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Suresh Krishnamurthy

THE administered interest rate on Employees Provident Fund has been hiked, probably for the first time in a couple of decades. It had held steady during the 1990s and started declining since 2000.

If the increase in rates creates an impression of a throwback to the old days of high-administered rates, that may not be quite right. Radical changes are afoot that can permanently alter the character of employees provident fund.

The proposed changes may represent the first steps in the process of converting the EPF from a defined-benefit fund to a defined-contribution fund, perhaps a decade from now. Simply put, a defined contribution scheme is one in which the returns are not assured.

Given the budgetary constraints, this is probably inevitable. Given the potential for higher returns, it is desirable too. The way these changes may be put through, however, could create apprehension in the minds of EPF subscribers.

Radical changes: Viewed from investment management angle, the Employees' Provident Fund is a staid and passive organisation.

It invests the moneys collected in special deposit schemes of the Central Government or other approved securities and holds them to maturity. The interest earned each year is allocated to accounts of EPF subscribers.

Now, the EPF is to be given the freedom to sell securities before maturity. The EPF is also exploring the possibility of investing in equities. These proposed changes follow the closure, last year, of the assured-return special deposit scheme for fresh money flowing into EPF.

The closure forced the EPF to invest in the market, and the yield on such investments was no longer assured. The freedom to sell securities before maturity and invest in equities too will introduce a greater element of active management into EPF. Increase in active management also implies uncertain returns.

As things stand, EPF subscribers are being assured a return of 9.5 per cent for 2004-05. This assurance appears to be a government guarantee that is set to cover for the expected uncertainty that will stalk portfolio returns. It may, however, be premature to consider this as government guarantee as the Finance Ministry is yet to clarify on this issue.

The policy, however, will change when EPF starts to invest in equities.

The returns, positive or negative, can make it difficult for the government to sustain assured returns. This will pave the way for the conversion of EPF into a defined contribution scheme with uncertain returns.

Implementation risk: EPF subscribers need not, however, be unduly concerned about the risk associated with uncertain and volatile market returns. Even without investing in equity and active management, portfolio returns are volatile.

If anything, the introduction of equity into the portfolio will only reduce this volatility while also increasing returns.

There is evidence to believe that a portfolio without equities is riskier than a portfolio with a small proportion of equities. Introduction of equity thus will only enhance the value for EPF subscribers.

EPF subscribers, however, need to be worried about how equity investing would be managed by the fund. It is possible that a proportion of the fund will be invested in an index fund or given over to state-run asset management companies to run. Both may lead to sub-optimal results.

Index investing has proved less rewarding for investors. Even over longer periods, indices such as BSE-100 or S&P CNX 500 have generated returns that are much less than what is earned by investing in debt.

For instance, between 1994 and 2003, the Sensex earned negative returns while actively managed funds such as Franklin India Bluechip managed to earn about 20 per cent per annum.

If the EPF recognises the downside to index investing and opts for active investing then restricting the choice of fund managers to state-run asset management companies would unfairly exclude some excellent fund managers.

A better approach would be to leave to the subscribers themselves the choice of whether to invest in equities at all as well as the choice of the fund manager.

For instance, if a subscriber wants to invest in schemes such as HDFC Top 200, Templeton India Growth, SBI Magnum Contra, HSBC Equity, UTI Mastergrowth or DSP Opportunities, they should be allowed to do so.

Alternatively, if a subscriber does not want to invest in equities at all, he should be allowed to exercise that choice. Such an approach would be equitable and more in keeping with democratic traditions.

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