Big changes needed at the EPFO

One year into the potentially historic entry of equity into the investment portfolio of the Employees' Provident Fund Organisation (EPFO), these investments have generated little except hot air from those opposed to it, and apparently, a great deal of confusion about how to account for them. In fact, the equity investments have served primarily to point out just how antiquated the EPFO's structure is and how small-scale tinkering won't do much to enhance the actual returns that its customers get.

The quantum of these investments is tiny, being just about five per cent of fresh inflows, although there has been some talk of increasing this to 10 or even 15 per cent. Thus, the role that this equity portion plays in the EPF member's returns is not relevant yet. As I've pointer out earlier, this tiny amount of equity exposure is functionally useless. The EPFO invests five per cent of incremental investment in equities. No assets are shifted from the fixed income part and then redeployed into equity. At this speed, it could take a decade or more, depending on the differential between withdrawals and deposits, and between equity and fixed-income returns, for the equity exposure to reach five per cent or more.

And if you think about it, a five per cent exposure means the worst of both worlds. When the equity markets drop, the usual suspects will cry themselves hoarse about the losses, but when the markets rise, the tiny exposure to equity means that gains that are meaningful to EPFO members will be hard to come by.

In the time since equity investments have started, a further problem has come up. The EPFO does not really have a way for the returns from equity to be incorporated into the returns that are realised by investors. For the existing fixed income investments, it pays an interest rate that is based on interest that is actually realised from its investments. The equity part cannot work like this. There is no actual transfer from the ETFs that are used to invest in equity. Last year, the EPFO tried to shoehorn equity returns into its existing structure by inventing a methodology that deemed a certain return as normal, and transferring returns above it into an 'Equity Stabilisation Reserve'. This method was rejected by the CAG, and rightly so.

The name of this 'stabilisation reserve' shows the conceptual struggle that is going on. The labour ministry would like it if somehow equity returns could be made to appear like a smooth and stable straight line. This is not a new desire. Almost every fixed income investor who wants the returns of equity investments wonders if there is way get those returns in a predictable line as if they were fixed deposits. The harsh truth, demonstrated over decades, is that there is no way of doing this, and India's labour ministry is unlikely to invent one. In fact, in past decades, government organisations like Unit Trust of India and Canbank Mutual Fund have come a cropper trying to do exactly this. I hope there's someone among the decision-makers who understands that history and prevents a replay.

There is no safe and fair way for the EPFO to incorporate equity returns except the tried and tested structure practiced by the mutual funds, the National Pension System, and even the insurance industry. It must divide the entire corpus into units and each member should know how many units he or she owns and how many are allotted with each salary. The EPFO must then periodically calculate and announce a Net Asset Value (NAV) based on the market value of its investments. Depending on the balance between inflows and outflows, it must sell and buy securities to meet its obligations. There's nothing radical about any of this--all it has to do is to copy and paste the methodology being followed by the NPS.

Of course, that immediately raises the question about why must the EPFO continue to exist? Why not incorporate its entire activity into the NPS itself? But that's a more complex question. As far as its members' interests are concerned, the EPFO should set its equity accounting house in order before the mess becomes any bigger.