The interest rate for the Employees Provident Fund is a very touchy issue when it comes to both individuals and companies.
The government too is very involved for two reasons: one, the fund has millions of members (read vote bank) and, two, it provides a significant implicit subsidy to it. Not surprisingly therefore any news pertaining to the EPF almost always hits the front pages.
Here are our views on the current controversy regarding returns offered by EPF.
EPF is a defined benefit plan, i.e. irrespective of external factors and what actual earnings of the fund are, the return earned by you is fixed. In current times you know that the return on your EPF account will be 9.5% p.a.
Given that the fund is meant to invest in 'safe' securities, the investment avenues are very limited. In fact, over 80% of the money is parked with the government in special deposit schemes, which currently pay 8% pa (an implicit subsidy, as market rates are much lower).
The rest of the money is invested in bonds, which are approved by the government. What this also implies is that the returns earned by investing in these instruments are low (low risk, low return).
How is this deficit going to be funded?
One solution is to dip into the EPF reserves to meet obligations. The other, which has come to light now, is to have a differential rate depending on the income level of the investor (a lower rate for higher income groups).
The first option is irrational. The reason is that the decline in the return earned by the EPF is not a temporary phenomena.
It is likely to continue for some time and if the Trustees keep dipping into the reserves, sooner or later they will have none of it left. But this option suits the politicians just fine. After all they have only a five-year vision for the country!
The second reason is interesting to say the least. While it is not sure how this will be implemented if adopted, the idea will definitely lessen the burden on the fund (the higher income group naturally has a much larger share of the deposit).
While the higher income groups will almost surely object, sooner or later the reality will sink in -- better less than none.
What's our view?
Well, if the functioning of the EPF is not reformed immediately, all those associated with the scheme could turn out to be big losers (though not a perfect example but, remember Unit Trust of India?). This is how:
The Investor: When you retire, the fund may not be in a position to meet its obligations (refer recent comment by the prime minister).
The Government: Given political implications, the government will need to meet all obligations i.e. higher subsidy, more pressure on fiscal deficit.
The Companies: Some companies manage the EPF assets of their employees on their own. Already these companies are meeting obligations out of profits. Over a period of time, the companies' obligation could grow dramatically thus jeopardizing their existence (General Motors in the US is a perfect example of this).
The long-term solution to this 'problem' is that the EPF should become a 'defined contribution plan' as against a 'defined benefit plan.'
In a defined contribution plan, as the name suggests, only your contribution is defined and there is no guarantee of returns. The return earned would depend on what the EPF earns. The possibility of building a deficit is thus eliminated.
Moreover, individuals should be allowed to control their EPF contribution in two ways -- one, in terms of allocation between equity and debt and two, deciding who should manage the money.
We believe that such reform would greatly benefit investors though in the near term there may be some anxiety among investors.
Our advice to you, the investor, is to be rational and understand that no instrument which offers assured returns that are out of line with market rates of interest is likely to sustain over a period of time. This is not to say that you are in danger of losing your money. But the end result may not be as 'defined' as you think it to be.