EPFO’s equity turn: what it means for you

While stocks exposure may increase returns, current limit of up to 5% is too small to have a significant effect

The Employees’ Provident Fund Organization (EPFO) has started investing in the stock market through the exchange-traded fund (ETF) route from Thursday.

An ETF is a basket of securities that tracks the stock prices of the companies on an underlying index, and is traded on the exchanges. Being a passive fund, it not only comes with a much lower expense ratio but also obviates the fund manager risk.

The labour ministry has allowed for 5-15% of Employees’ Provident Fund (EPF) money to be invested in equities. But, to begin with, EPFO has decided to take an exposure of up to 5% of the incremental corpus through ETFs. “We have decided to take it slow and see how it goes. So, we will start with an investment of up to 5% of the incremental corpus in ETFs,” said K.K. Jalan, central provident fund commissioner, EPFO. The Organisation will allocate `5,000 crore by March 2016 in ETF and could increase it to as much as `7,000-8,000 crore, said Jalan.

For now, the Organisation will invest in two schemes of SBI Mutual Fund—SBI-ETF Nifty and SBI Sensex ETF. Jalan said that out of the total investable corpus in equity asset class through ETFs, 75% will go into SBI-ETF Nifty and the remaining 25% in SBI Sensex ETF.

“SBI is our sole banker, so we have decided to go ahead with SBI Mutual Fund for now. Also, we didn’t have time to come out with a tender and spend another year finalizing the asset management company. In future, though, we will consider looking at others as well,” he added.

Before understanding what an equity exposure would mean to the money that you invest in your EPF account, let’s start with a quick look at how EPF works.

How EPF works

Every month, a salaried individual contributes 12% of her salary in the EPF account and the employer matches the contribution. A part of the employer’s contribution goes to the Employees’ Pension Scheme. The contributions made to EPF then compound at a rate declared by the EPFO every year. Currently, the rate of interest on your EPF money is 8.75% p.a.

Contribution by the employee up to `1.5 lakh qualify for a tax deduction under section 80C of the Income-tax Act, 1961. A deduction reduces your taxable income. The interest that your fund accumulates along with the contributions made are tax-free on withdrawal if you withdraw the money after five years of continuous service.

In terms of withdrawing your money, the rules allow EPF withdrawal only at the time of retirement, medical contingency or an unemployment period of two months. Given that EPF has exempt-exempt-exempt treatment of taxation—which means that your contribution and interest are both tax-free—it’s one of the top recommendations by financial planners for a person’s debt investment portfolio.

It is with the aim to improve returns further that EPFO has decided to enter the stock market. “If we remain invested in fixed income alone, then the interest rate is likely to remain subdued and see further downward trend in coming years. If we hadn’t changed our investment philosophy, then it would be difficult to give good rate of returns to subscribers. So, it was considered appropriate to a bring change in the methods of management of funds cautiously and carefully” said Bandaru Dattatreya, Minister of State for Labour and Employment (independent charge).

With equity investments the expectation is that EPF will offer a meaningful real rate of return. “There is no proper social security net for an Indian household. So, they end up putting their money in bank FDs (fixed deposits). In a way this is good for banks but does not do much for the savers,” said Arundhati Bhattacharya, chairperson, State Bank of India. “When inflation is high, bank interest can’t keep pace and doesn’t beat inflation. Hence, despite saving, savers lose money. If you take a longer-term view, equity gives superior returns,” she added.

Equity support for EPF

Currently, EPF invests largely in government securities with the help of five fund managers, namely SBI, ICICI Securities Primary Dealership Ltd, HSBC Asset Management (India) Pvt. Ltd, Reliance Mutual Fund and UTI Asset Management Co. Ltd.

“Currently, we invest around 65% in government securities and the remaining in public sector and private sector bonds. In private sector bonds, our exposure is less than 5%. Since our portfolio is held to maturity, the role of fund managers is not much and so the fund management is very less, of around 0.00005%, which is deducted from the fund,” said Jalan.

Considering that even the equity investments will be managed passively, there will not be a fund manager, but even ETFs come with an expense ratio that will be borne by the investor.

“SBI Mutual Fund has given us a discount on the expense ratio as we will pay only 0.07%. The expense ratio will be deducted from the fund value,” said Jalan. Given that mutual funds are not allowed to offer differential pricing, this discount benefits even individual retail investors.

“We are already seeing the spill-off as the race to the bottom has begun. Reliance and ICICI Pru mutual funds have reduced their expense ratios from 0.5% to 0.03% on their Sensex and Nifty ETFs in the hope to get a share of the EPF money. For retail investors, this is certainly good news as it will reduce tracking error of the funds,” said Manoj Nagpal, chief executive officer, Outlook Asia Pvt. Ltd.

Returns kicker missing

What will equity investment mean for your EPF money? It’s too early to say, feel most financial planners. “This move will help create a buzz around EPFO and people may start watching this asset class. However, we don’t expect interest rates to improve as of now since the exposure (to equity) is very small and won’t have such a big effect on the overall investments,” said Surya Bhatia, a Delhi-based financial planner.

Others agree that the 5% limit imposed is very small. “The amount that will be exposed to ETF is minuscule. It is difficult to say if it will give better returns since it is only 5% of the overall corpus,” said Suresh Sadagopan, a Mumbai-based financial planner. This means that you may not really see a significant improvement in your returns.

“Investing 5% of the incremental corpus may mean that the returns improve by about 10 basis points. For equities to have a significant impact, they (EPFO) will need to increase the investment to 10-12% of the incremental corpus,” added Nagpal. One basis point is one-hundredth of a percentage point.

However, unlike mutual fund investments, which show the net asset value (NAV) of your investment on any given day to help you track the performance of the fund, the EPF money going into ETFs will for now continue with the same system of declaring a rate of interest on your overall portfolio.

EPFO declares a rate of interest at the beginning of the year, which is the rate at which your money will compound for the year. In future, this rate will also reflect the returns made from the equity market, and EPFO is working towards making the system more transparent. “We are studying the various pension systems around the world and will come with an accounting methodology soon. In some cases, a part of equity returns are distributed whereas a part is kept as reserves which can be dipped into if the markets turn volatile. We are looking at various ways and should be able to finalize soon,” said Jalan.

For the stock markets, too, the move is good news as it will bring in long-term money, which lends to stability.

“Given that EPFO will invest in equities on a regular basis, it’s like having an SIP (systematic investment plan). The current SIP book is about `2,000 crore and I see this book doubling with EPF money in the coming years. This will reduce volatility,” said Nagpal.

For you, the good news is that EPF has finally entered the stock market and as contributions begin to increase over the long term, it may mean better returns on your investments.

Source: http://www.livemint.com/Money/nYf04GWyTbEYtdY3EPkNVK/EPFOs-equity-turn-what-it-means-for-you.html