We need a wholesome approach to retirement

 

From Amar Ramachandran

For an individual, especially one who is not pensionable, retirement planning is rightly a 30-year consideration but, in reality, most would only start to look at their financial circumstances in the last five to ten years to retirement.

While we should be concerned that 6.1 million out of the nearly 15 million Employees Provident Fund (EPF) members have less than RM10,000 in their EPF accounts, simplistic proposals to tinker with the dividend rate based on the amount held in one’s EPF account misses the broader, longer-term issues germane to establishing a complete retirement financing ecosystem.

The current system and its flaws

A comprehensive study done for the World Bank in 2014 outlined some broad weaknesses in the EPF system as follows:

i. Gross replacement rate (%) of 35.1% for men and 31.9% for women coming in at one of the lowest after Indonesia (14% for men and 13% for women) compared to Asean and OECD averages (c. 54%). In other words, men receive on retirement 35% of their gross pre-retirement annual earnings notwithstanding that we have one of the higher total contribution rates of 23%. The various withdrawals allowed by EPF likely lead to this scenario.

ii. Fragmentation in the management of retirement savings with various institutions and government departments/agencies managing retirement benefits for their respective niches, eg Armed Forces Fund, Public Service Department for civil service pensions, Socso, EPF and the private retirement scheme (PRS).

Duplication of capabilities and loss of scale in operations, especially for the public sector-driven schemes, are evident. Fragmentation also occurs in the context of segments of the populace who do not have an EPF account, especially the self-employed where only 1% of this group voluntarily save with the EPF.

iii. The EPF functions primarily as a retirement savings investment fund instead of a full-fledged pension fund. Meaningful recommendations have been made in the 2014 study to implement an annuity-based pension scheme instead of a lump-sum payout upon retirement. However, it was also noted that the average EPF account had too little to enable an annuity payment mechanism to be implemented.

By way of illustration, if an individual retired and had RM10,000 in his EPF account, he or she would be entitled to receive c. RM872 per annum for the next 20 years assuming a discount rate of 6%, which is more or less the opportunity cost as represented by EPF’s dividend rate. Comparatively, to receive a monthly pension of RM2,000 for 20 years would require a corpus sum of c. RM279,000 upon retirement assuming a similar discount factor.

In a more recent study, Malaysia’s EPF was given a C-grade (index value of 50–60) in a 2021 Mercer-CFA Institute global pension study of 45 retirement systems covering 65% of global population. The study ranked retirement systems based on three factors – adequacy, sustainability and integrity.

The index value ranged from 40.6 (Thailand) to 84.2 (Iceland). A C-grade retirement system is one where there are some good features but also major risks/shortcomings that could affect the efficacy and long-term sustainability of the retirement system.

Malaysia’s overall index value of 59.6 and ranking of 23 out of 43 retirement systems saw reduction in our sustainability ranking and negligible improvement in the adequacy ranking compared to 2020.

EPF investment strategy

Section 27 of the EPF Act 1991 requires the EPF Board to declare an annual dividend of not less than 2.5% for the non-shariah accounts and towards this end, the EPF has been declaring between 5% and 6% over the years on average.

EPF’s investment strategy has broadened considerably over the years and their asset allocation is likely to provide a more optimum risk-return reward in tandem with their risk appetite. Interfering in this market-driven process to infuse socialistic elements such as different dividend tiers based on the ringgit value in an EPF account would be a folly.

The EPF holders who are discriminated against would agitate to withdraw and transfer their funds elsewhere. In terms of value, based on December 2020 figures, EPF account holders with more than RM500,000 make up c. 25% of EPF’s total AUM of RM936 billion and a withdrawal of these funds would reduce the benefit obtained through economies of scale in EPF’s operations.

The nation already has a progressive tax system through which the upper middle class and top class pay considerably more taxes. The burden should not be placed on individual citizens or a class of citizens to fulfil what rightly is the responsibility of the government. As someone once said very wryly, the best way to help the poor is to not be one yourself!

The role of government

In 2008, the World Bank came up with the five-pillar approach to a pension conceptual framework as follows:

Zero Pillar: a non-contributary basic pension from public finances. In Malaysia, some would have been entitled to cash assistance in past years based on the requirements in the federal government’s annual budget for some schemes – bantuan prihatin and assistance for the recent pandemic for example.

First Pillar: a mandatory public pension plan with contributions linked to earnings. In Malaysia, pensionable civil servants are entitled to a basic pension under the defined-benefit pension system where 17.5% of their monthly remuneration is paid towards this. However, there is a serious underfunding in the public pension scheme given that the benefits are specified as opposed to the EPF system of defined contribution.

Second Pillar: a mandatory fully-funded occupational or personal pension plan. The EPF fulfils this role and Socso in a limited way for disability and workplace injury.

Third Pillar: a voluntary, fully-funded occupational or personal pension plan. In Malaysia, the PRS system fulfils this role. There is a tax benefit capped at RM3,000 for annual PRS investment.

Fourth Pillar: a voluntary system outside the pension system providing support, including insurance, healthcare and housing. In Malaysia, we have these though the lower middle class and poorer individuals do not generally avail them citing affordability.

The elephant in the room is the zero support for the 15 million workers and EPF contributors from the Zero Pillar and I would expand on this from two angles:

i. Federal government affordability:

Civil servants pay 17.5% of their monthly remuneration towards their future pension and notwithstanding that this represents some earnings-linked contribution, their pension entitlement follows a defined benefit model. Based on the formula for pension computation, a civil servant who retired earning RM7,000 a month and served for 30 years would be entitled to a pension of RM4,200 upon retirement. In addition, they are entitled to a lump sum gratuity of 7.5% of last drawn salary multiplied by months of service. There are also disability and survivorship benefits in the pension scheme.

Pension payments to reach RM46.6 billion in 2030.

Pension cost has been increasing at 10.3% CAGR in the last 10-years. Presently we have more than 1.7 million civil servants and the pension cost can be expected to go higher as stated by the prime minister himself in Parliament.

KWAP (Kumpulan Wang Persaraan) which was formed in 2007 and started managing the Retirement Trust Fund’s RM42 billion in funds from then on also took over the pension management and payment operations in 2015. It is believed that KWAP’s assets currently total c. RM150 billion and gross investment return averages c. 6%. Without continued support from the government, its returns do not meet the growth rate in pension cost on an annual basis.

Looking at the trend in the annual federal government’s budget where operating expenditure utilises almost the entire revenue with emoluments and pension cost making up c. 50% of the operating expenditure, serious thought has to be given by the federal government to either increase productivity of the civil service or reduce this cost over time.

If this could be addressed and evidently it would take time, all Malaysians or at least retired working Malaysians in the B60 category could be entitled to a living cost indexed monthly cash pay-out from the government.

ii. Becoming a higher-income nation

Malaysia’s mean household income was RM7,089 in 2020 down nominally from RM7,901 in 2019. Notwithstanding that our GNI per capita in 2021 at US$11,200 was just marginally short of the World Bank’s US$12,535 threshold to be classified as a high-income nation, back in 2013 the World Bank had already alluded to Malaysia being stuck in the middle-income trap and recommended expanding our “modern” sectors and for “high-productivity modern sectors to replace low-productivity traditional sectors by growing and hiring more labour”. In this regard it also noted that the service sector in Malaysia has yet to modernise and contribute substantially.

The point being driven at is a higher income nation would alleviate the burden of the government in meeting citizens’ retirement needs either through higher revenue from taxation or a greater number of people being able to fend for themselves.

Key to this process is having a sufficiently skilled workforce and fiscal policies to attract higher value-added investors – and these would be medium to long-term considerations.

Conclusion

At the outset, I had mentioned that there are long-term issues to approaching retirement. Perhaps it may take a generation or 20 to 25 years to evolve into a wholesome scenario. To conclude, the following solutions and their timeline are instructive:

i. To increase the tax benefit threshold for PRS and encourage employers to contribute towards PRS with tax incentives. This would strengthen our third pillar. This can be implemented in the short-term. While employers could start their own defined-contribution plans, there is perhaps more scale and is more cost-effective to utilise the existing PRS framework where licensed fund managers with the requisite expertise are already managing the PRS funds.

ii. Rationalise the civil service and improve the federal government’s operating cost ratio which can be done in the medium-term or in the next five years.

iii. Arising from point ii above, greater support could be availed by deserving Malaysians post-retirement from public finances.

iv. In the longer-term a highly skilled workforce has to come about in tandem with policies to support high-value added industries.

Points ii and iv would inevitably touch upon aspects of the New Economic Policy (NEP) and its successive policies but this is a necessary bullet we would have to bite in the interest of the nation. - FMT

Amar Ramachandran has more than 20 years of experience as an investment professional in the contingent liability industry.

The views expressed are those of the writer and do not necessarily reflect those of MMKtT.