Scarier than UTI

Vikas Dhoot

Dear Kunal,
I'm glad you are settling into your new job. Your mother keeps fretting whether you are getting decent food. Anyway, I am writing to you for another reason. I am scared. I can't sleep at night. When I do catch some sleep, I dream I am running for my life. Or maybe from my life. I wake up in a sweat and then pace around like a man possessed. Your mother dragged me to a cardiologist. He says I'm fine. I know. It's not my physical health that's bothering me. It's the health of my finances that's scaring the living daylights out of me. 

No, it's not the five lakhs that I had naively kept with Unit Trust of India (UTI). I have already come to terms with that mistake of mine. I fear that there are far greater troubles ahead for me. Most of my life's savings are now lying in my provident fund account. Is it safe there? I spoke to the personnel director of our company a few days ago. He was all sunshine. "Why are you worried about your provident fund," he asked me incredulously. "It's absolutely safe." I would have liked to believe him, but he had told me something similar three years ago when I told him I wanted to sell my investments in UTI. I know that nothing is safe these days.

Not even our pensions and provident funds.

I have been reading up a bit during those sleepless nights. My provident fund has promised to pay me an annual interest rate of 9.5% a year. Almost 90% of the money is compulsorily invested in government securities. Today, one can barely earn 8.5% on a government security. Do you follow what I am saying? The provident fund earns 8.5% but it promises to pay me 9.5%. The sums just do not add up. Where is that extra 1% return going to come from?

My amateur mind is in a whirl, which is why I have decided to write to my economist son. I read in the newspapers the other day that a credit rating agency estimates that almost Rs 45,000 crore of state government debt will slide into default over the next few years. How much of this debt is held by the provident funds? Nobody knows. Let's say it's Rs 30,000 crore. That alone will blow a hole in our financial system that will make the UTI scandal look like a minor driving offence. 
Then there is the government pensions mess. Your uncle from Kochi called last week - he just retired from the Kerala State Road Transport Corporation. He's really distressed. Not only has the company not paid him his provident fund, gratuity and pension dues, even a staff welfare fund that employees contributed to, has not paid up. Apparently, this has been going on since the year 2000. The corporation says it has no money.

Luckily, your uncle has found a buyer for his small farmhouse in Athirapalli - he's planning to sell it to make ends meet till the matter is resolved. What I can't digest is that after 40 long years as an accountant with a state government corporation, does your uncle deserve this or did he ever even anticipate this? No. When we were young, getting a government job was something people would die for - with all the perks of housing, healthcare, and, of course, the power that came with the job. Moreover, unlike the private sector, the government also took care of your retirement funds without deducting money from salaries. That implicit promise now looks like an explicit lie. 
I am sure you must have read about the situation in Bihar - where employees of the state government and state corporations haven't been paid their salaries for a decade now! Pensions haven't been paid either. We keep on reading about the financial crises faced by various state governments. They clearly do not have any money left in their coffers. How long before retired people from other states face penury?

The other day I was surfing channels during a commercial break on television. CNN was showing a protest rally in China. There were all these old people telling the reporter how they had not got their monthly pensions. They already have a name for such occasions - pension riots. Can you imagine! Pension riots! How long before we, too, have to take to the streets? I wonder if I need a new pair of shoes to help me run away when the police arrive. Just joking!
So, now you tell me. Am I a needlessly paranoid wreck? Or does this all add up to something? My provident fund earns less than it pays out. I have no idea what muck lies in its portfolio. Various state governments do not have money to pay their employees. Doesn't this all look like UTI once again, though on a much larger scale? But nobody seems to be concerned. It's almost like a conspiracy of silence. Tell me, am I over-reacting? Perhaps I am. I don't need a cardiologist. I need a psychiatrist.

Baba

Dear Baba, 
Your letter came as a pleasant surprise but the contents are very disturbing. Your concerns about your retirement savings are pertinent and rational. So there's no need to visit a shrink. I wish others were as concerned as you are. The middle-class is living in a dream from which it is about to get jolted. The coming pensions crisis will hit us hard in our collective guts. Old and young. Government employees and private sector employees. Rich and poor. We're talking about at least 25 million people here. UTI was just the beginning.

I have been speaking to some friends at our institute who have been doing research on the coming crisis in old-age financial security. Remember Ram and Alka? They've just started on a big research project on this issue. So brace yourself while I try to unravel the Great Indian Pensions Explosion. The two showed me the latest annual report of the Reserve Bank of India (RBI) last night. I was shocked. It says that the Eleventh Finance Commission has called the government pensions mess "a ticking time bomb". The RBI has later described the current system as a "Ponzi game". So let me tell you what the problem is.

The provident fund and pension system has not changed much since independence. It is a pay-as-you-go system. This means that people do not have individual retirement accounts. Their contributions go into a general pool. So the current employees pay for the retiring and the retired. It's a bit like what UTI did. It raised money from me and paid it to you. The problem starts when the inflows are less than the outflows. That's when Ponzi schemes crumble.

As far as pension schemes go, the main shock comes from the changing demographic structure. The crisis is unbelievably bad in countries like Japan, which are rapidly ageing. Over the next 10 years, it will see a 25% drop in its working population under the age of 30. The story repeats itself with unerring regularity in other developed countries, many of which will have less than one tax-paying worker for every pensioner by 2030. Official estimates tell us that in the next 30 years, the rich countries will have to spend at least an extra 9-16% of their GDPs to meet the financial promises made to their aged. Unfunded pension liabilities are already at an eye-popping $35 trillion.

India is still a young country, but not for long. Our population is expected to rise by 23% between 2001 and 2016. The number of people over 60 will rise by a whopping 58%, to 113 million. And the number of people joining the workforce to pay for these retiring elders is falling by the day, as companies cut back on hiring in a bid to become lean and mean. The World Bank (WB) reckons that the ratio of elderly-to-working age people will more than double, from 6.4% in 1991 to 13.3% in 2026. Seems like a sure recipe for disaster.

That moment of reckoning is still some way off. The immediate problem is how the provident funds are going to get 7.5% to equal 9.5%. They could currently be on safe ground because of the older high-interest bonds they hold. But that cushion cannot be depended on for too long, especially since many public sector companies are busy refinancing their high-cost debt. It is this dilemma that goaded some private provident funds like the Seamen's Provident Fund to park their money with rogue outfits like Home Trade, which promised to trade aggressively and cover the missing 1% return. Eventually, the entire Rs 93 crore fund sunk without a trace.
Perhaps our provident fund commissioners need to bring in Enron's auditors to solve this impossible sum: how does one and one equal three? Central government securities give only 7.5% today, and not 8.5% as you said in your letter. State governments and public sector units pay a bit more. But nobody knows how many bankrupt state electricity boards and financial institutions have sold their bonds to the people who manage our provident funds.

If you were to ask me, I think that the Rs 45,000-crore estimate for state government bonds that could potentially default is a bit too modest. There is this entire web of guarantees that has not been accounted for. What state governments have been doing is this: investors in various weak projects have been comforted by promises that in any trouble, the government will step in and ensure that payments are made. Remember: this is what Maharashtra promised Enron. It was a costly mistake.

Do you have any idea how much all these guarantees add up to? Hold your breath: Rs 1,68,712 crore. These are hidden away from the public eye. They are off-balance sheet bombs, of the type that Enron and WorldCom used to hoodwink their investors. If even half these guarantees have to be fulfilled, all sorts of state government debt could sink. That's, perhaps, why the RBI has recently warned provident funds that there is no reason to assume that all state government debt is automatically risk-free. No: Rs 45,000 crore does not give us the whole picture.

Yet, let's stick with it. Even then, the numbers are horrendous. Their PFs' total corpus is about Rs 1,07,000 crore and reserves are just Rs 20 crore-30 crore (0.2%). A modest 2% gap in earnings will leave the provident funds with a loss of Rs 2,000 crore. Then there is the risk of default by many 'safe' government firms. That could be, let's say, Rs 30,000 crore. And then there are the government's unfunded pension liabilities, which are being paid out of current tax revenues. They have been growing at a compounded annual  growth rate of 20% while revenues have been growing at a CAGR of only 14%. To take a really long view, at this rate, the government's entire revenues will be inadequate to pay its pension bill in 58 years.

But, for now, there is an unfunded pensions gap of Rs 60,000 crore in the government's account. That is, pension benefits are being earned for which there have been no savings. Add all the numbers up - the interest gap, the potential bad investments and the unfunded government pensions - and we're talking about a staggering Rs 90,000 crore-plus here, Baba.

If UTI was a Diwali cracker, this has the makings of a thermonuclear explosion. Ram attended a seminar on the debt market arranged by DSP Merrill Lynch in Mumbai last week. One of the discussions veered round to the looming pensions crisis. One participant told the audience that he expected the problem to erupt within a year. "The provident funds can carry on like this for another year," he said. Alka was in Hyderabad last week for another seminar focused on Indian pension reforms. International experts on public policy, social security and insurance were there to counsel India on its pension framework. Most agreed that the Indian situation is dangerously poised and needs some sustained incremental changes, instead of waiting for a perfect system to be put in place overnight. Sadly, she observed that the Indian regulators attending - including the Securities and Exchange Board of India (Sebi) and the Insurance Regulatory Development Authority (IRDA) - didn't consider the situation to be a crisis at all! 

"Though we might be better off than countries like China, in terms of the sheer numbers, the critical thing is to realise that there is a need for urgency nevertheless and continuous change," said Mukul Asher,  professor of public policy at the National University of Singapore. And though everyone felt that pension funds should bear some risk to maximise returns, they felt that the recent Indian trend of pension funds being made to invest in development projects (through state government guarantees) is too risky. These projects are more like 'venture capital' investments rather than 'blue chip' investments. International experience in this supports our fear - regular dividend or interest payments are often far from certain and historically, many such projects fail. 
Financial literacy and education for Indians was a concern for everyone - the insurers, experts, activists - since any reform towards voluntary participation and choosing between different pension schemes will need to prepare the public to make these decisions right - else the purpose is defeated as has been seen recently in the UK, where menu-based pension products were mis-sold rampantly by intermediaries. The mood, Alka says, was better and more action-oriented than it has been at pension conferences in the past - this could be a sign of real action on its way.
There have been some attempts at reforming the pensions mess. The World Bank kicked off serious research on the subject in 1994. In India, the social welfare and empowerment ministry asked former UTI chairman S.A. Dave to look into the problem of old-age security. His panel submitted its Old Age Social And Income Security (OASIS) report in 1997 amid a lot of fanfare. It is supposed to be the cornerstone of reform in India.

Going by the OASIS Report, the government should eventually do away with the pay-as-you-go pension system, allow private players to offer pension and annuity products, give fund managers more freedom to invest in the stockmarket and promote individual retirement accounts. All these recommendations are in line with the prevailing international consensus of that time. But I wonder if we could soon be back to the drawing board. The meltdown in international equity prices, the collapse of the Enron pensions fund and the backlash against uncontrolled financial liberalisation is forcing many Western policy makers to reconsider their views. We could follow soon.
But that's a personal guess. For now, the situation is scary. That said, I suspect that the government will do its best to see that our pension system does not collapse. It could, perhaps, use part of its privatisation proceeds to recapitalise the pension system, as some countries like Peru have done. I can only guess.

So your fears are not unfounded. Don't worry, though. You have me to fall back on. Ma and you can always come over and stay with me. But only on two conditions. Ma has to cook her unparalleled sambar at least once a week. And you have to let go of the TV remote on weekends so that I can watch some football. Is that a fair deal?

Kunal 
Additional reporting by Mayanka M. Singh.