Introduction to Pension Schemes

Introduction to Pensions

• Pension schemes protect against income loss when individuals are no longer gainfully employed, offering financial security
• Pension schemes protect citizens against social risks, maintaining living standards after retirement or in unforeseen circumstances

Pension Scheme Definition

• An arrangement providing benefits to members upon retirement or specified contingencies
• Benefits include a lump sum, annuities, or a combination
• Schemes are designed to protect formal sector workers and their dependents throughout their economically active lives

Key Features of Pension Contracts

• Agreements are long-term
• Used to provide income during retirement for individuals and their dependents
• Provision of other benefits such as lump sum payments to dependents if the individual dies before retirement

Contingencies

• Benefits include regular income or lump sums to members based on main contingencies
• Normal Retirement Age reaches the retirement age
• Retirement age typically varies by country and sometimes by gender
• In Egypt, entitlement begins at 60 and to be extended to 65
• Scheme members can often elect to retire early within a specified range, such as 60 to 65
• Death: Death of a member, spouse or dependents may receive benefits as determined by scheme status
• Disability or Incapacity: Benefits may be provided with illness injury, or occupational disease
• The scheme may provide a pension or lump sum irrespective of age, may vary based on injury severity, and duration of treatment

Withdrawal From Service

• Active members voluntarily leaving a fund become deferred pensioners
• Deferred pensioners may receive an immediate lump sum payment
• In the event of resignation, termination or transfer, or early pension:
• If the actual subscription period of the member in the fund is less than 5 years, the member is given total contributions paid
• In the event that the actual subscription period of the member exceeds 5 years, the member is paid an amount subject to insurance according to reaching the age of sixty years, and is then reduced according to the following reduction table approved by the General Authority for Financial Supervision for each year or part of the year remaining to reach the statutory age of retirement (age of sixty years), and the minimum advantage is the total of the subscription fees paid.

Pension at Retirement Age

• These values show a potential percentage of payment based on retirement age
• 39% at age 46, or 14% at age 31
• 41% at age 47, or 15% at age 32
• 44% at age 48, or 16% at age 33
• 48% at age 49, or 17% at age 34
• 51% at age 50, or 18% at age 35
• 54% at age 51, or 20% at age 36
• 58% at age 52, or 21% at age 37
• 62% at age 53, or 23% at age 38
• 67% at age 54, or 24% at age 39
• 71% at age 55, or 26% at age 40
• 76% at age 56, or 28% at age 41
• 82% at age 57, or 30% at age 42
• 87% at age 58, or 32% at age 43
• 93% at age 59, or 34% at age 44
• 100% at age 60, or 36% at age 45

Providers of Pension Programs

• Social Security Pension System: It is a legal system ensuring economic security sponsored by the government, covering many residents
• Governmental pension
• Public pension
• Private employer-sponsored pensions
• Personal pensions: Established and funded by individuals

Types of Pension Scheme Members

• Actives: Currently accruing future pension earnings
• Deferred members: Those no longer accruing future benefits but have a benefit entitlement in the future
• Current Pensioners: Members currently receiving their benefits

Main Types of Pension Schemes

• Classified by coverage, benefits, contributions, and funding
• Coverage relates to the coverage of working people
• Benefits and contributions pertain to how benefits are structured and what contributions are made
• Funding pertains to how the scheme is funded

Coverage of Pension Schemes

• Single member schemes are set up by individuals via policies that allow for account accumulation for adequate retirement income
• Group pension schemes cover groups sharing a common interest, work
• Setup implemented by an employer compensating workers, or is administered by employee agreements guaranteeing additional income to the basic state pension

State Pension Schemes

• State pension schemes are initiated by governments which provide social programs for citizens
• State schemes have compulsory membership, acting as major sources of pension benefits for retirees
• Occupational pension schemes within supplementary role to state schemes, providing types and levels of benefit

Benefits and Contributions

• The main types include defined benefit schemes, defined contribution schemes, and hybrid schemes
• The type of scheme determines the benefit type and risk allocation between member and sponsor
• State-sponsored and occupational pension schemes can be defined benefit, defined contribution, or hybrid
• Personal pensions are considered Defined Contribution in nature

Defined Benefit Schemes

• Benefits are calculated using a specific formula
• Benefits are defined by scheme rules, independent of contributions, and not directly related to investments
• Benefits are dependent on service length and pensionable salary or career average
• Benefits are defined by member's work duration, and salary at retirement

Pension Entitlement

• Pension entitlement relates to pensionable service length, as defined by scheme rules
• Memberships at retirement and membership duration are examples
• Pension entitlement for serviceable years relates to pensionable salary level
• Amount that which pension increases rates for each service year is named the 'Accrual rate'

Pensionable Salary

• Pensionable salary is defined in three ways
• (1) annual salary at retirement ("final salary") based on earnings at the point of retirement
• (2) average annual salary in the few years (3-5) before retirement ("final average salary")
• (3) average annual salary during scheme membership ("career average salary"or "lifetime earnings")
• Mitigates the effects, inflationary increases uses index of prices
• Some schemes do not count overtime, bonuses, commissions

Defined Benefit Scheme Example

• A pension from retirement of 1.5% of final salary given for each service year with the company
• A member retires on salary of £25,000 having worked 20 years
• Calculate annual pension entitlement

Defined Benefit Schemes Solution

• The annual pension comes to £7,500
• (1.5% * 20 * 25,000 = £7,500)
• Remain at the same level with no offers of pension increases
• Pension increases with fixed index-linked or discretionary options
• Note that the figure 1.5% equates to 15/1000 and this is known as the 'accrual' rate

Defined Benefit Scheme Example 2

• A member of defined benefit scheme is entitled to a pension from a retirement of 2% of final salary $60,000 for each year of service and worked for 30 years
• Annual pension is calculated as $36,00 annually
• (Pension = 2% * 30 * 60,000 = $36,000)

Defined Contribution Schemes

• "Money purchase schemes"

• Includes frequency, timing of contributions, contributions with fixed percentage from salary

• Benefits dependent on investment returns accumulated over the years until retirement

• Member has the choice as to which asset classes contributions are invested in

• The pension is not defined, depending on investment returns achieved by assets

• Use accumulated at retirement to meet their post-retirement needs

• Choice at retirement for how to use found, dependent on regulation

• Secure a pension with a life insurance company by purchasing an immediate annuity (or employer may provide with occupational scheme)

• Money as a lump sum cash amount, although there may be tax implications

Defined Contribution Scheme Example

An individual aged 60 exactly is making savings of £5,000 each year on his birthday into a defined contribution scheme. Pre-age 60 he has already saved £100,000 and will retire at age 65 at which point he plans to purchase an annuity. His investments earn a return of 5.5% pa.

• Calculate his accumulated fund at age 65 (note that he won't make a contribution on his 65th birthday, the day he retires!)
• Calculate the annual pension he can buy if the annuity rate is 16 (in other words if it costs £16 to buy a pension of £1 pa for the rest of life).

Defined Contribution Calculation Solution

• Accumulated fund = £160,136
• 100,000x(1.055)^5 + 5,000x(1.055)^5 + 5,000 x (1.055) + 5,000 x (1.055)^3 + 5,000 x (1.055)^2 + 5,000 x (1.055)
• Annual pension = £10,009pa
• 160,136 / 16

Hybrid Schemes

• Combination of defined benefit and defined contribution schemes
• Defined benefit scheme with a money purchase underpin
• Money purchase scheme with a defined benefit underpin
• Scheme with a choice of money purchase and defined benefits
• Defined contribution scheme with a defined benefit formula that can be modified to accommodate the changing experience of the scheme