During the week, the board of the EPFO (Employee Provident Fund Organization) announced interest rates on PF at 8.1% for FY21-22. This is the lowest rate of interest offered since 1977. In a way, the EPFO is on the right track and it just needs to cut EPFO rates much faster.

Why EPFO still pays so much?

 The EPFO is perhaps one of the few investments left in the world that pays exorbitant rates of interest, which are out of sync with the market. At a time when bank FDs pay 5.5% coupon rate, the EPFO has been paying 8.5% till the latest cut. That is not all. It is a very politically sensitive subject so it often happens that the EPFO board suggests a rate cut but the central government strikes it down. Before that, let us look at how much an individual earns from the EPFO in effective yield terms.

Your effective yield will be depending on the fact that interest is fully tax free and the contribution gives tax exemption u/s 80C of the Income Tax Act. Assume you are in the 20% tax bracket, then your effective yield on CPF at 8.1% interest works out to 12.5%. However, in case you are in the 30% tax bracket, your effective yield is above 16%. Remember that this is an assured return product with zero default risk. Earning 16% plus yields on such a product is an absolute distortion. You just cannot earn that kind of yields on a total risk free type of investment. That is why it must change.

It is a huge cost burden

Today, EPFO manages Rs.11.50 trillion of public funds. That is about $150 bn. By reducing rates by 40 bps to 8.1%, the government saves $600 million per year or around Rs.4,500 crore. Ideally, the government should cut EPFO rates to 6.5% and that would save an amount of Rs.22,500 crore per year for the government in interest payouts. Even at 6.5%, investors would earn 13.5% yield in the 30% tax bracket and 10.5% in the 20% tax bracket. That is still very attractive for the risk entailed. At some point, the government has to cut the rate on EPF to market levels and the sooner it is done, the better it will be.

There is also the distortion risk

At a macro level, there are 2 key risks in paying such exorbitant rates on EPF. Firstly, when you have assured return debt schemes paying attractive returns, there is no incentive for people to look at other debt sources. This has stymied the growth of the debt markets in India and emergence of a credible yield curve. The second issue pertains to the risk-return trade-off. India is the only country where long term funds go into debt and short term funds go into equity. That is the reason the progress on equities was so slow in India. Ideally, PFs should invest a much larger portion of the corpus (not just 15%) in equities and returns should be market driven. That is how it works the world over!