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Perils of the NPS Systematic Lump Sum Withdrawal Option

The Pension Funds Regulatory and Development Authority (PFRDA) has recently launched a work document relating to the implementation of the systematic flat-rate deduction (SLW) for the benefit of members of the National Retirement System (NPS).

The underlying proposition is very simple: under current rules, an NPS participant can withdraw a maximum of 60% of the pension corpus as a lump sum and a minimum of 40% as an annuity upon retirement. The SLW option applies to the 60% portion of the total corpus in which the participant has the option of keeping funds with the NPS Trust but withdrawing a pre-designated amount on a monthly, quarterly, semi-annual or annual basis. The SLW will have a maximum duration of 15 years to 60 years, ie after reaching 75 years, the available shares will be redeemed and the balance will be transferred to the bank account of the subscriber.

This proposal has been with NPS since its inception and is a direct replica of a similar withdrawal option given by Chilean pension funds. However, there is a difference: the payment in Chilean funds is fixed according to a governmental formula which converts the balance into a monthly payment which takes into account the age, the sex, the marital status of the pensioner and the evolution of mortality. The discussion document has nothing on this.

Let’s understand the financial engineering of this proposal before we address many serious questions about why this proposal is such a bad idea.

At first glance, SLW looks like a 15-year sinking fund. Another comparable financial product available on the market is the annuity deposit, which allows the depositor to pay a single lump sum and receive it in equivalent monthly installments, comprising part of the principal amount as well as interest on the declining principal amount. . The only difference is that SLW is a variable return sinking fund; therefore, the ratio of principal to return will vary with returns and, at times, may be 100% of principal for certain withdrawals.

As is the nature of the sinking fund, after the last installment, the balance must be reduced to zero. This is also what the discussion paper concludes when it says, “After reaching age 75, available units will be redeemed and the balance will be transferred to the subscriber’s bank account. This amount will be less than the initial 60% of the total corpus at age 60.

After understanding the basic engineering, three problematic aspects immediately emerge.

First, the lack of appreciation that age-specific longevity has improved at all ages in India, over the year. Longevity at age 60, which is relevant for SLW, according to abridged life tables based on the 2015-19 SRS, is 17.5 years for males and 19 years for females. The age of 75 has remained unchanged for a long time and, if SLW is to be accepted, this age must be raised to at least 79 to ensure that SLW lasts to the expected life at age 60.

In any case, an individual who opts for full (or even partial) SLW, and who survives beyond the life expectancy at age 60, is sure to see a drop in consumption at the end of the duration of the SLW because the accumulated capital will be reduced to zero and the entire old-age consumption will be based on a derived pension in the amount of 40%. It is a kind of outright dissaving and a guaranteed path to old age poverty.

The second problematic aspect of SLW is that it encourages continuing in the fund as an inactive participant, that is, earning returns but making no contribution. Since the total returns of the defined contribution pension fund are a function of both the time contribution rate and the market rate of return, this option increases the overall cost of managing the fund. The Employees Provident Fund Organization (EPFO) has been struggling with dormant accounts for years and eventually had to stop paying interest on those accounts.

The third aspect relates to the broader purposes that pension funds serve. The objective of the pension fund is to smooth consumption by guaranteeing a reasonable replacement rate, before and after retirement. Any proposal on withdrawal must optimize the replacement rate and not exhaust it. This is more important in defined contribution (DC) funds than in defined benefit funds because the replacement rate is variable in the former and fixed in the latter. So SLW’s purported benefit that it “adds flexibility, provides liquidity, and therefore optimizes retirement benefits” doesn’t cut much ice.

How to organize the decumulation phase of the DC pension fund is too vast a subject to discuss here. But it is a fact that there was hardly any discussion of this aspect during the formative years of pension policy in India. The successive leadership of the PFRDA paid little attention to this. However, if we compare the behavior of retirees across countries, in middle-income countries (mainly in Asia), retirees are highly dependent on income from assets to finance their consumption. Retirees do not finance their consumption by dissaving, except in countries where transfers are significant, such as those in the pay-as-you-go system.

In conclusion, SLW as a proposal does not impress this author very much and should be discarded. Assuming we don’t go that far, it’s quite surprising that there isn’t a formula for how the SLW will work taking into account all of the life cycle risks. The current system is totally disconnected from the evolution of life expectancy at age 60, which exposes retirees to an increased risk of old-age poverty through dissaving.

The Discussion Paper is one-sided in the sense that no financial risk is contemplated in SLW. The question of how fund returns will be affected, once a large cohort retires, can always be answered by other portfolio strategies and SLW need not be an instrument to achieve this.

(The author is a banking system economist. The opinions expressed here are personal)