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The decks have been cleared for India's National Pension System (NPS) to return to its earlier avatar of a state-of-the-art pension system with a design architecture (how costs and benefits are placed in a product and how it is engineered to prevent mis-selling) that is possibly the best in the world. The owner and regulator of the NPS, the Pension Fund Regulatory and Development Authority (PFRDA), is now a statutory entity and top-level changes in the body augur well for the road map to roll-out as planned.
A quick recap. After attempts to internally transform the Employees' Provident Fund Organisation (EPFO) from an entity with fuzzy and often conflicting objectives of "policy making, regulation and monopolistic service provision to a viable pension regulator failed, a new pension system was envisaged that would solve some of the most obtuse problems in pension markets worldwide in the very design of the product around costs and mis-selling. This product design rests on four legs that have been broken in the past two years by the pension regulator making the NPS a strange creature that is a wannabe mutual fund (MF) but isn't.
Leg one was to separate product manufacturers from sellers to prevent a product push market. The fund managers would concentrate on their core strength – fund management — and the points of presence would collect the money. A centralized record-keeping agency is the bridge between the two that would funnel money from the points of presence to the asset managers. A year ago, the regulator allowed the pension fund managers to talk to the sales points or "synchronise" their actions. This will eventually lead fund managers to distribution and that, the original design says, is the road to mis-selling.
Leg two was to restrict choices to make it easier for investors to choose. PFRDA used fresh research from the buzzing behavioural finance labs overseas to reduce choice to investors to just three options from three fund managers (a total of nine products to choose from), since too wide a choice is seen to freeze investors. This list was expanded to six fund managers in 2009, making the choice set a bit more complicated (18 products to choose from) but still within the cognitive grasp of most investors. In 2012, PFRDA quietly opened the doors for all "eligible" pension fund managers, breaking the second leg of the product's design.
Leg three was the thin costs of fund management that came from an auction-driven system that saw pension fund managers bid low costs in order to get the mandate to manage pension money. The NPS was envisaged as a product with very thin costs, knowing that fat fees and charges work more for the industry than the investors, especially when the investing horizon is 30 years or more. A one percentage point difference in fund management fees can reduce returns substantially when computed over a working lifetime. In 2009, UTI Asset Management Co. Ltd bid the wafer-thin cost of 0.0009% (PFRDA is held guilty of having costs that are too low to be sustainable, but it was actually a fund manager that bid this number), the other fund managers had to offer the products at the same cost. Two years ago, PFRDA hiked the fund management fee to 0.25%. By arbitrarily changing the core design of an auction-based system, other parts of the product began to fall apart.
Leg four was to allow investors' money exposure to equity in the safest possible manner. The NPS was designed with three asset-based options that allowed a person to choose an allocation between very safe government bonds, fairly safe corporate bonds and an index fund where the investor could put half her money. The index fund road was taken to keep costs low (exchange-traded funds in the US now cost as little as 0.2% a year as expense ratio) and keep out the fund manager risk, or the risk of a fund manager's wrong calls. If you invest in an index fund that hugs the broad market index, you buy the index. It is a very low-cost, low-risk way to expose pension money to equity. But in January 2013, the pension regulator quietly, without any debate, allowed pension fund managers to actively select stocks from a basket of 149 stocks (shares of companies listed on the BSE and the National Stock Exchange on which derivatives are available became the universe from which a fund manager could pick stocks), breaking the leg of providing a safe equity road.
To be sure, the regulatory motivation must have been to give a push to the NPS that had remained stuck in very low individual interest since inception in 2009. What the regulator did not consider is that the solutions put in place were all supply-side interventions when what is needed is a demand-side push. The new regulator needs to go back to the basics and spend his energy on removing the bottlenecks that come in the way of demand. A campaign of public awareness needs to precede the big push to get points of sales to deliver. The NPS needs to be at par with the other pension products in the market in terms of tax breaks. And the compulsory annuity of 40% of the corpus at retirement needs better options than are available today
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