Voluntary pension scheme: viable alternative to PF
By Ali H. Shirazi

Chile on May 1, 1981 (aptly coinciding with International Labour Day) became the first country to bring free market reform to privatise the social insurance system. The Chilean economy, the South American basket case of the 1970s, is now the South American miracle, with the highest standard of living in South America, and real growth over 7 per cent since the reform. The savings rate has increased to 28 per cent.

After studying the Chilean model, the Securities and Exchange Commission of Pakistan (SECP) last year also took the first step towards pension reform by granting licenses to four private sector asset management companies to act as pension fund managers under the recently promulgated Voluntary Pension System Rules. Pension reforms are essential to ensure that the macroeconomic gains of the last few years are passed on to the masses. While there has been an exponential rise in consumer spending, the saving rate has remained alarmingly low. Moreover, due to inflationary pressures, the real value of money is continuously reducing. Cognizant of this fact, the government introduced the Voluntary Pension Scheme (VPS).

Currently both private and public sectors offer occupation savings schemes in the shape of provident funds and gratuity schemes. However, in their truest sense, provident funds and gratuity schemes are not retirement products. Fund withdrawal, job switching and loans against the schemes are a norm. Invariably, individuals are therefore left with depleted savings at the time of retirement. The introduction of VPS, managed by private pension fund managers, will aid mobilisation of savings, which in turn will help individuals become self-reliant in old age, reduce financial liability for government and employers at large and relieve financial obligation for younger generations. 

The scheme is funded and the tax incentives will enhance both savings and investment. VPS is launched to serve as a primary saving vehicle for retirement savings of individuals with an umbrella structure comprising of three (the number in due course may increase, subject to SECP approval) sub-funds in the form of unit trust schemes. Contributions received from investors are allocated proportionate to their respective preference. The salient features of VPS are that all Pakistani nationals over 18 years old holding a valid National Tax Number or Computerised National Identity Card may participate. Moreover overseas Pakistanis with a National Identity Card for Overseas Pakistanis may also join the scheme. The individualised pension account is in the name of the investor and customised according to the specific needs and requirements of the investor. VPS offers individualised asset allocation, enabling individuals to allocate contribution between equities, debt and money market instruments in accordance with risk tolerance and investment horizon.

Whether the contribution comes from the investor or the employer, the benefit of the investment goes to the individual investor. The benefit is not dependent on the length of service or any other condition of employment. In addition, VPS is portable. In other words, the individual’s account will stay with the investor even if he or she changes jobs. Contribution can be resumed at any time either through the new employer or based on personal contribution. The investor can also transfer the account to and from another Pension Fund Manager without bearing any cost.

An important feature of VPS is the up front tax advantage offered to the investors. Tax treatment of VPS is governed under the Exempt, Exempt, Tax – EET - system, whereby contributions made shall be entitled to a tax credit up to a maximum of Rs 500,000 and the income shall accrue tax free. Retirees shall be taxed on the benefits they receive (in this case 25 per cent of the savings shall be received tax free and the remaining 75 per cent shall be taxed). Investors can contribute any amount; however they can only claim a tax credit for theair contributions of an amount equal to 20 per cent of their taxable income, subject to a maximum credit of Rs. 500,000 per year. Investors over the age of 40 can claim an additional 2 per cent per annum for each year exceeding 40 years of age, subject to a maximum contribution of 50 per cent of the taxable income. Employers making contributions on behalf of their employees are also exempt from tax on the contribution amount. Premature withdrawal before retirement age and benefits received after retirement are taxable.

Most licensed pension fund managers are also providing free insurance cover in the event of accidental death and disability. Furthermore, most are also offering a Shariah compliant fund that offer the same features as the conventional fund, except that all investment are Shariah compliant.

As for retirement, the investors choose their retirement age between the ages of 60 to 70 years. Should an investor have to retire early due to any disability that renders the individual unable to continue work, pension can be paid immediately from the accumulated balance in the pension account, subject to satisfactory medical evidence. Assuming at retirement, the investor chooses to receive a lump sum payment of up to 25 per cent of the accumulated balance, with the remaining portion of seventy-five per cent of the accumulated balance, the investor can enter the Income Payment Plan managed by the pension provider. The Income Payment Plan also comprises of the three sub-funds (equity, debt and money market) but will give investors an income on a monthly basis. The other option for the investor is to purchase an annuity from a life insurance company.

At present the pension liability of the government of Punjab alone is approximately Rs450 billion and the budget allocation for payment of pension was about 20 per cent of the total budget for the year 2007-08. In the long run this is an unsustainable situation. It is encouraging to see therefore that both the federal and provincial governments are considering funding its liability by moving towards defined contribution. The recently promulgated Punjab Pension Act 2007 goes some way in trying to address the burgeoning pension liability of the Punjab government. The government of Sindh is following suit as well. Moreover, the Ministry of Finance is also taking the initiative by contemplating the introduction of defined contribution pension for new civilian employees of the federal government.

VPS marks the first step towards pension reform in Pakistan. However, in order to make the product truly marketable the following proposals require the attention of SECP and FBR: Withdrawal of pension from VPS, after reaching the retirement age, should be exempt from income tax to make it compatible with pension schemes offered by government and private sector. As Non Resident Pakistanis and those on presumptive tax regime will not be availing tax credit on contribution, it would be inappropriate to subject them to income tax on pension withdrawal. Self-employed individuals such as auditors, lawyers, doctors and architects currently under the presumptive tax regime should be brought under the normal tax regime. Similarly amendments in the Income Tax Rules, 2007 are required to enable transfer of Provident Fund balance to VPS.