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Challenges of a pension system

If a country’s population is ageing, pension entitlements have to be borne by a shrinking workforce for a growing group of retirees.

ONE aspect of an ageing society is obvious to everyone – care for the elderly will take on greater importance. How adequate are Malaysia’s pension systems?

In western societies, most countries have achieved universal coverage, with net income replacement values ranging from 29% in the United Kingdom, to 96% in the Netherlands (based on OECD data).

Most of these countries operate defined benefit (DB) schemes, with multiple schemes layered on top of each other, although defined contribution (DC) and hybrid schemes have become more popular.

For example, the Dutch system has a universal public pension paid for by contributions from citizens and linked to the minimum wage and indexed for inflation; an occupational pension (typically on an industry basis) with funding from salaries and employer contributions; and, a voluntary pension tier.

The challenge in these western economies is one of sustainability. The problem with DB schemes is that they are based on the principle of pay-go – current workers’ contributions pay for the pension entitlements of retirees. This is not an issue if the demographic profile of the country is relatively stable.

But if the country’s population is ageing, pension entitlements have to be paid by a shrinking pool of workers for a growing group of retirees. The result is a growing mismatch between pension assets and future pension liabilities.

Three reforms have been typically implemented to ensure sustainability. The first is to increase the retirement age, to keep retirement periods in line with increasing life expectancy. The second is to reduce or eliminate indexation, and the third is to directly reduce the level of pensions paid. All three reduce the real benefits retirees get from their pensions, thus trading off adequacy for sustainability.

Malaysia’s challenges are different. Our main retirement scheme is of course the Employees Provident Fund (EPF), which is a DC scheme.

In addition, we also have the Retirement Fund Incorporated (Kumpulan Wang Amanah Pension or KWAP) which is a DB scheme for the civil service, while the Armed Forces Fund Board (Lembaga Tabung Angkatan Tentera or LTAT) provides benefits for armed forces personnel.

Each of these institutions face different problems in meeting their mandates. For EPF, sustainability is not an issue, but adequacy and coverage are. Out of over 14 million members in the EPF system, less than seven million are active contributors. And, 72% of members don’t meet the basic savings requirement at the age of 54, just prior to the withdrawal age of 55 – two-thirds of 54-year-olds have less than RM50,000 in their accounts, or less than a quarter of the basic savings level of RM228,000.

EPF covers only salaried workers, which leaves out the self-employed, the informal sector, and those who are out of the workforce (such as housewives).

LTAT faces similar issues with adequacy, as our servicemen on limited terms of service have inadequate time to build up substantial savings. KWAP on the other hand faces some of the same issues as DB schemes in developed countries.

Currently, pensions for retirees and gratuities for retiring civil servants are paid for out of general taxation. In theory, that means KWAP can focus on accumulating assets to meet the potential future pension liabilities. In practice, however, as the Government’s pension and gratuity outlay has grown much faster than the economy and is expected to continue to do so well into the future, KWAP is squarely up against a growing asset-liability mismatch.

Over and above these, there is also the voluntary Private Retirement Schemes (PRS), and that old fallback – the family unit.

Take-up of PRS has been slow, as few households have the resources to save much due to inadequate incomes. Family support continues to be a mainstay of old-age retirement, but this too is breaking down as the average Malaysian family size has been in decline.

So just like advanced economies, Malaysia has a pension crisis. It’s been a quiet, under the radar crisis, mainly because Malaysia remains a relatively young nation.

Our preoccupations and issues of the day revolve around the issues of the youth, like jobs, affordable housing and the cost of living.

But at the rate Malaysia’s population is ageing, it will ironically be this very same generation of youth who will be most affected, if we neglect to implement reforms.

What can be done?

The biggest gap in our pension system is the lack of a universal national pension, to cater for those who fall out of the formal workforce. This can be very expensive, but is also the most pressing need.

I believe coverage here is more important than trying to meet some impossible standard of adequacy.

Even a modest income supplement would be preferable to leaving people in poverty. Funding such a system would have to be done with care to ensure acceptance and sustainability.

A second reform would be to extend the retirement age. While there is considerable (and understandable) resistance to this, the financial mathematics of pension sustainability and adequacy make this an inevitable step we will need to take. The extra years in work make an enormous difference to post-retirement incomes.

A third reform is to switch the civil service to a DC format, rather than a DB format. This is to ensure that government pensions remain on a sound financial footing, though it will entail some loss of benefits after the changeover.

Every citizen should have the right to a dignified retirement, but Malaysia is sitting on a demographic time-bomb. Whichever route we choose to take, we need to make these decisions soon.

Nurhisham Hussein heads the Economics and Capital Markets Department of the Employees Provident Fund. This is the fourth of a six-part fortnightly series.

Family Community , EPF , retirement , savings , pension , crisis