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Does Not India Need a Default Option in the New Pension System?

Pension reform modules that take care of the changing demographic profile of a population have put forth a number of suggestions. The accepted defined benefit pension system, which was the broader goal of a welfare state, is slowly giving way to the defined contribution system where risk is borne by the final beneficiaries. This paper, bringing out the many shortcomings of the New Pension System in India, examines the need to include the default option in the scheme. The default option is a necessity to make the dc system more acceptable and successful. A number of countries have this option but not India. A model portfolio is also proposed.


Does Not India Need a Default Option in the New Pension System?

H Sadhak

Pension reform modules that take care of the changing demographic profile of a population have put forth a number of suggestions. The accepted defined benefit pension system, which was the broader goal of a welfare state, is slowly giving way to the defined contribution system where risk is borne by the final beneficiaries. This paper, bringing out the many shortcomings of the New Pension System in India, examines the need to include the default option in the scheme. The default option is a necessity to make the DC system more acceptable and successful. A number of countries have this option but not India. A model portfolio is also proposed.

The author is thankful to S Doss, National Insurance Academy, Pune for support in statistical analysis in the proposed default option, and to Rajas Parchure, Gokhale Institute of Economics and P olitics, for going through the first draft and offering valuable suggestions. This is an academic exercise and the views expressed here are the p ersonal views of the author. Neither the views nor the simulated results in this article are to be considered as any form of recommendation.

H Sadhak ( is Chief Executive Officer of the LIC Pension Fund and is based in Mumbai.

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1 Pension Reforms and Defined Contribution System

hanges in the demographic profile, the gradual withdrawal of the State from direct social security support, the unsustainable fiscal burden of the defined benefit schemes of savings/retirement and the readjustment of state p olicy with the emerging economic reality, etc, have thrown challenges to old age survival. It is not a cause of concern for the individual only but also a great challenge to the community, economists, politicians and policymakers as a whole. The defined benefit (DB) or pay as you go (PAYGO) pension system is used widely as part of a broader goal of a welfare state. But in a marketdominated emerging economic environment, DB has been gradually losing its utility due to the fiscal burden on the state exchequer. Pension reform, therefore is not only an economic necessity but also a social priority, and has emerged as the focal point of concern/discussion of our times. Experts and policymakers all over the world have advanced a number of suggestions and s olutions to tackle the devastating impact of the unsustainable unfunded DB system. However, the most talked about and well accepted among them is the defined contribution (DC) system characterised by self financing and risk sharing by the members. DC is a system of individual choice and action. Under such a system the capital market risk is borne by the participants/members of the pension system, who are the final beneficiaries. Though employers often contribute a part of the pension contribution they do not bear the risks or returns.

Reform Models

Though the developed and emerging countries are both facing the dilemma of pension reform, there is no uniformity among them as regards appropriate model of reforms and each country has adopted its own pension system depending on the social-political and economic needs and circumstances. However, they can be broadly clustered around models, namely, the parametric reforms and the systemic reforms (notional defined contribution).

While in the parametric reforms the risk is still borne by the pension providers, in case of systemic reforms longevity risks are transferred to the pensioners since the basic structure of pension changes from DB to DC.

Parametric reforms have been undertaken by countries which want to retain the existing unfunded PAYGO system through substantial enhancement of benefits, to take care of increased longevity. The important instruments to implement the parametric reforms are: increasing the pensionable age; changes in the rate of contribution and changing the earning base for calculation of

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pension; revaluation of past earnings for pension; indexation of pension, etc. Most of the Organisation for Economic Cooperation and Development (OECD) countries including Austria, Denmark, Germany, United Kingdom (UK), Netherlands, Italy, Hungary, etc, introduced parametric reforms. Systemic reforms, on the other hand, adopt a new system of funded DC by replacing the unfunded DB structure. The longevity risk is also transferred from the pension provider (under DB system) to the pensioners (under DC system). There are two types of DC model, namely, the multi-pillar World Bank model and notional defined contribution (NDC) model.

Under the DC system many countries have transformed their pension structure from defined benefits to defined contribution through mandatory privately managed individual accounts. The switchover to the new pension model has also encouraged replacing the single pillar system by a multi-pillar, mostly consisting of tax-financed unfunded first pillar for redistribution; a mandatory, privately managed fully funded pillar for retirement savings and; a voluntary pillar for additional savings for old age protection. Most of the Latin American countries (Mexico, Argentina, Peru, Bolivia, etc) following Chile have introduced three pillar pension reforms.

Notional Defined Contribution

Another kind of pension reform that is slowly being accepted by many countries is NDC, which attempts to integrate some characteristics of the DB and DC system. The NDC is a shift from DB plans to a notional account under which pension depends on the contribution of the member but the interest rate (notional) is decided by the government. Therefore, the rate of return and risk of investment depends on the centrally determined interest rate by the government and thus, individual i nvestment risk is relatively lower compared to the risk in the DC system. Countries like Sweden, Hungary, Poland, Italy, Estonia, etc, introduced NDC model for the second-tier system.

1.1 New Pension System in India

The Indian social security system suffers from many shortcomings, like poor coverage, increased burden on the exchequer, long-term fiscal unsustainability, absence of formal social security coverage to the unorganised sector, etc. Though India is still a young country with an average age of 26, increased longevity is pushing it towards an aging nation. As against the general population growth of 1.8%, the growth rate of elderly population is 3.8%. In spite of having several programmes (mostly for the

o rganised sector), 89% of the workers remain without any social security coverage, and according to some estimates there is no formal social security for 310 million willing workers in the unorganised sector. The civil service pension system has become unsustainable, as 12% of the tax revenue of the central government and 16% of the tax revenue of state governments was spent for pension payment in 2004-05. Therefore there was no alternative but to reform the existing pension system in India.

The process of pension reforms began in August 1998, when the Ministry of Social Justice sets up an eight-member interministerial expert committee under Project OASIS under the chairmanship of S A Dave. Subsequently several other committees and

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groups were formed which came out with various suggestions. Finally the government of India announced in the Union Budget 2003-04 the establishment of a New Pension System (NPS) initially to be available to civil servants and other workers and thereafter to be made available on a voluntary basis, to all persons including self-employed professionals and others in the unorganised sector. Accordingly the government of India introduced a new defined contribution pension scheme through a notification in December 2003. The new scheme came into operation with effect from 1 January 2004. The government of India established the Pension Fund Regulatory and Development Authority (PFRDA), on 10 October 2003, as the prudential regulator for the NPS.

Subsequent to the announcement of the central government about the implementation of the NPS, 21 state governments joined the NPS for their new employees. The NPS established by the g overnment of India is a fully funded defined contribution twotier system, which is mandatory for new recruits to the central government service except for those in the armed forces who joined services after 1 January 2004.

The individual account based NPS is a two-tier pension system, tier-1 being mandatory, non-withdrawable and tax d eferred p ension account; and tier-2: a voluntary, withdrawable s avings account.

Contributions and investment returns in the NPS would be deposited in individual pension account. As per the NPS rules, under tier-1, the employees will contribute 10% of the salary (basic+ dearness allowance) and an identical matching contribution by the government, totalling 20% contribution will be transferred to the pension account of the employees. In addition to the tier-1 mandatory pension account, each individual may also have a voluntary tier-2 withdrawable account at his option. This withdrawable account does not constitute pension investment, and would attract no special tax treatment.

In order to make the NPS a more effective retirement savings, there is provision for mandatory annuitisation. Individuals can normally exit at the age of 60 or at superannuation from tier-1 of the pension system. At the time of exit the individual would be mandatorily required to invest at least 40% of the pension wealth to purchase an annuity (from an Insurance Regulatory and D evelopment Authority (IRDA)-regulated life insurance company). However, in that case, the mandatory annuitisation would be 80% of the pension wealth. Every subscriber under NPS will be issued an unique permanent retirement account number (PRAN) by the central recordkeeping agency (CRA) which will maintain the functions of recordkeeping, accounting and switching of

o ptions by the subscriber. The PFRDA has selected the national securities depository Ltd (NSDL) as the CRA. The NPS is “portable” and the members will be entitled to switch over from one scheme to another scheme as well as from one fund manager to another fund manager.

In order to make the NPS more competitive and provide wider choice to the investors, the concept of multiple fund managers have been introduced. The subscriber will have a choice to select from multiple pension fund managers and multiple schemes. There will be no implicit or explicit assurance of benefits except market-based guarantee mechanism to be purchased by the s ubscriber. The PFRDA has selected three fund managers, namely, LIC Pension Fund, SBI Pension Fund and UTI Retirement Solution. Under the NPS, the pension fund managers will offer multiple schemes to the subscribers. The fund manager will offer three to four schemes to the government servants, viz, Option A, B and C based on the ratio of fixed income and equity. In order to provide wider choice to the subscribers, according to risk tolerance there will be a choice of (a) predominant debt-oriented schemes (low risk), (b) predominantly equity-oriented scheme (high risk), and

(c) balance schemes (medium risk). Though at present there are only two schemes – Scheme 1, allowing the fund managers to invest 85% in debt instruments, 10% in equity-linked mutual funds and 5% in equity, Scheme 2, is a 100% government securities (G Sec) fund (but not yet operational).

2 Investment Options in DC Pension System

The defined contribution pension system is characterised by selffinancing and risk sharing by the employees (or members), and emphasises the active participation of individuals by exercising choice – choice of fund manager, choice of investment plan, choice of asset allocation, etc. Ideally, an investor should take i nformed investment decisions through active participation, since the risk tolerance and return requirements and time horizon of investment differs from investor to investor. However, very

o ften, this does not happen and the members remain reluctant to select a fund/portfolio, or even to participate in the system, if it is not mandatory.

There are also a number of investment options under defined contribution schemes, which are mostly the combination of risks and returns of different degrees. There are equity-oriented schemes, debt-oriented schemes, balanced schemes, and government security oriented schemes. However, it has been observed that most often investment decisions and selection of funds is left to fund managers by opting for default funds. The popularity of default funds is increasing day by day in the United States (US) and other countries in spite of the efforts of the government and employers to induce the employees to select appropriate funds themselves.

Default option is an alternative to the active choice of portfolio selection in a defined contribution pension plan. Due to a variety of reasons, when someone is unable to take an active decision, she/he may leave it to the professional fund manager under a default option having an outline of predetermined pattern of a sset allocation and often have legislative support to the default option. Asset allocation, however is age-based instead of riskbased like that in general mutual funds. The default option takes away the burden of employees to venture into the complex world of asset allocation, which can be left to the professional fund managers. Moreover they are free from complex number-crunching to select an appropriate fund, instead of that the employees can select a single fund, i e, default option.

Crongvist and Thaler (2004) in their study of retirement funds in Sweden have observed that when in 2000 Sweden privatised the social security, 43.3% of new participants chose the default plan for retirement savings, despite the fact that 456 plans were available for selection. This percentage further increased to

62 91.6% after three years, in spite of several attempts by the government to motivate employees to choose specific plans. In recent times employees in the US have been going in a big way to select default option for retirement savings. In a recent study Choi, Madrian and Metrick (2003) observed that up to 80% of assets in different plans are invested in default plans. The same trend is also noted in the UK. A study conducted by the consulting firm Hewitt Bacon and Woodrow observed that 80% of the members of group personal pension schemes in UK accepted the default

o ption provided by the plans (Bridgeland 2002). Pension Decision Research, a pension research company in the US, after studying 31 large plans across eight different sectors found that 80% of employees favoured default funds rather than alternatives put forward by their employers.

Financial planners and economists are often puzzled at the factors behind the growing popularity of default investment plans. One of the reasons may be the lower level of financial l iteracy to choose an appropriate investment plan for retirement savings. Asset allocation is a technical job requiring a wide spectrum of knowledge in economic and financial parameters, understanding of duration and timing for rebalancing of assets risk a ssessment in respect of financial instruments and total portfolio, etc. In fact, in a highly developed literate country like the US, the employees find it difficult to take decision to select a fund for their savings plan. A survey of defined contribution savings plans in the US conducted by John Hancock Financial Services (2002) reported that 38% of respondents have little or no financial knowledge, 40% respondents reported that they believe money market funds contain stocks and two-thirds of respondents did not know that it was possible to lose money in government bonds. A similar trend was also observed in Japan in a survey on financial literacy conducted by the Pension Fund Association of Japan in 2007 among the DC plan sponsors and participants. It noted that 53.2% respondents do not understand how DC plans work. This shows why it is so difficult for any employee to select an appropriate investment plan for their retirement savings. The complexity of asset allocation also leads the employee to delay enrolment which has been noted by Iyengar, Huberman and Jiang (2004). They also observed a negative relationship between the number of funds offered in the 401(K) Plan and 401(K) participation rate. More the funds, less the participation rate. Behavioural econo mics has forwarded some explanation through non-standard theory of self-control problems. Della Vigna (2007) in the pioneering research paper “Psychology and Economics” mentioned that: “Evidence from the field observed that individual preferences are assumed to be time consistent and independent of the framing of the decision – but laboratory experiment shows that the decisions are time – inconsistent.”

In view of the factors mentioned above and due to other reasons, the regulators, particularly in emerging markets moved very cautiously in designing pension products.

During the first two decades of pension reforms in Chile, participants were not allowed to exercise active choice of fund selection, and in 2002, the fund managers were allowed to offer only five investment option. Mexico introduced a still more conservative approach. In order to overcome the constraints of defined

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contribution pension, attention has been diverted towards the default option, which provides some answers to choice r elated problems.

Life Cycle Investment in Default Option

In spite of the proliferation in the number of plans, the most p opular pension plan in the US and many other countries like UK, Sweden, etc, default option has emerged as the most popular pension plan. The default option is a variant of life cycle plans and is being called the pension plan of the future. However, among the declared pension schemes in India, default option has so far not featured. This paper attempts to examine whether, there is any need to have the default option in our NPS. Default option is a variant of the life cycle funds used for enhancing retirement savings and risk adjusted returns in a DC pension system. The concept of life cycle funds is basically built upon the theory of life cycle consumption and portfolio choice, which help designing financial plans for retirement savings. The concept of life cycle savings is centred around among others, the age of the investors which is a determinant of risk tolerance limit. The model assumes that the age of the investors has a significant implication on the risk exposure as such and with ageing the i nvestor tends to reduce risk exposure. The life cycle portfolio model also broadly provides guidance to investors about present and future savings and investing, therefore, it is a great help to our investors, to plan retirement savings and investing. Bodie et al (2007) emphasised the life cycle portfolio approach for such a retirement savings plan. Therefore any default pension plan built upon life cycle savings and consumption needs to reflect on the consideration of total wealth.

Another distinctive characteristic of life cycle default option asset allocation is its focus on the age of investors and the horizon of investment, and the model is called “age-based investing” as against risk-based investing by mutual funds and asset management companies. In case of mutual funds and other return maximising investing companies, the fund managers focus on risk adjusted return through portfolio diversification. Mutual funds investing and asset allocation are basically driven by the concept of mean variance analysis, with emphasis upon risk minimisation through portfolio diversification over a single p eriod and the same assets are maintained in the portfolio, i rrespective of changes in the risk tolerance level which varies with the age of investors. Risk-based investing therefore fails to take care of investing risk that is associated with retirement investing and the concept of age-based investing is a better solution for retirement investing. Age-based saving is strongly rooted to the risk tolerance level of investors and long-term return of securities.

Types of Life Cycle Funds

In order to understand the operating mechanism of life cycle funds, we may refer to such funds as in operation in the US. In the US, a wide variation is observed in the types of default life cycle funds though the basic principle of default fund, i e, agebased investing is the same everywhere. Therefore, there are a variety of default funds, which are broadly categorised as

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lifestyle life cycle, target retirement funds, etc. Though often lifestyle funds are termed as default funds, they are basically mutual funds, because lifestyle funds are risk-based rather than age-based. A ccording to Viceira (2007) the main characteristics of lifestyle funds is that “they change the stock exposure of the fund as a function of investors risk tolerance” where as the life cycle fund reduces the “stock exposure of the fund as their target maturity date approach”. Life cycle funds are age-based asset allocation funds and the portfolio gets readjusted not with the changes in the market but with the changes in the age profile of investors, which is decided at the beginning. According to Kintzel (2007) “The General Life Cycle proposition calls for investment portfolios that hold a decreasing proportion of assets in equities (associates with higher risk) and a greater proportion in fixed return investments (associated with lower risk) as an individual ages”.

Public Policy for Default Option

Public policy aims at protecting the interest of investors selecting the default option by providing guidelines on product design and asset allocation pattern. Public policy also focuses on quantitative restrictions on asset allocation and the required changes in portfolio over period of time depending on the changing age p rofile which influence the risk tolerance level of subscribers/ members. Public policy is therefore an attempt to put in place an age-based investment model in place of the risk-based model. We may examine the nature of such policies in some countries.

Chile: In Chile, the legislative measures for default funds are linked to the age of the members. There are four funds, differentiated by the limit of equity investment. The maximum and minimum equity investment in Fund A is 80% and 40%, while for Fund B, it is 60% and 25%, Fund C it is 40% and 15% and Fund D 20% and 5%. Fund B is mainly a fixed income securities fund. The rule divides the members into three age groups and allows default investment in B, C and D type of funds, Fund B is assigned to men and women below 35 years of age; Fund C is assigned to men between 36 and 35 years and women between 30 and 5o years of age; Fund D is assigned to men older than 56 years and women older than 51 years of age.

Sweden: Sweden introduced the contribution based DC system of financial accounts, or the FDC system administered by the P remium Pension Authority (PPM). The insured may choose a maximum of five different funds, approved by FDC. The PPM r equests the new entrants to choose a fund. However, when an individual does not choose a fund, her/his contribution is deposited in a default fund, called the Seventh AP Fund, which is an independent government agency.

Australia: In Australia, regulatory requirements call for trustees to identify a default strategy whenever an investment choice is offered to standard employee-sponsored members and most of the superannuation funds default option – which is basically a balanced fund which normally follow a balanced diversified p ortfolio – spreading investment across the regions and across

the instruments. There is no age-based portfolio differentiation required liquidity to overcome the unforeseen need for payments
but a wide range of instruments have been included in the to the investors, to protect the investors from any drastic slump in
p ortfolio with relatively higher weight age to stocks (Australian the stock market, and default by the bond issuers. Therefore, in
and international shares). order to reduce the systemic risk a diversified portfolio of securi
ties must be considered.
US: The Pension Protection Act in the US requires that the department of labour (DOL) provide fiduciary protection for default Table 1: Indicative Portfolio of Non-Default Funds (%) Fund Type Equity Debt/Bond Liquid Stocks Total Expected Risk-Return
investment in the defined contribution plan. In the light of this Equity fund 60- 70 20-30 10-20 100 High risk
provision, DOL issued the regulation for qualified default invest- High return
ment alternatives (QDIA). According to this regulation default Bond fund 20-30 10-20 100 Moderate risk
funds would include diversified portfolios including balanced funds, life cycle or target dated funds and managed accounts. 60-70 Moderate return G Sec fund 10-20 70-80 10-20 100 Low risk Low return
Default options are also legalised in many other countries
i ncluding Italy, Russia, Slovakia, etc. But many countries includ- The portfolio suggested under the three funds – based on
ing the Czech Republic, Israel, Poland, South Africa, etc, do not e quity, bond and G Sec – are factors like risk tolerance level, low
have a default option. per capita income of investors, and also from the fund manage
ment perspective.
3 Designing Investment Options in DC Pension System
Pension funds are life saving devices for retired employees, Equity Fund: Though in a DC system the investors exercise active
therefore utmost care should be taken to protect the pensioners choice and bear the risk but fund managers and regulators have
to earn enough returns in their post retired life. Though, theo the responsibility to ensure safety of funds and reasonable return
retically the investors are expected to exercise active choice, as to the retiree. Therefore, some amount of diversification among
we have noted in reality it does not happen. Therefore, the funds the various asset classes would be a prudent decision. Such diver
should have an automatic protection mechanism in the form of sification would not only protect the asset base in time of extreme
asset diversification. This precaution is much more required in a market decline but also provide liquidity in a situation of quick
country like India, which has low level of financial literacy and cash requirement.
low per capita income. Care should be taken to d esign such A recent study by OECD (“Pension Market in Focus”, December
funds. Some recent studies have shown that a large number of 2008, Issue 5) mentioned that “by October 2008, the total assets
investors are not fully equipped to exercise active investment of all pension funds in the OECD countries had declined by about
choice for retirement savings. A survey by Securities and Ex $3.3 trillion or nearly 20% relative to December 2007. Including
change Board of I ndia (SEBI)-National Council of Applied Eco other private pension assets, such as those held under personal
nomic Research (NCAER) on Indian investors (2000-01) showed pension plans in the United States (i e, IRAs) and in other coun
that “the behaviour of investor households has generally shown tries, the loss increases to about $5 trillion”. The study has fur
negative correlation between the degree of risk and choice of ther shown that the devastating effect was more in countries
instruments of investment…it is because Indian investors are “where equities represent over a third of total assets invested”,
risk averse and they go for investment offering moderate return with Ireland the worst hit at -30% (equity exposure of Irish
and lower or nil credit risk”. A study by NCAER-Max-New York p ension fund is 66% on an average). Pension fund investment is a
Life (Shukla 2008) quotes D Swarop of PFRDA, “The main chal long-term proposition and the fund is expected to undergo
lenges, to my mind, are to empower the subscribers to take s everal business and stock market cycles. Hence prudence in
a ppropriate investment decisions based on their risk and return portfolio design is absolutely essential.
profile, provide safety and high returns, extending coverage to
as many people as possible and to improve financial literacy Bond Fund: Bond funds consist of corporate bonds and debt in
l evels.” Therefore while designing a pension fund one should struments including those issued by the public sector and govern
keep in mind the socio-economic environment, level of financial ment companies and are considered to be less risky than corpo
literacy, etc. Moreover the investors should be able to identify rate equity. However, it should be borne in mind that by design
themselves with such funds and at least be able to assess the the Indian bond market has yet to gain the required depth. There
implicit risk level. are not many quality papers and bond trading is extremely thin.
Further, there would be a need for quick cash in case death takes
3.1 Designing Portfolio of Non-Default Pension Options place. Therefore an inbuilt provision is to be made for such a situ-
Though our primary focus in this paper is the life cycle default ation by keeping at least a small percentage of assets in liquid
option, we would like to propose indicative portfolio option for i nstruments. Therefore a small percentage of equity in bond
some non-default funds like equity fund, bond fund and govern funds would enable the funds to maintain a reasonable return in
ment securities fund which according to investors’ perception are the interest of investors.
high risk-high return funds, moderate risk-moderate return funds
and low risk-low return funds. While designing such funds we Government Securities Fund: As in the case of bond funds, the
have kept in mind that any pension fund should have minimum government securities funds should be a semi diversified fund
64 november 14, 2009 vol xliv no 46 Economic & Political Weekly

with liquid assets as well as some equity since the return from government security is very low.

3.2 Designing Life Cycle Fund (Default Option)

There are several innovative life cycle default option plans in the US and other countries based on a variety of assumptions, but they mostly focus on the age based allocation in equities. The most well-known thumb rule approach is “100 minus age”. This rule dictates that equity portion would be an amount equivalent to 100 minus age. If age of an investor is 30 years, the equity in the portfolio would be 70%, i e, 100-30 (Malkiel 1990). Similarly there is another thumb rule “your age in bond” which dictates the percentage of bond in portfolio would be equivalent to the age of investor, i e, if the age of an investor is 30, the bond in the portfolio would be 30%. Hickman et al (2001) analyse “your age in bond” by using the Monte Carlo simulation. There are several other studies by eminent authors on how to determine allocation of assets for retirement funding. The Shiller (2005) Plan is the life cycle model which is aggressive at a young age and tends to become conservative at a later age. According to Carroll et al (2005), “Defaults may be socially optimal when agents have a shared optimum and the default leads them to it”.

Low and High Risk Default Options

Against the backdrop of the above discussions, it is absolutely necessary that in India we need to have a two default option for members with low and high risk tolerance level and to encourage them to exercise their option to select a need base default option (semi active decision). We have adopted the thumb rule of “age” in designing the options and deciding the proportion of bond and equity investment. Option A can be called the “age in bond default option” due to its emphasis on bond/debt investing. This is a less risky default option. Option B can be called as the “100 minus age” which is riskier than default option A but the risk is much lower than a portfolio with 100% equity investment.

Asset Allocation under the Proposed Default Option A

Asset allocation under the options have been formulated on the assumptions of two major considerations, namely, investment h orizon and level of risk tolerance “age in bond” asset allocation model, meaning that the percentage of assets in bond/debt would be equivalent to the age of the investor (Table 2). Upper age limit of the group has been considered for the purpose of bond/debt investment. Asset allocation begins with allocation of bond which is equivalent to the upper limit of age in the group.

This age in bond default life cycle model is designed for investors with a lower level of risk tolerance. In this fund initial equity

Table 2: Asset Allocation under Default Option A (Age in Bonds)

Age Government (Corporate Debt-Max)* Domestic Equity (Foreign Cash/Other***
Group Bonds Equity-Max)**
25- 35 35 (15) 55 (15) 10
36-45 45 (15) 45 (10) 10
46-55 55 (20) 35 (5) 10
56 and above 60 (20) 25 (nil) 15

* allowed from permissible limit of government bond. ** allowed from permissible limit of domestic equity investment. *** include fixed deposits with banks, investment in mutual funds, money market instruments, etc. Source: Author’s assumption.

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component would be higher (55%), and thereafter it tends t owards bonds/debt (25%) as retirement approaches. Investment in bonds/debt would be proportionate to the age of the investor at all times and the remaining assets would be allocated for e quity and other instruments. It is also felt that the portfolio would better serve the needs of the unorganised sector, particularly those who are with lower level of risk tolerance.

Asset Allocation in Default Option B (100 Minus Age)

In this model allocation begins with higher equity investment and thereafter the balance amount is invested in debt and other instruments (Table 3). For example, an investor who is 20 years old would invest 80% (100 minus 20) in equity. However, as the investor moves towards retirement the portfolio weight to equity reduces and that of bond/debt increases. It is also assumed that some percentage of equity funds will be invested in foreign equity and corporate debt for diversification and better return.

Table 3: Asset Allocation under Default Option B (100 Minus Age)

Age Group Domestic Equity (Foreign Equity)* Government Bonds (Corporate Debt )* Other***

20- 34 80 (5) 20 (10) 0

35-44 65 (5) 30 (15) 5

45-54 55 nil 35 (20) 10

55 and above 45 nil 45 (25) 10

* allowed from permissible limit of domestic equity investment. ** allowed from permissible limit of government bond. *** include fixed deposits with banks, investment in mutual funds, money market instruments, etc. Source: Author’s assumption.

4 Risk Adjusted Return under Proposed Default Options

Keeping in view the suggested default options and asset allocation pattern as above, we have made an attempt to see the risk return relationships in our portfolio and terminal pension wealth of an employee. Though our primary objective is to examine the risk adjusted return under to default option which replicate to some extent the balanced funds, we have also examined the risk return relationship of the portfolio of 100% investment in government security or 100% investment in equities. Accordingly, our investigation includes four types of asset allocation pattern.

  • Risk adjusted return in default option (A).
  • Risk adjusted return in default option (B).
  • Risk adjusted return of portfolio with 100% investment in debt instruments.
  • Risk adjusted return of portfolio with 100% investment in e quities.
  • A portfolio with 100% investment in government securities would be considered as the benchmark for risk-free asset and the risk (return performance of the earlier models would be evaluated against this model); while a portfolio with 100% a sset allocation in equity fund could be used to evaluate and determine the optimum scope of equity exposure for the p ension fund.

    The asset allocation strategy based on the age factors upper and lower age of the investors under Model A, the upper age range of these different age groups would be considered as the adequate exposure for secured investment, i e, bonds and the rest of the assets would be invested in domestic equity and other investment instruments like fixed deposits, mutual funds and money market, etc. Here the ratio of equity, government securities and others would approximately be 40: 50: 10. Hence, this model can be considered as the balanced model. Under Model B, the same concept would be applied for assets, where the equity exposure of the investment would match 100 (the entry age), of the e mployee, e g, if the entry age of an employee is 20 years, then 80% (100 minus 20) of his investment would be made in equity and the rest in securities like government securities, bank deposits, corporate bonds, etc.

    4.1 The Data and Assumptions


    (i) Yield on subsidiary general ledger (SGL) – with 10 years maturity – from 1981 to 2008 has been considered as the indicator for government security return, (ii) Bombay Stock Exchange (BSE) indexed (national) values from 1981 to 2008 were used as proxy for equity returns, (iii) Long-term deposit rates (above five years) from Reserve Bank of India (RBI) for the period from 1981 to 2008, (iv) Consumer price index (CPI) values for industrial workers for the 1981 to 2008 has been taken as the indicator for inflation, and (v) RBI’s prime lending rates (PLR) have been collected and the inflation adjusted real interest rates were also calculated (PLR – CPI).

    Stock returns were calculated on the basis of harmonic mean by calculating the growth rates using the formulae

    t0 – t–1

    LN *100 t0


    To evaluate the performance of the above asset allocation m odels, the following assumptions and the necessary preliminarily analysis have been considered as relevant:

  • * In every age group, the model provides the accumulated fund value at the end of the term, which would help evaluating the d ifferent risk-return options.
  • * Every month Rs 2,000 is deposited in the pension account of an employee (Rs 1,000 by the employer and Rs 1,000 by the e mployee).
  • * A compounded accumulated fund value is estimated at regular time intervals – at the end of 10 years, 20 years, 30 years and 35 years, respectively.
  • * The monthly contribution of Rs 2,000 is compounded to an annual lump sum of Rs 24,904 with a monthly average interest rate of 0.67% that has been compounded for 12 months (an a nnual savings rate of 8% (one year bank deposit rate) is assumed to estimate the compounded annual value).
  • * The projection of future accumulated pension fund values for the various terms (10 years, 20 years, 30 years and 35 years) were estimated using simulated returns obtained from Monte Carlo simulation.
  • * Since we intend to project long-term wealth accumulation, say 30 to 35 years, reasonably a longer term, almost 28 years (1981 to 2008) historical annual data of all the essential variables, i e, equity returns, SGL yield at different maturity periods, long-term deposit rates (above five years) were used. CPI, and
  • 66 RBI’s prime lending rates, were compiled and used for the analysis.

  • * Further, keeping in view the long-term projection of asset a ccumulation, the long-term historical data were used in the analysis, it has been assumed that interest rates, and SGL yields in the long period would follow a normal distribution, and the stock r eturn is expected to follow log-normal distribution.
  • * The annual compound value (Rs 24,904) was first apportioned in the same ratio of asset allocation as proposed in all the four models. Then, the future accumulated fund values were estimated for various period of time (at the end of 10 years, 20, 30 and 35 years) using the simulated return values forecasted at the corresponding period of time for the selected asset mix.
  • * The Monte Carlo simulation model has been used to examine the relative performance of the proposed default options portfolios with different asset allocation options. Second, to estimate the future accumulated pension fund values at different p eriods of time (at the end of 10 years, 20, 30 and 35 years), the future return values of all the important parameters (yield on SGL, stock return, long-term bank deposit rates, and CPI values for industrial workers were generated by using the past trend of their distribution with the necessary model parameters with the help of the Monte Carlo simulation method with 1,000 runs. Further, the simulated values were validated by examining the descriptive statistical values of these parameters as well as their visual plots of their respective distribution. All these measures indicated that the simulated future returns of these parameters significantly represents the past trend of their r espective d istributions.
  • * Table 4 exhibits the future forecasted return values for the s elected parameters at different periods of time (10, 20, 30 and 35 years) as well as their mean return values and the standard deviations. All these values again conform to the long-term a verage return values of these parameters as suggested in the earlier studies.
  • Table 4: Return Forecast
    As we notice
    Forecasted Returns
    from Table 4, the Forecast Years Types of Investment
    long-term return SGL Equity (%) Others
    values of SGL for First 10 years 9.50 14.48 8.00

    Next 10 years 9.00 11.77 8.50

    30 years maturity

    Next 10 years 8.50 19.82 7.90

    has a mean value

    Last 5 years 8.05 20.00 7.03

    of 10% with the

    Overall mean 10.13 16.08 8.00
    standard devia-
    Overall stdev 2.19 20.17 1.79

    tion of 2.19. The overall values of the stock return also indicates a mean return of 16% with standard deviation of 20% and the long-term deposit rate is well with the overall mean return of 8% and standard d eviation of 1.76.

    5 An Evaluation of Performance of Wealth Accumulation

    In order to assess the relative risk adjusted return of default

    o ptions we have worked out the fund values under different models on the basis of the assumption outlined above and forecasted return from various financial instrument. The future fund values were obtained by compounding the simulated return values for the different selected time periods.

    november 14, 2009 vol xliv no 46 EPW Economic & Political Weekly

    Table 5: Default Option A (Age in Bond) Portfolio Asset Allocation of risk adjusted return of default portfolio with that

    (Monthly Contribution = Rs 2,000 Assumed Annual Return = 8% Annual Compounded Value = 24,904)

    of portfolio of 100% investment in equity and a port-

    Age Groups Asset Distribution Cumulative SGL Equity Others Total Fund Value folio with 100% investment in G Sec will give us fur-

    Annual contribution 8,717 13,697 2,490 24,904 ther ideas about the relative risk and return under

    25-35 years 1,35,632 2,71,140 36,078 4,42,850 respective models. Therefore we have made an esti(The fund is invested for 10 years) (The fund value at the end of 15 years) 4,42,850

    mate of return and pension wealth under two types

    Annual contribution 11,207 11,207 2,490 24,904

    of portfolio, i e, a portfolio of 100% investment in

    36-45 years 1,70,267 1,94,495 36,946 4,01,708

    e quity and a portfolio with 100% investment in gov-

    The fund is invested for 10 years 1,99,283 1,99,283 44,285 4,42,850

    ernment securities on the basis of the assumptions

    (Fund value at the end of 20 years) 4,71,774 6,06,348 1,00,128 11,78,250 7,76,542

    under default option.

    Annual contribution 13,697 8,717 2,490 24,904

    46-55 years 2,03,203 2,24,268 35,907 4,63,378

    Risk Adjusted Return of a Portfolio with 100%

    The fund is invested for 10 years 4,27,098 2,71,790 77,654 7,76,542

    Investment in Equity

    (Fund value at the end of 30 years) 9,65,662 16,57,777 1,66,104 27,89,543 32,52,921

    Annual contribution 13,697 8,717 2,490 24,904 Assuming that our investor has a very high risk tol

    56-60 years 80,438 64,878 14,330 1,59,646 erance level and the objective investment is to

    The fund is invested for 5 years 17,89,107 1138522 325292 3252921

    (Fund value at the end of 35 years) 26,34,875 28,33,008 4,56,879 59,24,762 57,65,116

    Total accumulated fund value 57,65,116

    Table 6: Default Option B (100– Age) Portfolio Asset Allocation

    (Monthly Contribution = Rs 2,000 Assumed Annual Return = 8% Annual Compounded Value = 24,904)

    achieve high growth, there one may select a portfolio of 100% investment in equity. Accordingly, the accumulated wealth will be much higher than even the default option with a predetermined portfolio as indicated in Table 7. The risk adjusted return after

    Age Groups Asset Distribution Cumulative30 years and 35 years is expected to be Rs 71,53,569 SGL Equity Others Total Fund Value

    and Rs 1,76,15,039, respectively.

    Annual contribution 4,981 19,924 0 24,904

    20-34 years 77,504 3,94,386 0 4,71,890

    Risk Adjusted Return of a Portfolio with 100%

    (The fund is invested for 10 years) (The fund value at the end of 15 years) 4,71,890

    Investment in G Sec

    Annual Contribution 7,471 16,188 1,245 24,904

    35-44 years 1,13,511 2,80,937 18,473 4,12,921 Now let us assume that our investor has very low

    The fund is invested for 10 years 1,41,567 3,06,728 23,594 4,71,890 risk tolerance level and prefers to select a least risk

    (Fund value at the end of 20 years) 3,35,140 9,33,268 53,347 13,21,755 9,08,834
    Annual contribution 8,717 13,697 2,490 24,904
    45-54 years 1,29,311 352,421 35,907 5,17,640
    The fund is invested for 10 years 3,18,092 4,99,858 90,883 9,08,834
    (Fund value at the end of 30 years) 7,19,200 30,48,879 1,94,401 39,62,480 44,80,120
    Annual contribution 11,207 11,207 2,490 24904
    55-60 years 65,813 83,414 14,330 1,63,558
    The fund is invested for 5 years 20,16,054 20,16,054 4,48,012 44,80,120
    (Fund value at the end of 35 years) 29,69,108 50,16,588 6,29,241 86,14,937 84,51,380
    Total accumulated fund value 84,51,380

    fund, he/she can invest in a fund having 100% investment in government securities. Accumulated wealth under such a fund after 30 years become Rs 15,88,199 and after 35 years becomes Rs 21,92,742. Therefore the value of retirement wealth under this model, risk is much lower than the accumulated wealth under default options.

    Comparative pension wealth after 30 years and after 35 years under different portfolio options given

    in Table 7.

    It can be observed that a fund having 100% investment in e quity is expected to provide comparatively much greater fund value and retirement income to an investor but looking at the volatility of

    Table 7: Comparative Return under Default and Non-Default the stock Options

    Risk Adjusted Return under Default Option (A): This model generates a future fund value of Rs 4,42,850 at the end of the first 10 years, then, Rs 7,76,542 at the end of 20 years, Rs 32,52,921 at the end of 30 years and finally, at the end of 35 years, Model 1 generates the accumulated fund value of Rs 57,65,116 (Table 5).

    Risk Adjusted Return under Default Option (B): The portfolio under this model consists of a larger amount of equity and thus is expected to provide higher terminal return. This portfolio generates accumulated retirement wealth of Rs 44,80,120 after 30 years and Rs 84,51,380 after 35 years basically due to higher a llocation to equity (Table 6).

    5.1 How Default Options Compares with Non-Default Asset Allocation Models?

    The performance of default options having predetermined asset allocation pattern can be evaluated by comparing the accumulated future values generated by the default portfolio at the end of age 30 years and 35 years, respectively. Further a comparison

    Economic & Political Weekly

    november 14, 2009 vol xliv no 46

    market it is Fund Option Pension Wealth (Amound in Rs)
    not advisa- After 30 Years After 35 Years Risk Profile
    ble to invest Government security fund 15,88,199 21,92,742 Least
    the retire- Equity fund 71,53,569 1,76,15,039 Highest
    mentings sav com- Default option (A) Default option (B) 32,52,92144,80,120 57,65,11684,51,380 Low High

    pletely (100%) in equity as in the worst case scenario, it can wipe off the long-term savings of the retired persons drastically. On the other hand, investing entire savings into debt instruments would generate insufficient wealth to comfortably take care of retirement needs. However, the risk content under a portfolio of 100% equity can be reduced by including some debt instrument as indicated in Table 1 (p 64) and retirement wealth under the portfolio having 100% investment in G-Sec can be improved by i ncluding some equity instruments in the portfolio as also However, expected return at each level, needs to be calculated i ndicated in Table 1. with realistic assumptions of equity and bond/debt market

    The models/portfolios proposed here are the indicative mod-r eturns in the backdrop of expected volatility. More analysis els in the context of the prevailing and expected macroeconomic would be required to put in place the final default model. Howenvironment, financial market, state regulation, perception of ever, there is no denying that default option is a necessity to make risks, age of retirement from working, state of healthcare, the DC s ystem more acceptable and successful, particularly to the

    l ongevity, etc, which may undergo a change over the long run. u norganised sector.


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