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The Caged Tiger: Indian pension assets

June 14, 2008


What are man’ s basic need?
Food, Clothes, Shelter, Love and perhaps a good mutual fund.

I said, perhaps, because these days in our country, pension funds are practically for all reasons worthless. Turning up a return over extended periods of time with paltry rates like 1% or 2%, I wonder if they even hold any water in todays inflation scenario. This is in contrast with returns of 5% elsewhere in the world. And when you consider the huge time period for which it stays invested, the returns in real money terms get huge.

Consider this, I have invested in SBI Pension Plan with a 3 year lock in period. And the time horizon for which I intend to stay invested is around till 50. So roughly around 26-27 more years. Now if you consider a paltry 1% growth over an extended period of 26 years compared to another fund with returns of 5%, the difference becomes huge. Immensely huge.

Capital Invested Returns with 1% Returns with 5%
Rs 1000/- Rs 1295/- Rs 3555.67/-
Rs 5000/- Rs 6476/- Rs 17778.4/-
Rs 25000/- Rs 32381.4/- Rs 88891.8/-

The above table shows the huge disparity between the sums returned after a 26 year 1% and 5% yoy growth in the asset invested in an ordinary pension fund.And hate to break it, but its huge. Discouragingly huge!

One of the prime reason that John Doe’s (or rather in this case: Hari Kumar’s) asset in pension fund returns so less, is because the inherent clauses, subclauses and phrases of Section 80C. Yeah, the same form you fill up for saving tax by investing ELSS. There are two things worth talking about here.

  • The financial instruments a particular pension fund can invest in:

  • And, the cap till which they can invest

A very interesting focus comes into view, when say your Hari Kumar, invests in pension funds of upto 1 lakh per year, on instruments which invest in :

  • Central and State government securities
  • Special Deposit Schemes
  • Bonds of public sector undertakings and that of public sector financial institutions
  • Certificates of deposits with banks

Now is it any surprise that our pension funds regularly come home with a bloody nose and a 1% in hand? In a bull market,like ours, where supply shock inflation is embedded in the system, interest rates are often taken for a ride. And with such an active tinkering with interest rates, bonds are DESTINED to perform lower than expected.

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For the Mathematically Inclined:
Susan Thomas, conducted a research way back in 2000, stating that if another strategy of investing in equity is adopted, the returns are much higher.
She argues, that circa around 23.4% is the growth rate of Indian markets , risk factored in [I assume the present growth to be more say around 28%]
With risk discounted it comes to around 12% returns per year. So for a pension fund if the renumeration is like this:

Contributions + Investment returns = Benefits Paid

then the terminal contribution which is risk adjusted [that is I invest it in a bond, by the way bond investment is assumed to be riskless and inflation factored in], to the return of 2% and the investment returns are assumed to be varying from 10%-12%, [the second part of the LHS ;its varying since it cannot be exactly predicted], then the returns are found to be huge.
Huge when compared to the previous table I showed.

Crux of the Matter

The entire crux of the matter comes to this point that, although there is an inherent amount of risk involved with investment in equities,but the returns are disproportionately huge. And what else, this risk can actually be engineered to be much lower that what a comparable returns will ask for. These days with derivatives in place on S&P50 index, I can assure the powers to be who think equity investment and pension dont go hand in hand, that this risk can be substantially low and returns comparatively high!
What better tradeoff can you get???

The Hidden Agenda
I have a reason and a motive behind this. Even if I to assume that there is around 35 million tax paying individuals, then the amount of capital they invest in pension funds is huge. If I have to assume a weighted average of capital invested in pension funds per person as around Rs 3 lakhs per year. It is huge! Huge money to say, in the tunes Rs 1050 billion or around $250billion per year. That is a huge money, huge liquidity and huge depth in the market. The price discovery mechanism will get more smoothened and there will be sustained bull runs.
After all, the investment window is pretty long term, around in the periods of 20 years so this essentially will return two things. First a much more dynamic industrial scenario in our country, much better development system and a much higher return for individual investor.
I am looking at the bull run which is to come with a tiny change in the policies. And I assure you this bull run will not be an 8 year run or 6 year run fuelled by the Western Credit bubble. This will be a home grown investment surge and a sustained one that too.

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