The Employees’ Provident Fund (EPF), India’s mandatory retirement savings scheme for formal sector employees, recently streamlined the rules on withdrawals from the provident fund corpus before retirement. Crucially, the move merged 13 fragmented partial withdrawal clauses into just three — essential needs, housing needs, and special circumstances — and reduced the minimum service period for withdrawals to a uniform 12 months. This rationalisation presents a paradox: The changes simplify the process of withdrawal, allowing members faster and more flexible access to their savings. But they raise deeper questions about the nature and purpose of the EPF itself: Is it a long-term accumulation product meant to provide income security in old age, or is it a flexible savings account meant to deal with contingencies during working life?
At present, both employer and employee together contribute the equivalent of 15.67 per cent of wages to the EPF system (12 per cent from the employee and 3.67 per cent from the employer, the rest of the employer’s contribution amounting to 8.33 per cent going toward the Employees’ Pension Scheme). This system is different from other savings products — such as mutual funds, or insurance-linked investment plans — in three key respects. First, contributions to the EPF are mandatory (at least for those covered under the EPF Act) to ensure that individuals build up a minimum level of a corpus. Second, the interest rate to the EPF is guaranteed, shielding members from market risk but simultaneously capping their potential upside compared to market-linked investments. Third, the build-up of savings is meant to provide for consumption after retirement.
For an individual who enters the workforce at age 25, the accumulations would ideally be accessible 35-40 years later, at age 60 or 65, thus providing the means to finance consumption in old age. If members are allowed to withdraw substantial portions of their balances during their working life, the justification for compulsion, or a guaranteed interest rate, is weakened. If the EPF is treated as just another liquid savings product, households could as well be free to invest their money wherever they choose — in mutual funds, gold, real estate, or private pension schemes. Households will then get to make their decisions based on a risk-return trade-off that suits their preferences.
There is legitimate concern that households require liquidity in times of financial stress. There are more transparent and coherent ways to achieve that goal. Liquidity challenges faced by workers are often episodic, driven by unemployment spells or health emergencies. These can be better addressed through policy instruments, such as unemployment insurance, short-term credit facilities, or health insurance. The question of home ownership could be addressed using dedicated home-loan products.
Another measure is to reduce the contribution rate itself. At present, the contribution of 15.67 per cent is a substantial share of formal wages. If one were to add the EPS contribution, the total contribution rate is 24 per cent, almost one-fourth of a worker’s wage. This is especially high for lower-income workers, many of whom also face housing and consumption pressures. A reduction in the contribution rate increases a household’s immediate disposable income, thus solving the liquidity problem without compromising the remaining retirement savings. The final outcome between a high contribution rate with partial withdrawals or a low contribution rate with no withdrawals may not be too different. While the financial trade-offs created are highly variable depending on the frequency and timing of pre-retirement withdrawals, a back-of-the-envelope calculation helps illustrate the point.
Consider an employee earning Rs 100 per year, with nominal wages growing at 5 per cent per year. Over a 35-year working life, with combined employer and employee contributions of 15.67 per cent, the cumulative savings, assuming the standard EPF interest rate of about 8 per cent, amount to roughly Rs 4,800. Now, suppose that employee exercises the option of a withdrawal of 75 per cent of her accumulated balance around the 15th year of her employment. The final corpus at the end of 35 years is drastically reduced to approximately Rs 2,700. This decision compromises the worker’s retirement safety net.
A policy alternative where the mandatory EPF contribution rate is immediately reduced to a lower level, say 9 per cent (6 per cent employee plus 3 per cent employer), instantly increases the worker’s monthly take-home pay. Crucially, if this lower contribution is kept untouched until retirement, the final accumulated corpus after 35 years is approximately Rs 2,790. The retirement corpus under the alternative policy of a lower mandatory contribution (Rs 2,790) is marginally higher than the corpus generated by the high mandatory contribution that suffered a single, mid-career withdrawal (Rs 2,700). A lower contribution rate provides the household with the choice of investment, and reduces the administrative burden on the EPFO. Even if this calculation will not bear out for all types of partial withdrawals, the issues of choice and lowering of administrative burden remain pertinent, and should be important considerations for the design of any product.
EPFO’s reforms are caught between two opposing policy goals. While the streamlined withdrawal processes help towards “ease of living”, they compromise the product’s identity as a retirement instrument. In trying to offer both security and flexibility, the EPF may end up providing neither effectively. It needs to either commit fully to a true, rigid retirement product with minimal access, or, if immediate liquidity is the priority, embrace financial freedom by reducing the mandatory contribution rate, thus delivering a more economically rational policy outcome.
The writer is managing director of TrustBridge Rule of Law Foundation
