The Palimpsest of Sawbones Surio

Pessimism of the Intellect, Optimism of the Will

Are PPFs really that risky?

with 10 comments

I started responding to some of the points raised by Mr. Burntout’s posts on PPF in India (equivalent of the state pension in other countries). Being a 4 part series, I was getting scattered all over the place. I have collected my thoughts here to burntout’s observations and placed them in a single place here.

However in the PPF scheme in India, even withdrawals are not taxed, making it unique and extremely attractive to investors. This is a tremendous gift form the government of India to the people, since in effect, it means that the money invested in PPF is never taxed!

Historically, Indian politics has transmogrified today from an anti-colonial freedom movement into a uni-party parlimentary democracy that has now fragmented to coalition based horse-tradery. And since we know that this form of politics purely sychronises with populism and vote banks, this EEE-PPF fund is one milch cow that no party will dare to touch (with barge pole).

table shows the PPF rates since the inception of the scheme

The above table is Mr. B’s PPF interest rates. I understand Mr. B’s point, but here’s a better table that compares PF returns against bank fixed deposit rates, to show how the PPF returns have matched, fared or trailed these cases (and it has done all three).

Now with the bank fixed deposit interest rates, it is easier to compare

  1. Notice from the table that over the years, the government has promised and delivered a rate of interest that is much higher than the prevailing market rate at that
    time. Ed’s note: Check! 
  2. Every time the market rates have gone up, the government has been forced to increase rates in the PPF scheme, to keep money flowing into the scheme.  Ed’s note: Not always true, look recent numbers. 
  3. Again this year, as the RBI has increased interest rates to keep inflation in check, the collections into the PPF scheme have dropped significantly.
  4. The government depends on having a strong cash flow every year into the PPF scheme, and it had to increase the interest rates for this year to keep the scheme viable. Ed’s
    note: : In the 80s, this seemed to be the case
     
  5. The government from this year, has pegged the PPF
    interest rate to the 10 year G-sec yield with a margin of 0.25%.  So if the G-sec yield is 10% for a given year, the PPF interest rate will be 10.25%  Ed’s note: Thank you for the info.

So, basically, we can see that B’s points bears out, but only obliquely. In the last few years, the PPF rates have actually been very steady when compared with the market — even during the bullish 2007-2008 phase. Yes, they did
increase their rate recently as B points out, but it is too early to draw any conclusions from any of that — definitely not enough data to be calling it a Ponzi yet. Just look at the pre-1992 numbers and compare to market rates, and you can take comfort that the numbers were more alarming then than now. After all, this is the first significant move in the last 10 years, and the average return for both banks and PPF is the same (8%).

For starters the PPF interest rate is pre-defined by the government at the beginning of every year, and for decades has had no correlation to market returns. The interest rate is in fact a political issue, and is decided by politicians, rather than economists. Typically the interest
rate is kept higher than prevailing market rates, ostensibly to encourage small savings, but also as a political ploy to please the voting populace.

This point connects to the first EEE point made at the beginning of the post. From sheer size of population that invests in PPF, the momentum is going to keep this scheme going. The same mindset of the population that continues to buy into bonds and treasury bills the world over, will also keep investing in ISAs, PPFs and 401ks. No doubts about it.

The PPF scheme is pretty opaque in terms of how the account is managed, where the money is invested and current status of the scheme. Asset Management Companies (AMCs) in India are regulated by SEBI and are required to publish a detailed list of their financials every quarter, that include their investment portfolio, balance sheet, expense ratio, rate of return etc. 

Well, Mr. B’s very harsh here. No amount of regulation prevents companies going belly-up though. However state pension schemes are like hornet’s nests. Disturb them at your own political peril. No Government worth its salt wants to be seen as defaulting on its assured payments either at home or abroad, no matter how hopeless the situation seems to be. I like to offer two case studies. In the first case, the Brazilian Real. This is a classic case of medium unrest locally, but in the end everyone weathered the storm with good results all round. Next up, the Argentinian crisis. Here, the Government defaulted rather than adopt the kind of thinking that Brazil displayed. Even India “opened itself up” when it faced imminent bankruptcy due to internal cronyism in the 90s (As much as I have mixed feelings about that move it seemed better than suicide — given the political leadership leading to that stage back then). Given an informed choice, most nations will choose to go the Brasilian way and bolster internal confidence, which will go a long way in keeping the nation solvent. As for the EU crisis, it is still being played out. Let us wait and watch.

The PPF scheme on the other hand is nowhere near as transparent. A recent audit of the EPF (Employee Provident Fund) scheme showed an excess of funds, that prompted the finance minister to increase the rate of return for the last financial year in the EPF scheme. The “finding” of these excess funds, in itself, was hotly debated for the correctness of the financial audit. Mr.Ponzi also did not maintain clear records, and it was impossible to fathom where the money deposited by his investors went.

Well, this is very true even for the large backbone institutions such as the LIC or even SBI. However, the LIC and SBI are exposed to the markets which bring in some kind of risk into the picture. The PPF on the other hand functions like sovereign debts by the public to the
Government of India. Therefore, failures of state pensions are treated in the same vein as sovereign defaults! So, B can be rest assured, the Government will resort of any trick in the book (going all the way to increasing retirement age!) to pay its obligations towards the citizens.

The PPF scheme depends on new investors coming in yearly with their fresh deposits to keep the scheme running. When the collection began to drop for this financial year, the government stepped in and increased the interest rates to make the scheme more attractive. This has been done in the past as well, to keep the inflow going.

While not mandated by law, most companies open for their employees an ipso defacto PF account and deposits the minimum required funds into it. Based on demographics and population size, this policy by companies will ensure that decent amount of funds will be making its way into the PPF coffers for some time.

The way B sees the EU crisis playing out and similarities with the PPF  is where I differ from him. Brasil and Argentina have had similar financial routs, but Brazil did manage to find its feet. And the EU crisis is still playing out and the end game is not in sight yet. Good luck to them all, and hopefully sanity will prevail.

We have demographics on our side in India. The population is *very* young when compared to the USA/Europe or even Japan and this might stagnate in a few decades, but not right now. Therefore, there is no danger of US level (pension) payouts like the one imagined in Ponzi schemes for the next generation (mine) at least.

There is one more idea that, while not popular, offers some peace of mind towards worries of these nature. The concept of “Ricardian equivalence“, while hotly contested, has been empirically observed and validated as true.

Ricardian equivalence suggests that it does not matter whether a government finances its spending with debt or a tax increase, because the effect on the total level of demand in the economy is the same. 

In other words,

present borrowing would be matched by increased bequest to future generations in order to pay future taxes expected to pay the debt on the government bonds.

So, because PPFs are effectively “sovereign debt”, there is no danger of this turning into an elaborate Ponzi scheme, ever.

Concluding Remarks:

I understand, and applaud burntout’s intent behind the  post. I was reminded of the mantra Diversify, diversify, diversify which cannot be understated! Thanks, burntout. I agree with him on that. Paradoxically and ironically however, if everyone abandons the financial instruments such as PPFs in droves and crowd the stock market (as people in the USA did in the 80s), the inevitable that B warns of — the failure of the PPF scheme — will actually happen, just like its is happening in the USA. It would be far more sensible to balance risk against something as tweed-like as the PPF, the ISA or the 401k and chiefly plan on rebalancing your lifestlye like some of these luminaries have. :-P

Alternatively, get yourself FI, and then you could even launch a second innings like Jacob has (YaY! Go Jacob, go!)

Mr. B, I am very glad to have come across your blog. May our tribe increase! :-)

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Written by Surio

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10 Responses

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  1. Many Americans, and me included, do not consider Social Security as a ponzi scheme. However, faith in the credit of the SS system is waning. The SS plan was never intended to be a retirement plan of itself, rather an addenum to one’s carefully planned own program. there is now talk of SS going “needs based”. This also, was never an intention of the program, and neither was payouts barked to a market rate of return. SS for retirees was built to prevent poverty of the elderly, and based on the total inefficieny of those people “doing” any personal planning. They did not in many cases, depending on the government “come” from SS to carry their elderly mail into the coffin.
    SS in and of it’s original intent is indeed a brilliant idea. It should have and could have worked well.
    Call it a little cake icing for the otherwise well planned. SS is also not intended to be a hand out, rather it is something paid for by the receiptent. All in all, SS, as it stands, is a good thing. Changing it around is just foolish. Employment and paying into SS is the fix for it in future years.

    HSpencer

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    • I don’t think the SS is ponzi either. That was one of the reason for writing this post.

      “The SS plan was never intended to be a retirement plan of itself” This point is missed by, like 99.9% of the general population.

      “Employment and paying into SS is the fix for it in future years.” With declining fertility and population size, perhaps increasing retirement age is one way to go about it, you think?

      Surio

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      • I think the US gubbermint is gradually continuing to increase the age at which payments can begin. Currently, a reduced benefit can be taken at age 62. Full retirement benefits at age 66, and even a larger payment at age 70. Here is the problem with these age to draw factors: The guy taking at age 62 faces about a 20% lower payment. However the guy taking at age 66 must wait until age 78 to “catch up or break even” with the guy taking at 62. Now both guys are age 78 and have drawn the same amount. Gamble.

        HSpencer

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  2. I was reading today where India could be yet another country going into economic turmoil. Akin to the current situation in Italy, and then there was Greece. India and China, which are referred to in some economic circles as “Chindia”, do have a multitude of economic producing resources and potentials. Both are members of the Nuclear families now growing leaps and bounds world wide. India’s warring neighbor, Pakistan, has fallen from grace recently, and is standing to be a “regime change” on the to-do list. (*)
    I found the article quite interesting, and what I have learned of the PPF in India was enlightening.

    (*) Yes I am very sarcastic on the various “to-do” lists of the US/Israel business models. One quick note would be that our hopeful Ron Paul will quell all this arrogant interference in other people’s business. Ron Paul at present, however, is getting about an average of 40 seconds of presentation on the Republican debates televised lately. Ron is not a “home boy” for the powers that be!

    (Surio raises yet another eyebrow over HSpencer’s arrogant proliferation of his blog pertaining to US politics)!

    HSpencer

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    • @Spencer,
      We are not exactly on a bed of roses and most of our new found wealth is either very concentrated, or restricted to Shanghai accounting on dodgy P&L statements. There’s a side effect in the form of increased consumerism, fuelled by debt, easy-pay schemes, aggressive paired marketing and all that. But wealth is not measured by your fridge, or the house you intend to flip as a lot of Americans found out. So, it is a case of, this time it’s our turn :-)

      Surio

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  3. > This is a tremendous gift form the government of India to the people, since in effect, it means that the money invested in PPF is never taxed!

    Dude, you hafta get old enough to draw that pension without tax before you can count on it. The history of the world is full of governments fiddling with the rules. At the moment India is full of young people a long way from retirement, so the government will promise them the earth.

    Hopefully they will resist the temptation when these young people get old, to say ah well, we need to tax your total income etc. Thirty to forty years is a long time in politics. They can get their hands on your money. They can inflate it away. They can tax you on a total income basis. I will never get a bean out of the government to defray my property taxes in the UK, because I have capital. If I had been a feckless SOB they would pay this and more. There are lots of ways for a government to change things to your disadvantage, if you have something they want. In general you either pay tax on the way in, or you pay it on the way out. It’ll happen in India too by the time you retire, so factor it in now.

    Just saying…

    ermine

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    • Yes, I agree, I went all rosy-eyed and stitched up there!
      I made amends to that with another post grabbing the population plight!

      Surio

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    • “you hafta get old enough to draw that pension without tax before you can count on it. ”

      Unless I am missing something obvious – PPF is not age based. It is a for a period of 15 years from the date the account was opened, with a provision to extend it a couple of time by 5 years each at the end of the initial term. My ever thoughtful dad had opened my PPF account 11 years back and coaxed me to invest in the same every year. I can get my hands on the pot just 4 years from now, when I am just 36 years old!

      rags

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  4. […] punctured my optimistic balloon in the PPF post with a good comment. I admit I was foolish in not catching the obvious regarding the passage of […]

  5. Another point on Social Security, and including Medicare (USA of course here)

    Social Security and Medicare are also misunderstood by many, not sure if it would be the vast majority, still many.

    Both programs are “benefits”, not “entitlements”, meaning they are paid for by the receiver. One need only look at one’s payroll slip to see the deductions. SS is taxed at 7% for employees and 14% for the self employed. These are programs that are purchased through employment or being in a business. Much as one might purchase life insurance or contribute to an IRA.

    Where the social security system gets into “entitlements” is through the SSI side of the house, the disability payments and various “assistance” payments. If I lose my legs and cannot work, I can draw “SSI” disability payments. (Acutal inability to work for money is the basic premise). If I can’t emotionally handle being in a building or around people, I can also still (with a crafty doctor’s note) also draw SSI payments. If I am a single mother with one, two, three, or more children under 18, I can get lots of payments, depending on the family size, plus lots more locally as well. :-)

    Yes the government attempts to fight fraud. A citizen investigation on even a very small scale would rate this effort as a failure.

    It is the SSI, the social program side of the house, that is destroying the SS system. Additionally, Medicare, although paid with SS deductions, is weak financially due to intense fraud.

    Thought these points would be useful to my previous post.

    Thanks

    HSpencer

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