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Ranadev Goswami

EQUITY investment by pension and provident funds has been the subject of recent debates on pension reforms. Many experts have argued that smart investment, considered synonymous with equity investment, could be the panacea to the problem of low returns from retirement funds.

The Bhattacharya Committee that did the groundwork for the keenly-awaited Pension Reform Bill appears to have finally given a nod to equity exposure. The Bill may permit 10 per cent equity investment by pension funds. Apparently, this is not bad at a time when dipping interest rates on provident funds have become an annual ritual. A little portfolio diversification may help shore up the investment performance of these funds.

However, given the current conditions, such portfolio limit relaxation appears to be premature. The disturbing fact is that instead of the pension market looking for equity exposure, the equity market is chasing pension savings.

The efficacy of equity investment should be viewed in the larger context of a benefit programme's goals. The primary objective of a retirement savings system is to secure a stable income stream for the elderly. In other words, a pension scheme typically targets to replace a percentage of the retiree's pre-retirement income level to help maintain his living standards. Aggressive investment styles, therefore, may not be consistent with a pension scheme's risk tolerance limits.

Why then do many countries allow pension savings to invest in equity stocks? This needs some clarification. In countries such as the US equity investment has been popular with occupational pension plans like the 401(k). However, with equity markets finally catching up the trajectory of Newton's proverbial apple, the limitations of these investment strategies are coming to the fore.

The pitfall of excessive reliance on equity stocks is best seen in the Enron fiasco. Employees owning millions of dollars in their retirement accounts have been rendered penniless with the collapse of the Enron stock.

More importantly, the occupational and voluntary pension schemes are the second or third pillar of pension savings in these countries. Western workers still have access to their much maligned tax financed social security system to provide for the basic level of retirement income. In the Indian context, the first pillar of pension savings is going to be rocked and threaten the very survival of the elderly.

Some Latin American countries permit investing the first pillar of pension assets into equity markets. However, there is a catch. In most cases, the governments provide a minimum pension guarantee in case of adverse market conditions. The cost of such guarantee could be enormous in the Indian context, and could jeopardise the Government's aim of reducing the fiscal deficit figures.

Equity premium problem

The proponents of smart investing often cite the existence of "equity premium" to support their claim. Research shows that in many countries, the risk-adjusted long run return from equity stocks has outperformed returns from any other asset class. In India too, long run returns from equities have been significantly higher.

However, there are two principal reservations against accepting this as the all-clinching evidence for equities. First, the equity market has gone through many changes in the last decade. Past evidence does not guarantee, nor current conditions do not promise, that we will see similar performances from equities in the future.

Second, even if we accept that there will be equity premium, it does not protect the retirees from periodic fluctuations. What happens to an employee who is retiring at a time when the market is down? Age adjusted investment styles can probably mitigate the risk, but not fully.

The swindlers list

What goes against equity investment the most is, however, not the volatility of the market, but India's notoriously thin regulatory paraphernalia. Even after a decade of reform, collective financial fraud is rampant in the Indian markets. An ineffective regulatory watchdog, perhaps coupled with political patronage, has resulted in the Indian bourses becoming a perfect sanctuary for white-collar criminals. The remarkable consistency with which fresh scams surface each year does not instil confidence in the would-be-retirees to pour their hard-earned savings where they do not grow but simply vanishes.

Also, recent events suggest that the provident funds are ill-prepared to mange new complexities. These already beleaguered organisations first need to set their houses in order. An alarming proportion of employers default paying the contributions, and yet go scot-free.

Investments in many PSU bonds are not repaid in time tying the retirees' savings in courtroom battles. More recently, the Seamen's Provident Fund was hoodwinked by about Rs 90 crore. Together, these incidents indicate that good governance is still a distant dream with our pension administrators.

No haste please

Policymakers should take cognisance of these ground realities, and focus on other more important aspects of pension reforms.

Equity investment, per se, may not be bad, but it should not be done in haste. Educating the workers about the nuances of retirement savings investments, and building regulatory capacities to safeguard their interests are two issues that should receive immediate attention. A well-thought-out reform policy, implemented in stages, will go a long way in building a robust pension architecture.

The bottomline is simply this: Equity investment can wait, but pension reforms cannot. Intertwining the two may not benefit the retirees. Remember, nothing is more disastrous than an idea whose time has not come.

(The author, a Fellow of IIM Bangalore, works with Tata Consultancy Services. The views expressed are personal.)

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