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Why big changes are needed at EPFO

Source | The Economic Times 

One year into the potentially historic entry of equity into the investment portfolio of the Employees’ Provident Fund Organisation (EPFO), these investments have generated a little except hot air from those opposed to it, and apparently , a great deal of confusion about how to account for them. In fact, the equity investments have served primarily to point out just how antiquated the EPFO’s structure is and how small-scale tinkering won’t do much to enhance the actual returns that its customers get.

The quantum of these investments is tiny, being just about 5% of fresh inflows, although there has been some talk of increasing this to 10 or even 15%. Thus, the role that this equity portion plays in the EPF member’s returns is not relevant yet.

As I’ve pointed out earlier, this tiny amount of equity exposure is functionally useless. The EPFO invests 5% of the incremental investment in equities. No assets are shifted from the fixed income part and then redeployed into equity. At this speed, it could take a decade or more, depending on the differential between withdrawals and deposits and that between equity and fixed-income returns, for the equity exposure to reach 5% or more.

And if you think about it, a 5% exposure means the worst of both worlds. When the equity markets drop, the usual suspects will cry themselves hoarse about the losses, but when the markets rise, the tiny exposure to equity means that gains that are meaningful to EPFO members will be hard to come by.

In the time since equity investments have started, a further problem has come up. The EPFO does not really have a way for the returns from equity to be incorporated into the returns that are realised by investors. For the existing fixed income investments, it pays an interest rate that is based on interest that is actually realised from its investments. The equity part cannot work like this.

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