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A Nudge from EPFO

EPFO's change in members' account presentation could have far reaching benefits

A Nudge from EPFO

The Ministry of Labour seems to have taken a leaf out of recent Economics Nobel winner Richard Thaler's idea of nudges. Last week, the EPFO board decided to implement what is, at its heart, just a new way of presenting the account information to EPFO subscribers. However, while that sounds like a trivial change, it will be a crucial input to the long term acceptability of equity investments as part of the EPFO kitty. This change could also play a role in the broadening of the equity investment culture in India. Not just that, it could also point the way to the eventual transformation of the EPFO into an NPS-like entity as far as investment management goes.

The change that the EPFO board has made is that the equity part of each member's account balance will be presented, segregated from the debt part. The debt part is the traditional EPFO investment while the equity part--which was started just two years ago--is managed by SBI Mutual Fund through two exchange-traded funds. As it happens, the traditional EPF debt part has been earning 8.65 per cent, while the equity part has generated a return of 21.9 per cent.

At this point, the percentage of equity exposure is too low to make a huge impact to the amount of money that is being made. Nevertheless, the difference in the rates of return is instructive. At a full 85-15 debt-equity asset allocation that the EPFO should achieve, 15 per cent of the assets could generate almost half the return at this rate. However, 'at this rate' is the key qualifier. Even the most die-hard equity proponents (and I count myself among them) would want to claim that this rate of return is sustainable. Over the long-term, average returns of 12 per cent to 15 per cent would be great, and would make a big difference to EPFO members' lifetime savings.

However, the big issue would be handling the inevitable declines in equity value along the way. Given the role that PF plays in people's lives, and the expectation of stability that comes with it, a decline of value would be a big crisis. That's where these recent changes would play a role. EPFO members would be able to see that while the debt part is increasing steadily, it's only the equity part that is volatile. Moreover, depending on how the returns information is presented, it should be clear to members that even though equity is volatile, it actually makes them much more money on an average. In fact, given falling interest rates, the debt part will barely keep up with inflation, generating a real (inflation adjusted) rate of return of no more than one or two percent.

Real wealth, which will take care of people during their long retirements, can only come from equity. It is indeed fortuitous that the EPFO added equity only in 2015, and had a great experience for the first two years. This means that whenever the first true volatility hits, there will already be a track-record to point to. Had the EPFO started off with equity in, say, 2007, then the experiment would have been abandoned quickly, and never tried again.

As I said in the beginning, this new account presentation format could also lead to greater acceptability of equity investing beyond the EPF. Crores of Indians who would otherwise never have dipped their toes into equity, will see the wealth that can be created. Certainly, a certain percentage of them will become equity investors on their own account as well. If not equity in general, there will be a rub-off on SBI Mutual Fund, which is actually running the EPFO ETFs at a miniscule cost which is a fraction of what such funds normally charge.

Another interesting point is that this will be the beginning of a new phenomenon, wherein EPFO members will see part of their money being managed by an external asset manager. Eventually, one can hope, this will lead to an NPS-like arrangement whereby there is a set of external managers competing with each other while there is a distinct administration and management organisation that tries to optimally manage that alone.

In any case, after decades of stagnation and decay, the EPFO is moving forward in ways that will actually benefit members.