India: Recent Economic Developments and Selected Issues

India rebounded strongly from its 1991 balance-of-payments crisis, aided by structural reforms and other policy adjustments. The government has sought to reinvigorate the process of structural and fiscal reform. The paper examines trends in interstate differences in rural poverty; reviews India's postal saving system and possible reform issues; describes and evaluates the current system of pensions and provident funds, and discusses reform options. The paper also briefly reviews the structure of and recent developments in the Indian foreign exchange market.


India rebounded strongly from its 1991 balance-of-payments crisis, aided by structural reforms and other policy adjustments. The government has sought to reinvigorate the process of structural and fiscal reform. The paper examines trends in interstate differences in rural poverty; reviews India's postal saving system and possible reform issues; describes and evaluates the current system of pensions and provident funds, and discusses reform options. The paper also briefly reviews the structure of and recent developments in the Indian foreign exchange market.

IX. Pension Reform in India1

1. Pension reform is a subject of active debate in India today, for several reasons. First and foremost, the coverage of existing pension programs is extremely narrow—only about 11 percent of the current working-age population. Second, the system is complex and has not achieved the objective of ensuring adequate savings for retirement. Third, the pension system for government employees is likely to place increasing pressure on the budget in the years ahead.

2. In contrast with many other countries, demographic pressures on the pension system are a less pressing concern in India. Currently (according to projections by the U.S. Bureau of the Census), roughly 7 percent of the population is over 60, with less than 5 percent over 65. These proportions are projected to increase to roughly 20 percent and 15 percent, respectively, by 2050. Two countervailing trends are likely to mitigate the effect of this increase. First, the share of the population below working age is projected to decline significantly. Consequently, the total dependency rate is likely to fall for the next 20-30 years. In addition, mortality rates are projected to decrease, leading to a substantially longer life expectancy and an increase in the normal retirement age. The total dependency rate with a working age of 20-65 is projected to be roughly the same in 2050 as the present dependency rate with a working age of 15-60.


Population Dependency Rates 2000-2050

(In percent)

Citation: IMF Staff Country Reports 2001, 181; 10.5089/9781451818550.002.A009

3. This chapter describes and evaluates the current system of pensions and provident funds, and the proposed revisions contained in the Old Age Social and Income Security (OASIS) report commissioned by the Ministry of Social Justice and Empowerment.

A. The Current System of Pensions and Provident Funds

4. Currently, India has a complex of different provident fund and pension schemes, targeted at different segments of the labor force.

The Organized Sector

5. Most workers in the organized private sector participate in two schemes, the defined-contribution Employees Provident Fund (EPF) and the defined-benefit Employees Pension Scheme (EPS).2 These workers constitute 49 percent of the salaried work force and slightly more than 7 percent of the estimated total work force.

6. Employees Provident Fund. The EPF was established in 1952 and participation is mandatory for private and public enterprises in 177 specified sectors (excluding Jammu and Kashmir) that employ more than 20 persons. As of March 1999, the EPF covered about 23.1 million workers in 318,430 establishments. Establishments outside these 177 sectors may voluntarily join the EPF. There were 22,502 such establishments as of March 1999. The system covers those employees whose initial basic wages and “dearness” allowances were below Rs 5,000 per month. Workers whose wages later exceed this threshold are required to contribute on only the first Rs 5,000 but may voluntarily contribute on amounts in excess of this amount.

7. The Employees Provident Fund Organization (EPFO) oversees the EPF. Contributions can be deposited into a fund managed by the EPFO, but employers can also seek an exemption to manage their own funds, as long as they meet regulatory requirements enforced by the EPFO. As of March 1999, there were 315,307 nonexempt establishments, accounting for 82 percent of contributors and 64 percent of contributions, in the EPF (Table IX.1). Not only were exempt establishments larger, but the average wage on which contributions were calculated was almost three times as large. In recent years, however, the share of workers in exempt establishments has been decreasing, along with their relative wages. With few exceptions, employees are required to contribute 12 percent of wages, with employers making contributions of 3.67 percent.3 Benefits are paid out as a lump-sum upon retirement.

Table IX.1.

India: Employee Provident Fund and Employee Pension Scheme, 1996/97–1998/99

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Sources: EPFO 1998/99 Annual Report and Fund staff estimates.

8. To cover administrative expenses, nonexempt employers contribute 0.65 percent of wages, while those from exempt funds contribute 0.09 percent of wages to cover expenses related to their supervision by the EPFO. The difference in administrative costs provides a strong incentive to seek exempt status. Prior to retirement, employees may make partial withdrawals for specified purposes like house construction, illness, natural disasters, and higher education of children. Employees may also withdraw 90 percent of the balance in their accounts in the year before retirement.

9. Returns paid on funds managed by the EPFO are set annually by the government and are usually announced around the time of the government’s annual budget—the rate had been fixed at 12 percent since 1989/90, but was reduced to 11 percent in July 2000. The government’s 2001/02 budget announced a further 150 basis point cut in returns.4 Exempted funds may not credit members with a return lower than that announced by the EPFO, and shortfalls from investment income on fund assets must be made up from employers’ other income. When employers declare a return higher than that declared by the EPFO, the excess is treated as taxable income for the employer. The real compounded rate of return enjoyed by contributors has averaged 1.9 percent per annum since 1977, which has helped cause balances in EPF accounts at retirement to be very low. For example, in 1998/99 EPF retirement claims averaged less than Rs 19,000.

10. Perhaps the most serious drawback of the EPF is the regulations for the investment of contributions. Funds are required to be invested in government and government-guaranteed securities, or securities issued by public enterprises or government-owned banks. Partly reflecting the fact that most of these securities pay less than the required return on deposits, 85-90 percent of funds had in the past been invested in a special deposit scheme (SDS) of the government. The SDS provided a 12 percent yield from 1986 to July 2000, and an 11 percent yield in 2000/01. However, since April 1997 new subscriptions cannot be invested in the SDS, though interest earned from the SDS can be reinvested. The average rate of return on the EPF portfolio has been estimated at 12.1 percent per annum. Given the required rate of return on deposits, it is clear that there is no room for the accumulation of reserves to meet contingencies. As of end-March 1999, accumulated funds under management by the EPFO were Rs 413 billion. Total assets including exempt establishments were Rs 700 billion.

11. Employees Pension Scheme. The EPS, also overseen by the EPFO, was established in 1995 as a replacement for the Family Pension Scheme (FPS), which had provided survivor benefits. Its membership is lower than that of the EPF; as of March 1999 it covered about 20.5 million workers, with 1.9 million of them belonging to exempt establishments. Establishments may be exempted from the EPS if they provide benefits that are at least as good. However, the rules for exemption from the EPS are not entirely transparent, and there is currently a case before the Supreme Court regarding the conditions under which schemes may be exempted from the EPS.

12. The EPS is currently funded by employer and government contributions—8.33 percent and 1.16 percent, respectively, of employees’ basic wages plus dearness allowance. However, exempt funds do not receive the government contribution. The EPS provides pension benefits that are calculated on the basis of a worker’s average salary in the twelve months preceding retirement, and a multiplicative factor calculated as years of service divided by seventy. The maximum replacement rate is 50 percent, and workers who have more than 20 years of service or have reached the retirement age of 58 years of age get credit for two additional years of service. Consequently, a 58-year-old worker with 33 years of service can retire with the maximum replacement rate. Finally, early retirement is possible at age 50 with a reduction in benefits for each year between the age of retirement and 58. A portion of EPS benefits is payable as a lump sum at retirement. The tax treatment of EPS benefits is similar to that of EPF benefits. Survivor and disability benefits also are provided by the EPS.

13. Up to 1997, assets inherited from the FPS and the government contribution to the EPS were invested in the Public Account of the Government of India—which earned 8.5 percent interest—and interest paid was reinvested in the Public Account. Other contributions were invested in accordance with the guidelines for EPF investments. However, new investment in the Public Account was suspended in April 1997, so that all new contributions since then have been invested in accordance with EPF guidelines. Because of the investments in the Public Account, the average nominal rate of return on the EPS portfolio has been estimated at roughly 10 percent per year, about 2 percent less than that for the EPF. As of end-March 1999, accumulated funds in the EPS were Rs 220 billion.

14. Special provident funds. There are also some mandatory provident funds linked to specific occupations or states, such as the Coal Miners Provident Fund (1948), the Assam Tea Plantation Provident Fund (1955), the Jammu and Kashmir Provident Fund (1961), and the Seamens’ Fund (1966). Although managed by different trusts and fund managers, they all generally follow the same investment and return rules as those funds regulated by EPFO. Total membership in these schemes is roughly 2 million.

15. Voluntary programs. There are also a number of voluntary group pension plans that exist primarily because of rules barring high-income employees from participating in the EPF system. These pension schemes are either privately run by managers appointed by employers, or are run by the Life Insurance Company (LIC). The provisions of the Insurance Act 1938 and the LIC Act 1956 make the LIC the only enterprise allowed to provide annuity schemes to the Indian public, since the annuity business is considered a part of the life insurance business. As a result, privately run pension schemes can accumulate and invest funds, but are required to purchase annuities on behalf of retiring employees from the LIC. Although they are neither mandatory nor sponsored by the government, they are mentioned here because they receive tax preferences and because they are subject to restrictive investment and annuity regulations.5

16. As of March 1998, the total accumulated funds for these group pension plans was about Rs 65 billion (Gupta, 1998), of which the LIC managed Rs 49.7 billion on behalf of 4719 schemes. Annuity payments arising out of these schemes, covering about 210,000 persons, totaled Rs 3.1 billion in 1998. Voluntary individual annuity schemes can also receive preferential tax treatment.6 In 1998 there were about 670,000 such annuities, which paid out about Rs 14.5 billion.

The Informal Sector

17. There are no mandatory retirement-saving programs for the self-employed or for workers in the informal and unorganized sectors of the economy. Although these workers are ineligible to join the EPF even on a voluntary basis, they can join the Public Provident Fund (PPF). Members of the PPF can contribute between Rs 100 and Rs 60,000 per fiscal year, and PPF accounts mature in 15 years. Early withdrawals are permitted after five years. Three fourths of net PPF contributions have been distributed as loans to state governments at 14 percent interest, while the remainder is invested in the public account of the central government. The PPF and EPF earned identical returns until January 15, 2000, at which time PPF returns were reduced to 11 percent while EPF returns continued to be 12 percent. With the reduction in EPF rates to 11 percent in July 2000, PPF and EPF rates again became identical. The rates have since diverged, as the 2001/02 budget ordered a 150 basis point reduction in the rates for provident funds which the EPFO has not fully implemented. The PPF has not been marketed aggressively, and net collections have grown slowly. As of March 1998, there were 2.76 million accounts in the PPF, representing less than one percent of the working population, with total outstanding balances of approximately Rs 50 billion.

18. The poorest elderly are covered under a separate social assistance program—the National Old Age Pension Scheme (NOAPS)—that provides a benefit of Rs 75 per month. However, relatively few elderly have applied for this benefit and, in any case, coverage is limited to 10 percent of the population over 65.7

Civil Service Retirement Programs

19. Civil servants participate in a noncontributory pension plan, a contributory provident fund, an insurance plan, and mandated gratuity pay. The government has recently set up a commission in the Ministry of Finance to estimate the contingent liabilities arising from these schemes.

20. Civil service pension system. The CSPS covers federal and state civil servants, a workforce of over 12 million (Table IX.2). Workers make no contributions, and benefits are financed directly from the respective federal or state government budgets. The CSPS pays a retirement benefit at age 60 that is based on years of service and average salary in the last year of service. The accrual rate is slightly over 1.5 percent replacement per year of service, so that a worker with 33 years of service will get a 50 percent replacement of final salary, as in the EPS. Survivor benefits are also provided. Within the central government, pension schemes are organized by occupation, with separate schemes—which have somewhat different rules of eligibility—for railways, telecommunications, defense, and line ministry personnel. Civil service salaries and benefits are adjusted in line with civil-service compensation every 10 years by the decennial Pay Commissions.

Table IX.2.

India: Civil Service Pension System, 1998

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Sources: Shah (2000) and Fund staff estimates.

21. Both pay and pensions can be adjusted during the intervening years by a dearness allowance. The Fifth Pay Commission prescribed minimum and maximum pensions of Rs 1,257 and Rs 15,000 per month, respectively, in 1999. Workers may borrow funds from their accumulated pensions for certain purposes, such as purchasing a house, and on retirement may also withdraw a part of the pension as a lump-sum payment. As of March 1998, total outlays due to pensions at the state and central government level amounted to about 1.3 percent of GDP. The largest component of the central government pension bill as of March 1998 was for defense personnel (0.33 percent of GDP).

22. Government Provident Fund. The GPF is a defined-contribution plan in which employees contribute 8.33 percent of their salaries, and receive a lump sum upon retirement. GPF funds are deposited in the Government of India Public Account, and no explicit interest accrues. Consequently, the system has essentially operated on a pay-as-you-go basis. Between 1986 and March 2001, participants have received an average rate of return of about 12 percent. In line with other major provident funds, the 2001/02 budget ordered a 150 basis point reduction in GPF returns. As of 1996, accrued balances were about 1.2 percent of GDP (Patel, 1997).

23. Other civil-service plans. There is also an insurance scheme into which employees pay a small monthly premium determined according to civil-service rank. It provides a survivor benefit equal to a multiple of the monthly premium in the event a worker dies prior to retirement. Otherwise, it provides a lump-sum payment equal to the accumulated premiums. Upon retirement civil servants also receive a lump-sum gratuity based on final salary and years of service (one-half month for every year of service). Workers can also make early withdrawals against their gratuity for specified purposes such as housing costs.

B. Problems with the Current System

Coverage and equity

24. The most serious problem with the current pension system is that it fails to reach the vast majority of the population, particularly the poor, who have no alternative safety net and do not have the financial resources to save for old age. The average income of the workers covered by the EPF/EPS and the CSPS/GPF is roughly Rs 2,900 per month, a large multiple of the average income of workers in the informal sector. Similarly, the average EPS (CSPS) benefit is on the order of Rs 1,000 (Rs 2,000), compared with the NOAPS, which has a benefit of Rs 75 per month and reaches only a small proportion of the elderly poor.

25. In addition, benefits net of contributions and the implicit rate of return on contributions vary substantially across program, occupation, sector, etc. This results in inequities, and means that pension rights are not portable, creating impediments to labor mobility.

Fiscal sustainability

26. Potential fiscal problems reflect the large unfunded liability of the system, and are concentrated in three areas:

  • Civil Service Pension System. As Table IX.2 demonstrates, there is a fundamental imbalance between wages and pension benefits in the civil service which reflects several factors. First, given the average dependency rate of 59.4 percent, the pension age is almost certainly too low (Table IX.3).8 Second, even with a low pension age, the average replacement rate is still over 45 percent. Consequently, the pension bill is over 25 percent of the wage bill. The situation is much more serious at the central government level, particularly in the areas of defense and railways.

  • Employees Pension Scheme. The financial position of the EPS appears unsustainable in the long run. The World Bank estimates that the cash-flow deficit in the EPS will grow to almost 1 percent of GDP over the next several decades. With a retirement age of 58, 33 years of service, a life expectancy at age 58 of 17.2 years, a contribution rate of 8.33 percent and inflation of 3 percent, the implicit real rate of return on contributions necessary to fund pensions abstracting from survivor and disability benefits and any indexation for inflation is 4.5 percent.9 This rate of return is well beyond the feasible return under the current restrictive investment regulations, and the survivor and disability benefits, and any ad hoc indexation for inflation, simply add to the imbalance.

  • Tax preferences. The tax preferences in the current pension system add to the strain on government finances, and almost certainly benefit the highest-income workers. Contributions by employees and employers into retirement saving schemes are tax exempt up to Rs 60,000, so that the maximum tax free contribution per worker is Rs 120,000, well beyond the limits of participation in the mandatory schemes. In addition, the tax system provides a significant incentive to realize benefits as lump-sum distributions rather than annuities or programmed withdrawals, which appears to be counter to the objective of assuring retirement income.10

Table IX.3.

India: Parameters of the Civil Service Pension System

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Sources: Shah (2000) and Fund staff estimates.

Investment policy and administrative rates of return

27. Investment rules in India require most funds to be placed in public sector instruments, and there are strict limits on investments in corporate bonds and equities. This has severely reduced their return, and imposed an implicit tax on contributors.11 It has been estimated by the World Bank that a mixed portfolio, with one third of funds invested in a broad equity index since 1979 would have resulted in EPF balances more than twice the actual balances in 1999. In the 1990s, provident funds held 30 percent and 46 percent of the net aggregate domestic liabilities of the central government and state governments, respectively. Thus, these funds represent an important source of captive financing for fiscal deficits.

28. By contrast, a prudent-investor paradigm would allow pension and provident funds to take prudent risks in order to increase returns. This approach would not necessarily require more active fund management than has been the case in India, where for the most part fund managers are only authorized to purchase and hold specific securities to term. Higher returns can be achieved by investing in funds that mimic the average return of selected markets.

29. A related problem is that the government instruments in which provident funds invest are not freely marketable, and they bear an administered, rather than a market-based, rate of return. The setting of rates is highly politicized, which has caused the decline in administered rates to lag the drop in market rates. This has contributed to fiscal pressures, as well as pressure on the banking system, which faces difficulty in competing for deposits.

Regulation and administration

30. Trustee-managed pension funds and funded gratuity plans are not supervised by any statutory body, and the data on their operations are available only with a substantial lag. Also, although the EPFO supervises exempt EPF funds, there is a relative paucity of data regarding the operations of the exempt funds. The EPFO does not publish its audit and actuarial reports, nor are these reports prepared in a timely manner. In addition, there is an implicit conflict of interest in having the EPFO approve and supervise exempt provident funds, since the existence and growth of these funds reduce the resources under EPFO management.

31. The weak regulatory environment is reflected in the quality of service provided by the mandatory schemes. Delays in processing claims, crediting interest to members, and issuing annual account statements are common. For example, during 1994/95–1997/98, between 20 percent and 50 percent of interest earned was not received in the year earned. Improvement of service is a major reason for setting up exempt funds in the EPF.

Multiple uses of retirement saving

32. Retirement savings can be used for many purposes in advance of retirement—including higher education of children, housing, funerals, and weddings of family members. This has resulted in very small shares of contributions that are distributed at and after retirement, and suggests that the system is not adequately ensuring a sufficient level of post retirement income.

C. Ongoing Reform Efforts

33. In response to growing concern about the current system of provident and pension funds, and its likely adverse impact on poverty amongst the elderly, a number of groups have evaluated how the current system should be changed. Recently, the World Bank has completed its analysis of old-age income security and suggested a set of reform options. In addition, the Asian Development Bank Institute, the Asian Development Bank, and the Colombo Plan Secretariat organized a conference in November 2000 in New Delhi with a major emphasis on pension reform in India. On a parallel track, the Ministry of Finance has convened a committee to evaluate reform options for the civil service retirement plans. Each of these efforts builds on the work of the Old Age Social and Income Security (OASIS) project.12

Project OASIS

34. In 1998, the Ministry of Social Justice and Empowerment asked an eight-member expert committee that constitutes Project OASIS to examine the current vehicles for retirement saving and recommend changes to encourage saving by a broader cross section of workers. The committee report (Ministry of Social Justice and Empowerment, 2000) details many of the problems with the current system described above, including the need to insulate retirement saving policy from politics, better target tax incentives, and reach out to the informal sector. To achieve these goals, the committee recommended that the existing scheme be augmented by a system of Individual Retirement Accounts (IRAs) with the following features:

  • IRAs would not be linked to employers, but rather to workers, and each worker would be given a unique account number that would not change with employment.

  • To ensure accessibility to a broad cross section of the labor force, the minimum contribution would be initially set at Rs 500 per year, with flexible conditions for payment in order to encourage participation by workers who do not earn a steady income. Contributions would be tax exempt up to Rs 60,000 per annum.

  • To minimize transactions costs, (i) a system of “points of presence” (post offices, banks, etc.) would be established to collect contributions and distribute benefits, and (ii) a depository would be created to pool individual contributions into large blocks of funds, which would then be passed on to fund managers. The depository would also be the main record keeper.

  • To give workers a choice regarding the investment of their funds, and to substantially increase returns from their historical levels, a system of six competing private pension fund managers (PFMs) would be established. Each PFM would offer three investment portfolios, distinguished by level of risk and return, from which workers could freely choose.

  • At retirement at age 60, workers would be required to use at least a portion of their balances to purchase annuities from insurance companies. The report anticipates that with the recent liberalization of the insurance sector, a competitive market for annuities would emerge in the near to medium terms.

  • To narrow the focus of the plan on retirement, the proposed system bans early withdrawals, except where account balances exceed Rs 200,000. Even in these cases, the withdrawals would be subject to a 10 percent tax to discourage such behavior. The plan would allow workers to take out loans of up to Rs 5,000 against balances that exceed Rs 10,000. However, in such cases subsequent contributions would first be applied towards loan repayment, so that minimum contributions would equal the sum of loan repayment and Rs 500.

  • To ensure the smooth functioning of the system, prevent abuse and fraud, and safeguard workers’ investments, an independent regulator would be set up to license PFMs, oversee the entire system, disseminate information about the performance of the PFMs, and make improvements to the system where necessary.

  • To encourage individuals to purchase annuities upon retirement, all lump-sum withdrawals would be taxable, while income from annuities would be tax exempt.

  • A National Senior Citizen’s Fund (NSCF) would be established to encourage, catalyze and complement NOAPS and private-sector efforts to improve the quality of life of the elderly. The present government contribution to the GPS would be redirected to this fund for three years to provide initial capital, and then discontinued. In addition, 25 percent of all premature and lump-sum withdrawal taxes would be deposited in the fund.

35. With respect to existing provident and pension funds, the OASIS report makes the following recommendations:

  • The EPF would be restructured along the lines of the IRA program, with premature withdrawals curtailed, workers given the option to switch to the IRA plan and exempt funds switching over to same investment strategy used for the IRAs.

  • Government contributions to the EPS should be discontinued, and the EPS would (i) implement a uniform 10 percent (employer) contribution, (ii) adopt the IRA investment guidelines, (iii) perform an annual actuarial review and adjust parameters to assure the system is self-financing, and (iv) move away from lump-sum distributions toward annuities.

  • Because the Ministry of Finance had already appointed a committee to review the CSPS, the OASIS committee recommended only that the system be made contributory and put on a self-financing basis.

  • The PPF should phase out its current system and channel all new contributions into a new fund (PPF-2) that does not rely on small saving instruments (see Appendix DC. 1 and Chapter VIII). This new fund would be segregated from the Public Account, and would be managed professionally in an open and transparent fashion.

  • NOAPS would be continued because, despite its limitations, it still plays an important role.

36. The government is committed to reforming the system broadly along these lines, and formal reform proposals are expected in the Fall of 2001.

Assessing the OASIS proposal

37. The OASIS committee recommendations appear a broadly appropriate response to the problems of the existing system. However, there are several issues that bear further consideration:

  • An almost complete reliance on voluntary thrift. The report recognizes that the overall fiscal situation in India requires a pension system based on self-help and thrift. However, it remains to be seen how poor workers in the informal sector would be able to set aside sufficient resources to provide even minimal support in old age. Therefore, it would be appropriate to explore options for a redistributive element, combined with mandatory participation. The proposal for the NSCF moves in this direction, but options for additional funding could be explored, including a redirection of a larger share of the fines for premature withdrawal.13

  • Overoptimism regarding returns. The report implicitly assumes a real rate of return of 6 percent, which appears overoptimistic. In order to achieve a rate of this magnitude, assets would need to be invested entirely in equities, which would expose depositors to significant risk. Therefore, in preparing the reform plan it will be important not to overestimate the gains or underestimate the risks from these reforms.14

  • The administrative infrastructure for regulating pension policy, managing investments and maintaining records. The combination of “points of presence,” a depository, and private fund management is an innovative approach, aspects of which have been implemented or are under consideration in other countries. However, the cost estimate of 0.25 percent of fund balances may be optimistic, given the complexity of the scheme. The objective of encouraging PFMs to compete on fees rather than performance promises also appears appropriate, but care would be needed to ensure that differences in fees can be distinguished from differences in risks. The experience of the Thrift Saving Plan—essentially a provident fund for U.S. government federal employees—might be informative. In this case, the plan trustees specify the indexed funds to be offered, firms compete on fees to provide them, and the plan participants can mix their investments.15

  • Rate of return guarantee. The report also recommends that the nominal value of contributions be guaranteed for long-term (10 years or more) participants. In other words, the value of the fund would never fall below the sum of contributions for these investors. This appears an innocuous guarantee, since it provides for zero nominal growth, but could be very expensive in the event of deflation or a substantial equity market correction.

  • Annuitization. The report expresses the opinion that liberalization of the insurance industry will allow it to offer “fair-priced” annuities to retirees. However, even in the most developed financial markets the transactions costs in the purchase of an individual annuity are very high. It would be useful to consider options similar to the depository that could pool risks efficiently and purchase group annuities, so that retirees would not have to forego such a high percentage of their savings.

Reforms to the defined-benefit programs

38. The OASIS report is largely silent on needed reforms to the EPS and CSPS. One aim of pension reform should be to unify and rationalize the rules under which these systems operate. At the very least, all new employees in each plan could be enrolled under new rules that are as similar as possible. A more ambitious goal would be to design a transition rule under which existing employees would be phased into the new system. The design of the new system will need to reflect carefully considered decisions on the following dimensions.

  • Sustainable self-financing. It will be important for the EPS and CSPS to internalize the costs and benefits of the new system to both employers and employees. At least prospectively, contributions should be sufficient to finance benefits, without the need to resort to additional budget transfers. Standardizing contribution and benefit rules across the two systems would reduce the appearance of inequity and promote mobility between the public and private sectors.

  • Level of benefits. A primary purpose of these defined-benefit plans is to allow for the sharing of risks across cohorts.16 The system can be structured so that all workers of different ages receive the same rate of return on their contributions, regardless of the particular draw from the distribution of rates of return experienced during their lifetimes. The question to be answered is what overall replacement rate should be expected from the pension system, and what share should be obtained from a defined-benefit system and what share from a defined-contribution system.

  • Retirement age/replacement rate. There is a clear trade-off between retirement age and replacement rate in a defined-benefit plan. As noted in the OASIS report, life expectancy at the current retirement age of 60 is over 15 years, and will grow in the future. By increasing the age for “normal” retirement, a larger replacement rate can be achieved with a given contribution rate. For a given replacement rate, the contribution rate could be cut by between a quarter and a third.

  • Wage base for setting pensions. Basing pensions on average wages over the last year of employment weakens the link between contributions and benefits. For given average lifetime wages and contributions, a worker with a flat wage profile will receive a smaller pension. Increasing the averaging period would eliminate this inequity, and to give appropriate credit for the timing of contributions and account for inflation, wages should be indexed in calculating the average. A number of options exist, but the choice will need to be consistent with structure of benefits and the degree of funding in the system. The replacement rate will have to be consistent with the chosen index, as well as the average rate of return earned by the pension fund’s assets. To be consistent with the defined-benefit design, the wages should be indexed with long-run average rate of growth in the index chosen. Otherwise, the intergenerational risk-sharing will be foregone.

  • Indexation of benefits. Even a modest inflation rate can rapidly erode benefits. At 5 percent inflation, real benefits fall by 40 percent in the first 10 years. Ignoring inflation puts the beneficiaries at substantial risk; requiring the budget to maintain real benefits shifts that risk to taxpayers. Neither is equitable. Rather, allowance for expected inflation should be built into the benefit and contribution structures, and indexation should be automatic and transparent. In this way, workers can finance their own inflation protection. Indexation is expensive, however. For instance, for a 4 percent real rate of return on investment and 5 percent inflation, the contribution rate necessary to fund a given replacement rate is on the order of 30 to 40 percent higher with indexation than without.

  • Special consideration for certain occupations. The expected work life is shorter in some occupations than in others—two examples are military service and mining. The pension system may need to reflect these differences, but it should do so explicitly, avoiding arbitrary and unintended cross-subsidies. If one occupation requires an earlier retirement age, it should show up as a compensating difference in total compensation. Then, either compensation net of contributions will be higher, or a larger share of compensation will be saved for retirement. Prospectively, for example, the higher costs of military retirement should be reflected in higher contributions for active military.

  • Transition. If all new employees are hired into a new, restructured system, the question then becomes what to do with existing employees. One option is to pick an age—say 35—and require all younger workers to join the new system. Their ultimate benefit could then be a blend of the benefits under the old and new rules, weighted by years of service under each. Finally, if it is in the best interest of the employer—either private or public sector—for older workers to switch, they could be offered an incentive to do so.

D. Concluding Remarks

39. In summary, the foregoing discussion suggests that reform of the retirement saving system in India could follow four separate tracks:

  • Institute OASIS-like reforms to improve the administration and management of provident funds and expand their coverage.17

  • Restructure the EPS and CSPS to obtain a financially sound first-tier pension that is both self-financing and appropriately sized. This would need to be coupled with reforms that stopped the accumulation of actual and contingent government liabilities in both systems and eliminated the explicit government subsidies to the EPS.

  • Estimate the “tax expenditures”—that is, foregone revenues—that result from the current tax preferences for retirement saving and make explicit decisions about the appropriate size and progressivity of these preferences.

  • Begin to plan if and how retirement income for the poor can be enhanced.

40. Encouraging steps have already been made toward addressing these reform priorities during the past year. Although demographic trends do not appear as pressing in India as in many other countries, the fiscal constraint is severe, and it will be important to avoid delaying reform and to ensure that it is consistent with a sustainable public sector position.

India: Small Saving Schemes

There are a large number of small-saving schemes, which provide small savers with significant tax advantages—in most cases interest earned is tax exempt and deposits are deductible from taxable income. However, these schemes are not in general intended to be retirement saving schemes, and their tax advantages mean that they attract a substantial amount of funds that would otherwise be invested in provident and pension funds. The 1999/2000 budget estimates indicate that by the end of the 1999/2000 fiscal year total outstanding deposits would be Rs 1,802 billion (9 percent of GDP). Details of these schemes as of end-2000 are as follows:

  • Post Office Savings Accounts (POSA) are limited to Rs 50,000 per individual. These are current rather than time deposits, and currently the rate of return for the POSA is 4.5 percent per annum.

  • Post Office Time Deposits (POTD) are unlimited in their size and may have one-, two-, three-, or five-year maturity, paying 9, 10, 11, and 11.5 percent rates of return, compounded quarterly but payable annually, respectively. Interest income is tax exempt up to Rs 10,000.

  • Deposits to the National Savings Scheme (NSS) are limited to Rs 40,000 per individual, and are deductible from taxable income. Deposits have a maturity of four years from the end of the year of opening the account, and carry an 11 percent rate of return.

  • Deposits in the Post Office Monthly Income Scheme (POMIS) are limited to Rs 204,000 per individual, and are of a six-year maturity with a 12 percent rate of return. There is a 10 percent bonus upon maturity, and a 5 percent discount in case of premature withdrawal.

  • There is no investment limit for the National Savings Certificate (NSC), and deposits are deductible from taxable income up to annual limits. Deposits have a six-year maturity, and pay an 11.5 percent rate of return.

  • Deposits in the Indira Vikas Patra (IVP) and Kisan Vikas Patra (KVP) are doubled in a specified period (currently 6 years). There is no maximum on the size of deposits, but interest is not tax exempt.

  • Post Office Recurring Deposit Amount (PORDA) requires a minimum investment of Rs 10 per month, has a five-year maturity, and an 11.5 percent rate of return.

  • The Deposit Scheme for Retiring Government Employees (DSRGE) and the Deposit Scheme for Retiring Employees of Public Sector Companies (DSREP) have a minimum investment amount of Rs 1,000, and total deposits cannot exceed the employee’s total retirement benefits. There is no maturity period, and they have a 9 percent rate of return, payable half yearly.

Deposits to small savings schemes flow to the central government, and three fourths of net collections (gross collections less withdrawals) of small saving in each state are onlent to the state in the form of long-term loans—typically 25 years. In order to encourage collections, for every 5 percent increase in the rate of small savings in a state above the national average an additional long-term loan of 2.5 percent of net collections is also given. Also, 50 percent of net collections under the DSRGE and DSREP in each state are advanced to the state as long-term loans. The rate of interest charged by the center on these loans is currently 14 percent, with a grace period of five years.

The treatment of small savings in the central government’s budget changed in 1999/2000. Up to 1998/99, inflows of deposits were treated as capital receipts, and the amounts onlent to the states were treated as government spending (net lending). A National Small Savings Fund (NSSF), into which all small savings and provident fund collections would be paid, was established in April 1999. All withdrawals by depositors are also made out of the NSSF. For 1999/2000 the total inflow into small saving schemes is projected to be about Rs 250 billion, compared with Rs 290 billion in 1998/99.


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Prepared by Robert Gillingham and Daniel Kanda.


These workers also participate in the Employees’ Deposit Linked Insurance Scheme (EDLIS), a third program overseen by the EPFO, which pays a lump-sum death benefit to the survivors of workers who die before retirement. The benefit is equal to the accumulated balance in the worker’s EPF account up to a maximum of Rs 35,000. Employers contribute 0.5 percent of workers’ salaries, and until 1996 the government also contributed 0.25 percent. Funds contributed up to March 1997 are invested in the Public Account, while subsequent contributions are invested according to the guidelines for EPF investments. At end-March 1997 accumulated funds were Rs 19 billion. The average rate of return for the EDLIS portfolio is 8.7 percent per annum. Establishments that wish to be exempted from this program must demonstrate that their employees already enjoy comparable or superior benefits, without additional contributions. As of end-March 1998, 7,261 establishments had been exempted. Since this is a life insurance rather than a pension plan, it is not analyzed here, although to the extent that premiums do not cover benefits, it represents a potential drain on public finances.


For five industries—essentially industries suffering from economic stress—the contribution rates are 10 percent for employees and 1.67 percent for employers.


The EPFO resisted this cut, and initially only approved a 75 basis point reduction in returns.


Contributions to these schemes by employers are tax deductible up to a limit of 27 percent of workers salaries. Employee contributions attract tax credits of 20 percent of the contribution, up to a maximum contribution of Rs 60,000. Income from investments is tax exempt. At retirement, one third to one half of benefits may be withdrawn as a lump-sum payment, which is tax exempt. However, annuity payments are taxable as income. Returns on investment have exceeded those for the EPF. Between 1996 and 1998, gross returns exceeded 14 percent, while the net return received by members was 12.5 percent. As with other pension plans, withdrawals before retirement are not permitted.


Contributions to these schemes are tax exempt up to a maximum of Rs 10,000. However, as with other pension schemes, annuity payments are taxed as income.


In addition to NOAPS, the poorest elderly may also be eligible for social assistance at the state level. Unfortunately, little information is available on the design and financing of these programs, which appear to vary significantly across states.


The only other explanation would be that there has been a drastic reduction in the size of the civil service, and the high number of current beneficiaries is a result.


This calculation is for a hypothetical worker whose real income increases at a 5 percent rate between ages 25 and 50 and is stationary thereafter.


Interest income and lump-sum withdrawals from provident funds are tax exempt, but benefits or annuities are not.


In 1998, investments were allowed in corporate bonds with a minimum AAA rating up to 2 percent of fund inflows. However, the majority of funds have not yet been invested in corporate bonds.


Project OASIS, in turn, built on earlier analyses by Patel (1997) and Dave (1999).


Two possible options for covering more of the poor would be to (i) provide matching contributions to IRAs to entice more workers into the system or (ii) expand the coverage and benefits of NOAPS to directly subsidize living expenses for the elderly poor.


For instance, in the discussion of annuitization, the report foresees a range of rates of return from 3 percent with a safe portfolio—higher than the rate of return on U.S. government bonds—to (implicitly) almost 9 percent—much higher than the expected return on an all-equity portfolio.


A wide range of additional ideas is presented in Shoven (2000) and Mitchell (1998).


The benefit formula could also be designed to redistribute within generations as well as across generations.


This is not to argue that the exact OASIS proposal be implemented, but rather that its principles be adopted and its innovative proposals for structure be given careful consideration in the reform process.

India: Recent Economic Developments and Selected Issues
Author: International Monetary Fund