Unveiling a new draft Code on Social Security to streamline schemes meant for India’s fragmented workforce, the NDA government has also proposed the ‘corporatisation’ of the Employees’ Provident Fund Organisation (EPFO). The corporatisation move seems to revolve mainly around giving the Centre greater oversight and tweaking its top management to reflect a corporate structure.
But it will take far more than such cosmetic tinkering for the EPFO to shape-shift into a corporate entity. For the EPFO to transform into a professionally managed retirement vehicle on the lines of its global counterparts, a complete overhaul of its muddled investment, accounting and fund management practices would be in order.
One big reason for the EPFO’s immense popularity with the salaried class is that its returns are seemingly immune to swings in market interest rates. In the last four years, interest rates on government bonds have dipped from 8.5 per cent to 6.5 per cent, but the fund has steadfastly ‘declared’ interest rates of 8.55-8.65 per cent. But its subscribers are unlikely to be aware that this is thanks to the rudimentary accounting practices that it uses.
Given that it uses the cash and not accrual system of accounting, the EPF’s estimated ‘surplus’ for any financial year is a ballpark figure that comes from simply deducting interest paid to members from interest/dividend receipts on its investments for the year. This method of estimating surpluses is problematic on two counts. One, the EPF credits the interest into its members’ accounts for any given year only in the succeeding year. Two, late updation of members’ accounts often results in credits being further delayed. In FY11, after declaring a bumper interest rate of 9.5 per cent based on an estimated ‘surplus’ of over ₹4,600 crore, the EPF ended up with a deficit of ₹510 crore after properly accounting for interest credits, inviting nasty comments from the CAG. Massive sums (over ₹54,000 crore in FY18) lodged in the EPF’s legacy inoperative accounts further muddy the waters, with returns for active subscribers padded up by earnings from dormant accounts.
Such ad-hoc accounting misaligns the EPF’s interest declarations with its portfolio returns and market interest rates, casting doubts on the sustainability of its payouts.
The EPF’s simplistic accounting methods have the potential to create even greater complications on liabilities, given that it owes lumpsum payouts to its retiring members at maturity. Thankfully so far, inflows into the fund by way of contributions have comfortably outpaced payouts to retirees, allowing it to simply rotate its cash.
But in the long run, if the EPFO is to be taken seriously as a retirement vehicle, it needs to expedite the shift from its cash system of accounting to a commercial accrual system that can present the true picture of its assets and liabilities.
Black box portfolio
With the EPFO’s investment pattern decided strictly by Central government rules, there’s a general belief that not much can go wrong with its investment bets. But the recent revelation that the fund holds troubled bonds from IL&FS, DHFL and Reliance ADAG has challenged this notion.
From parking its portfolio mainly in sovereign bonds, the EPF has been nudged by successive governments to take on riskier market bets, in recent years. As per the latest 2015 investment pattern, the EPF is required to allocate just 45-65 per cent to government bonds, with leeway to park 20-45 per cent in corporate bonds (both public and private sector) and a 5-15 per cent allocation to equities.
Now, diversifying out of the safety of government bonds may be critical for the EPF to generate inflation-beating returns for its subscribers. But market-linked investments, given their risks, must necessarily go with portfolio disclosures that make it easier for investors to gauge portfolio performance.
On this count, the EPF’s portfolio choices remain a black box to its investors. The fund publishes its annual audited accounts after a long delay (the latest one pertains to FY17). The accounts lack any granular details on its mammoth investment portfolio. The CAG has been regularly pulling up the fund for not disclosing the market value of its investments. With equity investments recorded at cost, investors have no way to gauge if they’re making or losing money on the EPF’s equity ETF bets. Debt investments valued on amortisation basis obscure knocks to the portfolio from defaults or downgrades. The EPF’s response to the recent bond debacles has been to withdraw completely from private sector bonds. But this comes at the cost of portfolio returns and is at odds with its decision to continue with its equity bets.
To reinvent itself as a professional money manager, the EPF needs to transition to mark-to-market valuation of its portfolio, with unit accounting for its investors. Public scrutiny can then act as a check on fund managers taking undue risks with market investments.
Muddled equity strategy
An equity component is certainly a useful return kicker for a retirement vehicle that manages retail money. Therefore, the EPFO’s decision to peg up its equity investments from 5 to 15 per cent of its incremental flows in the last four years is positive for its investors. So is its decision to stick to low-cost index ETFs to make these bets.
However, having decided to dabble in equities, the fund appears to be quite confused about how to go about it. After repeated tweaks to its equity strategy, in June 2018, the fund ended up with over a ₹31,700-crore equity portfolio (at cost) spread across two Nifty50 and Sensex30 ETFs, with another ₹3,800-crore exposure to the Bharat 22 and CPSE ETFs.
While the fund has approved these ETF choices on the grounds that they deliver portfolio diversification, this reveals a poor understanding of concept of diversification. The Sensex30 and Nifty50 indices feature sizeable overlaps, resulting in duplicated holdings.
The two thematic ETFs devoted to PSU stocks expose the fund to concentration risks. That the fund has ignored specific recommendations from its consultant CRISIL to diversify its portfolio using the Next50 or Midcap indices, points to the Centre exercising undue influence on its investment choices too.
Shifting fund managers
For a retirement vehicle to deliver healthy returns, stability and continuity of a fund management team which can take a long-term view of its portfolio is critical.
But the EPFO’s practice of outsourcing its investment function to third-party portfolio managers, selecting them for their rock-bottom fees and reshuffling them every 3-5 years actively militates against continuity and encourages short-termism. Just last month, the fund approved replacing its present set of five fund managers (UTI AMC, Reliance AMC, SBI PMS, ICICI Sec and HSBC AMC) with two new choices (SBI Funds Management and UTI AMC) after the latter bid sharply lower fund management fees.
Given that the EPFO’s corpus at last count (at ₹10.3 lakh crore) was nearly half the size of India’s entire mutual fund industry, there’s no reason why it can’t attract good money management talent or build an in-house team to professionally manage its equity, debt or credit exposures without any conflicts of interest.