Saturday, October 31, 2009

Side-effects - Ignorance isn't bliss

I wasn't expecting any pension and it came as a surprise that I was eligible for one. So, why am I bothered when the amount turned out to be about Rs. 1000 per month (US$22 sounds even better!).

Anyway, I decided to understand the pension scheme and its implications. Amazingly, the pension depends only on the final pensionable salary which is approximately the average salary during the last year of service and the number of years of service. The formula is

Monthly member's pension = Pensionable salary X Pensionable service / 70

A small Python program was helpful in understanding it:

start_sal = 10000
av_incr = .1 # 10%
av_return = .085 # 8.5%
pf_acct = 0
for year in range(N):

salary = start_sal*(1 + av_incr)**year
pf_acct += salary*(1 + av_return)**(N - year - 1)

pension = 12*N*salary/70. # annual
eff_ret = 100*pension/pf_acct
print N, salary/start_sal, pension, eff_ret

The legal requirement for an employer is restricted to Rs. 6500 per month. Hence, if the employer contributes 8.33% of the legal requirements, we are clearly the loser. At the end of 35 years, the pension would be equal to a little over 3% return.

However, if the average increase in pensionable salary is 10%, which is a very conservative estimate, the return is 21% and one wonders who is paying for it! This assumed the current EPF interest rate of 8.5% which may not be sustainable. The retirement salary would be 25 times the starting salary in 35 years. A very low estimate in my opinion.

LIC pays me an annuity at, I think, 6.75%. However, I have neglected the fact that the capital will disappear once recipient disappears and government contributes 1.16% to the contribution as well. This may result in a correction of about 2% in the return, hardly enough to avoid bankruptcy.

It becomes a pyramid scheme where our children or grandchildren will be stranded with a bankrupt organisation!

Still, it does not make sense that why would the government create an organisation which was destined to failure. There must have been a rationale.

Probably, the scheme was introduced when our interest rates were high. If we assume the return is 12% and the salary increase is 10%, the pension corresponds to about 12% return.

For me, the low pension was a side effect of leaving a corporate job and joining a college on a contract assignment! Since the pensionable service was the minimum 10 years, the impact is not meaningful. Still, it bothers :)

Update 25/11/2009: The pension office informed me that currently by law, the pensionable salary is limited to Rs. 6500 only. Hence, my pension is correct, but which raises the issue, why should anyone be a member of a pension scheme which will give only 3% return? Why is government not scrapping this scheme and allowing people to use the New Pension Scheme instead?

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