EPFO may have ruined your retirement plans. Here's how

After he retires, the head of a leading mutual fund house plans to file a class action suit against the Employees' Provident Fund Organisation (EPFO). His charge: by delaying the decision to invest in stocks, the Central Board of Trustees of the EPFO did not let retirement funds gain from the stock market rally. The EPFO will now invest 5% of future contributions in stocks but many think it is too little and too late. "If this decision was taken 20 years ago when the Sensex was at 3,500, imagine how much richer all PF subscribers could have been," fumes the fund house chief. 
Are you also angry that your retirement savings missed the 700% rise in the Sensex in the past 20 years? ET Wealth crunched some numbers to calculate the extent of the damage of the EPFO's historical aversion to equity. We looked at the interest rates offered on the Provident Fund in the past 20 years and calculated the corpus of a hypothetical subscriber who joined the scheme in June 1995. 
Since PF contributions are linked to salary, the calculation factored in a 10% increase every year in line with the annual hike in income. For the sake of simplicity, we ignored the small portion of the employer's contribution which flows into the Employees' Pension Scheme every month.

If our hypothetical subscriber started by putting Rs 2,000 a month (which includes his employer's contribution) in the EPF from June 1995, his PF balance would have grown to Rs 29.35 lakh today. Not a very impressive figure and certainly not something that you can hope to retire with at today's prices. Assuming that the money is invested to earn 9% returns and inflation is a mild 6%, the corpus won't sustain inflation-adjusted withdrawals of Rs 30,000 a month for even 10 years. 
But what if 5% of the monthly contribution went into stocks? We calculated the impact on the retirement corpus if 5% of the contribution was invested in Nifty stocks in the same proportion as their weightage in the index. It may sound unbelievable but the corpus would have been only 2.4% bigger at Rs 30.05 lakh. The 7,000-point rise in the Nifty in the past 20 years would boost the corpus by a mere Rs 70,517. 
Not impressed, we tweaked the calculation and increased the equity allocation to 15%, in line with the investment pattern that NPS funds for government workers are allowed to follow. Even then, there were no fireworks. A 15% allocation to Nifty stocks would have increased the corpus by Rs 2.11 lakh (or 7.2%) to Rs 31.46 lakh.

Why stocks haven't helped

Why is the difference in the corpus of the pure debt-based PF and 5% investments in stocks so slender? For one, the EPF was offering very high rates in the past. Between 1995 and 2001, the interest rate on the EPF was 12%. It was lowered to 11% in 2001 and later to 9.5% in 2002. Except for 2012-13 when it was 8.25%, the EPF rate has remained above 8.5% since 2005. The government-managed scheme has delivered SIP returns of 9.08% in the past 20 years.

On the other hand, while the Nifty has witnessed a compounded annual growth of almost 12% in the past 20 years, a 5% allocation to equities has not been able to make a meaningful difference. In the first year, the monthly investment in stocks was only Rs 100 (5% of Rs 2,000). In the first 10 years, the total investment in stocks was Rs 19,125. The SIP returns with 5% equity exposure are only 9.28%. 
How big your PF could have been

If someone started contributing Rs2,000 a month (including the portion contributed by his employer) to the EPF in June 1995 and increased the contribution by 10% every year.

Raise allocation to equities

We increased the equity allocation to 50% to see if the results were any better. This is the maximum allocation to stocks allowed in the NPS for the private sector. The results were definitely better but still not satisfactory. The corpus became 24% bigger at Rs 36.40 lakh. 

The situation changes drastically if instead of the Nifty, the 5% is invested in an actively managed diversified equity fund. We chose the Franklin India Bluechip Fund for the purpose. The large-cap oriented scheme has been a consistent performer with an impeccable record. The results were eye-popping. 

If the 5% exposure to stocks was through the Franklin India Bluechip, the corpus would be bigger by more than 10%. A 15% exposure increases it by 31%. If 50% of the monthly contribution was put in the fund, the corpus would now be Rs 59.69 lakh—more than double of what the purely debt-based Provident Fund yielded. "Actively managed funds are better products and can give significantly higher returns than ETFs," says Chandresh Nigam, MD and CEO of Axis Mutual Fund. 

But this has not been a smooth journey. Before it churned out more than Rs 30 lakh additional returns in 20 years, the hypothetical portfolio also suffered many hiccups. For the first 30-odd months, the value of the corpus was below the value of the pure debt-based PF corpus. It moved up in the fourth year when the markets rallied but fell again after the dotcom bubble burst.
In October 2001, it was Rs 30,000 below the PF value. Things improved when the markets rallied and by January 2008, the ultra-safe PF portfolio was Rs 16 lakh behind the aggressive portfolio. But the subsequent stocks crash narrowed the difference down and by March 2009, the aggressive portfolio was only Rs 4.4 lakh more. Then stock markets rallied again and by the end of 20 years, it was Rs 30.5 lakh ahead. Investors should be ready to stomach that volatility if they want higher returns. 
"Active strategy can certainly get better returns but there is no political appetite for actively managed funds and the risks attached," says Gautam Sinha Roy, Vice-President and Fund Manager, Motilal Oswal Asset Management. That's true. It is unlikely that the Central Board of Trustees of the EPFO, who have allowed a 5% investment in stocks after years of debate, will permit a higher allocation to equities. Similarly, EPFO will not agree to active management.

But if you invested in a top fund

The situation would have been different if the equity investment was in an actively managed fund* 

Take cue from NPS

Perhaps, the EPFO should take cue from the NPS on its equity allocation. The government-sponsored pension scheme allows up to 15% allocation to stocks for NPS funds for government workers. Private sector employees can invest up to 50% in equities. For those who are unable to decide how much to invest in stocks, the Lifecycle Fund of the NPS is a perfect option. The equity allocation is linked to the age of the investor. Till 35, the exposure to equities is 50%. After that it reduces every year by 2% till it becomes 10% when the investor is 55).

This reduction in the equity allocation is in keeping with the strategy to opt for higherrisk-higher-return portfolio mix earlier in life. As the individual grows older, he gradually moves to a more stable fixed-return-low-risk portfolio. This is a unique product because it is customised to the individual's age. 
The NPS itself is poised to change. The Bajpai Committee, which was set up to suggest improvements in the government-run scheme, has suggested several fundamental changes. The panel recommends a higher equity exposure in NPS funds for government employees and the investment universe expanded from the Nifty to the NSE 100 index.

More importantly, it has suggested active management instead of a dogged replication of the index. NPS funds should be allowed to invest in a range of assets, including private equity, real estate investment trusts, mortgage-backed securities, CBLOs, alternative investment funds and commodities.

Returns from stocks are high but volatile

The EPF returns were higher than inflation in the first few years but later declined. Stocks have given very volatile returns.

What investors should do

For investors saving for retirement, especially those in their 20s and 30s, the message is loud and clear: a small allocation to equities will not make a significant difference to your nest egg. If you are saving for a long-term goal with a 15-20 year horizon, you should take a much higher exposure to stocks. "Since the EPF will not allocate too much to stocks, investors should separately put money in stocks for their retirement," says Roy. This exposure to equities can be through direct stocks, actively managed funds or indexlinked ETFs depending on the individual's understanding of equities and his risk appetite," he adds. 
Some may argue that given the small difference in the returns, it is not really necessary to invest in stocks. After all, as our study has shown, a 5% exposure to stocks made the corpus only 2.4% bigger. That's true. However, the high interest rates offered by the EPF in the past is now history. In the coming years, the interest rates will not be able to match inflation. 

On the other hand, experts are confident that the stock markets will deliver good returns in future as well. "If the nominal GDP growth rate is 13-14% a year, the stock market can grow by 17% annually," says Roy. Good quality actively managed funds can yield even better returns.

However, you will have to monitor the performance of your funds. Even a good fund will not be able to consistently stay on top for longer periods of 10-15 years. That's not a big problem. As we have repeatedly advised our readers, one should review one's portfolio at least once in a year. If a fund has been consistently underperforming for 2-3 quarters, all you need to do is switch to a better fund.