The EPFO Needs Fixing: It’s Not About The Returns, But How It’s Structured

The NDA government, which has tied itself in knots over the employees’ provident fund (EPF) scheme, both by attempting to tax withdrawals and by trying to prevent premature withdrawals before retirement, is needlessly setting itself up for another public excoriation. While the first proposal, made in the Union budget for 2016-17, was scrapped when there was a chorus of protests against it, the second was suspended when garment workers started rioting in Bengaluru.

Now, it is again (but more cautiously) entering the vortex of labour discontent by suggesting a lower return of 8.7 percent on EPF balances in 2015-16. This small cut comes after rates were raised steadily from 8.25 percent in 2011-12 to 8.75 percent in 2014-15. The EPF Board of Trustees had suggested another hike to 8.8 percent in 2015-16, but the finance ministry (rightly) feels this would be imprudent in a declining interest rate scenario.

The problem is not that the ministry is wrong; it is about why the ministry should at all be involved in this exercise of determining what rates should be paid. If the EPF Board, in its wisdom, wants to pay more, it should be allowed to do so; the only thing the finance ministry needs to make clear is that it can’t be expected to subsidise the Board in case interest rates decline further in the year ahead.

The EPF does need fixing, but not in the way the finance ministry is seeking to do so. Here are the issues.

First, the EPF has an implicit government guarantee on returns, which is no longer sensible. The scheme needs to be converted from a “defined returns” scheme to a “defined contribution” scheme – just like the National Pension Scheme (NPS). This should be goal one.

Second, the government cannot avoid guaranteeing returns altogether, especially for the lower income groups. This means that the EPF Board should be encouraged to conserve profits in its surplus years, and pay these out in years of low returns. The government can guarantee, say, a minimum of eight percent returns for low-income EPF subscribers – say those with salaries below Rs 3 lakh per annum. This guarantee should be operationalised only if the EPF agrees to even out returns over the medium term. It means the guarantees would be invoked only when returns fall consistently for long periods of time.

Third, the EPF should not be made compulsory for anyone with a salary above Rs 3 lakh per annum (or any other relevant threshold). The reason is this: investors need choice. If you make EPF compulsory, there will be an expectation that returns will be guaranteed. We need to break the psychological link between EPF subscription and returns. Migration to NPS voluntarily ought to be the norm, as proposed by the government but still not operationalised. But, of course, the NPS itself needs to be fixed before that, especially its poor annuity schemes.

Fourth, the EPFO is not necessarily a well-managed organisation. In 2010, for example, the organisation discovered that it had an unexpected surplus of Rs 1,731 crore in its “interest suspense account” – and paid out an additional interest of 1 percent in 2010-11. The Comptroller and Auditor General (CAG) later said that this surplus was unverifiable, since the EPFO had not updated its subscriber accounts in time. This is because every year many accounts become inoperative as people change or lose jobs, and interest may not be payable. (Interest is not paid once an account is inoperative for three years) This means there is often a gap between interest payable and interest actually paid into operative accounts. This needs to be fixed, or else dues payable to one lapsed subscriber may well end up as a surplus and paid to someone else.

Fifth, like the NPS, the EPF too needs options - the safe options, where most investments are in bonds, and options with higher risks and possibly higher returns, where equity is part of the investment corpus.

The Economic Times informs us that the EPFO is set for a brand makeover shortly, but it will be money down the drain unless the fundamental issues are addressed about how it will be structured, what is being guaranteed, who it will bear the risks, and who is the targeted beneficiary.