S Akhtar

1
S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• Karachi Sheraton, 5 April 2007
• Early Bird Seminar on
• Looming Old-Age Crisis for Retired Pakistanis
• A Presentation by Samee-ul-Hasan, FIA, FPSA,
  FCII, FLMI, ASA
• Consulting Actuary
• 3rd Floor (Annexe), State Life No 1 Building,
  Chundrigar Road, Karachi 74000, Pakistan
• Phone [phone] Fax [phone]
  Email actuaries_at_akhasan.com
• www.akhasan.com

2
S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan
Subjects discussed
3
S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• Present and Projected Pakistani population aged
  60 and over
• The population at different ages is the starting
  point for studying the old age income problem.
  Table 1 shows this.
• Table 1
• Pakistan Population according to 1998 census (in
  millions)

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S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• The 1998 census counted 3.8 million males
  3.2 million females aged 60 . Males
  out-numbered females by 19!
• The Indian Census 2001 showed 37. 8 million
  males and 38.9 million females at 60 . Females
  out-numbered males by 3 ! Clearly, Pakistani
  females are under-counted.
• The age-wise data is unreliable anyway.
• But let's take 1998 age wise count as we find
  it. Let's use population mortality rates in 2001
  Pakistan Demographic Survey, smooth and extend
  them to old ages, and project some improvement in
  mortality. Result is in Table 2.

5
S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• Table 2
• Projected number of Pakistanis age 60 and over
  (In millions)

Based on (i) 1998 census age-wise population (ii)
Mortality by age and in 2001 Pakistan Demographic
Survey. PDS mortality rates were smoothed,
extended to older ages, with some projected
improvement. The proportion of women over 60
would rise gradually because of lower female
mortality rates. Actual results will differ from
these projections, because of errors in census
age reporting, uncertainty of current population
mortality estimates, and uncertain future
mortality improvements.
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S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• Pakistanis aged 60 currently number around 9
  million.
• Possibly about 1.5 million1 Federal,
  Provincial, and Defence Services pensioners aged
  60 .
• 200,000 EOBI pensioners aged 60, including
  spouses.
• Number of pensioners of non-government
  employers not known, but small.
• So 80 of Pakistanis over 60 get no pensions
  at all. If we consider couples where the male is
  over 60, at a guess more than 70 of such couples
  get no pension.
• 1This is less than total government pensioners,
  because many of them are under 60

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S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• In 21 years from now, the number over 60 is
  likely to double, to around 18 million.
• We MUST think NOW about pensions for them.
  This issue must be given appropriate priority in
  the national agenda.
• This is the core issue in the looming crisis.

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S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• Existing schemes have limited relevance to
  population over 60
• Government Schemes cover about 15 of
  Pakistanis aged 60 . If we take couples where
  male is 60 , coverage increases to perhaps 23 
  or so. Assume this proportion will remain
  unchanged.
• The scope of EOBI has remained un-changed
  since it was set up 31 years ago. At present, it
  provides pensions to only 2 of those over 60.
  If we take couples where male is over 60, then
  cover increases to maybe 3.5 .

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S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• Pension schemes of non-government employers
  cover a small number of persons. This is likely
  to continue.
• Coverage of VPS scheme remains to be seen.
  There are about 1.5 million income tax payers.
  Experience of such schemes in other countries is
  that over long period, perhaps about 40 of
  income tax payers buy such products. Perhaps a
  few non-income-tax payers will find the scheme
  attractive.

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S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• Need for a National Basic Pension Scheme
• One doesn't have to be a genius or rocket
  scientist to realise that Government Pension
  Schemes, EOBI in its present form, pension
  schemes of employers and VPS, all taken together,
  cannot deliver pensions to great majority of 60
  Pakistanis.
• Problem has been studied by many persons. The
  World Bank's report "Averting the Old-Age
  Crisis", recommended basic pension scheme as
  follows

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S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• It should apply to entire work-force.
• It should provide subsistence or basic
  pensions, not linked to actual salary or income.
• Basic pensions should be reviewed annually to
  compensate for inflation.
• It should be on a pay as you go basis. No
  large Fund should be built up.
• World Bank's reason for objecting to large
  Fund was that in hands of a Government body, this
  is likely to be mis-invested.

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S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• DC schemes are irrelevant. There is no way
  old Pakistanis can pay for their pensions out of
  accumulated savings. There has to be
  inter-generational transfer, and scheme has to be
  based on open group costing. Such a National
  Basic Pension Scheme is Social Insurance, not
  commercial pension business.
• Cost methods like Projected Unit Cost (PUC) or
  Entry Age Normal (EAN), vital for schemes of
  industrial or commercial entities, are not
  relevant for National Basic Pension Scheme. These
  cost methods are red herrings, not applicable to
  open groups like EOBI or a National Basic Pension
  Scheme, where new entrants come in by statute.

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S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• Conversion of EOBI into National Basic Pension
  Scheme
• Scope of EOBI was fixed in 1976. Applies to
  establishments with at least 10 employees. Most
  government and semi-government organisations
  excluded. Banks are also excluded.
• During past 15 or 20 years, several
  Commissions, Committees and individuals have
  recommended that scope of Scheme should be
  extended in phases to cover entire Pakistani work
  force. At the end of this phased expansion there
  would be no exceptions whatsoever.

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S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• No action taken so far on these
  recommendations. These recommendations regarding
  a National Basic Pension Scheme to cover the
  entire work-force should be studied urgently and
  implementation should commence.
• Regrettably, Finance Act, 2006, took reverse
  step. Thresh-hold for new establishments to join
  EOBI raised to 20 employees. This was zero sum
  game, in favour of owners of establishments with
  10 to 19 employees, against employees. In time,
  the unfortunate 2006 amendment will deprive tens
  of thousands from pensions. One presumes that the
  amendment was made without a full appreciation of
  its implications. It requires reconsideration and
  reversal in 2007.

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S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• On the face of it, the Benefit and
  Contributions of the current EOBI scheme respond
  to the needs of a National Basic Pension Scheme.
  The matter may require further detailed study,
  but perhaps the benefit and contribution
  structure in place at present may not have to be
  disturbed to any substantial extent.

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S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• Financial structure of National Basic Pension
  Scheme
• Financial structure of Pay As You Go schemes
  must provide reasonable financial discipline, to
  ensure that pension promise is sober and will be
  fulfilled. Following methods have been used to do
  this.
• (a) UK National Insurance system of 1945
  calculated contributions by actuarial formulas,
  assuming entry into scheme at age 16. But scheme
  applied from Day 1 to everybody, even if much
  older than 16. Naturally, pensions of these older
  persons not built up out of life time
  contributions. This method has long since fallen
  out of use.

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S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• (b) Scaled premium method. A scale period is
  selected. Relation between benefits and
  contributions is designed so that benefits
  during any year in the scale period will always
  be covered by total of contributions plus
  investment income in year. This system followed
  by US Social Security when started in 1937.
  Also been followed by EOBI for more than 25
  years.
• Scaled premium system builds up a Fund. The
  longer the chosen scaling period, the bigger the
  Fund, and the bigger the contribution of
  Investment Income.

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S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• (c) Long-range actuarial balance Only small
  Working Balance is maintained, equal to
  projected benefits during next one or two years.
  Projections are made for long periods (75 years
  in the US), with planned changes in contribution
  rates. Alternative scenarios test whether
  current and planned future contribution rates
  will result in maintaining Working Balance at
  all times.
• No substantial fund is built up, so investment
  income is relatively small, but influence of
  demographic factors is very important.

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S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• Methods (b) and (c) take into account future
  new entrants who will enter scheme under the
  law. In fact, US Social Security, UK National
  Insurance, and other National Pension Schemes
  are always "open group".
• Which financial structure will suit our
  National Basic Pension Scheme requires careful
  study. But finances will not stand in the way,
  if the political will exists.

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S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• Why Employers moving away from Defined Benefit
  Pensions
• Let us turn to a subject of more immediate
  interest to those present.
• Suppose pension is defined by Final Salary,
  or Final Average of last few years. Then
  employer is issuing blank cheque. Amount will be
  filled in many years, perhaps decades, later.
  Employer is exposed to future salary risk.
• Expectation of life after retirement has
  increased more than projected. Employer is
  exposed to longevity risk.

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S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• Investment returns can fluctuate. Value of
  pension fund investments can fluctuate,
  especially if invested in shares or long term
  fixed interest bonds.
• Cost reported under PUC method mandated by IAS
  19 to measure DB liability is unstable. This
  gives rise to measurement risk.
• Despite these risks, DB schemes dominated for
  decades. Because most comparable employers
  offered DB schemes, employers regarded such
  schemes as necessary to maintain a competitive
  remuneration package.

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S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• Financially they worked over long periods,
  because investment returns offset salary
  increases. Entry Age Normal and/or Aggregate
  cost methods used formerly in UK and Pakistan
  stabilised reported pension costs.
• Employees like these schemes because it gives
  them comfort about the relationship between
  pension and final salary.
• But many Employers now think there is no good
  business reason to take on future salary,
  longevity, investment and measurement risks of
  DB schemes. It distracts them from their core
  business. It could affect their rating. It could
  impair competitiveness.

23
S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• Strong body of opinion that problems of DB
  schemes over- rated, that history shows that in
  long run these have worked well. In an article
  in US "Pension Section News" of Jan 2005, Mark
  Ruloff pointed out that DC schemes make employer
  vulnerable to recruitment, retention and morale
  problems.
• But in business and economic affairs, as in
  height of women's hemlines, there are fashions.
  A few decades ago, conglomerates were in
  fashion. Later, they went out of fashion.
  Mutualisation was in fashion at one time. Now,
  demutualisation is in fashion. In pensions,
  current fashion decidedly favours DC schemes.
  Maybe a decade or two later, DB schemes may come
  back into fashion.

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S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• Special problems with DB schemes in important
  countries
• Economic basis for actuarial valuations of
  pension schemes is critical, namely rate of
  return used to discount liabilities and rates of
  salary increases and pension increases.
• In a certain large and important country,
  employers decide economic basis for pension
  valuations. Actuaries do not have to comment on
  appropriateness of economic basis.
• When interest rates were high, employers
  required actuary to use 9 pa or 10 pa to
  discount pension liability, with NO provision
  for pension increases.

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S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• Interest rates very often respond to inflation
  rates. So in this way, employers took credit for
  inflation on income side, but ignored its effect
  on outgo side. The economic basis was internally
  inconsistent.
• They justified this by not giving increases to
  pensioners even in relatively high inflation
  conditions, which is unfair.
• When interest rates fell, discounting rate
  fell, reported pension liability increased
  sharply, which translated into lower reported
  profits.

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S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• Also, in many important countries large
  investments in ordinary shares resulted in
  contribution holidays when share market was up,
  and big deficits when market went down.
• These sharp fluctuations in reported profits
  were aggravated by Projected Unit Credit cost
  method mandated by accounting standards.
• DB schemes became unpopular with
  share-holders, accountants and analysts.

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S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• Scenario in Pakistan
• Outside EOBI and Government and Defence
  Personnel, pension schemes are relatively few.
  Some, but not all, multi-nationals and some
  public sector organisations have such schemes.
  Hardly any Pakistani private sector organisation
  has pension schemes.
• The economic valuation bases of almost all
  Pakistani pension schemes have generally been
  internally consistent. In high inflation
  conditions, high interest rates were offset by
  assuming correspondingly high salary increase
  rates and also pension increases.

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S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• The few Pakistani pension schemes that exist
  are in fairly good shape. Pakistani actuaries
  can take some credit for this.
• But Pakistani subsidiaries of multi-nationals
  in Pakistan have to accept directives of
  parents, based on experience in their home
  countries.
• Hardly any new pension schemes set up in
  recent past.
• Many existing DB pension schemes have been
  converted to DC. One or two have been shut down
  altogether. In some cases, the Employer has
  offered 100 commutation, so that he sheds all
  his risks.

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S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• Risks borne by Employer and individual
  participants
• Generic problems include (a) Final salary
  risk, i.e. risk that pension will not be
  reasonably related to final salary
  (b) Investment risk during service (c)
  investment risk after retirement and (d)
  Longevity risk.
• Table 3 analyses these risks. To complete the
  picture, DB Gratuity Schemes --- still very
  prevalent ---- and Provident Fund schemes have
  been included. Also individual savings outside
  any scheme. Employers, employees and individuals
  can use Table 3 as a menu for selecting their
  path forward, having regard to their own
  circumstances.

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S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• Table 3
• Analysis of risks by Employer and Employee/
  participant

23/4E because some schemes require employee
contributions, he gets no tax relief on
this. 31/2E because Employee must contribute at
least half of cost, gets no tax relief on this.
31
S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• Table 3 (cont'd)

4Tax regime assumes funded gratuity 53/4T
because 1/4 accumulated amount can be taken tax
free 6Because income draw down schemes will
assume 100 survival to age 75 7Too complicated
to summarise. Income tax relief on Mutual Funds.
No relief on other saving.

32
S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• Remarks on Table 3
• The investment return objective for retirement
  planning must be real yield, net of tax, net of
  inflation (and, if applicable, net of zakat).
• Net of above factors, no investment in
  Pakistan8 offers safety of income or capital.
  Real yields can alter sharply, but are probably
  more stable than nominal yields.
• The benchmark on nominal (not real) safety of
  capital is yield on Government Securities.
• 8In the UK, USA, Canada, France, and other
  countries, Index linked Government Securities
  offer such safety of capital and income.

33
S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• The pre-tax IRR on SSC's if held to 3 year
  maturity is 9.34. Provident or DC Pension Funds
  would get this. Net of inflation at current
  level of 7.59, yield would be 1.71 pa10.
• Would 1.71 pa keep up with net-of-inflation
  salary increases? Probably not, especially if
  promotions are reckoned. This Final Salary Risk
  is transferred to Employees under DC schemes.
  Over working career of 35 years, it could have
  substantial effect on money available on
  retirement.
• A retiree holding SSC's to redemption would
  get a net of inflation net of tax IRR of only
  0.84 p.a.
• 9In this presentation, inflation has been taken
  everywhere at current level of 7.5 pa
• 10((1.0934/1.075)-1)100

34
S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• Bahbood pays 0.96 per month pre-tax, IRR
  12.15 pa. Retiree holding maximum Rs 3 million
  would get IRR 3.25 net of inflation and tax, if
  he pays 10 tax at end of year. His income after
  10 tax is Rs 25,920 p.m. But he should spend
  only Rs 8,125 p m in first year, and re-invest
  difference of Rs 17,795 to maintain real income
  in Year 2. But hardly anybody does this. Retiree
  will gradually be impoverished.
• Ordinary shares dividends have in past
  maintained purchasing power better than income
  on fixed interest investments. But under "life
  cycle" concept, a retired person would move out
  of ordinary shares by the time he retires!

35
S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• A paper in the North American Actuarial
  Journal studied this question in depth. The
  authors' conclusion was that there is no
  evidence to support the "life cycle" concept.
• Employers who prefer DC pension schemes should
  not just walk away from the risks transferred to
  employees. They should perhaps have non-binding
  targets of retirement income, monitor the
  progress of such schemes measured against this
  target, and make "course corrections" if
  required.

36
S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• Employers, asset managers, investment
  advisers, bankers etc, should be candid with
  employees and participants.
• Retirement planning, and sales illustrations,
  should be on yields net of inflation, and net of
  income tax and asset manager's charges, if
  applicable.
• Net of above factors, risk adjusted yields
  will probably be under 2 pa on a fixed return
  portfolio, maybe around 3 pa if a limited
  proportion acceptable to the retiree is in
  ordinary shares. This realistic picture will
  encourage higher saving rates. Unrealistic
  pictures based on double digit yields will lower
  savings rates, causing disappointment and
  disillusion, which could boomerang.

37
S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• The effect of Improving Mortality on annuity
  business
• On studying experience of more than 40 years
  in Pakistani pension schemes, especially those
  for management, Akhtar Hasan found a
  considerable improvement in mortality of
  relatively well-to-do Pakistanis, like those here
  today.
• This improvement will continue. It is always
  hard to project future improvement. But
  actuaries have to stick their necks out and make
  some estimate. Allowing for projected future
  improvement, here is how we estimate survival
  rates among well to do Pakistanis.

38
S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• Table 4
• Projected survival probabilities of Pakistani
  management pensioners

39
S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• Only time will tell whether survival of VPS
  participants will follow this experience. But it
  is prudent to assume that they will have light
  mortality.
• The high probability of survival to age 75
  means that compulsory annuitisation at that age
  under VPS scheme, is a real possibility and has
  to be reckoned with. In fairness, VPS sellers
  should be ready to answer questions on this.

40
S Akhtar Hasan (Pvt) LtdActuaries, Karachi,
Pakistan

• For life insurer, annuities are a difficult
  market. Prudent estimates of longevity have to
  be made. Improving longevity also means it may
  be hard to find matching investments, which
  means prudent yield estimates.
• Annuity rates which insurer's Appointed
  Actuary is prepared to certify as prudent for
  the insurer may be thoroughly unattractive for
  buyer.
• This could be Achilles Heel of VPS system.
• High chances of surviving to old ages may call
  for a new paradigm, to replace the age old
  annuity concept.