PF or EPF (Employees’ Provident Fund) is a creature of the 1950s and has barely changed since then. The EPF Act was passed in 1952 and is designed for a world of jobs-for-life and factory work that no longer exists. Many people think that they can use the PF as a retirement savings vehicle or an investment option. In this article, I will argue why they are wrong.
How does the EPF work?
So how does the EPF work? In general, if you are an employee in a firm with more than 20 workers, your employer has to register under the EPF Act. He has to deduct 12% of your basic salary + dearness allowance and pay it into the EPF. He also has to pay another 12% of your basic salary + dearness allowance into the EPF system, from his own pocket. I say ‘own pocket’ but this amount will be included by your employer in your CTC or Cost-to-Company. The 12% deduction from your monthly pay, completely goes into the Employees’ Provident Fund (EPF). However the 12% paid by the employer is split into two parts – 8.33% goes to Employees’ Pension Scheme (EPS) and 3.67% goes to the Employees’ Provident Fund (EPF). Out of these two segments, EPF and EPS, only EPF earns interest.
There are some major positives in the the EPF system. The EPF has historically had interest rates slightly above the prevailing bank FD and PPF rates. The rate for 2017-18 was 8.55%, above the PPF rates of 7.6%-8% for that year (note that the PPF rate is changed every quarter, while EPF rate applies for the whole year). The EPF interest is tax free, with some ifs and buts. Finally, the maturity amount of the EPF is also tax free, thereby giving it the much coveted status of an Exempt-Exempt-Exempt (EEE) instrument. The EPF also comes with a pension – EPS or Employees’ Pension Scheme which you can get after turning 58. The actual pension amount is determined by a complex but fairly generous formula which takes into account your years of service and pensionable salary.
However the devil lies in the details. The EPF interest is only tax free as long as you are an active subscriber in the EPF. In other words, you are employed in an establishment with 20 workers or more which is registered in the EPF. If you become unemployed, take a break to study or have kids, start your own small business or simply move to a smaller firm, you cease to become an active subscriber. From that time onwards, your EPF interest becomes taxable. If this situation continues for more than 3 years, the EPF account also stops earning interest. The money remains in the account in your name, but it steadily loses value to inflation with each passing year. The only exception to this scenario is if you move jobs from one EPF registered firm to another. In this case, you can simply transfer your account to the new firm instead of withdrawing your EPF balance.
How about the EPS? The EPS or Employers’ Pension Scheme is only paid out if you have worked in an EPF registered firm for at least 10 years. If you have worked for shorter time periods, withdrawing the EPS amount is your only option. If have worked for less than 6 months in an EPF registered company, you can’t even do this – the EPS amount is forfeited.
Another major drawback is that you have no say on how the EPF money is invested. This is decided by the EPFO (Employees’ Provident Fund Organisation) at a central level. The EPFO makes no distinction between a young employee with a strong risk appetite and a senior one who is fast approaching retirement. The money of both these individuals would be invested the same way. This is quite different from the NPS where you can select asset allocation and the fund manager. The EPFO now invests 15% of fresh inflows into the EPF system in equities which will push up returns. The investment is made through exchange traded funds (ETFs) rather than active stock-picking or actively managed mutual funds. The relatively small equity allocation (15%), no regard to a subscriber’s risk appetite and choice of ETFs over active management are major drawbacks in the EPFO’s investment structure.
Last but not least, the EPF system is replete with red-tape, forms and a clunky tech platform. The EPFO has been trying to move the system online but it has to deal with a legacy of forms and rules that make the system extremely user-unfriendly. The introduction of UAN (Universal Account Number) and Aadhar linkage brought some improvements here, but there is now a question mark over them after the Supreme Court judgment on Aadhar.
So what should you do about EPF?
Thankfully, you can withdraw 100% of your EPF balance after two months of unemployment. In this case unemployment will include things like taking a break to study, moving to a non-EPF registered firm or launching a start-up. You can invest this withdrawn money productively in PPF or NPS depending on your risk appetite. You can find out the procedure of withdrawal from EPF, here.