EPFO should first fix the basics
How should an institution managing retirement funds invest? Should it aim to minimise risk and invest in risk-free assets, or should it take some risk to enhance returns for its investors? While the answer will depend on a number of factors, including the profile of contributors, generally, it makes sense for such fund managers to take moderate levels of risk. One of the biggest advantages such fund managers have is that their funds are of long-term nature, which gives greater flexibility in management. However, things may not be as straightforward if the fund management institution is run by the government and contributions are compulsory in nature as is the case with the Employees’ Provident Fund Organisation (EPFO).
The EPFO has traditionally invested in debt and it was only in 2015 that it started investing 5 per cent of its incremental flows in equities. This has now risen to 15 per cent and the EPFO is reportedly considering increasing it to 25 per cent. Increasing equity exposure makes sense as it tends to outperform other asset classes, particularly debt, in the long run. The average return from equity over the past five years was about 18 per cent, which was significantly better than the one for government bonds. Even after the recent increase in the policy rate, the benchmark 10-year government bond is yielding just about 7.5 per cent, and is still lower than the 8.1 per cent rate of interest approved by the EPFO for 2021-22, which itself is a multi-decade low. But it’s better than all other risk-free instruments and the tax treatment makes the return even more attractive.
Increasing equity exposure will help boost returns in the long run. However, this will not be easy because of the nature and status of the EPFO. Although it invests in exchange-traded funds (ETFs) tracking benchmark indices and central public sector enterprises, it’s not clear how equity investment performed over the years. In 2020, for instance, it deferred crediting part of the interest because it was dependent on the redemption of ETFs. This is clearly not the way to manage equity assets. Equity is inherently risky and cannot be depended upon to provide near-fixed returns. Besides, equity does well in the long run and it’s not prudent to regularly pull out of the market to credit annual interest to the subscribers’ accounts. Such issues will only get more complicated with increasing equity exposure.
Therefore, while the idea of increasing equity exposure is worth following — though it should be done gradually — the retirement fund manager should first set some of the basic things in order. For instance, it is important to give the subscribers a choice to opt for equity exposure. It is likely that some of them may not be comfortable with the idea. The selection process can easily be enabled online. The EPFO can also look at high-rated corporate debt to increase returns. In fact, it can give the subscribers, say, five different fund options, with one being totally risk-free and others with varying degrees of corporate debt and equity exposure. It can also give switching options under certain conditions. To be sure, this will not be very difficult to implement as most asset management firms offer such choices. However, this would require professional management and a high level of transparency. Just increasing equity exposure may not yield the desired benefits.