CAN YOU RETIRE?

As promised, this week we will start the conversation about pensions by looking at retirement and your options generally.?The questions we will address are:

• Can you afford to retire?
• Will you be able to live on your retirement income?
• What is different today compared to when our parents retired?

But before we do that let’s take a brief look at the history of pensions.?Pensions are a fairly recent development.?The first pension funds originated over 300 years ago in Germany to support the widows of clergymen and teachers who served the crown.?Later on, pensions in the form of annuities were granted by the rulers of the day as compensation for the loss of spouses (especially for officers killed in action), loss of limbs (again, mostly for the wounded in action) or in return for acts of merit, either military or civil.

Around 1889, the German Empire established a fully-fledged pension system for workers aged 70 and over.?Workers in Great Britain had to wait until 1908 to be eligible for a state-pension and after World War II the UK’s National Insurance Act provided universal social security coverage.?We have similar benefits in Trinidad and Tobago.

The National Insurance Board’s (NIB’s) Retirement Benefit?

The NIB’s Retirement Benefit is designed to supplement the income of individuals after retirement.?Every employee who has paid National Insurance contributions is entitled to a Retirement Benefit.?You qualify for the Retirement Benefit at any time between the ages of 60 and 65 if you are retired or at age 65 whether you retire or not.

The Benefit may be either: A Retirement Pension payable for life to persons who have 750 contributions or more - the minimum requirement for a basic pension; or a Retirement Grant, which is a one-time lump sum payment, subject to a minimum sum of $3,000.00 paid to persons who have made less than 750 weekly contributions the minimum requirement for a basic pension.

An average rate of contribution is calculated by considering all the contributions paid. The earnings class to which this average rate corresponds is the class in which the benefit will be paid. You should note that for every block of 25 contributions paid in excess of 750 one increment is added to the basic pension rate. Notwithstanding the benefit rates in respect of retirement pension the board shall pay with effect from February 1, 2012 the sum of $3,000.00 monthly, as a pension to each person qualifying for a Retirement Pension.

• Where the insured person reached retirement age on or after January 7, 2008. The retirement grant will be equal to 3 times the value of total contributions, subject to a minimum of $3,000.00.
• Where the insured person reached retirement age on or after April 10, 1975 the Retirement Grant is equal to 3 times the value of the total contributions paid by both employer and employee, subject to a minimum of $200.00.
• Where the insured person reached retirement age between April 10, 1972 and April 9, 1975 the Retirement Grant is equal to 5 times the value of the total contributions paid by both the employer and the employee, subject to a minimum of $200.00.

This is obviously not enough for most of us to live on and will have to be supplemented by a company pension, your individual retirement plan, income from accumulated savings and investments, or income from continued employment post retirement.

Employer Pensions—Defined Benefit Plans

The defined benefit (DB) plan was the most popular and common type of retirement plan through the 1980s.?A DB plan is an employer-based program that pays benefits based on length of employment and salary history.?The plan typically guarantees a specific benefit or pay-out upon retirement.?The employer may opt to pay a fixed benefit or one calculated according to a formula based on years of service, age, and average salary.?The employer typically funds the plan by contributing a regular amount, usually a percentage of the employee's pay and, depending on the plan, employees may also make contributions.?The employer’s contribution is, in effect, deferred compensation.?You should note that the employer, not the employee, is responsible for all of the planning and investment risk of a DB plan. ?Based on actuarial calculations and the performance of the plan’s investments, the employer’s contributions may increase substantially.

Upon retirement, the plan may make monthly payments throughout the employee’s lifetime, a lump-sum payment, or both. ?For example, a plan for a retiree with 30 years of service at retirement may state the benefit as an exact dollar amount, such as $500 per month per year of the employee's service.?This plan would pay the employee $15,000 per month before tax in retirement.?If the employee dies, some plans distribute any remaining benefits to the employee's beneficiaries.?Payment options commonly include:

• a single-life annuity, which provides a fixed monthly benefit until death
• a qualified joint and survivor annuity, which offers a fixed monthly benefit until death and allows the surviving spouse to continue receiving benefits thereafter, or
• a lump-sum payment, which pays the entire value of the plan in a single payment.

Defined Contribution Plans

Today defined contribution plans are the more common type of retirement plan.?A defined-contribution (DC) plan is a retirement plan that's typically tax-deferred, i.e., it allows employees to contribute a fixed amount or a percentage of their pre-tax pay checks and invest in capital market accounts like an investment-linked annuity policy on a tax-deferred basis.?This means that income tax will ultimately be paid on withdrawals, but not until retirement age when the funds accumulated in the account are used to purchase a retirement pension at any age typically between 50 and 70 years.

As an added benefit, the employer has the option to match a portion of the employee’s contributions.?These plans restrict when and how each employee can withdraw funds without penalties.?Unlike DB pensions, in which retirement income is guaranteed by an employer, DC plans have no guarantees. ?Therefore, there is no way to know how much a DC plan will ultimately pay you when you retire since contribution levels can change, and the returns on the investments may go up and down over the years.?After the blood bath in the international financial markets so far this year, the projected pay-outs on many DC plans would have declined dramatically.

UNLIKE DEFINED BENEFIT PENSIONS, IN WHICH RETIREMENT INCOME IS GUARANTEED BY AN EMPLOYER, DEFINED CONTRIBUTION PLANS HAVE NO GUARANTEES.

The returns on DC plans are dependent on the skill of the investment managers at the insurance companies.?This means that some managers may invest in improper portfolios, for instance, over-investing in certain sectors rather than a well-diversified portfolio of bonds and equities in various geographies and industries.?DB pension plans, in contrast to DC plans, guarantee retirement income for life from the employer as an annuity. ?DC plans have no such guarantees, and many workers, even if they have a well-diversified portfolio, are not putting enough away on a regular basis and so will find that they do not have enough funds to last through retirement.

In my generation, retirement income was seen as a tripod.?One of the tripod’s legs is the state provided retirement pension, i.e., the pension provided by the NIB.?Another is the pension provided by your employer, usually a DB plan, and the third is the income generated by your savings and investments.

A lot has changed since.?What has been responsible for this shift?

Explanations include increased workforce mobility, pension under-funding due to a decline in long-term interest rates, the move to more market-based accounting, the increasing regulatory burden and uncertainty of the effects of increased longevity on plan costs for employers.

Workers are more transient today.?It is highly unlikely that you would work for the same employer for 30 or 40 years.?Many of you have had, or will have, multiple jobs and careers and don’t have the traditional employer provided pension plans.?Therefore, DB pensions are not as attractive because they are not portable (you cannot move with them) and their benefit formulas are “backloaded”, favouring long-tenured employees.

Also, interest rates are much lower than they used to be so that fixed income investments like treasury bills and bonds are not providing the level of income needed and therefore employers must contribute more to fund DB pensions.?This is also compounded by today’s rising life expectancy, extending the payment of pensions for much longer time periods.?It is also linked to regulatory and accounting reform that is making these risks more transparent.?Since DC contributions can be fixed, either as a set amount or as a percentage of salary, migrating to a DC plan offers employers more control over their employee costs.

The bottom-line is that we need to take responsibility for planning, saving and investing for our own retirements.?This may mean that we will have to work longer.?Retirement may not be an option.?Next week we will look at how you should be calculating the amounts needed for retirement.?As usual, I look forward to your questions and comments.

PLEASE NOTE THAT AN EARLIER VERSION OF THIS ARTICLE NOTED THAT THE MAXIMUM MONTHLY NIB PENSION WAS TT$3,000. THIS WAS INCORRECT. THE MINIMUM IF YOU HAVE MADE AT LEAST 750 CONTRIBUTIONS IS TT$3,000. I WOULD LIKE TO THANK MY GOOD FRIEND MARK MAUNDY FOR BRINGING THIS ERROR TO MY ATTENTION.

Cheers, Nigel

Nigel Romano, Partner, Moore Trinidad & Tobago, Chartered Accountants