Minimum assured returns can make defined contribution pension schemes more popular

Under the defined benefit system, the government promised a certain percentage of income as pensions irrespective of the return on financial markets. (Representative image)

There has been some media discussion on India’s pension markets. Deepak Mohanty, the newly appointed chairperson of the Pension Funds Regulatory and Development Authority (PFRDA) has mentioned at multiple occasions that the regulator will roll out a minimum assured return scheme (MARS) in the near future. Section 20 of the PFRDA Act (2013) lays out the legal framework for developing a National Pension System. Within Section 20, the Act says “the subscriber, seeking minimum assured returns, shall have an option to invest his funds in such schemes providing minimum assured returns as may be notified by the Authority”. Therefore, the PFRDA Act specifies that the PFRDA should develop a minimum assured return scheme for the subscribers.

MARS, as the name suggests, assures minimum returns on the invested amount. If the actual returns are less than the minimum assured, the shortfall amount is paid by the sponsor. If the actual returns are more than the floor, the surplus amount remains with the investor. For example, say an investor invests Rs 100 under MARS, which has set a minimum assurance of two percent return. At the time of maturity, if the fund loses value and is at Rs 101, then the loss of Re 1 will be paid by the sponsoring fund to ensure that the investor gets at least Rs 102. If the maturing value of the fund is in surplus at Rs 103, then the investor gets the entire amount of Rs 103.  In this way, MARS assures a minimum return on the investment whereas a surplus is earned by the investor.

The need to have MARS in pension schemes was felt when the pension systems in most countries shifted from a defined benefit system to a defined contribution system. Under the defined benefit system, the government promised a certain percentage of income as pensions irrespective of the return on financial markets. Under the defined contribution system, employees had to contribute a percentage of their incomes towards their pension. As there was no government protection, the return on pension funds was dependent on the return on financial markets. Most pension funds invest a majority of their assets in bond markets and the remaining in equity markets. The returns on bond and equity markets in turn will lead to returns on the pension funds.

In order to incentivise this shift from relatively risk-free defined benefit to relatively risky defined contribution, minimum assurance was introduced by some countries. MARS was also introduced in some countries as the 2008 crisis eroded confidence in pension investments. MARS acts as insurance for pension investors.  There are other design features in MARS.

First, assurance can be provided on nominal interest or real interest terms. All countries which have MARS such as Belgium, Switzerland and Germany have based them on nominal terms. Second, the returns could be absolute or relative to a benchmark. Countries such as Belgium and Germany provide absolute returns, whereas countries such as Chile and Denmark provide relative returns.

Third, the guarantee could be ongoing and remain at all periods of time. Or it could be terminal which ends with retirement. Fourth, the guarantee could be fixed which remains unchanged throughout the period. Or it could be flexible which needs to be reset with changing interest rates. Fifth, the pension funds meet the costs of providing MARS via annual fees from investors. Or they could charge annual fees from net assets or net profits.

Given the basics and complex design behind MARS, the PFRDA has gone slow on the scheme. In May 2021, the PFRDA floated the first tender for the appointment of a consultant to design a minimum assured return scheme under NPS. In February 2022, the PFRDA appointed E&Y Actuarial Services LLP to design the scheme under the New Pension Scheme (NPS). In March 2022, the then PFRDA chairperson Supratim Bandyopadhyay in an interview gave some ideas on the proposed MARS. He said the assurance should attract investors but at the same time, the returns cannot be unrealistic. He said absolute fixed guarantees are difficult in these volatile times. The returns will be flexible and set periodically.

In a September 2022 article, the PFRDA shared more details on the proposed scheme. E&Y had proposed six designs but the PFRDA board chose the simplest one of fixed returns for a fixed number of years. Accordingly, the fixed period for MARS was to be ten years. This means that an investor will have to keep investments for ten years and the scheme will also run for just ten years. The PFRDA will work out the fixed return. For the fund managers, the PFRDA kept eligibility criteria of net worth of at least Rs 50 crore of which at least Rs 25 crore should be the capital. The board also noted that few state governments had chosen to opt out of NPS and move to the old pension system (OPS) based on defined benefits. The MARS will help bridge this gap between the OPS and the NPS, as OPS promised assured returns whereas NPS returns were based on markets.

In December 2022, Bandyopadhyay clarified that the fixed return will be only for one year. The returns will be reset every year in line with changing market conditions. The guarantee will also be less than the ten-year government bond. As fund managers will have to bear the shortfall, the PFRDA will also come out with insolvency norms for fund managers.

The current Chairperson Deepak Mohanty in his recent interviews given in May and June 2023 said that the rollout of MARS should happen soon in the near future. He added that the low cost has been the key feature of NPS and with MARS, the costs will increase.  There will be a need to balance the risks, costs, and returns of the NPS. Based on the above, most of the pieces of the MARS jigsaw puzzle have been put on the board. We have to wait now for other pieces to be added to complete the puzzle and the eventual rollout of MARS.