EPFO should have a cautious approach towards equity

Representative Image

Representative Image

The Employees’ Provident Fund Organisation (EPFO) under the guidance of the Central Board of Trustees (CBT) manages the Provident Fund (PF) corpus of all employees who are contributing towards EPF in India.

As per the PF scheme, the government is empowered to notify the investment pattern for PF contributions. The CBT also issues additional guidelines for safety and security of such investments. Historically, as per the notified investment pattern and the guidelines issued by the CBT, the EPFO had been investing the PF contributions in secured instruments such as government securities and debt instruments to generate stable returns with no/low risk of capital.

With increasing pressure to generate higher returns, the government amended the investment pattern in 2015 to invest up to 15 percent of incremental PF contributions in ‘Equities and Related Investments’ such as (a) shares of companies listed on BSE or NSE that have market capitalisation of not less than Rs 5,000 crore and derivatives of such underlying shares, traded in BSE or NSE; (b) mutual funds which have minimum 65 percent of their investment in shares of companies listed on BSE or NSE; (c) Exchange Traded Funds(ETFs) based on Sensex or Nifty; (d) ETFs issued by SEBI-regulated MFs constructed specifically for disinvestment of shareholding of the Government of India in body corporates, and; (e) exchange traded derivatives for the sole purpose of hedging.

However, the CBT decided to invest only in ETFs due to ETFs’ low operating/transaction costs and diversification of portfolio across various companies. An ETF is listed on a stock exchange and invests in shares of companies which are backed by an underlying index such as Nifty or Sensex. Thus, from 2015 onwards, the EPFO started investing in ETFs based on Nifty, Sensex, Central Public Sector Enterprises (CPSEs) and Bharat 22 Indices. As on date, the EPFO does not directly invest in shares of companies, mutual funds or derivatives.

Given the long-term outlook, investing only in debt instruments may not help to beat cost inflation. The added exposure to equity through ETFs may provide the additional boost to generate higher rate of returns subject to market risk. The exposure to equity also helps the EPFO to compete with the National Pension Scheme (NPS). However, under the NPS, a subscriber can choose to invest up to 75 percent in equity and to automatically reduce exposure to more risky investment options as they get older.

While there is a fixed interest income from debt instruments, which is revenue in nature, the income from equity or the ETFs is mostly capital in nature, reflected by change in market value. The income from the ETFs can only be realised when the ETF units are sold. Until the ETFs are sold, any profit/loss is notional.

The EPFO is required to credit interest to employees’ PF account each year. This credit of interest every year makes its structure fundamentally different from other retirement plans such as the NPS or other retirement-based mutual funds. The yearly credit of interest gives a guarantee on safety and security of investments.

As with all equity-based investments, the returns are subject to market performance. In the long run, equity-based investments have provided higher returns than debt investments, subject to market risk. However, in the short-run, the equity-based investments are impacted by business cycles and abnormal circumstances such as COVID-19. Due to COVID-19 and subsequent market slowdown, the market value of EPFO’s investments in the ETFs dropped significantly. As the market started stabilising, the CBT, in its meeting in September, allowed the EPFO to redeem the ETF units by December 31 and utilise the sale proceeds to declare the interest rate for the FY2019-20 at 8.5 percent. Out of 8.5 percent, 0.35 percent will come from sale of the ETFs.

Also read: How the EPFO can improve as India’s largest social security provider

The EPF is one of the key long-term retirement savings plan for most of the employees. The main objective of the EPF is to provide social security. Accordingly, the investment strategy of the EPFO is based on the notified investment pattern, guidelines issued by the CBT and the social security objective. Keeping in view the social security aspect and interest of the employees, the CBT through the EPFO may have a cautious approach towards equity given the market volatility.