The Employees’ Provident Fund Organisation (EPFO) started investing in equities from FY2015-16 onwards when the investment regulation mandated 5 percent to 15 percent investment of annual incremental accretion in equities.
The objective of mandating investments in equities was to enhance returns to its subscribers, thereby improving their income replacement rate upon retirement. However, after five years of commencing equity investments, is the overall structure aligned to meeting this objective?
To answer this question one needs to understand how the EPFO values its investments and recognises income on its overall portfolio.
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Fixed income portfolio is valued at cost and coupons received are accounted as income. For the equity portfolio, the EPFO, after attempting unitisation (which met with regulatory and operational roadblocks), switched to cost-based accounting where only the realised gains and dividends received are accounted as distributable income among subscribers.
This meant that the EPFO either churned the equity portfolio or relied on dividends received for income recognition. However, historic data tells us that majority of the return from equities is from capital appreciation and not from dividends. This leaves the EPFO with no choice but to frequently churn the equity portfolio.
Frequent churning, however, has the following pitfalls: (a) it reduces exposure to equities in the overall portfolio (given regulatory restriction of reinvestment as per the investment pattern); (b) requires equity markets to deliver positive returns year-on-year; (c) may entail transaction/impact costs given the size of the EPFO’s corpus, and; (d) shortens the investment horizon for an asset-class which other-wise is long-term.
At the heart of this problem lies the very structure of the Employees Provident Fund (EPF) scheme liability, where it disconnects with equity as an asset class — fixed liability but variable return asset-class where the disconnect only grows with the growth in corpus. The EPF scheme guarantees rates of returns to its subscriber which when credited cannot be reversed. Simply put, the EPFO cannot declare and credit a negative rate in any year even if it has earned it. To put pressure on the system, the subscribers and the unions expect higher rates every year irrespective of the market condition.
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With the expectation to declare higher rates or at least sustain the rate declared in the previous year, all the underlying investments held in the portfolio are expected to deliver positive returns year-on-year. In a year where equity market tanks or the EPFO is not able to time the market, an equity portfolio is not able to contribute positively to the overall portfolios’ return, thereby reducing the PF rate. It is worth noting that subscribers who leave the EPFO’s membership during such years (where the equity market has tanked), end up subsidising subscribers who stay back and enjoy higher rates when equity market rebounds, gains are realised and passed on to subscribers. While this is also true for the larger fixed income portfolio, outsized returns on equities and income recognition issues cited above only amplify the element of cross-subsidy. Therefore, the true benefit of equities may not get transmitted to all the subscribers.
Furthermore, the asset-allocation strategy assumes a ‘one-size fits all’ approach. To elaborate, the equity allocation decided by the EPFO assumes that all its subscribers have similar attributes — age, future service and risk appetite, which is certainly not the case. Evolved structures of defined contribution plans allow subscribers to choose their asset-allocations based on their needs and risk appetite.
To conclude, while the EPFO may continue investing in equities, which has the potential to offset lower returns from fixed income instruments, absorb delinquencies in the fixed income portfolio and facilitate diversification, the objective of enhancing replacement rate upon retirement would be seldom met unless liability side reforms are carried out.