EPFO's accounting needs transparency jab

The EPFO is larger than four of the largest mutual funds put together, yet it has opaque accounting practices with no portfolio disclosure even at year-end

The Employees’ Provident Fund Organisation’s (EPFO) trustees announced 8.5 per cent interest for 2020-21, well after more than 10 months had passed in the financial year. This rate, tax-free to boot, sounds too good to be true and stands in sharp contrast to the interest rate on long-term government securities (G-Secs) being at a record low during the year.
 
If newspaper reports are to be believed, this was mainly because equities bought in 2015-16 were sold at a good profit. A little digging into the EPFO’s latest available annual report for 2018-19 shows (on page 180) that more than 99 per cent of the G-Secs it holds yield more than 6.5 per cent interest and 37 per cent yield more than 8.5 per cent. This high rate of interest on G-Sec holdings is perhaps the major reason why the 8.5 per cent rate was possible. This annual interest rate announcement ritual and its subsequent approval or paring down by the finance ministry has an opacity that does not befit our country. 

 
The EPFO manages around Rs 13 lakh crore to provide long-term social security to over 4 crore subscribers. Around 94 per cent of its funds are invested in debt securities and about 6 per cent in equity-related investments. The EPFO is larger than four of the largest mutual funds (MFs) put together. Yet it has opaque accounting practices with no portfolio disclosures even at year-end (unlike the monthly disclosures made by MFs). Its annual accounts are available on its website with at least a two-year delay. It reportedly follows the cash system of accounting. How that cash system is applied in terms of income recognition, credit losses, diminution or increase in the value of investments, etc is not provided anywhere in the annual report (or at least I could not find it). It is this opacity that leads to the smoke-and-mirror game of announcing the interest rate after almost the entire financial year is over.

 

The political leadership’s involvement in what is essentially a long-term fund management business means there is a great emphasis on short-term optics rather than long-term results. This emphasis on the short term combined with opacity is a recipe for disaster.

A simple example will demonstrate this. A large proportion of the G-Secs held by the fund provide surprisingly high interest rates. It is possible that they were bought at par when interest rates were higher. The value of such securities would have appreciated when interest rates dropped. Subscribers who have withdrawn from the fund have been treated unfairly as they did not get the benefit of such increase in value.

If these high interest-bearing securities were bought recently after interest rates dropped, they would have been bought at a premium, which will be lost when the securities are redeemed in the future at face value. The price of this loss will be paid by the subscribers in the scheme at the time of redemption. Either way some subscribers are treated unfairly.
 
The situation gets exacerbated in the case of equity investments where prices are more volatile, though at the current level of holdings (around 6 per cent) it has limited impact. Since higher equity and other alternative investments are planned, the accounting methodology needs an urgent relook.

 
No substantive reforms have happened in the EPFO on the fund management side. This reform-minded government should look at turning this body into a vibrant and modern fund management business.  
The writer heads Fee Only Investment Advisers LLP, a Sebi-registered investment adviser