Pension Schemes
A pension is a fixed sum to be paid regularly to a person, typically following retirement from service. There are many different types of pensions, including defined benefit plans, defined contribution plans, as well as several others. Pensions should not be confused with severance pay; the former is paid in regular installments, while the latter is paid in one lump sum.
The terms retirement plan and superannuation refer to a pension granted upon retirement of the individual. Retirement plans may be set up by employers, insurance companies, the government or other institutions.
A pension created by an employer for the benefit of an employee is commonly referred to as an occupational or employer pension.
Occupational pensions are a form of deferred compensation, usually advantageous to employee and employer for tax reasons. Many pensions also contain an additional insurance aspect, since they often will pay benefits to survivors or disabled beneficiaries.
Occupational Pension Schemes
An occupational pension scheme is an arrangement under which an employer provides pensions for employees when they retire, income for the families of members who die, and deferred benefits to members who leave. A ‘group scheme’ is the typical scheme which provides for a number of employees.
The reasons for having a worthwhile pension scheme are that it: demonstrates that the organization is a good employer; attracts and retains high-quality people by helping to maintain competitive levels of total remuneration; and indicates that the organization is concerned about the long-term interests of its employees.
Occupational pension schemes are administered by trusts which are supposed to be outside the employer’s control. The trustees are responsible for the pension fund from which pension benefits are paid. The pension fund is fed by contributions from employers and usually (but not always) employees.
The size of the fund and its capacity to meet future commitments depend both on the size of contributions and on the income the trustees can generate. They do this by investing fund money with the help of advisers in stocks, shares and other securities, or through an insurance company. In the latter case, insurance companies offer either a managed fund (a pool of money managed by the insurance company for a number of clients) or a segregated fund which is managed for a single client.
An occupational scheme in which employees as well as employers make contributions is called a contributory scheme. Pensionable earnings are total earnings from which may be excluded such payments as overtime or special bonuses.
The level of contributions varies considerably, although in a typical contributory scheme, employees would be likely to contribute about five per cent of their earnings and employers would contribute approximately twice that amount.
A scheme that has been approved by the ministry of finance is called an approved scheme and Members of such a scheme and their employers obtain full tax relief on their contributions. The company also recovers tax on its contributions and the income tax deductible.
Pension Industry in Kenya
The Pensions Act, Cap 189 (Revised 2009), provides for the granting and regulating of pensions, gratuities and other allowances in respect of the public service of officers under the Government of Kenya. In addition there are private retirement benefits schemes governed by the Retirement Benefits Act, 1997(Revised 2010) through which private employers and their employees as members make contributions towards retirement.
A Retirement Benefits Authority was established for the regulation, supervision and promotion of retirement benefits schemes, which have been largely taken up by formal employers and workers.
In case of formal workers, the rules provide that on the death of a member the lump-sum benefits payable from the scheme shall be paid to the nominated beneficiary, and if the deceased member has not named a beneficiary then the trustees shall exercise their discretion in the distribution of the benefits to the dependants of the deceased member.
The retirement benefits industry in Kenya is composed of the civil service scheme, the National Social Security Fund (NSSF), occupational schemes and the individual pension schemes. The coverage of the pension schemes is currently estimated at less than 15% of the total labour force.
The NSSF has the highest proportion of membership at 67% with estimated membership of 800,000 followed by the civil service pension scheme at 22%.
The occupational retirement benefits schemes and individual retirement benefits schemes, which are currently about 1350, account for about 11% of total scheme membership in the country.
Prior to 1997, the retirement benefits industry was unregulated with the only regulations governing the sector being those in the Income Tax Act and Trust Laws which were very broad.
Some of the problems that faced the pension industry which led to the enactment of the Retirement Benefits Act in 1997 include:
- Mismanagement of schemes’ funds;
- Schemes were not adequately funded;
- Arbitrary investment of funds without independent professional advice;
- Records and books were not well kept;
- Lack of protection of the interests of members and dominance of sponsors (employers) in scheme affairs and many schemes were run through insurance companies that tended to operate in a non-transparent manner.
Hence many investment decisions were made in the best interest of vested parties and not in the interest of members or of the economy as a whole.
Provident Fund
Employee Provident Fund (EPF) is an employee benefit scheme generally prescribed by a statutory body of the government which provides facilities to the employees of an organization with regard to medical assistance, retirement, education of children, insurance support and housing.
Provident fund means a scheme for the payment of lump sums and other similar benefits to employees when they leave employment or to the dependants of employees on the death of those employees, while in a pension fund a proportion of the retirement fund is paid as lump sum at retirement and the remainder paid out as periodical payments.
Provident fund vary by country, but in general their purpose is to provide financial support for those who meet the plan’s defined retirement age. Governments set the age limit at which withdrawals are allowed to begin (penalty-free), though some pre-retirement withdrawals may be allowed under special circumstances, such as for medical emergencies.
If a worker dies before receiving benefits, his or her surviving spouse and children may be able to receive survivors’ benefits from the provident fund. Some countries also allow individuals to receive an early payout if they immigrate to another country. Those who work past the minimum retirement age may face restricted withdrawals until full retirement.
Types of Schemes
Retirement Benefit Scheme can be classified into: Defined Contribution and Defined Benefit schemes.
Defined Contribution Schemes
Defined contribution Schemes are arrangements where the retirement benefit is not known or defined in advance. Rather the level of retirement income receivable on pay-out date is related to the: level of contributions made over the accumulation period; the charges deducted by the product provider; the investment returns of the fund during the accumulation phase; and the annuity rates at retirement.
Members’ and employers’ contributions are fixed either as a percentage of pensionable earnings or as a shilling amount, and a member’s retirement benefits has a value equal to those contributions, net of expenses accumulated in an individual account with investment return and any surpluses or deficits as determined by the trustees of the scheme.
Defined Benefit Schemes
A defined benefit (DB) Scheme is an arrangement where the benefits, which are ordinarily determined by the scheme rules, are defined in advance. Benefits are often related to the final salary and/or years of service of the employee. The main risk for beneficiaries is the solvency of the employer so as to be in a position to meet the promised benefits. Hybrid Schemes seek to combine features of DB and DC schemes in some way and can take a variety of forms. For purposes of categorization, hybrid schemes are DB schemes because of the promises they make to members.
Individual Retirement Benefits Schemes (IRBS) in Kenya
IRBS also known as Personal Pensions Plans (PPPs) are recognized independent legal entities established for the sole purpose of operating a retirement savings fund. Regardless of the sponsor, the assets of the IRBS are kept separate from the assets of the sponsors usually under the name of the scheme. The scheme has to be registered with the Retirements Benefits Authority and must constitute a Trust and Deed as the legal structure upon which the scheme is governed. The provisions of the Trust Deed and Rules must necessarily comply with the Retirement Benefits Act provisions. The scheme must appoint trustees who are fully liable and accountable to all matters regarding the scheme.
IRBS are open to the general public regardless of employment or income affiliations and have a wide geographical branch network for easy accessibility. IRBS are however most convenient for all those willing to save for their retirement and have limited access to any other scheme.
These include, workers in companies where the employer fail to set up an occupational scheme; very small companies where setting up an occupational scheme is not viable; self-employed professionals including lawyers, architects, doctors and accountants; business people and the informal sector; and, anyone who needs to make additional savings for their retirement.
Employers who are unable to start their own schemes are encouraged to enjoin their employees as a group to own preferred scheme and also make contributions on behalf of their employees. The employers will be required to periodically remit the contributions collectively for all members to the plan.
In 2003, the government harmonized the IRBS terms with those of occupational schemes. Upon registration with the Kenya Revenue Authority (KRA), members enjoy a tax exempted lump-sum benefits payout on exit of Kshs 48,000 per year of savings for a maximum of ten years; tax deductible contributions up to the given limit of Kshs 17,500 at that time, which has since then gone up to Kshs 20,000, and investment returns tax exempted.
Factors That Influence Participation in Personal Pension Plans
A number of factors come into play in influencing participation by individuals in Pension schemes. These include: Age, educational background, occupation, gender, number of children, marital status, homeownership, individual expectations of future financial position.
In addition, there are other factors such as pension education, alternative investments, government policies and existence of employer based occupational schemes, some of which are discussed below.
The young cohorts purchase personal pensions to take advantage of compound interest effect which increases the financial value of contributions. The necessity to keep old age savings for financial security in retirement becomes more vivid as individuals grow old.
Individuals and households with a higher propensity to save and keep other forms of saving have a higher propensity to make additional voluntary contributions for retirement. Such individuals generally start saving at an earlier age enabling them accumulate more assets. Individuals with no pension savings are most likely not to have other forms of savings.
Individuals with higher incomes and financial assets besides having the capacity to save place a higher discount factor for the future and would therefore save for retirement.
Low income earners have a low capacity to save and low discount factor for the future. They would place higher present value for consumption.
Married households are more likely to save than singles as a way of building up assets.
Saving practices rise with educational attainment. The more educated the individual the more appreciative of role of saving for retirement.
Education attainment is specific to saving for retirement because the more educated individuals the more appreciative and the more their understanding on importance of keeping savings for retirement.
Education campaign is a communication that seeks to influence behavior. The benefits of saving for retirement as a wise choice, if well-articulated, have positive outcomes in retirement savings. A few hours of general pension education increases the tendency to save a lot, although the effects diminish or reverse with time.
Personal pensions are affordable alternative options for employers to enjoin their employees to the retirement benefits schemes, when employers are unable to set up occupational schemes for their employees. Employees caught up in such a predicaments can then save for their retirement benefits. On the other hand, employers provided pension schemes act as disincentive to individuals to make voluntary contributions to pensions.
Government policies influence participation in personal pensions. Favourable policies attract greater participation and unfavourable policies tend to discourage participation. When returns on pensions are lower than alternative investments, members are motivated to evade contributions or altogether withdraw from membership.
A low rate of return on a defined contribution scheme in comparison to what the worker could have earned acts as a hidden tax that workers seek to evade. Fixed expenses charged against individual accounts, or high administration expenses are factors that cause the low rate of return to arise. Because of the better rate of return elsewhere individuals opt to save in alternative ways.
Advantages of Pension Plans
Portability of Benefits
Pensions are defined contribution based which favours easy portability of benefits whenever members change jobs without loss in benefit value.
Tax efficient way of saving
Pensions offer a tax efficient way of saving for retirement. Because pension savings are long term in nature, governments provide fiscal incentives to attract savers. Commonly, governments directly exempt savings in the pensions and investment incomes from taxation. In some instances for every given amount of savings with the pension the Government tops up or matches by a given percentage of the contribution.
Contributions to National Savings
Debate on whether promotion of voluntary savings to pensions enhances new savings or crowd out personal savings has been ongoing. It is deduced that because pension savings enjoy favourable tax treatment, personal pensions increase the net return to saving. However, income-substitution determines the net effect on savings. Whereas the favourable tax application for pension savings acts as an attraction for individuals to save more pension savings, to the extent of substituting other savings.
Disadvantages of Personal Pension Plans
When the costs of maintaining a persona pension account is fixed, not varying by the amount in the account, then they end up penalizing low income workers in terms of charges for expenses.
Low income workers with small accounts generally bear higher charges relative to their account balances than high income workers. This causes the net rate of return on pension’s accounts to be higher for large accounts. This is made worse when charges are waived for large account balances or the fee diminishes as a percentage of the account balance as the account balance grows.
Where charges on pensions are on a continuous basis, the low income workers are again disadvantaged. Lower income workers are more likely to be in the labor force intermittently and they are more likely to be at times unemployed. Charging this group of individuals for periods when they genuinely are not financially capable of making their regular contributions is by itself retrogressive.
In cases where members of members move in and out of the formal sector, eventually returning to rural areas, because of lack of knowledge as to how to claim benefits or because of difficulty in claiming benefits, many never claim benefits to which they are eligible.
Choosing a Personal Pension Plan
Since Individual Retirement Benefits Schemes (personal pension plans) are private in nature and many in existence, it is necessary for individuals to shop around for the one that best suits their needs. When choosing a personal pension plan, individuals compare schemes by considering the following:
- personal circumstances and plans for the future
- the reputation of the company directors and shareholders,
- technical capacity of the provider
- Customer care and Services e.g. do they offer personalised services record keeping
- Past results taking note that past performance does not guarantee future success.
- what were the causes of failure if any administrative costs
- penalties and charges imposed when one is not able to make regular contributions due to, for example, loss of employment, illness or career break
- contribution payments – whether regular amount of contributions are to be paid for a given number of years or one has the flexibility to change the amount and whether it is at a cost
- whether one can participate in selecting investments of the funds
- extras such as educational programs, annual general meeting
