UPS: Understanding the fiscal implications of govt's new pension scheme

The Centre and states together spent about Rs 9.6 trillion on the pension of their employees in 2023-24 (FY24, revised estimates), accounting for 3.3 per cent of India’s gross domestic product (GDP). The proportion peaked at 3.8 per cent in the pandemic year of FY21 and fell to 3.3-3.4 per cent later. The average spending was 3.3 per cent in the decade beginning FY15. 

Most of the burden was caused by the old pension system (OPS). Under the new pension system (NPS), effective for employees recruited from January 1, 2004 in central services, excluding the army, and most states, governments earmark only 14 per cent of their basic pay each year.

With their combined outgo topping Rs 5 trillion for the first time in FY24, the pension bill of states exceeded that of the Centre by more than Rs 82,000 crore. States’ spending was higher than the Centre’s in the three financial years till FY24.

However, as a proportion of revenue receipts, the states’ outgo was 4.2 percentage points lower than the Centre’s in FY24. This has been the trend for a decade.

This analysis included defence and railway pensions while calculating the Centre’s bill. Defence personnel are paid under OPS. Railway employees are paid from a separate fund.

OPS-NPS-UPS

The NPS was touted as the milestone pension reform to lessen the burden on the exchequer. However, government employees were aggrieved as they would not get assured pension linked to inflation, as was the case with OPS.

Now, based on the recommendations of the T V Somanathan committee, central government employees, other than defence personnel, have the option to shift to the Unified Pension Scheme (UPS) effective April 1, 2025.

Under UPS, government employees with a minimum 25 years of service are guaranteed 50 per cent of their last drawn basic pay over the past year as pension. The scheme increases the government’s contribution to pensions from 14 per cent of an employee’s basic pay to 18.5 per cent. UPS pensions are inflation-indexed.

Finance Minister Nirmala Sitharaman has clarified that states may adopt UPS at their discretion.

States’ pain

Pensions are a disproportionately high burden on some states and growing faster than their own tax revenues (OTR), causing financial pain. Their pension bills have grown at a compound annual growth rate of 12.3 per cent, while OTRs have grown at 11.3 per cent in the decade ended FY24.

As a proportion of revenue receipts, the pension expenditure of states was higher in FY24 compared to FY15. This ratio is higher for the central government, but declining and likely to be the lowest in a decade in FY25.

In Himachal Pradesh, Punjab and Kerala, pensions accounted for 26.1 per cent, 22.5 per cent and 21 per cent of revenue receipts in FY24, almost twice the average for other states.

Fiscal sense

Lekha Chakraborty, professor and chair at the National Institute of Public Finance and Policy (NIPFP) says it may be premature to say if UPS is a step in the direction of reform, but it makes fiscal sense.

“The UPS is fiscally prudent for both the Centre and states, given the fiscal rules to maintain a particular threshold of fiscal deficit to GDP ratio every year,” she says. 

Sumit Shukla, MD and CEO of Axis Pension Fund, believes that increasing the pension fund allocation to equity is likely to be a “game changer” in the long run. “More money on the equity side will give fund managers an opportunity to invest in more stocks and generate higher returns for the subscribers. That would push us to look at new instruments and new companies for investment,” he says.

Shukla adds that fund managers will get higher equity funds to work with if equity investments for the government pension scheme are allowed to go beyond 25 per cent or 30 per cent of the total corpus. But some clarity on the scheme is still awaited.

Of the 18.5 per cent contribution by the Centre, 8.5 per cent of the basic pay may be earmarked for the corpus. "This amount — 8.5 per cent of basic pay — will be invested by the PFRDA (Pension Fund Regulatory and Development Authority) in a manner that will be decided later," says a person in the know.

Maharashtra was the first state to approve the UPS for its employees.

OPS question

Chakraborty of NIPFP explains that since state governments have limited fiscal space due to “uncertainties” and a “hawkish interest rate management”, OPS is “fiscally unsustainable.”

But what is the guarantee that the 18.5 per cent contributed by the Centre will not result in a gap between returns on these and employee's portion of investments and the amount payable to the retired workforce? People in the know say 18.5 per cent is an estimate that may not lead to this gap. This estimate is based on assumptions of inflation, interest rate, stock market returns, etc.

“The calculation takes the last 30 years' averages of these variables. That is how they come to 18.5 per cent for the government funding,” says one of the persons cited above. Sources say the contribution by the government will be reviewed every three years. “For example, if the stock market is continuously booming, even 18.5 per cent may not be required,” says one of the sources.  

The UPS is seen to be different from OPS since it is funded every year and the burden does not fall on future governments.

From a fiscal point of view, UPS is much better than OPS, sources assert.