Pension funds vs Provident funds

Suresh Krishnamurthy

THE Insurance Regulatory and Development Authority of India is moving fast on the introduction of the pension funds.

The Finance Ministry appears keen on the introduction of pension funds given that many reports have indicated that a majority of Indian citizens will be lacking security in their old age. However, for the successful introduction of pension funds changes in the Income-tax Act relating to tax concessions will be required.

The Government appears eager to promote long-term savings habit through pension funds with tax concessions. However, if such tax concessions are provided on pension funds then the existing concessions on other instruments may have to be pruned.

This will involve restricting the tax rebate under Section 88 to instruments such as Provident funds and Insurance schemes. It does appear that the Government may favour this approach. Committees such as those constituted under Messrs Y. V. Reddy and Parthasarathy Shome have also advocated a similar approach.

This, however, will lead to a different kind of complication for investors. Investments in provident funds, also a vehicle for retirement savings, will generate a tax rebate of 20 per cent and the proceeds received on redemption from these instruments will be tax-exempt.

In contrast, subscription to pension funds, the competing retirement savings product, will be excluded from income (implying higher tax savings, initially compared to subscription to provident funds) but will suffer tax when the investment and the interest on the investment are withdrawn after retirement.

The investor, therefore, will have to assess which of the two is the more efficient vehicle. For the salaried class falling under the high-networth category, there will be no complications. They will invest fully up to the limit provided for both pension funds and provident funds.

For the not so privileged, it will be an important question. This is because the end-result could vary substantially depending on which scheme is chosen. This is again a fall-out of the effect that compounding has over large number of years. A difference of half a per cent can make a difference of a few lakhs of rupees.

As of now, provident funds come with better features, compared to pension funds. Withdrawals from government and employee provident funds are also allowed for specific purposes. In the case of public provident funds too, withdrawals from the seventh year onwards are possible. On the other hand, pension funds are likely to have more restrictions attached to them. This is an important advantage for provident funds over pension funds.

Another important factor is that the returns on provident funds are guaranteed. The returns may decline or rise along with general movement in interest rates. The returns will still be guaranteed. Yes, it is true that LIC's Jeevan Suraksha offers guaranteed returns.

However, pure pension schemes that may be introduced by the private sector are not likely to offer guaranteed returns. In such a backdrop, provident funds may be deemed superior to pension funds by many investors, especially because they come with central government guarantee.

In such a backdrop, the serious threat to provident funds will come only from insurance-linked pension plans such as Jeevan Suraksha. In their case, the benefit of insurance may just persuade investors to consider including such investments in their portfolio. Otherwise, investors still have to exhaust their options for provident fund before considering the pension schemes as a retirement savings option.