Pension regime needs a rethink in UAE

This article appeared originally in Gulf News: link to original article

A while ago, I worked on a sample of few hundred people in an effort to project how pension funds work and what determines the health of their cash flows. Promotions where factored in as per a set policy, i.e., with fixed number of years, and assuming a smooth transition from one grade to another.

However the contributions of new recruits were not factored in to see if the model will sustain itself in two different environments: 1. Current retirement salaries, 2. Increased retirement salaries. But before getting into the analysis details and results, which will be stated at the end of the report, let’s first look into how pension funds are managed in general and in different countries before getting into the more specific example of the UAE, which is currently reviewing its pension law. After that, I will state the results of the sample analysis.

From a very broad point of view, pension salaries are known to be low. Yet, many government pension funds are underfunded. It’s actually rare to find ones that are doing very well, and that’s what the report is about.

Back to the sample, and in the UAE, contribution is 20 per cent of the basic salary, which is the major proportion of the later retirement salary; social allowance; child allowance (I don’t know why); cost of living allowance; and housing allowance. The percentage is divided into two proportions where the employer pays 15 per cent and the employee pays 5 per cent which are deducted directly from salaries.

When thinking about this, and considering the very low contribution — because of the generally low basic salary in proportion to other allowances — one would wonder how pension funds can survive.

Here is the thing. These low contributions work when the greater percentage of the working force, who are contributing to the same fund, are young and the retirement age is not, relatively, low. So what happens when demographics shift like in Japan?

Retirement age is increased … not in Japan, but generally. OK, what else? In most cases, nothing else is done and is subject to how well the pension fund is doing in terms of investments and the returns on them. And when the pension goes under, it’s the government that needs to bridge the gap in cashflows — a problem Spain faced towards the end of 2013.

The question — is this sustainable? Considering here that many countries with current pension-favourable demographics will eventually be in Japan’s situation. There will also be a time when countries facing that shift are much greater than those where there are more contributors than retirees. What then?

To answer these questions, and many more related to pension funds, I had a look at the largest pension funds based on 2013 data. Guess which is the largest? Japan’s.

I find this fascinating — the fact that you knew what issue you are going to face in the future and taking steps now to mitigate future pension risks. Japan’s Government Pension of Investment, as the fund is called, had a return of 9.4 per cent in 2013 with its assets’ value exceeding $1.2 trillion (Dh4.41 trillion). This is a very good return for a fund this large.

In the book, Intelligent Investor, big funds are expected to achieve less return than small and medium funds. The return is also much higher than the world’s average inflation for 2013, which is calculated to be 2.3 per cent. The reason I am quoting inflation here is that pension funds normally play it safe and are happy with bank deposit rates.

It cannot be all roses though. According to Melbourne Mercer Global Pension Index, Japan’s pension system falls into grade D, which means that the pension ‘has major weaknesses and/or omissions that need to be addressed’.

In previous columns, I talked about the classic pension system which is basically matching what goes in with what goes out while making a bit of money, maybe, with bank deposits — this anyway isn’t sufficient once demographics shift towards older populations. I mentioned too how there is a system called Notional Defined Contribution (NDC), and I also referred to two countries at the time, Sweden and Latvia.

So what is this model about? How good is it in terms of sustainability … if it actually is sustainable? Well, and according to Allianz Pension Sustainability Index 2014, Sweden ranked second worldwide while Latvia ranked ninth. Sweden adopted NDC in 1998 with more details being explained in a paper published in 2000 by the Centre for Retirement Research.

Sweden’s new pension required a contribution rate of 18.5 per cent: 16 per cent towards a notional account and 2.5 per cent towards the contributor’s account. Then, the contributor’s account swells up when the individual retires with a minimum retirement age being set in place. At retirement, the account switches to an annuity which is calculated based on life expectancy.

Then, the contributor starts receiving monthly payments up to the life expectancy age that has been computed into the model. What happens after that? Every person cares for themselves.

Latvia does it differently. One main point here though is that the contribution rate in Latvia is 34.09 per cent compared to 18.5 per cent in Sweden and 20 per cent in the UAE. Latvia’s pension covers three pillars: 1. NDC that is the main model in Sweden’s pension, 2. State mandated pension scheme, and, 3. a voluntary private pension scheme.

Latvia introduced the NDC close to when Sweden did, and then introduced the voluntary private pension scheme. The state mandatory pension scheme was only introduced in 2001. What is clear from both examples is the significance of NDC and its use by different countries compared to the previous classic model.

And since it computes life expectancy, it encourages employees to find other ways to make sure that they maintain the same income after the NDC stops paying them. In Latvia’s case, other options were made easily available for people to plan their retirement better via the second and third pillar.

Australia too, ranked first in the Allianz Pension Sustainability Index, has three pillars in its pension system. Other countries ranked high in the index also have multiple pillars irrespective of the model used.

To sum it all up, the classic model is out of fashion and does not serve today’s world where demographics are shifting towards older populations and higher lift expectancies. The NDC is a better option for two main reasons: 1. Dividing contribution into a notional account and an individual one, 2. Computing lift expectancy into its calculation.

NDC could work on its own if the country’s culture encourages people to save more towards retirement. Otherwise, and to ensure sustainability without increasing government payout, the private pension system is nonetheless compulsory in making ends meet.

While writing this report, I received a phone call from my bank to inform me of a new investment fund they are starting. The idea in brief is to allocate a fixed amount of your monthly income, even if only Dh1,000 per month, which the bank invests on your behalf via the newly created investment fund. All allocations will be invested and the proceeds reinvested at an annual rate of 5-9 per cent (Islamic banks do not give fixed return rates).

The capital and the profit must remain locked in the fund for no less than seven years. At the end of the period, you are provided with two options: take out your investment and profits, or allow the bank to keep investing on your behalf with no additional payments to be made by you.

You can keep this rolling for as long as you desire and withdraw the money whenever you feel like it. That’s not it. The bank provides the investor with a Takaful insurance where you or your family get a total amount of Dh1 million in case anything happens to you. Do you think this could be a good retirement plan?

For the sample mentioned earlier, the pension in scenario 1 could be maintained even without new recruits. When retirement salaries are increased — scenario 2 — the model could not be maintained for more than 20 years after which it starts losing money despite contributions being 4-11 times higher than those in scenario 1.

The thought I want to leave you with: why not, for now at least, adopt the NDC as the UAE’s main pension model?