An opportunity to rethink India’s pension system

The evolution of pension systems in India reflects a shift from welfare-oriented approaches to market-driven models, highlighting the need for balanced, sustainable solutions that protect citizens while managing fiscal responsibilities.

Background

• Shift from welfare approach to market- oriented growth : Historically, two models of governance have consistently been in conflict: the state welfare approach and the market-oriented approach.
  • State welfare approach: When World War II ended in 1945, the state welfare approach came to prominence. The state assumed the responsibility of ensuring the well-being of its citizens, leading to the establishment of safety nets for them. This included measures to support citizens during economic crises, provisions for old age, insurance, free education, healthcare, and overall welfare. While this approach was beneficial, it also had its disadvantages. 
    • The state became a “nanny state,” taking care of individuals from cradle to grave, which led to a sense of carelessness among citizens who relied on government support. Furthermore, the extensive number of schemes initiated by the state contributed to a high fiscal deficit, slowing economic growth and straining government resources.
    • Issues such as bureaucratic mismanagement and poor implementation also came to the forefront.

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• Market-oriented approach: As a result of the above approach, during the 1970s and 1980s, voices like the U.S. President Reagan and British Prime Minister Thatcher championed the slogan “rollback the state.”  They argued that the state was doing too much and that its role should be limited to oversight and regulation.  The extensive schemes operated by the state were seen as unnecessary, with the belief that leaving it to the market would ultimately benefit everyone.
  • This perspective aligns with Adam Smith’s concept of the “invisible hand,” which suggests that the market has the inherent ability to determine what is needed and how much should be produced. Therefore, if the government decides what to produce and how much, it could be detrimental, as the market is better equipped to respond to supply and demand independently. This shift in thinking gave rise to neoliberalism.
  • Neoliberalism and its shortcomings 
    • The liberalisation, privatisation, and globalisation (LPG) reforms introduced in 1990 and 1991 initially resulted in an increase in economic growth rates. However, it soon became apparent that this growth was often “jobless,” failing to create adequate employment opportunities. The 2008 economic crisis further highlighted the shortcomings of a purely market-driven approach.
    • As a result, it became evident that if everything were left solely to the market, vulnerable populations would be disproportionately affected, and not all control could be relinquished to market forces. 
• Social-liberalism: After realising the shortcomings of this system, it was felt that a balance is necessary to ensure that those who are left behind receive support, as a purely market-based system could exacerbate income inequality. Thus, the new approach of social-liberalism came to light which emphasises integrating both perspectives—recognizing the importance of market efficiency while also upholding the state’s responsibility to protect the welfare of its citizens. By targeting state schemes to support the vulnerable and needy, this balanced approach aims to address the shortcomings of neoliberalism and ensure that the most disadvantaged members of society are not left behind.

Evolution of the Pension System

1. Old Pension Scheme (OPS)

The Old Pension Scheme (OPS), which was in place before 2004, was introduced during a time when the state took full responsibility for citizens’ welfare. Under this system, government employees received a defined benefit pension after retirement, ensuring a stable and predictable income for life.

Key Features of OPS

• Defined Benefit: The pension amount was calculated based on the employee’s last drawn salary. For example, if Priya had a basic pay of ₹30,000 and a dearness allowance (DA) of 40% (₹12,000), her total salary would be ₹42,000. Upon retirement at age 58, she would receive 50% of her last drawn salary as a pension—₹21,000 per month.
• Inflation Indexation: The pension amount would increase with inflation, as the DA would be adjusted accordingly. For instance, if inflation rose by 5%, the DA could increase to 45%, adding ₹1,500 to her pension.
• Employee Contribution: There was no employee contribution under OPS; the government bore the full cost of the pension.
• Low Flexibility: The benefits were fixed, independent of market performance, ensuring financial stability for retirees.
• Family Pension: After the retiree’s death, the family would continue to receive a pension, typically at a reduced rate. In Priya’s case, her family would receive 60% of her pension, or ₹12,600 per month.

There was no market risk for employees. Regardless of economic crises or market fluctuations, the government took on the full financial burden. The scheme reflected the government’s commitment to social security and a welfare-oriented approach. Employees did not have to worry about economic downturns, as the government absorbed all risks.

Challenges of the Old Pension Scheme

• Burden on Government: The increasing number of retirees placed a heavy financial burden on the government. Funding these pensions without employee contributions strained public finances.
• Intergenerational Problem: To meet pension obligations, the government would often take loans, leading to debt that would be passed onto future generations, creating a long-term fiscal challenge.
• Disincentive to Retire Early: There was no incentive for employees to retire early, as higher current salaries led to larger pensions. This reluctance to retire early affected workforce dynamics, as many employees preferred to continue working to maximise their pensions.  

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2. New Pension Scheme (NPS)

In 2004, the Old Pension Scheme (OPS) was replaced by the New Pension Scheme (NPS), marking a fundamental shift from a defined-benefit model to a defined-contribution model. Unlike OPS, the government made it clear under NPS that there would be no guaranteed pension—the amount received after retirement would depend on how the investments performed, leaving retirees exposed to market fluctuations.

Key Features of NPS

• Contribution-Based: Both employees and the government contribute to the pension fund.
  • Example:
    • Employee Contribution: 10% of Basic Pay + DA (₹4,200 per month).
    • Government Contribution: 14% of Basic Pay + DA (₹5,880 per month).
    • Total monthly contribution: ₹10,080.
• Market-Linked Returns: Contributions are invested in financial markets, such as government bonds, corporate bonds, and equities. The pension payout depends on the performance of these investments.
  • Assuming an 8% annual growth over 30 years, the total corpus could grow to approximately ₹1.5 crore. Based on annuity rates, the annual pension could be ₹12-15 lakh. 
• Risk Exposure: Unlike OPS, the risk is borne by the employee. Market downturns, like economic crises or poor bond yields, could lead to lower pension payouts, making retirement income vulnerable to market volatility.
• Family Pension: Like OPS, NPS offers a family pension, but it is dependent on the accumulated corpus at the time of death.
• Flexibility: Employees can choose between aggressive (more equity) or conservative (more bonds) investment options, allowing them to tailor their pension plan based on their risk tolerance.

The introduction of NPS reflects a broader neoliberal shift that reduces the state’s involvement in providing welfare, transferring much of the risk to individuals. The system aims to promote financial market-based growth while lessening the government’s financial burden.

Criticism of NPS

• Risk and Uncertainty: Many employees were unhappy with the inherent risks in NPS, as they prefer the stability and predictability of OPS. The market-dependent nature of NPS exposes them to economic downturns, which could jeopardise their financial security in retirement.
• Financial Instability: In cases where the market underperforms, the pension may not be sufficient to meet retirees’ needs, making them vulnerable in their old age. This is a stark contrast to the fixed income guarantee under OPS.
• Political Promises and Reforms: NPS has faced opposition from employees and political parties, with some promising to reinstate OPS if elected.

In response to these criticisms, the government has introduced reforms aimed at making the system more appealing.       

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3. Unified Pension Scheme (UPS)

The Unified Pension Scheme (UPS) strikes a balance between the Old Pension Scheme (OPS) and the New Pension Scheme (NPS), combining the guaranteed pension of OPS with some aspects of market-linked contributions from NPS. This approach is designed to address concerns raised by both employees and the government.

Key Features of UPS

• Guaranteed Pension: The UPS guarantees a pension of 50% of the average basic pay from the last 12 months before retirement, provided the employee has completed at least 25 years of service.
  • Example: If Priya retires at the age of 58, with a basic pay of ₹30,000 and a dearness allowance (DA) of 40% (₹12,000), her pension would be 50% of the basic pay, which amounts to ₹15,000 per month.
• Inflation Indexation: Like OPS, the UPS pension includes inflation adjustments. For instance, if inflation increases by 6%, Priya’s pension will increase to ₹15,900.
• Employee and Government Contributions:
  • Employee Contribution: 10% of Basic Pay + DA, which equals ₹4,200 per month.
  • Government Contribution: 18.5% of Basic Pay + DA, totaling ₹7,770 per month.
• Family Pension: In the event of the employee’s death, the family receives 60% of the pension. For Priya, the family would get ₹9,000 per month.
• Lower Risk: Compared to NPS, the UPS offers lower risk since a minimum pension is guaranteed.
• Limited Flexibility: The scheme allows investment only in government-approved funds, which ensures security but limits investment options.

Concerns with the Unified Pension Scheme

• Increased Financial Strain: Implementing a defined pension system could impose a substantial financial burden on the government. For instance, arrears alone may amount to ₹800 crore in the first year, with annual expenditures potentially reaching ₹6,250 crore. This situation could put considerable pressure on public resources.
• Risk of Unsustainable Liabilities: The integration of features from both the Old Pension Scheme (OPS) and the New Pension Scheme (NPS) within the Unified Pension Scheme (UPS) could result in unsustainable liabilities. As pension payouts increase, there is a concern that future budgets might need to allocate additional funds to cover these pensions, potentially compromising funding for other public services.
• Unequal Benefits: In a country like India, where poverty is prevalent and wages in the informal sector are considerably lower, the government must prioritize the welfare of this segment to effectively address poverty. The Unified Pension Scheme (UPS) mainly advantages central government employees, while the unorganised workforce—lacking collective bargaining power—remains inadequately supported, which could exacerbate economic inequality. 

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Conclusion

To ensure the success and sustainability of the Unified Pension Scheme (UPS), several key measures must be implemented. Regular assessments are crucial for evaluating the financial viability of the scheme, enabling necessary adjustments to government contributions and ensuring a balance between employee benefits and fiscal responsibility. This approach aims to prevent the government from becoming overburdened or making unsustainable pension promises that could lead to future economic crises. Additionally, stakeholder consultations should be prioritised, fostering regular engagement with government employees, unions, and relevant parties. Open dialogues will facilitate valuable feedback, address concerns regarding the scheme, and ensure its evolution aligns with the needs of employees while adhering to broader fiscal objectives. Finally, the establishment of performance metrics is essential to gauge the effectiveness of the UPS. By tracking financial sustainability, employee satisfaction, and overall retirement security, the government can continuously monitor the scheme, making timely adjustments to enhance its long-term success and adaptability.

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