Philosophy and Objectives of Pension Reform Act, 2004
By Fola Adeola
The systems for providing financial security for the old are under increasing strain especially in a developing country like Nigeria. Most employees neither have any meaningful retirement benefits nor earn enough during their working life to cater for their retirement. The extended families and other traditional ways of supporting the old are already weakening under the pressure of urbanisation, industrialisation, and increased mobility. Indeed, the Pay As You Go Defined Benefit Scheme in the public sector is burdened with a lot of problems and has increasingly become unsustainable. Against the backdrop of an estimated N2 trillion deficit, arbitrary increases in salaries and pensions as well as poor administrative structures, the need for pension reform is glaring and inevitable. The longer the reform is delayed, the more urgent and difficult it becomes.
Overview of Existing Pension Schemes
The pension system in Nigeria was largely characterised by Pay-As-You-Go (PAYG) Defined Benefits scheme in the public sector and provident funds and NSITF scheme in the private sector.
Until the enactment of the Pension Reform Act, 2004, there was no comprehensive framework for the regulation and supervision of the pension industry. The framework was fragmented with different regulatory authorities such, as the Joint Tax Board, Securities and Exchange Commission and the National Insurance Commission, all performing limited supervisory roles which in some cases were conflicting. The situation had encouraged regulatory arbitrage and also left many workers not covered by any form of retirement benefits scheme. Even for the mandatory schemes, there were widespread evasion and non-compliance.
Philosophy and Objectives of the Pension Reform
When the Nigerian Government set out to fashion a pension reform strategy, it was guided by many factors. Besides addressing the problems of the pension industry, the government needed a system that world, among others, be financially sustainable, simple and transparent, less cumbersome and cost effective, and encourage savings among workers. The over-riding principle was to have a system that would ensure that pensioners have adequate, affordable, sustainable and diversified retirement benefits. This is to ensure that every person who had worked receives his/her retirement benefits as and when due so as to prevent old age poverty and secure a decent retirement. The system is intended to provide workers with the means to sustain themselves when they are no longer able or too old to work. The reform was also concerned with establishing a system that would ensure workers receive benefits generated by their own savings and not dependent on government subsidies or future generations.
There are essentially two choices for a pension reform. One approach is to carry out minor reforms or adjustments to the existing public schemes. Adjustments may include changes to eligibility criteria for receiving pensions the benefit structure or the administration of the scheme. These are usually referred to as parametric reforms. Unfortunately such adjustments are not sufficient to address the underlying problems of public pension schemes but do succeed in deferring the fiscal crisis Such minor reforms are bound to be repeated which undermines the view that pension scheme provides certainty of retirement benefits. Instead, the reform creates uncertainty of retirement benefits for the worker. The other approach is a major reform initiative.
In view of the problems associated with the first approach, the government decided to adopt a major reform strategy that entails substantial changes to the pension system by replacing the largely defined benefits scheme with a defined contribution scheme that is fully funded.
The primary objectives of the reform can therefore be summarised as follows:
Establishing a Sustainable Pension System
The reform seeks to establish a Defined Contribution Scheme in private and private sectors which is more sustainable in the long-run. The defined benefit scheme is not sustainable. This type of scheme is structurally flawed. By taxing workers to finance the benefits of the retirees the link between contribution and benefits is lost. There is no relationship between what a worker contributes and the benefits he/she gets from the system. Obviously such a system creates a set of behaviours that undermines the scheme itself. Human being by their nature want to minimise what they can contribute to a system and maximise what they receive from it. As a result special interests and privileged groups usually tinker with retirement benefits in their favour regardless of the funding implications of such decisions on the pension scheme. For instance, in the public sector some group of workers have less stringent eligibility criteria and enjoy more generous retirements than their other colleagues of lower status. In some cases, political leadership could be tempted to increase benefits for political reasons thereby creating large unfunded pension liabilities that cannot be sustained in the long-run. The reform would therefore de-politicise pension and make it an economic issue.
With fundamental demographic trends and aging, there would be fewer workers and more pensioners. As the support ratio of workers to pensioners falls, the PAYG scheme will be under increasing pressure particularly given the generous nature of the old scheme. This will further exacerbate the already huge unfunded pension liabilities in the public sector. An analysis of age groups in Nigeria showed that in 2000, Nigerians that were 60 years and above constituted 4.2 percent of the total population. This ratio is projected to grow to 5.9 percent by 2030. Indeed, the ratio may rise substantially with increased prosperity and improved health care system.
The adoption of the defined contribution scheme will stem the growth of fiscal costs of pension deficits which would release resources to support growth and development of the country.
Empowering the Worker
Under the defined contribution scheme, the worker has control over his/her retirement savings account and determines which Pension Fund Administrator manages his account. This arrangement will address the problems of the failure of sponsors of defined benefit scheme to deliver on promised benefits or guarantee reasonable returns on investments. The regular monitoring of the savings account by a worker will also improve their financial literacy.
Labour mobility is expected to improve because the accounts are portable and workers can move with their accounts whenever they jobs. The incentive for workers to withdraw from the labour market which early retirement schemes tend to encourage under the defined benefit scheme will no longer exist.
Ensuring Efficient Management of Pension Funds
The reform promotes private management of pension fund. The new scheme requires pension funds to be privately managed by Pension Fund Administrator (PFA) and the assets held by Pension Assets Custodian (PAC). The poor track record of public schemes made it imperative for pension funds to be privately managed. Historically, public managed schemes had performed well. In fact, there is always a concern that businesses managed by government are not properly run. By allowing private management of pension, funds can be separated from the political process. Through competition among PFAs, workers are mostly likely to receive better rates of returns.
Encouraging and Promoting Savings Culture
Defined contribution scheme being compulsory form of savings generate long-term funds. Workers desire to secure a certain standard of retirement life would encourage them to work for longer period and accumulate savings. These long-term investible funds will deepen and strengthen the financial markets as well as facilitate the lowering of cost of capital in our country. Consequently, higher economic growth will be promoted.
This objective of the reform appears to be misunderstood by some persons. These persons had argued that the government would divert pension funds to finance its own pension scheme and other programmes. Such an argument reveals a general misconception of the scheme. If the government cannot confiscate savings accounts of depositors of banks, it is equally impossible for it to so in the case of pension scheme in which each worker will have a retirement savings account. In any case, existing schemes do have investments in capital and money markets which were never taken away from them.
Securing Compliance With Scheme's Requirements
It is expected that the defined contribution scheme which links contribution to benefits will promote voluntary compliance through regular and prompt payment of contribution. Thus, coverage of pension schemes will improve. Nigeria has a much lower coverage ratio when compared with other countries. The active coverage rate based on active population for the period 1990 to 1999 was only 1.3 percent as against 16.64 percent and 60 percent in Cameroon and Mauritius respectively.
Establishing Strong and Robust Regulatory and Supervisory Framework
Key Elements
The new pension scheme will be contributory, fully funded, based on individual accounts that are privately managed by Pension Fund Administrators with the pension funds assets held by Pension Assets Custodians. The pension industry will be regulated and supervised by the National Pension Commission.
Contributory System
It is contributory because both the employer and employee will contribute a minimum percentage of employee's monthly emolument to be credited to the retirement savings account of the employee. However, an Employer may elect to contribute on behalf of the employees such that the total contribution shall not be less than 15 percent of the monthly emolument of the employee.
Fully Funded
The contributions are deducted immediately from the salary of the individual and transferred to the relevant retirement savings account (RSA). By so doing, the pension funds exist from the onset and payments will be made when due.
An Alternative to fully funded RSA, it has been proposed should to retain the PAYG - Defined Benefit but open a National Defined Contribution Account. Have workers accumulate pension contributions based a contribution and a notional interest rate (or indicator of economic growth as in Sweden). A worker in Sweden is required to contribute 16 percent of his/her earnings to the public scheme and credited to a notional account which is used to keep track of the contributions made. In addition, a worker is required to contribute 2.5 percent to a fully funded account. Each account attracts interest rate that reflects income growth. At retirement, the account is transferred into annuitised-benefits and the resulting pension will be based on lump sum contributed and life expectancy of the retiree.
Individual Accounts
The employee opens an account to be known as a 'Retirement Savings Account' in his name with a Pension Fund Administrator of his choice. This individual account belongs to the employee and will remain with him through life. He may change employers or pension fund administrators but the account remains the same.
The use of retirement savings account was chosen because of many advantages. A worker owns the account and has the freedom to manage his wealth. It also allows an employee to own resources, have property rights over the savings account and exercise freedom to manage their retirement plan consistent with their needs. Rather than perpetuating culture of dependence on employer, the scheme helps to improve the life of an employee through work and savings. Because of its portability, the RSA eliminates the need for different systems for different categories of workers depending on whether they work for the public or private sector as was the case in the old pension system.
Privately Managed
The new scheme requires pension funds to be privately managed by PFAs and PFCs. Private management was adopted because of the general distrust of government enterprises. Private management enhances the efficient and effective management of investment portfolios and promises better services to workers through competition.
Pension Fund Administrators (PFAs) will be duly licensed to open retirement savings accounts for employees, invest and manage the pension funds in fixed income securities listed and other instruments as the Commission may from time to time prescribe, maintain books of accounts on all transactions relating to the pension funds managed by it, provide-regular information on investment strategy to the employees or beneficiaries and pay retirement benefits to employees in accordance with the provisions of the new law.
Safety Net
The scheme also provides minimum pension guarantee for employees that have worked for certain number of years and were unable to accumulate enough savings.
The new Pension Scheme embodies a number of checks in order to preserve the pension fund assets. In addition to the separation of functions between PFA and PAC; a custodian must issue a guarantee to the full sum and value of the pension fund and assets held by it or to be held by it; Government contribution shall be a first charge on the Consolidated Revenue Fund of the Federation; certain investment instruments must be rated by licensed rating agency; every PFA shall employ a compliance officer who will responsible for ensuring compliance with the provisions of the law regarding pension matters as well as the internal rules and regulations of the particular PFA; a PFA shall maintain a statutory reserve fund, which shall be credited annually with 12.5 percent of the net profit after, or such percentage as may be stipulated by the NPC to meet claims and PFAs and Custodians must disclose their rates on return and publish their audited accounts.
The National Pension Commission
The new scheme will entail the establishment of a National Pension Commission (NPC), to regulate, supervise and ensure the effective administration of pension matters in Nigeria.
Conclusion
One incontrovertible fact is that in our society today, most workers are not covered by any reasonable form of retirement benefit arrangement while the few schemes suffer from poor management. It is also pertinent that Nigeria must avoid minor pension reforms that are repeated periodically because of the political problems associated with such adjustments. When defined benefit schemes are frequently redefined, they only create uncertainty of retirement benefits. It is for these reasons that a major and comprehensive pension reform was undertaken.
There are strong indications that the reform will be sustained. The reform is a key component of the reform programme of the government There is the political will and continued commitment by the government to implement the reform. Above all, the reform strategy was locally developed consistent with our unique environment. It has also received the input and support of many key stakeholders including this Association especially during the legislative process.
Adeola, recently nominated as Chairman of the National Pension Commission (NPC) by President Olusegun Obasanjo pending National Assembly's approval, presented this paper at a recent workshop on Pension Reform Act, 2004 organised by the Nigerian Insurers' Association (NIA).
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