Friday, October 30, 2015

Concerns about fundamental changes in the New Pension System

by Ashish Aggarwal.

The recent report1 of the PFRDA constituted Committee headed by former SEBI chairman GN Bajpai to review investment guidelines for NPS schemes has re-opened three important questions. Its recommendations on these appear to be misplaced. From 1999 onwards, a consensus came together about the wisdom of the design of the NPS. PFRDA is now set to jettison the core design concepts of the NPS, without having adequately argued the case for the change. PFRDA needs a much more rigorous approach to the financial regulatory process, than it has demonstrated in the recent years.

Investment management approach: Active or passive?

The NPS has traditionally followed a passive approach to equity investment where Pension Fund Managers (PFMs) replicate the portfolio of a chosen market index. To illustrate, if a fund had tracked BSE Sensex since its inception 36 years ago, it would have delivered annualised returns close to 15.79 per cent. For an example, see the remarkable returns on Nifty and Nifty junior in history. The Bajpai Committee has advocated a shift to active investment management. In this approach, PFMs create a portfolio of stocks and decide the timing of their purchase and sale with an aim to beat passive investment returns.

From 1999 onwards, the policy thinking that led up to the NPS has emphasised passive investment, for good reason. Passive management costs much less than active management. For example, the expense ratio of Nifty BeES, an Exchange Traded Fund (ETF) tracking Nifty, is 0.49 per cent. Globally, index funds and ETFs like Vanguard 500 charge expense ratios of 0.05 to 0.17 per cent. Passive funds costs less as their task is relatively simple and can be largely mechanised. In contrast, actively managed funds have to spend a lot more on human-intensive procedures, and routinely charge expenses of around 2 to 2.5 per cent. A one per cent increase in cost can reduce the pension corpus by 24 per cent over 40 yearsa.

Second, global wisdom suggests that while active management can generate higher returns, these are mostly offset by the higher costs. Importantly, active funds that consistently outperform their benchmarks are a rare breed. Here is one recent report2 which finds that actively managed funds have generally underperformed their passive counterparts and experienced high mortality rates (i.e. many are merged or closed). Here is another report3 which shows that over a 10 year period, 82 per cent of large cap managers underperformed their benchmark. Mid and small cap managers have fared worse. The data on Indian mutual fund managers shows that about 50 per cent of them have underperformedb their benchmark.

The GN Bajpai report does not show the rationale in favour of this major change in policy direction. There is a discussion in the report about moving to a `prudent man' regimec. While the up-side from the change is not obvious, the upward pressure on fund management costs is.

Following the report, PFRDA has gone ahead and changed the investment guidelines4 to permit active fund management. The Government sector schemed already permits investing in individual
stocks. As a result, there is no scheme now which offers passive management in the NPS. This is a fundamental shift from the concepts of the NPS which had been articulated from 1999 onwards.

Role of fund managers: Should they market the schemes or only manage them?

The Committee recommends that the PFMs should market and sell the NPS, ostensibly in order to grow the customer base. This is a bad idea. Push sales strategies have worked where they are backed by high commissions, opaque products (where costs and benefits are not transparent) or both. NPS is an unbundled design where PFMs focus exclusively on managing investments. POPs (Points of Presence) comprising banks and other distributors are responsible for sales. The Chinese wall between POPs and PFMs ensures that they do not collude to push a particular scheme. This restricts mis-selling.

The issue of mis-selling is often associated with insurance and mutual funds who take a lead in marketing and selling their schemes. The Committee suggests that with the notification of the PFRDA Act, the consequent empowerment of PFRDA through various provisions on investigations, enquiry, penalty, and other enforcement actions besides customer protection measures envisaged in the various regulations under the Act, the issue of mis-selling will be addressed. While the logic of the committee on this count cannot be faulted, a similarly empowered IRDAI and SEBI have been battling this challenge for about two decades. The very design of the NPS was motivated by the problems of the conventional approach seen at SEBI and IRDA.

Allowing PFMs to do marketing is contrary to the basic design of NPS. The committee wants to change this design. To remain within the precincts of the Act, it recommends that, the PFs (PFMs) may canvass the product while the actual on-boarding may be done through the PoPs.

Another Committee, headed by former union finance secretary, Sumit Bose, set up to examine the issue of mis-selling and distributor incentives recently recommended5 that the POPs in NPS should be paid an AUM based trail fee. This would provide them the needed incentive and align their interest with the consumer over long term without increasing the risk of mis-selling. This would also leave the Chinese wall between the PFMs and POPs intact. PFRDA should examine these aspects before setting off on solutions to convert the NPS into a conventional SEBI/IRDA style system.

Fund management fees: auction based or fixed?

The Bajpai Committee recommends that the regulator should introduce a fixed and variable component in the fee. The variable fee should depend upon other performance indicators like relative returns generated. It has recommended that PFRDA examine this without compromising on the cost.

It is not apparent how increasing fees will not compromise costs. The Bose committee, has taken a contrary view and specifically recommended against any change of fees for the PFMs as they are
discovered through an auction process. The NPS auction is an transparent and efficient means to achieve lowest pricing in fund management. The remaining contestants have to match this lowest
fee. The consumers get the benefit of lowest cost and can also choose their PFM based on performance. Once the rules of the auction are transparent and apply equally, PFRDA should not have to worry about how to pay PFMs more.

Case for a rigorous approach

PFRDA has been grappling with the above questions over the last few years. It had in 20136 and 20147 re-affirmed passive investment management as the norm. In about a year, it has changed direction towards active management without adequate evidence or rationale. The approach to the issue of PFMs role with regard to marketing and sale of NPS has similarly lacked rigour. In 20138, PFRDA brought in a change and permitted PFMs to market the NPS. Within a few months, in November 2013, this was reversed. This left the PFMs stranded as is evident from the feedback PFRDA received from a PFM:

"Following the new guidelines of 2012 that expanded the permissible activities that can be undertaken by PFs, many PFs made significant investments towards setting up promotion and distribution infrastructure. Clarity about role along with the incentives / revenues available to fulfil this role is a prerequisite to enable the PFs to plan their operations and business plan over a medium to long term."

Clarity on the policy direction on PFM fees is missing. The auction based system was dumped in 20129 in  favour of a fixed fee of 0.25 per cent of assets, a significant increase over the earlier fee of 0.0009 per cent discovered through auction. Since 201410, PFRDA has reverted to an auction which again resulted in a low fee of 0.01 per cent. As PFRDA heads for another round of selection for fund managers, it might need to examine the approach to this issue more closely.

On these questions, we should be concerned about the extent to which PFRDA has failed to bring knowledge about pensions into its thinking. The problem runs deeper. If the processes at PFRDA do not produce sound answers on the questions outlined above, they could similarly come up with unsound answers on other issues in the future. As an example, PFRDA might feel like responding to the clamour of assured returns in the NPS.

Rigorous analysis is required before setting sail on such matters. Poor policy decisions are very expensive. Decisions need to be grounded in evidence, be well documented and disclosed transparently.

In the past, sub optimum processes have resulted in sub optimum outcomes in case of PFRDA's regulations11. RBI and SEBI also lag on this12 count. The government has prepared a Handbook13 which lays down sound practices on regulatory governance and lists the procedures that Indian regulators should follow to achieve better governance in regulation making. All financial sector regulators have agreed to comply with the Handbook procedures on framing regulations for: (a) all regulations from 31st October, 2013, and (b) all subordinate legislation -- which includes circulars, notices, guidelines, letters -- from 31st December 2014.

Going by the Handbook, the draft investment circulars/guidelines should have been published by PFRDA with a statement of objectives, the problem that is to be solved, and a cost-benefit analysis (using best practices). Thereafter, comments should have been invited from the public and all comments should have been published on the web site of the regulator.

Conclusion: Undo, rewire and reboot

NPS is over a decade old. It would be useful to close the discussion on fundamental design questions, and bring predictability to the scheme on multi-decade horizons that are required in pension planning. This would increase confidence among consumers, PFMs and POPs. Rapid progress on implementing the best practices laid down in the Handbook would help achieve outcomes in the best interest of consumers. PFRDA could start by applying these to review the questions at hand. Till such time:

  • NPS schemes should emphasise passive investment management.
  • PFMs should continue to focus only on fund management, while the selling is done by arms length POPs who are neutral between all PFMs.
  • The fee for PFMs should continue to be auction based.


  1. An annual investment of Rs. 100,000 over 40 years with net annual returns of 11 per cent would result in a corpus of Rs. 64.58 million. An additional one per cent cost would reduce the
    net returns to 10 per cent and the corpus by 24.62 per cent to Rs. 48.68 million. back
  2. Over last 10 years, out of 19 mutual funds tracking CNX Nifty, 10 outperformed the benchmark and 9 underperformed. Of the 16 tracking the BSE Sensex, the number of out-performers and under performers were equal. During this period, the category average
    returns by large cap equity mutual funds in India stood at 13.43 per cent per annum. As against this, the reference index, BSE 100 delivered an annualised return of 12.16 per cent. The top performer in the above fund category delivered 18.29 per cent while the bottom performer delivered 7.76 per cent. Flexicap category had similar results. (Category Average: 14.49 per cent, Top Performer: 19.34 per cent, Bottom Performer: 5.53 per cent). Data from Morningstar database. back
  3. Under the prudent man rule, if the process followed for taking investment decisions in prudent, then the decisions are prudent. For example, it is imprudent to invest in lottery. The relative prudence does not get affected even if one wins the lottery. back
  4. In the government sector scheme, PFMs can invest in individual stocks. Here, NPS follows the pattern notified by the government which permit a maximum of 15 per cent exposure to equity as against 50 per cent in the private sector scheme. The Bajpai Committee has rightly recommended that government employees should have the same scheme option as private sector. This has prompted PFRDA to review the status quo with the government. PFRDA has tied the NPS lite/ Atal Pension Yojana (APY) to the same norms that apply to the government scheme. This should also be reviewed as customers of these schemes too have no scheme choices. back


  1. PFRDA, Report of the committee to review investment guidelines for NPS schemes in private sector, April 7 2015. back
  2. Morningstar,  Active/Passive Barometer, June 2015. In addition to analysing active funds, the report finds that failure tended to be positively correlated with fees (i.e. higher cost funds were more likely to underperform or be shuttered or merged away and lower-cost funds were likelier to survive and enjoyed greater odds of success). back
  3. S&P Dow Jones Indices, SPIVA US Scorecard, 2014. back
  4. PFRDA, Investment guidelines for NPS schemes (Private Sector), September 10, 2015. The eligible stocks should have a market capitalisation at least Rs. 50 billion and should have derivatives trading in either BSE or NSE. The criteria for being considered for derivatives trading includes being in top 500 stocks in terms of average daily market capitalisation and average daily traded value in previous six months in a rolling basis. NSE currently has 163 eligible stocks for trading in derivative segment. back
  5. Ministry of Finance, Report of the Committee to recommend measures for curbing mis-selling and rationalising distribution incentives in financial products, August 7, 2015. back
  6. PFRDA, Clarifications on investment guidelines for private sector NPS, April 17, 2013. Prior to 2013 also PFMs were not permitted stock picking. Passive investment management was required to be done through in-house replication of Index funds or ETFs that tracked BSE Sensex or NSE Nifty Index. Investing in ETFs or Index funds of AMCs which charged a management fee was not permitted. Further, investment in equity mutual funds was not permitted. The PFMs were required to choose which index they intended to track in advance on a yearly basis. back
  7. PFRDA, Revision of investment guidelines for NPS Schemes, January 29, 2014. back
  8. PFRDA (Registration of Pension Fund Managers) 2012 Guidelines, July 12, 2012. back
  9. PFRDA, Circular No. PFRDA/CIR/1/PFM/1, August 31, 2012. back
  10. PFRDA, Revision of investment management fee for private sector NPS, August 1,
    2014. back
  11. Arjun Rajagopal and Renuka Sane, Difficulties with PFRDA's Draft Aggregator Regulations 2014, July 2, 2014.  back
  12. Arpita Pattanaik and Anjali Sharma, Regulatory governance problems in the legislative function at RBI and SEBI, September 23, 2015. back
  13. Ministry of Finance, Handbook on adoption of governance enhancing and non-legislative elements of the draft Indian Financial Code, December 26, 2013. back


  1. Dear Ashish

    in my view the NPS is yet another ULIP but under the banner of Insurance.

    There is one clause which will make the investor's nominee loose and maybe badly - the clause about closure of the NPS upon demise of the individual. We all know the cyclic ups and downs of the stock market. What if the time of demise the stock market is at a rock bottom. the nominee stands to loose a lot

    My take

    There should be an option to mature the policy that day or at the discretion of the nominee. should the nominee not have an immediate need to en-cash the policy, let them wait when the stocks are at the high / on the rise.

    yes a minimum gestation period may be stipulated - say 8-10 years after which it is left to the nominee to en-cash the pension

  2. I agree with your views. I think most of the funds / schemes boast of beating benchmark returns but very cleverly avoid talking about fund management charges. The expense ratio of UTI Nifty Index fund is 0.51 % as per Value Research which is at least three times higher than Vanguard 500 but still much lower when compared to actively managed funds. I appreciate your calculation - A one per cent increase in cost can reduce the pension corpus by 24 per cent over 40 years.
    I think the tax treatment of NPS should be EEE rather than EET. I understand it is being considered by the Government. Once implemented, it should make NPS very lucrative. The thought of paying heavy taxes at the retirement age and that too from the corpus meant for pension, is very scary. I hope NPS will soon be EEE like PPF & EPF.


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