Pension Reform: ‘Relatively Low Hanging Fruit’

Zafar Masud

THERE has been an enlight ening seminar organized by SDPI recently on pension reforms.

It was not only educating but an eye-opener to an issue which has multifaceted impact on the performance of the Government and it’s delivery, as it’s directly related to the performance and compensation of civil servants.

I was invited as one of the penalists due to my active engagement in the past on tapping long term project finance funding through capital market instruments, and exposure to this concept of being on the board of various public sector entities.

I have always been aware about the seriousness of the issue of growing pension liability for the Government and the public sector entities, but it was only during the research on this topic, it was dawned upon me how grave are the circumstances.

I must, at the outset, thank my colleagues, Saacyem Ali and Irteza Qureshi, who had done the research for me on this very critical topic which helped me realize how this existing/ emerging fiscal burden could be addressed.

This also motived me to put a brief paper together on the subject and was invited to write for newspaper for the mass awareness on this very critical matter, which touches almost entire populous one way or the other.

Let’s begin with context and extent of challenge of the rising pension bill. Federal pension bill has increased to Rs 480bn in 2021, from Rs 150bn in 2011. According to reports from donors, federal government’s unfunded liability currently stands at around Rs 3trn.

Post 7th National Finance Commission award, provincial governments’ pension bill have also increased exponentially to Rs 500 bn in 2020, from Rs 75 bn in 2011. This is clearly an unsustainable path.

Studies suggest that with no changes to the existing pension arrangements, federal pension bill will rise to an alarming level of Rs 750bn by 2023. Provinces are likely to face similar challenges.

This is very frightening situation indeed which becomes more complicated due to the presence of fiscal pressures from compromised tax collections, SOE losses, accumulating circular debt, etc.

However, silver-lining is that out of all fiscal challenges of the Government, this appears to be an easier one to plug, given that this problem was faced by almost every country, particularly in developed world where the average life expectancy is must higher. There’re real examples of how various countries had dealt with this issue successfully.

Before we go any further, would like to elaborate on fundamental concepts about pension scheme options which will help readers, especially who’re not much familiar with this theme, to understand it and relate to ensuing discussion better. Employee benefits classify post-employment plans into two categories:

1). Defined Contribution (DC), whereby employer’s liability is limited to the amount that it agrees to contribute to the post-retirement fund, consequently, actuarial risk and investment risk falls on the employee.

In other words, the risk of investment performance of fund, and resultant pension returns, rests with the employee or its representatives.

The return could be better or worse depending on market factors and competence of fund manager(s); whilst, on the other hand,

2). Defined Benefit (DB), is the scheme where the amount of pension benefit is defined; therefore, all actuarial as well as investment risks are borne by the employer.

Irrespective of what the market circumstances are, and if pension liability is funded or not, the employee will get a defined (pre-set) return post retirement; there will be no upside or downside for the employee(s), unlike DC.

Experience from last 30 years show significant changes in pension schemes in most developed and emerging markets.

As per international best practices, Pakistan Government’s DB and unfunded pension arrangements are out of line.

Non-contributory, or DB, schemes are reducing: many countries have switched to DC plans due to financial stress.

PAYG financing is also reducing: most countries have moved to full or partial funding of future pension liability.

Advantage is that financing burden can be spread across different periods in a more stable and predictable manner.

New accounting standards have helped Governments to better understand the underlying accrued liabilities and the long-term costs of their pension arrangements. DC pension program, therefore, are replacing DB plans.

DC system, by very nature, automatically ensures that the accrual of benefits are fully funded. Thus, employers are guaranteed that no unfunded liabilities would emerge.

However, this could have an adverse impact on employees since, the value of their accumulated pension assets are not defined, and because they depends on the investment performance of underlying pension funds. Most importantly, DC schemes allow employees to play a role in the investment decisions.

This allows individual risk/ reward preferences as well as other religious (such as, investment in Islamic securities, etc.) or ethical views, etc., to be incorporated into the management of pension assets.

The employee will essentially become master of his own destiny with respect to investment decisions about his retirement benefits, and may fetch more satisfying returns (both financially and otherwise) than he or she could have under the guaranteed DB system.

With enhanced life expectancy and widening fiscal deficits in emerging markets, this problem is becoming more glaring.

There’re successful examples from the countries where the make-up of the society and the community are very similar to our’s and they have been able to put a check on this mushrooming concerns around this dilemma.

Some of these country experiences worth evaluating for adoption in Pakistan which are: India, Philippines, and Thailand.

Starting from the most relevant one – India: All new entrants in the government with effect from 2004 were hired on the National Pension System, a DC pension arrangement into which 10% of pay is contributed by both the employee and the employer.

Those hired prior to 2004 continues to receive pension benefits based on the earlier DB pension program.

In 1997, Philippines set—up an institution called Government Service Insurance System (GSIS) which provides DB retirement benefits

Employees pay 9% of their salary to GSIS and the employer adding another 12%. Retirement benefits are determined based on age and years of contribution and are a combination of lump-sum amount and lifetime annuity.

In Thailand for new hires starting 1997, parametric changes were made in the DB pension method, supplementing it with a DC pension arrangement to which employee and employer contribute 3% each.

Therefore, Pakistan has ample instances to draw on, in order to box-in this looming crisis of sorts at the Government level.

There’re, however, some islands of excellence in this space within our own country, albeit on a micro-level, and that also in public sector only, which shall be looked at, celebrated and encouraged in other public sector entities.

Oil & Gas Development Company Limited (OGDCL) management and board, in June 2016, took cognizance of the menacing situation of ballooning pension liability for the company, which was posing an unprecedented threat to cash flows and sustainability of pension scheme itself, decided to rationalize the pay package and introduced far-reaching changes in the structure of both pay and pension, as they both are bosom-buddies and can’t be separated.

Accordingly, maximum salary caps were introduced for each pay-scale, which by default put a check on the extent of extreme liability for each grade of employee, plus started creating much-needed difference between performers and non-performers within the organization.

Concurrently, effective 1st January 2016, DB pension formula was discontinued for new inductees.

While existing employees continued to enjoy protection of their terms & condition of service, including DB pension entitlement, new inductees have been governed under a gratuity scheme which does not put the company under any long term obligation.

As a result of foregoing steps, at that time, actuaries worked out a cumulative benefit of Rs. 186bn to OGDCL in the form of savings in salaries and pension contribution over the next 10 years.

Based on the above, this could be concluded that on fiscal management front, Pension Reforms are “low hanging fruit in relative terms” and could be fixed while keeping below considerations in perspective:
“Political Will” is required to implement pay & pension reforms. Tried & tested solutions could be borrowed from across the globe.

All new hiring in Government shall be under DC system with restructured pay-scales having ranges backed by pension fund management structure.

Other than maximum salary & pension entitlement capping, halt on retrospective increase in future retirees, and (subject to legal provisions) cull the number of pension beneficiaries; extending retirement age or provide less benefits in early retirements are two option which could be implemented in the existing DB plans as a package.

There is no argument that pension funds are needed to be developed in Pakistan, and pension liability of the Government is required to be funded. There has to be a plan which should be managed through pension fund regime only.

Existing DB pension liability shall be funded through a combination of in-kind assets of the Government (for example, existing properties/ offices given to pension funds and rented back by the Government, lands could be handed to funds for development, etc.) and in-cash, albeit in tranches, as funding in one-go is not possible, as Government is in borrowing mode and that would put unnecessary debt burden on the Country.

This plan ticks lots of boxes with the biggest box being conversion of dead assets into an earning ones.

Pension Funds have multifaceted benefits for the Country:
Capital Market Development: OECD countries pension assets stood at over US$ 33 trillion (38% of Global GDP) in 2020.

US has the largest pension assets (88% of GDP), followed by UK (123% of GDP), Australia (132% of GDP) and Switzerland (143% of GDP).

Yield curve emergence: Pension funds are the biggest investors in the global equity and bond markets, contributing 70% of the market capitalization in some of the OECD markets. Unfunded government pension arrangements are a key factor for the low depth in our bond and equity markets.

Real Estate/Mortgage funding: Real estate developments will help grow the market for pension funds and vise versa.

Most important will be the growth in long term debt markets through pick-up in housing market mortgages as they require purchase value of the home to be spread out over around twenty years or more, at a fixed rate.

Buyers of such long-term Fixed Rate bonds are typically pension and life insurance fund managers. This whole idea fits perfectly with the Government’s vision of promoting housing and construction activities, particularly low cost housing.

Enhanced saving options: In Pakistan, the overall saving rates are one of the lowest in the world. In 2020, the national savings fell below 10% of GDP. Even the Bond markets in Pakistan are small at less than 5% of GDP.

Corporate bond markets are virtually non-existent, which would be given a necessary boost by the active pension funds; thus, offering safe & secure saving products to general public.

Alternate to Government’s Public Sector Development Program (PSDP): Pension funds, by very nature of return requirements, typically have long term liquidity and appetite for high risk assets which generally are out of the scope of banks.

A robust pension fund regime would mitigate the fiscal pressure on the Government for funding important infrastructure projects with long gestation periods.

Investment in commerce & industry: If we look around the globe, pension funds own large businesses and industries; thus, offering a very solid partnership opportunity for local and international investors to promote trade and commerce and create jobs.

Development of Universal Health Insurance: The universal insurance schemes being launched by the provinces are going to boost the Assets Under Management (AUMs) of the insurance companies, a key component of the pension arrangements in most countries.

Therefore, pension funds will go hand in hand in promoting the universal health insurance initiative of the Government.

To reiterate, DC pension arrangements are fully funded while return depends on underlying pension fund performance; therefore, it must allow employees to be party to investment decisions of their own funds.

This is a way of empowering employees and making them incharge from their own fate about their future decisions.
—The writer is President & CEO Bank of Punjab.