A reader asked, “What is the effective interest rate of the Unified Pension Scheme?” A discussion. As a pension scheme, it can be compared with life insurance policy annuity schemes that offer a pension in exchange for a lump sum. These schemes have an interest rate, also known as an annuity rate. See LIC Pension Plan (Jeevan Akshay) Annuity Rates Applicable from Feb 2024. In this article, we try to guesstimate the effective interest rate of the Unified Pension Scheme.
Please note that multiple parameters are involved in this complex process of offering inflation-adjusted pensions. This is a crude guesstimate based on scanty information. The actual average effective rate may be considerably different.
When the Unified Pension Scheme was announced, I asked if it was sustainable. I pointed out that the NPS corpus that moves into the UPS and future contributions must be prudently managed to earn a sizeable return to handle the payouts.
As readers may know, we have released two NPS vs UPS calculators since then.
Initially, I thought the starting pension would only be 50% of the last 12-month average of the basic pay. Since then, I have learned that the DA rate at retirement will also be added to the pension (YouTube video of UPS presentation. Timestamp 4:30 to 5:40, thanks to Dr. Sachin Pandey on Twitter). Then, the government’s pension burden will be much higher than I initially thought.
If this is the case (and it is likely), our calculators linked above will show you that it will be tough for the NPS to beat UPS. That is, we check if the projected NPS corpus at retirement is enough to provide the same starting pension guaranteed by UPS via an annuity and handle inflation via systematic withdrawals. Unless the salary and NPS contributions are high, UPS is typically more beneficial.
One way to find the effective interest rate of the UPS is to determine the guaranteed pension as of today (if eligible, ten years minimum service) and then divide that by the current NPS corpus. This will give you the annuity rate if you were to retire today.
First, I ran this with my numbers. I reduced my current basic pay by 25% to represent the 12-month average, multiplied it by (1+50%) – the current DA rate, and divided it by my NPS corpus. I got about 14%.
This means I need to buy a pension product that gives me a 14% return yearly to get the constant minimum pension guarantee proposed by UPS. This 14% is for a perpetual annuity. The rate will be slightly lower since it is only for the employee’s lifetime (family pension will be 40% lower). Being in a large pool of employees is likely to lower it further.
Even if we conservatively assume it is only 9-10%, we still have to account for the dearness relief. This will hike the pension by about 5% every year. Then, the effective rate of the perpetual pension will be about 19%. Realistically, the annuity until the pensioner’s lifetime should be at least 12-14%. Slowly decreasing over time as the scheme stabilises and inflation goes down.
My mother’s pension over the last 22 years has increased at an average rate of 13%. The UPS pension growth has to be significantly lower for it to be sustainable.
We posted a poll on social media asking government employees about their service, basic pay and current NPS corpus. We received 133 entries, but many were ineligible as their service was more than the age of NPS! Surprisingly, too many entries had exactly ten years of service (this is the minimum requirement to receive UPS benefits). So, we discarded those as well and were left with 69 entries.
The average perpetual annuity of this data computed above (the equivalent of 14% above) is about 9%, with a median of 8%. Let us assume 7% will be the effective annuity for an employee who lives about 20-25 years after retirement (some will die early and some later). We may get about 9-10% on average if we add the inflation indexation. Those with higher salary slabs may have a higher rate, but the number of such employees would be small.
Please note this is a very crude estimate. Not all government employees will retire at the same time. Most of them will have small salaries, etc. I expect the effective average annuity each year to be about 9%.
As mentioned earlier, the key difference between the OPS and the UPS is the capital market-linked (especially equity) NPS corpus (of those who switch to UPS), which has grown largely untouched for the last 20 years. The future growth of this, plus further contributions, should take care of near-term sustainability. However, this has to be periodically reviewed.
Also, the employee did not contribute to the scheme in the OPS. In the UPS, it will be 10% of basic + da. The government will contribute 18.5%, increasing the scheme’s effective annuity rate.
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