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New Pension System (NPS) in India: A Blessing for Equity Markets

Keynote Capitals presents note on the New Pension System (NPS), which has been made available to private sector employees effective May 1, 2009. NPS was made mandatory for public sector employees since January 1, 2004.

The Pension Fund Regulatory and Development Authority (PFRDA) was established by the Government of India in August 2003 mainly to promote old age income security by establishing, developing and regulating pension tunds and to protect the interests ot subscribers to schemes ot pension funds.

As a tirst step towards instituting pension reforms, the Government of India moved from a defined benefit pension to a defined contribution based pension system by making the New Pension System (NPS) mandatory for its new recruits (except armed forces) with effect from January 1, 2004.

The NPS architecture was made operational for Central Government employees from April 1, 2008, and has also been offered to State Governments to manage the pension corpus of their employees. The State Governments are at different stages of adopting the NPS.

The NPS architecture has been in operation for over a year. Since April 1, 2008, pension contributions of Central Government employees covered by the NPS are being invested by professional Pension Fund Managers in line with investment guidelines of Government applicable to non-Government Provident Funds. The NPS corpus of Central Government employees currently amounts to Rs21bn or $420mn.

The three Pension Funds generated returns of 12%-16% on the NPS corpus during FY09, weighted average return being over 14.5%.

The necessary infrastructure for the roll-out of NPS is in place. The NPS will be available to all citizens of India from May 1, 2009. Tier-I of the NPS constituting the non-withdrawable Pension account will become operational from that date and Tier II (withdrawable account) of the NPS account will become operational in about six months.

Highlights of investment guidelines laid down by the PFRDA

• Pension Fund Managers will manage 3 separate schemes, each investing in a different asset class, viz.,

(i) Equity (E),
(ii) Government securities (G) and
(iii) Credit risk bearing fixed income instruments (C).

• Investment by an NPS participant in equity would be subject to a cap of 50%. Also the corpus will be invested only in index funds replicating either BSE sensitive index or NSE Nifty 50 index.

• The subscriber will have the option to actively decide as to how the NPS pension wealth is to be invested in the three asset classes.

• In case the subscriber is unable or unwilling to exercise any choice as regards asset allocation, his/her contribution will be invested in accordance with the 'Auto choice' option. In this option the investment will be determined by a predefined portfolio. At the lowest age of entry (18 years) the auto choice will entail investment of 50% of pension wealth in E Class, 30% in C Class and 20% in G Class. These ratios of investment will remain fixed for all contributions until the participant reaches the age of 36. From age 36 onwards, the weight in E and C asset class will decrease annually and the weight in G class will increase annually till it reaches 10% in E, 10% in C and 80% in G class at age 55.

Likely Impact on Equity Markets

We note the tremendous potential of the NPS.

The NPS was made mandatory for new Central Government employees, effective January 1, 2004. It is also being offered to State Government employees and will be offered to private sector employees.

The NPS corpus of Central Government employees currently amounts to Rs21bn or $420mn. The NPS has been made voluntarily available to  private sector employees effective  May  1,  2009.

We expect the NPS to be a huge success and garner a tremendous response from private sector employees, once the distribution network of the NPS grows, to cover the entire country. However, a full national rollout of  NPS  may take  a couple  of years.

In view of the investment guidelines of the PFRDA, requiring upto 50% of the NPS corpus to be invested only in index funds, we expect substantial inflows into the latter, over a period of time. This, in turn would be invested in index stocks, pushing broad market indexes BSE Sensex and NSE Nifty 50 higher. However, inflows into index funds and therefore into index stocks, would depend on the growth in the NPS corpus collected from private sector employees, as also from employees of the Central Government and   State  Governments.

As per the Economic Survey 2007-08, the number of employees in the public sector in India as at March 31, 2005 stood at 18mn, while private sector employees was 8.4mn, constituting the organised sector. The total workforce as of the same date was 384.9mn, which means as many as 358.5mn employed persons  belonged  to the  unorganised  sector as  of that  date.

We are not aware of how many of the Central / State Government employees were eligible for NPS and contributed to the corpus of the latter. However, in view of the growth in employment in the private (organised) sector over the last 4 years or so, in segments like IT / BPO / textiles, we believe the number of private sector  employees   may   have  grown   substantially.

With such private sector employees now being offered NPS, we believe the NPS corpus can grow substantially going forward, albeit over a period of time. Even the unorganised sector employees can contribute to the   NPS  corpus.

All  in  all,  we  expect the  NPS  to  be  a  blessing  for the  secondary  markets.