Occupational pension schemes: some regulatory concerns

IN THE Indian context there is no dedicated legislation governing the working and operations of occupational pension schemes. The Income-tax Act 1961 and the Income-tax Rules provide a framework for the constitution, operations (including the pattern of investments) and the termination of approved superannuation schemes. But the framework does not completely address the regulatory concerns that are likely to come to the fore with a growing understanding and appreciation of occupational pension schemes.

This paper raises some of the regulatory concerns that need to be addressed through a comprehensive legislation governing these schemes on lines similar to the Pension Act 1995 in the U.K. and Employees' Retirement Income Security Act 1974 (ERISA) in the U.S. The time has come to pay serious attention to this particularly since the pension sector is about to be thrown open. Since only a small portion of this market has been tapped so far, the potential for growth is great.

The first part of the paper dwells on the features of defined benefit schemes and defined contribution schemes because the regulatory concerns associated with the two types of schemes are different. The second part examines the regulatory concerns related to defined benefit schemes. The third looks at the regulatory requirements related to defined contribution schemes. The fourth briefly deals with the issue of consumer education on pension matters. The fifth and last part dwells on the need for having a regulatory authority for monitoring the working of occupational pension schemes and a pension ombudsman for investigating disputes and complaints concerning these schemes.

Types of schemes

Occupational pension schemes can be divided into two main types. Defined Benefit (DB) pension schemes where the scheme rules set out how benefits for members are calculated. The total contribution required is an unknown quantity, depending among other things, on the level of benefits. The format of the DB scheme is illustrated in Diagram 1.

A ``question mark'' has been placed against employer's contribution rate to highlight the fact that the financing cost of their scheme (from the employer's viewpoint) is not uniform over time.Defined Contribution (DC) or money purchase schemes where the minimum level of contribution is defined in the rules and the level of benefits provided depends on the investment performance of the contributions. The format of the DC scheme is illustrated in Diagram 2.

There are also hybrid pension schemes. For example, some defined benefit pension schemes are established with a money purchase underpin (that is, the benefits will never be less than what could be purchased by a specified rate of contributions accumulated in the fund), and vice versa.

The principal difference between DB and DC schemes is in terms of who bears the investment risk inherent in the occupational pension scheme. In a DB scheme, the investment risk is largely borne by the employer; and consequently his contribution rate (as shown in Diagram 1) is a variable quantity. If investment performance, for example, is better than expected over time, the employer's contribution rate tends to decrease over time. On the other hand, if investment performance is worse than expected, the employer's contribution rate increases over time. In a DC scheme, the investment risk is typically borne by the employee. The level of eventual retirement benefit is thus dependent upon the contributions paid, the investment performance of the fund, expense deductions and the financial conditions at the time benefits are secured.

In fact most occupational pension schemes in the U.K. are in the defined benefit format. But that does not necessarily lead to the conclusion that DB schemes are more popular than DC schemes. Clearly, as there are different companies with different employee profiles, different types of pension schemes can be appropriate. In fact, since the late Eighties there has been a progressive shift towards DC schemes in countries such as the U.S. and the U.K. The important factors driving schemes towards DC are:

Cost Control: From the discussion on DB and DC schemes, it is clear that DB schemes impose an open-ended liability on the employer. Adverse experience, particularly investment experience, will increase the cost to the employer. In a defined contribution pension scheme, the employer's costs are fixed. It is the employee who is affected by adverse experience such as poor investment performance.

Mobility of workforce: The labour markets in most developed countries have been experiencing increased mobility of the workforce. A job is no longer a job for life. Under this scenario DC schemes are perceived as offering better, or at least more comprehensible or fairer, benefits for early leavers.

Increased administrative burden: Layer upon layer of legislation has made some DB schemes, at least many smaller ones, uneconomical in relation to the administrative effort. By contrast DC schemes are outside the purview of many legislative controls applicable to DB schemes.

Of course, many of the aforesaid inadequacies of DB schemes can be addressed through appropriate changes in the benefit design. If these inadequacies are addressed, the sentiments can swing back to DB schemes.

K. Sriram

Visiting Faculty - Finance,

Indian Institute of Management (B)

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