If you belong to the four crore (40 million) employees who have their savings in the Employees Provident Fund, you must have been pained to hear that the government is about to reduce the rate of interest on the EPF to 8.5% from the 9.5% it used to pay earlier.

Is it justified?

The finance ministry, which has been campaigning for bringing the rate down to 8.25%, points out that no other fixed deposit or small savings scheme offers a return of 9.5%.

In fact, the actual rate of return on the EPF is much higher, because the savings under the scheme are eligible for tax deduction under Section 80C and there is no tax on the interest earned. So the effective rate of return on the EPF is much more.

Also, the 10-year central government bond has a yield to maturity (return you get if you hold the bond till maturity and do not sell it before the tenure ends) of around 7.1% and the 17-year bond earns a return of 7.5%.

Hence, taking into account that the EPF is illiquid (you cannot take out the money whenever you want), 8.5% seems to be a reasonable rate.

You must understand that the money in EPF can only be invested in notified securities like government bonds, with a small proportion in corporate bonds. Given the low interest rates, obviously it can't pay much.

Further, the corpus is managed by government employees and not professional fund managers.

Interestingly, the world's largest pension fund, CALPERS, the pension fund for employees in California, is investing in the Indian stock market. And, pension funds in the US and Europe regularly invest in stocks.

If the EPF too is allowed to invest a proportion of its funds, say 20%, in then stock market, the return it could generate could easily surpass 8.5%.

To do this, checks and balances must be in place to ensure that the money is invested responsibly, and professional fund managers are employed.

• Understanding provident funds

The government cannot afford it

True, 9.5% is too high a rate to pay in this era of low interest rates. But the truth is that the government just cannot afford to pay it. Even by paying 8.5%, there will be a big hole in the EPF.

If the interest rate had been maintained at 9.5%, the hole in the account would have been over Rs 1,000 crore (Rs 10 billion).

This gap would have to be filled by a government subsidy. In other words, the non-EPF holding taxpayers would be subsidising those who have EPF accounts.

The ones with the EPF accounts are the workers and managers in the organised sector. They account for a mere 10% of employment in this country. They are also the ones who are relatively better off compared to workers in the unorganised sector and the daily wage labourers.

So a higher-than-sustainable rate of interest on the EPF account means is that those who are relatively worse off will have to subsidise those employed in the organised sector.

That's not all---even within the EPF scheme, studies have pointed out that most of the low-wage employees withdraw their provident fund prematurely to meet permitted expenses like building a house or a daughter's marriage.

So the people who benefit from the high interest rates offered by the scheme are actually the relatively affluent within the organised sector. This is the argument trotted out whenever anybody talks about keeping the current high EPF rates.

• The best tax saving funds

Is there any option?

On the other hand, why should you be satisfied with an 8.5% rate when equity mutual funds easily give you three or four times that amount?

Sure, tax saving mutual funds too fall under Section 80C but you have no guarantee of return. These Equity Linked Saving Schemes are mutual funds that invest in shares of various companies and sectors. But, if the fund performs badly, you could lose your money.

The Public Provident Fund gives a lower return of 8% and has an annual investment limit of Rs 70,000.

The ideal solution would be along the lines of those who are arguing for pension fund reform. In this case, the provident fund and pension fund schemes would be thrown open to the private sector and the investor would be given a choice between the schemes.

The risk-averse than could choose a fund that invests solely in debt (fixed return investments). Others could choose a mix between debt and equity (shares), while the more adventurous could choose equity oriented schemes.

There is no reason for the government to assume that the needs of all employees on retirement are the same.