How return to pay-as-you-go pension scheme could turn into a fiscal disaster

The PAYG scheme was in vogue in most countries prior to 1990's, but was discontinued given the problem of pension debt sustainability, an ageing population, explicit burden on future generation and the incentive for early retirement (as the pension is fixed at the last drawn salary). The PAYG scheme thus had no accumulated funds and or stock of savings for pension obligations and hence was a clear fiscal burden

An increase in the old-age dependency ratio imposes significant demands on the working-age population to maintain the intergenerational flow of benefits to the pensioners and to that extent PAYG scheme is unfair to the younger generation, says Soumya Kanti Ghosh, SBI group's chief economic advisor

Mumbai: Pay-as-you-go (PAYG) pension scheme is unfair to the younger generation, says an internal economic research study by SBI. Recently, State governments of Rajasthan & Chhattisgarh have reverted back to this old pension scheme. PAYG scheme is commonly defined as an unfunded pension scheme where current revenues fund pension benefits.

India had a PAYG scheme prior to 2004. Under such a PAYG scheme, the contribution of the current generation of workers was explicitly used to pay the pensions of current pensioners. Hence a PAYG scheme involved a direct transfer of resources from the current generation of tax payers to fund the pensioners. The PAYG scheme was in vogue in most countries prior to 1990s, but was discontinued given the problem of pension debt sustainability, an ageing population, explicit burden on future generation and the incentive for early retirement (as the pension is fixed at the last drawn salary). The PAYG scheme thus had no accumulated funds and or stock of savings for pension obligations and hence was a clear fiscal burden. Interestingly, the PAYG scheme is always an attractive dispensation for political parties as the current aged people can benefit from PAYG even though they may not have contributed to the pension kitty.

Is the PAYG scheme fiscally viable? First, the trends in the pension liability of the State governments over the long run shows a very sharp increase. The CAGR in pension liabilities for the 12-year period ended FY22 was at 34 per cent for all the State governments. As on FY21, the pension outgo as percentage of revenue receipts is around 13.2 per cent for all states combined and 29.7 per cent of own tax revenue. In fact, 56 per cent of expenditure of the states that is committed (interest payments, salary and pension payments) is met out of state revenue receipts. In FY21, the total committed expenditures of states as a percentage of state own revenue receipts was at a staggering 125 per cent. For larger states like Punjab, the committed expenditure is as high at 80 per cent, followed by Kerala (73.9 per cent) West Bengal (73.7 per cent) and Andhra Pradesh (72.2 per cent) as a percentage of state revenue receipts. If we take the committed expenditure as a percentage of state own tax revenue, these numbers are higher by 149 per cent -191 per cent for these 4 states.

Secondly, PAYG financing often masks the long-run cost of promised pension obligations. One way to estimate it is to quantify the present value of this future stream of expected benefits known as the 'implicit public pension debt.' This implicit debt is a complicated function of the number of workers and retirees, entry age of workers, the expected life spans, the size of the average benefit, the retirement age and the discount rate used to calculate the present value.

We endeavoured to quantify the implicit pension debt in the Indian context through the following methodology. In respect of National Pension Scheme (NPS), data on the state-level participants is not available. Consolidated data given by NPS Trust informs us that there are 55.44 lakh contributing state-level employees as of Feb 2022. If we assume that all states migrate to the old scheme, and assuming an entry level age of 28 years, with a 5 per cent inflation indexation, the current present value of the implicit pension liabilities is around 13 per cent of GDP, discounted by the current G-sec yield on 40 years. This is the implicit pension debt that will be unfunded as per the PAYG scheme.

The above fact clearly underlies World Bank's warning that PAYG schemes are illusory. Specifically, when the population is young it induces the government to offer generous benefits as the costs are low. But the implicit pension debt will explode rapidly as population ages.

Thirdly, India's demographic profile is currently undergoing a structural change with declining fertility, increasing longevity and an ageing Southern States coupled with young Northern States. As per India's demographic profile, the Ageing Index (adapted from Rakesh Mohan, 2004) for India defined as the number of persons 60 years old or over per hundred persons under age of 15 years is likely to reach 76 by 2036 from the current value of 40. The old-age dependency ratio defined as the number of persons 60 years and over per one hundred persons 15 to 59 years is to touch 23 per cent by 2036 from current 16 per cent. By 2050, India's population will be 164 crores, out of which 32 crore will be of age 60 years and above.

"An increase in the old-age dependency ratio imposes significant demands on the working-age population to maintain the intergenerational flow of benefits to the pensioners and to that extent PAYG scheme is unfair to the younger generation," says Soumya Kanti Ghosh, SBI group's chief economic advisor.

Taking all these factors into account, the Government had moved to a system of defined contributory pension benefit scheme, NPS in 2004. All states have migrated to NPS, with the exception of West Bengal and Tamil Nadu.

The current government has taken many steps to make the NPS scheme attractive. The Government now makes a 14 per cent matching contribution against the 10 per cent monthly contribution of employees. Secondly, the Government has also notified that subscriber would be adequately compensated for any non-deposit or delayed deposit of contributions during 2004-12. Thirdly, the employee has now the exclusive right to choose the fund manager and his investment pie. There is an additional yearly tax rebate of Rs 50,000, 60 per cent of the corpus is tax free and the entry age has now been raised to 70 years.

Going forward, the NPS scheme can be made further attractive, by incentivizing SME/MSME sector covering its employees to be covered under NPS. Secondly, it is mandatory for any company with more than 20 employees to file EPFO employee contributions. This can be made more flexible by introducing NPS and allowing the corporates to select between EPF & NPS.

Thirdly, the government may increase tax benefit on employer's contribution for tier- I account holders from existing 10 per cent of Basic + DA to 14 per cent of Basic + DA (at par with Central govt employees). Finally, the government may further extend the benefit of tier-II tax saving schemes to all citizens of India.

We should not commit fiscal hara-kiri in the quest for populism. Otherwise, it will be disastrous for the country's growth potential and at the same time place higher burden on our younger generation, the report says.