The Union budget’s proposal — now unfortunately rolled back, given the furore — to rationalise the tax treatment across the NPS and EPF had raised quite a storm. Withdrawals greater than 40 per cent of the accumulated balance in the EPF would be subject to tax, unless they were used to purchase an annuity. For the EPF, this had meant the EEE tax-treatment would become EET (as 40 per cent would still be tax-exempt).
One aspect of the discontent was the tax itself. The withdrawal of a tax-break never goes down well. This is especially pertinent for those with incomes below the tax bracket, who didn’t get an exemption when making the contribution but would have been taxed on retirement. However, a larger issue was that the tax was only applicable on a lump-sum withdrawal and not on annuity purchase. In effect, the proposed tax policy was nudging members towards annuitisation. Such state paternalism — mandating members what to do with their retirement savings — wasn’t going down well.
On the face of it, annuitisation is not such a bad idea. A pension system should be judged by its ability to provide for an adequate consumption post retirement, and not during the working life or at the point of retirement. Since the accumulated wealth has to provide for consumption for the lifetime of the individual, how it’s drawn-down is an important policy question. For far too long, EPFO members have used the EPF as a mechanism to finance large durable purchases, or for emergency-funding. This may have served its purpose when Indian finance didn’t have other instruments. Despite the roll-back, we should revisit the practice and work on ways to reorient the EPF as a retirement scheme.
This requires a rethink of policies at the time of entry. We need to evaluate the optimality of the current contribution rate, allow for choice among pension funds, broaden investment regulations, and rationalise taxation across pension products. We need to develop better credit markets so that people don’t use their provident fund accumulations as the creditor of first resort, and if they must, pay a price for it.
But just mandating annuitisation is also not enough. We must ask what level of annuitisation is optimal. Different countries have approached this differently. The Chilean approach has been to restrict lump-sum distributions and mandate fixed inflation-indexed annuities or lifetime-phased withdrawals. Australia is more flexible in allowing lump sums. Most recently, the UK has done away with its rule of mandating the purchase of an annuity by the age of 75, allowing for programmed withdrawals. The US has very little mandatory annuitisation. If the objective is to ensure a minimum consumption after retirement, annuitisation can be mandatory only to the extent required to buy the minimum annuity. The nominal annuity may not be able to buy a minimum consumption basket if inflation rises over the retiree’s lifetime. Policy then needs to consider mandating the purchase of an inflation-indexed annuity.
Annuities can be expensive for the poor as they have lower life expectancy. If they die early, they end up subsidising the rich. Annuitisation may not lead to pricing that’s in the interest of low-income workers. We should consider an option of a programmed withdrawal, with or without a deferred annuity that begins in late old age.
India’s annuity market is also underdeveloped. Life insurance companies are often reluctant to enter annuity markets because of the lack of good mortality tables as well as instruments for hedging longevity and inflation risk. Governments need to set up processes for solving market failures that may impede the functioning of annuities markets.
Once individuals are choosing the annuity product as they retire, issues of mis-selling are likely to come to the forefront. High commissions without appropriate consumer protection, for example, can bias distributors to sell annuities without regard to customer suitability. Poor outcomes on annuities can be even more damaging than poor outcomes on products bought in the working life. Consumer protection regulation in the annuity space will thus be critical.
The government’s idea of rationalising taxes across the EPF and the NPS, and bringing in an element of annuitisation, important and useful. The next time round, it should put in a lot more rigour before proposing changes, so that they don’t get rolled back.