Personal Finance

How the defined retirement scheme works in Kenya

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Contributions made by members lower their taxable income thereby enabling tax savings. file photo | nmg

This is the third part of my series of articles on the retirement benefit sector in Kenya. In the first part, I focused on how retirement schemes are structured in Kenya and how the structure helps to protect members and reduce risk of mismanagement.

The second article covered the various types of retirement schemes offered in Kenya and the ways they can be classified. I ended by explaining that most schemes are structured as either Defined Contribution (DC) or Defined Benefit (DB) scheme. In this article, we will start to explore the differences between DB and DC schemes.

To understand the key difference between how a DB and a DC scheme operates, you simply have to look at the name. In a defined contribution scheme the required contributions are defined in the rules of the scheme.

The scheme’s Trust Deed and Rules — the legal document governing the scheme’s operations — states the contributions that must be made by both the sponsor and the member, typically defined as a percentage of the member’s pensionable salary.

On the other hand, in a defined benefit scheme it is the benefit that is defined in the rules of the scheme, not the required contributions. In a DB scheme, the rules will spell out the formula which is used to determine a member’s benefit at retirement or earlier exit from the scheme.

This formula is typically a function of the pensionable service and the pensionable salary of the member at their time of exit. There is no magical secret to how schemes operate and all schemes must follow a basic principle: what goes into the scheme (contributions and investment income) must equal what comes out of the scheme (benefits and expenses). In the case of the DC scheme, the contributions going into the scheme are defined.

In the case of a DB scheme, the benefits coming out of the scheme are defined.

Let’s now take a deeper look at DC schemes and how they work. As explained, a DC scheme requires the employer (sponsor) and the employee (member) to remit a defined amount of contribution to the scheme each month.

READ: Why it’s critical to start retirement planning early

The contributions are credited to each specific member’s account and all the scheme’s assets are invested by the trustees to generate income. Based on the income earned each year, the trustees will declare interest which is credited to the member’s account.

Effectively, this is like a notional savings account into which a member’s contributions are deposited and interest is also credited depending on the performance of the investment.

Over the working life of the employee, their account grows with new contributions each month and potentially with interest. When the member eventually retires, the retirement benefit will be dependent on:

i) Level of contributions,

ii) Net investment returns; and

iii) Annuity factors (the rates offered by insurance companies for converting your lump sum member account into a monthly pension).

The first two factors will affect the size of the member’s account at the time of retirement; the third factor affects how much the member account is worth in terms of the cost of buying retirement income in the form of a monthly pension.

For example, the DC rules may require the employer and the employee to each contribute five per cent of the employee’s monthly basic salary. Each month, a total of 10 per cent of basic salary would be contributed to the scheme and credited to the member’s account.

However, members have the freedom to contribute more than the defined rate. A member may decide to contribute seven per cent of their salary instead of five per cent. This additional two per cent is referred to as an Additional Voluntary Contribution (AVC).

The net annual investment returns earned on the scheme’s investments will be reflected in the interest declared by the scheme trustees each year. The interest declared is credited to each member account. The investment returns will depend on the types of investments in the scheme and the amount of risk undertaken.

In times of poor performance, trustees may declare a negative rate of interest. The income at retirement that the member is entitled to depends entirely on the total accumulated benefits in the member’s account which is used to buy or provide a monthly income through retirement.

It is important to note that it is not possible for a member to know in advance what monthly retirement income they will receive. Although members know the size of their account at any given time, this is a lump sum figure.

How much the lump sum is worth, in terms of a monthly income, will depend on investment conditions and the cost of purchasing an annuity at the time of retirement. Nevertheless, projections can be made to get an estimate of the likely level of benefits based on the assumptions made.

This type of arrangement has its advantages, including:

Control. Members can decide how much they want to set aside for their retirement through additional voluntary contributions. Although rare in Kenya, in some DC schemes members can also choose the type of investments they wish to have based on their own risk appetite and unique circumstances;

Flexibility. There is more flexibility in the form in which a member may take a benefit. For example, a retiring member can choose the type of pension annuity including the level of increases and attaching benefits for their spouses and children;

Early Leaver Benefits. These benefits in a DC scheme are typically higher than those in a DB scheme which typically focuses on rewarding long service;

Simplicity & Transparency.

DC schemes are felt to be simpler and more straightforward, making them easier to understand and communicate compared to the more complex DB schemes;
Tax Benefits. Contributions made by the members lower their taxable income, enabling tax savings.

However, there are some risks involved such as:

1 . Inadequate retirement benefits. Members may realise too late that their total accumulated funds at retirement are insufficient to allow them to live a comfortable life in retirement. Additionally, members do not have a target retirement income and hence have no idea how much more to contribute now to achieve that target.

2. Investment risk. Members are exposed to the risk of the investments of the scheme underperforming. Also, the returns each year are uncertain. In a DC scheme, the sponsor’s obligation is limited to making the required contribution each month and the investment performance of the scheme directly affects the member (because the investment performance will directly affect the size of the member account).

Adil Suleman is Head of Actuarial Division at Zamara.