Pension system: private or non-profit?

Updated 17 Aug 2020

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Savings policy, like education, requires a long-term vision. Results will emerge after many decades. — File photo
Savings policy, like education, requires a long-term vision. Results will emerge after many decades. — File photo

Economic sovereignty depends on domestic savings. So does the dignity of old age.

Pakistan has two strategic choices: one, a private model that directly links individuals to financial firms like the voluntary pension system (VPS); and two, a non-profit system like the Employees’ Old-Age Benefits Institution (EOBI) or employer funds that aggregates individual savings under one entity.

Chile is the floundering poster child of a private model. The Netherlands is the shining example of a non-profit system. Both offer valuable lessons.

A non-profit system will deliver 30 per cent higher pension assets and income to each age cohort. Two reasons make it better — governance and significantly lower costs.

Savings policy, like education, requires a long-term vision. Results will emerge after many decades. Our uncompromising North Star should be the welfare of citizens and the size of domestic savings. Appeasement and compromise in the formative stage will wreak enduring damage. The orchestra of capital market development needs to take a back seat.

Read: How necessary are pension reforms?

Many ancillary topics enjoy global consensus. Everyone agrees that mandatory enrolment is necessary, withdrawals should be stopped, the long-term goal should be income security and not asset accumulation, the system should be prefunded, tax incentives should be non-discriminatory and employers cannot bear investment and longevity risks.

They should not become diversionary clutter in this policy debate.

Private pastures

Arun Muralidhar, an economist and leading authority on the subject, had this to say on the World Bank’s global initiative during the 1990s to privatise social security in a recent CFA Institute publication:“I realised it made no sense at all. Privatisation was based on myth and people’s personal biases, but it wasn’t based on finance science and was likely to lead to bad outcomes and transfer wealth from the poor to the rich — the exact opposite of the World Bank’s mandate.”

An individual account–based system cannot transition into a lifelong income solution. Nor can it overcome behavioural pitfalls

The private system has advantages. The most advertised benefit is ‘life cycle investing’ — an elegant approach that asks investors to reduce risk as they age. But it is useful only for a tiny minority of high-income financially literate people. The big majority will fall victim to fear, greed, herd mentality, recency bias and self-indulgence.

A good employer will limit withdrawals to curb wastefulness. No such guardrails exist in VPS. Withdrawn savings can evaporate into holidays and Ponzi schemes. Giving investment autonomy to the uninformed is like pushing sheep into the jungle and expecting them to stay safe.

The other over-rated benefit, known as ‘account portability’, enables the continuity of investment account when employees switch jobs. It has horrendous side effects.

Employment ties weaken. An unhealthy culture of investment and trading walks into the work space. News, rumours and marketing blitz of fund managers grab attention. Employees get distracted. Their emotions ride the roller coaster of stock market news. Performance and learning take a back seat to checking daily net asset values.

Another drawback is higher cost. A portfolio comprising 5pc cash, 75pc bonds and 20pc stocks would annually cost 1.98pc in VPS and 0.8pc in employer funds. Under a non-discriminatory tax regime, the accumulated savings in employer funds would be higher by 21pc, 25pc and 30pc over a 30-year, 35-year and 40-year work life, respectively.

Our tax policy, beholden to the capital market symphony, has farcically eliminated the low-cost advantage of retirement funds.

A private model can be a supporting pillar but not the main building block. VPS should serve as an additional option to build a nest egg. No more.

Non-profit system

A non-profit entity creates governance that has big advantages: unemotional and structured decision making, performance evaluation and benchmarking, access to best investment expertise, quicker adoption of better ideas and a badly needed ability to protect the constituency.

Should Pakistan then attempt to build institutions like Canada Pension Plan (CPP)? Or should it rely on employer- or sector-based funds like the Netherlands?

CPP-style funds are not an option for us. Our government has limited capacity and big challenges ahead. It will have to expend significant political, human and financial capital on building infrastructure and essential public services. It cannot bear the additional burden of building investment institutions.

Employer funds are a better choice in our socio-political context. Priority should now shift to their support and reform.

One area is enforcement. It is difficult to monitor compliance of thousands of employers’ funds. It can become a lot easier if there is coordination between the Federal Board of Revenue and the Securities and Exchange Commission of Pakistan (SECP). The tax commissioner should not grant and renew the tax-exempt status if any employer fund is non-compliant on the website of the SECP.

All retirement funds must be made to operate under an institutional custody arrangement right away. The signing authority on bank accounts should vest solely with the custodians. It will make the system safer. The custodians’ IT system can flag non-compliance to the SECP immediately.

Enforcement is also not possible without gathering all the retirement funds under one trade body. Its CEO and board members should not be connected to financial firms. An added bonus would be the continuous flow of ideas from global pension providers (MNCs) operating in Pakistan.

By the same token, all employer funds and not just contributory schemes should be brought under the explicit domain of a dedicated department in the SECP.

Lastly, the mandatory enrolment of workers in the informal sector should take place with the EOBI.

Brave new world

The retirement industry is transitioning to newer solutions that overcome the irreversible challenges of increasing dependency ratio, higher life expectancy and lower returns. At the heart of these solutions is a foundational recognition that ordinary people cannot manage investments and life-cycle risks.

Two ideas herald a paradigm shift.

The first idea is to centralise IT, administration, compliance, accounting and performance reporting of all investment managers under an organisation like the Central Depository Company of Pakistan (CDC). Every investor in Pakistan will log into a CDC-run system where the colour, logos and schematics will differentiate competing firms.

The unbundling of investment and non-investment functions will dramatically lower costs, ease regulatory oversight and bring down entry barriers for aspiring portfolio managers.

The second idea is to adopt tontine-like structures that provide the additional benefit of mortality credits and enable lifelong income without the burden of a defined benefit plan. Mortality credits are unconsumed savings of people who die early. They benefit fellow fund members. All state pensions and annuity products are organised on this principle.

An individual account-based system cannot provide governance. Neither can it transition into lifelong income-based solutions nor can it overcome behavioural pitfalls. It is akin to a copper wire solution in a 5G world.

Our future lies with an employer fund system as the default option. No other system can match their skin-in-the-game orientation.


The writer is the CEO of Magnus Investment Advisors Ltd. The views expressed in the article are his own

Published in Dawn, The Business and Finance Weekly, August 17th, 2020