Dr. Pius Apere (PhD / FCII)
(Actuarial Scientist / Chartered Insurer)
Deputy Managing Director
Linkage Assurance Company PLC
The Nigerian pension industry currently consists of three pillars, namely the public sector Pay-As-You-Go (PAYG) defined benefit (DB) schemes, private sector defined benefit (gratuity and pension) schemes and the contributory pension schemes (CPS) under Pension Reform Act (PRA) 2014 which repeals the PRA 2004. Depending on a person’s situation, a retired person may be entitled to benefit(s) from either the first pillar, or second pillar, or third pillar, or from the first and third pillars, or from the second and third pillars, but not from all the three pillars.
This paper highlights the implications including the key challenges and opportunities arising from the enactment of PRA 2014 that affect the effective management of the private sector gratuity and pension schemes. The private sector schemes considered are mainly employer-sponsored schemes.
Impact of PRA 2014 on Existing Private Sector Schemes
The enactment of PRA 2014 has an immediate effect on the existing defined benefit and defined contribution schemes operating in the Nigeria Pension Industry prior to the introduction of CPS.
Defined Benefit (DB) Pension Schemes in the Private Sector
Section 50 (1)(a)(d) of Pension Reform Act (PRA) 2014 states that any defined benefit (DB) pension scheme in the private sector existing before the commencement of the Act may continue to exist provided that the pension scheme shall be fully funded. Furthermore, every employee in the existing scheme shall be free to exercise the option of coming under the new contributory pension scheme (CPS). The existing scheme shall be closed to new employees and such new employees shall be required to open a retirement savings account (RSA) under CPS (Section 50 (1)(h) of PRA 2014). This implies that no new defined benefit pension scheme will be established by any employer after the commencement of the PRA 2004. Thus, the unfunded pension schemes will not be allowed to exist.
Defined Contribution (DC) Schemes in the Private Sector
Section 50 (1)(a) of PRA 2014 also requires that for any existing defined contribution scheme in the private sector prior to the commencement of the PRA, the contributions in favour of each employee including the attributable income shall be computed and credited to a retirement savings account (RSA) opened for the employee under CPS.
Defined Benefit (DB) Gratuity Schemes in the Private Sector
The enactment of PRA 2004 led to the winding-up of many employer-sponsored gratuity schemes in the private sector in order to start the new CPS with the aim of reducing costs of running two schemes at a time.
However, the Act did not actually prevent any employer that had a gratuity scheme prior to the commencement of the PRA or that desires to adopt a new gratuity scheme from establishing a Gratuity Fund for its employees subject to the terms and conditions of their employment, in addition to the compulsory contributions into the new CPS.
Thus, establishing a gratuity scheme is in line with the provision in section 4 (4) (a) of PRA 2014 that “an employer may agree on the payment of additional benefits to the employee upon retirement” by whatever name it is called (gratuity, severance or terminal, lump sum, long service award) over and above the employee’s retirement benefits stated under section 7(1) of PRA 2014. The above implies that the gratuity schemes operating in the private sector are opened to new employees.
Rationale for Improvement in Management of Private Sector Schemes
The main objective of PRA 2014, as far as private sector schemes are concerned, is to establish a uniform rules, regulations and standards for the administration and payments of retirement benefits as and when due (section 1 (a)(c) of PRA 2014). Thus, this objective is aimed at improving the management of private sectors. In addition, there are other reasons why scheme sponsors would seek to improve the management of their schemes.
Meeting Employer’s Objectives
Regardless of the size and the number of private sector schemes operating in the pension industry there is need to improve the management of the schemes in order to meet the employers’ objectives (both financial and non-finance related) in setting up the scheme. The employer’s objectives include but not limited to the following:
• Maximizing profits by attracting and retaining the services of good quality employees.
• Providing benefits that are at least in line with those offered by competing employers.
• Controlling the costs of financing the benefits
Exposure to Financial Risks
There is a confluence of factors that has prompted scheme sponsors to improve their management of the financial risks in DB funded schemes:
• Pension under-funding and its persistence due to a decline in long-term interest rates.
• Effects of increased longevity on scheme costs.
• Effect of increase in accounting and statutory regulations.
• The sponsor’s attitude to risk.
Increase in Private Sector Gratuity Schemes
In practice, the usually non-contributory DB gratuity schemes in the private sector have become popular among the employers in recent times. This popularity can be attributed to the fact that the employer’s contributions to fund the gratuity benefits may be considered as the additional voluntary contributions (AVCs) over and above the compulsory minimum contributions which would have been paid to provide additional retirement benefits for its employees under CPS. This is applicable where the employer decides not to take sole responsibility of funding the CPS (section 4 (4)(b) of PRA 2014).
Furthermore, an employer would prefer to provide AVC to fund gratuity benefits in the private sector instead of paying it into employees’ CPS because of:
• Easy accessibility of gratuity benefits at any point of exit than benefits from RSA under CPS which has an age limit on withdrawal of benefits.
• Investments of the gratuity funds would be under the control of the employer.
• Gratuity income may be subject to lesser variability than retirement income from CPS.
As the gratuity schemes are opened to new employees, they are also likely to increase in size and number over time, and therefore there will be a need to improve their management of the financial risks facing them.
Challenges of Managing Private Sector Schemes
No New DB Pension Scheme Designs after PRA 2014
The existing pension schemes in the private sector are mainly designed as balance of cost final salary schemes which are funded. In this case, the employees make defined contributions and the sponsor pays the remainder of the unknown cost of providing benefits. The contributions are payments towards the estimated cost of the benefits.
The PRA 2014 prevents new private sector DB pension scheme designs to be made in the future but only the amendments to existing DB pension schemes are required (such as reduction of benefits because of insufficient funds available to provide the pension benefit).
Lack of Actuarial Inputs in Gratuity Scheme Designs
Gratuity (which is a lump sum benefit) can be defined as a part of salary that is received by an employee from his/her employer in gratitude for the services offered by the employee in the company.
In practice, the most common DB gratuity scheme designs existing in the industry after PRA 2004 are non-contributory in nature, the level of benefit relates to final salary and length of service with the employer payable on death, disability, retirement or resignation.
The accounting regulation, IFRS as set out in IAS 19, requires that defined benefit schemes may be unfunded or they may be wholly or partly funded. Thus, many employers design and operate the gratuity schemes on an unfunded pay-as-you-go basis due to lack of actuarial involvement. This is against the provision in the PRA 2014 that private sector pension schemes should be fully funded at all times (Section 50(1)(a) of PRA 2014).
Increase in Employment Costs
The increase in employer’s compulsory contribution rates from 7.5 % to 10% in CPS (section 4 (1) (a) of PRA 2014) has significantly increased the employment costs and due to affordability companies may need to review the levels and design of their total employee benefit packages (e.g. gratuity schemes). This review would pose a greater challenge to employers without an actuarial input.
Absence of Guidelines on Actuarial Valuation Method
The accounting regulation, IAS 19, specifies that the projected unit credit method (PUCM) should be used in the valuation of gratuity/pension benefits, leading to standardization of actuarial valuation results of private sector schemes,
However, the statutory regulation, PRA 2014, does not give any guidelines on pension scheme valuation method. Therefore, the choice of valuation method is at the discretion of the actuary, leading to non-standardization of valuation results, which makes peer reviews and comparative analysis quite impossible for regulatory purposes.
Furthermore, employers operating unfunded (PAYG) gratuity schemes tend use the book reserving methodology (which requires making provisions in the company’s accounts for unfunded benefit liabilities payable in the future for which no funds have been set aside) being the most appropriate valuation method for unfunded schemes. The balance sheet of the company will show the full value of the unfunded benefits as liabilities of the company and there will be no specific assets earmarked to provide the benefits. The challenges of book reserving are insecurity of reserves, liquidity problems, overstatement of profits for taxation and insecurity of benefits.
No Minimum Level of Adequacy
Regulator(s) require that defined benefit (gratuity/pension) schemes must always have appropriate and adequate assets available to pay the benefits. The financial assessment framework (which defines the statutory funding objective), is normally part of the Pensions Act and sets out the requirements for the financial position of a gratuity/pension fund. A gratuity/pension fund’s financial position is reflected largely by the coverage ratio. This expresses the relationship between the fund’s assets and the liabilities to be paid in the future. There should be a minimum coverage ratio (e.g. 105%), that is, the assets must amount to 105% of the liabilities.
However, section 50 (2) of PRA 2014 only specifies that any defined benefits scheme in the private sector shall undertake an actuarial valuation to determine the adequacy of the pension fund assets, but without stating clearly the level of adequacy (i.e. no minimum coverage ratio) required which is a regulatory challenge. The above implies a minimum coverage ratio of 100% (i.e. the assets must amount to 100% of the liabilities) which no doubt is likely to create an insolvency risk for private sector schemes, particularly when there is volatility in the financial market.
In addition to the minimum coverage ratio, a gratuity/pension fund must also hold enough buffers to be able to cope with financial setbacks or volatility in the financial market. The size of these buffers depends on many factors, but for an average gratuity/pension fund the required coverage ratio including the required buffers is approximately 125%. On average the greater the investment risks and the higher the average age in the gratuity/pension fund, the higher the buffer requirements. The determination of the level of buffers is a task that requires actuarial techniques, having considered the risk appetite of the scheme.
No Guidelines on Recovery Plan
Section 50 (1) (g) of PRA 2014 requires that an employer shall undertake to the PENCOM that the pension fund shall be fully funded and any shortfall (in scheme assets required to meet the liabilities) to be made up within 90 days. This means that if there is a funding shortfall (i.e. coverage ratio of less than 100%), the employer must submit a recovery plan to PENCOM. The steps to be taken to regain the minimum coverage ratio within the period of 90 days (i.e. the requirements of a recovery plan) are not clearly specified by the regulator, PENCOM. The challenge is that this regulatory function has not been effectively carried out and/or neglected by PENCOM.
Lack of adequate Supervision of Private Sector Schemes
There are no clear regulatory guidelines on the administration of private sector gratuity/ pension schemes since the Pension Reform Act was first enacted in 2004, despite the fact that the number of gratuity schemes operating in the pension industry are on the increase. Thus, private sector gratuity/pension schemes have not been effectively regulated and supervised by the regulator (PENCOM) relative to CPS, probably because the supervisory roles (e.g. to determine an appropriate level of adequacy of scheme assets, section 50 (2) of PRA 2014) relating to the former schemes require more actuarial involvement and expertise.
However, the enforcement of accounting regulation, IFRS as set out in IAS 19, for listed companies operating private sector gratuity/pension schemes in Nigeria effective from 2012 by Financial Reporting Council of Nigeria (FRCN) is a welcome development.
There is a tax disadvantage for an employer’s contributions into gratuity schemes relative to paying the same amount as AVCs into CPS (section 10 (1) of PRA 2014). The contributions, investment returns and retirement benefits in the CPS are tax exempt section 10(1)(2) (3) of PRA 2014 while the employer’s contributions and gratuity benefits are not taken as tax exempt. However, any income earned on any AVC under CPS is taxable at point of withdrawal within 5 years of making the AVC. Furthermore, the retirement benefits payable from CPS are also not taxable (section 10 (3) of PRA 2014) whereas the gratuity benefits are taxable in the hands of the employees.
Management and Custodian of Private Sector Pension Funds
Section 50 (4) of PRA 2014 states that the management and custodian of pension funds for private sector pensioners shall be undertaken by licensed Pension Fund Administrators (PFAs) and Pension Fund Custodian (PFCs). This is also applicable to every employee in the existing pension scheme in the private sector who wants to exercise the option of coming under the new CPS.
The above provision may require a bulk transfer of private sector pensioners’ and/or individual employee funds to the PFAs and PFCs for effective management and custody respectively. This process would involve the determination of the bulk transfer value by an actuary for the pensioners and/or individual employee. The challenge is that the bulk transfer value would have a negative impact on the future financial position of the private pension scheme for the remaining active members.
Opportunities of Managing Private Sector Schemes
Actuary’s Expertise in Managing Risks
The engagement of actuaries (as required by law (PRA 2014 and/or IFRS) and/or scheme Trust Deed/Rules in the management of private sector gratuity/pension schemes would result in adequate assessment of funding needs thereby reducing the risk of insolvency.
Actuary’s expertise can be used in managing the risks arising from the administration of gratuity/pension scheme by:
• Modelling the asset and liability stochastically in order to determine an appropriate investment strategy in line with the volatility risk in employer’s contribution(s) into a balanced of cost scheme over time (arising from the effect of gearing and also lower than expected investment returns on the fund assets).
• Providing appropriate advice to meet new accounting and statutory regulations for technical provisions and/or solvency margins of the schemes that will emerge in the future.
• Determining bulk transfer value of gratuity/pension scheme in event of mergers and acquisitions of a company.
The major stakeholders, namely sponsors, regulators and operators require actuarial services in order to effectively manage the private sector gratuity and pension schemes.