Why auction isn’t working for NPS
Rock bottom prices work in a mass product but NPS is yet to achieve scale
Pension fund managers (PFMs) of the five-year-old National Pension System (NPS) will have to battle for a second time as Pension Fund Regulatory and Development Authority (PFRDA) has reintroduced the auction system to choose fund managers. This is the second time that the pension sector regulator has changed the rules: it started off with an auction system, then disbanded it and has now reintroduced it.
In 2009, when PFRDA decided to go with an auction system to choose fund managers, potential bidders raced to bid with the lowest fund management fee, among other things. The remaining contestants had to then match the lowest bid to stay in the game. Perhaps this was the first time a financial sector regulator had used the auction system for price discovery of a financial product. In mutual funds or insurance, for instance, the sector regulators have relied on market competition for price discovery and have instituted caps on the expenses to keep them under control. In NPS, an auction was supposed to ensure that this mass product could be standardized with the least cost. Bidding, in that sense, was meant to arrive at the lowest operable cost that would help develop the pension market. But what ensued was contrary to expectations.
UTI Asset Management Co. Ltd bid with the lowest fund management charge of 0.0009%, and the remaining five bidders agreed to match this. Given that fund management cost is the only charge that a PFM could levy, financial sustainability became a serious challenge.
What made matters worse was that NPS didn’t take off as expected. Left alone to compete with other financial products with intermediary muscle, NPS worked nothing like a mass product. The numbers trickled in slowly and unable to sustain any longer, one fund manager shut shop.
Compared with a fund management fee of up to 1.35% that insurers charge and up to 1.50% in mutual funds, 0.0009% did seem a little too ambitious, but this number was predicated on the back of a bumper performance by NPS. The second PFRDA chief, Yogesh Agarwal, took steps to undo the damage, but ended up making very serious changes to the NPS design. His mandate was to increase NPS’ footprint and to do so, PFRDA disbanded the auction system, instituted a cap of 0.25% on the fund management fee and allowed all qualified entities to become fund managers. But only three new PFMs joined taking the total tally to eight fund managers.
Further, PFRDA allowed these fund managers to participate in marketing NPS, a role the original architecture had frowned upon. So when Agarwal’s stint came to an abrupt end in November 2013, the change of guard at PFRDA decided to go back to the original architecture of NPS. It once again decided to choose PFMs through auctions.
In February this year, PFRDA opened the first round of technical bids and on 16 April it called for commercial bids. Given the experience with 0.0009% fund management cost, one would have thought the commercial bids this time would be more rational. But again, the unexpected happened. Reliance Capital Asset Management Ltd bid with a fund management fee of 0.01% (i.e., one paisa for every Rs.100). However, UTI Asset Management Co. Ltd quoted the highest bid of 0.25% this time.
Nine companies that submitted commercial bids will now have to match the lowest bid of 0.01%. PFRDA plans to choose eight fund managers. But the process has got delayed because HDFC Standard Life Insurance Co. Ltd, which floated HDFC Pension Management Co. Ltd in 2012 as a pension fund manager, took PFRDA to court for disqualifying it from the commercial bids. Consequently, on 25 April, PFRDA announced that it was postponing its decision to issue letters to selected fund manager to 9 May. This also gives PFRDA some time to think things through.
The main question here is that is a fund management cost of 0.01% sustainable? Let’s do a quick back of the envelope calculation. Pension fund managers need to pay an annual fee of Rs.2.5 lakh or 0.005% of the assets under management (AUM) of the previous financial year, whichever is higher, to PFRDA (it was Rs.10 lakh earlier). At a cost of 0.01%, a fund manager will need AUM of at least Rs.250 crore to pay the annual fee alone. Currently, barring a couple of PFMs, most others have an AUM size of less than Rs.100 crore in private sector NPS.
Rock bottom prices work in a mass product but NPS is yet to achieve scale. Rough estimates suggest that in the five years of its existence, NPS has been able to tap just about 1% of the potential subscriber base. Unless PFRDA focuses on driving up scale, price discovery through the auction route may not work. But it seems that it has gone into auctions with an open mind this time. In its request for proposal to PFMs, it reserved the right to negotiate fees and charges with the lowest bidder. Sources suggest the negotiation route was a safeguard against high fund management charges. Given the earlier auction experience, this was a potential danger, but now PFRDA can actually negotiate the charges, based on the range that the bids have thrown up as reference, to arrive at a sustainable price structure. PFRDA’s mandate this time should be to lend stability to NPS.