By Analyst
The cost of pensions, relative to both the GDP and to government spending has been rising inexorably in the past forty years. In the mid 1970s Dr. N. M. Perera when he was the Minister of Finance, realized the threat to the public finances posed by the spiralling pensions bill and being imbued with a sense of responsibility decided to scrap the non-contributory pensions scheme for public servants. But the nature of our politics is such that the then opposition party agitated against the proposal for narrow political advantage, whipped public opposition and the proposal was torpedoed. Now after 25 years of fiscal damage, those who indulged in such irresponsible politics have revived the proposal. In his recent budget speech the Minister of Finance announced that new entrants to the public service, would have to contribute to a pension scheme. They would contribute 8% of their salaries while the government would contribute 12%. What a damning indictment on our politics. Even this is more likely to have been inspired by the IMF/World Bank rather than a proposal out of a sense of responsibility from our politicians. When will our politicians put the nation and the economy before partisan vote winning politics, the public interest before political advantage?

Funding Pensions

The non-contributory pensions scheme that was available to the public servants hitherto was affordable as long as the numbers in the public service were small. But after 1956 successive governments sought to solve the unemployment problem, particularly of their party supporters, by recruiting them to the public service. All of them were also given the non-contributory pension at retirement. The pension scheme was extended to parliamentarians too. But they serve continuously only for five years. So the benefit of pensions had to be given by reducing the eligibility for pensions to a mere five years service. But the MPs were not satisfied. So the defined pension benefit was also raised to 90% of the retiring salary. The colonial pension was limited to 2/3 of the retiring salary after 35 years of service.

The public servants pension scheme was not funded in the sense that money was not put aside each year to meet the future pension liabilities. Instead the moneys due each year to pay pensions were voted each year in the budget. This would not have mattered if the numbers were small and if the funds were met from taxation. It is a pay as you go scheme. In the year 2000 the pensions bill exceeded 21 billions. The new contributory pensions scheme is modelled on the private sector EPF scheme, a provident fund where the retiree draws out his money in one single sum. Since this is not prudent it is better to give them monthly pension instead.

Increasing benefits was a scam

It is always possible to give extraordinary gains to those who join early in any investment scheme. Paul Samuelson the economist pointed out as early as 1965 that extravagant pension schemes on a pay as you go basis, were akin to pyramid scams, which take hold of people from time to time. Such schemes promise to double your money in as much as 90 days and the Albanian economy collapse when an investment fever swept through the people there. There were similar wild pyramid schemes in Indonesia and Egypt, which also collapsed with many losses to the later investors in the schemes. The crooks that promise extravagant returns honour the promise to the early investors, which induce thousands of others to join in.

The extravagant payments to the early investors are paid from new collections just as finance companies did not so long ago. When the bubble bursts the scheme collapses and the sponsors disappear. The politicians who delivered extravagant benefits and were the first to draw them were no different from such pyramid scheme crooks. So the over-generous pensions scheme introduced by our politicians in the 1980s was a scam in which the public officials joined in. It was only more dishonest and self-serving than the other scams like free education where the middle classes fooled the people to get extraordinary advantages for themselves.

If the government were to leave the non-contributory scheme as it is, it would have to continue to borrow more and more to meet the annual pensions bill. The government must recognize the scam and scale down the benefits to the previous rules of eligibility and limit the maximum pension to 2/3 of the retiring salary or better still the average salary considering the arbitrary salary adjustments that have been made from time to time under various pretexts of correcting anomalies. The government cannot hope to solve the burden of pensions by doing away with the scheme for the future entrants only. 90% of retiring salary on a pay as you go scheme of non-contributory pensions is unsustainable.

We are now an aging population and the proportion of the people in the working age group will continue to decline, while the proportion of population of the young and the old the dependents, will increase. This means that those who are working will have to bear an increasing burden of the pensions bill. The dependency ratio was as high as 58% in 1991. Demography renders any defined benefit at a given retirement age, obsolete. Life expectancy has been steadily going up among those who retire at 60 years, by 1 or 2 years per decade. That makes a defined benefit of much value to those who retire. But of course their gains are being totally nullified by the high rate of inflation. It is the real value of the pension benefit that matters and enables the old aged to survive the loss of earnings through employment.

But every government cheats the pensioners by resorting to fiscal expansion, which causes inflation. So they are often left with a negative return. The new scheme of contributory pensions should not repeat the scenario. If those new entrants who will be called upon to contribute to their pension, find the real value of future benefits will be less than that of all their contributions, they will campaign against such a scheme unless all public servants are required to contribute. Governments have a strong incentive to continue the inflationary policies of the past since it reduces the real burden of pensions as well as the burden of interest. Interest rates are fixed and the principal is repaid at face value. So the employees are very likely to be cheated out of the real value of their contributions.

The EPF provides negative real returns

The Employees Provident Fund is being managed by the Central Bank on behalf of the government. The bank keeps the accounts of the Fund as well as of the individual balances of the members. There are allegations that there is a hole in the funds of the EPF. The Central Bank publishes data about the Fund and its members in the Annual Report. There is no Balance sheet or Income expenditure account published in the Report. Unlike in the earlier years when the Fund was set up, the demand for refunds is increasing as employees who joined in the fifties and early sixties now retire. Such refunds will continue to increase in the coming years. Refunds are now close to 100,000 each year and the sum involved in such refunds exceeds Rs. 10 billion. The annual contributions aggregated Rs. 16 billion in the year 2000.

The time is not far off when the incoming contributions will not be sufficient to pay out the refunds. What then? The Fund will have to draw on its reserves. Since these reserves are invested it may have to realize some of them to maintain liquidity. There must be sufficient liquid funds so as not to realize investments at a loss. A considerable sum has been invested in equities. But the stock market is in a deep slump for the last several years. These investments cannot be realized except at a loss. If by chance the Fund is unable to meet its liabilities then the government will have to step in. So it is in the public interest to demand that the true position of the Fund is made known to the employees.

With the stagnation in the economy it is unlikely that the new members contributing each year will increase dramatically. What is more likely is that with the decline of competitiveness more and more businesses will have to retrench staff and restructure. So while the number of persons retiring, will increase each year and they will live longer and the number of people paying contributions will fall. It wont be long before the number of contributors equal the number of persons retiring each year. The government is to set up a similar fund for the new entrants to the public service. But the government has not stated how it will organize the new pensions scheme. Perhaps the accumulated balances in the member accounts will be converted into a monthly pension scheme as in an annuity available for purchase from insurance companies.

A pension at retirement is in the nature of an insurance policy. It is as if the employee takes out a policy of insurance to provide for old age when he will not be in employment. He will pay insurance premium monthly so that when he retires he gets a pension benefit. But it must be based in an actuarially fair way, calculated on the basis of his expectation of life at the time of retirement. His pension should reflect not only the contributions he has made but also the interest earned on his contributions over the length of his period of employment.

The present EPF scheme for private sector employees provides very low returns. In the year 2000 the rate of return was only 12.95%. This means a negative real return since inflation was around 13-14%. The modern trend in developed countries is to give the choice of providing for his retirement to the individual employee, so that he can take charge of his retirement provision. But this will not do with our improvident employees. So an actuarially sound scheme of pensions must be designed and the employees assured of positive real value pensions at retirement.

Pension reform will benefit the economy

An important advantage of pension reform through funding rather than the pay as you go basis is that it will increase savings. The new public servants will have to contribute 8% of their salaries and pay for their future retirement. This will constitute extra savings. This extra savings should be useful in increasing investment, which could lead to faster growth in investment, which will eventually lead to a higher growth in GDP. Our rate of investment is too low to produce any dramatic growth rate for the GDP. The countries in East Asia and even in South East Asia invest around 35-40% of their GDP whereas we barely manage 25% and even this 25% is often wasted and not as productive as it should be.

The extra savings generated by pension reform if invested in the financial markets will develop the capital markets. Capital markets have a role to play in mobilizing new capital by providing a ready market for old capital, similar to the used car market, which promotes the purchase of new vehicles because the used vehicles can be readily disposed. It provides liquidity to capital. If the extra savings are invested in the government bond market or the corporate bond markets they could provide a similar function. So pension reform has its uses apart from helping the government to get out of the pension trap.