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Friday, October 30, 2015

Concerns about fundamental changes in the New Pension System

by Ashish Aggarwal.

The recent report1 of the PFRDA constituted Committee headed by former SEBI chairman GN Bajpai to review investment guidelines for NPS schemes has re-opened three important questions. Its recommendations on these appear to be misplaced. From 1999 onwards, a consensus came together about the wisdom of the design of the NPS. PFRDA is now set to jettison the core design concepts of the NPS, without having adequately argued the case for the change. PFRDA needs a much more rigorous approach to the financial regulatory process, than it has demonstrated in the recent years.

Investment management approach: Active or passive?

The NPS has traditionally followed a passive approach to equity investment where Pension Fund Managers (PFMs) replicate the portfolio of a chosen market index. To illustrate, if a fund had tracked BSE Sensex since its inception 36 years ago, it would have delivered annualised returns close to 15.79 per cent. For an example, see the remarkable returns on Nifty and Nifty junior in history. The Bajpai Committee has advocated a shift to active investment management. In this approach, PFMs create a portfolio of stocks and decide the timing of their purchase and sale with an aim to beat passive investment returns.

From 1999 onwards, the policy thinking that led up to the NPS has emphasised passive investment, for good reason. Passive management costs much less than active management. For example, the expense ratio of Nifty BeES, an Exchange Traded Fund (ETF) tracking Nifty, is 0.49 per cent. Globally, index funds and ETFs like Vanguard 500 charge expense ratios of 0.05 to 0.17 per cent. Passive funds costs less as their task is relatively simple and can be largely mechanised. In contrast, actively managed funds have to spend a lot more on human-intensive procedures, and routinely charge expenses of around 2 to 2.5 per cent. A one per cent increase in cost can reduce the pension corpus by 24 per cent over 40 yearsa.

Second, global wisdom suggests that while active management can generate higher returns, these are mostly offset by the higher costs. Importantly, active funds that consistently outperform their benchmarks are a rare breed. Here is one recent report2 which finds that actively managed funds have generally underperformed their passive counterparts and experienced high mortality rates (i.e. many are merged or closed). Here is another report3 which shows that over a 10 year period, 82 per cent of large cap managers underperformed their benchmark. Mid and small cap managers have fared worse. The data on Indian mutual fund managers shows that about 50 per cent of them have underperformedb their benchmark.

The GN Bajpai report does not show the rationale in favour of this major change in policy direction. There is a discussion in the report about moving to a `prudent man' regimec. While the up-side from the change is not obvious, the upward pressure on fund management costs is.

Following the report, PFRDA has gone ahead and changed the investment guidelines4 to permit active fund management. The Government sector schemed already permits investing in individual
stocks. As a result, there is no scheme now which offers passive management in the NPS. This is a fundamental shift from the concepts of the NPS which had been articulated from 1999 onwards.

Role of fund managers: Should they market the schemes or only manage them?

The Committee recommends that the PFMs should market and sell the NPS, ostensibly in order to grow the customer base. This is a bad idea. Push sales strategies have worked where they are backed by high commissions, opaque products (where costs and benefits are not transparent) or both. NPS is an unbundled design where PFMs focus exclusively on managing investments. POPs (Points of Presence) comprising banks and other distributors are responsible for sales. The Chinese wall between POPs and PFMs ensures that they do not collude to push a particular scheme. This restricts mis-selling.

The issue of mis-selling is often associated with insurance and mutual funds who take a lead in marketing and selling their schemes. The Committee suggests that with the notification of the PFRDA Act, the consequent empowerment of PFRDA through various provisions on investigations, enquiry, penalty, and other enforcement actions besides customer protection measures envisaged in the various regulations under the Act, the issue of mis-selling will be addressed. While the logic of the committee on this count cannot be faulted, a similarly empowered IRDAI and SEBI have been battling this challenge for about two decades. The very design of the NPS was motivated by the problems of the conventional approach seen at SEBI and IRDA.

Allowing PFMs to do marketing is contrary to the basic design of NPS. The committee wants to change this design. To remain within the precincts of the Act, it recommends that, the PFs (PFMs) may canvass the product while the actual on-boarding may be done through the PoPs.

Another Committee, headed by former union finance secretary, Sumit Bose, set up to examine the issue of mis-selling and distributor incentives recently recommended5 that the POPs in NPS should be paid an AUM based trail fee. This would provide them the needed incentive and align their interest with the consumer over long term without increasing the risk of mis-selling. This would also leave the Chinese wall between the PFMs and POPs intact. PFRDA should examine these aspects before setting off on solutions to convert the NPS into a conventional SEBI/IRDA style system.

Fund management fees: auction based or fixed?

The Bajpai Committee recommends that the regulator should introduce a fixed and variable component in the fee. The variable fee should depend upon other performance indicators like relative returns generated. It has recommended that PFRDA examine this without compromising on the cost.

It is not apparent how increasing fees will not compromise costs. The Bose committee, has taken a contrary view and specifically recommended against any change of fees for the PFMs as they are
discovered through an auction process. The NPS auction is an transparent and efficient means to achieve lowest pricing in fund management. The remaining contestants have to match this lowest
fee. The consumers get the benefit of lowest cost and can also choose their PFM based on performance. Once the rules of the auction are transparent and apply equally, PFRDA should not have to worry about how to pay PFMs more.

Case for a rigorous approach

PFRDA has been grappling with the above questions over the last few years. It had in 20136 and 20147 re-affirmed passive investment management as the norm. In about a year, it has changed direction towards active management without adequate evidence or rationale. The approach to the issue of PFMs role with regard to marketing and sale of NPS has similarly lacked rigour. In 20138, PFRDA brought in a change and permitted PFMs to market the NPS. Within a few months, in November 2013, this was reversed. This left the PFMs stranded as is evident from the feedback PFRDA received from a PFM:

"Following the new guidelines of 2012 that expanded the permissible activities that can be undertaken by PFs, many PFs made significant investments towards setting up promotion and distribution infrastructure. Clarity about role along with the incentives / revenues available to fulfil this role is a prerequisite to enable the PFs to plan their operations and business plan over a medium to long term."

Clarity on the policy direction on PFM fees is missing. The auction based system was dumped in 20129 in  favour of a fixed fee of 0.25 per cent of assets, a significant increase over the earlier fee of 0.0009 per cent discovered through auction. Since 201410, PFRDA has reverted to an auction which again resulted in a low fee of 0.01 per cent. As PFRDA heads for another round of selection for fund managers, it might need to examine the approach to this issue more closely.

On these questions, we should be concerned about the extent to which PFRDA has failed to bring knowledge about pensions into its thinking. The problem runs deeper. If the processes at PFRDA do not produce sound answers on the questions outlined above, they could similarly come up with unsound answers on other issues in the future. As an example, PFRDA might feel like responding to the clamour of assured returns in the NPS.

Rigorous analysis is required before setting sail on such matters. Poor policy decisions are very expensive. Decisions need to be grounded in evidence, be well documented and disclosed transparently.

In the past, sub optimum processes have resulted in sub optimum outcomes in case of PFRDA's regulations11. RBI and SEBI also lag on this12 count. The government has prepared a Handbook13 which lays down sound practices on regulatory governance and lists the procedures that Indian regulators should follow to achieve better governance in regulation making. All financial sector regulators have agreed to comply with the Handbook procedures on framing regulations for: (a) all regulations from 31st October, 2013, and (b) all subordinate legislation -- which includes circulars, notices, guidelines, letters -- from 31st December 2014.

Going by the Handbook, the draft investment circulars/guidelines should have been published by PFRDA with a statement of objectives, the problem that is to be solved, and a cost-benefit analysis (using best practices). Thereafter, comments should have been invited from the public and all comments should have been published on the web site of the regulator.

Conclusion: Undo, rewire and reboot

NPS is over a decade old. It would be useful to close the discussion on fundamental design questions, and bring predictability to the scheme on multi-decade horizons that are required in pension planning. This would increase confidence among consumers, PFMs and POPs. Rapid progress on implementing the best practices laid down in the Handbook would help achieve outcomes in the best interest of consumers. PFRDA could start by applying these to review the questions at hand. Till such time:

  • NPS schemes should emphasise passive investment management.
  • PFMs should continue to focus only on fund management, while the selling is done by arms length POPs who are neutral between all PFMs.
  • The fee for PFMs should continue to be auction based.


  1. An annual investment of Rs. 100,000 over 40 years with net annual returns of 11 per cent would result in a corpus of Rs. 64.58 million. An additional one per cent cost would reduce the
    net returns to 10 per cent and the corpus by 24.62 per cent to Rs. 48.68 million. back
  2. Over last 10 years, out of 19 mutual funds tracking CNX Nifty, 10 outperformed the benchmark and 9 underperformed. Of the 16 tracking the BSE Sensex, the number of out-performers and under performers were equal. During this period, the category average
    returns by large cap equity mutual funds in India stood at 13.43 per cent per annum. As against this, the reference index, BSE 100 delivered an annualised return of 12.16 per cent. The top performer in the above fund category delivered 18.29 per cent while the bottom performer delivered 7.76 per cent. Flexicap category had similar results. (Category Average: 14.49 per cent, Top Performer: 19.34 per cent, Bottom Performer: 5.53 per cent). Data from Morningstar database. back
  3. Under the prudent man rule, if the process followed for taking investment decisions in prudent, then the decisions are prudent. For example, it is imprudent to invest in lottery. The relative prudence does not get affected even if one wins the lottery. back
  4. In the government sector scheme, PFMs can invest in individual stocks. Here, NPS follows the pattern notified by the government which permit a maximum of 15 per cent exposure to equity as against 50 per cent in the private sector scheme. The Bajpai Committee has rightly recommended that government employees should have the same scheme option as private sector. This has prompted PFRDA to review the status quo with the government. PFRDA has tied the NPS lite/ Atal Pension Yojana (APY) to the same norms that apply to the government scheme. This should also be reviewed as customers of these schemes too have no scheme choices. back


  1. PFRDA, Report of the committee to review investment guidelines for NPS schemes in private sector, April 7 2015. back
  2. Morningstar,  Active/Passive Barometer, June 2015. In addition to analysing active funds, the report finds that failure tended to be positively correlated with fees (i.e. higher cost funds were more likely to underperform or be shuttered or merged away and lower-cost funds were likelier to survive and enjoyed greater odds of success). back
  3. S&P Dow Jones Indices, SPIVA US Scorecard, 2014. back
  4. PFRDA, Investment guidelines for NPS schemes (Private Sector), September 10, 2015. The eligible stocks should have a market capitalisation at least Rs. 50 billion and should have derivatives trading in either BSE or NSE. The criteria for being considered for derivatives trading includes being in top 500 stocks in terms of average daily market capitalisation and average daily traded value in previous six months in a rolling basis. NSE currently has 163 eligible stocks for trading in derivative segment. back
  5. Ministry of Finance, Report of the Committee to recommend measures for curbing mis-selling and rationalising distribution incentives in financial products, August 7, 2015. back
  6. PFRDA, Clarifications on investment guidelines for private sector NPS, April 17, 2013. Prior to 2013 also PFMs were not permitted stock picking. Passive investment management was required to be done through in-house replication of Index funds or ETFs that tracked BSE Sensex or NSE Nifty Index. Investing in ETFs or Index funds of AMCs which charged a management fee was not permitted. Further, investment in equity mutual funds was not permitted. The PFMs were required to choose which index they intended to track in advance on a yearly basis. back
  7. PFRDA, Revision of investment guidelines for NPS Schemes, January 29, 2014. back
  8. PFRDA (Registration of Pension Fund Managers) 2012 Guidelines, July 12, 2012. back
  9. PFRDA, Circular No. PFRDA/CIR/1/PFM/1, August 31, 2012. back
  10. PFRDA, Revision of investment management fee for private sector NPS, August 1,
    2014. back
  11. Arjun Rajagopal and Renuka Sane, Difficulties with PFRDA's Draft Aggregator Regulations 2014, July 2, 2014.  back
  12. Arpita Pattanaik and Anjali Sharma, Regulatory governance problems in the legislative function at RBI and SEBI, September 23, 2015. back
  13. Ministry of Finance, Handbook on adoption of governance enhancing and non-legislative elements of the draft Indian Financial Code, December 26, 2013. back

Sunday, October 25, 2015

Selective default on corporate bonds

by Ajay Shah and Bhargavi Zaveri.

M. C. Govardhana Rangan and Satish John have an article in the Economic Times where they describe selective default by Amtek Auto to some bondholders but not to others. We have been aware of this problem for a while now: it appears that when a firm gets into trouble, it undertakes a `soft default' where powerful investors get paid while less powerful investors are not. Sometimes what firms seem to do is respond to stress by paying out different bond holders with different delays, which is also a form of default.

This undermines the very concept of the securities market

Securities markets are about arms-length investing. The investor looks at public domain information about the issuer, at the rules of the game as articulated in securities law, and makes the decision to buy or sell. The investor should need to have no human relationships into the game, or possess political power or influence.

When the cashflows that emanate from a security depend on who the investor is, this is not arms-length investing; it is not a securities market.

Selective default clouds our databases about default, and makes it more difficult to analyse credit risk in the future. In a well functioning financial system, we should observe a binary event of default or non-default associated with each date of cashflow for a bond. With selective default, the information set becomes enormously complicated: the information set of interest is the list of bondholders who were paid and the date on which the payment was made. None of this is visible in the public domain. Enormous energy is expended by market participants in obtaining gossip about these questions of fact. Ordinarily, bonds are a superior way for society to organise loans for borrowing above a certain size, but the productivity gains are lost when expensive finance practitioners waste their time on information gathering about default.

At a philosophical level, the equal treatment of every security is fundamental to the concept of a securities market, much like the concept of equal treatment in the eyes of the State is essential to liberal democracy (e.g. as is done by Art. 14 of the Constitution of India).

The approach of present law towards equal treatment

Under present Parliamentary law, there is no equal treatment clause which imposes the burden of fair play upon issuers of securities.

There is a complicated landscape of subordinate legislation which has scattered references to the principle of fair treatment of holders of a class of securities. However, it is not clear whether a selective default is a violation on account of unequal treatment of investors.

SEBI has recently come out with Listing Obligations and Disclosure Requirements Regulations, 2015, which explicitly have an equal treatment clause for shareholders. The regulation of listed debt instruments is now folded into this single regulation. Given that equitable treatment has been embodied as a general overarching principle in these Regulations, we hope the principle will be applied to a class of securityholders (and not be restricted to holders of equity).

Fixing the legal foundations

Under a sensible bankruptcy code, paying some bondholders would not help, as the bondholders that you have not paid would go to a court and trigger an efficient bankruptcy process. Hence, there is no incentive to undertake selective default.

Under the present law also, a bankruptcy process may be triggered by a creditor to whom it has become obvious that the company is going to default. However, given the costs associated with initiating and taking a bankruptcy petition through, it makes sense for a bond holder to await a settlement than to resort to a lengthy winding up process which guarantees little chance of recovery. Hence, the present institutional infrastructure for bankruptcy is a causal ingredient for the phenomenon of selective default.

Beyond bankruptcy, the issue of equitable treatment of security holders deserves to be treated under a securities law. Under a sensible securities law, issuers would be obliged to treat all security holders equally. This is a deep concept which goes beyond default into corporate governance. As an example, in version 1.1 of the Indian Financial Code, S.217 says:

(1) Every issuer making a public offering has an obligation to ... (c) have in place systems of governance and processes to ensure that the issuer does not discriminate between the owners of a class of securities of the issuer;

Once this legal foundation is laid, we would require a well functioning `debenture trustee' institution to represent the dispersed bondholders and vigilantly protect their rights, of which equal treatment is a core right.

Today, the SEBI (Debenture Trustee) Regulations allow debenture trustees to discriminate amongst their clients on ethical or commercial considerations. This virtually allows a debenture trustee to pick and choose amongst its beneficiaries and is contrary to the principles of fiduciary responsibility. This is low-hanging fruit which SEBI needs to revisit. The incentive structures for debenture trustees is another area which needs systematic reform.

One approach to constructing sound market infrastructure

The depositories have the full list of bondholders and the characteristics of the bonds that were promised. We can envision a regulation which mandates that issuers pay bond holders only through a an electronic system, that is operated by information utilities such as depositories. So, once a bond becomes redeemable as per its terms, the issuer is compelled to pay those who choose to redeem only through a single large electronic transfer of cash to the system, who would send out thousands of electronic payments to such bondholders. On one hand, this yields greater efficiency in the processing of payments. Objective data would come out into the public domain about the precise nature of default which took place, if any. This would help alert debenture trustees and help them do their job better.

The very presence of such an arrangement would constrain issuers to behave better.

Tuesday, October 13, 2015

Drafting better laws

Deepak Patel has a useful article in today's Business Standard about the problems of poorly drafted laws.

Badly drafted laws and the problem of State capacity

It is widely understood that badly drafted laws induce legal risk. Some of this is at the level of syntax, e.g. the use of ambiguous words like "shall" or "may". Far more important is the semantic content. When it is not clear what the law says, government officials and private persons are continually at sea in thinking about what is to be done.

Badly drafted laws are about much more than legal risk, however. They go to the heart of India's crisis of State capacity. Our challenge is to go from government organisations which are shambolic rulers, to high performance organisations which are precisely structured agents of Parliament.

Parliamentary law is the contract between the principal (Parliament) and the agent (a government agency).  In India, these laws are often riddled with vague objectives (e.g. "the welfare of the people"), expansive powers (e.g. "any action that is necessary") and inadequate accountability mechanisms (e.g. lack of a mechanism for appeal or lack of a proper board of directors). Bad laws mishandle the principal-agent relationship and lay the foundation for pervasive failure on the part of the agent. The laws that have created organisations ranging from SEBI to RBI to the CBI are riddled with problems, and have caused low performance on the part of these agencies. A quantum leap in the laws is of essence in the task of achieving State capacity in India.

A key foundation of low State capacity in India is badly drafted law. State apparatus is integral to the process of drafting law in India. This gives a vicious cycle, as bad laws $\rightarrow$ low State capacity $\rightarrow$ bad laws. Getting to good quality laws, at present, is going against the grain. A great deal of effort is required to break with this vicious cycle, to get a first wave of high quality laws, which will induce better working of the State, which can potentially kick off a virtuous cycle.

How to do better: Contracting between the Principal and Agent

Private parties mitigate the risks of failure by applying skepticism and precision to the contracts they draft: A company might use a well-written contract to bind, motivate and monitor the canteen services vendor it has hired. The Principal does not believe the Agent is benevolent and means well. The Principal writes a contract which constraints the Agent into delivering results. The drafters of laws should apply at least the same level of skepticism and precision for writing a "contract" which establishes a government agency and asks it to do work.

How to do better: An analogy with computer software

A computer program is a precise set of instructions which tells the hardware what to do. In similar fashion, law is the precise set of instructions which tells a government agency what to do. Writing law is like computer programming. The law is written, it is enacted by Parliament, and then it induces certain effects. We would like for those effects to be the ones that we desire.

When computer programs are written, there is extreme care about every single letter of the code. A small core of high skill persons is given the ability to touch the code. Every little detail matters. There is a sense of craftsmanship about the product. We do not allow random people to make even minor edits in the code.

A similar culture is required when drafting law. The ability to touch the code should be restricted to small teams of very high skill. Every little detail should be thought through with great care. There should be an extreme sense of craftsmanship about the product.

With computer software, it is relatively easy to take an interim version, load it into the hardware, and try to run it. If the code is incorrect, we know fairly soon that there are problems. The trouble with law is that there is no easy way to visualise what will happen when a proposed text is enacted. This requires imagination and visualisation, grounded in deep domain knowledge. The teams which draft law have to thus be deeply grounded not just in law but in the domain knowledge. Every small proposed change must be exposed to extreme scrutiny by very capable people.

The journey to better laws in 11 steps

How can law be drafted better? The following principles are useful:

  1. Be wary of incumbents. "Do not judge your own cause" is a principle of natural justice, and this requires excluding incumbent agencies from the legislative process. The canteen contractor should not be given a say in the drafting of the canteen contract. In similar fashion, incumbent agencies should not be given a say in the drafting of laws which shape their objectives, powers and accountability mechanisms as they will exert their influence in favour of more power and less accountability.
  2. Malleability vs. the agency problem. Many laws achieve malleability by leaving procedural details to be written in the future in subordinated legislation. We should, however, be mindful of giving power to the canteen contractor to reshape the objectives, the powers and the accountability mechanisms of the canteen contractor. This principle guides the scope for powers given to the agent to write law.
  3. The Joint Secretary cannot manage these projects. The scale of time and effort that goes into a well drafted law is very large. Example. It is generally not possible for senior government officials (e.g. joint secretaries) to put in this kind of time. A different organisational arrangement is required.
  4. Writing law is different from reading it. Most lawyers in India are used to treating the law as given, and thinking about transactions or litigation. Writing law is a very different skill. It is primarily a skill that requires a combination of domain knowledge and public administration. Years of experience as a legal practitioner is not adequate preparation for writing law.
  5. Premature coding. In drafting projects, there is a temptation to start coding prematurely. It feels satisfying, particularly for lawyers, to be writing code. However, it makes more sense to first grow roots in the domain knowledge, and write sophisticated documents that articulate the thought process of the proposed law. This thinking process is a necessary preamble before the first line of code is written. There is an old adage in project management: `plan in haste, repent in leisure'. A long slow process is required, that builds clarity of mind, and results in a reasoned document of drafting instructions, after which the drafting can commence.
  6. Access control in the drafting / editing process. A very small team of persons should be constructed which has the ability to make changes to the draft. The management process should eschew edits coming in from people who are not fully steeped in the thought process of the law.
  7. The need for continuity and absorption. It is very hard for a new person to fully understand the logic of a large code. It is even more dangerous for a new person to propose or make changes in a large code without fully understanding it. High continuity of personnel who will own and refine a code, over long periods of time, is required. These personnel should be fully immersed in all aspects of the law, so as to keep all the moving parts in their heads, and be able to effortlessly and immediately see the implication of a change in Section $i$ for the working of Section $j$.
  8. Break with our traditional writing style. High levels of craftsmanship are required, with the use of modern English and simple direct precise sentences. The traditional Indian writing style is a recipe for introducing legal risk, executive discretion and ultimately in producing low State capacity.
  9. Gear up for a detailed law. A canteen contract of 1000 words, which is a skimpy high level statement, is almost surely a bad contract. It takes a lot of work to precisely write down a sound contract. In similar fashion, most Indian parliamentary laws have inadequate detail. We should go into drafting projects knowing that the parliamentary laws of the future will be much more detailed than those of our past.
  10. Given enough eyeballs, all bugs are shallow. Draft law should be put through elaborate processes of expert peer review, and public comment, in order to identify flaws ahead of time.
  11. Code reuse -- but in the future. Most existing law and jurisprudence in India has a high defect rate. Hence, law drafting projects should be skeptical about the existing landscape and try to replace it with clean building blocks for India's future. There are opportunities for code reuse -- but only in our future.


We are stuck in the wrong equilibrium. Most laws in India today are poorly drafted. Badly drafted laws are at the foundation of low State capacity in India today. As arms of the State presently play a dominant role in the drafting of laws, there is a vicious cycle there. If we don't make a big push to do law $n+1$ properly, by default, it will be mediocre. The normal processes are stacked in favour of failure.

The minimum required step up is from the conventional drafting quality up to the standards of commercial contracts. The SEBI Act (say) should match the quality of a commercial contract in terms of precision, level of detail, and a skeptical approach to the principal-agent problem. This level of improvement is relatively easy to obtain, in the sense that myriad detailed commercial contracts are being drafted by lawyers in India every day.

The bigger step up is to think of law as the DNA of government. The law is the computer code which is loaded into government. When this code runs, it has legal effects. This requires bringing public administration and economic thinking in envisioning the legal effects of every line of the code. The standards of craftsmanship and perfection which are found in the best computer programs are required in writing law.


I thank Pratik Datta and Arjun Rajagopal for useful discussions.