New pension scheme is better than the old one. Are state governments listening?

Also read: Decoding Punjab government’s decision to restore OPS

Here’s all that you need to know about the two pension schemes and how the move affects government employees and pensioners.

What is the old pension scheme (OPS) for government employees?

Pension payouts of central government employees who joined the workforce before January 1, 2004 are managed under the old pension scheme.

The formula for pension payout is fixed—50 percent of the last drawn basic pay plus dearness allowance at retirement or average emoluments earned in the last ten months of service, whichever is beneficial to employees. The employee should have completed at least ten years of service.

"Dearness allowance is linked to inflation and hence, can go up,” says Virjesh Upadhyay, former member of the Central Board of Trustees, Employees Provident Fund Organisation (EPFO). Therefore, pension liabilities for the government will keep rising.

“In addition, family pension is paid out to family members of the deceased pensioners,” says Prableen Bajpai, founder of Finfix Research and Analytics, a financial advisory firm.

Then, there were other advantages too. “Employees did not have to contribute towards pension under OPS. However, they should also remember that even now, the government, is contributing to the fund. Earlier, employer contribution was hidden,” says Upadhyay.

Given the assured payouts, no deduction towards pension from their salaries and financial security for their families after their death, it is not surprising that many employees favour the restoration of the old pension system.

Also read: Tax benefits that come with investing in NPS

Why was the new or National Pension System (NPS) for central government employees introduced?

The Centre introduced the new or National Pension System for its employees (except armed forces) who joined the workforce after January 1, 2004. Subsequently, most state governments, barring Tamil Nadu and West Bengal, too, switched to the new regime.

“The shift was necessitated by the growing pension liabilities of various governments. OPS was simply not feasible for the exchequer and it would be ruinous to go back to implementing it again," says Suresh Sadagopan, founder of Ladder7 Financial Advisories.

According to a State Bank of India (SBI) research note published in March this year, OPS, or pay-as-you-go-scheme, is simply an unfunded pension scheme where current revenues fund pension benefits.

“The trends in the pension liability of state governments over the long run show a very sharp increase. The CAGR (compound annual growth rate) in pension liabilities for the 12-year period ended FY22 was at 34 percent for all the state governments. As on FY21, the pension outgo as a percentage of revenue receipts is around 13.2 percent for all states combined and 29.7 percent of own tax revenue,” the research note said, explaining the pension liabilities’ chokehold over government finances.

An increase in the life expectancy of citizens, too, has added to the pension payout burden.

How does the NPS for government employees work?

Under NPS, government employees contribute 10 percent of their basic salary towards creating their retirement corpus, with their employer contributing up to 14 percent to the kitty. NPS is also open to private sector employees on a voluntary basis although some rules have been tweaked.

They can choose to invest across multiple asset classes—equity, corporate debt, government securities and alternative assets—although the overall structure is more conservative compared to the framework for private employees. For instance, the maximum exposure to equities in the case of the latter is 75 percent, while it is capped at 50 percent for government employees.

At retirement, they can withdraw up to 60 percent of the corpus as a tax-free lump-sum, while the balance 40 percent has to be mandatorily converted into annuities, which will generate a pension income for a lifetime.

Unlike the OPS which guarantees a certain payout, the NPS is market-driven. Rising equity markets, over the long term, favour the NPS but are prone to short-term volatility.

Given the long-term nature of NPS being a retirement vehicle, it works in the favour of the employee and also relieves the employer (state governments) of the burden of assured payouts.

Does NPS provide an assured pension, like OPS?

No, NPS is a defined contribution, and not a defined benefit, scheme.

In the case of government employees, as mentioned earlier, both the employer and the employee contribute 14 percent and 10 percent respectively, to build the corpus during working years.

“If employees want higher pension income, they can also voluntarily make larger contributions to the fund during their working years,” says Upadhyay.

The lump-sum payout (60 percent of the corpus at retirement) as well as lifetime pension income (paid out of the balance 40 percent used to purchase annuities from designated life insurance companies) are market-determined.

That is, the size of the corpus and annuity income depends on the performance of your funds, the interest rates prevalent at the time of buying annuities and payout options chosen by you.

“It depends on your exposure to equity and debt. If it is highly skewed towards debt, then the corpus could be somewhat smaller. If you choose a higher allocation to equities, it will be comparatively larger. The time when you started investing is also significant. If, for instance, the employee was 25 when her NPS contributions started, by 60 her corpus will be enormous,” says Sadagopan.

Since the NPS pension is not predictable, is OPS better suited for risk-averse employees' needs?

If you have no appetite for risk at all, you are bound to find the guaranteed payout feature in OPS attractive.

“From employees’ perspective, they do not have to make any contribution towards their pension under OPS. Guaranteed pension post-retirement and family pension were some of the key incentives for taking up government jobs. There was little pressure to build a retirement corpus. However, life expectancy has gone up today and OPS has become unsustainable for governments,” says Bajpai.

On the face of it, OPS looks like easy money and convenient for employees. But experts argue that given the financial doldrums that some European nations such as Greece landed in because of mounting debt - which included a bloated pension bill that was unsustainable- NPS is the way forward. It is more sustainable.

"Under OPS, the government bears the entire risk of longevity and inflation, which is obviously beneficial from an employee perspective. However, the replacement rate under OPS would be just about 50 percent (or may be marginally lower) and would not be enough. The typical global benchmark on replacement rate is over 70 percent (proportion of your current income needed to sustain the same lifestyle for post-retirement years. So this would not be enough," says Preeti Chandrashekhar, India Business Leader—Health and Wealth, Mercer.

Further, pension fund managers argue that all aspects considered, NPS could work out to be the more remunerative pension instrument over the long term.

“In India, government employees have not yet experienced the benefit that defined contribution (NPS) system can offer (as those who joined in 2004 are yet to retire),” says Shukla.

He believes NPS is finally bound to outperform OPS in terms of returns, and therefore deliver a larger retirement corpus and higher pension.

“NPS offers much more flexibility and the customer is in control of her destiny. Be it equity or debt, professional pension fund managers can ensure better returns and bigger corpus for retirement,” says Shukla.