THE design of the pension system and its funding arrangements have important implications on how they could affect the economy of a country. The majority of countries have traditionally used defined benefit (DB) pension schemes for their public pension systems. DB schemes pay earnings-related pension benefits to their employees. Some countries use defined contribution (DC) pension schemes, the pension benefits under this system depend on the contributions and the investment returns earned on accumulated assets throughout the term of employment.
Design of the pension system — DB vs DC: Pakistan uses a DB approach for its public pension system. In the DB approach, the entire responsibility and liability rests with the government. This is a traditional system used by most public and historically private pension schemes. However, the DB system is quite old in its nature and is actively being replaced with the DC system.
If we take the example of the UK, DB schemes have been losing popularity due to the heavy burden they place on employers. The majority of private schemes are no longer open to new employees. Several private DB schemes in the UK are in deficit and presently new employees are largely being offered the DC schemes.
In Pakistan’s case, a DC approach with compulsory member contributions would be a more suitable arrangement. The DC approach has the tendency to develop into a self-sustaining model in the long term and reduce the strain of pension obligations on the government. The transition from DB to DC would come at a cost but a prudent approach could involve closing DB to new members only and gradually moving to a complete DC system in a phased transition.
A shift to a funded basis could serve as a self-sustaining model for Pakistan in the long term.
Funded vs unfunded basis: Pakistan’s public pension system uses an unfunded basis which has accompanied DB schemes on a historical basis. In this approach, general revenues (such as tax) and contributions from current employees are instantly used to pay ongoing pensions.
It is very clear that the unfunded basis is not sustainable and an aging population is only going to make matters worse. The funded basis on the other hand involves setting up a pension fund that is regularly topped up with contributions from employees and the government, and the accumulated funds are invested to achieve long-term returns. A shift to a funded basis could serve as a self-sustaining model for Pakistan in the long term. Shifting from unfunded to a funded basis needs to be carefully weighed against transition costs and a phased approach needs to be adopted if required.
Retirement age — 60 vs 63
Fertility rates are declining, and life expectancies are rising due to increased access to better health services. This is resulting in an increase of the normal retirement age globally.
Pakistan’s life expectancy is not as high as that of some of the developed countries; however, it has seen improvement over the last few years. Pakistan’s retirement pension age is 60 years. It is lower than many other countries that have increased their retirement age to 65 while the UK, US and Germany are planning to increase it to 67.
In order to improve the pension levels, Pakistan should consider increasing the retirement age to 63. This could be done gradually rather than a one-off jump so that people closer to retirement are not adversely affected. This increase might not bring benefits in the short term as it will include paying employees for longer who were soon to retire but over the long term this would bring some savings for the government. This approach has also been recommended to Pakistan by the World Bank.
Final salary vs average salary: DB pension benefits have historically been calculated based on final salary and years of service by employees. Payment calculations based on final salary usually result in a big amount and such a method is susceptible to manipulation too. Many countries are now shifting to DC style while those who are still using DB are actively switching to an average-salary formula where the pension payment is determined by considering the average salary of the employees throughout their working life. The UK’s public National Health System still uses the DB approach but its new pension schemes use an average-salary formula.
Pakistan’s public pension system still uses a final-salary methodology for pension calculations, but it is high time that Pakistan adopts average-salary formula to reduce some of the excessive pension costs currently being paid out.
Lump sum vs annuity: Pakistan’s public pension system allows early withdrawals and lump sum payments to members during their working life as well as at retirement. Lump sums could pose an issue for both the government (as balloon payout expenditures) and for the members (by outliving their retirement savings). Many countries have started to use a more flexible approach where only a certain proportion like 25 per cent of retirement saving is allowed as lump sum payment while the rest is either taken out as an annuity or in the form of small regular drawdowns throughout life after retirement.
Pakistan’s social culture is different to that of Western countries and it is understandable that lump sum amounts are often required by elderly for medical reasons or for social needs. In such a cultural system, a flexible pension payment system would be most appropriate as it would help the retirees fulfil their social responsibilities without risking old-age poverty.
Globally, the designs and arrangements of pension systems are rapidly evolving to ensure flexibility for the retirees and the employers. It is high time that Pakistan caught up and evolved its public pension system by implementing new reforms followed by regulatory and legislative amendments. It is equally important that reforms are designed to help government tackle the prevailing pension situation but without shifting the burden to current and future generations of retirees.
The writer is a pensions investment consultant based in the UK.
Published in Dawn, April 2nd, 2021