Pension reversal puts focus on financial literacy

An article by RBI researchers shows that the fiscal burden from the old pension system will be 4.5 times compared to the fiscal burden from the new pension system.

Ever since some of the state governments chose to switch from the National Pension System (NPS) to the Old Pension System (OPS), pensions have been hotly debated across India. Why should a boring, old-age topic be so important for a relatively young population? To know why, we need to understand the economics behind pensions.

Deepak Mohanty, the Chairperson of the Pension Fund Regulatory and Development Authority of India (PFRDA) defined pension as a “long-term savings product ensuring [a] steady flow of income through one’s postretirement life”. To provide a steady flow of income post-retirement, a person must plan for it while in service. The process of saving in a financial product during the working years with the aim of receiving that savings during old age is pension management.

Ideally, individuals should be planning their pensions; but for two main reasons, governments have been managing pension planning.

First, the government sees pensions as a form of public good, which if left to the individual will not be done. This arises from the belief that people are myopic and focus on the short term. Pension being a long-term financial product will always disinterest individuals. Hence, it is upon the government to develop pension plans.

Second, since governments employ a large number of people, it made sense for governments to design pension plans for its employees. It was based on the promise that a percentage of the last drawn salary would be given as a monthly pension. This pension continued even after the demise of the employee, with a certain percentage going to the dependent family member.

Initially, the private sector followed the government’s example in designing pension plans for their employees. Either the entire contribution towards the pension corpus was paid by the employer or it was shared by the employee.

The promised pension plans were called ‘Defined Benefit’ plans as the benefits were defined by the government. The benefits had to be paid irrespective of the returns made by the pension investments. Soon, the DB plans started to get into trouble; both the government and private sector were myopic, and did not balance their earnings with the rising pension costs — riddling them with high debt. These pension plans were no longer financially viable.

This gave birth to ‘Defined Contribution’ plans where the onus shifted from the State/corporate to the individual. Under the DC plan, the pensions were dependent on the return from the markets and the sponsor’s cost (government or private sector) is limited to a prescribed rate of contribution.

The government and public sector initially had DB plans. In 1990s, the government realised that DB plans were unsustainable, and slowly migrated to the DC plans. The fiscal problems gave birth to the NPS, with the DB plans now being referred to as the OPS.

The NPS is a DC plan under which the employees’ defined contribution is 10 per cent of basic salary and dearness allowances, with a matching contribution from the state government. The NPS proceeds are invested in the financial markets. The promises from NPS made the Union government and state governments (barring West Bengal and Tamil Nadu) shift to the NPS system.

The pressure to win state elections has led political parties to promise returning to the OPS. A few states such as Rajasthan, Chhattisgarh, Jharkhand, Punjab, and Himachal Pradesh have even announced the switch back to the OPS. The electorate (consisting of employees) will obviously prefer the OPS over the NPS as they will get assured pensions without making any contributions. The states will gain over short term as they will not have to pay for the NPS but over the long term the pension burdens will increase significantly under the OPS.

In a September article, RBI researchers explain the overall burden to the exchequer in switching from the NPS to the OPS. They show that states’ expenditure on pensions increased from 0.6 per cent of the GDP in the early 1990s to 1.7 per cent of the GDP in 2022-2023. The growth rate of revenue receipts has been lower than pension outgoes. The pension burden of the states is more than that of the Centre. The rise in pensions has happened despite most of the states shifting to the NPS. Given these basic trends, the article shows that the fiscal burden from the OPS will be 4.5 times compared to the fiscal burden from the NPS! The rising pension burden will impose serious fiscal strain on the financials of the states.

The NPS has been a big unstated reform of the 1991 reforms which tried to restore India’s financial health. This is now being challenged with states/political parties promising to go back to the OPS. Probably, the state governments and political parties which promise this shift are aware of the financial risks involved — how many among the electorate realise that this promise is unlikely to be fulfilled?

This whole development points to another important aspect — the need for financial literacy, and the absence of depth in our policy debates.

Amol Agrawal is an economist teaching at Ahmedabad University.

(Disclaimer: The views expressed above are the author's own. They do not necessarily reflect the views of DH.)