Leaders of several Opposition-ruled States — Rajasthan, Chhattisgarh, Jharkhand, Punjab and Himachal Pradesh — have announced that they would revert to the old pension system (OPS). As a part of fiscal prudence, the OPS was replaced by the National Pension System (NPS) for all Central Government employees in 2004. All State governments, except West Bengal and Tamil Nadu, implemented the NPS for State government employees during 2003-13 (see Table).

The pension reform was inevitable for several reasons. First, the OPS is a defined benefit (DB) scheme where a retired employee is entitled to receive a guaranteed pension, roughly equal to half of his last salary, which is paid from the current revenues of the government(s). As the OPS is unfunded (pay-as-you-go), pension expenditure is typically a burden on the exchequer.

Second, the pension burden would increase exponentially as the average global life expectancy, according to the United Nations, is projected to rise from 72.9 years in 2022 to 77.2 years by 2050. Moreover, the share of the global population aged 65 years or above is expected to increase from 10 per cent to 16 per cent during the same period. As the OPS is unsustainable, several countries have shifted from defined benefit (unfunded) pension schemes to defined contribution (funded) pension schemes.

Third, as State governments’ committed expenditure under OPS would surge, discretionary expenditures, particularly capital expenditure, would shrink given their commitment to the FRBM Act.

Fourth, the intergeneration equity would be impaired as current taxpayers would continue to pay the OPS retirees on a perpetual basis.

Fifth, the social security argument in favour of OPS is weak as retired government employees constitute hardly 3.5 per cent of the workforce and they are relatively better off compared to the vulnerable section of the workforce engaged in the unorganised sector for whom social security is paramount.

Sixth, if the pension is a differed wage, it should ideally form a corpus outside the Budget under defined contribution by the employer and employees. This would grow during the tenure of the service and pension can be given to the retirees from the corpus fund without undue burden on the Budget. The NPS is essentially based on this principle.

Initially, the contribution of the employer was 10 per cent of the basic salary and DA with matching contributions by the employees. Since April 1, 2019, the Central Government’s contribution to the pension fund under NPS was enhanced to 14 per cent without a corresponding increase in employees’ contribution. Although State governments have accepted the enhanced contribution, implementation is pending in most States.

Fiscal prudence

The NPS is essentially a defined contribution pension scheme where the burden of pension is prudently shared between the employer and employees during the period of service without any guaranteed benefit after retirement. Nevertheless, retirees are entitled to pension benefits based on the growth of the pension fund. They can also withdraw a lumpsum at the time of retirement, similar to the commutation benefit under the OPS. The balance amount is converted into an annuity for pension purposes by a third party.

There is a lot of uncertainties about the size of retirement benefit under NPS as State government guarantee is no longer available. The retirement benefit may be elastic based on economic cycles. Moreover, the investment risk of the pension fund shall be borne by the employees. These concerns need to be addressed through market-driven solutions.

Globally, pension funds are offering multiple products based on the requirements of retirees. In India too, several pension products are available with a separate regulator for pension funds. There can be several hybrid-type pension schemes, which can combine both defined contribution and defined benefit — consisting of a minimum guaranteed pension and a variable component based on return. Similarly, pension products based on the pooling of retirees under collective defined contribution (CDC) can resolve the longevity risk.

As of now, both OPS and NPS are operating in India. Most of the NPS members are still in service. During the next 10-15 years, while retirees under OPS would gradually dwindle the retirees under NPS would increase. While the pension liability of the government(s) under OPS would diminish their contribution under NPS would increase.

According to a recent study by RBI, States’ contribution to NPS may rise from the current level of about 0.1 per cent of GDP to 0.2 per cent by 2039. On the contrary, if all States revert to the OPS, they can save the employer’s contribution for a short while, but the pension liability under OPS would surpass the savings they make by 2040. Thereafter, States’ pension liability would grow phenomenally and ‘the fiscal cost of OPS could be as high as 4.5 times that of NPS with additional burden reaching 0.9 per cent of GDP annually by 2060’.

In absolute terms, States’ pension outgo would increase from ₹4 trillion in 2022-23 to more than ₹18 trillion beyond 2050, which is unsustainable. Therefore, States reverting to OPS is certainly a step backwards — a recipe for fiscal disaster in the medium term.

The writer is currently RBI Chair Professor at Utkal University and former Principal Adviser and Head of the Monetary Policy Department, RBI. Views are personal