25th July 2016
Response to the Query from Shri.R.K.Sahni
1) On 16thJuly, I received a Mail from Shri.R.K.Sahni, requesting me to give my observations on the following two statements.
a) "As on 31/03/2015, there is an amount of Rs.33503.52 cr. in the LIC Employees Pension Fund...For 2014-15, LIC has paid Rs.839.42 cr. including commuted pension. The interest income alone is Rs.2425.16 cr. Even if our pension is upgraded with an increase by 100% on an average, the pension outgo will be less than 1% of the operating surplus." --- Mr C H Mahadevan in a blog.
b) Dear Mr Mahadevan,
b) Dear Mr Mahadevan,
I know that you wouldn't have come out with this statement unless you were convinced that your SOURCE is impeccable and can stand the scrutiny of a High Court judge and even pass it because I have a hunch that this may well be the fulcrum on which the entire case turns
2) I gave my response immediately. But, when Shri.Sahni asked me whether he can publish it in his Blog, I told him that it may not be prudent to do so, since many may not feel happy with my comments. After thinking over the matter for two days, I changed my mind, purely out of my personal regard for Shri.Sahni. He may not be aware of it, since we had never worked together and interacted also only on very few occasions. My response is given below, in the form of a fairly long article. It is more a statement of facts and it is left to the readers to arrive at the conclusion. As I have said, most of our members may not feel happy with what I have stated in the article.
3) Let us first take the statement, “Even if our pension is upgraded with an increase by 100% on an average, the pension outgo will be less than 1% of the operating surplus". This appears to be very simple. But, is it really so? What are the issues involved? Let us see.
4) It is not clear whether the term “Operating Surplus”, mentioned by Shri.Mahadevan, refers to the Revenue surplus emerging from the total operations of the LIC Employees’ Pension Fund or to the Revenue Surplus emerging from the total operations of the LIC. Let me first take up the case of LIC’s operations. Consider the data given in the Table-1 below. This has been extracted from the Revenue Account for the year 2014 – 2015, given in the corresponding Annual Report of the LIC (Pages 130 to 133 and Page 138). To simplify the presentation, I have considered only the Non-Linked, Within India business, which accounts for a major portion of the Operating Surplus.
TABLE – 1
Annual Report of the LIC, for the year 2014 – 2015
Non-Linked, within India Business
Total Premium Income
Total Investment Income
Policy outgo (Surrenders, death Claims, Maturity Claims and Annuity Payments
Employees’ Remuneration and Welfare Benefits
Other Operating Expenses
Operating (Revenue) Surplus [ A – B]
Increase in Liability
Valuation Surplus [C – D]
5) The value of, (Income – Policy Outgo – Management Expenses – Increase in Liability) is known as the Valuation Surplus. This is the equivalent of Profit in the case of non-life insurance companies. While the Operating Surplus is Rs.2,28,983 crores, the Valuation surplus, is only Rs.41,950 crores. That is less than 20%. The real surplus is thus only Rs.41,950 crores and one percent of it is about Rs.420 crores. Let me explain what is meant by Valuation Surplus.
6) A life insurance company incurs a liability (i.e. liability to the policyholders) whenever a new policy is issued and an additional liability when a renewal premium is received. This liability is to be estimated by actuarial techniques, using appropriate discount and probability factors. The difference between the total liability as at the end and beginning of a financial year is known as the increase in liability during the year. In the determination of valuation surplus, what is given as Increase in Liability is the difference between,
· The liability at the end of the year before the allocation of bonus and
· The liability at the beginning of the year
7) The increase in liability, given in the Revenue Account, is the difference between
· The Liability (after allocation of bonus) at the end of the year and
· The Liability at the beginning of the year
The Liability as at the end of the year, before the allocation of bonus, is not available in the Annual Report and I have derived its approximate value from the other figures given. The liability after allocation of bonus will be much higher than the liability before allocation of bonus. So, the increase in liability shown in the Revenue Account will be much higher than the real increase in liability. Consequently, the valuation surplus shown in the Revenue Account will be much less than the real valuation surplus.
8) Can just one percent of the valuation surplus be transferred to Employees’ Benefit fund, for improving the benefits to pensioners? The answer is a firm NO. Let us see why.
9) The first charge on the valuation surplus is Tax, @14.1625% (12.5% tax, 10% surcharge and 3% education cess). So, amount of tax payable is,
(14.1625% of 41,950) = Rs.5,941 crores.
The balance surplus is (41950 – 5941 = Rs.36,009 crores)
10) As per the LIC Act, not less than 95% of the balance surplus has to be allocated for the benefit of with-profit policyholders and the balance, not exceeding 5%, is to be paid to the Central Government as dividend on the capital provided by it. So, Rs.34,209 crores will be allocated to policyholders as reversionary bonus and Rs.1,800 crores will be paid to the Central Government as dividend. (This figure is available in the Revenue Account, under Appropriations – Page132 of the Annual Report)
11) To explain why only the valuation surplus and not the operating surplus is the real profit, let us consider the example of banking operations. A bank gets in a year, say Rs.10,000 crores, towards fixed deposit and Rs.6,000 crores as interest income on its investments. The total income for the year is Rs.16,000 crores. The management expense during the year was, say Rs.900 crore, and payment made towards deposits that were redeemed during the year was, say Rs.4,000 crores.. Its operating surplus during the year will be,
16,000 – 900 – 4,000 = Rs.11,100 crores.
If the bank thinks that it has a huge operating surplus and gives a percentage of it to employees each year as bonus, it will have to close down within a few years. From the operating surplus, it has to provide for the increase in liability arising from the net increase in deposits during the year and the interest accrued (but not yet paid) on the deposits.. Only the balance, if any, will be the Profit.
12) The first charge on this profit will be tax, @35% + surcharge + education cess. The balance left belongs to the shareholders.
13) In the case of Employee’s Pension Fund, the operating surplus will be used to cover the increase in liability during the year and generally, there will be no balance left, since the employers (in this case LIC) will not pay excess contribution
14) Let us go back to the case of Life Fund of the LIC. It is not possible to amend the Income Tax Act and the LIC Act in order to be able to transfer a portion of the valuation surplus for pensioners’ benefit. Suppose we are able to persuade the Central Government to transfer to the pension fund 20% of the dividend paid to it (i.e. one percent of the valuation surplus after tax). The pension fund will then get Rs.360 crores. In view of this additional amount, available, can we enhance the pension benefit by say 40%, if not by 100%? The answer again is a NO. Let us see why.
15) This time the auditors will come in the way. As per the Accounting Standards (AS26), once a certain quantum of pension benefit is agreed upon, the Actuarial Liability in respect of pensions payable in future has to be estimated and a fund equal to this liability has to be set up. The Employees’ Pension Fund as at 31.3.2015 was Rs.32,578 crores. It may be above Rs.37,000 crores as at 31.3.2016. If pension benefit is increased by 40%, the Fund required will be about Rs.51,800 crores and the Corporation will not be able to transfer another Rs.14,800 crores to the pension fund, without bringing down the bonus rates to significantly lower levels. Such a step will affect the future new business very adversely, which in turn may even jeopardise the viability of the Corporation.
16) There can also be a more serious problem. Twenty years ago, when the option was given between P.F and Pension, a clear indication of what the pension benefit would be, was given. Now, if there is significant increase in pension benefit, a second option has to be given to P.F optees (It is easy to enforce this legally). This may involve transfer of another Rs.7,000 crore to the Pension Fund. Neither the Corporation nor the Government will find it possible to identify resources for this additional (14,800 + 7,000 = Rs.21,800 crores).
One cannot then stop the Government from going for Disinvestment to raise the additional resources needed.
Whenever there is a significant change, for the better, in the nature of pension benefit, the Second Option has to be given to the PF optees.
17) The figures given in the Table below were taken from the Annual Reports of 2013 – 2014 (page 177) and 2014 – 2015 (page 185). The Annual Report of 2015 – 2016 is not yet available.
LIC Employees’ Pension Fund All Amounts in Rs.(crore)
As at March 2013
As at March 2014
As at March 2015
Fund at the beginning of the year
Fund as at the end of the year
18) The entire fund, shown in the last row does not belong to the Pensioners, as some would wish to imagine. About 80% of it would belong to Pension Optees among employees still in service and only the balance 20% to Pensioners and Family Pensioners. The fund shown in respect of Pensioners and Family Pensioners does not includethe actuarial value of the Pension Policies already purchased from the LIC under the Group Pension Scheme, since this liability pertains to LIC and not to the Employees’ Pension Fund. These values will not be available in the Annual report, and will be available only in the valuation abstract submitted by the LIC to the IRDA, which is a confidential document.
19) What does the Fund at the end of the Year represent? It represents the liability as at the end of the year. The components of this liability are,
· Liability in respect of pension optees still in service,
· Liability in respect of pensioners and
· Liability in respect of family pensioners
20) In the case of members (i.e. pension optees) still in service:
The liability will be the sum of the liabilities in respect of,
· Commuted Value of pension, payable on the date of retirement, in case the optee survives upto the date of retirement,
· Monthly pension payable after retirement, in case the optee survives upto the date of retirement,
· Increase in D.A (once in six months) corresponding to possible increases in the cost of living index,
· Restoration of commuted Pension in case of survival of the optee upto the end of 15 years after retirement
· Liability in respect of Family pension payable in case of death of the optee either while in service or after retirement
The quantum of pension payable will be estimated on the basis of,
· The service put in by the optee as on the date of valuation, subject to a maximum of 33 years and
· The expected salary of the optee at the time of retirement,
21) In the case of pensioners,
The liability will be the sum of the liabilities in respect of,
· Future pensions, taking into account the possible increases in dearness allowance, once in six months and
· Restoration of the commuted pension in case of survival of the pensioner upto the end of 15 years after retirement
· The family pension payable in case of death of the pensioner
22) In the case of family pensioners
The liability will be the value of future pensions, taking into account the possible increases in dearness allowance, once in six months. (I have deliberately ignored the value of possible pension payable to minor children in case of death of both pensioner and his/her spouse, since this liability is quite negligible.
23)Benefits paid during a year is the sum of,
· Commuted value paid to those who retired during a year,
· The cost of pension policies purchased under the group pension scheme in respect of pension optees who retired during the year,
· The cost of pension policies purchased under the group pension scheme in respect of increase in Dearness Allowance in the case of pensioners and family pensioners,
· The cost of family pension policies purchased under the group pension scheme in the case of pension optees and pensioners who died during the year
(The actual pension paid will not come under benefits paid, and this will appear only in the Revenue Account of the Pension department and is not available in the public domain)
24) Contribution paid is the total amount transferred by the LIC to the pension fund and is equal to,
[Pension Liability as at the end of the year ─
(Value of the fund as at the beginning of the year +Investment income received during the year ─ Benefits paid during the year)]
25) Value of the Fund at the beginning of the year will be the same as the Pension Liability at the beginning of the year. So, Contribution paid by the LIC will be,
[(Pension Liability at the end of the year – Pension Liability at the beginning of the year) – (Investment income during the year – Benefits paid during the year)]
So, Contribution Paid = (Increase in liability during the year – Operating Surplus during the year)
There will be no surplus in the Pension Fund unless additional contribution is paid by the LIC and so, there will be no scope for increasing the benefit.
26) As seen in paragraph (18), the entire fund does not belong to the Pensioners. About 80% of it would belong to Pension Optees among employees and only the balance 20% to Pensioner and Family Pensioners. The exact bifurcation is not available in the public domain and is also not material.
27) So, the Fund pertaining to the pensioners and family pensioners will only be (20% of 32,578 = Rs.6,516 crores). Since the Annual Report for the year 2015 – 16, is not yet available, I have given the figure as at 31st march 2015. The interest income per year on this fund, assuming a rate of return of 9%, will only be Rs.587 crores. This corpus of Rs.6,516 crores, with future investment income, will be barely sufficient for meeting the liabilities listed under (21) and (22).
28) The value of pension fund as at 31st March 2008 was Rs.3,273 crores and has increased to Rs.32,578 crores, as at 31.3.2015 (almost 10 times) in 7 years. The average rate of growth is thus about 39% per year.
29) Let us now consider the impact of the contributions to the Pension Fund. In 2014 – 2015, contributions made to employees’ pension fund was Rs.4,378 crores. This would have reduced the valuation surplus available by Rs.4,378 crores. There is also an indirect effect. This increases the total expenses by Rs.4,378 crores and the “Per Policy Expense” would have correspondingly increased. The per policy expense is defined as, [(Total Management Expense Less Expenses on Agency commission) divided by total number of policies].The liability per policy is defined as,
[Present Value of benefits payable (including future bonuses) + Present Value of future expenses + Present Value of future commissions – Present Value of premiums receivable in future].
When the expense per policy increases, the Present Value of future expenses, and hence the total liability will also increase, thus reducing the valuation surplus by a corresponding amount. So, as a result of the contribution made to the pension fund during a year, the valuation surplus will get reduced, directly and also indirectly. This, in turn, will reduce the bonus that can be declared. How much will be this decrease? In the absence of required data in the public domain, it is not possible to discuss this aspect. The approximate value of this reduction can be derived indirectly from the available figures. But, it is not proper on my part to do so in an article of this kind.
30) Now consider Table-3 below
Employees Remuneration, including transfer to pension fund
Amount transferred to Pension Fund
(3) as a Percentage of (2)
2007 – 08
2008 – 09
2009 – 10
2010 – 11
2011 – 12
2012 – 13
2013 – 14
2014 – 15
All the above figures have been taken from the respective Annual Reports. For example, in the year 2014 – 15, the figure in column 2 is available in Page 96 of the Annual Report and the figure in column 3 can be obtained from Page 183 of the Annual Report. In the year 2014 – 2015, the total expenses in respect of “Employees’ Remuneration and Welfare Benefits” is Rs.14,523 crores. [In Table-1, this figure was given as Rs.14,118 crores. Why this difference? Figures given in Table 1 pertain only to within India, Non-Linked business and were taken from Revenue Account. Figures given in Table-3 pertain to Total Business.
31) But the percentages given in the last column may be less than the actual percentages. The figure given in the second column is the total remuneration, including expenses in respect of employee benefits, of all employees. This includes the expenses in respect of P.F optees and also that of those not eligible for pension (i.e. new entrants). The figures given in column 3 pertain only to pension optees. This means that the denominator used in the calculation of percentages is higher than what it should be and so, the percentages given in the last column are less than their real value.
32) The last column of the Table gives the expenses due to pension benefit as a percentage of total expenses in respect of employees. This will give a clear idea of the strain on the finances of the Corporation (i.e. on the policyholders’ fund) due to pension benefit granted to employees.
33) Let us take a look at Table 4
Table – 4
Different Components of Expenses as
A percentage of Total Premium Income
Salary and other benefits excluding pension benefit
Other Management Expenses
Overall Expense Ratio
2007 - 08
2008 – 09
2009 – 10
2010 – 11
2011 – 12
2012 – 13
2013 – 14
2014 - 15
These figures were again taken from the Annual Reports. In the case of year 2014–15, these percentages are available in page 96. The percentage corresponding to “Salary and other benefits to employees” has been bifurcated into, “Salary and other benefits excluding pension benefit” and “Pension benefit”, by using the percentages derived in the last column of Table–3. As stated in paragraph (31), the percentages in the last column of Table–3 are a little understated. If the correct percentages can be derived, it would be found that the cost of the Pension benefit is about 2% of the Total Premium Income.
34) What is the significance of the above conclusion? If the cost of pension benefit is 2% of total premium income, can the pensions be doubled with just 1% of the operating surplus of the LIC (or, is it 1% of the operating surplus of the pension fund?)
It is left to the readers to answer this question.
35) It can be seen from Table-4, that Salary and other benefits, excluding pension benefit, constitute 4% of the total premium income. There was no pension benefit in 1994 – 95, twenty years ago. What would have been the ratio of salary and other benefits to the total premium income at that time? One would be surprised to know that it was about 9.3%. The reason was simple. In 1994 – 95, the total premium income was just 11,528 crores. In 2014–15, it was, Rs.2,39,483 crores. That is, almost 21 times. But, the total number of employees has increased only marginally. This was made possible by the remarkable improvements in the underwriting and policy servicing Systems that were brought about, without much fanfare, during the last twenty years. The credit for the growth in premium income goes to the tremendous efforts put in by the agents and the marketing wing. It was these efforts that sustained the pension benefit till now. But, it is an irony that, the agents did not get any extra benefit for the efforts they put in.
36) Now, with intensifying competition and diminishing scope for further system improvements, pension benefit is likely to come under pressure.
37) RBI has issued guidelines to Banks for choosing the basis for valuing retirement benefits. As per these guidelines, the rate of discount to be used in the case of pension benefit valuation is to be based on the average balance service left, before retirement, of the pension optees. If the average balance service to retirement is, say x years, the rate of discount to be used will be the yield, as on the date of valuation, on the Central Government bonds of duration x years. The rate of discount used by the LIC for valuing the pension benefit almost corresponds to this guideline. But the rate of inflation to be used is only 5% as per RBI guidelines and the rate used by the LIC is 6%. (This information too has been taken from the Annual Report). Thus the valuation basis being used by the Actuarial department is quite strong and consequently, the Pension Fund is also quite adequate.
With the yield on investments gradually falling, the discount rate, linked as it is to the yields on Government bonds, will decrease further, leading to further increase in pension liability and the contributions to be made to the pension fund.
38) As a consulting actuary, I have been doing pension benefit valuation for more than two decades. The basis chosen by me has never been as strong as that being used by the Corporation. Twelve years ago, when there were no RBI guidelines in this regard, adequacy of the liability estimated by me in respect of a public sector bank was questioned by the Auditors. In my detailed reply, I stated that,
“If the basis used is slightly weaker than what it should be, the value of the Pension Fund would also be less than what it should be. However, the contribution made to the pension fund will gradually become higher and higher each year. If, in my opinion (based on the balance sheets), the institution concerned would always be capable of making these increasing contributions in future, I would prefer to keep the liability at the minimum, but safe, level and allow the institution to deploy its resources more profitably in its day to day operations. I concluded my reply with the statement. “Adoption of a strong basis may lead to a very healthy fund position. But, such a strong fund position can also lead to a demand from employees for further enhancement of benefits and place additional strain on the resources of the institution".
My reply was accepted by the auditors. Three years ago, I gave a similar reply (orally) to the C.A.G Auditors, in respect of pension fund valuation of a public sector undertaking (PSU).
39) I am glad to note that the statement forwarded to me by Shri.Sahni, proves my point. The Actuarial department of the LIC should also take note of this. The sincerity displayed by it in ensuring the adequacy of the pension fund has to be appreciated. But not everyone will look at it in this light. My personal advice to it is to bring down the pace of funding and adopt the guidelines issued to the banks.
40) In paragraphs (15) and (16), the problems that the LIC is likely to be confronted with if pension benefit is enhanced, were discussed. One may ask as to how the Government is able to go on increasing the pension benefits, without any limit.
· There is no need for the Government to set up a pension fund and it pays the pension from current account, euphemistically called “Pay as You Go” system.
· It can always print paper currency to meet the pension payments.
· In the Government system, those who demand an increase and those who have to sanction it are both the same
41) A life insurance company does not have any of these advantages. The money required for any enhancement in benefit has to be taken from the premiums paid by the policyholders, reducing in the process the returns to policyholders. In a highly competitive environment, this can have serious impact on the flow of new business and the viability of the company itself.
42) One may ask as to how the viability of the company can be affected. Insurance Act, 1938 and Insurance Rules, 1939 prescribe ceilings to New Business and Renewal expense ratios. New business expense ratio is defined as the ratio of (total expenses pertaining to new business) to the (total weighted first year premium). The weights depend on the premium paying term. The weight is 100% for premium paying terms not less than 10 years and lesser percentages for lesser terms. Similarly Renewal expense ratio is defined as the ratio of (the difference between the total expenses and the expenses pertaining to new business) to the (total weighted renewal premium). On the average, these ceilings used to work out as 90% of the first year premium and 15% of renewal premium. These ceilings were imposed in order to safeguard the interests of policyholders.
43) In the mid sixties, when the renewal expense ratio of the LIC exceeded 15%, it received a warning from the Controller of Insurance. In 1971, the first year expense ratio exceeded 100%. After that, the LIC has been able to maintain the expense ratios well below the ceilings..
44) It seems that the IRDA has now lowered these ceilings (I have not yet seen the new regulations) and is also taking a serious view if the ceilings are breached. When a company breaches the ceilings for the first time, a fine is imposed and a warning letter is also issued. If the company is not able to bring down the expense ratio below the prescribed levels, the IRDA can ban the company from transacting new business till it is able to conform to the regulations. The idea behind this tightening of controls is purely to ensure a fair return to policyholders.
45) A private insurer can bring down the expense ratio by closing a few branch offices and retrenching staff. But, a public sector company cannot adopt such a method. It cannot also reduce the commission rates or salaries. It can be seen from Table-4 that, the “Other Management Expenses” are already quite low and there is not much scope for making any significant reduction in them. The only way to bring down the expense ratios is by raising the new business growth rate and increasing the premium income. In a highly competitive environment, it is easily said than done. So, once the expense ratios of the LIC breach the ceilings, it would be too difficult for the organisation to bring them down again. The bad publicity accompanying such a contingency will have a severe impact on the flow of new premium income, which in turn, will further increase the expense ratios and affect the very viability of the organisation.
46) Such a contingency may not affect the existing pensioners and family pensioners. Pension policies have already been purchased from the P&GS department, corresponding to their current level of pension and, as per Sec.37 of the LIC Act, 1956, these policies come under Government guarantee. But the pension optees among employees still in service will not have any such protection.
47) It was seen in paragraph (16) that, “Whenever there is a significant change, for the better, in the nature of pension benefit, the Second Option has to be given to the PF optees”. The only benefit that the PF optees are getting now is a contribution of 10% of their basic pay to the Provident Fund. The contribution being made to the Pension Fund would be higher than 15% of the Gross Pay (Basic + D.A). Even at the present level of benefits there is significant difference between the benefits being paid to the two groups of employees within the same organisation. Only legal experts can say whether such blatant differential treatment of two groups of employees can be justified.
48) The falling interest rates and improving mortality experience (i.e. reducing mortality rates), are also adding to the problem. Whenever a pension optee retires, a pension policy is purchased from the LIC by the pension fund, for the payment of his/her pension. A policy is purchased also when the commuted pension is to be restored to a pensioner. Similarly, pension policies are purchased in respect of pensioners and family pensioners whenever the D.A. increases. Due to the falling yield on investments and decreasing mortality rates, the Corporation has been revising (upwards) the premium rates under pension policies. With every such revision, the cost of purchasing new pension policies is going up, placing additional strain on the Pension Fund.
49) Another problem that is now emerging is the changing composition of LIC’s new business. It is found that continuously increasing proportion of single premium policies is being issued. One may wonder as to what connection can be there between this and the pension benefit to employees.
50) In paragraph (42), mention was made about the ceilings on expense ratios. In the case of single premium policies, there will be no renewal premium income. When more and more single premium policies are issued, the renewal premium income will start reducing. In the calculation of the weighted average first year premium income, the weight given to single premiums is also quite low. The combined effect of reduction of renewal premium and lesser weight to single premium may increase the expense ratios and the probability of these ratios breaching the prescribed ceilings will also increase. There is nothing wrong, per se, in encouraging single premium policies. But, it has to be ensured that these single premium policies are not procured by cannibalisation of regular premium policies. It is the duty of actuarial department to alert the management in this regard.
51) If I am asked as to what are the major strengths of the Corporation, my unhesitating reply would be (a) its agency force and (b) its Computer professionals
· Its agency force is the major strength of the Corporation and more attention has to be paid to its training and retention. Such a step would not only increase the new business flow, but would also raise the public image of the Corporation.
· The Corporation has built up a very good team of highly skilled computer professionals over the last 50 years. The number of such professionals in its service can be the envy of any organisation. Proper utilisation of these professionals can bring down its expense ratios and increase the valuation surplus and hence the bonus rates..
52) Much more can be written on this topic, but I would like to conclude the article for the present. My sincere thanks are due to Shri.R.K.sahni for giving me an opportunity and also inducing me to place the above facts on record.
25th July 2016