Perils of NPS Systematic Lump Sum Withdrawal Option
Pension Fund Regulatory and Development Authority (PFRDA) recently floated a discussion paper on introduction of systematic lump sum withdrawal (SLW) for the benefit of National Pension System (NPS) subscribers. 
The underlying proposal is very simple—under the current rules, an NPS participant can withdraw a maximum of 60% of the pension corpus as lump sum and a minimum of 40% as annuity upon superannuation. SLW option applies to the 60% portion of the total corpus wherein the participant has the option to retain funds with the NPS Trust but withdraw a pre-designated amount on a monthly, quarterly, half-yearly or annual frequency. The SLW will have a maximum tenure of 15 years at age 60, that is, after attaining 75 years, units available will be redeemed and the balance will be transferred to the subscriber’s bank account.
This proposal has been with NPS since its inception and is a direct replica of a similar withdrawal option given by Chilean pension funds. However, there is one difference: the payout in Chilean funds is set according to a government formula that converts the balance into a monthly payout that takes into account the retiree’s age, sex, marital status and trends in mortality. The discussion paper has nothing on this front.  
Let us understand the financial engineering of this proposal before we address many serious issues on why this proposal is an ill-conceived idea.
On the face of it, SLW appears like a 15-year sinking fund. Another comparable financial product available in the market is the annuity deposit which enables the depositor to pay a one-time lump sum amount and receive the same in equated monthly instalments, comprising a part of the principal amount as well as interest on the reducing principal amount. The only difference is that SLW is a sinking fund with a variable return; hence, the ratio between principal and return will vary with returns and, at times, can be 100% principal for some withdrawals.   
As is the nature of the sinking fund, after the final instalment, the balance must reduce to zero. This is also what the discussion paper concludes when it says, “After attaining 75 years, units available will be redeemed and balance will be transferred to the subscriber’s bank account.” This amount will be less than the initial 60% of the total corpus at age 60.
Having understood the basic engineering, three problematic aspects immediately emerge. 
First, is the lack of appreciation of the fact that age-specific longevity has improved across all ages in India, over the year. Longevity at age 60, which is relevant to SLW, as per current SRS Based Abridged Life Tables 2015-19, is 17.5 years for males and 19 years for females. The age 75 years has remained unchanged since a long time and, if SLW is to be accepted, this age must be raised to at least 79 years to ensure that SLW lasts till expected life at age 60.   
In any case, an individual who opts for full (or even partial) SLW, and survives beyond expected life at age 60, is sure to see a fall in consumption at the end of the term of SLW because the accumulated capital will be reduced to zero and the entire old age consumption will rest on annuity derived from 40% amount. It is a kind of outright dissaving and a guaranteed road to old age poverty. 
The second problematic aspect of SLW is that it encourages continuing within the fund as a dormant participant, i.e., earning returns but making no contribution. Since total returns on defined contribution pension fund are the function of both, temporal contribution rate and market rate of return, this option increases the overall cost of managing the fund. Employees provident fund organisation (EPFO) has been struggling with dormant accounts for years and had to eventually stop paying interest on such accounts.
The third aspect is related to larger objectives that pension funds serve. The purpose of the pension fund is to smooth consumption by ensuring a reasonable replacement rate—pre- and post-retirement. Any proposal on the withdrawal must optimise the replacement rate and not deplete it. This is more important in defined contribution (DC) funds than in defined benefit funds as the replacement rate is variable in the former and fixed in the latter. Thus, the purported benefit of SLW that it “adds flexibility, provides liquidity and hence optimises the retirement benefits” does not cut much ice.
How to organise the decumulation phase of the DC pension fund, is too vast a topic to be addressed here. But it is a fact that there was hardly any discussion on this aspect during the formative years of the pension policy in India. The successive leadership at PFRDA has paid scant attention. However, if we compare the behaviour of pensioners across countries, then in middle-income countries (mostly in Asia) pensioners rely heavily on asset income to fund consumption. Pensioners do not fund consumption by dissaving except in those countries with large transfers, such as from the pay-as-you-go system. 
In conclusion, SLW, as a proposal, does not impress this author much and should be discarded. Assuming we do not go that far, it is quite surprising there is no formula for how the SLW will work out taking all lifecycle risks into account. The current mechanism is completely delinked with the evolution of life expectancy at age 60 which puts the pensioner at greater risk of old age poverty through dissaving. 
The discussion paper is one-sided in the sense that no financial risk is envisaged in SLW. The issue of how the fund returns will be impacted, once a large cohort retires, can still be addressed through other portfolio strategies and SLW need not be an instrument to achieve that.
(The author is an economist in the banking system. The views expressed here are personal)
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