Conversion from DB to DC Funds. Did we do the right thing?
The history of Retirement Funds in SA
South Africa is one of the first countries in the world to come up with a legislation that governs private sector retirement funds, the Pension Funds Act 24 of 1956 which is also still very much in use in South Africa and Namibia today. Initially, all retirement funds that were set up were based on a Defined Benefit Funding basis and although beyond the understanding of the average man in the street, the system was for most part a healthy one.
The basis of Defined Benefit funds lie in statistics and assumptions (made primarily very conservatively to reduce volatility and risk) and aims at a longer-term horizon to manage a retirement fund cost effectively and efficiently. It sets a definition of retirement (historically an average of 2% of a person’s final salary for each year of membership). With this target defined, contributions for members were usually a fixed percentage of say 7.5% of salary whilst employer contributions were adjusted from time to time to make up for the balance needed to hit the target.
As mentioned above, a degree of stability was continually sought to keep the employer balance pf payment contributions to a reasonable and stable level and should any degree of underfunding exists, this was mitigated by a set plan to bring funding levels up to par within a reasonable time. I cannot recall a single case where an employer was suddenly faced with an insurmountable crisis of underfunding.
Fund administration costs were also fairly cheap in comparison to today as member retirement benefits were a function of a formula and not dependant on detailed and costly tracking of individual choices and other particulars.
Success in retirement for a member was based on years of membership and the delivery of a rules-based promise and as a result was fairly risk-free. The employer on the other hand carried the risk having the obligation to ensure there was sufficient funding to deliver on each of these member promises.
Employers and their service providers therefore managed these funds between themselves without member input nor representation. In a politically charged environment as there existed at the time, workers displayed a lot of mistrust and scepticism and things were about to take a dramatic twist.
The winds of change - Conversion of the Pension Funds into Defined Contribution Provident Fund
With the accelerated change to the political landscape in the 1980’s, Labour was at the forefront of the conversion of defined benefit pension funds into defined contribution provident fund purely because the latter is easy to understand while the former is complicated for an ordinary member to understand. There was also this belief that with defined benefit fund the employer could easily embezzle the members’ money.
With defined contribution (money purchase) provident fund, what you and your employer contribute to your retirement savings is what you get out plus investment growth when you retire or withdraw. It works just like a savings account.
The downside of a defined contribution provident fund is that a member carries the investment risk hence members are given member investment choices or defaulted if they don’t make use of the member investment choices. With a defined contribution provident fund members receive lump sums on retirement. In most instances members lack the financial management skills to handle such bigger amounts and few years down the line they are bound to become penniless.
Comparing this to a defined benefit pension, as stated above, when you retire your benefit is determined by a formula that takes into account your years of services and salary as at the date of retirement. It gives a member a fixed guaranteed benefit.
With these funds also structured as pension funds, a maximum of one-third could be taken as a lump sum and the balance had to be used to provide a monthly pension. Albeit perhaps seen as a very paternalistic approach, the upside of this arrangement is that not allowing members to access their retirement benefits all in one lump sum, mitigates the risk of it all being squandered in a short space of time. The end result is that members also received a monthly pension that provided for them in retirement and for members with long service periods, these pensions were invaluable.
Except for the GEPF and the Transnet Pension Funds (both are public funds and have their own legislation) most of the remaining defined benefit pension funds that are still in existence today are either closed i.e. they don’t take new employees. New employees can only join defined contribution provident funds.
Was the conversion good for members? For many people, the jury is still out on this one. With the benefit of hindsight I think the conversion robbed our people of guaranteed pensions and a lot more. No wonder so few people will retire comfortably in SA.
I strongly believe that there should be some serious debate on the issue of whether defined contribution provident funds are still relevant today given all the challenges facing members that are retiring and receiving lump sum benefits.
Withdrawal vesting scales – no longer applicable.
It used to be that if a member who worked for a company and contributed to the company-sponsored retirement fund resigned, he would only become entitled to his own contributions plus a portion of the employers contributions made towards his retirement savings depending on the number of years he had completed. If for example a member needed to complete 5 years before becoming entitled to 100% of the employers contributions and the member has completed 1 year on resignation, he would only become entitled to 20% of the employers contribution, the 80% reverted to the fund. Legislation was changed in 2001 to remove the vesting scales and to allow withdrawing members to take the total of their contributions as well as net employer retirement contributions (after costs for administration, insured benefits, etc.).
Another milestone was achieved in 1996 when the Pension Funds Act was amended to cater for at least 50% members’ representation on the boards of trustees. Prior to this, members had no control or representation over decision affecting the management of their retirement funds.
The early 90s saw the introduction of hybrid funds (pension fund and provident funds which were side by side arrangement but operated separately). Because contributions to pension funds were tax deductible whereas contributions to provident funds were not, hybrid funds were to address this anomaly. Members would contribute to the pension fund and the employer would contribute to the provident fund. This sounded like a win-win situation for both the employer and the members.
Umbrella funds have become quite common in SA, fuelled by a drive towards consolidation supported by both Government and predictably, the large service providers who are the sponsors of these funds. Umbrella funds pool a number of un-related companies to participate in a retirement fund for mainly economies of scale. As such, Umbrella funds are recommended for smaller companies that cannot afford their own free standing retirement funds because of the higher costs of running retirement funds in South Africa. Perhaps another bone of contention as there are numerous self-standing funds of varying sizes that claim they can still cost-effectively compete and offer more independent open-architecture in their setup and use of specialists in the different fields of investments, risk, etc.
Some umbrella funds are set up specifically for a particular industry e.g. hospitality, chemicals, etc. while some pool companies that cover a variety of industries.
Until the enactment of the Pension Funds Second Amendment Act of 2001 which came into effect on 7 December 2001 (Surplus legislation) ownership of the surplus assets in a retirement fund was a grey area. A retirement fund has a surplus if its assets are more than its liabilities. If the fund’s liabilities exceed its assets we speak of a deficit or shortfall which the employer needs to make good to return the fund to a fully funded status (i.e. financial soundness position). For a fund to be in a sound financial position its assets are supposed to match its liabilities. Among a number of factors that contribute to the existence of surplus in a retirement fund I have chosen the use of vesting scales. You can imagine that over the years as members left and the vesting scales were applied retirement funds ended up with excess assets that they were unjustly keeping. Those amounts became excess assets or surplus in the retirement funds. Companies could deal with the surplus as they pleased. Until around 1999 while I was still working for one of my previous employers we used to apply to SARS for approval of payment of what was then called Greater Benefits. An MD of a company would on retirement be entitled to say R3m and the company would ask us to apply to SARS for payment of a Greater Benefit say R2m from the fund surplus. The surplus raiding scandals of the late 90s and early 2000 was caused by this uncertainty over ownership of surplus. A company would simply buy another company not necessarily because it was interested in that company for commercial reason but simply to raid the surplus in the retirement funds sponsored by that company. This is exactly what the likes of Peter Ghavalas had in mind when he bought Lifecare Holdings in 1999.
The Pension Funds Second Amendment Act (Surplus legislation).
In 2000 it was reported that there was R80 billion surplus sitting in the retirement funds.
The Surplus legislation which became effective on 7 December 2001 required funds to undergo actuarial valuation to determine whether they had surplus or not and if they had surplus to come up with the surplus allocation scheme to be submitted to the FSB. For the purposes of the Surplus legislation retirement funds were to go as far back as 1 January 1980 and consider all members since then.
Surplus Improperly Used
First and foremost retirement funds were required to recoup the surplus that companies used improperly before the enactment of the Surplus legislation. The contribution holidays taken by the companies and greater benefits paid to retiring directors that I mentioned above before the Surplus legislation were considered to be surplus improperly used.
All those members for whom vesting scales were used resulting in them leaving some of the employers’ contributions in their respective funds were to take the first bite of the cherry. All other stakeholders (active members, pensioners, employer, deferred members or pensioners) would be considered for the residual surplus.
Surplus Apportionment Schemes (schemes)
Some retirement funds submitted their schemes to the FSB, other retirement funds submitted the nil surplus schemes. Retirement funds could apportion the surplus once their schemes have been approved by the FSB.
Parity – Pension Funds and Provident Fund
Treasury has been at pains to ensure that there is parity between pension funds and provident funds. Currently provident funds and pension funds are treated the same from the tax point of view except that the annuitisation of retirement benefits payable from provident funds still need to be finalised.
Treasury’s concerns regarding costs of retirement funds especially post retirement annuities
Treasury has introduced a number of reforms for the retirement fund industry lately. We have seen a number of regulations from Treasury lately the idea being to make retirement savings as cost effective and members as well informed as possible.
I still maintain that converting defined benefit pension fund into defined contribution provident funds have impoverished a number of members of provident funds. This situation needs to be arrested before it goes out of hand and the only solution is to do away with provident funds and reintroduce defined benefit pension funds. Is this doable?
Yes, I think it is if there is a political will otherwise if nothing is done SA will soon be facing a retirement crisis of unimagined proportions. We may churn out so many legislation and regulation as we can but for as long as those regulations are not addressing the looming retirement crisis they will be of no benefit to an ordinary member.
Executive Director, Absolute Employee Benefits
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