BEWARE OF AMBIGUITY IN LAW. THIS seems to be the big lesson for the insurance regulator IRDA after its public spat with Sebi over the regulation of unit linked insurance plans (Ulips). So, when finance minister Pranab Mukherjee visited Hyderabad last week, IRDA was quick to pitch for clarity on the tax treatment of pension plans.
IRDA has specifically sought tax exemption for pension plans offered by insurance companies in the direct taxes code (DTC) that will replace the archaic income tax law. This will mean bringing unit linked pension plans on par with the new pension scheme (NPS). The NPS is proposed to be exempt from tax at all three stages — contribution, accumulation and withdrawals — when the DTC comes into force. In jargon, this is the EEE method of tax treatment for savings schemes.
The regulator’s demand comes just weeks after it was given the mandate under law to oversee Ulips, that are akin to mutual funds with a life cover thrown in. The intent is to protect the interests in life insurance industry. A tax-free status will make Ulips attractive for investors and bolster the profitability of insurers.
However, the revised discussion paper on the DTC has made it clear that only pension schemes administered by the Pension Fund Regulatory and Development Authority (PFRDA), pure life insurance products and annuity schemes will be taxfree at all three stages. The PFRDA administers the NPS that is now available to all citizens of the country, whereas the IRDA regulates pension plans offered by insurers. The lack of clarity on the tax treatment of similar financial products could trigger more turf wars among regulators. And the next round could well be between the PFRDA and the IRDA on the remit over pension plans. So, the IRDA may not want to take any chances. The IRDA has backed its case for tax exemption, saying that it has tightened regulation and raised the risk cover on pension plans. The regulator has also made it mandatory for insurers to offer guaranteed return to policyholders even when the markets crash. The IRDA is hopeful that this will encourage long-term savings and help policyholders build a nest egg to cater to their needs as they grow old.
However, offering a guaranteed return, and that too on equity-linked pension plans, defies free-market principles. Equity is risky and risk-averse investors should not invest in unit linked plans. IRDA should not have been populist. Recall in 2002, the government was forced to bail out UTI to honour its obligations to unit holders, after massive erosion in the portfolio of US-64 and other assured-return schemes. Sure, insurers have to earmark enough capital to cover guaranteed payouts. But pressures to bail out policyholders cannot be ruled out if a company goes bust.
Life insurers in Japan had a disastrous experience with guaranteed products. Many of them turned unviable when interest rates on government bonds crashed. In the UK too, Equitable Life was almost ruined in 2000 after it failed to earmark enough capital to cover guaranteed payouts on some of its pension plans.
IRDA should look at alternate ways to achieve the goal of helping policyholders’ build a nest egg such a longer lock-in period or lower commissions that will enhance returns. The NPS, reckoned to be a well designed scheme sans any loads, does not offer a guaranteed return. There is a case for IRDA to reverse its decision on guaranteed returns.
However, the larger issue is the tax treatment of savings instruments. The original DTC had proposed transition to the exempt exempt tax (EET) method of taxing withdrawals from long term savings schemes. But this was abandoned in the revised discussion paper. The problem of putting in place social security scheme in the near future, administrative, logistical and technological challenges were cited as the reasons for abandoning the proposal. Some of these challenges were known, given that the transition to the EET method of tax treatment was proposed five years ago. Surely, India has the software prowess to address these technological challenges.
Countries such as Germany provide basic social security benefits to their citizens, but pensions are taxed at maturity. Pension costs have soared due to the ageing population and these countries are now encouraging their citizens to save more for retirement. India should do the same.
The existing tax treatment of financial savings is indeed distortionary, resulting in economic inefficiency and inequity. Today, the NPS is taxed at maturity. But it will become tax free if the government goes ahead with its proposal in the revised discussion paper on the DTC. A policy flip flop is unwarranted, especially if the goal is to end exemptions.
The proposal in the draft DTC to allow a higher income tax deduction on savings schemes that are taxed at maturity can encourage people to save more. The EET method allows individuals to postpone their tax liability till the amounts are withdrawn. Moderate tax rates can soften the blow on senior citizens. The government should do a rethink on EEE.
By :HEMA RAMAKRISHAN