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Suresh Krishnamurthy

THE defined benefit pension scheme of the Government has been replaced with a defined contribution scheme for the new employees. The change is part of a series of steps taken by the Government over the past few years to reduce its expenditure. This should mean that the new employees are getting an unattractive deal compared to the benefits enjoyed by existing employees. This is true. A deal that offers a high level of assured pension is always better than one in which the pension depends on the vagaries of the capital market.

But the new scheme is not a bad bargain at all. It holds promise, even at low rates of return. For young entrants, the scheme also holds the promise of a potentially better standard of living, especially post-retirement, as part of the contribution can be invested in the equity market.

In essence, the scheme represents trading in the option of `near-certain' returns and receiving, in return, the possibility of superior returns. But the option of near-certain returns could turn out to be an empty promise as well. This is because the Government is simply not in a position to sustain the pension burden. The option for superior returns thus appears more attractive. The capital market risk does sound less threatening considering that the economy promises to grow at a steady rate over a longer period.

Defining moment: The shift to a defined contribution scheme with a part of the funds to be invested in the equity market could turn out to be a defining moment in India's economic history.

The availability of long-term risk capital could power economic growth. If even a rate of economic growth of 7 per cent is sustained over 15-20 years, it could produce attractive returns to investors in the equity market.

For investors in the defined contribution scheme, this should lead to the accumulation of wealth that would ensure a higher standard of living. This new deal would prove better than the defined benefit pension scheme.

Low returns will do: In addition, for the defined contribution pension scheme to work, substantial contribution from the equity market is not necessary at all. In a defined benefit scheme, employees get a fixed sum every month, which works out to roughly 50 per cent of their last-drawn monthly salary.

Under the defined contribution scheme, to receive this level of pension for 15 years after retirement, a new employee who is 25 years old requires returns of about 7.5 per cent over a 50-year period on contributions made by the Government monthly. This is achievable. For those who are 30 years old, the required rate of return would be 8 per cent over a 45-year period. Again, this level of returns is achievable.

The calculations have also been made without considering the returns from contributions from the employee's salary. The new scheme requires matching contributions from the employee too. Income from wealth generated by the employee's contributions would thus ensure that the post-retirement income is almost equal to the last drawn salary.

Equities needed: There are, however, a couple of caveats. Investments in equities are essential. Even a return as low as 7-8 per cent cannot be achieved without contribution from equities.

A minimum of 20 per cent needs to be invested in equities. Investment of about 20 per cent in equities could push the expected returns to about 9 per cent, making the employee richer.

The presence of equities is not a risk-enhancing factor. It will actually reduce risks compared to a portfolio invested completely in government securities.

Equities will protect your wealth if the government artificially pushes down interest rates to pare budget deficits. Again, equities could come to your rescue if inflation rises sharply.

The presence of equities, however, requires a good fund manager. Investments in index funds would be a poor choice. Active fund management holds the potential to deliver attractive returns.

Again, equity mutual funds operating in the country need to be roped in. So far, they have done a reasonable job. That needs to be recognised and investors should be given the option of entrusting them with their contributions.

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