Chapter 5

Question 1

What are the key features of pension contracts?

Answer 1

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

Question 2

How can scheme members be divided?

Answer 2

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

Question 3

What are the main types of pension schemes?

Answer 3

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

Question 4

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

Answer 4

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

Question 5

How are these pension schemes paid for?

Answer 5

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

Question 6

How are the contributions set?

Answer 6

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

Question 7

Who are the main benefit providers?

Answer 7

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

Question 8

Who are the main benefit providers: The State

Answer 8

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

2. 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

3. 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

4. Educate about importance of providing for future

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

5. 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)

Question 9

Who are the main benefit providers: Employers

Answer 9

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

3. desire to look after employees and dependents financially beyond level provided by State
4. 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

Question 10

Who are the main benefit providers: Individuals

Answer 10

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

Question 11

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

Answer 11

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