In India, it is generally seen that ”Personal finance” is one of the most ignored or neglected area. People generally ignore this due to either lack of understanding or due to lack of time. Lack of regulations, commission driven sales approach of distributors are few of the factors which are adding on to the lack of trust among people in engaging any service provider. Having said that, I am sure that the government’s efforts are in the direction of making this a regulated profession wherein the advisors will be accountable for their advises, thus ensuring protection of customer’s interest.
Provident Fund (PF) has been one of the most common investment avenue for majority of people. Unfortunately, most of the investors are unaware about the benefits and the basic features of this investment avenue. Supreme court’s order of October 2016 that directed the Employees’ Provident Fund Organisation (EPFO) to revise pension of 12 petitioners under the employee pension scheme created lot of euphoria among private sector employees. Many of our clients immediately approached us to discuss about the implications. What came out of such formal and informal discussions was a clear lack of understanding of how contributions made towards provident fund during active employment works. Through this article, I am attempting to throw some light on the little known facts about Employees’ Provident Fund Scheme (EPF) and Employees’ Pension Scheme (EPS)
Most organisations today offer the facility of PF. EPF and EPS are the two different retirement saving schemes under Employees’ Provident Funds and Miscellaneous Provisions Act, 1952, specifically meant for salaried employees. It is mandatory for every employee drawing a salary of up to Rs. 15,000 per month to make contribution towards EPF & EPS. However, employees drawing salary over Rs. 15,000 per month have an option to get PF deducted from their salary. It is to be noted that this decision to opt out of scheme should be taken at the start of your career. In case, you have been a member of EPFO once, then you are not allowed to opt out of the scheme. The term “Salary” for the purposes of PF is defined as Basic Pay + Dearness Allowance.
Typically, both the employer and employee contribute 12% each of employees’ salary. The entire 12% of employee’s contribution is added towards EPF, while 8.33% out of the total 12% of the employer’s contribution is diverted to the EPS or pension scheme and the balance 3.67% is invested in EPF. However, if the salary of an employee exceeds Rs. 15,000 per month, the contribution towards pension scheme is restricted to 8.33% of Rs. 15,000 (i.e. Rs. 1,250 per month) and the balance of employer’s contribution goes into EPF.
Let us look at the following table to understand this better:
It is important to note here that in case of scenario 2 the contribution towards EPS is restricted to Rs 1,250 (i.e., 8.33% of Rs 15,000). Hence, Rs 1,250 is the maximum cap for contributions towards EPS. Any amount above this cap, will be allocated towards employee‘s PF account.
In March 1996, the EPS Act was amended to allow members to raise pension contribution to 8.33% of full salary. In other words, the above mentioned cap of Rs 1,250 (as per scenario 2) was removed. However, due to lack of awareness, very few members only opted for this.
Interest on EPF contributions is decided by the central government. The ongoing interest rate is 8.65% p.a. For EPF, compound interest is paid on the amount standing to the credit of an employee as on 1 April every year. However, EPS being a pension scheme, interest is not applicable. Hence, no interest is earned on the amount accumulated in EPS.
It is recommended to transfer EPF account at the time of joining a new company instead of withdrawing it, as EPF forms the debt part of your portfolio and gives good tax-free returns. If you withdraw the EPF amount before completing five years of service with an employer, the corpus withdrawn is taxed. The amount is added to your salary income and taxed accordingly. On the other hand, if left untouched, it is completely tax-free.
For EPS, if the service period is less than 10 years, you have an option to either withdraw your corpus or get it transferred by obtaining a ‘scheme certificate’, if there is a break in service. This way the number of years of service that you have put in gets transferred to the new account that you open in the new organisation.
An employee can start receiving pension under EPS only after rendering a minimum service of 10 years and attaining the age of 58 or 50 years. However, no pension is payable before the age of 50 years. Early pension, that is an employee receiving after completing 50 years of age but before 58 years, is subject to reducing factor @ 4% for every year falling short of 58 years. In case of death / disablement, the above restriction is not applicable.
The pension amount is payable to the eligible subscriber till he survives. On the death of the employee, members of his family, whom he has nominated, are entitled for the pension.
Under EPS, the monthly pension is decided on the basis of ‘pensionable service’ and ‘pensionable salary’.
The formula to calculate pension is:
Monthly pension = (Pensionable salary X Pensionable service) ÷ 70
The amount of pension you get depends upon a fixed formula, which is average monthly salary of the last 60 months of service multiplied by the number of years of service divided by 70.
Suppose you had not opted for a higher contribution to EPS as per the provisions of EPS amendment of March 1996. In such a scenario, your employer shows your salary as Rs. 15,000 for EPS, so the pension is calculated on a monthly salary of Rs. 15,000. Assuming you have worked for 35 years, your monthly pension will come to Rs. 7,500 ([(Rs. 15,000 X 35 years)] ÷ 70). The amount of pension is too less.
Comparing the scenario with an investment Rs. 1,250 in a recurring deposit (compounded on monthly basis) at 8% interest rate per annum for 35 years, you would get Rs. 2,867,353 as maturity value. If this maturity amount is used to purchase an immediate annuity plan offering 7% returns p.a., the monthly pension would be Rs. 16,726 which is much more than twice of Rs. 7,500.
There are clear tax advantages of EPF contributions. EPF is one of the most important investment tool which when used with other avenues can create a sizeable corpus for retirement.
Disclaimer: The above article is for the purpose of investor awareness only.
Pradeep Kumar
Excellent write. Thanks for such a simple explanation.