The Hindu Business Line : Paving the way for better retirement returns

Imagine domestic investments of Rs 24,000 crore being pumped into the Indian stock market! This would compare well with the investments made by fund-houses and insurance schemes. Where would this money come from?

The amount mentioned above is just 15 per cent of the total corpus managed by the Employees’ Provident Fund Organisation (EPFO) as of March 2007. The Ministry of Finance has allowed non-government provident funds, superannuation funds and gratui ty funds to invest 15 per cent of their corpus in equities with effect from April 1, 2009.

More leeway in investing

Infusion of EPF managed funds into the equity market is only one small component of the larger reform package that has been initiated for the country’s social security schemes.

After pushing the New Pension Scheme (for government employees) on a defined contribution basis and appointing public sector fund managers for the same, the Government has also nudged the Employees’ Provident Fund Organisation (EPF) to go in for private fund managers to manage the EPF corpus.

The Ministry of Finance has recently published a notification that provides more leeway on the investment pattern of non-government provident funds, superannuation and gratuity funds from April 2009. This comes as a modification to the investment pattern notified in January 2005 and would expand the universe of investment options available to these funds, enhance the limit of equity investments and provide a flexible ceiling for various categories of investments, among other benefits.

Equity investing – still a far cry?

The notification allows EPF funds to invest in stocks of the NSE and the BSE, on which derivatives are available and in equity-linked schemes of mutual funds together subject to a limit of 15 per cent of the funds managed.

This modification will not only increase the permissible equity exposure (from 5 per cent earlier) but also expand the universe of investible stocks by including all stocks in the NSE and the BSE that are sanctioned for derivative trading. This would bring about 267 stocks (which have single stock futures) under the EPF’s investment radar.

Allowing a 15 per cent equity allocation will pave the way for better returns over the long term, at the same time the additional risks can be managed because of the rest of the corpus, which will remain invested in debt.

Central and State Government securities, which historically account for a majority of the EPF’s investments, have for sometime now failed to provide returns that could beat inflation. Hence the addition of equity may improve the chances of a respectable post-retirement corpus for investors.

While strong arguments can be make for equity investment, the biggest question remains on whether provident funds would make use of the enabling clause to actually invest in equity. Reports have it that the EPFO is yet to exhaust even the existing 5 per cent limit presently allowed in equities. This reluctance stems out of the fact that the EPFO does declare a certain fixed return each year.

Private provident funds have to provide returns that are not less than the amount guaranteed by EPFO, failing which the employer has to bear the difference.

The interest declared for 2007-08 was 8.5 per cent. In volatile markets such as the present one, an erosion of 30-40 per cent in the equity portfolio could well negate the returns earned by the debt component.

Hence, achieving a ‘minimum return’ on a yearly basis may pose a challenge, should equities be made a significant part of the EPF portfolio.

This apart, a liberal move such as the present one has to be accompanied by changes in disclosure practices and accounting rules relating to the portfolio, to balance out the risks of equity investing.

In this context, a move that offers room for optimism is the short-listing of asset management companies such as HSBC, ICICI Pru, Reliance and SBI, who are seasoned asset managers in the mutual fund space, by the EPFO for the management of its corpus.

One can look forward to more professionalism if these asset management companies, with a good track record in portfolio management, secure the mandate.

Another change that could be positive for equity investing is the flexibility allowed to churn stocks in the portfolio as long as the turnover ratio (value of securities traded dividend by the average value of portfolio at the beginning and end of the year) does not exceed 2.

This essentially allows the portfolio managers to set target returns and book profits on stocks on a periodic basis. This could significantly curtail volatility of returns and even make the yearly return targets easier to achieve.

Expanding debt options

While more of the EPF corpus may flow into stocks, the menu of debt options available has also been widened.

The EPF will now be allowed to be invested in debt securities of companies including banks and financial institutions, term deposits of banks and rupee bonds of multi lateral funding agencies, all subject to specified maturity periods. These investments can comprise up to 40 per cent of the portfolio value. Another 5 per cent would also be allowed to be invested in money market mutual funds and money market instruments. Up to 55 per cent of the funds can continue to be parked in Government securities as well as gilt funds.

This expansion of the debt universe may leave no room for the EPFO to hold huge cash balances in its coffers quoting absence of Government securities to invest in. Further, debt instruments of corporate with a good credit rating and term deposits of banks often return higher than government securities.

But here again, the risk-taking ability of the trust would determine the return potential. Earlier in December, the Central Board of Trustees had rejected a proposal by the Government to invest the funds in debt instruments such as rupee bonds.

Clearly, the risks involved and the pressure of achieving the one-year target return comes as a hurdle for long term returns. This could be overcome by creating an equalisation reserve from profits that are periodically booked from equities.

The same could be used for distribution of interest during volatile stock market phases.