Employees will need to consider their retirement plans from an early age as the local pension industry is moving increasingly away from defined benefit obligation (DB) schemes towards defined contribution (DC) schemes.
STEPS, the largest pension fund in Guyana with over $5.6B in pension funds, is also considering such a switch to achieve certainty of cost, head of its management committee, Michael Knight confirms. STEPS covers pension funds for a number of businesses including the Guyana Sugar Corporation and Demerara Distillers Limited.
"The rationale behind the proposed change from defined benefit to defined contribution is not to reduce cost, although that may be a result, but to achieve certainty of cost," Knight told Stabroek Business recently. He said it is the same logic behind hedging or forward selling Guysuco's Euro receivables, which is not to achieve a better exchange rate, although that may be a result, but to secure a budget exchange rate and certainty.
Under a DB scheme, the employer bears the risk associated with any shortfall in the fund to meet the pensionable payout to employees at retirement. But in the DC scheme, employees face the exposure.
In the DB scheme, pensions are typically linked to the length of service and the level of salaries a retiree would have earned in the last three years of employment. Because of the potential of salaries rising faster than investment returns, there is an associated risk that employers (sponsors) would have to finance a deficit in the pension fund.
Michael Knight
On the other hand, in the DC scheme, the pension an employee would receive would not be based on any previous year salary but rather on the value of his/her fund (which comprises his/her and the employer's contribution plus returns accruing) at the time of retirement. This means that a pensioner could be worse off if the investment returns were poor.
A Guyana National Co-operative Bank (GNCB) Trust official argues that if an employee wants a higher pension, he/she would have to increase the contributions to his/her account to allow for this.
However, actuary, Patrick van Beek is concerned that defined benefit schemes will be discontinued and replaced with poorly designed defined contribution schemes which fail to provide a level of benefits similar to those the previous scheme would have offered.
He notes that if investment returns continue to fall, this will be reflected in the returns an employee will get under the defined contribution scheme. He also notes the restriction on pension funds from investing abroad really does not help the situation. Section 112 of the Insurance Act of 1998 allows a maximum investment overseas of 20% plus an additional 10% for each percentage point invested in common stock or long-term debt of companies in Guyana. Hence pension plans may invest between 20% and 30% overseas but there is a misconception that the limit is 10%.
"My fear is with investment returns falling and employers no longer willing to bear the majority of the costs of retirement benefit provision, including a large DB scheme deficit or the risk of one arising, the ultimate benefit of people when they retire could be much less than would be required for a suitable standard of living at that time," van Beek says.
But the GNCB Trust, which manages $9B in pension resources out of a total of $14.54B or 61% of the pension funds, says Bacon, Woodrow and DeSouza, a Trinidadian firm, is advising it on the defined contribution schemes to be implemented by its clients in Guyana and will cover safeguards so that the pensionable income does not fall too low. In the UK, there is a guarantee limit price indexation of a 5% increase a year on the annuity purchased to secure a pension. The employee pays for the indexation guarantee on the annuity through a reduction in the level of income.
According to Maria van Beek, Commissioner of Insurance, there is a split in the number of applications for pension registration with almost half of these for defined benefit schemes and half for defined contribution schemes. She has noticed that several companies have recently switched or indicated an intention to switch from DB to DC. She says, "Like any changes to contractual benefits, changes to pension benefits need to be done in a well thought out manner. Sponsors need to be clear on the objective(s) for making a change to benefits - usually to reduce cost or to improve benefits. If a change is to be made, an important consideration is equity, i.e. fair treatment to all members. Changes to pension benefits are often quite difficult given the complexity of the benefits and usually the advice of technical advisors such as an actuary is necessary.
"One concern employers and trustees must have if the process isn't done in accordance with the trust deed or without thorough consultation is the possibility of being taken to court by members of the plan who may not have been fairly treated. It is therefore important, especially in such a fundamental change as switching from DB to DC, that the correct steps are taken to ensure existing members are not any worse off after the switch and that they are kept informed at all," the Commissioner said.
The Insurance Act 1998 covers the regulation of occupational pension plans. All pension plans are required to be registered with the Commissioner of Insurance as well as any changes to pension plan benefits or the trust deed. The Commissioner adds that the absence of a Trust Act makes the operation and regulation of pension plans much more difficult since case law provides the main legislative framework for settlement of pension litigation. However trustees still have a fiduciary duty to the beneficiaries of the trust and should ensure that changes such as switching from DB to DC are in accordance with the trust deed and that beneficiaries are fairly treated.
The industry
As at June 2003, total pension funds stood at $14.54B. Of this $4B was held in deposits in the banking system, $1.8B in government securities, $5.4B in equity in the private sector, $1.3B in other instruments and $1.8B invested abroad. There is a marginal $60M in mortgage loans.
STEPS pension funds stood at $5.6B and the Bauxite Industry Pension Plan $2.6B, a total of 56% of total pension resources.
However, the investment mix of most of the industry's asset is very conservative as can be seen from the figures above. Though pension funds by virtue of their size in the banking sector will attract more attractive rates, these have seen declining incomes in the last few years. Cash is not considered a real asset, as there are no guarantees that its returns will meet the salary increases associated with DB schemes.
However, GNCB Trust says its investments had been earning beyond the actuarial determined rate of return of 7% up to 2000 but this has dropped to 5% since then because of the prevailing economic circumstances.
As a result, pension trustees are lobbying the Minister of Finance to have the restriction on overseas investments waived and for the limit to be increased. Among supporters of this lobby are Trust Company Guyana Limited and GNCB Trust.
The restriction had been imposed when Guyana was experiencing serious balance of payment difficulties and exchange rate difficulties. Trinidad has a limit of 25%.
"When you have a local constraint such as a limit on investments abroad in the case of a DB scheme, you need high yielding instruments which are not available," the GNCB official stressed.
Because pension plans have short and long termed liabilities, it requires an investment mix which reflects both income generation and capital appreciation. The GNCB official says exposure is limited to three per cent of any fund value in the case of equity investment in Guyana. And the investment in foreign government bonds and US dominated investments provide a good hedge against capital depreciation.
But the GNCB Trust official notes the dire need in Guyana for a bond market and argues that the government Treasury bill ought to be discounted to start the process. He said there is need for an active capital market and supporting institutional framework for a bond market to flourish.
Rationale for the switch to DC schemes
According to GNCB Trust, no existing pension plan has made a formal decision to switch from a DB to a DC scheme - at least none of the plans under its trusteeship.
"A decision has not been made but the matter is being examined. Employers need to reduce employment costs of which pension plans contributions are an integral part," the official said, noting that with international accounting standards, if a pension plan has a deficit, it has to be duly recorded on the balance sheet of a company.
The factors pushing the switch, the official says, are the reality of globalisation and the need for companies to become more competitive, as well as the need to enhance shareholder value. The official notes that salary increases are granted far in excess of yields and with lower investment returns locally this will result in deficits to the DB scheme, which an employer will have to finance.
From the employee perspective, the official notes that the workforce is declining and the current force is expected to carry the cost of those who may have retired 20 or 25 years ago.
Knight says Guysuco is committed to providing a suitable level of pension to its staff but has to strike a balance between cost and benefit. "Under a DB scheme, the corporation is obligated to contribute to the pension plan whatever amount is necessary to ensure that each retiree will receive the defined benefit i.e. the level of pension defined in the scheme rules. In times of low investment returns, both within Guyana and internationally, such as we have seen in recent years, this means the corporation has to increase contributions. The trend looks set to continue," Knight says.
But this is a worldwide phenomenon, says Knight, pointing out that both in the US and UK many companies have switched from DB to DC schemes. He also notes that two rating agencies recently cut General Motors debt rating owing to concerns over its substantial pension obligations and that company had to raise US$10B in debt to refinance its pension plans. He adds that many European governments have found it necessary to undertake pension reform.
"In an era when Guysuco's preferential markets are under threat, cost control is vital. We cannot be in a position where a significant feature of our largest cost, employment cost, is not under control. The corporation remains committed to providing a suitable level of pension to staff but must strike a balance between cost and benefit," says Knight.
The National Bank for Industry and Commerce Limited (NBIC), which has to finance a pension fund deficit, is not considering such a switch, however. Its managing director, Michael Archibald says employees would be better off with the DB scheme as their benefits are more certain.
The Bank, he says, is picking up the deficit and unless this gets out of hand, it would not be a worrying issue for the bank. He said while the yields may not be as good as one would like, the alternative is to seek better investment opportunities.
"It has been a conscious decision to fund the deficit to ensure that employees get defined benefits and it is from a desire to ensure staff members get better benefits at the end of the day," Archibald said. And as his credit director, John Alves puts it; the employees are the best assets of any organisation at the end of the day.
The mechanics of the DC schemes
But there already exist a number of DC schemes in Guyana. According to Chandra Gajraj, head of Trust Company Guyana Limited, which manages some $2B in pension resources, most of the schemes under her purview are defined contribution schemes and have been so from their inception.
As to the investment returns on the scheme under Trust Company portfolio, Gajraj says while these have declined "a bit", the diversified portfolio held cushioned the effects and the actuarial results are very healthy.
In the event of the switch, a number of options are available to employees. That is, the DB scheme can be continued and a new scheme started for new employees, or the DB scheme can be discontinued and the funds divided and transferred into separate accounts for each employee.
In a DC scheme, each employee has a separate account and contributions are paid into this account and accumulate with investment return earned on that account, less any expenses. The final benefits to an employee will depend on the account balance and the terms of securing pensions at retirement.
The GNCB official says that at retirement, retirees can use their pension funds and buy annuities or make other forms of investment, absolving the employer from the responsibility of funding a pension.
Annuities are products sold by insurance companies which retirees can swap their pension funds for. The retirees would then be paid a pension by the insurance company at the agreed rate (annuity rate). It is possible that a retiree can die before he/she receives the full benefits of the pension swap.
And if the pensionable payout under the DC scheme is inadequate, the GNCB Trust official says that employees will have to upplement that income with personal pen/.sion .
"During the life of active employment, an employee can request information from a trustee with regard to the projected pension retirement income. Having analysed that information, the member can decide to supplement that benefit either by additional voluntary contributions (AVCs) or purchasing an investment annuity linked policy plan with an insurance company to ensure the adequacy of his retirement benefit," says the GNCB Trust official.
But while the DC scheme brings increased risks associated with investment returns, it is also seen as a good measure for employees with career breaks and changes. It is also seen as being more attractive to employees because of the ownership of the account and an opportunity for employers to reduce cost and transfer the risk associated with pension schemes.
That is, if an employee has five years membership in a pension scheme, he/she is considered vested and has the right to opt for deferred pension if he/she should leave the employment before retirement.
Under DB schemes, employee contributes 5% of their salaries and the employer 12% but in DC schemes, this is expected to be 5% and 7% respectively. It is clear from this that the pension payable under the DC scheme will be lower than the DB scheme.
Insurance companies also administer a number of depo-sit administration schemes while a number of companies administer their own pension schemes.
According to the GNCB Trust official, a number of models are being contemplated for the DC scheme, which can be tailored to suit the needs of the sponsoring companies.
How to plan for your future
According to the GNCB trust official, employees have to start planning for their retirement at an early age to ensure that at retirement, their standard of living do not deteriorate. They would need to employ an investment strategy to maximize their returns.
The official says in the first ten years of a persons working life, he/she should seek to acquire assets, term insurance, immovable property, shares and other forms of investments. After the first 10 years, he/she should look at what expenses they are likely to have at retirement and then opt to buy annuities or invest in more shares.
"The necessity arises for an employee to ensure that there is effective and proper financial planning for his or her retirement which should commence from the first day of employment," says the trustee.
A model developed by GNCB Trust on the essentials for financial management and estate planning sets as the first step the identification of goals be it early retirement, the acquisition of wealth or the financing or one's children university education without scholarship.
Because of the lack of treasury inflation protection securities locally, GNCB Trust advices on an investment mix that will provide a cushion against inflation and allow for higher returns but an awareness of the greater risk involved.
In the first stage, GNCB advises on the accumulation of assets by saving a percentage of one's salary (30%) and purchasing insurance policies in the form of annuities and term plans for protection coupled with the purchase of shares and bonds.
Having accumulated savings, one is then advised to acquire immovable property by way of mortgage and to ensure that there is a mortgage protection plan for the indebtedness to be settled should the principal income earner die before its redemption.
In the second stage, persons are advised to use the equity in a property to finance investments, which should have a mix of income generation and capital appreciation such as real estate, stocks, bonds and annuities. The Trust says subscription to mutual funds can reduce the exposure to risks.
After the second stage, one would have to start implementing a retirement plan to ensure that a reasonable standard of living can be enjoyed for at least 10 years after retirement.
GNCB trust recommends that an analysis of one's projected pension benefit be made on retirement to determine the extent of the need to supplement the pension. And if the need arises for the pension to be supplemented, then one should subscribe to a personal retirement plan to ensure a stead income stream after retirement.
After retirement, GNCB Trust says a person needs to review his/her income every two years to determine whether there is the need to covert some of his assets into cash to ensure a comfortable retirement.
Additional, it is advised that persons review their assets to ensure they are properly distribution upon death by making a will with the beneficiaries named.