Why should you consider EPF in your retirement plan?

One of the major attractions of a government job has been its monthly pensions after retirement. Those working in most government organisations before April 1, 2004, are entitled to pensions to the extent of half the last drawn salary at the time of retirement. Moreover, the monthly pension keeps pace with inflation through regular revisions by the Pay Commission.

In turn, those working in the private sector need to build their retirement corpus to derive pensions from it. And in this effort, the Employee Provident Fund (EPF) role is often overlooked.

What is EPF?

EPF is a retirement benefits scheme under the Employee Provident Fund Act, whereby an employee makes regular monthly contributions from his salary towards the EPF account.

In contrast, an equal contribution comes from his employer. This contribution structure applies to most companies that have 20 or more employees.

The Employee Provident Fund Organization (EPFO) manages EPF accounts, and its interest rates are reviewed annually by the EPFO. For the financial year 2022-23, interest rates were fixed at 8.15% per annum. 

Example of a young individual

Assume, a 25-year-old earning Rs 25,000 (basic salary) a month works in a private company. His monthly contribution towards EPF would be 12% of his basic pay, or Rs 3,000. 

Employer matches the employee’s contribution of 12% in two parts. For one, 8.33% of the basic salary (subject to a limit of Rs 1,250) goes towards Employment Pension Scheme (EPS), administered by EPFO. In this case, since the amount exceeds the prescribed upper limit, Rs 1,250 is deposited into EPS, while the remaining Rs 1,750 (Rs 3000-1250) is deposited in the EPF account of the employee in the first year. 

If one assumes an annual salary hike of 8%, by the age of 60, he could accumulate Rs 3.55 crore in his EPF account. 

Could it give him the kind of pension that a government employee gets?

Here, the individual would retire with a last-drawn salary of Rs 3.42 lakh (in the 35^th year). Assuming a 4% withdrawal rate in the first year, a monthly retirement income of Rs 1.18 lakh is possible in the first year. It tantamounts to 35% of his last drawn salary. This is lesser than half the salary a government employee would get. 

While EPF, in this case, forms a significant part of retirement kitty, it’s certainly not enough if one wants to lead a comfortable retirement lifestyle. 

A thumb rule

Financial planners make retirement computations a bit differently. They work out the target household expenses by multiplying current costs with the inflation factor. So, for instance, if you are leading a comfortable lifestyle with an expense of Rs 50,000 a month.

At an annual inflation rate of 6%, you would need Rs 3,84,000 a month by 2058 to lead a similar lifestyle. 

The thumb rule is to have at least 25 times the annual expense at the time of retirement as your retirement kitty. The individual would require a retirement nest of Rs 11.5 crore as mentioned above. With an EPF balance of Rs 3.55 crore, he achieves only about 31% of his retirement corpus through investment in EPF. 

The rest needs to be built through savings over a period. If his salary grows at a lower rate of 5% every year, his EPF corpus is only 19%, as against 44% if it grows at 10% annually.

So, whichever way you look at it, while EPF can partially help you reach the goal, it cannot rely solely on your retirement.

Caveats

EPF calculations are based on several assumptions. It assumes that one doesn’t dip into the EPF corpus. And that the individual works continuously till his retirement at the age of 60 years. 

Also, interest rates on EPF have been moving down over the years. It was 8.8% in 2015-16 and has moved to 8.1% for 2022-23. As the economy develops, there is a high chance that the interest rates will fall, as has happened in the past for developed economies. This could potentially reduce your retirement corpus at the time of retirement. 

Need for Growth-orientation

Moreover, one must have an asset–allocation strategy to achieve one’s retirement goal. EPF is an overwhelmingly debt-based product, and you need to consider equity-heavy products.

In the above example, a SIP of up to Rs 19,000 (with a 5% annual step-up) is necessary to bridge the deficit in the retirement corpus. The SIP amount would be more if not for allocating the partial portfolio into equities. 

Equity-based investments like equity mutual funds have the best potential to provide ‘real’ returns to their investors. ‘Real’ returns imply returns that are above inflation rates. Inflation has been galloping at high rates in the past. Equity funds, while riskier than most debt products, also have the potential to earn 10%-12% annual returns over the long term. The earlier you start this journey, the better it is. 

Takeaway

EPF could significantly contribute to your retirement nest if you desist from premature withdrawals for buying a home or children’s education. To meet the deficit, adopt equities.