Beware! Govts do default on pension liabilities

The faith displayed by employees in a future government's ability to pay pension is perplexing when stories abound of state governments having difficulty in paying salaries

Let us begin with the story of an emperor who ruled over a prosperous kingdom. His employees demanded a pay hike for which the royal treasury didn’t have the resources. The emperor instead promised them a gold coin every month after retirement for as long as they lived. The employees agreed.

When the first batch of employees retired, the promised gold coin was paid religiously each month. More of his subjects flocked to become royal employees due to the attractive pay and pension. However, the royal treasury didn’t have enough money to buy the gold coins. It borrowed from moneylenders who obliged as the emperor had an impeccable track record of repayment.

All was well for many years. But as the ranks of retirees swelled, the royal treasury had to borrow more. The moneylenders grew worried it wouldn’t be able to bear the burden. They demanded a higher interest rate.

The emperor was succeeded by his son who quickly grasped the dire situation. He instituted a new programme for fresh employees. In addition to paying them a salary, the treasury would contribute a proportion of the employees’ salary into a separate employee fund each month. The employees would also contribute to the fund. On retirement, the fund would be used to buy the gold coin.

The treasury was now paying money into a fund immediately instead of making a bald promise to give a gold coin in the future. The employees could also see the fund in their own names and no longer had to depend on the emperor’s promise. The new system was adopted and ran smoothly for a few years.

However, the emperor was overthrown and was succeeded by a short-sighted opportunist. The royal treasury had got further depleted, making contributions into the employee accounts difficult. He was advised to stop contributions and revert to the old system of making a bare promise to pay in the future (by which time he wouldn’t even be around). Besides saving on contribution, he would also have an additional source of immediate revenue by annexing the substantial funds accumulated in the employees’ accounts under the new scheme.

Many gullible employees were willing to take the new emperor’s promise to pay larger sums far out in the future as they would also not have to contribute their share into their employee fund. They were even willing to allow him to annex the sums lying in their employee accounts. But the moneylenders, already worried about the state of the royal treasury, demanded that full details of all the promises made for the future be disclosed by the emperor. They threatened to increase the interest rate and even stop lending otherwise.

Let’s switch from the fable to the actual story on the demand for the Old Pension scheme. The politicians’ incentive can be understood as it helps them save on the employer’s contribution to the National Pension System (NPS) that runs into thousands of crore each year and gives them a chance to “earn” some immediate revenue by annexing the money lying in their employees’ NPS accounts. It is the faith displayed by the employees in a future government’s ability to pay their pension that is perplexing, especially when there are so many stories of state governments and civic bodies not being able to pay even salaries. Look at an example such as Greece to understand what happens when governments make reckless pension promises. Even more perplexing would be if employees let the politicians take over the money lying in their NPS accounts.

Truth be told, the only long-term solution for reckless pension promises is to remove the incentive to make them. The governments concerned should be required to continue their contributions to the NPS to meet their future pension liability. They should also be required to account for the liability to pay the difference in the future on the basis of an actuarial valuation. But no government has ever followed this sound principle of accounting for accrued liabilities and it would be a miracle if this suggestion is implemented.
 

The writer heads Fee-Only Investment Advisors LLP, a Sebi-registered investment advisor

Twitter: @harshroongta