This article has been written by Sakshi Garg, pursuing a Diploma in International Business Law from LawSikho and edited by Shashwat Kaushik.

It has been published by Rachit Garg.

Introduction

Longevity risk is the possibility that people live longer than expected, leading to higher costs for insurance companies and pension funds. This risk arises because more and more people are living longer, and this can cause these companies and funds to pay out more money than they planned for. The types of plans most affected by this risk are those that promise lifetime benefits, like pension plans and annuities. In summary, longevity risk is about the uncertainty of people living longer than predicted, which can create financial challenges for insurance companies and pension funds. This is due to the increasing number of people reaching retirement age and the longer life expectancies of policyholders and pensioners. Plans that guarantee lifetime benefits are most vulnerable to this risk.

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Managing longevity risk in pension funds is a crucial aspect of ensuring the financial sustainability of retirement plans. Longevity risk refers to the uncertainty surrounding the lifespan of individuals and the potential for retirees to live longer than expected, resulting in increased pension payments and financial strain on the pension fund. To effectively manage longevity risk, pension funds employ various strategies and techniques. 

Historical context of pension funds in India

The history of the Indian pension system dates back to the dependent period of British-India. In 1881, the Royal Commission on Civil Establishments first awarded pension benefits to government employees. The Government of India Acts of 1919 and 1935 made further provisions.

The right to a pension in India is provided in Article 366(17) of the Indian Constitution, and this right has been upheld by the Supreme Court of India. In March 1997, there were 34.29 million individuals in India (10.92 percent of the 1991 labour force of 314 million) who were covered under any formal social security system. The combined government employees of the Central, State and Union territories covered 11.14 million (32.5 percent of the total), while the remaining were salaried employees in the private sector.

Government employees in India are provided with three types of retirement benefits. The first is gratuity, governed by the Payment of Gratuity Act 1972. This Act applies to both the public and private sectors.

The second is the Defined Contribution (DC) scheme. Each government employee contributes at a rate of 6.0 percent of wages to the Government Provident Fund (GPF), with no matching contributions from the government

The third and most significant retirement benefit is the Defined Benefit (DB) non-contributory (for the employees), unfunded, indexed pension scheme. There are also disability and survivor benefits. The maximum replacement rate is 50 percent of the average wage for the last ten months of service. There is also a maximum ceiling on the absolute amount of pension of 50 percent of the highest pay in the government.

How does pension funds work in India

In simple terms, India, like other developing countries, doesn’t have a universal social security system to provide financial stability to the elderly population. The high levels of poverty and unemployment make it all the more challenging to implement a state pension arrangement funded by payroll taxes for those who are closer to old age.

Instead, India follows a pension policy where both employers and employees contribute to the pension fund. However, this system only covers workers in the organised sector, leaving out the wide majority of people working in the unorganised sector without access to formal support for their old age.

Despite its limitations, India has a long history of pension and old age income support systems. It started during Colonial rule when pensions were first provided to government employees in 1881. Over time, these schemes were expanded to cover retirement benefits for all public sector workers. After gaining independence, many provident funds were started to include private sector workers in the pension system.

Today, the most popular retirement schemes in India are provident fund, gratuity and pension schemes. The first two schemes give only lump sum benefits at the retirement stage, but the last pension scheme makes payments on the monthly annuity. These schemes have certain common features  that are important to understand. Those are mandatory, occupation based earnings related and these schemes are also helpful in disability and death because of insurance coverage. In case the worker becomes disabled and passes away in this situation, under this scheme, his/her family will get financial support and benefits.  

The current state of pension funds In India

In the pension sector, there were some major changes that took place because of important reforms in the financial sector of India in the past few years.

Introduction to the National Pension System (NPS)

The NPS is a government-backed voluntary contribution retirement savings scheme launched in 2004. It’s a very popular scheme; anyone can join this scheme in India and save money for their retirement. The NPS gives you two options for investing your money : In stocks or In Bonds

Expansion of pension fund managers

 Initially, there were only a few companies managing the money in the National Pension System (NPS). These companies are called pension fund managers, but the government made some changes and allowed more companies to become PFMs.

Atal Pension Yojana (APY)

The Atal Pension Yojana is a government sponsored pension scheme targeted at the unorganised sector and aimed at providing pensions to individuals based on their contributions.

The government decided to allow more money from foreign sources to be invested in the pension sector. This change means that pensions can now get more investment from international sources. While other parts of the financial sector in India have seen organised and carefully planned reforms, the changes in the pension sector have been less systematic and more disorganised. The main reason behind this irregular change in pension funds is that it is complicated and interconnected with various points like fiscal and tax policies, labour markets, health and the insurance sector. This complicated aspect makes the pension reforms more challenging and time-consuming.

Fiscal and tax policies: Government fiscal and tax policies affected by pension funds These policies determine how much individuals get tax benefits on their contributions to pension schemes and how pension funds are taxed on their income. 

Labour markets: The state plays a significant role in pension funds. When people have stable employment, they are more likely to contribute regularly to their pension funds. 

Health and insurance sector: The health and insurance sectors are linked to pension funds because health and insurance needs are essential considerations during retirement. Rising health expenses can put pressure on pensioners’ finance, impacting their withdrawal pattern from pension funds

Due to this complication, pension reforms have not been given a high priority compared to other financial sector reforms. The government first likes to smooth other areas before fully clearing the complexities of pension funds. This approach, although expected, can sometimes delay the overall reform process.

The interconnections of the pension system with other sectors make the reform process diligent and lengthy, and they can potentially disrupt or delay the pace of the overall financial sector reform.

Analysis of pension fund regime in India

Most individuals are outside the pension scope in India. Unorganised sector workers have no structured social security system. The Insurance Regulatory and Development Authority has submitted a report on October 31, 2001, to the Government of India, making some timely recommendations for pension reforms in the unorganised sector. Some of reforms suggested below:

  1. There should be some public awareness programmes conducted so people are aware of the pension scheme in a better way and use those schemes for their benefits.
  2. Contributions for pension plans and the selection of schemes can be done in various ways and through different organisations, such as banks, asset management companies, post offices, NGOs, and other groups with common interests.
  3. The integrated provider will be responsible for keeping records of the contributions made by the customers.
  4. The contributions’ fund management can be handled either within the integrated provider organisation or through a specialised approved organisation.
  5. It’s more important to continue pension regulation updates and should check that they are relevant and effectively fulfilling the needs of retirees.

Need for pension reforms in India

Global comparison: India ranked 41 out of 44 countries in the Mercer CFS Global Pension Index. The MCGPI is a comprehensive study of 44 global pension systems, accounting for 65 percent of the world’s population.

The index ranks countries on three criteria:

  1. Adequacy: What benefits are future retirees likely to receive?
  2. Sustainability: Can the existing systems continue to deliver, notwithstanding the demographic and financial challenges?
  3. Integrity: Are the private pension plans regulated in a manner that encourages long-term community confidence?

A large portion of the Indian population, particularly those in the unorganised sector, remains uncovered by any pension scheme. This lack of coverage leads to financial insecurity for the elderly.

At least 85 percent of current workers in India are not members of any pension scheme, and in their old age, they are likely to remain uncovered or draw only social pension. Even for those covered under pension schemes, the amount received is often meagre and insufficient for sustenance. The variation in benefits based on programmes, occupations, and sectors leads to inequities within the pension system. Of all the elderly, 57 percent receive no income support from public expenditure, and 26 percent collect social pensions as part of poverty alleviation. The pension sector currently places a significant burden on the government’s fiscal plan. Reforms should aim to create a sustainable pension system that is financially viable in the long term, balancing the needs of retirees with the fiscal constraints of the government. The system for old age income support entailed 11.5 percent of public expenditure, and sub-national governments bear more than 60 percent.

The current system of tax exemptions on post-retirement benefits is not effectively targeting those in need. Reforms should ensure that the benefits reach the intended recipients, rather than primarily benefiting the high-income group.

Some key approaches used in the industry

Actuarial modelling

In this approach, we use statistical and mathematical techniques to determine the future mortality rate and estimate the life expectancy of pension plan participants. Actuarial modelling uses statistical models to manage financial uncertainty by making accurate predictions about future happenings corporations use actuarial modelling.

Risk pooling  

The purpose of the pension fund process is to collect money from people and invest it together. This process helps to reduce the impact of uncertainty about how long individuals will live, which is called longevity risk. Through this process of putting everyone’s money into a pool, the funds can handle the situation when some people live longer than expected. When a diverse group of people participate, the extra costs to support longer living people set up with the people who pass away untimely. In this way, the risk is divided among many individuals, making it easier for the pension fund to manage and plan for everyone’s retirement needs.

Some pension funds use insurance policies and annuity contracts to save themselves from the risk of people living longer than expected. They transfer their risk to the insurance company. They enter into an agreement. According to this agreement, pension funds pay a certain amount to insurance companies, but in return, insurance pays the retirees a regular income for as long as they live. In this way, pension funds don’t have to worry about paying back benefits if the individuals live longer than the estimated time because the insurance company will be responsible for payback.

Contract drafting

Smart investment with pension funds is the perfect way to deal with the risk of people living longer. They try to earn money from their investments to cover the increasing cost of paying people who are living longer. They do this by deciding where to invest their money and by selecting investments that have the potential to earn higher returns. By making this right investment decision, pension funds make sure that they have sufficient money to pay back pensions not only now to individuals but in the future, when people are living longer.

Regular monitoring and rebalancing

Pension funds regularly check how much money they have and how much risk they will face if people live longer. If the amount of money that they need to pay increases because people are living longer, the pension fund may have to change its strategy. They can adjust how they invest their money, how much money people contribute to the funds, and how much they pay back as pensions. All these changes in strategies help pension funds stay financially strong and make sure that they can pay their obligations to retirees.                  

Risk transfer through derivatives

A special agreement strategy is used by some pension funds, like longevity swaps and longevity options, to shift the risk to other organisations, like banks. These agreements act as a form of insurance for the pension fund, helping them and saving them from insufficient funds if the individuals live longer than estimated. Under these contracts, the impact of longer lifespans on their finances is reduced.                                                     

Asset-liability management (ALM)

Line up the investment strategies of pension funds with their payback liabilities, which is called asset-liability management. For managing the risk of people living longer, pension funds use ALM techniques in which the timing and amount invested match the time and amount of pension payments they need to make. Through this planning, they make sure that they have sufficient money available to pay their pension in the future. This helps the pension funds reduce the impact of people living longer than expected.                                                        

Progress of pension-sector in India

Since the introduction of NPS and, more recently, APY, the pension sector has expanded in India. The total number of subscribers has increased over three-fold from 1.5 crore in March 2017 to over 5.2 crore by March 2022. In terms of numbers, as could be expected, it is dominated by APY. The total number of APY subscribers (including its earlier version, NPS Lite) increased over four-fold from 93 lakh to 405 lakh . APY subscribers account for over 78 percent of the pension subscriber base .

The pension assets under management have increased over four-fold from Rs. 1,75,000 crore to Rs. 7,37,000 crore during this 5-year period. The bulk of the assets are held by NPS, which rose from Rs. 1,70,000 crore to Rs. 7,11,000 crore, accounting for 96 percent of total assets; the balance percent is contributed by APY. NPS in the private sector, which includes corporate and all citizen models, accounts for 16 percent of total assets. Thus, while pension numbers are driven by APY, pension assets are led by NPS.

Disaggregated APY subscriber data shows improvement in gender mix, with female subscriber share rising from 37.6 percent in March 2017 to 44 percent by March 2022; age mix is also rising in favour of the younger cohort in the age group of 18-25, from a share of 32 percent in March 2017 to 44 percent by March 2022. However, the bulk, or about 77 percent, of APY accounts were for a pension amount of Rs. 1,000 per month, followed by 15 percent for Rs. 5,000, with the remaining 8 percent in-between. The overwhelming share of Rs. 1,000 pension in APY could be due to several factors, the predominant cause being economic, with the target population being low-income households where day to day consumption expenditure takes precedence over savings.

A survey by PFRDA on the socio-economic characteristics of NPS subscribers (all citizen models) for the 5-year period 2016-17 to 2020-21 showed that 24 percent were female subscribers, with the balance of 76 percent being male subscribers. This is in contrast to a better gender balance in the case of APY. The majority of the enrolments were from the age groups of 26- 35 years (33 percent) and 36-45 years (31 percent). Most of the subscribers were highly educated: over 81 percent of the subscribers were graduates or with higher qualifications.

Most of the subscribers were from a relatively high-income group: two-thirds of the enrolments were from the income groups of Rs 5-10 lakh (36 percent) and Rs 10-25 lakh (30 percent). Among various states, enrollment from Maharashtra was the highest, accounting for 17 percent.

Going forward, NPS (private sector) is poised to expand rapidly as an increasing number of corporate employees and relatively better off households, for example, the self-employed and professionals such as doctors, lawyers and small business owners, see the merits of joining NPS. There is potential for NPS in rural areas for larger farmers and traders and those with lumpy income, as NPS does not require a standard monthly contribution.

The rate of returns in various NPS schemes since inception in the range 9.0-12.7 percent has been very competitive vis-à-vis alternate saving instruments. In the last five years, the range has been 8.1-13.3 percent. As could be expected, the equity-oriented NPS scheme has clocked an annual return of 13.3 percent. An ultra-conservative government-securities-oriented NPS scheme has posted an annual return of over 8 percent. APY has also posted a high average annual return of 8.8 percent in the last 5 years, with the annual return since inception being 9.4 percent (Table-3).

The coverage of the population in pension under these two schemes (NPS and APY) during the 5- year period 2016-17 to 2021-22, has increased from 1.2 percent to 3.7 percent as a share of the total population, and assets as a proportion of GDP have increased from 1.2 percent to 3.2 percent (Table-4). This will suggest that the pension-sector, though it started late, is progressing much faster than the nominal growth of the economy as well as the population. Impressive as these numbers are, they pale in comparison with development in a number of other countries. For example, almost everybody in OECD countries has access to a pension in some form or another, which doubles as old-age social security benefits.

The future outlook on pension funds in India

Here are some key aspects of the future outlook on pension funds in India:

  1. Rising demand: The demand for pension products and schemes is increasing with the growth of the elderly population. Good pension schemes provide life support and play a very important role in the financial security of an elderly person’s life.
  2. Expanding coverage: There should be some pension scheme provided to individuals in the informal sector to cover broader retirement security.
  3. Technology adoption: Pension funds should connect to advanced technology, improve efficiency, and provide more personalised retirement plans to individuals.
  4. Financial literacy: Financial literacy among the public will be a priority to encourage individuals to participate in pension schemes and make informed retirement planning decisions.
  5. Investment diversification: Pension funds might consider investing in many types of plans to get more returns and reduce the chance of losses. With this planning, they can manage their fund and risk.
  6. Regular reforms: Regular reforms are essential to face the challenges , ensure consumer protection and also manage the funds according to the economic changes.
  7. Public-private partnerships: Public and private partnerships help individuals provide better investment plans and schemes with better returns, which provide attractive benefits to retries.

Conclusion

In conclusion, it is very important that people living longer than expected stay financially sound under the pension scheme. People are living longer than expected so it’s becoming a challenge for the insurance company and pension funds. To face this challenge, the insurance company must devise some good strategies to handle this risk effectively. 

To deal with the risk of people living longer, pension funds can do a few things and make some strategies. They can use insurance to transfer some of their risk and manage their assets and  liabilities accordingly. They have to use technology to better reach people, including those in the informal sector. It’s also important to make sure that the individuals understand their plans too. These approaches will help shape the future of pension funds in India, make them more secure and provide more benefits according to their needs

 References

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