The Hindu Business Line : Pension, a ticking time-bomb?

The standards should mandate that pension fund assets are treated as if they were investments and accounted for as such separately from the liabilities.

The schemes of EPFO (Employees Provident Fund Organisation) have several shortcomings, undermining service provision, financial soundness and, hence, effectiveness as a pension mechanism.

The rules governing EPF do not cater to matching of pension wealth over the work-life span. If the accumulated EPF balance at retirement were used to buy an annuity, it yields a pension which is 9 per cent of per capita GDP. This is way beyond the current accumulations at about 2.4 per cent of GDP.

In the case of EPS, concerns have been expressed about the funding status. The 10-year interest rate fell dramatically from 13.4 per cent on January 1, 1997, to 5.1 per cent on October 18, 2003, and some modest improvements in mortality took place over this period. However, there was no change in either the contribution or benefit rate for EPS. This suggests that EPS was either over-funded in 1998 or under-funded in 2003. While the law requires that an actuarial report be produced every year, no such recent reports have been released into the public domain.

There are difficulties in implementing and administration of EPFO's programmes that were established in the 1950s. The issues are not integrated with the transformation in technology and knowledge about pension policies and processes.

There are weaknesses in the mechanisms of funds management, transparency and governance. Even if a participant does not exploit windows of opportunity to withdraw assets, the fund management of the EPFO yields low rates of return.

The lack of use of IT in dealing with databases relating to employee information from the entire country has led to difficulties in reconciliation. More important, the valuation framework used is one where all bonds are valued at cost, regardless of market price.

Accounting for change in pension regulations

The current global pension accountings standards are fairly incomprehensible — and India is no different. Most readers of accounts probably do not get beyond the number for the deficit.

So how did we get here? It started with a view that assets and liabilities should be measured at their market value. The difference is either a surplus or a deficit and under international rules, this number initially goes on the balance-sheet. So far so good.

It became complicated when the accounting standard setters in the international arena realised the annual change in the surplus or deficit could be huge. For some companies this number would swamp all the other numbers appearing in the profit and loss (P&L) account.

The instinctive reaction was that such huge numbers don't look good so the accounting standard setters decided companies could either ignore most of this impact or put it somewhere less high profile than the income statement.

But the economic reality is that pension funds are often a huge risk so the reflecting numbers must necessarily be huge. Where else can you get away with financing highly leveraged debt with mostly equity investments and then not reflect the impact in the income statement? Some companies are only waking up to this now. By virtue of their pension liabilities, many of Britain's largest and most famous companies have the risk profile of an insurance company and not a widget maker.

Assets as investments

First, the standards should mandate that pension fund assets are treated as if they were investments and accounted for as such separately from the liabilities. Some would consider this too radical as most pension funds control their assets through independent trusts. The reality is the performance of pension fund assets has a direct impact on contributions and, hence, shareholder value.

This approach ends the idea of creating profits from the expected return on equities, an unusual concept with quite bizarre outcomes — some entities show their entire profits from this source.

Second, pension liabilities should be accounted like any other liability of the company and reflected in full on the balance-sheet. Entities do not have a liability for future pay rises so these should be excluded. Discounting at a high quality bond rate seems a reasonable compromise for dealing with the complex risk profile of pensions. Annual movements in other liabilities whether they come from changes in estimates or otherwise are normally reflected as income.

The Government of India accounts for its pension and EPFO obligations on cash basis and, hence, no projected obligations and payment liabilities over the workers' life get accounted for. It would be next to impossible without a comprehensive system of information warehouse to determine the total payment obligation of the government over a period of time.

In the light of commitments made by successive governments relating to enhanced pensions of government employees by raising their pay and DA or their refusal to align rates of interest of provident fund to markets, pensions will simply become unaffordable as our young population ages.

In Europe and the US this is already beginning to show and pension cut-back by government is a reality. We need to wake up to the truth that unless reforms in retirement benefits are swift and rapid, we will drive the meagre social security system in India into an era of insecurity for our aged.

(Concluded)

(The authors are, respectively, partner with Price Waterhouse and a chartered accountant.)

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