This regime, which allows tax exemptions to contributions and investment income and then taxes the benefits at the time of withdrawal, has been endorsed by the Central Board of Revenue and the required amendments in the Income Tax Ordinance 2001 will be notified in the Finance Bill 2005-06.
Existing asset management companies and life insurance companies will be eligible to apply for licenses to set up pension funds and EFU Life Insurance Company and about three asset management companies including Arif Habib Investments and Atlas Asset Management Company intend to apply.
“The system will encourage capital formation and provide a systematic way to plan for retirement,” says Salman Shaikh, commissioner of non- bank finance companies at the Securities & Exchange Commission of Pakistan, which will regulate the pension system.
Pension reform was initiated by Prime Minister Shaukat Aziz during his tenure as finance minister when he set up a task force to build a defined contribution scheme in which future benefits are based on amounts contributed to each account.
The task force followed the model developed in Chile in 1981, which was subsequently mirrored by several countries including the US. According to a 2004 World Bank report, 12 Latin American countries followed Chile and shifted away from defined benefit systems (which commit to paying fixed pensions) to individual voluntary plans.
The report shows that pension reform resulted in several benefits including improved fiscal sustainability, capital market development and improvements in equity. Over the last five years, the size of pension fund assets as a share of GDP in the region has almost doubled.
In Pakistan’s private sector, with the exception of a few multinational corporations, most firms run either provident funds or gratuity schemes rather than pension funds. And in the government sector, employees’ pension schemes are not systematically invested but met out of current budgets. This has become of increasing concern since economists have forecast that pension payments will top 10 per cent of GDP unless reform comes through. Now that rules have been framed for a VPS, the government is also contemplating switching to such a scheme. How it will work:
According to the Voluntary Pension System Rules, 2005, citizens with national tax numbers will be able to set up individual pension accounts with pension fund managers as long as they are not employed in any position entitling them to benefits under an approved pension scheme.
The scheme will also be open to non-resident Pakistanis for contributions up to Rs500,000 for which they can take advantage of the double taxation treaties Pakistan has signed with some 40 countries. Pension funds will be required to establish three sub-funds, one each of equity, debt and money markets with a seed capital of Rs50 million each.
Fund managers will allocate according to certain guidelines which are currently being worked out by the SECP. One asset allocation method under consideration is an age-based formula which allows a younger depositor to hold more price-volatile stocks and less low-risk bonds and then gradually adjust this ratio over his life cycle so that by retirement age, he holds virtually no price-volatile instruments and is invested largely in bonds.
The returns on investments will accrue on a tax-free basis until the depositor’s retirement which can be at any age between 60 and 70. After this, the depositor can withdraw 25 per cent of his accumulated fund while the rest must be converted into an income plan or an annuity with a life insurance company. These pension payments are then subject to tax but since, according to tax laws, older citizens pay half the rate of tax, an advantage still remains. Advantages:
The major advantage of this new system is that it provides a substantial tax incentive to investing in a retirement planning scheme. Since individual pension accounts will be held in the account holder’s name, portability is another major plus. As a worker moves from one job to another, for example, his retirement account remains unaffected since it is held in his name and not linked to his employer.
The rules also allow account holders to switch at any time between schemes or even make contributions to a multiple number of schemes. The rules require the net asset value of each fund to be published daily and every six months, the SECP will publish a comparative statement showing the performance of all funds.
Moreover, the system will create an environment of savings to balance out the high levels of consumerism being seen in the economy and will bring depth to the capital markets as well. “Our capital markets need a constant regular flow of money rather than major flows of money which go in and out,” says Nasim Beg, CEO of Arif Habib Investments. Concerns:
Although the rules have been developed through consultation with the private sector, certain concerns remain. First, although the rules require the establishment of a debt sub-fund, the corporate debt market is narrow which is why most fixed income mutual funds have the bulk of their funds invested in the carry-over transactions market. How will the SECP require pension funds to invest a certain portion in debts when the market remains shallow?
Second, the proposal to allocate assets on the basis of age makes financial sense but does not take into account sociological differences among workers. “For example why should a driver who is 19 years old put more of his money in risky stocks when he knows he will always be a driver in the same income strata,” says one financial expert.
“And similarly a bank president who is 38 doesn’t need to start diversifying into fixed income since he will always be in a higher strata.” How does the SECP plan to tackle this balance?
Third, the rules say fines and cancellation of registration could be imposed by the SECP if performance of pension funds is not up to the mark but the formula to determine performance has been questioned.
The SECP will calculate an index of the weighted average investment return of all sub-funds for all pension funds every year. The benchmark for investment performance of the sub-fund will be the index less 2.5 percentage points. This measure has been questioned by financial experts since it does not take into account longer term trends. They suggest that funds should be penalized if they under-perform the average performance by 25 per cent over three to five years.
Fourth, given the commission structure permitted in the rules, there are worries that sales agents will not have enough incentive to sell and this could result in poor outreach. According to the rules, pension fund managers will charge a maximum front end fee (sales charge) of three per cent of all contributions made by the individual and an annual management fee of 1.5 per cent of the average value of net assets for the year.
“The rules are geared more towards group pensions rather than individual plans,” says Mohammed Ali, assistant general manager of EFU Life. “Insurance agents are not going to be very keen to sell with such a low commission structure.” He says that the three per cent commission structure permitted under the rules is too low for individual products which usually come with commissions of 30 to 40 per cent. Ali suggests a high commission structure of 30 per cent in the first year reducing to lower levels in year two and three.
In group accounts, commission range from 0.5 to 1.5 per cent. He hopes EFU will be able to generate Rs500 million in funds under management within the first 12 months the bulk of which will come largely from corporate group accounts. For the future:
Even if these problems are ironed out, the scheme is sure to take at least five years to emerge as successful and critics should take a long-term view. Since the base of possible investors is already limited to the existing number of taxpayers estimated at about 1.5 million, experts do not expect more than 400,000 to sign up to pension funds in the first two years and assets under management to touch Rs2 billion.
“It will be a slow growing business,” says Habib ur Rahman, CEO of Atlas Asset Management Company. “Self-employed people will start off in this but over time we should aim at phasing out provident funds in favour of the more flexible pension funds.”
The government, regulator and private sector will also have to assure that certain parameters are met. To begin with, the state and private sector employers should not use the onset of voluntary pension schemes to walk away from their obligation to provide for their employees after retirement.
Second, since the schemes are based entirely on the assumption of Pakistan risk, fund managers should be permitted and required to invest a certain portion of funds internationally. Since these are retirement funds at stake, the risks of a severe recession should be carefully hedged.
Third, the SECP will have to initiate aggressive outreach and investor awareness programmes without leaving this to the private sector. Judging by the performance of mutual funds which have grown to a Rs120 billion industry but have no more than 5,000 individual investors each, this will take a major effort.
Then, advertising standards will have to be set and self-monitored as well to ensure misleading promotion does not hurt individual investors. Along the same lines and perhaps most critically of all, regulatory monitoring will have to be stringent to ensure best practices by fund managers and full protection for unit holders.