regulators. But it is unclear if larger institutional pension funds will be able to scale their delivery to meet service expectations of beneficiaries. Also, such consolidation results in a one-size-fits-all impact on design and delivery—the bane of Indian pension. Remember, most exempt PFs operate due to service inefficiencies of larger institutional alternatives.
Focus on governance and trusteeship: The events of this year will also result in greater focus on trusteeship and investment governance. The role of the trustee in a Trust, the responsibilities and liabilities of the trustee will come into sharper focus. Equally important will be the governance surrounding the trusts and its functioning. The functioning of these plans have been focused on compliance and regulation. Accounting, controls, reporting, governance, investment control will become important pillars for their functioning. Indeed, the sophistication with which such plans need to function due to their size and the lives they impact is significant. The days of leaving the functioning of the trust to the local accountant are over.
A potential pull back: The NBFC issue is not the first time retirement plans have faced risk. Long before this crisis, defaults occurred from IFCI and various state government undertakings. Retirement fund trusts were saved then by government intervention, lackadaisical accounting and an era of small retirement fund trusts. Little has changed since then. Limited and unviable exit options coupled with the inability to engage in costly litigation and the consistent necessity to invest in such instruments remain a recipe for toxic risk. Little has changed on the supply side too. A pull back to safety may not be unthinkable.
As reality dawns on the extent to which the IL&FS and NBFC crises have singed retirement funds, we need to ask ourselves a question that was asked all those years ago—in the pension conclaves—pension money in India may be ready for a wider asset allocation but are those markets ready for pension money?