Over the past decade, the number of employers running occupational pension schemes on a defined benefit (DB) basis have reduced significantly across the world.
More employers are increasingly opting for defined contribution (DC) schemes.
In my previous articles, I explored the two types of schemes in detail. Today I will focus on implications of this shift to our economy.
As I have earlier explained, the key difference between a DB and a DC scheme lies in who bears the risk. In DB schemes the employer bears the risks.
The employer guarantees a defined amount of lifetime income at retirement to members and is solely responsible for realising this promise.
The risk that the scheme’s investments don’t perform well is taken on by the employer.
Other risks, such as rising life expectancy, have led to growing concerns that employers may be required to increasingly divert resources to fund the costs of the promised benefits.
In DC Schemes, the member bears risks. Both the employer and the member make a defined amount of contribution to the scheme, with the contributions credited to each member’s account and invested on the member’s behalf to generate income.
The account forms retirement benefits and the amount is expected to last throughout retirement.
The risk of poor investment returns is borne by members as the employer has no further obligation to the scheme and the member.
Risk aversion by employers
That the employer accepts an unknown cost commitment in setting up a DB is a deterrent to employers who would rather shift the risk of providing adequate retirement benefits to staff.
The current generation continues to retire and live longer than previous generations making DB schemes increasingly expensive to fund as additional contributions must be made to provide the promised benefit.
The rising life expectancy reduces companies’ profitability because of the higher costs of benefits.
Regulation: Strict funding and solvency requirements have led to increased complexity in the management of DB schemes.
The complexity also increases the cost of running DB schemes.
New economy: Today’s mobile workforce makes DB schemes a less effective way of saving for retirement.
Research shows that today’s worker will, on average, changes employers 10 times in their lifetime. DB schemes reward long service. DC schemes are hence more suited to this generation which requires more flexibility and demands more control over asset allocation.
Market trends: In the spirit of keeping up with global competition, employers are increasingly offering DC schemes whose simplicity is an added advantage to both the member and the employer.
More employee participation: Members are involved in how much they can contribute and therefore have greater potential to grow their retirement benefits. Members may have a say in where assets of the scheme can be invested according to their needs.
However, there is a downside to this shift which raises the question of how well prepared we are for retirement.
Procrastination often results in members ignoring retirement planning until it is too late.
Unpredictable retirement benefits: In our previous discussions we established that DB schemes provide better predictability to members than DC schemes.
Given that DB schemes may be phased out in a couple of years, this shift suggests that members of the new economy will retire with more uncertainty over benefits.
This points to the need for careful planning and monitoring to track one’s progress against their savings targets.
Also, as life expectancy continues to rise, the cost of providing a lifetime pension will continue to increase.
To put this in context, if an insurance company is willing to provide a 60-year-old with a lifetime pension of Sh1 million per year at a cost of Sh10 million lump sum premium, the cost of providing the same annuity will increase over time as people continue to live longer.
Millennials may be called upon to lean heavily on their savings and enterprises to diversify their income sources to ensure an adequate retirement income.
We recognise, however, that this generation embraces a spending culture rather than one of saving. But do they have the tools and know-how to save through proper channels?
Whether young or old, it is important to be financially literate to understand retirement savings. Here are some tips to keep you on the right track.
Start early by contributing more through additional voluntary contributions; do not rely solely on the contributions that the company is making on your behalf.
Save as much as possible by taking advantage of the contributions that the employer is making on your behalf.
Get information on the right tools and proper channels through which you can save for your retirement.
There are many questions that we need to ask ourselves as individuals, regulators or policy makers.
Retirees fall into the category of the Vision 2030 pillar which aims to improve the quality of life for all Kenyans, hence we should ensure that adequate preparation is made ahead of the period. Are we embracing the shift in ways that enable us to retire comfortably?
Adil Suleman is Head of Actuarial Division at Zamara. Email: [email protected]