Despite the setback, the EPFO must persist with equities
Employee Provident Fund Organization (EPFO) has decided to pay only 8.15% out of the 8.50% interest committed by the government for FY2019-20. The balance will be paid by December 2020 subject to equity surplus available with the EPFO corpus. This rate was already the lowest paid in last 43 years.
Why did EPFO report losses?
The government had allowed EPFO to invest up to Rs.100,000 crore in equities which has been done through the ETF route. The equity component, however, has given negative returns of -8.3% for the year due to the negative impact of COVID-19 and the lockdown. With such a huge gap in returns, there is only 8.15% that the EPFO can pay out of its debt earnings. The balance 0.35% will be subject to positive returns on the equity portfolio during the year.
Asset allocation is a challenge
In the past, returns on debt used to be around 10-12% and hence EPFO could pay higher returns to the PF holders by just investing in debt. But rates are now at their lowest ever and that is not good news for debt investments. That has forced the EPFO to use the ETF route to participate in equities. Globally, most long term liabilities are matched to equity assets and there is a risk in the short term. The negative return on equities gets magnified due to the fact that returns on debt are already low.
Don’t lose the equity edge
This is likely to revive the old debate on whether the EPFO should invest in equities at all? That debate has been settled. Provident funds and pensions represent long term liabilities and they must be matched with long term assets like equities. By definition, equities have the potential to generate negative yields at times. However, they still are the best value creators over the long run. Even if you just look at the Sensex, it has given 16.5% CAGR over last 40 years and that is the kind of returns that would be a dream for the EPFO. Not only must the EPFO persist with equities but it must also adopt a proactively dynamic approach wherein the EPF automatically invests more in equities when valuations are lower. It’s time for dynamic returns!
Position EPFO as an asset class
A 9% assured return scheme with zero risk is impractical in the current market conditions. Long term liabilities like PFs must be matched with equities. Here are 3 things. The focus must be on long term CAGR returns and not on one-year returns. Secondly, the overall portfolio returns matter more than individual asset class returns within the EPFO. Lastly, EPFO must move towards a dynamic reward structure wherein the assured component is lower. Additional returns can be benchmarked to market so that investors get the best deal for their investments in the long run!
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