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Will you be able to live on your pension?

Published:Sunday | August 17, 2014 | 8:00 AM

Oran Hall

I noted with interest a recent news item in which several persons spoke about the inadequacy of their pension. In addition to these persons and others like themselves, there are many others who look to their retirement years with apprehension.

Let us accept that pension will not fully replace pay and it is therefore important to make additional provisions for meeting the expenses of living during the years after the end of the active working years.

There are several reasons why this is so. In the first place, the maximum pension allowed by law for members of approved pension arrangements is 75 per cent of final salary where the pensionable service equals or exceeds 37.5 years. Additionally, pensionable salary does not include every aspect of a salary package.

Pension is often fixed and so loses its purchasing power over time as the level of inflation increases. To counter this, some pension arrangements include a provision for indexing pensions to the full extent of the previous year's inflation.

The size of a pension is determined by several factors, some of which I will mention.

In the case of a defined benefit pension plan, in which the pension is based on a formula and the risk of making the pension fund adequately funded is borne by the employer, the definition of pensionable salary has a bearing on the size of the pension. For example, pensions may be based on career average salary, modified career average salary or final salary.

Under the final salary plan, pensionable salary may further be defined as final annual salary or the average annual salary over a set number of years such as the last five years. The final salary plan tends to give the best result.

The size of the pension is also influenced by the length of pensionable service - the longer the better - investment returns, and the contribution rate, that is, the proportion of income that is contributed to the pension plan, and the quality of the vesting formula.

These all hold true for both the defined benefit plan and the defined contribution or money purchase plan, which carries no guarantee from the employer but is instead based on the level of contributions to the pension plan by employer and employee and the level of investment returns thereon.

With respect to defined benefit plans, there is one other factor that may influence the size of the pension - provision for indexation.

The replacement ratio is also important. This is the annual pension during the first year of retirement expressed as a percentage of the annual salary at the retirement date. Earlier, we observed that the law limits pensions to 75 per cent of final salary. Therefore, the maximum replacement ratio allowed by law is 75 per cent.

The pensioner who needs more than 75 per cent of final salary to live at a reasonable level has to find other ways to fill the gap. The National Insurance Scheme - which is an insurance scheme and not a pension plan - offers some benefits which can assist in filling the gap. But another very important source has to be the pensioner's investment portfolio.

Investment returns, though, have fallen appreciably so it is even more important that sufficient financial resources are put aside for the future at a time when many families are under pressure due to family members being underemployed or not employed at all.

In other cases, some employees have not had salary increases for several years, meaning that they have not been able to increase the level of their contributions to their pension funds.

Being a member of an approved pension plan still has advantages. There is full tax relief on pension contributions, on investment returns on those contributions and on that portion of the pension which is taken as a lump sum at retirement.

Additionally, a properly managed fund that is well diversified should give better returns than prospective pensioners could generate from investing the funds themselves.

capitalise on skills

Retirees may boost their income by engaging in part-time employment if their health allows it and if there are available opportunities. They may also start a business by capitalising on their skills and their experience from their working years, or may develop the income-earning potential of their hobbies.

It should be noted that some life insurance policies generate significant savings and investment returns that can be used as income in the retirement years.

To improve the chances of deriving a good pension, it is important to start saving for retirement early, make the highest level of contributions allowed, check periodically for the replacement ratio to be guided as to the size of the gap and how to go about managing financial resources to close it, and resist the temptation to encroach on funds designated for retirement.

Oran A. Hall, a member of the Caribbean Financial Planning Association and principal author of 'The Handbook of Personal Financial Planning', offers free personal financial planning advice and counsel.finviser.jm@gmail.com