This article appeared originally in Gulf News: link to original article
What if the solution isn’t fixing the current pension system that we have, but a new one altogether?
Similar to a business venture that went awry, the most appropriate and cost-efficient next step is to cut your losses and move on with a new venture. When evaluating fixes to the pension system in the UAE, there’s no easy solution.
However, that shouldn’t be a precursor to throwing good money after bad, given that there’s wide speculation on one of the fixes being higher contribution rates by individuals still paying into the federal pension fund.
Though there’s no doubt that such a fix would help placate the pension headache for a few years, it is not a long-term fix for a pension that does not associate future benefits with past, current, and future contributions.
Cash-flow gap with ‘pay-as-you-go’
The current pension comes with a legacy issue of a “pay-as-you-go” system, where individuals contribute a fixed percentage out of their salaries towards an ambiguous pension payout in the future.
As a result, and unless pension money is being invested in instruments providing phenomenal returns — junk bonds and co — there is no doubt that the pension will continue to have a cash-flow gap every few years as additional individuals are subscribed to the current pension and others get phased out from contribution to receipt.
Not only that, the cashflow gap is further exacerbated by inflation that is not being accounted for since the federal pension is not an inflation-linked one. Payout is fixed regardless of inflation rate in post-retirement years.
Raising retirement age
Another widely speculated fix to the current pension is raising the retirement age, which would increase unemployment if conditions in the job market do not allow for enough jobs to be created.
This could be because of lack of public and private investments into the economy, a skills mismatch between jobseekers and jobs on offer, or any other reason.
Raising the retirement age is a multi-faceted issue regardless of the economy and the population demographics.
To illustrate, when the retirement age was raised in multiple European countries post-2008, the fix was problematic for individuals who did not want to wait any longer before being able to claim their pension benefits. Such a fix was one way for those countries to defer a pension pay-out versus pay-in problem.
Enabled by their ageing versus youth populations, raising the retirement age did not worsen unemployment among the youth beyond what bad economic conditions have done.
According to multiple sources, four European countries rank among the Top 10 in both the size of their ageing populations as well as populations that work the longest until retirement. Those countries are Italy, Greece, Germany and Portugal.
As for the UAE, the case is a bit different. Demographics here are going through a bulge in the youth population, which means that the number of individuals who join the prime working age category – identified by the Organisation for Economic Cooperation and Development (OECD) as “people aged 25 to 54” — will keep growing.
If the job market falls behind as explained earlier, a higher retirement age could risk increasing unemployment rates, which is considered today to be among the lowest 30 worldwide.
That same bulge in the youth population is also one that provides an unprecedented opportunity. As different fixes are being weighed to prevent a future cash-flow problem in the current UAE’s federal pension fund, a new pension fund can be created especially for future job market entrants.
A new pension fund can be established for individuals entering the job market in the coming five to 25 years, providing the UAE with two very interesting outcomes.
The first outcome is that the current federal pension fund can be eventually phased out, mistakes and fixes included, as individuals who started contributing to it in 2018 retire in 25-35 years’ time. Future cashflow issues can be assessed and investments made today to ensure that the fund can continue paying for future retirees, after which it must cease to exist altogether if cash-flow planning gets adequately done and executed.
The second outcome is that the UAE will have a new pension fund that is free of past mistakes and is not a pay-as-you-go one, where future benefits are determined by current and future contributions. The new pension fund can also be designed to accommodate solutions for early retirement, investment options weighing return versus risk, availability of emergency withdrawals, and changes in investment strategy based on changes in targeted pension benefits.
Moreover, the new pension fund can be further enhanced by allowing multiple pension layers. That is, the public fund must not be the sole pension provider but one option among others, where individuals have the choice to subscribe to private savings and pension plans offered by insurance companies, banks, etc.
For this to work though, the new pension fund could provide the option of financial and investment advisers to better guide individuals’ pension decisions. Taken altogether, public and private pensions must cumulatively result in desired future pension benefits, with pressure taken off government coffers.
Moving forward, the current federal pension in the UAE is turning into what economists coin a “sunk cost”. It was created decades ago, worked for a while, and now time and efforts expended at saving it are not worth the sweat.
Instead, and taking into account today’s and future demographics in the UAE, it is time to consider having a new pension fund that is more appropriate of upcoming age groups.
The last thought that I want to leave you with: why not have multiple, small pension funds with different returns for various age groups?