Unified Pension Scheme – delight for subscribers but ominous for the government budget

The recently introduced Unified Pension Scheme (UPS) for Central Government employees has opened a flurry of questions on its impact. The back-breaking cost of guaranteed pensions is why the world has seen a movement away from guaranteed pensions. The introduction of UPS bucks this trend. Our analysis suggests that UPS will be a delight for its subscribers but can turn out to be an expensive proposition for the government. The return that must be generated to meet the UPS pension obligation looks steep. 

Difference between defined benefit and defined contribution pension plans

Pension plans come in two forms – defined benefit and defined contribution. Defined benefit (DB) plans define the pension a subscriber will receive upon retirement. Because the pension benefit is defined, DB plans are guaranteed plans. Defined contribution plans, on the other hand, define the contribution a subscriber will make and not the pension benefit. The pension a subscriber receives in a DC plan depends on the returns the pension fund earns.

It is easy to see why DB plans went out of flavor. For the pension provider, a DB plan is a huge responsibility. Guaranteeing a stream of cashflows that will kick in many decades later can be a recipe for disaster. Even the most sophisticated forecasting techniques will struggle to project how financial markets will behave many decades down the line. The world is changing every 10 years – how do you project what interest rates, inflation and equity returns are going to be 50 years down the line?

For instance, an OECD study in 2011 highlighted the devasting impact that low interest rates have had on pension plans that have defined payouts to subscribers. Pension plans in the developed world, designed prior to the 2008 global financial crisis, struggled with the protracted zero interest rates policies. 

You certainly cannot fault the pension administrators for not forecasting zero or negative interest rates. This is why DB plans are on the verge of extinction- they are a dinosaur, and most pension plans have shifted to DC plans. In DC plans, the pension a subscriber receives is a function of their contributions and the return the pension fund earns. The pension provider refrains from guaranteeing any pension – you may say this is unfair to pensioners, but this is the only practical approach. Given the super long-term nature of pension plans, committing to a defined pension beforehand would require a crystal ball – and not just any but a very far-sighted one. 

UPS is like an Okapi

On a trip to Africa, you might encounter a strange animal – Okapi, which is half giraffe and half zebra. We now have an equally strange animal in India’s pension landscape – UPS, which is half Old Pension Scheme (OPS) and half National Pension Scheme (NPS).

OPS, which is how pensions are planned in many States in India, is a quintessential DB plan. It defines the benefit that pension subscribers will receive – about half of their drawn salary will be provided as a pension, adjusted for inflation each year. In the OPS, contributions from current subscribers pay for a pension of the retired. It’s easy to see that this model is sustainable when contributors outnumber pensioners, i.e, when the workforce demographic is young. For an aging workforce, this pay-as-you-go plan is a ticking time bomb.

NPS, on the other hand, is a DC plan. It defines the contribution – both the employer and the employee contribute a defined percentage of basic salary to the pension fund. The pension that the retiree will draw is not guaranteed and depends on the returns earned by the pension fund. 

UPS is a mix of OPS and NPS. It guarantees a pension – half the last annual salary will be paid out as a pension each year, and this pension will be upped with inflation each year. In this respect it resembles OPS. However, unlike OPS, the employee will contribute 10%, and the employer will contribute 18.5% of their basic salary, which will flow into a pension fund. In this respect, UPS resembles NPS.

Indicative IRR behind the UPS cashflows

To evaluate the returns that a UPS subscriber will earn, we will need to look at the cashflows for a typical case. We have built an illustration for a subscriber who joins UPS at age 25 with a basic salary of INR 6 lakhs p.a. and has a life expectancy of 90 years. This individual will contribute 10% of her basic pay, and the Government will contribute 18.5% of her basic pay into the UPS corpus. 

When salary hikes by 10% every year, by the retirement age of 60, the UPS corpus will swell to about INR 16 crores. From this INR 16 crores, the Government will need to provide an inflation-indexed pension amounting to 50% of the last annual basic pay.

In our example, the pension in the first year of retirement is close to INR 77 lakhs, which increases by 8% each year. The return earned by the UPS corpus is assumed at 10.3% – this has been calculated as the break-even IRR for the UPS corpus to last till the subscriber’s life expectancy of 90 years.

Thus, after factoring in the contributions and the pension withdrawals, the cashflows presented in the table represent an IRR of 10.3%. This IRR is the hurdle rate for the pension administrator to achieve. If the management of the UPS corpus is unable to generate this IRR over the lifecycle of the subscriber, the Government will need to fund the deficit out of budgetary support.  

Age	Basic Salary (in INR lakhs, p.a.)	UPS Contribution (Employee Share, 10% of Basic Salary, in INR lakhs)	UPS Contribution (Government Share, 18.5% of Basic Salary, in INR lakhs)	Total UPS Contribution (in INR lakhs)	Return earned by UPS Corpus (in INR lakhs, p.a.)	UPS Corpus with accumulated Returns (in INR lakhs)	UPS Pension (in INR lakhs, p.a.)
25	6.0	0.6	1.1	1.7	0.2	1.9	–
26	6.6	0.7	1.2	1.9	0.2	4.0	–
27	7.3	0.7	1.3	2.1	0.4	6.4	–
28	8.0	0.8	1.5	2.3	0.7	9.4	–
.	.	.	.	–	.	.	.
.	.	.	.	–	.	.	.
.	.	.	.	–	.	.	.
59	153.3	15.3	28.4	43.7	145.3	1,602.3	–
60	–	–	–	–	164.7	1,690.4	76.6
61	–	–	–	–	173.8	1,781.4	82.8
62	–	–	–	–	183.1	1,875.1	89.4
.	.	.	.	.	.	.	.
.	.	.	.	.	.	.	.
.	.	.	.	.	.	.	.
89	–	–	–	–	131.8	699.3	714.1
90	–	–	–	–	71.9	–	771.2

Source: Samasthiti Advisors

Note: (1) We have assumed that basic salary increases by 10% each year (2) The return earned by the EPF corpus is 10.3%, which is the break-even rate for the UPS corpus to last till life expectancy of 90 years (3) UPS pension is 50% of the last drawn basic salary (4) We have assumed that pension will increase by 8% each year

Is 10% too high a hurdle rate?

At first glance, generating a return of 10% over a long investing period does not look challenging. If we look at historical equity and debt returns, this hurdle rate looks immensely achievable. But can history really act as a guide here?

Our financial market is young, and we can only procure reliable historical data for the last 45 years. Within the time span of this data, our economy has witnessed several structural changes, and data that goes back too far may not be relevant to us. The author’s research suggests that looking at data beyond the last 25 years may not be useful. 

On one hand, we can use the history available to us only for the last 25-odd years. On the other hand, the lifespan of a typical subscriber in UPS may span more than 50 years. In a rapidly changing world, how do you reliably estimate what asset returns are going to look like half a century later?

Pension administrators in the developed world designing pension plans during the 1990s and early 2000s could not have foreseen that the debt part of their pension fund’s asset allocation will earn zero returns, or worse, negative returns.

Leaving aside the problems in forecasting returns, there are three key reasons why the estimated 10% hurdle rate can turn out to be too steep. 

Pension funds need to be conservatively allocated.

Prudence demands that the asset allocation for pension funds needs to be conservative. In fact, pension funds generally run a more conservative asset allocation than the typical 60% debt and 40% equity portfolio – and rightly so. Generating a continuous and inflexible monthly pension severely limits the ability of the pension administrator to take risks. In the Indian context, our research suggests that the optimal portfolio for generating an inflation-indexed pension should have an allocation of 60% to debt, 30% to equity, and 10% to gold.

Asset returns have been falling

A simple examination of equity and debt returns in India shows that nominal asset returns have witnessed a declining trend. While there are several factors that influence nominal returns, one key determinant is inflation. The long-term declining asset returns mirror the long-term declining trend in inflation. If this trend continues, nominal returns will further compress, whereas Dearness Allowance (DA) to UPS subscribers, paid as compensation for inflation, may not show a commensurate decline due to political reasons.

Sequence of return risk

Our calculations above assume that the pension administrator can generate a 10% annualized return each year. In reality, the pension fund will witness substantial volatility due to presence of riskier assets like equity. In fact, even a pension fund with a 100% allocation to debt will witness volatility due to changes in interest rates. The ability of the pension fund to meet pension obligations will depend not only on the average annualized return over the lifespan of a subscriber but also on the sequence in which those returns were earned. To account for this sequence of return risk, the required return for the pension fund will be higher than 10%.

Comparison with NPS

In our illustration, we saw that a 25-year-old UPS subscriber, with a basic salary of INR 6 lakhs today would receive a guaranteed life-long inflation-indexed pension of around INR 77 lakhs at age 60, on a UPS corpus of INR 16 crores. This translates to an IRR of 10% for the subscriber. 

What would these numbers look like for an NPS subscriber? Let’s assume that an individual has accumulated the same INR 16 crores in NPS at age 60. This individual will not have the luxury of receiving a pre-defined guaranteed pension but will need to approach annuity providers to generate a pension income from their NPS corpus. The rate provided by annuity providers varies with time, so the exact pension that this individual can secure cannot be pre-determined.

Below are the rates currently offered by different annuity providers.

Annuity Service Provider	Annuity Rate (Annuity for Life, Without Return of Purchase Price)
Aditya Birla Sun Life Insurance Co. Ltd	8.52%
Bajaj Allianz Life Insurance Co. Ltd	7.73%
canara HSBC Life Insurance Co. Ltd.	8.10%
HDFC Life Insurance Co. Ltd	9.07%
ICICI Prudential Life Insurance Co. Ltd	7.44%
IndiaFirst Life Insurance co. Ltd	8.72%
Kotak Mahindra Life Insurance Co. Ltd	8.26%
Life Insurance Corporation of India	9.06%
MAX Life Insurance Co. Ltd	9.06%
PNB Metiife India Insurance Co. Ltd	7.59%
SBI Life Insurance Co. Ltd	7.83%
Star Union Dai-ichi Life Insurance Co. Ltd	8.57%
TATA AIA Insurance Co. Ltd	7.57%
Average	8.27%

Source: https://cra-nsdl.com/CRAOnline/aspQuote.html , as accessed on 19 Sep 2024

Note: The actual annuity amount will depend on the prevailing rates at the time of purchase of an annuity.

The rate varies across different providers – the average is 8.3%. If we assume that our NPS subscriber can secure an annuity purchase at this rate of 8.3% on the accumulated corpus of INR 16 crores, the annual pension will be INR 1.3 crores, which is higher than the starting pension of INR 77 lakhs in UPS. However, there is a catch here!

While the UPS pension will increase each year, the NPS pension will not. Every year, our NPS subscribers get the same INR 1.3 crores. At the age of 85, the UPS pension would have increased to an annual amount of INR 5.25 crores, while the NPS pension would remain the same at INR 1.3 crores. 

While the UPS subscriber makes a 10% IRR due to increasing pension, our NPS subscriber with constant pension will earn an IRR of only 7.4%. The IRR earned by the NPS subscriber is not only significantly less than UPS but also less than their annuity rate, as there is no return on the annuity’s purchase price. 

	UPS		NPS
Age	Accumulated Corpus (in INR lakhs)	Pension (in INR lakhs)	Accumulated Corpus (in INR lakhs)	Pension (in INR lakhs)
59	1,602	–	1,602	–
60	–	77	–	133
61	–	83	–	133
62	–	89	–	133
63	–	97	–	133
64	–	104	–	133
65	–	113	–	133
.	–	–	–	–
.	–	–	–	–
.	–	–	–	–
85	–	525	–	133
.	–	–	–	–
87	–	612	–	133
88	–	661	–	133
89	–	714	–	133
90	–	771	–	133
	IRR	10.3%		7.4%

Source: Samasthiti Advisors

If pension was the only factor in determining our employment preferences, its clear what our choice would have been.

Conclusion

UPS is an improvement over OPS but falls far short of NPS. It was because of the unmanageability of pensions that the NPS was introduced in 2004, which heralded a bold move from DB plans to DC plans in India. A recent RBI study highlights that the cumulative fiscal burden of guaranteed pensions could be as high as 4.5 times that of NPS. 

Twenty years back, NPS managed to put the genie of guaranteed pension back in the bottle. Now, the genie is out again. What impact it will have on our public finances, only time will tell, but the signs are ominous.

The views and opinions expressed in this blog are those of the author. All content provided is for informational purposes only and should not be taken as professional advice.

Ravi Saraogi, CFA, is a SEBI Registered Investment Adviser (RIA) and co-founder of www.samasthiti.in and specializes in retirement planning.