Abstract

With the increasing cost of living and dropping interest rates, it becomes imperative to plan your retirement, saving from the early working years, says Nikunj Kedia.

The number of Indians over the age of 60 will grow from 7.6 crore in 2000 to more than 21.8 crore in 2030. As per projections in the next 50 years, the median age of the population will rise by 17 years from the current level of 21 to 38 years. Today, at the age of 60, an individual in India has an expected lifespan of 75 years – by 2020 an individual of 60 will have an expected lifespan of 80 years.

However, India still does not have a universal social security system which provides economic support to individuals across the income spectrum in their retirement years. According to studies, only about 11% of India’s working population has any form of social security at all. A change in social structures from joint families to nuclear families has resulted in a situation where the younger generation are also unable or unwilling to support the elder generation.

Pensions: Current Scenario

Pensions are a lumpsum payout and/or a guaranteed annual payout to a retired employee. A pension plan that defines the amount you will receive on retirement is known as a defined benefit plan. This is calculated by multiplying a conversion rate into the number of years of service and the level of wages. In a defined contribution plan, you specify your contribution amount into an account. The final value of the retirement account is determined by the level of contributions and the rate of return on the investments, and hence the benefit is not defined.

Pensions in India are primarily covered under the Employees' Provident Fund & Miscellaneous Provisions Act, 1952. This Act is applicable to establishments engaged in one or more of the specified 182 industries and which employ 20 or more persons, drawing a salary of Rs 6500 per month. The major retirement schemes in India for the organised sector include the Employee Provident Fund (EPF), the Gratuity Scheme and the Employee Pension Scheme (EPS). The first two schemes provide lumpsum retirement benefits while the last one makes a payment in the form of a monthly annuity. Employees in the unorganised sector can also use the Public Provident Fund (PPF) or invest in schemes offered by insurance companies and mutual funds to build a retirement corpus.

Employee Provident Fund (EPF)

The EPF is a defined contribution scheme, which pays a lumpsum benefit to its members on retirement, depending on the level of contributions made and the rate of return on the investments.

Some of the key features of the EPF include:

• The vesting age is 55 years.
• Establishments covered by the EPF can either have the Employee Provident Fund Organisation (EPFO) manage the provident fund, or manage it themselves.
• Subscribers to the EPF have the option to make partial withdrawals for specified purposes such as house construction, higher education for children, marriage and medical expenses.
• Voluntary higher contributions are also acceptable at the joint request of you and your employer.
• If you have worked continuously for a period of five years, the withdrawal of EPF is not taxed.

However, since the accumulated balances are paid in lumpsum, this does not cover for inflation and longevity risks, when an individual surpasses the usual life expectancy and consequently draws down the retirement corpus.

The EPF rate has been steadily decreasing over the last decade and the rate in 2004-05 was 9.5% compared to 12% in 1995-96. The rate for the financial years 2005-07 has yet to be finalised by the govt, though the recommendation made is 8%.

Employees Pension Scheme (EPS)

The EPS is essentially a defined-benefit programme providing you with earnings-related pension on retirement. The EPS has replaced the erstwhile Family Pension Scheme (FPS) in 1995. The amount of the pension benefit is based on your average salary during the final year of employment and the total number of years of employment. If you joined the scheme after 1995, the monthly pension is calculated as -- (Pensionable salary x Pensionable service)/70.

Hence, if you have worked for 20 years and your pensionable salary is Rs 50,000, your monthly pension will be Rs 14,300. You are also allowed to commute up to 1/3rd of your monthly pension -- in this case the value of the commutation would be 100 times the amount of monthly pension you desire to withdraw and the pension amount would be correspondingly reduced.

Some of the other features of the EPS include

• A minimum of 10 years of eligible service to be entitled to the pension.
• Members must be at least 58 years old.
• Members can opt for a monthly pension after the age of 50 provided they have completed 20 years of service.
• The EPS provides a pension for the child and the spouse on the death of the member.
• A member can also opt for drawing a reduced pension and avail the facility of return of capital. In this case, the member gets less than the full amount of pension admissible to him, and after his death, a lumpsum is returned to his nominee.
• The employer and the Central Govt are liable to make contributions only up to the amount payable on Rs 6500.

Employees’ Deposit Linked Insurance Scheme (EDLIS)

The EDLIS provides life insurance benefits to employees. It offers a lumpsum benefit on the death of the employee, based on his provident fund balance. No amount is recovered from employee's wages and the employer pays 0.5% of total wages subject to a ceiling of Rs 6500 per month.

Gratuity

If you have put in at least five years of service, you are eligible for gratuity. A lumpsum amount is paid to you based on your length of service and wages. The gratuity amount is calculated as 15 days’ salary for each year of service or part thereof -- the salary calculated is on basic plus dearness allowance. The maximum amount to be paid out is Rs 350,000, but it can be increased at the discretion of the employer. The cost of gratuity is borne entirely by the employer.

Public Provident Fund (PPF)

The PPF is a self-funded defined contribution scheme. Its key features include:

• Current rates: 8% compounded annually.
• Investment limit: Rs 500 to Rs 70,000 annually.
• Early withdrawal: From the seventh financial year, you can make one withdrawal every year, not exceeding 50% of the balance at the end of the fourth year or the year immediately preceding the withdrawal, whichever is lower.
• Loan against PPF: You can take a loan from the third year onwards -- it should not exceed 25% of the amount to your credit at the end of the financial year before you apply for the loan.
• Lock in period: 15 years.
• Can continue after 15 years, in blocks of 5 years.
• A PPF account can be opened in any of the nationalised banks.
• An individual can have only one PPF account.

One of the key benefits of the PPF is the Exempt – Exempt – Exempt (EEE) nature of the investment – investments into the fund, the accrued interest and withdrawals from the PPF are all tax exempt. However the govt intends to change this in future to an Exempt -- Exempt --Taxable (EET) scheme, where the withdrawals from the PPF account will be taxable.

An amount of Rs 70,000 invested annually into the PPF account (assuming no withdrawals) will result in a corpus of Rs 20.52L at the end of 15 years. Including tax benefits (assuming taxation at marginal rate), the annualised returns on the investment over a period of 15 years is over 12.5%. However, the interest rates on the PPF account are fixed by the govt and hence are variable – the rates have dropped from 12% per annum in the past to 8% now.

Planning Through Insurance

The decision to open up the annuities market to private sector insurance companies has increased the options available for an individual. The retirement planning products offered by insurance companies require annual payments into either a Unit Linked Insurance Plan (ULIP) or a fixed benefit plan.

The fund generates value over time, based on the returns on the investments. On the date of retirement, the individual has an option to withdraw 1/3rd of the accumulated balance in the fund as a lumpsum, whereas 2/3rd of the balance has to be used to purchase an annuity. The lumpsum amount is tax free, but the annuity is treated as income and taxed accordingly.

All the insurance companies offer a free market option. As per this option, at the time of retirement, you can buy the annuity from any service provider and is not bound to the insurance company from where you bought the original policy.

Generally, the following options are available to you with respect to the annuity:

Most of the insurance companies offer ULIPs which provide you the flexibility of choosing the assets you want to invest in. In a ULIP, the individual pays a regular premium which is used to buy investment units. There are choices available to you to invest in accordance with your risk appetite. These plans give you the flexibility to choose your premium, sum assured and retirement date. However, be careful in investing in a ULIP since the high upfront charges to your premium will reduce the maturity value of the product.

Problems in the Indian Pension System

• Political interference: The current pension system is heavily regulated by govt agencies, resulting in lack of transparency. Constant interference by political parties has dampened the growth of an efficient retirement structure in the country.
• Lack of options for unorganised sector: Most of the retirement savings schemes like provident and pension funds predominantly cover workers in the organised sector which constitute only about 10% of the aggregate workforce. The majority of workers in the unorganised sector do not have access to any formal system of old age economic security. Provident funds have limitations with regards to retirement planning because they do not provide protection against the whole length of the retired life and hence cannot be used as a substitute for a pension.
• Low rates of returns: Conservative investment norms for provident funds to safeguard the interest of the members have resulted in inadequate rates of return from these schemes. As a result, the retirement corpus available to an individual from these schemes is inadequate. In addition, a substantial proportion of the accumulated contribution is dissipated prior to retirement, due to the provisions of liberal withdrawal facilities.
• Financially unviable: The defined benefit plans are putting increasing pressure on govt’s budgetary allocations. The estimated shortfall in the EPS fund is Rs 17,000 crore. As a result, these schemes are financially unviable in the future.
• Poor customer service: The current schemes suffer from extremely poor customer service with no availability of account statements, delays in withdrawal, no transfer provisions etc.

Reforms: New Pension Scheme

The Pension Fund Regulatory and Development Authority (PFRDA) was established by the Govt of India on August 23, 2003. PFRDA is the regulator for the New Pension Scheme (NPS).

Some of the key features of the NPS are

• NPS will be available on a voluntary basis to all persons including self-employed professionals and others in the unorganised sector. Currently, only govt employees can join the NPS.
• It is based on the concept of Individual Retirement Accounts (IRAs). You can save and accumulate assets into your IRA throughout your working life.
• Under the NPS, the fund manager will offer alternative products to members including risk-free options under which all funds would be invested in govt securities and stock market linked products with variable returns.
• There will be various options available to the members with respect to the Pension Fund Managers (PFMs) they want to allocate their funds to.
• You can access and operate your account through the multiple Points of Presence throughout the country.
• You can normally exit at or after the age of 60 from the pension system. At exit, you would be required to invest at least 40% of the pension wealth to purchase an annuity.
• Life Insurance Corporation, UTI AMC, State Bank of India and Punjab National Bank are among the front-runners to become fund managers.

The NPS can be positioned as an alternative to other forms of old age income security like EPFS and EPS, as well as the existing indexed defined benefit pension scheme of the govt for its employees. As per the latest figures, about three lakh employees have joined the NPS and the fund has grown to approximately Rs 1,700 crore.

While You Plan….

To ensure you are able to meet your financial needs comfortably during retirement, it is important to have a plan in place. The three steps to building a retirement portfolio which will see you through your golden years are:

• Plan your financial requirements during retirement:
  This includes estimating your regular expenses and any one-time expenses you might have once you retire. You need to understand your total investable assets and based on this, evaluate the returns you need to generate from your portfolio to be able to meet your requirements. The returns should be sufficient to protect your portfolio from the ravages of inflation as well.
• Build a well diversified portfolio in line with your requirements:
  Generally, people fail to think of their retirement corpus as a source of regular income and end up putting their investments into a savings bank account to protect the safety of their capital. However, this can be very suboptimal. You need to ensure you have a well diversified portfolio with investments in slightly riskier asset classes like equities as well, if required. A low cost index fund which tracks the performance of a broad based market index would be an efficient way of getting exposure to equity markets. Your portfolio should be generating sufficient returns in line with your liquidity requirements. Investing surplus cash in the liquid schemes of mutual funds or in short term deposits are a better way of investing your money than leaving it behind in a savings bank account.
• Monitor the performance of your portfolio:
  This is essential to ensure its performance as per expectation. Any changes to your personal situation need to be factored into your plan as well to ensure there are no surprises later.

The key to a successful retirement plan is starting as early as possible and sticking to the plan.