Freny Patel: Fund managers benefit most from new PF norms

J Raghuram, the chief financial officer of a leading multinational company in the IT sector, faces a major dilemma today. He is not sure whether it would be wiser to hang up his boots and give his company's provident funds to the Employees' Provident Fund Organisation (EPFO).

By passing it to the EPFO, he would be absolved of his fiduciary responsibility of meeting the stipulated guaranteed annual return of 9.5 per cent on contributions made by the employees.

A conservative Raghuram is not confident whether he is cut out for the new complexities following the changes in investment options. If he is not able to generate such returns, the company has to make good the difference each year.

If Raghuram hands over the funds to the EPFO, however, costs also go up since the EPFO charges 4.5 per cent of the annual contribution by employees as management fees.

The biggest beneficiaries of the government's decision that allows provident funds to invest up to 5 per cent of their incremental funds in the stock market, of course, are the markets themselves since less than one per cent of household savings are invested in the capital market.

The mutual funds have had only moderate success and today manage just 1.5 per cent of the current market capitalisation. But unlike the stock market which rose reacting to the news, the Raghurams of the industry are far from elated.

The stipulated guaranteed return has been hiked to 9.5 per cent even as the return on most PF trusts today is around 7 per cent. The change in the investment pattern by allowing up to 5 per cent exposure to equities may not help the cause.

"I know what my shortfall is going to be on account of falling interest rates on the debt portfolio. But I have no clue as to whether I'll see a high return from equity or find my capital completely eroded," says Raghuram.

Adds Hindustan Lever Limited's trustee Nihal Kothari who handles a corpus in excess of Rs 1,000 crore, "It may not be a large sum, but if something goes wrong, there will be a major impact."

Other PF trustees fear companies could utilise the equity allocation to inflate their own or group companies' stocks.

The Enron saga is a clear case where not only did thousands of employees lose their jobs but, when the company declared bankruptcy, workers also lost about $ 1 billion in retirement savings which were invested in the company's shares.

On January 28, the government notified new asset allocation for investment by non-government provident funds, superannuation and gratuity funds. Effective April 1, these funds can invest up to 5 per cent incremental assets in equity.

The choice of equity is, however, limited to those companies whose credit rating is of investment grade. In addition, funds can invest in equity-linked mutual funds or private sector bonds up to 10 per cent.

The idea may have been to enhance PF returns in a falling interest rate regime. But most players interpret the move as a step to deepen the equity markets at a time when they are mostly dependent upon foreign institutional investors (FIIs).

Under the asset category of public sector undertaking (PSU) bonds, the incremental minimum allocation has been reduced from 30 to 25 per cent. Some PF trusts have been investing in unrated or even junk bonds, lured by the high interest rates offered. Now they will have to invest only in those bonds which have an investment grade.

While allocation in government bonds and gilt funds remains unchanged (from a minimum of 25 per cent to a maximum of 55 per cent) the government notification requires that trusts cap exposure to individual mutual funds at 5 per cent. What's more, trusts are also permitted to trade their central government securities portfolio, subject to a cap of 10 per cent of the previous year's total portfolio.

"Most PF trusts are not equipped with risk management systems and processes to handle a scenario where they invest in market-linked assets," says Amit Gopal, vice president of India Life Capital. Mutual funds too share this view.

"We would first like to offer them advisory services through our wealth management division as we do not expect them to jump at the offer of direct equity investments," points out Ashutosh Bishnoi, executive director, UTI Asset Management Company. He is in talks with a number of corporate entities managing their own PFs.

Nor is is just the privately run funds that are reluctant to enter the market. The EPFO is also not keen to park its funds in the stock market.

When the government permitted PF trusts to invest in corporate bonds some years ago, the EPFO refrained from such investment even though such bonds offered higher returns than those offered by government and state government securities.

"It is unlikely that we will park our funds in equity, not even blue-chips, unless there is a fundamental change in the way we declare our assured returns," points out a senior EPFO official.

The total corpus of provident funds is around Rs 124,000 crore today. Of this, the EPFO manages Rs 72,000 crore of unexempted funds directly while the rest is managed by corporates themselves subject to guidelines issued by the EPFO (these are called exempted funds).

Indeed, till the labour ministry ratifies the finance ministry's revised investment proposal, even the 2,564 exempted funds will not be able to invest in the stock market.

Till this happens, only a third category of funds, excluded funds, will be allowed to follow the new norms and invest in the market "" typically, IT firms fall in this category of excluded funds.

In the meanwhile, the government's decision to hike the annual return that provident funds have to deliver is certain to create a hole in the pockets of both corporates as well as the EPFO. 'The newer the trust, the bigger the hole (deficit) there will be," says Gopal.

India Life Capital manages over 150 PF trusts in the country and estimates that most companies will have to shell out between one and three per cent of the corpus sum to make good the loss.'

The EPFO is in no better state and has asked the government to meet the deficit of over Rs 902 crore that will arise from the decision to hike the rate "" about 80 per cent of EPFO's funds are deposited in the Special Deposit Scheme which yields just an eight per cent return.

While most agree that investing in the market gives a better return over a longer time frame "" Bishnoi of UTI AMC cites the example of UTI-II's Mastershare that has been giving a compound annual return of 14.5 per cent over the last 18 years "" the simple fact is that provident funds don't really have a long term horizon.

If people like Raghuram are not able to make the requisite return in any year, or actually lose money due to fluctuations in share prices, the company needs to make good the deficit.

Equity investment over a long term makes sense, provided the government removes guarantees and the employees begin to bear the investment risk. However, since the Left is unlikely to give its nod to this, this is not the end to Raghuram's dilemma.