Should states avoid switching back to the old pension scheme? RBI economists think so

The report by RBI economists points out that while switching back to the old pension system may yield some short-term benefits, the scheme may end up costing four time as much in the long term
Switching back to the old pension system will be penny wise and pound foolish, RBI economists warned (Express Illustrations)
Switching back to the old pension system will be penny wise and pound foolish, RBI economists warned (Express Illustrations)

Even as many states are contemplating switching back to the old pension scheme from the new pension plan introduced in 2009, an analysis by economists at the Reserve Bank of India has revealed that this may be a short-sighted decision that will cost them far more in the long run.

The analysis found that States will end up with an estimated annual pension outgo of approximately Rs 16 lakh crore, or 0.5%-0.6% of GDP, by 2050 if they revert to OPS, as against Rs 4 lakh crore, or around 0.1% of GDP, if they stick to New Pension Scheme (NPS).

Currently, there are two groups of state government pensions. OPS subscribers, who joined prior to the adoption of NPS in 2009, and NPS subscribers, who joined thereafter. OPS is direct benefit scheme, where State government employees get a pension fixed at 50% of the last drawn salary, besides dearness relief revisions. The payout is fixed and there's no deduction from employees' salary during service. In other words, OPS is an unfunded, pay-as-you-go system, where taxpayers finance retiree pensions. It's also an enormous financial burden for states as future salaries are unknown, and so are States' pension liabilities.

In contrast, NPS is a defined contribution scheme, where employees' contribute 10% of basic salary and dearness allowances, with a matching contribution from the State government. The corpus is invested in equity and debt markets, and employees get a lumpsum besides an annuity by a third-party provider. For States, NPS outgo won't be a burden, thanks to the defined contribution of both the employee and the employer.

NPS was introduced only for those who joined from 2009 onwards. Those who joined after the scheme was introduced would need to contribute a share of their salary towards building their pension corpus.

The state governments also started making monthly contributions for employees who joined service from 2009 onwards.

At the same time, people who are retiring continue to retire under the old pension scheme as they joined before 2009. This means that the state governments are currently funding pension expenses under both schemes — under OPS for people who are retiring, and under NPS for people who are joining.

This has put them under fiscal strain, enticing many of them to consider shifting back to the OPS to shed the obligation of making monthly contributions under the new, corpus-based scheme.

For example, states' expenditure on pensions shot up from 0.6% of GDP during early 1990s to 1.7% in FY23, far outstripping the growth of revenue receipts. Though at a disaggregated level, the pension burden varies across states, collectively, it's higher than the Centre's outgo both in absolute terms as well as a percentage of revenue receipts. For instance, the pension outgo exceeds 25% of own revenue receipts in states like Bihar, Kerala, Punjab, Uttar Pradesh and West Bengal.

This prompted a few states like Rajasthan, Chhattisgarh, Jharkhand, Punjab and Himachal Pradesh to switch back to OPS from NPS. These states will see an immediate reduction in annual pension outgo, but as the study reveals, it may exert severe financial pressure in the long-run.

The study by RBI's economists shows switching back would be a mistake with far-reaching consequences.

Titled Fiscal costs of reverting to the Old Pension System by the Indian States -- An assessment, the study revealed that the current pension outgo for OPS subscribers is about Rs 4.6 lakh crore, or 1.7% of GDP, but will eventually touch Rs 16 lakh crore by 2050, or 0.5%-0.6% by 2050. The last batch of OPS beneficiaries will likely retire by early 2040s, but will continue to draw pension under OPS for the remainder of their lives, or till 2060s based on estimated life span of individuals.

On the other hand, the States' projected pension outgo under NPS is currently about Rs 27,000 crore, or 0.1% of GDP, but will likely peak to 0.2% of GDP by 2039. However, it's expected to decline back to 0.1% of GDP by 2050 or approximately Rs 4 lakh crore by 2050.

Meanwhile, if these NPS subscribers are now allowed to switch back to OPS beginning 2023, then states' will save upon the employer's contribution towards retirement corpus fund and consequently, states' outgo will drop to zero. But as employees retire, states' outgo will increase as they draw pension in line with the older pension system.

By the mid 2030s, the outgo would compare sizably to what it would have been under the NPS, but may exceed it by 2040 and rise to 0.9% of GDP by early 2060s. This outgo will be over and above the pension burden of older OPS retirees, who will continue to get pension until the 2060s. In all, the total pension outgo including OPS and NPS contributions will be significantly higher in the long-run, noted the analysis — which does not reflect the official stand of the RBI.

Thus, the authors concluded that a switchback to OPS may look lucrative for States' in the short-run, but the future burden will eclipse the short-run gains. By switching back to OPS, States can only save 0.1% of GDP on an average in annual pension outgo till 2040, but may incur an average additional increase in pension expenditure by 0.5% of annual GDP after 2040 and even higher at 0.9% of GDP by 2060, assuming a nominal GDP growth rate of 10%.

Worryingly, the burden will rise even further if the growth rate moderates. For instance, a 1 percentage point fall in average growth rate may increase the fiscal burden from 0.9% to 1.3% of GDP by early 2060s. A 2 percentage point fall increases the annual outgo to a staggering 1.9% of GDP.

In short, the fiscal cost of the switch will likely be about 4.5 times than that of the NPS. The actual future pension outgo could also be difficult to assess due to the changes in the underlying interest rate, longevity and salary/pension growth which could raise risk premium and cost of capital in the economy. Thus, the study concluded that the short-run reduction in States' pension outgo that's driving decision to restore OPS would be eclipsed by the huge rise in future unfunded pension liabilities in the long-run.

As on November 2022, the cumulative number of State government employees subscribing to NPS stood at 50 lakh with their cumulative contribution in NPS corpus amounting to Rs 2.5 lakh crore. The six large states include Uttar Pradesh, Rajasthan, Madhya Pradesh, Maharashtra, Chhattisgarh and Karnataka account for about half of all the subscribers to NPS.

As a committed expenditure, higher pension outgo compels governments to cut down on capex, have distortionary effects on the labour market, savings and investments as well as capital market development and dampen the country's medium-term macroeconomic outlook.

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