Private pensions are in stasis. There are three straight-forward remedies — a trade body to represent employer-sponsored funds (EFs), one national regulator and an income solution without liabilities. Delay of public pension reform should not hold back reform of private pensions.

The two broad categories of private pensions in Pakistan are Voluntary Pension System (VPS) and EFs. The latter category includes provident funds (PFs), gratuity and superannuation funds.

The EFs are a regulatory orphan today as no government entity takes their full ownership. They have to deal with multiple authorities — provincial government under the new trust act, the Federal Board of Revenue for tax exemption and the Securities and Exchange Commission of Pakistan (SECP) for filing requirements.

The result is a Dickensian tale of two cities. Many large EFs follow global best practices. The ones sponsored by small private companies lie bruised and broken.

The VPS falls under the exclusive domain of the SECP. It is managed by Asset Management Companies (AMCs) whose representative body, ‘Mutual Fund Association of Pakistan (MUFAP)’, is great at advocacy. The regulator is deeply engaged and actively supportive. The VPS is well run with uniform standards.

Just as a mule cannot gallop no matter how well-fed and well trained, a flawed pension design cannot gain traction no matter how good are its regulations and fund managers

But here lurks the danger. The VPS is an individual account-based system and the EFs are pooled arrangements. A pooled arrangement is vastly superior to an individual account-based system. The regulatory abandon of the EFs and organised support of the VPS has led to a tax policy that penalises PFs and favours VPS. We are starving a horse and feeding a mule.

Individual accounts versus pooled arrangements

The purpose of pensions is to deliver lifetime income. This necessitates the use of structures that can maximise savings for workers and deliver a higher lifetime income to retirees.

Two questions follow naturally. Which structures have lower costs? Who should manage investment risks?

A pooled arrangement unbundles various services. It has significantly lower costs as trustees can outsource certain services and choose different vendors. A pooled fund is the preferred option for governments and employers globally. Assuming a neutral tax rate and a 35-year employment period, a PF can deliver 25 per cent higher savings than the VPS.

The trustees, who typically are among the most informed members of the workforce, manage investment risk or asset allocation in a pooled fund. They have skin in the game as their personal savings are part of the pool. They can avail the best investment expertise. Their collective decision making is unemotional, reflective and long-term.

Board supervision is easy. A review of one pooled fund means a review of each employee’s nest egg.

An individual account-based system is at the opposite spectrum. Each participant is free to choose asset allocation. The nexus between the trustees’ individual portfolio and employees’ savings is broken. As behavioural finance rightly predicts, the vast majority of participants fall victim to emotional blunders — fear and greed, overconfidence, market timing, recency bias, narrow framing etc.

Occasional investment seminars arranged by employers fall on deaf ears. The burden of managing nest-egg creates unhealthy distractions and lowers productivity. Board members have limited interest beyond compliance matters as they cannot influence an employee’s asset allocation.

The upshot is that the median savings in an account-based system will not just be lower but participants of the same age cohort and similar salary will have significantly different balances. Is that a desirable or a fair outcome? A lower accumulated balance means a lower income for life.

No surprise that the VPS is unpopular among employers. Just as a mule cannot gallop no matter how well-fed and well trained, a flawed pension design cannot gain traction no matter how good are its regulations and fund managers.

Chile is a great example of what can go wrong in an individual-account based system. After many decades, the system has delivered dismal savings, inadequate income, brought people to the streets, forced the government to allow the use of pension pot for current consumption and sown seeds of a bigger crisis. The results would be very different had Chile followed the Dutch model of employer-based funds.

The results of 401 (k), a similar but non-mandatory system managed by employers in America, have also been dismal for the vast majority of participants. But US citizens have a safety net called Social Security — a pooled system — which gathers all payroll taxes and delivers lifetime income.

Pension renaissance

The first step is to create a trade body to represent the EFs just like the MUFAP. Membership should be mandatory to avail tax benefits. It is farcical that the EFs currently have no forum to come together and communicate with the government. Financial institutions and their connected persons should not be allowed to become office bearers of this trade body.

The second priority should be to place the EFs and the VPS under the same regulatory ambit. This move will at once create regulatory neutrality and a holistic perspective in policymaking.

The single regulator will have every reason to build a broad and deep intellectual capital in behavioural finance, income solutions, profit versus non-profit pension models, implications of high cost and international failures and successes. Mastery of these topics is a prerequisite for providing a clear roadmap for supportive legislation and tax reform.

The EFs need regulatory support and oversight. They all must be made to operate under a custody arrangement to prevent deviant conduct of small companies. Tax credits to participants should not discriminate between the VPS and PFs. The leakages from the VPS and PFs are significantly draining our national pension pool and this must stop.

There is a risk. A newly created single regulator can over-reach and burden the already good EFs with unnecessary regulations instead of curing the malaise in smaller companies. But this is a risk we must take. A well-functioning trade body, trial and error and a self-correcting regulatory mindset will produce the pension Derby winners that our country so badly needs.

The third priority is to choose one mandatory structure for lifetime income. As outlined in these columns previously, modernised tontines are the best option for lifetime income in emerging markets like Pakistan. Tontines are easier to regulate. They do not create liabilities. They can be easily adapted to the Shariah rules. They deliver a higher payout than an annuity.

Local capital markets are not ready for annuity solutions. Fixed annuities are not possible without liquidity in 20-year to 30-year fixed coupon sovereign bonds. A menu of variable annuities will force unqualified individuals to make irreversible choices on different asset classes.

The low and negative interest rates in Japan since the 1980s and now prevalent in Europe and America should be a warning sign to any proponent of variable annuities.

Our government cannot and should not replicate the Social Security system of the US or public pension funds of Canada. Instead, it should move immediately to create a trade body for EFs, place all private pensions under one national regulator and legislate tontines for lifetime income.

A well-designed pension system can wrest back the financial freedom of our country in thirty to forty years and deliver a dignified retirement to our future generations.

Continuation of the status quo will keep us in the beggar zone forever.

The writer is the CEO of Magnus Investment Advisors Ltd.

Published in Dawn, The Business and Finance Weekly, December 6th, 2021