An unintended though useful by-product of the recent debate on the New Pension System (NPS) distribution strategy is a sudden interest among policy makers on questions of behavioural finance, sales practices and the cost of buying financial services.
Fees and charges levied on customers of long-term savings products like the NPS should, indeed, be of considerable interest as these accumulate and interact in complicated ways over the lifetime of a subscriber and directly impact retirement wealth. The Pension Fund Regulatory and Development Authority (PFRDA) faces a range of rather difficult options as the experience from both domestic and global markets does not reveal any magic formula. For instance, charges can either be front-loaded (contributions-based) and help recover the initial capital costs of service providers, or back- loaded (asset-based) or a combination. Service providers may levy flat annual charges, flat transaction-based fees, charges proportional to contributions, asset-based charges, or a combination of these. The charges could either be fixed and based on a regulated ceiling, or free and determined through competition.
Designing commercial incentives that align the interests of the manufacturers, distributors and consumers of financial services is obviously not easy. But it’s easily the single most important factor that influences sales practices and consumer behaviour — both key ingredients to building a mass-market for finance.
The distribution model and commercial incentives for mutual fund sales, for example, is largely responsible for AMCs achieving unstable assets, a small base of mainly high-income retail investors concentrated in a few cities, and a relatively insignificant share of household savings. Since mutual fund sales incentives have been skewed heavily towards transactions and investment volumes, it is not surprising that distributors have shown little interest in delivering value added advisory services or in growing the underlying investor base.
On the other hand, the life insurance industry, with well over 100 million individual customers, is the only finance vertical other than banking to have achieved a true mass-market status. But a closer scrutiny of the underlying motivations of life insurance customers reveals a somewhat disturbing picture: Less than one in ten insurance customers have a term policy and only a very small percentage view insurance as a tool for covering their mortality risk. Although this may simply be a demonstration of widespread financial illiteracy, the more obvious reason for this outcome is the large difference in sales commissions between term and other savings-linked insurance products.
The experience with both third-party and tied distribution models perhaps tilted PFRDA’s decision to sidestep the “push” approach and to instead adopt a more passive “pull” strategy with NPS. Instead of building an expensive distribution model, the PFRDA has focussed on building a scheme that is simple to understand and easy to operate.
However, despite its superior design and even if the retirement saving concept is actively promoted by the regulator, achieving a mass-scale behavioural change and a mass market for the NPS will not be easy for two key reasons. The first, as many argue, is that pensions, like insurance, will not be bought and will need to be actively sold. And a pull strategy, especially for a multiple decade savings product that targets a population which has never actively thought of “retirement”, will have limited success. There may be some merit in this thinking since PPF also used a similar pull strategy and ended up with less than four million customers in the last 40 years. But if the NPS succeeds to the extent it should, it could have an important systemic impact on how finance is sold and bought in India and may, therefore, displace established practice and conventional wisdom.
The second is that NPS coverage will depend largely on the last mile interaction between potential subscribers and PFRDA regulated points of presence (POPs). But POPs are also distributors of life insurance and mutual fund products that pay a much higher commission than the NPS. Hence, the NPS will need to compete with the prevailing commercial incentives for insurance and mutual fund products since distributors will have a natural inclination to promote products on which commissions and fees are higher. Therefore, NPS fees and charges will need to, at the very least, match the commissions offered by life insurers and AMCs. In reality, however, if insurance and mutual fund distributors are to be motivated to deliver the NPS, fees on NPS would need to be even higher than the fees on competing products.
Competing with existing commissions is, however, not a sustainable option for the NPS since a large proportion of potential NPS members include low and middle-income workers. High front-end commissions (or entry loads) on the NPS will crowd out the lower and lower-middle income segments and in turn lower the system’s potential coverage.
Also, high fees and charges will adversely impact retirement incomes and once again compromise a core goal of the NPS. Hence, although PFRDA has already taken the first step on the tightrope between commercial incentives and subscribers interest, it’s not evident yet that the NPS incentive structure or its pull strategy will deliver the twin policy objectives of rapid voluntary coverage and optimum retirement outcomes. Going forward, the PFRDA may need to recalibrate how the fees paid by NPS subscribers are distributed across each category of intermediary.
As things stand, however, the new pension scheme is unlikely to attract meaningful voluntary coverage unless households actively go against the advice they will undoubtedly receive on choices between NPS and other financial products. This could, of course, change if distributors were paid identical commissions across all financial products, just as a uniform 80C addressed inefficient consumer behaviour resulting from a differential tax treatment across financial products.
In this case, however, as different distribution models produce very different costs, a uniform incentive structure across finance verticals is perhaps not a feasible short term option. However, it should certainly be feasible for the RBI, IRDA and Sebi to also put more focus on the impact of fees and charges levied on finance customers.
Finance customers tolerate high costs as long as costs are not transparent. Greater transparency on this front could, therefore, motivate customers to demand lower charges and hence help bring down the cost of buying finance. And we could then stop subsidising distorted incentive structures and inefficient distribution practices.
Gautam Bhardwaj is director, Invest India Economic Foundation firstname.lastname@example.org