5 pointers on pensions and the JDX

Rezworth Burchenson, Guest Writer. Email:rburchenson@primepensions.com

Over the past month, discussions have centred on the advantages and disadvantages of the recently announced Jamaica Debt Exchange (JDX) and the varied reasons why it is required now in the economic history of the country.

One of the largest holders of these instruments, pension-plan stakeholders - that is, members, sponsors and pensions - will be affected and have many questions regarding their financial future, including the safety of hard-earned contributions.

However, a key distinction must be made between the two types of pension plans: a defined benefit plan (DB), and a defined contribution plan (DC).

Under a DB plan, an employee is promised a pension based on years of service and the average salary for some period immediately preceding retirement. Therefore, the employer takes all the investment risk to ensure that the pension plan is able to meet those obligations when they fall due.

'pot of money'

Any deficiency will be a cost to the employer to enable the payment of the promised benefit.

Under a DC plan, both the employer and employee make a contribution, which is invested by the investment manager under the guidance of the trustees.

Those monies then accumulate over the years of service to the date of retirement.

This 'pot of money' is then used to purchase a pension at retirement.

Therefore, the amount of pension earned at retirement is directly related to the amount of money accumulated - which, of course, also depends on how many years that member contributed - the amounts contributed by the employer and employee and the investment returns over that period; and the cost of purchasing a pension.

When interest rates are high, the price to secure a pension is low, thereby providing a higher monthly sum to persons heading into retirement.

However, as reported in the Financial Gleaner of January 22, 2010, if the interest-rate environment falls after the JDX, the cost of purchasing a pension could rise, reducing the monthly payments for persons heading into retirement.

Here are answers to five of the major questions being asked by key stakeholders:

Q How will current pensioners be affected?

A Persons who have already retired and are currently receiving a pension will not experience a reduction in their pension payments.

However, the ability of the trustees to grant periodic pension increases could be constrained unless the investments are allocated to assets which can provide attractive long returns.

Q How will a pending retiree be affected?

A Members in a DB plan will not be affected, as the additional cost to secure the required pension will be borne by the sponsor.

Members in a DC plan who are about to retire could experience a reduction in their monthly pension payments due to the increases previously discussed.

It is hoped that the reduction in inflation, one of the key objectives of the JDX, will be realised, allowing pensioners to maintain their standard of living during their golden years.

For too long, pensioners have suffered severely during retirement as inflation eroded the purchasing power of their monthly income.

With a projected reduction in inflation to between six and seven per cent in the near term, pensioners should be somewhat comforted.

Q How will the JDX affect members going forward?

A Members in a DB plan will not be affected as the additional cost to secure the required pension will be borne by the sponsor.

However, since in many instances the credited interest is based on investment performance, all plan members - both DCs and DBs - should ensure that the assets of the plan are allocated, where appropriate, based on the circumstances of each plan towards investments that can outperform inflation over the long term.

Members many years away from retirement are encouraged to maximise their pension contributions, both mandatory and voluntary, to ensure that they secure the highest possible pension when they retire.

Q What is the immediate impact on pension plans?

A There are two sources to consider: the loss in value of assets, and the reduction in interest income going forward.

The materiality of the value loss will depend on the allocation of fixed versus variable-rate instruments, and whether these securities were trading at a premium or discount, and also regard to the percentage allocation of these assets in the plan.

Information that we have gathered seems to suggest that the value impact has been both negative and positive, but not material.

Since pension plans invest in a wide cross section of assets - equities, real estate, Government of Jamaica, US dollar bonds, GOJ and other fixed-income securities, and short-term money-market instruments - the overall future investment returns will depend on the allocation among these assets.

While the interest income in GOJ bonds under the JDX will fall, we anticipate an uptick in equities and USD bonds, which could offset this reduction.

We anticipate that trustees will be busy engaging their investment managers in the near term towards reviewing asset allocations to more attractive opportunities.

Q Pension investments in a post-JDX world?

A As stated above, while the interest income on certain bonds within pension portfolios will now earn a reduced rate, trustees are encouraged to review the asset allocation of their plan towards other attractive investment options that have the ability to outperform inflation and all other benchmarks.

Our research has indicated that equities have outperformed all other asset classes over the long term, but trustees should also consider the average age of their pension-plan members, the solvency ratio, the type of pension plan, and the financial standing of the sponsor before making drastic changes in the investment strategy.

In closing, we encourage members to maximise their voluntary contributions which can be used to top up one's pension at retirement.

Since your pension contributions are tax deductible, the more you contribute to your pension plan, the less taxes you pay.

Additionally, the investment gains on your contributions also accumulate free of withholding taxes.

These benefits when compounded over many years will significantly bolster your nest egg at retirement.

Rezworth Burchenson is managing director of Prime Asset Management Limited, a company engaged in pension fund investment management and administration.