Conference on the Voluntary Pension System (VPS)

Conference on the Voluntary Pension System (VPS) Karachi, 11 Aug 2005 Sponsored by the Securities and Exchange Commission of Pakistan VPS in the Context of the Whole Retirement System Apresentation by Samee-ul-Hasan Consulting Actuary, Akhtar & Hasan (Pvt) Ltd

SAkhtar & Hasan (Pvt) Ltd Actuaries Contents A. Introduction B. Points from Labour Force Survey 2003- 2004 C. Growth of the informal sector D. (EOBI) E. Retirement schemes other than EOBI F. Total number of Provident, Pension, Gratuity Funds. G. Critical current issue for such Funds H. How will VPS fit into the scene?

SAkhtar & Hasan (Pvt) Ltd Actuaries A. Introduction • The VPS should be warmly welcomed. It will raise the level of pension consciousness, and introduce new players into the market. • I congratulate the SECP and CBR on a thorough job, with good co-ordination between themselves. • The description of the VPS has been assigned to other speakers. The object of this presentation is to place VPS in the context of the whole retirement benefit system in Pakistan.

SAkhtar & Hasan (Pvt) Ltd Actuaries • This presentation does not refer to the pension and “general provident fund” schemes run for Federal and Provincial Government Servants, Railways, Defence personnel and certain other government, autonomous or semi-autonomous bodies. It relates primarily to other categories of employed persons, and self-employed persons, in the so-called “formal sector”.

SAkhtar & Hasan (Pvt) Ltd Actuaries B. Points from Labour Force Survey 2003-2004, based on 18,912 households • Est Population 1 Jan 04: 148.72 million • Employed Persons: 41.75 million (34.69 males + 7.06 females) • Un-employed Persons: 3.48 million (2.44 males + 1.04 females) • Civilian Labour Force: 45.23 million (37.13 males +8.10 females)

SAkhtar & Hasan (Pvt) Ltd Actuaries • Distribution of employed persons aged 10 or more by monthly income:

SAkhtar & Hasan (Pvt) Ltd Actuaries Clearly, most Pakistanis live from hand to mouth. Their capacity to save is limited or zero. When they can no longer work, they depend on their children or family members, or charity. In many cases, they live in dire poverty.

SAkhtar & Hasan (Pvt) Ltd Actuaries C. Growth of the informal sector • The informal sector grew from 65% in 2001-2002 to 70% in 2003-2004. • The reason for this growth in the informal sector is a subject by itself. This is not the place to discuss it. But allow me to quote from the Labour Survey: “However, the inhibiting influence of government’s long held predilection to generate revenue by hook or crook cannot be discounted altogether as a reason for the surge in informal activities”

SAkhtar & Hasan (Pvt) Ltd Actuaries • The rest of this presentation relates to the “formal sector”, which covers less than 30% of the work-force.

SAkhtar & Hasan (Pvt) Ltd Actuaries D. Employees' Old-Age Benefits Institution (EOBI) • Currently EOBI pays old-age, spouses, and invalidity pensions to 200,000 people. This is a fraction of people over 60, widowed and invalid persons, who in a civilised society should be getting subsistence pensions. • Only 1.5 million individuals working in 33,000 establishments are currently insured, and stand to get pensions eventually. • EOBI is and will remain the pension scheme with the largest coverage.

SAkhtar & Hasan (Pvt) Ltd Actuaries • BUT the great majority of Working Pakistanis remain out in the cold. • The ONLY way to provide a minimum subsistence income for working Pakistanis is to expand the EOBI scheme, and convert it into a National Minimum Pension Scheme. Commissions, Committees and some individuals have made do-able recommendations on EOBI’s phased expansion to cover the entire working population. But there has been zero action. The scope of EOBI remains the same as it was in 1976.

SAkhtar & Hasan (Pvt) Ltd Actuaries • EOBI’s expansion requires political will, and a real concern for the average Pakistani. Let us hope this political will and this concern can be generated in future.

SAkhtar & Hasan (Pvt) Ltd Actuaries E. Retirement schemes other than EOBI. • GRATUITY SCHEMES With very rare exceptions, Pakistani gratuity schemes are Defined Benefit (DB), and the gratuity is defined in terms of last drawn basic or gross salary. (a) Statutory Gratuity under the Standing Orders: Every industrial or commercial establishment in which 20 or more “workmen” are employed must, if the “Standing Orders” apply to it, pay a gratuity of 30 days’ last drawn gross wages for each year served on the cessation of a “workman’s” service

SAkhtar & Hasan (Pvt) Ltd Actuaries BUT if there is a Provident Fund to which the Employer's contributions equal those made by workmen, no gratuity applies to the period for which the Provident Fund has existed. (b) Non-statutory gratuity schemes: A very large number of employers have set up gratuity schemes outside the scope of the Standing Orders. These apply to employees who are not workmen governed by the Standing Orders. They may also apply to workmen who get a Provident Fund, but for whom the Employer has in addition provided a gratuity, either voluntarily or as a result of collective bargaining.

SAkhtar & Hasan (Pvt) Ltd Actuaries There is no legal requirement to fund a gratuity scheme. But income tax law encourages funding. Many schemes remain un-funded, backed by Book Reserves. But many employers have set up Income Tax approved Gratuity Trust Funds.

SAkhtar & Hasan (Pvt) Ltd Actuaries • PROVIDENT FUNDS These are Defined Contribution Schemes, in the form of Tax approved Trust Funds. The Employee can contribute up to 10% of basic salary. The law does not require the Employer to contribute. But under almost all Provident Funds set up outside Government and the Defence Services, the Employer matches Employee contributions. There are very many Provident Funds, covering a large number of employees.

SAkhtar & Hasan (Pvt) Ltd Actuaries • PENSION SCHEMES • Pension schemes have been set up for decades by progressive employers under the Income Tax, 1922, and the corresponding provisions of the Income Tax Ordinance, 1979, and the Income Tax Ordinance, 2001. • There is no statutory requirement to Fund a pension scheme. But with very rare exceptions, all existing Pension Schemes are run as Trust Funds Approved by the CIT.

SAkhtar & Hasan (Pvt) Ltd Actuaries F. Total number of Provident, Pension and Gratuity Funds, their total size and coverage • This question is of great interest. Unfortunately, the information is buried in the files of the Income Tax Department, the Central Directorate of National Savings, Banks, listed companies, mutual funds and other organisations. Nobody has extracted and collated this data. • One can only guess at the total.

SAkhtar & Hasan (Pvt) Ltd Actuaries • The number of Funds is probably well into 4 figures. The total number of employees is probably well into 6 figures, perhaps even into 7 figures. The total size of these Funds is probably well over Rs 100 billion. And the total amount they have to invest each year, including new money and maturity of old investments, is probably well over Rs 10 billion. • Also, there are a large number of un-funded gratuity schemes

SAkhtar & Hasan (Pvt) Ltd Actuaries G. Critical current issue for Provident, Pension and Gratuity Funds • The issue at the top of the agenda of all Funds is where to invest the money. • New investment in National Savings Schemes was stopped on 25 March 2000. • NS Schemes were to be replaced by Pakistan Investment Bonds. But for various reasons, this has not worked out, (except for some jumbo funds). • There are illogicalities and inconsistencies in the investment regulations of such funds. The regulation is split between the SECP and the CBR.

SAkhtar & Hasan (Pvt) Ltd Actuaries • This is a subject by itself, and there is no time to go into details today. • Apart from the regulatory aspect, if Government securities are excluded, is there enough scope for the existing retirement funds + VPS (plus life insurance organisations, EOBI, NIT and other mutual funds) to invest in shares and the corporate debt market? I personally don't think so. It will be like trying to fit a gallon into a pint pot. As of now, Income Funds have invested heavily in COT and similar things. Do we want to base our retirement plans on such investments?

SAkhtar & Hasan (Pvt) Ltd Actuaries H. How will VPS fit into the scene? • VPS has not come into a vacuum. There is a substantial existing retirement system, based on EOBI, Provident Funds, Pension Funds, Gratuity Funds and un-funded gratuity schemes. • As with any new law, experience may require some corrections. • Only time will tell how VPS will work. • It is important for it to work to the Golden Rule of selling: sell only what you yourself would buy if you were in the same position.

SAkhtar & Hasan (Pvt) Ltd Actuaries • Care should be taken to build up trust in VPS. • Fiascos like pension mis-selling in the UK should be avoided. UK proved that a Voluntary, Personal or Insured Pension scheme cannot provide a better through-put to the employee than an Employer's self-administered scheme. A self-administered scheme has no marketing costs. Administration costs are generally lower, for all but very small employers. And there is no profit element to be passed on. Pakistan will not gain if VPS takes the easy way out by cannibalising or replacing existing Provident Fund, Pension or Gratuity Schemes.

SAkhtar & Hasan (Pvt) Ltd Actuaries • Life insurers will no doubt keep in mind the draconian compensation provisions of S.76(4) of the Insurance Ordinance, 2000, and SECP Insurance Rule 31. UK life companies came to grief on account of similar provisions, when their agents persuaded people to switch OUT of their employers’ self-administered schemes and IN to personal pensions • VPS seems specifically designed for self employed persons and persons whose Employers provide no pension.

SAkhtar & Hasan (Pvt) Ltd Actuaries • Pakistan will gain if the VPS develops this large un-tapped market. This is essentially based on sales to individuals. • Sales will be made one by one. The VPS fee structure may need re-tuning to suit this individual market. Tax relief will be a powerful tool. Even so, 3% seems too low to cover sales costs, especially for annual contribution plans. Expenses allocated by cost could mean higher sales and other charges as % of contributions, offset by lower fees as % of assets.

SAkhtar & Hasan (Pvt) Ltd Actuaries Points which may need attention now or in the future: • Compulsory annuitisation at age 75: • Improving mortality means well over 50% of those who retire at age 60 will survive to age 75. • As of now, there is no annuity market in Pakistan to speak of. • For a life insurer, conventional annuities are a difficult business. Annuity rates which are actuarially sound for the insurer may be un-attractive for the purchaser.

SAkhtar & Hasan (Pvt) Ltd Actuaries • In modern life insurance products, like unit-linked or universal life, life insurers offer no guarantees on mortality, investment income rates or expenses. The actual experience is passed through to policyholders, and the insurer is effectively a manager acting on their behalf.

SAkhtar & Hasan (Pvt) Ltd Actuaries o • Flexible annuity products can be designed on similar lines. It remains to be seen whether they will prove attractive or understandable to a 75 year old person. • I look forward to Mr Omer Morshed's and Mr Javed Ahmed's observations on annuities.

SAkhtar & Hasan (Pvt) Ltd Actuaries • Investment Management Charges It is good that the fee of 1.5% of the average value of net assets is less than 2% or 3% for mutual funds generally. Investment management fees as % of MV of assets is market practice. But it creates a conflict of interest between the Fund Manager and participants. The Fund Manager gains if market prices rise. Participants, as buyers, gain if market prices remain low, i.e. a low P/E.

SAkhtar & Hasan (Pvt) Ltd Actuaries • Consideration should be given to a composite fee for investment management, partly based on the market value and partly on the income. As mentioned earlier, realism could mean higher charges as % of contributions, and lower for investment management. • The charges and expenses of the Pension Fund Manager, on a compound basis, could amount to a noticeable % of the Fund over a period of 20 years. This aspect may need re-examination.

Conference on the Voluntary Pension System (VPS)