Friday, September 19, 2003

Pensions and inflation

There has been much talk recently about the expected inflationary outturn for 2003. The Bank of Jamaica expects that inflation will be in the region of 13%, higher than the single digit inflation projected at the start of the year. This should be of importance to persons who will reach pensionable age within the next ten years.

High inflation environment
In a high inflationary environment pensions are always significantly affected as happened during the period of the early nineties. Inflation has caused many pensioners to be bordering if not below the poverty line. Between 1990 and 2002, the Bank of Jamaica numbers show that we have had cumulative inflation of some 294 per cent, which was reigned in only by the single digit inflation from 1997 to 2002. There are not many persons that would have seen their wages keep pace with that type of inflation and thus their pension would also suffer, as it is tied to wages. In fact, in order to beat inflation, the pension investment would have had to be returning in excess of 22 per cent compounded during that period. Not many pension funds were consistently showing that sort of return.

The pension regulations in seeking to protect the investment, does place restrictions on the type of investments that the trustees can participate in. These are usually safe investments such as government paper and certain blue chip equities, which will not give the same return as riskier investments. With that said though, this is a good thing as if there were no such restrictions there may have been serious consequences resulting from the 1990s financial crisis, as many more pension funds may have been seriously eroded.

Credible inflation numbers
In a recent article Raymond Forrest questioned the credibility of the published inflation statistics. There has been some doubt surrounding what is included in the basket of goods used to measure inflation and whether it has been updated to reflect the current trends. I don’t know what the truth is but if the published numbers are in fact lower than the reality then this will only serve to hurt the pensioner further.

Pensions are usually tied to wages and annual increases usually guided by the officially published inflation statistics. In addition, if we are not honest with ourselves as to what the true inflation numbers are then this will lead to a false sense of security as to the expected returns from the pension investments.

Defined contribution versus defined benefit plans
There are basically two types of pension plans, defined contribution and defined benefit.

The defined contribution plan is where the amount of the pension contribution is set as a percentage of wages. The employer usually matches the amount put in by the employee up to ten per cent of salaries. On retiring the employee will receive actuarial payments equivalent to the contributions plus the returns based on the investment gains over the period. Under this plan the pension is not guaranteed and in fact could be nil if the proper investments were not made.

The defined benefit is where the employer will guarantee a payment amount on the retirement of the employee. The risk of any deficiencies in the pension plan is borne by the employer. This exposure is one reason why some companies will not consider this plan, as in a high inflationary and unpredictable environment it is difficult to project what the company’s exposure will be. The result is that the risk of inflation is left to the employee. In some industries with a naturally high turnover rate, this exposure is reduced as the persons leaving will create a surplus in the pension plan that can be used to offset any deficiencies in the future requirements.

International Accounting Standard (IAS) 19, which deals with Employee Benefits, clearly makes this distinction and requires separate accounting treatments for both types. One of the disadvantages of IAS 19 for companies with a defined benefit plan is that it requires an actuarial valuation to be done each year for the annual report. A recent discussion I had with a representative from a pension company informed me that a $100 million pension will cost anywhere between $300,000 and $500,000 to prepare a valuation. This is an added cost to the company and for that reason he said that some companies were moving away from the defined benefit plan. On the other hand the argument can be made that this valuation is necessary to protect the members and also provide accurate financial reporting, as without this disclosure a company could go belly up without adequately protecting the employees’ pension.

A high inflation model will therefore significantly affect pensioners as it did in the 1990s and create a wider disparity between the wage earner and the person with capital. The long run effect is that the quality of life will decrease for many and there will be a greater dependence on state resources.

Even with a low inflation model, however, employees need to understand that the more popular defined contribution plan will not allow them to replace their income on retirement. Companies must shoulder the responsibility of educating their employees about other methods of savings and so remove the reliance on pension plans.

Some of the issues surrounding pensions will also be addressed in the new regulations being introduced. In the final analysis though it is up to the individual to protect his/her future income by paying close attention to their pension funds and saving in other ways during their working life.


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