Anchor pension policy to its core design principles

by Renuka Sane.

Pensions policy, at its heart, stems from paternalism. When people stop working, they stop earning, and if they haven’t saved enough, face the risk of destitution in old age. In most societies, the state feels compelled to step in with tax-payer funded cash transfers in the form of old age pensions. Over time, these commitments have expanded to cover entire populations. Yet financing the consumption of all elderly citizens through welfare transfers is fiscally unsustainable. As a result, pensions policy has focused on how to force individuals to build wealth during their working life. This coercion is justified on the grounds that people tend to underestimate their future needs, and discount the future too heavily. Assessment of pension policy, therefore, must recognise that it flows from the state’s decision to compel individuals to save for their own future consumption. The legitimacy of this coercion depends on whether it contributes towards preventing poverty in old age. This article examines pension policy from such a perspective. The design of means-tested transfers for the already impoverished elderly, while significant, is not addressed here.

Four elements of a sustainable pension

This paternalistic foundation shapes the four defining features of a funded pension system. First, participation is mandatory. Second, the savings are illiquid. Third, the structure is low cost. Fourth, it converts savings into a stable stream of income in retirement. These features make a pension different from other forms of saving or investment. Take away one of them, and the system begins to resemble an ordinary investment account rather than a vehicle for old age income security.

Let us begin with the first feature: mandatory participation, where individuals are forced to save a proportion of their monthly income into a pension account. But, compulsion requires an employment relationship so that contributions can be enforced. Extending such schemes to the informal sector where workers move between jobs or remain outside formal payroll systems is a challenge. Further, there is the question of what contribution rate to mandate: if it is set too low, the accumulated savings will be inadequate for retirement; if set too high, it will unduly constrain consumption during working life.

The second feature, illiquidity, is put in place to provide income in old age, not to finance mid-life consumption. This design feature is always contested. Individuals argue that since it is their money, they should be able to access it when they need it. Such demands become greater when contribution rates are very high. Policymakers often give in, allowing partial withdrawals or loans against the accumulated corpus. But withdrawals can leave retirees with inadequate balances, defeating the entire purpose of the mandatory contribution.

The third feature, low costs, is crucial because of the long horizon of pension saving. Fees and commissions, even if small annually, compound heavily over decades. High costs can erode a significant portion of the final corpus. Keeping costs low is especially important because participation in a pension scheme is compulsory; having coerced individuals to save, policy cannot then channel their money into high-cost funds that primarily enrich fund managers. The global experience suggests that keeping costs low requires deliberate policy design. This can be achieved through two ways.

1. Auction-based system for selecting limited fund managers (as was the case of India’s National Pension System (NPS)). The larger the corpus with a fund manager, the lower the fees. For example, Vanguard S&P500 ETF has assets of about US$1.5 trillion, and an expense ratio of about 0.03% (3 bps). When fund managers are given a specific mandate to manage a large corpus, costs can be negotiated down. Pension policy, especially when the market is very small, must then decide between the competing trade-offs of multiple managers and choice vs. limited fund managers and low costs.

2. Limit investment options to low-cost passive index funds. Over long periods, index funds typically outperform most actively managed funds, net of costs. Critics argue that restricting investment options stifles innovation and deprives individuals from exercising choice. But the idea of unfettered choice has also been questioned, given that most individuals may not be equipped to make complex financial decisions. These trade-offs become relevant because of the forced nature of savings.

A reasonable middle ground lies in offering a limited number of fund managers who provide a restricted menu of low-cost index fund options. Index funds with equity exposure provide for an upside and international exposure can help reduce risk through diversification.

The final feature, a retirement income, is what completes the cycle. This can be achieved through an annuity, which converts the accumulated balance into a guaranteed stream of payments for life. In the case of an inflation-indexed annuity, the payments are adjusted for inflation throughout retirement. While annuities provide longevity insurance (and can sometimes provide inflation protection), they are often unpopular because they appear to offer poor returns and lack flexibility. Pricing of annuities may be a challenge when the bond market is itself underdeveloped. The compromise in many systems is to mandate partial annuitisation requiring that a fraction of the corpus be used to buy an annuity while allowing flexibility for the rest. The other alternative is to design systematic withdrawal plans that allow for gradual withdrawals from the corpus. This doesn’t insure against longevity risk, but is often preferred for its simplicity and flexibility.

It is important to emphasise the word funded when outlining the four features. If taxpayer resources are used to finance retirement, features such as guaranteed returns can be built in. However, such arrangements are often vulnerable to funding pressures over time. If the system is to remain self-sustaining, the investment risk must rest with the individual unless that risk is explicitly priced and paid for.

Pensions in India

The central question for any government, then, is how to achieve these four features. Let’s consider how the EPF, NPS fare on these parameters, especially relative to a mutual fund that is not a pensions product.

Feature	Mutual fund	EPF	NPS
Mandatory	No	Yes (for formal sector)	Somewhat
Illiquidity	No	Cannot withdraw 25% of corpus	Yes
Low cost	No	Somewhat	Yes
Retirement income	No	No	Yes

A mutual fund is not mandatory, or illiquid, or low cost. It makes no promises of a retirement income. These features are not expected from a mutual fund, as it is not a pensions product.

EPF

The Employees Provident Fund (EPF) functions effectively on the issue of mandatory contributions, as it is meant for formal sector workers, where employment is defined and contributions are linked to payroll. However, its contribution rate, around 24%, is high, making it burdensome, particularly for low-income workers. Early withdrawals from the EPF have been a persistent concern. The EPFO has recently restricted withdrawals to 75% of the corpus (and hence 25% of the corpus is illiquid till retirement), which is an improvement, but still undermines the purpose of a pension product. The EPFO needs to consider a calibration of the contribution rates. The administrative costs, borne implicitly through an employer levy of about 0.5% of wages, make it relatively expensive. Moreover, it offers no choice in investments and provides a guaranteed rate of return, which limits both flexibility and upside potential. Finally, by paying out a lump sum at retirement, the EPF exposes individuals to longevity risk. From a pension design perspective, the EPF would benefit from reforms across all four foundational elements of a pension system.

NPS

The National Pension System (NPS) did not encounter challenges of coverage when participation was mandatory for government employees. The total AUM of NPS in September 2025 was about US$178 billion (Rs. 15.8 lakh crore), of which 85% was with the three public sector fund managers (SBI Pension Funds Pvt Ltd, LIC Pension Fund Ltd, UTI Retirement Solutions Ltd). The Pension Fund Regulatory and Development Agendy (PFRDA) has capped investment management fees for all pension fund managers, which continue to be some of the lowest in the world (between 3bps – 9bps). As the total corpus grows these may further come down. The NPS permits equity exposure but limits international investments, thereby constraining diversification opportunities. The scheme allows only three partial withdrawals during the entire subscription period and limits the amount that can be withdrawn. It would do well to reserve these safeguards, which reinforce the principle of lliquidity that underpins any pension scheme. It requires artial annuitisation at retirement and offers a systematic ithdrawal plan, with ongoing efforts to design additional tructures that can strengthen income security in old age. These are steps in the right direction.

Despite these advantages, the transition to the Unified Pension Scheme (UPS) has brought forth a fundamental challenge for the NPS: building a base of contributors for whom saving is compulsory. The natural tendency will be to compete in the market for voluntary savings. More recently, under the Multiple Scheme Framework (MSF) fund managers are permitted to design and offer multiple schemes tailored for different subscriber segments. While this will allow more choice for subscribers, it runs the risk of diluting what makes the NPS a pension product. A mature mutual fund industry already caters to voluntary investors, and an excessive focus on marketing voluntary contributions risks undermining the NPS’s defining advantage – its low-cost, low investment options structure.

Conclusion

Retirement schemes, whether the EPF or the NPS, are only one component of an individual’s broader savings portfolio. et, for the portion that is locked into a dedicated pension scheme, fidelity to the four core design principles is crucial. This is especially important as both schemes, and particularly the NPS, consider various reforms related to the design of different schemes, valuation models and withdrawal options. The focus of a pension system should remain on expanding wholesale participation through large-scale group subscriptions, rather than competing directly in the retail savings market.

The authors is a researcher at TrustBridge Rule of Law Foundation.

Source: https://blog.theleapjournal.org/2025/11/anchor-pension-policy-to-its-core.html