Widening the net in Pakistan

The most discussed issue in Pakistan's pension market is the recently launched Voluntary Pensions System (VPS), which is regulated by the government. It is only in an initial phase, however, and more established pension systems exist in the public and private sectors.

With the highest participation in the country's overall pension arena being attributable to the civil pension system, a high proportion of non-government employees and the unemployed are not covered by any pension scheme. Not all of these individuals need recourse to social security; but a large majority of them do.

Possibly the natural way to encourage retirement pensions was the establishment of an effective state pension scheme. The thought initially may have been to cater for pensions to the working population rather than as an overall social security system for the country. This may have been much too expensive and somewhat more difficult to administer. The civil pension system therefore evolved strongly and today covers all civil servants; whether or not the benefits are at a satisfactory net replacement ratio (NRR) is another question. Benefits from the armed forces' pensions are however at a much better NRR.

For the private sector, the government set out rules that each company must have a pension plan, through the employees old age benefit institution (EOBI) scheme and a gratuity or provident fund scheme (or both if it so wished). The pension scheme was facilitated by EOBI, a government institution, in which all private sector schemes were required to participate, given some eligibility conditions. The EOBI provides defined benefit pensions to all employees of participating firms based on the same benefit formula. The scheme is funded and a single contribution rate is charged to all employers.

The EOBI scheme was never fully implemented and very few employers participate in the EOBI pensions system. The trend is more towards setting up a provident fund and/or gratuity schemes. Employers are able to contribute to either of these schemes as a tax-deductible expense; investment income on these is tax free to a large extent and so are benefit payments. So it may be considered as an EEE structure within certain limits. Whether defined contribution or defined benefit, schemes paying out lump sums at retirement (like gratuity and provident funds) don't really solve the pension issue. This is because most of this lump sum is subject to abuse at the hands of the receiver, who may not realise its value in later years.

To accentuate the situation the annuity "market" in Pakistan is so poor as to be almost non-existent. Only a few insurance companies offer very conventional forms of annuities and pricing is not that competitive. The extreme of innovation in this area may be a joint life or last survivor level annuity; even if someone is able to negotiate an increasing annuity, he can't expect more than a predetermined fixed rate of increase. Index-linked or investment- linked annuities are unheard of. So although a very primitive product exists in one form or the other, we can't really call it a "market".

Asset management companies are not allowed by law to offer any product that envisages life or longevity risks - so this rules out the possibility of them entering this market. The only product they can bet on is some form of annuity certain. Insurance companies are not willing to take any initiative on development of the market as this business is absolutely negligible on their books, most of the time nil over a couple of years. As part of overall employee welfare, almost all companies do offer some sort of insurance benefits in the form of group insurance purchased from insurance companies.

As orthodox as it can get, the Civil Pensions System is a pay-as-you-go (PAYG) scheme, with the current pensions being financed by taxation of the current working population - the deficit being met by government in various ways. Private sector pension, gratuity and provident fund schemes were given a choice to be set as DB or DC. As we stand today, most of the private sector schemes are DB unfunded schemes; but there are all sorts of combinations available in the market, with a general trend of moving towards DC.

Like the rest of the world, Pakistan is also feeling the effects of low birth rates accompanied by greater longevity. The ratio of working population to retired population is decreasing steadily and the government feels the need to change its stance of continuing with an unfunded PAYG scheme. The first step to counter this was to introduce the voluntary pensions system (VPS) and monitor its progress in the private sector to see if it could later be possible to introduce the system nationwide.

The VPS structure was in the pipeline for almost a decade until the Securities and Exchange Commission of Pakistan issued a concrete piece of regulation, the VPS Rules 2005. There have been a few amendments to the original document and a lot more are expected as the system develops. Recently the regulator has also issued record keeping and advertisement/marketing guidelines. The system was initially meant to replicate Chile's voluntary pension system.

Arif Habib Investment Management is one of four asset management companies that have been granted registration as a VPS pension fund manager by the regulator. CEO Nasim Beg was one of the initiators of the idea and has been involved with the government and the regulator at various levels in setting up the VPS structure.

VPS follows an EET regime, where contributions, investment income and capital gains enjoy tax rebates, whereas pension and/or drawdown payments are taxed. There are however tax penalties if the investor wishes to withdraw funds in the VPS before retirement or more than 25% cash at retirement.

Contributions are invested in the contributor's choice of investment policy from those available. Investment choices are available in the form of at least five plans, each of which is invested in different proportions in equity, debt and money market funds. There is a lot of debate that plan names set by the regulator are actually misleading for the investor (see table). For instance the plan investing 100% of contributions in debt and money market funds is described as the "very conservative plan" in the regulations while the plan investing 65- 80% of contributions in equity fund is the "aggressive plan". These names reflect just the market risk (or volatility risk) and ignore the most important risk when it comes to maintaining purchasing power of the investments over longer durations, possibly up to 40 years into the future - inflation risk. An individual with little knowledge of the various investment
risks and their importance in different circumstances will most likely select the "very conservative" plan and expose himself to a real risk of negative real returns over longer investment horizons.

The life cycle plan addresses this issue but to the extent that the investor actually chooses this plan. The choice of investment policy at the discretion of the individual investor is one of the best achievements this system could attain. The existing traditional gratuity and provident funds are largely invested in fixed income securities, with only a very few taking exposure to the stock market via mutual funds. When DB, the extra cost goes to the employer and, when DC, it is the pensioner who has to suffer the ultimate loss in returns and purchasing power of his investments in such schemes. This, trustees of these schemes believe, is the best and the most conservative investment strategy; there still is no concept of liability hedging and asset/liability management.

The issue at retirement again boils down to the question of translating the saved pool of money into pension payments. After allowing a maximum of 25% tax-free lump sum cash payment, the balance of the fund has to be used to provide monthly pensions. As an initial step, the government has allowed the asset management companies to offer some form of income drawdown plan to the retiring investor until the age of 75, after which it becomes mandatory to purchase a life annuity from a life insurance company with the remaining balance in the fund. This gives some scope for development of an effective annuity market in future but its success is very much dependent on the success of the VPS.

The VPS is itself not flawless. There are inconsistencies, conceptual errors, issues and ambiguities all open to debate - but then that is natural; you can only expect any start-up project to get somewhere near to perfection with time. But the good part lies in there being strong debate and participation from all interests in the country ranging from actuaries and accountants to insurers, regulators and legal advisers.

A conservative project feasibility study carried out by Arif Habib Investment Management suggests the company would break even on the initial capital employed in almost four or five years after launching the product.

This however may vary significantly depending largely on the interest government is able to maintain in future. And of course this figure is very much dependent on the business acquisition projections that the company has input to calculate the break-even year. The VPS structure is not a proxy for a gratuity or a provident scheme, at least one of which is currently required under law. This means that setting up a VPS pension scheme does not relieve the employer of the requirement to set up a gratuity or a provident fund scheme. The single step of making VPS a substitute for these schemes could mean huge success for it.

The mutual fund industry in Pakistan is managing assets worth approximately Rs180bn ($3bn) with almost half of this resting with the government-run savings trust, the National Investment Trust. This industry is still very young and compared to the Indian industry which is almost $63bn (but with seven times larger population) the current potential of Pakistan mutual fund industry may be estimated to be at least $9bn.