Chapter 5 Flashcards
What are the key features of pension contracts?
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
How can scheme members be divided?
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
What are the main types of pension schemes?
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
What investment scheme is followed in respect of the liabilities associated with each type of pension scheme?
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
How are these pension schemes paid for?
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
How are the contributions set?
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
Who are the main benefit providers?
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
Who are the main benefit providers: The State
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:
- 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
- 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
- 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
- Educate about importance of providing for future
o Impose regulations for min levels of info to be disclosed be pension providers
- 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)
Who are the main benefit providers: Employers
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
- desire to look after employees and dependents financially beyond level provided by State
- 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
Who are the main benefit providers: Individuals
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
Who are the main benefit providers: Financial institutions and other corporations
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
