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The EPFO black box: Masking

shoddy practices with high returns
Arundhati Ramanathan
17-21 minutes

In about 10 days, the Employees’ Provident Fund Organisation

(EPFO) will announce the rate of interest for the year ended March
2022. It’s a much-anticipated annual event for many of EPFO’s
members—some 60 million employees across India who, along with
their employers, salt away a part of their salary each month with the
EPFO.

The EPFO is a behemoth. Since its establishment in 1952, its corpus

has swelled to about Rs 16,00,000 crore ($211 billion). This makes
it the country’s largest retirement corpus provider, and among its
largest money managers, next only to LIC and the mutual fund
industry.

Building the nest egg

Many employees contribute 12% of their Basic Salary and Dearness

Allowance each month towards their Employees' Provident Fund
(EPF) account. Their employers contribute a similar amount. A part
of the employers’ contribution goes to the Employees’ Pension
Scheme (EPS).
If the past is a precedent, EPFO’s members should have much to
cheer about this time too. 
The interest rates on the EPF for the years ended March 2021 and
March 2020 were 8.5%. This, when rates had fallen sharply across
the board. Despite some gripe about the 8.5% being the lowest EPF
rate in years, it was much higher than comparable instruments such
as bank fixed deposits (5-6%) and small savings schemes such as
the Public Provident Fund (7-8%). 
The higher-than-market rate is likely to continue in the current
year. “That’s the expectation,” K.E. Raghunathan, member of the
Central Board of Trustees (CBT) of the EPFO, tells The Ken.
Raghunathan is an employer representative in the 43-member CBT,
the apex decision making body of the EPFO. Chaired by the Union
Labour Minister, the CBT decides the EPF interest rate each year,
which is then ratified by the Ministry of Finance. 
This year, the EPFO could declare a rate of 8-8.5%, say market
observers. Factor in the tax exemption on interest accrued from the
EPF, and the effective pre-tax return could go as high as ~12%. An
equity-like return on a safe, debt-like investment. What’s not to
like?
Turns out, there are a fair few catches. For one, many experts
question the sustainability of the high rates being declared by the
EPFO. 
“The rates are populist and politically sensitive. There is no clarity
on where the money is coming from. In that sense, the EPFO is a
black box that churns out high rates,” says Shashi Singh, founder of
financial planning firm FinMyn. “Paying higher than market rates is
not sustainable in the long run,” he adds. 
The populism was on clear display in 2020, when the EPFO did
something unusual. Reluctant to cut rates sharply, it declared a rate
of 8.5% for the year ended March 2020. But this was to be paid in
two parts—8.15% first from the debt portion of the corpus, and
0.35% later subject to redemption of equity ETFs ETFs Exchange
traded funds An exchange traded fund (ETF) is a basket of
securities that tracks an underlying index and trades like a stock on
exchanges . Luckily, the stock market rebounded in the latter part of
2020, some equity investments were sold, making it possible for the
entire 8.5% to be credited in one shot around December 2020. 
“Providence smiled, else 2020 would have been a difficult year for
provident funds” says Amit Gopal, India Business Leader
(Investments) at management consultancy Mercer. 
Other policy experts agree and want reform. Mukul Asher,
independent consultant in economics and public policy, says that
the EPFO should be paying to members annually what it actually
earns from investments and other income, with contingency
reserves set aside. “The administered rate of return to members
which the EPFO follows is not a sound global practice,” he adds.
Asher was formerly a professor at the Lee Kuan Yew School of
Public Policy at the National University of Singapore.
The doubts swirling around the EPFO’s high rates arise from the
investment pattern, portfolio disclosures, and accounting practices
it follows. More than 90% of its corpus is in debt investments
—mostly in government instruments. While these offer high safety,
the trade-off is low returns. The EPFO’s equity exposure through
exchange traded funds (ETFs)—meant to improve overall returns—
has increased from 5% of incremental inflows in 2015-2016 to 15%
15% The Ken The 800-pound gorilla in India’s ETFs Read more
 now, mostly in the benchmarks Sensex and Nifty 50. But some of it
is in sub-optimal sub-optimal Livemint EPFO in a spot after dismal
CPSE ETF and Bharat 22 ETF returns Read more  investments such
as the CPSE ETF and Bharat 22 ETF so the government could meet
its divestment targets.

The EPFO’s disclosures are also dated and sketchy. With the year
ended March 2022 nearing its close, there’s little information on
how the EPFO has done this year. Its annual report for the year
ended March 2021 does not have details of corporate debt
investments that have gone bad. Nor does it have details of the
surplus left with the EPFO after payouts. It doesn’t help that, rather
than the widely accepted accrual accounting accrual accounting
accrual accounting In accrual accounting, revenue and expenses are
recorded when transactions occur. In cash accounting, revenue and
expenses are recorded when payments are received or made.
approach, the EPFO follows the cash system of accounting that may
not lay out an accurate picture of ground realities. 
Besides, the actuarial valuation of the liabilities under the
Employees’ Pension Scheme (EPS) has been pending for quite some
time now; the deficits in earlier years do not make for a pretty
picture. Moreover, the low yield on debt investments earned by the
EPFO’s portfolio managers, relative to its payouts, is a key concern. 

Giving more than you get?

Altruism may be a virtue, but not for retirement corpus providers.

The EPFO though has consistently given out higher interest rates
than what it has been getting on its debt investments. 
Consider these numbers tucked away in its annual reports, which
themselves are tucked away obscurely on the EPFO portal. The
portfolio managers appointed by the EPFO generated a yield on
debt investments of about 7.5% in the year ended March 2020 and
6.87% in the year ended March 2021. This was far lower than the
8.5% rate of interest declared by the EPFO in these 2 years.

 It bridged these shortfalls through gains from selling some equity
ETF investments. The year ended March 2021 annual report says as
much. 
Now, there’s nothing wrong about selling equity to pay interest, per
se. But the trouble is that the gap in the declared rate for the year
ended March 2020 was met by the sale of the equity ETF units, not
in that financial year but the next. In short, the EPFO had
predetermined a high rate and then scrambled to close the gap after
the year had gone by. It passed this off as an exceptional case. 
It is also not clear whether the sale of the ETF units was sufficient
to meet the rate gap in the two years, or whether the EPFO also
tapped into regular contributions from its employee members to fill
the hole. That may have been the case in many of the earlier years
as well. The rates of interest declared then, too, were higher than
the yields earned. Despite this, in most years, there were no equity
sales. 
Financial planners frown upon such transactions. “The EPFO could
become underfunded if it continues paying high interest rates,” says
Sumit Duseja, co-founder of financial advisory firm Truemind
Capital Services. The chief executive of the EPFO did not respond to
questions sent by The Ken. 
In another world, such transactions might be deemed Ponzi
schemes. But experts think such a categorisation would be taking it
too far since the EPF is government-backed. EPFO is not a Ponzi
scheme, asserts Asher, adding that with greater professionalism
and reforms, the EPFO can help provide social security to tens of
millions of workers in India in a sustainable manner.
What may not be sustainable is the continued use of equity ETF
sales to act as a support pillar for high rates of interest. Equity is a
volatile asset class, and trying to predict its trajectory is a mug’s
game, especially over shorter time periods. “Guaranteed high
returns is never a good idea when the portfolio has a volatile equity
investment part,” opines Deepesh Raghaw, founder of financial
planning firm personalfinanceplan.in. 

Reforms imperative

Among the reforms that the EPFO should implement are more
regular and detailed disclosures of its portfolio composition and
performance. For instance, news reports news reports The
Economic Times Finance ministry approves 8.5% return on PF
deposits for FY21 Read more  sometimes mention the EPFO’s
estimated ‘surplus’ after the interest rate declarations. This is the
balance fund with the EPFO after it pays subscribers. But this key
metric and its calculations are conspicuously absent from the
EPFO’s annual reports.
The annual reports are also silent on details of the EPFO’s dud
investments. However, discussions in Parliament in early 2021
show that the EPFO took a hit of more than Rs 1,100 crore ($145
million) on debt investments in defaulting corporates such as
DHFL, IL&FS and Reliance Capital. Not all equity investments have
done well either. The CPSE ETF and Bharat 22 ETF, about 8% of
EPFO’s ETF corpus, have yielded relatively poor returns. Despite
rallying over the past year, their three-year annualised returns of
10-11% lag behind the 16-17% returns of the Sensex and Nifty ETFs. 
While equities in general could improve returns in the long-term,
and low-cost ETFs are a good way to take equity exposure, the
choice of ETFs matters. The CPSE and Bharat 22 ETFs mostly
invest in state-owned stocks; this leads to concentrated bets and
increases risk. In contrast, the Nifty and Sensex ETFs offer better
diversification benefits across stocks.
Regular disclosure of the portfolio’s market value is important, say
experts. “EPFO should set up an internal investment management
unit, and compare its performance with external asset managers,”
says Asher. But he adds that given the current level of EPFO’s
readiness to implement the change, the Mark-to-market is the
practice of valuing assets, liabilities, investments, etc at their most
recent market price process of its investments could be approached
gradually. 
Besides this, timely actuarial Relating to the work of compiling and
analysing statistics to calculate pension liabilities, and insurance
risks and premiums valuation of pension liabilities under the EPS
and its disclosure is something experts recommend. The actuarial
report pertaining to the years 2018 and 2019 is under government
consideration, and the appointment of the actuary. An actuary is a
person who compiles and analyses statistics and uses them to
calculate pension liabilities, and insurance risks and premiums for
2020 and 2021 has been initiated, says EPFO’s 2021 annual report. 
So, the latest data pertains to 2016 and 2017, and it shows a
significant deficit of about Rs 15,500 crore ($2 billion). Over the
years, the EPFO’s payment towards pensions has been rising.
Pension disbursements have increased from about Rs 9,200 crore
($1.2 billion) in 2016-17 to nearly Rs 12,200 crore ($1.6 billion) in
2020-21.The pension liabilities, if they come as a surprise, can pose
a problem to the EPFO in the future, says Deepesh Raghaw. 
For Amit Gopal, while portfolio disclosures are certainly good from
a governance and analytical perspective, they may not make much
of a difference to investors just yet given the low levels of financial
literacy and lack of choice in asset selection. The bigger issue that
needs addressing, he thinks, is the EPFO’s practice of declaring
almost fixed, guaranteed returns while its investments earn variable
returns. This, he says, needs to be de-risked with some form of
‘unitisation’.
That’s another key reform that’s been pending at the EPFO.
‘Unitisation’ means that investors would be allotted ‘units’ towards
their investments, each unit would have a net asset value akin to
mutual funds, and the total value of the units would reflect the
underlying market value of the investor’s portfolio. Unitisation has
attained more urgency in the past few years, given the EPFO’s
increased exposure to equity—a volatile asset class whose value
fluctuates daily.

There have been suggestions that instead of the entire portfolio,

unitisation could be done only for the equity component. But
complications in the modus operandi, given the legacy investments,
mixed asset structure of the EPF, and the prerequisite of mark-to-
market seem to have held up the process. Unitisation might also
require changes in regulations, says Amit Gopal of Mercer. Then,
there is the problem of explaining the seemingly complex step to
millions of investors who think of the EPF as a simple product. It’s
something worth pursuing, think some experts, for improving
transparency around portfolio disclosures and decision-making.
Amit Gopal says the investor benefits of the EPFO opening up to
equity investments are not fully realised by members due to the lack
of unitisation. 
In fact, unitisation has been one of the scoring points of the
National Pension Scheme (NPS), the other major retirement vehicle
in the country, over the EPF.  Investors, in general, value
transparency, ease of understanding, and knowledge of the value of
their investments—all things that unitisation allows. The experience
of the NPS in unitisation might come in handy for the EPF too.

EPF versus NPS

It’s not just financial market experts, a section of the government—

the Ministry of Finance in particular—also seems unhappy with the
way the EPFO is run. 
Over the past few years, it has tried to reduce the attractiveness of
the EPF for investors—for instance, by trying to cut the tax benefits
and withdrawal options. This has often been met with strong
resistance from employee investors, and the government has had to
back off back off The Economic Times Budget 2016: FM Arun
Jaitley rolls back proposal to tax EPF Read more on more than one
occasion one occasion Business Standard Govt rolls back PF
withdrawal norms after massive protests Read more . On the other
hand, it has been trying to improve the attractiveness of the NPS by
improving the tax breaks among other measures. 
The Ministry of Finance has also often asked for clarifications - The
Economic Times "Does EPFO really have enough money left for the
year after IL&FS? FinMin wants to know Read more  from the EPFO
on the rates it declares and related matters such as the surplus."
In his Budget speech in 2015, former Finance Minister, the late
Arun Jaitley, famously remarked that the EPF has hostages, not
clients. Clearly not a fan of the EPF, he had proposed a few far-
reaching changes, including offering investors the choice to shift
from the EPF to the NPS. 
Not much has come of this. That a powerful policymaker such as
Jaitley couldn’t quite make the proposal operationally effective says
much about the EPF’s sway among its investors. 
And with good reason. Investors view EPF primarily as a guaranteed
return product backed by the government, with rates hovering in a
range. The NPS, on the other hand, is a market-linked instrument
with returns varying based on portfolio performance. But its
additional tax break of Rs 50,000 ($660) a year is a sweetener. For
many, it’s not an either-or, rather it is both. A couple of young
investors The Ken spoke to said they invest or would invest in both
the EPF and the NPS. A Bangalore-based content creator says, “The
EPF is an auto-deduction from my salary and gives almost
guaranteed returns that’s better than other debt options. I also
invest in the NPS because it gives me added tax breaks and will help
supplement my retirement corpus.” 
“The portability from EPF to NPS, if introduced, could pose some
challenges to provident funds”, says Amit Gopal. But members
shifting from the EPF to the NPS en-masse seems unlikely, he adds.
This, despite the NPS delivering better returns than the EPF, thanks
to the former’s higher equity exposure, on average. Unlike the EPF,
the NPS offers investors the flexibility to choose their asset mix. 
Never say never, though. The NPS was started in 2004, more than
50 years after the EPFO. But it already has assets under
management (AUM) of about Rs 7,00,000 crore ($92 billion),
compared with the EPFO’s Rs 16,00,000 crore ($211 billion). It’s
also growing faster than the EPFO. 
“The EPFO show can go on as long as inflows from current and new
members exceed the outflows to retiring members,” says an expert.
But when the demographic profile changes with faster ageing, it will
hurt, they add. Also, a bear market, when the EPFO will not be able
to tap into equity sales, will impact its interest payouts.    
Over the years, there have been many operational improvements in
the way EPFO functions, especially on the customer-facing
digitisation initiatives. But much remains to be done on the
investment management side. On the other hand, “the NPS has
globally compatible architecture for regulation and investment
management, and for record keeping,” says Asher. 
In November last year, the Centre formed four panels to look into
the functioning of different aspects of the EPFO. And in January
2022, the EPFO decided to appoint an independent auditor to track
its fund managers and keep an eye on their investment
transactions. 
The EPFO will have to go beyond this—making fundamental
changes in the way it runs its investment operations, and in
sensitising its members about the market-linked nature of the EPF.
Best to disrupt oneself before someone else does.
Lead image credit: Kristopher Roller/Unsplash