Improving pensions

Policies and regulations can increase the returns on pension funds; these can reduce the politics over the issue

The debate over the Old Pension Scheme (OPS) and the National Pension System (NPS) in India usually centres around distribution. Who should contribute how much to the investments? And, who should bear the risks? The risks are usually considered exogenous but this is questionable. Even the expected return rates are not exogenous. 

Returns on investment constitute the bulk of the accumulated amount at the time of retirement; the investment itself, though pivotal, is relatively small at that stage. This is because for pension funds, the investment horizon is very long and the compound interest is powerful. It is important then to understand and improve the returns on investments. 

The long-term real return rates on debt instruments are low. Two reasons contribute to this. Firstly, banks need to observe the so-called statutory liquidity ratio in India. Effectively, banks need to invest at least 18 per cent of their funds in government bonds. So, the demand for such bonds is high and accordingly their prices are high. Relatedly, the yields are low. Secondly, for giving a push to economic growth, now and then the Reserve Bank of India (RBI) keeps the real repo rate at a low level. The two policies tend to keep the real interest rates more generally at relatively low levels. The result is the returns on pension funds suffer. 

Another important part of the story of returns on investments includes three risks. First is the inflation risk. If the inflation rate shoots up, this can reduce the real value of the nominal value of the corpus with the pension funds. Also, a rise in the inflation rate can push up the nominal interest rates, which can reduce the nominal value of the corpus itself. Second is the interest rate risk. Interest rates can fluctuate considerably. These affect bond prices and even equity prices. Last but not the least is the risk that sentiment can change in the asset markets even when there is little rhyme or reason. Equity prices and even bond prices can change for a significant period. The risks affect the pension funds. 

The risks in investments are, in part, a function of what the public authorities do. Asset markets do not function in a vacuum. These operate within a macroeconomic policy and a regulatory framework. If these are not appropriate, there can be very high risks in returns. Conversely, risks can be reduced and the pension funds can gain if there is a suitable change in policy and regulations.     

What is the prevailing macroeconomic policy? Let us focus here on the RBI. It is supposed to target 4 per cent consumer price index inflation with a leeway of 2 percentage points. This de-jure leeway is 50 per cent! The de-facto leeway can be even higher, as seen already from 2019 until recently. The huge possible variations in the inflation rate imply a big inflation risk for asset markets, which negatively impacts pension funds. 

Furthermore, the main policy tool with the RBI for macroeconomic stability is the repo rate. Alongside keeping this at a low level on average, the RBI changes this rate considerably over an economic cycle and over “an inflation cycle”. The changes affect interest rates more generally in the economy, but more significantly, there is often an overreaction in the asset markets. The risk this poses to pension funds is obvious. 

Finally, consider the regulatory framework under which investments happen. Here, the main issue is an act of omission rather than commission. The role of sentiment is quite pervasive in asset markets, but the regulations are more or less silent on this. It is true that the regulatory framework cannot reduce the irrationality of participants but what it can do is to enable and facilitate a market for credible, independent, sound, easily accessible, and reasonably priced financial advice. Such measures can substantially reduce the role of sentiment and lead to less volatile asset prices. Accordingly, its impact on pension funds will be lower.

All the above analysis raises the following questions. Is it possible to meaningfully reduce the repression in real interest rates for savers? Next, is it possible to have a policy that maintains low and stable inflation and looks after other macroeconomic objectives without increasing the interest rate risk for asset markets? Finally, is it possible to have a regulatory framework that can significantly reduce the risk due to changing sentiment in asset markets? The answers are mostly yes. My forthcoming book, Macroeconomics and Asset Prices — Thinking Afresh on Policy, shows how and why. But that is a long story. The point here is that policy and regulation can substantially increase the risk-adjusted and inflation-adjusted returns for pension funds. This can reduce the usual politics surrounding this issue.

The writer is visiting professor, Ashoka University. gurbachan.arti@gmail.com. Vanshika Tandon contributed to this article