Stasis and rebirth of retreats – Journal
Private pensions are stagnant. There are three simple remedies: a professional body to represent employer sponsored funds (EFs), a national regulator, and a no-liability income solution. The delay in the reform of public pensions should not slow down the reform of private pensions.
The two main categories of private pensions in Pakistan are the Voluntary Pension System (VPS) and EFs. This last category includes provident funds (PF), gratuity and retirement funds.
EFs are today orphaned by regulation because no government entity takes full ownership of them. They have to deal with multiple authorities – the provincial government under the new trust law, the Federal Tax Council for tax exemption, and the Securities and Exchange Commission of Pakistan (SECP) for filing requirements.
The result is a Dickensian tale of two cities. Many large EFs follow global best practices. Those sponsored by small private companies are bruised and broken.
VPS is the exclusive domain of SECP. It is managed by asset management companies (AMCs) whose representative body, the Mutual Fund Association of Pakistan (MUFAP), is excellent in advocacy. The regulator is deeply committed and actively supports. The VPS is well managed with uniform standards.
Just as a mule cannot gallop, no matter how well fed and well trained it is, an imperfect pension design cannot gain traction no matter how well its regulations and fund managers.
But here is the danger. VPS is an individual account based system and FEs are pooled arrangements. A joint arrangement is far superior to a system based on an individual account. The regulatory abandonment of FEs and organized support for VPSs have led to a fiscal policy that penalizes FPs and favors VPSs. We starve a horse and feed a mule.
Individual accounts versus grouped agreements
The purpose of pensions is to provide a lifetime income. This requires the use of structures that can maximize workers’ savings and provide higher lifetime income to retirees.
Two questions naturally follow. Which structures have lower costs? Who should manage the investment risks?
A pooling agreement groups together various services. The costs are significantly lower, as administrators can outsource certain services and choose different providers. A pooled fund is the preferred option of governments and employers around the world. Assuming a neutral tax rate and an employment period of 35 years, a PF can generate savings 25% more than the VPS.
Trustees, who are typically among the most knowledgeable members of the workforce, manage the risk of investing or the allocation of assets in a mutual fund. They have skin in the game because their personal savings are part of the pool. They can benefit from the best investment expertise. Their collective decision-making is emotionless, thoughtful, and long-term.
Supervision of the board is easy. A review of a mutual fund means a review of each employee’s nest egg.
A system based on an individual account is the opposite. Each participant is free to choose the asset allocation. The link between the individual portfolio of trustees and employee savings is broken. As behavioral finance rightly predicts, the vast majority of participants fall victim to emotional blunders – fear and greed, overconfidence, market timing, recency bias, tight framing, and more.
The occasional investment seminars organized by employers fall on deaf ears. The burden of managing the nest egg creates unhealthy distractions and reduces productivity. Board members have a limited interest beyond compliance matters as they cannot influence an employee’s asset allocation.
The result is that the median savings in an account-based system will not only be lower, but participants of the same age cohort and with a similar salary will have significantly different balances. Is this a desirable or fair outcome? A lower accumulated balance means lower income for life.
No wonder the VPS is unpopular with employers. Just as a mule cannot gallop, no matter how well fed and well trained it is, a flawed retirement design cannot gain traction, no matter how well its regulations and fund managers.
Chile is a prime example of what can go wrong in an individual account based system. After many decades, the system has generated dismal savings, insufficient income, pushed people onto the streets, forced the government to allow the use of the pension fund for everyday consumption, and sowed the seeds of a deeper crisis. serious. The results would have been very different if Chile had followed the Dutch model of employer funds.
The results of 401 (k), a similar but not mandatory system run by American employers, were also dismal for the vast majority of participants. But American citizens have a safety net called Social Security – a common system – which collects all payroll taxes and provides a lifetime income.
Renaissance of pensions
The first step is to create a professional body to represent FEs like MUFAP. Membership should be compulsory in order to benefit from tax advantages. It is ludicrous that EF currently has no forum to meet and communicate with government. Financial institutions and their related persons should not be allowed to become agents of this professional body.
The second priority should be to place FEs and VPSs under the same regulatory framework. This decision will create both regulatory neutrality and a holistic perspective in policy making.
The Single Regulator will have every reason to build a broad and deep intellectual capital in behavioral finance, income solutions, for-profit or not-for-profit retirement models, the implications of high costs, and international failures and successes. Understanding these topics is a prerequisite for providing a clear roadmap for supporting tax legislation and reform.
EFs need regulatory support and oversight. They must all be made to operate under a custodial arrangement in order to prevent deviant conduct by small businesses. Tax credits granted to participants should not discriminate between VPS and FPs. The leaks of VPSs and PFs are severely depleting our national pension pool and this must stop.
There is a risk. A newly created single regulator can go too far and overload already good EFs with unnecessary regulations instead of addressing the malaise in small businesses. But it is a risk that we must take. A well-functioning professional body, trial and error and a self-correcting regulatory mindset will produce the Derby winners of the pensions our country so badly needs.
The third priority is to choose a mandatory structure for life income. As noted in these columns earlier, modernized tontines are the best option for lifetime income in emerging markets like Pakistan. Tontines are easier to adjust. They don’t create liabilities. They can be easily adapted to the rules of Sharia. They offer a higher payout than an annuity.
Local capital markets are not ready for annuity solutions. Fixed annuities are not possible without liquidity in 20 to 30 year fixed coupon sovereign bonds. A menu of variable annuities will force unqualified individuals to make irreversible choices on different asset classes.
The low and negative interest rates in Japan since the 1980s and now prevalent in Europe and America should be a warning signal to any supporter of variable annuities.
Our government cannot and should not replicate the social security system of the United States or the public pension funds of Canada. Instead, it should act immediately to create a trade body for FEs, place all private pensions under a single national regulator, and legislate lifetime income tontines.
A well-designed pension system can regain the financial freedom of our country in thirty to forty years and provide a decent retirement for our future generations.
The pursuit of the status quo will keep us in the beggar zone forever.
The author is the CEO of Magnus Investment Advisors Ltd.
Posted in Dawn, The Business and Finance Weekly, December 6, 2021