1 Voluntary Pension System Its Development, Structure & Prospects Nasim Beg 11 th August 2005

2 Pensions in Pakistan The Background

3 Dependant on the next generation to provide for us Like most countries of the world, Pakistan has weak provisioning for pensions. We primarily depend on the next generation to provide for us during our retirement. Most governmental jobs are covered by unfunded pensions – current employees will be paid pensions by taxing the next generation. Some private sector employees and the organised sector labour are covered by funded pensions. Funds are primarily invested in government bonds, which will be repaid by the next generation. A very large section of the population has no pension provisioning – totally dependant on the joint family support system.

4 Pensions that exist are mostly inadequate Most government jobs entitle one to a pension linked to one’s last drawn salary but the salary does not necessarily reflect one’s true earnings – mostly salaries are low and are supplemented by benefits, which can include plots of land that help make up on the low salary. Thus the pension is a fraction of the true wage. Private sector pensions are better but applicable to a very few. Most employers require a minimum years of service to get pension rights. Only EOBI allows for portability of pension rights.

5 Employers worldwide want to get away from defined benefit plans Defined benefit pensions systems require employers to ensure availability of funds to meet the obligation. Many plans set up in Pakistan under a high real interest rate environment are now creating an additional burden on the employers. High market volatility makes the investment of pension funds even more burdensome. Employers would rather have defined contributions and let the employee carry the burden of the final benefit. In turn, the employee would get portability through the defined contributions system.

6 Tax Breaks Most pension regimes give varying degrees of tax breaks. Most pension savings and incomes in Pakistan are tax free. Some long-term savings which can be used towards retirement by individuals are entitled to tax deferral. Some savings towards annuity plans give tax rebates.

7 Pension Reforms in Pakistan Reforms have been considered on several fronts – funding of government pensions, allowing for portability, compulsory provisioning by all employers, proper regulatory authority, etc. There has been some discussion on a national pension scheme but many difficult issues have forced the government to initially concentrate on the Voluntary Pension System.

8 Development of the Voluntary Pension System

9 Initiated by the Finance Ministry The current Prime Minister (then Finance Minister) initiated the process soon after taking charge of the Finance Ministry. The SECP was given the assignment to develop a pension system. Several models were studied. The first proposal of 2002 recommended a mandatory system. This was not accepted by the Finance Ministry. The SECP then commenced work on a second proposal for a voluntary scheme.

10 Evolution of the Voluntary Pension System The SECP set up a committee in June 2003 consisting of persons from Industry, the Ministry of Finance and the SECP itself. The committee had several meetings and developed a broad proposal recommending a voluntary scheme, with a tax deferral structure. This was presented by the SECP to the then Finance Minister. Some additional research was conducted, including study of models in some emerging economies. The final draft was circulated and posted on SECP’s website and several meetings were held by the SECP with representatives of various financial institutions and members of the actuarial profession. The Voluntary Pension System Rules, 2005 were finally issued in January The SECP had continuous interaction with the CBR throughout. The Finance Bill 2005 has introduced several changes in the Income- tax law incorporating all the necessary features for an EET structure.

11 The Structure of the VPS

12 Main Features A self contributory pensions savings scheme open to all adult Pakistanis registered with the tax authorities, if not covered by other occupational pension schemes. Employers can also contribute. Certain limits on the maximum annual contributions with some catch-up provisioning for persons above 41 years age. Contributions to be invested in specially set up mutual funds, with flexibility of individualised asset allocation through individual accounts. Stringent requirements for licensing of pension fund managers under SECP regulation. Fee structure much lower that normal mutual funds. The individual can diversify savings (contributions) amongst more than one fund manager and can transfer the account to other fund managers. EET structure, i.e., tax rebated on contributions, investment income and gains accumulate tax-free, tax is paid at the stage pension is drawn.

13 The Legal Structure VPS Rules set up under the framework of the NBFC Rules, which in turn are issued under the Companies Ordinance, The VPS Rules allow for asset management companies and life insurance companies to be licensed by the SECP as Pension Fund Managers. Pension Fund itself is authorised by the SECP as a unit trust scheme and structured under the Trust Act. The Income Tax Act provides the tax breaks.

14 Structure of the Pension Fund Three sub-funds - equity, debt and money-market. Additional asset classes later. SECP mandated investment policy governing each asset class. Mandatory for each Fund Manager to offer a minimum of four pre-set asset allocation plans. Very Conservative plan with maximum 20% equity and Aggressive plan with maximum of 80% equity. Two additional plans (like life-cycle) may be offered by Fund Manager during first 5 years. Each sub-fund to announce NAV based prices daily. Management fee not to exceed 1.5% p.a. and Front Load 3% but no load on transfers. Funds will not distribute dividends but are totally exempt from tax.

15 Investment Limits & Restrictions Equity – Limits: 5% per company, 20% per sector. 1% per green-field, 5% total green-field. None in unlisted or PFM’s associated companies. Debt – Limits: at least 50% in government securities. Other debt range between 5% in any AA rated and 2.5% in BBB. Average duration of fund within 10 years. Money-market – Limits: GoP securities no limit; Others upto 20% (Minimum rating A-); Bank deposits no limit but 25% per bank. Average duration of fund not to exceed one year.

16 Participant’s Rights Tax rebate on contributions of upto 20% of income or Rs. 500,000 per year. Eligible persons investing under VPS (Participants) have right to save with one or more PFM. Right to transfer the account to some other manager/s once a year. No restriction if PFM is de-authorised. Select plan of choice within the offerings of each PFM. Select retirement age between 60 and 70 years. Cash out any time before retirement by paying tax. Draw 25% of fund at retirement tax-free (grey area). Opt for an annuity plan or income draw down plan at retirement. At age 75 funds left over must be invested in annuity plan. Receive account statements and financial statements.

17 Regulation SECP to license PFMs and authorise schemes. SECP shall measure performance against benchmarks. SECP may take corrective action. SECP will publish comparative performance each year. SECP can order Special audit. SECP can carry out inquiry/inspection. SECP can de-authorise manager and fund.

18 Prospects Wonderful opportunity for self-employed to build their own pension funds. Opportunity for employees not covered by occupational pensions to build their portable pension funds. Opportunity for corporate sector to supplement or replace provident funds with matching contributions to VPS for their employees. Opportunity for NRPs to build pension funds in Pakistan. Opportunity for individuals to build professionally managed portfolios, with optimal asset allocation. Example of asset allocation benefits: Rs. 1,000 invested each month and increased over time in line with salary growth (average 15% p.a.) over 30 years; Equities give Rs. 34 million; DSCs Rs. 24 million. Please note that DSCs no longer giving old level of real returns and are now taxable. Opportunity for corporate sector and local governments to benefit from inflows into the market. Regular inflows will help market stability. Over time should overtake investment in NSS and replace the traditional retirement savings and long-service plans of the corporate sector.

19 Thank you Questions welcome