Institutional Asset Management

Asset & Resource Management Company Ltd

ARM is a specialized pension fund manager with expertise in managing Defined Contribution and Defined Benefit Plans. ARM has extensive experience in establishing, managing and

restructuring pension funds in the private and public sectors.

May 2004

Pension Reforms in Nigeria –A Solution in Sight?

A Pay-As-You-Go(unfunded), defined benefit system is one in which an employee's pension benefits are paid from the employer’s current revenues or by government out of current taxes A Defined Contribution system is an arrangement where the employer and employee contribute an agreed amount to the employee’s retirement account. The benefit to the employee is the total contributions plus any income and capital gain (or loss) earned on investments made.

Pension legislation is often subject of debate. This is primarily because pension issues are connected tomany areas of economic and social policies, and these make their reform a difficult task to undertake.Following the Chilean and other Latin-American pension reforms, it is often implied that fundamentalreform represents replacing a monopoly of a Pay-As-You-Go (PAYG), defined benefit system with afully funded, mandatory defined contribution system. The purpose of this paper is to review the success of the Chilean pension reform, the proposedPension Bill and the likely consequences of implementing the reforms in Nigeria.

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What Reforms took place in Chile?

In May 1981, Chile replaced its government run Pay-As-You-Go retirement scheme with a privatesystem where workers fund their own retirements through compulsory savings. This system is a fully funded, defined contribution scheme that is mandatory for all workers who entered the labour forceafter January 1983. Workers, who were in the labour force prior to January 1983, had the option of remaining in the old government run system, (PAYG) or moving to the new system. Workers whoremained in the old system received their pension rights guaranteed under the new law, while those who moved received from government “recognition bonds” that acknowledged their contributionsunder the old system. The recognition bond matures when the worker reaches retirement age, dies, orbecomes disabled. The new defined contribution pension scheme is administered by specialized private companies called Administradoras de Fondos de Pensiones (AFPs) which are pension fund administrators. Each month, workers deposit a minimum of 10% of their wages in their individual pension savings accounts,managed by AFPs of their choice. The workers contributions are invested in various securities such as equities and fixed incomeinstruments amongst others. The contributions and the returns are tax deductible. The Chilean pension system is regulated by an independent government agency.

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What are the retirement options available to retirees?

At the point of retirement, beneficiaries are provided with three retirement options, as follows;

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Lifetime Annuity: Beneficiaries may use the accumulated monies in their retirement accounts topurchase lifetime annuities from insurance companies. The purchase of life time annuities enablesthe beneficiary to have entitlements to a recurring income stream for as long as he/she is alive

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Programmed withdrawals: Beneficiaries make programmed withdrawals from their accounts. Thisis based on their life expectancy and those of their dependents.

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Temporary Programmed withdrawals with a Deferred Lifetime Annuity: This is a combination of the first two. With this option, the worker chooses to transfer only part of his funds to a LifeInsurance Company, in order to finance a Life Annuity which will start payment at an agreed date. The balance which he decides to keep in his individual account will serve as a source of temporary income until such time as the payment of the life annuity begins.In the Chilean pension model, employers do not contribute directly to their employees’ retirementsavings account. However, at the onset of the reforms, employers had to increase employees’ salariesto cover the pension contribution.

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…the country’s economy grew at about 7% on average per year …as at December 2001, pension fund assets had grown to about US$35billion or more than 50% of Chile’s GDP! The country does not depend on short term capital flows because there is a large pool of internal savings to finance investments.Outstanding liabilities approximately 25% of GDP

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What has been the effect of the Chilean Pension Reform on the Economy?

The pension reforms in Chile have been reported to have contributed significantly to the economicgrowth of the country, although these were carried out at about the same time other economicreforms were being implemented. For example, the private pension system has been a major factor inincreasing savings. Between 1984 and 1997, the country’s economy grew at about 7% on average peryear, investment and savings boomed and inflation was reduced from around 25% to 2-4% range. This was an outstanding achievement which produced a massive change in the standard of living of thepopulation. There was however, a turnaround in 1999. The Asian crisis and the decline of external capital flows toemerging economies during that period had a negative impact on the Chilean economy which led toan economic recession. Nevertheless, by year 2000 the economy started its recovery. Between 2000and 2001, the economy experienced an average growth of about 3% annually. By December 2001,pension fund assets had grown to about US$35billion or more than 50% of Chile’s GDP!

It is strongly argued that private pension funds have been key in the development of the financialsector in Chile, especially in the development of the capital market. The country does not depend onshort term capital flows because there is a large pool of internal savings to finance investments. Theavailability of these additional resources from savings, and the experience gained by the financialintermediaries that administer them, have helped in expanding the scope and efficiency of financialmarkets, with a resulting stimulus to productivity and growth.

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What is currently the situation with pensions in Nigeria?

A reform of the pension system in Nigeria has become necessary as government can no longeradequately meet its pension obligations. Between 1998 and 2000, for instance, pension entitlementsincreased by about 750%

. This means that a pensioner on an allowance of N10,000 per month in1998 was, as at 2000 receiving about N75,000 per month. These increases in the pension entitlement were done with little or no thought to the fiscal consequences.In a Pay-As-You-Go system, the government taxes active workers to pay for the benefits of retired workers. Under this system, retirement benefits are a function of the rate of growth of the tax base, which in turn depends on the rate of growth of the labour force and the rate of growth of real wagesper worker (i.e. increases in labour productivity). Currently, the existing defined benefit Pay-As-You-Go (PAYG) pension scheme has become unsustainable with outstanding liabilities nationwideestimated at N2 trillion, or approximately 25% of the GDP. The increase in government spending onpension, currently estimated at 4.8% of the national budget and 1.15% of GDP

, is not near enough tocover this gaping hole. The private sector is not left out of the pension dilemma. Pension schemes in the private sector arenot mandatory, and even where they exist, unclear regulatory provisions and inadequate returns insome cases have made the beneficiaries dissatisfied with their administration.For these reasons, the Federal Government set up a committee to review the problems of pension inthe country and to provide recommendations to reform the system. Sequel to this, in September 2003,the Federal Government sent a draft bill to the National Assembly to establish a Contributory PensionScheme for employees in both the Public Service of the Federation and Private Sector. The proposedbill, if passed into law would abrogate the Pensions Act of 1990, as well as the Police and other Agencies Pension Offices Act 1990. The objectives of the bill are to:

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Ensure that workers receive their retirement benefits as and when due

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Assist improvident individuals save in order to cater for their livelihood during old age

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Establish a uniform set of guidelines and standards for administration and payment of retirementbenefitsSince the initial draft bill was presented to the National Assembly, there have been severalamendments in favour of various interest groups and for practical application purposes.

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May 2004 3

…employee shall maintain a retirement savings account in his name…

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What are the Major Provisions of the Bill sent to the National Assembly?

There is a great similarity between the proposed reform in Nigeria and that of the Chilean pensionsystem. We can only surmise that the Federal Government is keen to replicate the Chilean success inNigeria.Contributions to the proposed scheme are to be made by both the employer and employee, whotogether would fund the employee’s retirement benefit. Contributions by an employer or employeeshall form part of tax deductible expenses in the computation of tax payable by the employer oremployee under the relevant income tax law.In addition to this, the employer shall maintain a life insurance policy in favour of the employee.Every employee shall maintain a retirement savings account in his name with a Pension Fund Administrator (PFA) of his choice. The PFA would be allowed to invest in government and corporatebonds, shares, bank deposits and certificates as well as open ended investment funds, amongst others. Assets and funds of the pension fund would be held by Pension Fund Custodian (PFC). Theemployee will not be able to make any withdrawal from his account before attaining the age prescribedby the bill when passed to law. However at retirement, the employee would have the following choiceof benefits:

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Programmed monthly or quarterly withdrawals calculated on the basis of an expected life span

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Annuity for life purchased from a life insurance company, with quarterly or monthly payments

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A lump sum from the balance standing to the credit of the beneficiary’s savings account, providedthat the amount left after the lump sum withdrawal shall be sufficient to procure an annuity orfund programmed withdrawals that will produce an amount not less than 50% of the beneficiary’sannual remuneration as at the date of retirementGoing forward, tighter regulation is intended for pension practices. Such regulatory process will be vested in the National Pension Commission. The proposed bill makes provision for the issuance of a Federal Government retirement bond toemployees in the federal public service who are currently in existing pension funds that are unfunded. This bond would be redeemed when the affected employee retires and the amount at redemption would be added to the retirement savings account of the beneficiary.

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What are the likely consequences of the reforms on Employees?

The proposed bill in its present form encourages and mandates employers and employees to provideretirement funds for the latter. The expected contributions to be made by employees to the pensionfund may cause a reduction in employees’ disposable income. However, the pension system would bea major factor in increasing employees’ savings rate. The bill requires employees to choose their ownPFAs, consequently placing the huge responsibility of assessing PFAs on the employee. The PFA would manage independent accounts for each employee and the benefits that accrue to the accountholder will be a function of contributions to the account and performance of the PFA the employeechooses.

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What are the likely consequences of the reforms on Employers?

For employers that currently do not have a pension scheme, this would mean an additional cost to thecompany. However, retirement benefits are used as a motivating factor and retention plan by employers, which could have long-term benefits for the company in terms of staff turnover andperformance.Companies that already operate a pension scheme would be required to transfer the management of their schemes to duly registered Pension Fund Administrators (PFAs) and Pension Fund Custodians(PFCs), who would be regulated by the National Pension Commission. Understandably, companiesthat have successfully managed their own schemes for years are likely to be apprehensive about‘loosing’ control to a system that is new and untested. However, there are a lot of benefits formaintaining independence between the management of employees’ pension assets and the assets of the employers.