Chapter 5 Flashcards

1
Q

What are the key features of pension contracts?

A

Key features of pension contracts:

  • Primarily used to provide income in retirement for individuals and possibly dependants
  • May provide other benefits, e.g. lump sum payment to dependants if individual dies before retirement
  • May have option to change form or timing of benefit—exchange proportion of pension payments for cash payment at retirement
  • Long-term arrangements

Can be provided by the State or through private sector via:

Occupational schemes

o Offered by employers to employees, where employer usually pays % of cost of providing the benefits

Personal pension plans/ arrangements
o Purchased from insurance company by individual

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2
Q

How can scheme members be divided?

A

Scheme members can be divided in three types:

  • Actives – still earning future pension benefits e.g. current employee
  • Deferred members – stopped earning any future benefits but have existing benefit entitlement that will come into payment in future e.g. employee who left job of sponsoring company
  • Current pensioners – members receiving benefit entitlement
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3
Q

What are the main types of pension schemes?

A

Main types of pension schemes: (state-sponsored and occupational schemes can be all 3)

  • Defined benefit schemes
  • Defined contributions schemes (personal pensions)
  • Defined ambition schemes

The type of scheme drives type of benefit provided and where risks lie, either with member or scheme sponsor.

Defined benefit schemes: (final salary scheme)
- Scheme rules define the benefits independently of contributions payable and benefits are not directly related to investment of scheme
- Funded or unfunded
- Benefits are defined by set formula and can be linked to:
o how long member works for sponsoring company
o salary at retirement

Defined contribution schemes:

  • amount of individuals member’s benefits depends on contributions paid into scheme in respect of that member, increased by investment return earned on contributions
  • may have choice in which asset class contributions are invested in
  • pension not defined will depend on the investment returns
  • use accumulated fund at retirement to meet post-retirement needs, by securing pension with life insurance company by purchasing immediate annuity
  • move accumulated fund to income drawdown product—fund remains invested and member draws regular income
  • lump sum cash amount – may be tax implications
  • In SA, individuals retiring from DC arrangement can either take 100% or up to 33% of accumulated fund as lump sum BUT,
  • regulations were introduced to encourage annuity purchase – aim of improving retirement savings preservation

Defined ambition schemes:

  • risks are shared between different parties involved e.g. members, employers, insurers and investment businesses
  • aim to offer best of both worlds, but administration may be complex, and members may not fully understand their operation
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4
Q

What investment scheme is followed in respect of the liabilities associated with each type of pension scheme?

A

Investment strategy:

  • need to consider characteristics of liabilities, nature and term.
  • Defined benefit scheme may need mix of:

o Fixed-interest bonds to match benefits guaranteed in monetary terms

o Index-linked bonds & equities to match benefits guaranteed in real terms and expenses

o Cash for liquidity to meet immediate pensions and expense outgo and uncertain outgo

  • For defined contribution scheme, member may have investment choices
  • Difficult to determine appropriate strategy for defines ambition scheme dependent on benefits offered by scheme
  • PS often receive generous tax breaks – can influence investment choice
  • Investment strategy of PS constrained by regulation, which can restrict/prescribe what scheme invests in
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5
Q

How are these pension schemes paid for?

A

Paying for the pension scheme:

Defined benefit schemes

  • Cost of providing all benefits not known with certainty until all payments have been made
  • No money may be set aside in advance and money found just as each benefit payment is made—unfunded—benefits beings financed on pay-as-you-go basis
  • Or, scheme may be funded—money set aside before benefit payments are made

Defined contribution scheme:

  • Money set aside gradually over member’s working lifetime
  • Timing of when money is paid into the scheme is key – needs to be invested at right time to earn investment returns that will provide adequate pension
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6
Q

How are the contributions set?

A

Setting contributions:

Contributions, of defined benefit schemes, need to be sufficient to meet:

  • Cost of future benefits
  • Shortfall/surplus that has to be cleared because funding level has fallen below/risen above acceptable level

Defined contribution schemes

  • Contribution rate will be defined in scheme design
  • May be age and/or service related and members may have some choice about amount they contribute
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7
Q

Who are the main benefit providers?

A

Main benefit providers:

  • The State – often supplement healthcare needs by purchasing private medical cover
  • Employers
  • Individuals
  • Financial institutions – insurance companies, banks, mutual funds and investment
  • Other organisation
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8
Q

Who are the main benefit providers: The State

A

The State:

Major role in provision of benefits – direct provision or through encouragement of provision and regulation of provision

Role determined by political, economic and fiscal viewpoints

The major roles played by the State are:

  1. Direct provision of benefits

o Ensuring population receives or has opportunity to receive income after retirement

o Passing on responsibility to employers may help low-paid employees, but it will not alleviate problems for the self-employed or unemployed

o In developed countries, the state has responsibility for ensuring all citizens receive minimum level of income in retirement

o Higher the level of direct provision the higher the cost

o Cost met in long term by high taxation and short term by government borrowing

  1. Sponsoring of the provision of benefits – maybe by providing appropriate financial instruments (issue of bills and bonds, savings plans, deposits with State bank)

o In SA, employers contribute to retirement funds on behalf of employees

o Umbrella funds may help small employers

  1. Provision of financial incentives, usually through tax system

o In SA, individuals making saving in most pension scheme receive full tax relief on contributions that do not exceed 27.5% of gross income

o Tax relief on most pension scheme investments and some benefits tax-free

  1. Educate about importance of providing for future

o Impose regulations for min levels of info to be disclosed be pension providers

  1. Regulate to encourage or compel benefit provision

o Could make provision compulsory be requiring:

  • Each individual joins an employer or individual scheme
  • Min level of contributions or min level of benefits to be provided by employer or individual scheme
    6. Regulate bodies providing benefits, to ensure security for promises made

o State needs to strike balance between:

  • Degree of flexibility and freedom of action (in order to encourage)
  • Need for regulation and supervision (to protect)
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9
Q

Who are the main benefit providers: Employers

A

Employers:

  • Role in education and encouraging or compelling employers to plan benefit provision
  • MAIN role is the financing of benefits for their employees
  • Another role – provide facility for provision of benefits e.g. a scheme –employer may have greater control over benefits provided and costs involved
  • Employers has many reasons for sponsoring benefit provision:
    1. Compulsion or encouragement from the State – tax incentives to employers
    2. To attract and retain good quality staff

o providing benefits perceived by employees to be attractive

o providing benefits that are at least in line with competitors

o rewarding certain classes of employees e.g. loyal staff

  1. desire to look after employees and dependents financially beyond level provided by State
  2. pooling of expenses and expertise
    - Benefits can be provided through formal employer-sponsored scheme—can ensure a consistent approach across employees and help target certain groups e.g. long serves or high-fliers
    - Organisations can tailor benefits offered to employees using flexible benefit system

o Employees can trade in some of their existing benefits for other financially equivalent benefits

  • Employer-sponsored schemes do not have to be backed by a single employer but can be sponsored jointly by many employers e.g. industry-wide schemes
  • Single-employer schemes – financing shared by employer and employees who receive benefits
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10
Q

Who are the main benefit providers: Individuals

A

Individuals:

  • They are beneficiaries and finance benefit provision, because

o Compulsion or encouragement by the State or employers

o Individual’s personal preferences

  • Provision can be formally structured savings plans, generated by the State, employers or other financial organisations
  • Or can make informal unstructured arrangements
  • Individuals may use domestic property as an investment to meet retirement needs
  • Or use benefit from property though inheriting it
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11
Q

Who are the main benefit providers: Financial institutions and other corporations

A

Financial institutions and other corporations:

  • Vehicle for providing benefits often provided by financial institutions either via employer-run schemes or directly through inheriting it
  • Proactive in highlighting need to individuals to make provision
  • In SA informal benefit providers such as burial societies and stokvels also assist with the provision of financial benefits
  • Trade unions, credit unions and charities can also advise individuals on provision
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