Recent decisions by some states to revert to the old pension scheme (OPS), and a few others contemplating the same, pose "significant fiscal risks", according to Reserve Bank of India (RBI) economists.

The RBI study comes in the wake of latest decisions by a few states like Rajasthan, Chhattisgarh, Jharkhand, Punjab, and Himachal Pradesh to make a reversal to the OPS (old pension scheme) from NPS (national pension system).

In its latest monthly bulletin for September 2023, the RBI economists assess the "fiscal cost" of reverting to the "old pension scheme" by the Indian states via a study, which finds out it could have "distortionary effects" on the labour market, savings and investments as well as capital market development and dampen the country’s medium-term macro outlook.

After the launch of pension reforms during the first decade of this century, most states had adopted the NPS, a defined contribution scheme. However, against this, some states are now reverting back to the OPS.

The RBI study shows the "cumulative fiscal burden" in the case of OPS could be as high as 4.5 times that of NPS, with the additional burden reaching 0.9% of GDP annually by 2060. "Thus, short-run reduction in states’ pension outgo which may be driving decisions to restore OPS, would be eclipsed by the huge rise in future unfunded pension liabilities in the long-run," says the RBI.

The central bank says states reverting to the OPS will be a "major step backwards" and can increase their "fiscal stress" to unsustainable levels in the medium to long term.

Pensions provided by states in India are categorised under the OPS and the NPS. The OPS is a direct benefit scheme under which, after retirement, state government employees get a pension fixed at 50% of the last drawn salary and dearness relief revisions benefits. The pay-out is fixed and there is no deduction from the salary.

However, the OPS is an unfunded, ‘pay-as-you-go’ system in which current taxpayers continuously finance retirees’ pensions. While OPS may be more attractive from the employee’s perspective, it puts an "enormous financial burden" on the government, says the central bank.

Only West Bengal and Tamil Nadu continued with the OPS, posing significant uncertainty regarding the quantum of state governments’ pension liabilities for future years.

The NPS, on the other hand, is a direct contribution scheme under which the employees’ defined contribution is 10% of basic salary and dearness allowances, with a matching contribution from the state.

By investing a part of this contribution in equity and debt markets, the NPS aims to ensure a good pension for retiring employees, while reducing the budgetary burden. At the time of retirement, the employee gets a lumpsum amount from the accumulated fund, and the rest is converted to an annuity by a third-party annuity provider. The NPS also does not pose a pension obligation risk to the employer at the time of retirement, as the payments are made from the pension fund created through contributions from the employee and the employer during the service period.

As of November 2022, the cumulative number of state government employees subscribing to NPS rose to around 50 lakh with their cumulative contribution to the NPS corpus amounting to Rs 2.5 lakh crore. The six large states -- Uttar Pradesh, Rajasthan, Madhya Pradesh, Maharashtra, Chhattisgarh, and Karnataka -- account for around half of all the subscribers to NPS. Uttar Pradesh and Rajasthan are the only two states, which have more than five lakh subscribers.

Fiscal cost & pension outgo

The RBI says the immediate gain of reverting OPS is that such states will not have to spend on the "NPS contribution" of the current employees. In the future, however, the unfunded OPS is likely to exert "severe pressures" on their finances, especially with increasing longevity.

"For instance, if the current NPS subscribers stay in government service till 60 years of age, in the next 15-year period, i.e., during 2023-37, around 20% of the current NPS subscribers will retire. However, in the succeeding 15-year period i.e., 2038-52, 60% of the current NPS subscribers (numbering around 30 lakh) will retire. Consequently, any switchback to a defined benefit pension system by the State governments will impose a huge fiscal burden on their finances during this period."

In terms of pension outgo, the RBI says for the first group i.e., the OPS subscribers, the current pension outgo is around 1.7% of GDP and is expected to grow further. The last batch of these employees are projected to retire by the early 2040s and will continue to draw pension under OPS for the remainder of their lives i.e., till 2060s.

As for the second group, i.e., the current NPS subscribers, states' yearly contribution to their retirement corpus fund is expected to increase from 0.1% of GDP presently to around 0.2% of GDP by 2039 and will slowly start declining after that.

With some states reverting to OPS beginning in 2023, the state governments save upon the employer’s contribution they were earlier making towards these employees’ retirement corpus fund. Consequently, states’ immediate outgo towards these employees will drop to zero.

However, as these employees gradually retire, the states’ outgo will begin to increase again as these employees will now draw pensions in line with the older OPS beneficiaries. "By the mid-2030s the outgo would compare sizably to what it would have been under the NPS and eventually exceed it by 2040." Thereafter, the burden will increase rapidly, reaching around 0.9% of GDP by the early 2060s.

The projected outgo of 0.9% of GDP by 2060 is only a scenario with an assumed nominal GDP growth of 10%. The burden will rise even further in case of moderation in future growth, says the RBI study. For instance, a 1 percentage point fall in average growth rate raises the outgo from 0.9% to 1.3% of GDP by the early 2060s. A two percentage point fall will raise it further to 1.9% of GDP.

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