VOLUNTARY PENSION FUNDS, THE BEST WAY FORWARD

By: Tanweer Ahmad Haral

“Old age is the most unexpected of all things that happens to man” Leon Trotsky

A lot of discussion takes place amongst the financial industry participants, bankers and
economic journalists regarding the role of financial services industry, capital markets,
front- line and apex regulators to contribute positively for economic growth. And what is
the best way forward for capital markets to become the real engines of growth for
Pakistan.

Domestic capital markets & Mutual fund industry are maturing slowly & gradually, while
Voluntary Pension Funds are still at an infancy stage in Pakistan. History and empirical
data shows that Pension Funds can become a real catalyst for propelling economic
growth for any country provided the funds channelized are invested in productive sectors.
Our Government shall consider Pension Funds in its model for long term economic
growth. Latin American countries like Chile, Argentina, Eastern European countries like
Poland and Malaysia, Singapore, the Asian tigers and South Africa have reformed their
Pension systems and the results are significant. In these countries Pension funds’ assets
contribute more than 50% of the respective country’s GDP, a startling figure indeed. In
Pakistan, Voluntary Pension scheme rules were approved in 2005 and four asset
management companies were licensed which launched Pension Funds in June 2007.
However the idea has not been carried forward due to lack of awareness among general
public and mainly due to low marketing budgets of the Pension fund management
companies. Another major impediment is the inflexible attitude of Trustees of Employee
Benefits schemes particularly the Defined Benefit schemes.

Ministry of Finance and SECP can play a constructive role in building up public’s
confidence by adopting VPS model for State employees by making contributions in such
Pension Funds. Road shows and seminars can play a major part in creating awareness
among professionals and educated persons.

GoP can also makes certain revolutionary changes in the regulations for Provident Fund,
Gratuity and Superannuation (Pension) funds which are further classified into Defined
Contribution (DC) and Defined Benefit (DB) schemes. Most of the private-sector
organizations have set up employee benefit schemes, majority of them having only one
scheme, financial sector/banks generally have two schemes, while very few have all three
or even four Employee Benefit schemes. Barring a few leading names, majority of the
textile sector companies have only non-funded Gratuity scheme for their employees.
These schemes are managed by a group of employees who act as trustees of the
scheme(s). Traditionally this group is nominated rather than elected and normally
includes CFO/Finance Manager, employees’ representative, a professional from
Accounts/Audit/Human Resources function. Interests and leaning of all trustees are
diverse from each other and consensus decisions are rare, with more reliance placed on
the Finance professional. Majority of the Employees’ Benefit schemes prefer safest
available option of National Savings schemes or Deposits with Commercial Banks.

The working & labour class have a funded DB Pension Scheme managed by Employees’
Old Age Benefit Institution (EOBI) in which most of the employers contribute a
minimum amount every month for minimum monthly pension of Rs.2,000 after
retirement. Average lifespan of labour class is quite low as compared to office workers
due to malnutrition, safety hazards, lack of basic hygiene and healthcare facilities
available to them. Such employees’ safety net in shape of a Rs.2,000 monthly pension is
paltry and cannot cover even the food expenses leave alone rent, electricity bills and
other expenses necessary for a reasonable living. Most of the SMEs, textile and other
sectors’ employers do not provide group life cover and/or group health insurances. They
are required to contribute towards Social Security, however we know that these firms
generally prefer greasing the palms of Social Security Inspectors rather than contribute to
the Social Security. Even if these firms contribute to Social Security, ordinary working
class finds it difficult to access social security hospitals as they are far and few. Besides,
illiterate persons may not be generally aware of their rights to access medical and health
care being provided by Social Security Department.

Life insurance companies also offer Individual Pension plans coupled with insurance
protection, however Government withdrew certain tax incentives offered to Insurance
Companies’ Pension plans while allowing easy withdrawal from such pension schemes
and conversion into Voluntary Pension schemes.

There is a definite need to learn from the successful experiences of third world countries
the prime example being that of Chile. The dictatorial regime ruling Chile in early 80’s
abolished the state run bankrupt pension scheme and appointed six private sector Pension
Fund Managers to whom every employee makes 10% contribution of their salaries
retaining total control on type of investment and future payments (whether withdrawal or
annuity) at the time of retirement. Self-employed individuals are also allowed to invest
in such schemes.

The architect of Chilean private pension scheme was Jose Pinera, a former Chilean labour
and social security secretary and an economist trained at Harvard and University of
Chicago. His idea has caught on in Latin America, Eastern Europe and also being
followed in Asia. The Voluntary Pension Scheme launched in Pakistan was primarily
based on the Chilean model, yet this model has more flexibility and options as compared
to the Chilean model. In Pakistani model, the employer and/or employee can contribute
in the pension scheme, while Chilean model only envisages employees’ contribution
absolving employers of their contribution towards the social net. Private employees and
self employed persons in times of recession or joblessness cannot make contribution
towards their pension accounts. Therefore the Pakistani model though flexible must
include employers’ contribution in private pensions besides flexibility for the employee
who may not contribute in troubled times.

Unlike Provident Fund scheme which is a Defined Contribution (DC) scheme, Gratuity
Fund and Pension Funds schemes are to a large extent Defined Benefit (DB) schemes.
DB scheme promises a certain cash flow the employees thus exposing the employer to
funding liabilities, which largely depend upon the actuarial valuation of the assets of such
scheme. The actuarial valuation may recommend lowered funding in case of actuarial
surplus or enhanced funding for a deficit situation. Actuarial surplus or deficit is again a
function of discounting rate and estimated annual increase in compensation. We have
seen in recent turmoil the bankruptcy of General Motors, pension fund liabilities being
one of the major contributing factors. In the end GM employees did not get what they
were entitled to. British Airways and Chrysler Motors cases are the other examples of
the perils of Defined Benefit schemes.

In Pakistan, our State employs the Pay-As-You-Go (PAYG) system in which younger
generation pays taxes for pensions of previous generation. Effectively this means that a
son may be paying taxes to the State for funding his father’s (a retired public servant)
monthly Pension. The other most favourite mechanism of the Sate is to fund civil and
Armed forces pensions by borrowing under the garb of National Savings Schemes. The
National Saving schemes have no positive contribution in the economic development of
the country rather these schemes are reminiscent of a giant circular debt and may cause
catastrophe for the State in future. Additional liabilities of NSS are paid by additional
borrowing from the public & employee benefit schemes. High interest rates on DSCs
were blessings for the DB schemes, however the abolition of employee benefit schemes
investments in NSS in 2000 in Shaukat Aziz’s ministerial period, proved to be
instrumental in facilitating the birth of mutual fund industry. Dr. Khalid Mirza, during
his tenure as SECP Chairman took gigantic steps for promotion of mutual funds as an
alternate investment avenue for public. All good work was reversed by Mr. Shaukat Aziz
in 2007 when being the PM, he allowed the corporate sector and Employee benefit
schemes to invest in NSS again. The question remains, what prompted him to do so
resulting in almost an infanticide for Voluntary Pension Schemes after almost 10 years of
hard work put in by lots of people for launching the revolutionary concept in Pakistan.
World Bank did its due role by providing its consultancy and moral push to the Govt. Of
Pakistan to enact Voluntary Pension Schemes, on the flip side the creator of VPS, Mr.
Shaukat Aziz killed his creation with his own hands.

When trying to convince employers during the last two years or so, that Voluntary
Pension schemes’ benefits outweigh that of Provident Fund and more so for the Defined
Benefit schemes, from the point of view of both employees as well as employers. And
they shall seriously consider conversion of Provident Fund & DB schemes into Voluntary
Pension schemes, the trustees of such funds strongly resisted such suggestions. The main
cited reasons are “we don’t like losing control over employees funds” or “this is
employees’ hard earned benefit, why shall we hand it over to 3rd party managers”. More
flimsy grounds were “Encashment from Provident Fund is tax free, while premature
withdrawal from VPS attracts income tax penalty, also the employees can take loans
(based on mark-Up) and/or tax free partial withdrawals from Provident Fund for Hajj,
marriage or construction of house”. They fail to understand that safety net thins out when
an employee withdraws from Provident Fund before his/her retirement age. Without
judiciously analyzing the cost & benefit analysis of Voluntary Pension schemes, they cite
union problems and general aversion to any change. It is quite perplexing to know that
certain private as well as Government owned organizations allow loans against Provident
Fund balance to purchase life insurance policies.

Savvy individual investors having investable surplus are using VPS as a tax saving tool
by investing a lump sum amount at the tail end of the tax year. The basic theme of saving
at least 10% of monthly salary has not caught on among young professionals, who are
more debt ridden due to excessive spending culture driven by credit cards and personal
loans. The habit of saving for rainy days as well as post retirement is fast diminishing
among the younger generation.

The income tax credit available for contributions made each year in VPS the recent
increase in withdrawal limit to 50% at the retirement age and embedded insurance wraps
and optional insurance covers are all great incentives for self employed professionals,
salaried persons and Human Resource & Finance departments to become convinced for
adoption of VPS for the retirement planning.

To illustrate the tax benefit for common benefit, if a 30 year old salaried person pays
income taxes @ 10%, and invests Rs.5,000 per month enhanced by 10% each year to
catch up the inflation rate, the expected cumulative tax savings for the next 30 years
would be Rs.0.83 Million (according to current tax law), future value of which can
become Rs.2.855 Million if he/she can make an annual return (CAGR) of 10% p.a. on the
annual tax savings.

The case for conversion of Provident/Gratuity/Pension Funds schemes into

Voluntary Pension Schemes:
In Voluntary Pension schemes, each individual has a distinct individual Pension Account
like IRAs in USA. Investment choices are among conventional or Shariah compliant
Pension accounts with 6 different investment plans including Most Conservative to
Aggressive plans and lifecycle based pension plans.

On the other hand employee benefit schemes follows investment strategy laid out by the
trustees of the fund and members of these funds having no say in it. Another issue is
some absurd investment restrictions placed on these funds. A Provident fund is allowed
to invest 100% in NIT, an equity fund, however the same fund is not allowed to invest
more than 20% in an equity fund scheme enacted under NBFC Regulations (amended),
2008. Similarly a Provident fund can invest 100% in Bank Deposits (minimum credit
rating of ‘A’ & NSS, both debt based, however the same fund cannot invest more the
50% in open end mutual funds even if they are fixed income funds having a stability
rating of at least ‘A’. This kind of regulatory paranoia is suffocating for private sector
mutual funds.

Unlike India, where Provident Fund is portable i.e. if an employee switches job, the
accumulated Provident Fund is transferred to the next employer rather than doling out tax
free amount to the employee as is done in Pakistan. After 15 years of private sector jobs,
I have almost no savings for my Pension as Provident Fund is consumed on buying home
improvements or spent on luxury items/vacations, rather than reinvested for funding port
retirement Pension. In Singapore, there is a central Provident Fund in which every
employees as well as employers contribute an aggregate sum of 35% of the wages. That
is how their savings rate is one of the highest in the world. Both provident Fund scheme
and VPS are Defined Contribution schemes yet their features are poles apart.

Major differences between Provident Fund schemes and VPS

Sr. Provident Fund Scheme Voluntary Pension Scheme
No.
1 All investment decisions are made by Investment decision rests with individual
the trustees investor to invest in any one of six plans
and choice of Pension Fund Manager
2 Person leaving job/retiree does not get Assets are marked to market daily and
benefits accrued after annual closing unit prices announced for sub-funds
of accounts ensuring full benefits to investors
3 Employer can withhold own portion in Employer cannot touch individual’s
case employee’s services are pension Account, even a court order
terminated due to misappropriation. cannot seize an Individual’s Pension
account.
4 Accounting of PF rests with employer Accounting is totally outsourced to
Pension Fund Manager
5 Employee’s contribution is taxable, Employee’s/self employed person’s
while encashment proceeds are tax contributions entails tax rebate upto
free Rs.100,000/annum (Rs.125k for self
employed) while premature encashment
attracts tax penalty on withdrawal
amount
6 If Fund’s distributed return/interest No income tax liability on accumulated
exceeds 16% p.a. excess income is return/profit
taxable for the employee at respective
tax slab
7 Shariah compliant investments are Shariah compliant schemes available
difficult to manage as trustees do not under the guidance of Shariah council
have the expertise and knowledge including leading scholars

Conversion of Provident/Gratuity & Pension Funds into VPS has many benefits including
individuals making their own investment decisions which will enhance financial skills
and inculcate more close monitoring of their pension accounts, outsourcing of accounting
and book keeping making trustees focus on their core functions, side benefits like in-built
insurance plans, no major divestment takes place due to switching jobs/premature
encashment which ensures that assets are continuously deployed in the capital markets to
propel the engine for growth, removal of defined benefit risks in DB schemes,
possibilities of reduction in funding costs and last but not the least economic growth as
funds will be diverted towards efficient & productive sectors rather than plainly relying
on National Savings schemes.

Actuaries and Trustees of Provident/Gratuity & Pension Schemes generally show

resistance to adoption of VPS as a new scheme or conversion any employee benefit
schemes into VPS due to their own ulterior motives. However, the need of the hour is for
the State to act decisively for the future of our generations. We sincerely hope that the
incumbent Finance Minister, banker turned entrepreneur specializing in turning around
commercial banks, who presently is focusing on stabilizing economy, will also not ignore
the time tested model of Pension Funds as an engine for economic growth. State can set
the ball rolling by starting to fund contributions for new State employees in Voluntary
Pension Schemes. Any corporate organization offering one or more than one Defined
Benefit Schemes may be directed to convert at least one DB scheme to VPS. Employee
Benefit Schemes’ fuelling inflation by putting in money into National Savings schemes
shall again be barred from doing so. EOBI shall be privatized to reputable investment
manager and converted into a VPS, so that its assets/sub-funds can be marked to market
daily ensuring transparency, channelizing funds towards productive and efficient sectors.
Employers having only a non-funded Gratuity scheme shall be directed to gradually
convert such scheme into a VPS which will include employers’ contribution and optional
employees’ contributions. All Provident Fund schemes shall be converted to VPS and
VPS balances may be eligible for margin based borrowing from commercial banks for an
interim period till the individual investors become accustomed to Voluntary Pension
Schemes.

“The whole is much more than the sum of the parts” Aristotle.

The writer is SVP, Head of Product Management, Strategy & Business Development
Dept. at Arif Habib Investments Ltd. The views expressed are personal and may not be
construed as that of the employer.