Hasten slowly

Real risks for pension funds in equities

The Securities and Exchange Board of India (Sebi) chairman, U K Sinha, has come out strongly against rules that restrict or disallow pension fund investment in equities. This has been a matter of personal faith for Mr Sinha from his days as the head of UTI asset management. Since he is now the capital market regulator, his views need closer examination. Now, as before, he is driven by a desire to see a less volatile and deeper equities market where domestic institutions counter-balance foreign institutional investors which enter and exit quite rapidly in times of uncertainty. He has pointed out that there is perhaps no other significant country in the world that has the kind of restrictions as exist in India on investment in equities by pension funds. His point is that if an investor herself wants her pension fund to get into equities, regulation should not stand in the way. India is a beneficiary of such investment, as foreign pension funds are among those that have sought to benefit from the high returns that Indian equities offer in a well-regulated environment.

Among financial instruments, equities offer the best long-term returns and the volatility visible in them at any given moment mostly evens out over time. But there is by definition an underlying risk in equities and several issues need to be considered. One, even in the best regulated markets in the world, mis-selling of financial products is a fact of life. In a country like India, with its level of financial literacy, the chances of this downside are real. An investor’s choice is important but a lay investor may not always know what is good for her. Two, institutional players in mature markets do not always correctly assess the risks implicit in different products. In the run-up to the financial crisis that led to the Great Recession, even such risk-averse institutions as university endowments and municipalities took on exposure to complex derivative products and came to grief. Three, there is such a thing as a “black swan” event, something that happens once in a life time. With current levels of life expectancy, there can be a 50-year gap between the time a young person joins a pension fund and draws her last pension before departing this world. Thus, the need to be cautious when it comes to the regulation of pension funds cannot be over-emphasised.

Hence, there is a strong case in India for pension funds to be invested in government paper, bank fixed deposits and highly-rated bonds for the most part and the rest in equities so as to achieve a balance between the need for safety and a decent rate of return. The insistence of the trustees of the Employees Provident Fund Organisation (EPFO) in refusing to touch equities, reflecting the attitude of the trade unions, may be an extreme position, but regulatory caution restricting such exposure to low levels is eminently sensible. The pension regulator’s observation that under present circumstance restrictions on pension funds’ equity exposure should remain where they are appears quite sound. As for getting the EPFO to ease a little, there is only one way of doing it, by patiently selling the idea over time.