Oran Hall | Approved pension arrangements a safe option for retirement income
Published:Sunday | July 19, 2020 | 12:19 AM
ADVISORY COLUMN: PERSONAL FINANCIAL ADVISER
QUESTION: Is the pension scheme still the best and safest option for ensuring financial health after retirement?
– Douglas
FINANCIAL ADVISER: An approved pensioned arrangement is one that is sanctioned by the Government.
There are two types – a superannuation fund and a retirement scheme. The Financial Services Commission, FSC, is the government agency responsible for supervising and regulating the private pensions industry.
A superannuation fund is an approved pension arrangement set up by a company or association for its employees or members. It is also called a group pension plan.
A retirement scheme is an approved pension arrangement established to provide a pension for its members, being individuals who are not members of a superannuation fund – including self-employed persons.
Approved pension arrangements must have a board of trustees or a corporate trustee having responsibility to operate it according to its trust deed and rules in the best interest of the members and their beneficiaries.
Because all approved pension arrangements are established as trusts, they must have a trust deed, which is a contract between the sponsor and the trustees to manage them according to certain stated conditions. The rules expand on the contents of the trust deed and also introduce new items.
Members make a required, or basic, or mandatory contribution, which is a stated percentage of their taxable salary, to the approved arrangement but may also make a voluntary, or optional, contribution, which is also a percentage of taxable salary to the superannuation fund or retirement scheme.
Plan types
There are two well-known types of pension plans – a defined contribution, or money purchase, plan and a defined benefit plan. The required contribution rate of each member is defined, and the contribution is put into an account to be invested. Similarly, the contribution of the employer is put into an account to be invested.
The returns on the funds in each account may or may not be guaranteed. This makes it possible to invest the funds in instruments with the capacity to generate capital growth but which exposes the funds to more risk.
At normal retirement age (or earlier termination) the member will receive a pension determined by the value of all the accounts: the member’s basic and voluntary contributions and the employer’s contributions, each of which will have a specific value. An actuary generally determines the amount of monthly pension the funds can buy for the member depending on the option chosen.
Although only some superannuation funds are defined contribution schemes, all retirement schemes are defined contribution plans.
A defined benefit plan has a prescribed formula for determining the annual pension a plan member receives. Actuaries are engaged periodically to do valuations of the superannuation plans to determine, among other things, if they are able to make the contractual pension payments. The employer, or sponsor, funds any deficit but may reduce the employer contribution if there is a surplus.
Taxes and vesting
One very significant benefit of an approved pension arrangement is its tax efficiency. There is full tax relief on all contributions made, all investment returns on invested contributions, and on the lump-sum payment the member may take at retirement. It would take significantly more in contributions to a pension arrangement that is not approved to generate the same level of resources to provide the same level of pension from an approved arrangement.
How much pension the member receives depends on several factors. The following relate to both types of arrangements. The length of pensionable service is important – the longer, the better. The contribution rate, that is, the percentage of salary contributed, is also important. Additionally, the investment returns and the vesting formula also make a difference.
Vesting refers to the amount of money contributed to the arrangement other than made by the member that is available to pay a deferred pension to the member who chooses to leave the pension arrangement before the normal retirement age.
It usually occurs after a stated minimum number of years. A significant difference between a superannuation fund and a retirement scheme is that members of a retirement scheme vest immediately, while members of a superannuation fund may have to wait five or 10 years.
With respect to defined benefit plans, the definition of pensionable salary is important because it defines how the annual pension will be calculated. Of the various options, final salary is the best. In this arrangement, the accrual rate – the percentage of the pensionable salary – times the number of years of pensionable salary is important. For example, if the accrual rate is 2.0 per cent and the number of years of pensionable salary is 37.5, the maximum pension would be 75 per cent of pensionable salary, which is actually the maximum level in Jamaica.
Approved pension arrangements are professionally administered and managed, thus providing scope for independent expertise to be put to work in the best interest of the members of the pension arrangement. Of course, this comes with a cost, but on balance, this is small relative to the time, expertise, expanded investment opportunities, and risk-reduction strategies, which would have to be found otherwise.
Oran A. Hall, principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel.