Grappling with an ageing UAE pension regime

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

“In March 1812, a number of eminent Scotsmen gathered in the Royal Exchange Coffee Rooms in Edinburgh, to consider setting up “a general fund for securing provisions to widows, sisters and other females”. After a few years of careful consideration and planning, on January 2, 1815, the Scottish Widows’ Fund and Life Assurance Society’ opens for business.”

The above passage is quoted from the Scottish Widows website, possibly the first pension fund that had taken probability into its calculations as far back as 1744, and one that is still standing today. The calculation was based on data available at the time, including life expectancy, probability of the time of death, and number of dependents and future beneficiaries.

Not only that, the calculation even took into account an increase in contribution that will be matched by an increase in payout in the future. That sounds simple enough and forms the basis of all kinds of pension systems today.

Pension systems in their entirety could be broadly classified into one of two: 1. a defined-benefit one, or 2. a defined contribution one. The former means that the pension payout that you will receive in the future is a fixed one, while the latter has to do with a very specific contribution rate, with ambiguity associated with the final pension payout.

There are of course other systems that do not fit entirely into one of the above categories, however, they would most probably share a couple of similarities with one or both of them.

I mentioned the earlier two broad pension system categories due to their relevance to the UAE’s national pension system, which I intend to focus on in this article. And as part of the discussion, I will be taking into account the main characteristics of the UAE’s pension system, issues associated with it, and possible mid- to long-term solutions to those issues.

The UAE’s pension system is “pay-as-you-go”, like many others worldwide. The system as such counts on current contributions to pay for current pensions, and future contributions to pay for future pensions. This works fine whenever demographics serve the country best by the percentage of youth exceeding that of individuals moving closer to retirement, and subject to youth being employed of course.

However, when those conditions are not existent due to early retirement for instance, a “pay-as-you-go” pension system will subsequently fail.

The UAE’s pension system is mainly defined by three characteristics. One, it combines defined-benefit with defined-contribution, where the employer contributes 15 per cent and the employee 5 per cent of the basic salary plus other allowances. Two, the UAE’s national pension fund pays out a full pension salary after 25 years of service given that you have also met the predetermined minimum early retirement age of 49. Three, the pension salary ceiling for public sector employees is quite high, with flexible payout mechanism that could be inherited by the retiree’s beneficiaries.

Following the recent announcement of the one-month basic salary bonus to all federal government employees, I decided to run a pension simulation of how much contributions are going into the UAE’s pension fund today, how much is being paid out today, how much will be contributed in the future, and how much will be paid out in future. This announcement made such a simulation possible given that the basic salary makes up most of the pension salary.

The results can therefore be described as accountable and precise, though not entirely accurate. Using today’s population breakdown, the simulation provides insights on what the current pension’s cashflow looks like, and what the future pension’s cashflow would be. Additionally, the simulation helps in addressing whether an increase in contribution rate or retirement age, debated lately as fixes for the UAE’s pension, would solve the impending challenge of an underfunded pension in the future, especially as the population ages.

The simulation resulted in three key findings. The first finding is that regardless of contribution rate, there will be periodic pension gaps whenever a generation of the population retires. Though this is definitely subject to the rate of return that the pension fund is generating on its contributions, a “pay-as-you-go” system combined with the collectiveness of contributions and payouts does not ensure that an adequate amount is available in the fund to be invested.

Therefore, and based on the simulation, the pension fund will require a cash injection of tens, sometimes hundreds, of millions in UAE dirhams with every generation’s retirement. The amount will fluctuate based on the size of retirees and the pension fund’s investment performance.

The second finding is that an increase in retirement age does not provide an ultimate fix, but a possible short-lived one. The reason being here is that life expectancy in the UAE today stands at 77 years. However, passing the pension on as inheritance makes it very difficult to predict how long the pension fund will need to pay that pension salary beyond life expectancy.

As long as the probability of pension being inherited and the subsequent duration of that is not being factored into future pension projections, the issue of an underfunded pension will persist.

The third key finding is that the UAE’s pension fund, as it is today, relies greatly on the entry of young Emiratis into the labor market, hence their contributions to the pension. This is a double-edged sword. Their entry into the labor market and their contribution to the pension fund defers the issue without resolving, as the young generation moves towards retirement and the entire population ages.

So, if increasing the contribution rate and raising retirement age would not fix the pension issue in the UAE, what would?

First and foremost, proper data and statistics must be available for better informed decisions. The availability of better data will allow for better calculations of different probabilities in regard to expected durations of pension payout, in light of the current pension inheritance laws and any future changes in those.

Secondly, the pension payout is fixed in amount only but not in duration, which can be open-ended given the continuous advancement in life expectancy, and that dependents will continue to receive the retiree’s pension years after their death. Such an issue can be addressed by having a separate, independent pension account for every individual and future retiree.

Thirdly, the fund must be managed in a way similar to how investment funds are, creating a risk and desired return rate profile for every individual that will culminate in an x amount by x year in the future. The future pension payout will be from that same amount, and the retiree can choose to take it as a lump sum to invest it or can decide to receive monthly stipends until the account is emptied. This could be modelled after the Singaporean pension model.

Finally, the public pension fund must not be a standalone one. That does not necessarily mean the privatization of the fund, but rather partnering with private funds and raising awareness on the importance of saving and investing money towards one’s pension.

Doing so will not only alleviate some of the pressure on the national pension fund but will also ensure that individuals are better equipped in terms of managing their current finances and their future pensions, taking into account the lifestyle that they would like to retain upon retirement.

The last thought I want to leave you with: will a three-tier pension fund – local, federal and private – resolve the UAE’s national pension fund issue?