Rajasthan decision to revert to old pension a hard hit on NexGen finances

A recent announcement by the Rajasthan government to revert to the old pension scheme, called pay-as-you-go (PAYG) pension, has attracted considerable attention for the wrong reasons. Demand for a similar move is now gathering support in other states as well and Chhattisgarh has also approved a similar decision. This move is expected to worsen state government finances.

A report by the State Bank of India (SBI) has estimated the present value of future liabilities at 13% of gross domestic product (GDP) if all states follow suit. PAYG scheme is commonly defined as an unfunded pension scheme where current revenues fund pension benefits. This is supposed to be a whacking on the finances of the current generation of taxpayers.

The actual effect of the decision will be felt from 2035, although this may differ for different states when actual retirements will happen. Our country had a PAYG scheme prior to the launch of the National Pension System (NPS) in 2004. Under PAYG scheme, “the contributions of the current generation of workers were explicitly used to pay the pensions of current pensioners. Hence a PAYG scheme involved a direct transfer of resources from the current generation of taxpayers to fund the pensioners,” says the report authored by Soumya Kanti Ghosh, group chief economic adviser at SBI.

What’s wrong with the PAYG pension system?

The PAYG scheme was in vogue in most countries prior to 1990’s, but was discontinued given the problem of pension debt sustainability, an ageing population, explicit burden on future generation and the incentive for early retirement (as the pension is fixed at the last drawn salary). The PAYG scheme, says the SBI report, thus had no accumulated funds and/or stock of savings for pension obligations and hence was a clear fiscal burden. Interestingly, the PAYG scheme is always an attractive dispensation for political parties as the current-aged people can benefit from PAYG even though they may not have contributed to the pension kitty.

PAYG schemes are illusory, warns World Bank

PAYG pension scheme is not fiscally viable. First, the trends in the pension liability of the state governments over the long run show a very sharp increase.

As per the SBI report, the CAGR in pension liabilities for the 12-year period ended FY22 was at 34% for all the state governments. As on FY21, the pension outgo as percent of revenue receipts is around 13.2% for all states combined, and 29.7% of own tax revenue. In fact 56% of expenditure of the states that is committed (interest payments, salary and pension payments) is met out of state revenue receipts.

In FY21, the total committed expenditure of states as a percentage of states' own revenue receipts was at a staggering 125%. For larger states like Punjab, the committed expenditure is as high as 80%, followed by Kerala (73.9%), West Bengal (73.7%) and Andhra Pradesh (72.2%), as a percentage of state revenue receipts.

Second, PAYG financing often masks the long-run cost of promised pension obligations. “If we assume that all states migrate to the old scheme, and assuming an entry level age of 28 years, with a 5% inflation indexation, the present value of the implicit pension liabilities is around 13% of GDP, discounted by the current G-Sec yield of 40 years. This is the implicit pension debt that will be unfunded as per the PAYG scheme. The above fact clearly underlies World Bank’s warning that PAYG schemes are not real.

“We should not commit fiscal hara-kiri in the quest for populism. Otherwise it will be disastrous for the country’s growth potential and at the same time place a higher burden on our younger generation,” says the SBI report.