This article appeared originally in Gulf News: link to original article
When I decided to work on my retirement plan, and while filling the application, the employee asked me to choose the funds’ risk that I would like my money to be invested in. With my finance courses playing games in my subconscious mind, I chose a high-risk one.
Here is why. Risk is supposedly associated with age. At a relatively younger age, you choose to go for higher risk because high risk means high return. It also means that if for some bizarre reason, or market irrationality, you lost your investment; you are young enough to start saving and investing again, with lessons being learnt.
And at an older age, you choose to go for lower risk because a high return is not a priority now. Moreover, if the investment was lost for whatever reason; you can still save and invest, but there isn’t enough time to grow the portfolio.
So what is the issue, or issues, with the current pension system? Well, the whole scheme is ambiguous in terms of the risk being taken, what are the realised returns, and how much is the accumulated amount in individuals’ pension accounts based on quarterly, bi-annual, or annual reports — or online.
Let’s consider an example here. A fresh graduate who has just been recruited contributes the same as the person who has been employed for the past 20 years. The only difference is in the basic salary, if any, as it is the main component of the contribution to the pension calculation — that is 20 per cent, with 15 per cent by the employer and 5 per cent by the employee.
This is troublesome though for the following reasons.
One, a fresh graduate can, hypothetically, choose to contribute more than the total 20 per cent by increasing the individual contribution. The idea is to have a set target for pension salary, and that the whole contribution scheme works towards achieving that.
As the person grows older and the basic salary, presumably, increases in size, one can lower the contribution rate to even below the overall 20 per cent if they could see from their pension account that they are on the right track to achieving the targeted pension salary.
Two, a fresh graduate can “tick” a high-risk investment when signing up for pension, allowing the individual to aim for higher returns early in their careers. As the same individuals progress in their careers, they should be allowed — after x number of years of investing in the initial fund(s) — to switch to moderate-risk fund(s).
Then, and close to retirement, the same option should be provided if anyone would like to switch to low-risk fund(s). The options in both are of course non-obligatory, and an individual can choose to continue with high-risk, high-return funds to retire faster.
An individual can also maintain a moderate-risk fund if they are aiming for the ordinary retirement age. Also, an individual can go for low-risk funds if they think they would work post the retirement age, or if they thought the retirement age will be increased at some point in the future.
Third, contribution percentages should not be fixed. Even if they were lowered or raised, whether for individuals or overall, that doesn’t really matter because the contribution percentage should be at least go up or down in correlation with the basic salary plus the allowance taken into account for pension contribution calculations.
Not only that, but flexible contributions, that are of course limited by x number of years per career stage, could help better guide the choice of fund. For instance, you would want to contribute less to a high-risk fund, but perhaps contribute more to a moderate or low risk fund.
Altogether, this should lead to more transparent pension system, earlier retirement, and lower unemployment rates. The last question that I want to leave you with: if banks can provide low-risk, moderate-risk, and high-risk investment plans, why can’t a pension fund?